Jamia Millia Islamia University

Center for Management Studies

Business Economics
st
1 Semester MBA (IB) 2016-2017

Prepared by:
Homayoon Showjahi & Mohd Osma

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 The Break-Even Analysis (explained with diagrams)| Economics

Break-even analysis is of vital importance in determining the practical application of cost

functions. It is a function of three factors, i.e. sales volume, cost and profit. It aims at
classifying the dynamic relationship existing between total cost and sale volume of a
company.

Hence it is also known as “cost-volume-profit analysis”. It helps to know the operating

condition that exists when a company ‘breaks-even’, that is when sales reach a point equal to
all expenses incurred in attaining that level of sales. The break-even point may be defined as
that level of sales in which total revenues equal total costs and net income is equal to zero.
This is also known as no-profit no-loss point. This concept has been proved highly useful to
the company executives in profit forecasting and planning and also in examining the effect of
alternative business management decisions.

1. Break-Even Point:
The break-even point (B.E.P.) of a firm can be found out in two ways. It may be determined
in terms of physical units, i.e., volume of output or it may be determined in terms of money
value, i.e., value of sales.

ВЕР in terms of Physical Units:

This method is convenient for a firm producing a product. The ВЕР is the number of units of
a product that should be sold to earn enough revenue just to cover all the expenses of
production, both fixed and variable. The firm does not earn any profit, nor does it incur any
loss. It is the meeting point of total revenue and total cost curve of the firm.

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The break-even point is illustrated by means of Table 1:
Table 1: Total Revenue and Total Cost and ВЕР
Total Total
Output Total Fixed Variable
in units Revenue Cost Cost Total Cost
0 0 150 0 150

50 200 150 150 300

100 400 150 300 450

1150 600 150 450 600BEP

200 800 150 600 750

250 1000 150 750 900

300 1200 150 900 1050

Some assumptions are made in illustrating the ВЕР. The price of the commodity is kept
constant at Rs. 4 per unit, i.e., perfect competition is assumed. Therefore, the total revenue is
increasing proportionately to the output. All the units of the output are sold out. The total
fixed cost is kept constant at Rs. 150 at all levels of output.

The total variable cost is assumed to be increasing by a given amount throughout. From the
Table we can see that when the output is zero, the firm incurs only fixed cost. When the
output is 50, the total cost is Rs. 300. The total revenue is Rs. 200. The firm incurs a loss of
Rs. 100.

Similarly when the output is 100 the firm incurs a loss of Rs. 50. At the level of output 150
units, the total revenue is equal to the total cost. At this level, the firm is working at a point
where there is no profit or loss. From the level of output of 200, the firm is making profit

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Break-Even Chart:
Break-Even charts are being used in recent years by the managerial economists, company
executives and government agencies in order to find out the break-even point. In the break-
even charts, the concepts like total fixed cost, total variable cost, and the total cost and total
revenue are shown separately. The break even chart shows the extent of profit or loss to the
firm at different levels of activity. The following Fig. 1 illustrates the typical break-even
chart.

In this diagram output is shown on the horizontal axis and costs and revenue on vertical axis.
Total revenue (TR) curve is shown as linear, as it is assumed that the price is constant,
irrespective of the output. This assumption is appropriate only if the firm is operating under
perfectly competitive conditions. Linearity of the total cost (TC) curve results from the
assumption of constant variable cost.

It should also be noted that the TR curve is drawn as a straight line through the origin (i.e.,
every unit of the output contributes a constant amount to total revenue), while the TC curve is
a straight line originating from the vertical axis because total cost comprises constant / fixed
cost plus variable cost which rise linearly. In the figure, В is the break-even point at OQ level
of output

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Concept Of Cross Elasticity Of Demand And Its Types

Concept Of Cross Elasticity Of Demand

Cross elasticity of demand is the relation between the percentage change in demand for a
commodity to the percentage change in the price of related commodity. The cross elasticity of
demand between good A and B is : Cross elasticity (exy) = % change in quantity demanded
for A good / % change to price of B good.

Types Of Cross Elasticity Of Demand

Theoretically, there are two types of cross elasticity of demand:

1. Positive Cross Elasticity Of Demand (exy>0)

In the case of substitute goods, the cross elasticity of demand is positive. If the price of tea
rises, it will lead to increase in the demand for coffee. Similarly, a fall in price of tea will
cause a decrease in the demand for coffee.

2. Negative Cross Elasticity Of Demand (exy<0 comment0="">

In the case of complementary goods, cross elasticity of demand is negative. If the price of car
rises, it will lead to decrease in the demand for petrol. Similarly, the fall in the price of car
will bring the increase in the demand for petrol. Since, the price and demand change in
opposite direction, the
cross elasticity of demand is negative.

Concept Of Income Elasticity Of Demand and Its Types

Concept Of Income Elasticity Of Demand

The income elasticity of demand shows the responsiveness of quantity demanded of a certain
commodity to the change in income of the consumer. The income elasticity of demand is also
defined as ' the ratio of the percentage change in the demand for a commodity to the
percentage change in income'. Income elasticity of demand can be expressed as follows:
Income elasticity (ey) = Percentage change in quantity demanded / Percentage change in
income For example, consumer's income rises from $ 100 to $ 102, his demand for good X
increases from 25 units per week to 30 units per week then his income elasticity of demand X
is: ey = 5/25 x 100/2 = 10 It means that 1 percent increase in income results 10 percent
increase in demand and vice versa. The income elasticity may be positive or negative or zero
depending upon the nature of a commodity. As a rise in income leads to an increase in
demand, the income elasticity is positive. A commodity which has positive income elasticity
is a normal good. On the other hand, when a rise in income leads to a decrease in demand for
a commodity, its income elasticity is negative. Such a commodity is called inferior good. If
the quantity of a commodity purchased remains unchanged, even at the change in income, the
income elasticity of demand is zero.

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Types Of Income Elasticity Of Demand
There are five types of income elasticity of demand as follows:

1. Income elasticity greater than unity (ey>1)

The income elasticity of demand is greater than the unity when the demand for a commodity
increases more than percentage rise in income.

2. Income elasticity less than unity(ey< 1)

Income elasticity of demand is less than the unity when the demand for a commodity
increases less than proportionate to the rise in income.

3.Income elasticity equal to unity (ey=1)

Income elasticity is unity when the demand for a commodity increases in the same proportion
as the rise in income.

4. Zero income elasticity (ey=0)

If the rise in income, the quantity demanded remains unchanged, the income elasticity is
called zero income elasticity.

5. Negative income elasticity (ey <0>

In the case of inferior goods, the income elasticity of demand is negative. The consumer will
reduce his purchase of it when income rises and vice versa.

Demand Forecasting: It’s Meaning, Types, Techniques and Method

Meaning:
Forecasts are becoming the lifetime of business in a world, where the tidal waves of change
are sweeping the most established of structures, inherited by human society. Commerce just
happens to the one of the first casualties. Survival in this age of economic predators requires
the tact, talent and technique of predicting the future. Forecast is becoming the sign of
survival and the language of business. All requirements of the business sector need the
technique of accurate and practical reading into the future. Forecasts are, therefore, very
essential requirement for the survival of business. Management requires forecasting
information when making a wide range of decisions.

The sales forecast is particularly important as it is the foundation upon which all company
plans are built in terms of markets and revenue. Management would be a simple matter if
business was not in a continual state of change, the pace of which has quickened in recent
years. It is becoming increasingly important and necessary for business to predict their future
prospects in terms of sales, cost and profits. The value of future sales is crucial as it affects
costs profits, so the prediction of future sales is the logical starting point of all business
planning. A forecast is a prediction or estimation of future situation. It is an objective
assessment of future course of action. Since future is uncertain, no forecast can be percent
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correct. Forecasts can be both physical as well as financial in nature. The more realistic the
forecasts, the more effective decisions can be taken for tomorrow. In the words of Cundiff
and Still, “Demand forecasting is an estimate of sales during a specified future period which
is tied to a proposed marketing plan and which assumes a particular set of uncontrollable and
competitive forces”. Therefore, demand forecasting is a projection of firm’s expected level of
sales based on a chosen marketing plan and environment.

Procedure to Prepare Sales Forecast:

Companies commonly use a three-stage procedure to prepare a sales forecast. They make an
environmental forecast, followed by an industry forecast, and followed by a company’s sales
forecast, the environmental forecast calls for projecting inflation, unemployment, interest rate,
consumer spending, and saving, business investment, government expenditure, net exports
and other environmental magnitudes and events of importance to the company. The industry
forecast is based on surveys of consumers’ intention and analysis of statistical trends is made
available by trade associations or chamber of commerce. It can give indication to a firm
regarding tine direction in which the whole industry will be moving. The company derives its
sales forecast by assuming that it will win a certain market share.

All forecasts are built on one of the three information bases:

What people say?

What people do?
What people have done?

Types of Forecasting:
Forecasts can be broadly classified into:
(i) Passive Forecast and (ii)Active Forecast. Under passive forecast prediction about future is
based on the assumption that the firm does not change the course of its action. Under active
forecast, prediction is done under the condition of likely future changes in the actions by the
firms.

From the view point of ‘time span’, forecasting may be classified into two, viz.

(i) Short term demand forecasting and

(ii) (ii) long term demand forecasting.

In a short run forecast, seasonal patterns are of much importance. It may cover a period of
three months, six months or one year. It is one which provides information for tactical
decisions. Which period is chosen depends upon the nature of business. Such a forecast helps
in preparing suitable sales policy. Long term forecasts are helpful in suitable capital planning.
It is one which provides information for major strategic decisions. It helps in saving the
wastages in material, man hours, machine time and capacity. Planning of a new unit must
start with an analysis of the long term demand potential of the products of the firm.

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Forecasting Techniques:
Demand forecasting is a difficult exercise. Making estimates for future under the changing
conditions is a Herculean task. Consumers’ behavior is the most unpredictable one because it
is motivated and influenced by a multiplicity of forces. There is no easy method or a simple
formula which enables the manager to predict the future. Economists and statisticians have
developed several methods of demand forecasting. Each of these methods has its relative
advantages and disadvantages. Selection of the right method is essential to make demand
forecasting accurate. In demand forecasting, a judicious combination of statistical skill and
rational judgment is needed. Mathematical and statistical techniques are essential in
classifying relationships and providing techniques of analysis, but they are in no way an
alternative for sound judgment. Sound judgment is a prime requisite for good forecast. The
judgment should be based upon facts and the personal bias of the forecaster should not prevail
upon the facts. Therefore, amid way should be followed between mathematical techniques
and sound judgment or pure guess work. The more commonly used methods of demand
forecasting are discussed below:

1. Opinion Polling Method:

In this method, the opinion of the buyers, sales force and experts could be gathered to
determine the emerging trend in the market.

2. Statistical Method:
Statistical methods have proved to be immensely useful in demand forecasting. In order to
main tain objectivity, that is, by consideration of all implications and viewing the problem
from an external point of view, the statistical methods are used.

Regression Analysis:
It attempts to assess the relationship between at least two variables (one or more independent
and one dependent), the purpose being to predict the value of the dependent variable from the
specific value of the independent variable. The basis of this prediction generally is historical
data. This method starts from the assumption that a basic relationship exists between two
variables. An interactive statistical analysis computer package is used to formulate the
mathematical relationship which exists.

For example, one may build up the sales model as:

Quantum of Sales = a. price + b. advertising + c. price of the rival products + d. personal

disposable income +u Where a, b, c, d are the constants which show the effect of
corresponding variables as sales. The constant u represents the effect of all the variables
which have been left out in the equation but having effect on sales. In the above equation,
quantum of sales is the dependent variable and the variables on the right hand side of the
equation are independent variables. If the expected values of the independent variables are
substituted in the equation, the quantum of sales will then be forecasted.

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The regression equation can also be written in a multiplicative form as given below:
Quantum of Sales = (Price)a + (Advertising)b+ (Price of the rival products) c + (Personal
disposable income Y + u

In the above case, the exponent of each variable indicates the elasticities of the corresponding
variable. Stating the independent variables in terms of notation, the equation form is QS =
P°8. Ao42 . R°.83. Y2°.68. 40

Then we can say that 1 per cent increase in price leads to 0.8 per cent change in quantum of
sales and so on. If we take logarithmic form of the multiple equation, we can write the
equation in an additive form as follows:
log QS = a log P + b log A + с log R + d log Yd + log u

In the above equation, the coefficients a, b, c, and d represent the elasticities of variables P, A,
R and Yd respectively. The co-efficient in the logarithmic regression equation are very useful
in policy decision making by the management.

NOTE 2
Demand Forecasting: Concept, Significance, Objectives and Factors

An organization faces several internal and external risks, such as high competition, failure of
technology, labor unrest, inflation, recession, and change in government laws. Therefore,
most of the business decisions of an organization are made under the conditions of risk and
uncertainty. An organization can lessen the adverse effects of risks by determining the
demand or sales prospects for its products and services in future. Demand forecasting is a
systematic process that involves anticipating the demand for the product and services of an
organization in future under a set of uncontrollable and competitive forces.

Significance of Demand Forecasting:

Demand plays a crucial role in the management of every business. It helps an organization to
reduce risks involved in business activities and make important business decisions. Apart
from this, demand forecasting provides an insight into the organization’s capital investment
and expansion decisions. The significance of demand forecasting is shown in the following
points:

i. Fulfilling objectives:
Implies that every business unit starts with certain predecided objectives. Demand forecasting
helps in fulfilling these objectives. An organization estimates the current demand for its
products and services in the market and move forward to achieve the set goals. For example,
an organization has set a target of selling 50, 000 units of its products. In such a case, the

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organization would perform demand forecasting for its products. If the demand for the
organization’s products is low, the organization would take corrective actions, so that the set
objective can be achieved.

ii. Preparing the budget:

Plays a crucial role in making budget by estimating costs and expected revenues. For
instance, an organization has forecasted that the demand for its product, which is priced at Rs.
10, would be 10, 00, 00 units. In such a case, the total expected revenue would be 10* 100000
= Rs. 10, 00, 000. In this way, demand forecasting enables organizations to prepare their
budget.

iii. Stabilizing employment and production:

Helps an organization to control its production and recruitment activities. Producing
according to the forecasted demand of products helps in avoiding the wastage of the resources
of an organization. This further helps an organization to hire human resource according to
requirement. For example, if an organization expects a rise in the demand for its products, it
may opt for extra labor to fulfill the increased demand.

iv. Expanding organizations:

Implies that demand forecasting helps in deciding about the expansion of the business of the
organization. If the expected demand for products is higher, then the organization may plan to
expand further. On the other hand, if the demand for products is expected to fall, the
organization may cut down the investment in the business.

v. Taking Management Decisions:

Helps in making critical decisions, such as deciding the plant capacity, determining the
requirement of raw material, and ensuring the availability of labor and capital.

vi. Evaluating Performance:

Helps in making corrections. For example, if the demand for an organization’s products is
less, it may take corrective actions and improve the level of demand by enhancing the quality
of its products or spending more on advertisements.

vii. Helping Government:

Enables the government to coordinate import and export activities and plan international
trade.

Objectives of Demand Forecasting:

Demand forecasting constitutes an important part in making crucial business decisions.

The objectives of demand forecasting are divided into short and long-term objectives

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i. Short-term Objectives: Include the following:

a. Formulating production policy: Helps in covering the gap between the demand and
supply of the product. The demand forecasting helps in estimating the requirement of raw
material in future, so that the regular supply of raw material can be maintained. It further
helps in maximum utilization of resources as operations are planned according to forecasts.
Similarly, human resource requirements are easily met with the help of demand forecasting.

b. Formulating price policy:

Refers to one of the most important objectives of demand forecasting. An organization sets
prices of its products according to their demand. For example, if an economy enters into
depression or recession phase, the demand for products falls. In such a case, the organization
sets low prices of its products.

c. Controlling sales:
Helps in setting sales targets, which act as a basis for evaluating sales performance. An
organization make demand forecasts for different regions and fix sales targets for each region
accordingly.
d. Arranging finance:
Implies that the financial requirements of the enterprise are estimated with the help of demand
forecasting. This helps in ensuring proper liquidity within the organization.

ii. Long-term Objectives:

Include the following:

a. Deciding the production capacity:

Implies that with the help of demand forecasting, an organization can determine the size of
the plant required for production. The size of the plant should conform to the sales
requirement of the organization.

b. Planning long-term activities:

Implies that demand forecasting helps in planning for long term. For example, if the
forecasted demand for the organization’s products is high, then it may plan to invest in
various expansion and development projects in the long term. The Differences &
Comparisons

Difference Between Economies of Scale and Economies of Scope

Economies of Scale and Economies of scope are two important strategies used by most of
the organisations to gain cost effectiveness. The former represents the benefits received by
increasing the scale of production while the latter refers to the benefits obtained due to
producing multiple products using the same operations efficiently. People get confused
between these two techniques easily as they both results in proportionate saving in cost of
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production. But, there is a difference between economies of scale and economies of scope,
which has been discussed in this article in detail. Have a look.

Comparison Chart

BASIS FOR
ECONOMIES OF SCALE ECONOMIES OF SCOPE
COMPARISON

Meaning Economies of scale refers to Economies of scope means savings

savings in the cost due to in cost due to the production of two
increase in output produced. or more distinct products, using
same operations.

Reduction in The average cost of The average cost of producing

producing one product. multiple products.

Cost advantage Due to volume Due to variety

Strategy Old Relatively New

Involves Product standardization Product diversification

Use of Large amount of resources Common resources

Definition of Economies of Scale

By the term economies of scale, we mean the increase in the efficiency of production due to
the increase in size, output or activity level. Economies of scale occur due to the indirect
relationship between the quantity produced and the per unit cost of production. This is
because the fixed cost remains same irrespective of the level of production employed by the
organisation.

Therefore, with the rise in the scale of operation, the fixed cost is distributed evenly over the
quantity produced. So with every additional unit produced, the average cost of production
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tends to decline. Along with that, variable cost per unit also decreases, due to operational
efficiency and synergy. In this way, the enterprise gains cost effectiveness. There can be
internal and external economies of scale.

Definition of Economies of Scope

Economies of Scope refers to the reduction in the average cost per unit, by increasing the
variety of products produced. In this technique, the total cost of producing two products
(related or unrelated) is less than the cost of producing each item individually.

Economies of Scope focuses on better utilisation of the firm’s resources and common assets.
In this way, the utilisation of assets is spread over two or more products, i.e. shared by
multiple products to decrease the overall cost of production. As the costs are spread over
several products which lead to the decrease in the average cost per unit of each product.

Key Differences Between Economies of Scale and Economies of Scope

The major points of difference between economies of scale and economies of scope are
explained below:

1. A strategy used for cutting costs by increasing the volume of units produced is known
as Economies of Scale. Economies of Scope implies a technique to lower down the
cost by producing multiple products with the same operations or inputs.
2. In economies of scale is implemented, the average cost of producing a product is
reduced. On the other hand, economies of scope imply proportionate savings in the
cost of producing multiple products.
3. In economies of scale, the firm gains cost effectiveness due to volume, whereas cost
effectiveness in economies of scope is due to the varieties offered.
4. Economies of scale strategy are used by organisations since a long time. Conversely,
Economies of Scope is a relatively new strategy.
5. Economies of scale involve product standardisation while economies of scope involve
product diversification, using the same scale of the plant.
6. In economies of scale, a bigger plant is used to produce the large volume of output. As
opposed to economies of scope, in which the same plant is used to manufacture
distinct products.

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Conclusion

In this era of competition, it is very important for the firms to cut down their excess costs, to
offer their products at low prices and expand their share in the market. Both economies of
scale and economies of scope result in the savings in cost, but their concept is different,
whereby one lowers the cost by increasing the volume of output and the other by increasing
the number of products it offers.

The Indifference Curve: Meaning, Property and Assumption | Micro Economics

They were of the opinion that utility is a psychological phenomenon and it is next to
impossible to measure the utility in absolute terms. According to them, a consumer can rank
various combinations of goods and services in order of his preference. For example, if a
consumer consumes two goods, Apples and Bananas, then he can indicate:

1. Whether he prefers apple over banana; or

2. Whether he prefers banana over apple; or

3. Whether he is indifferent between apples and bananas, i.e. both are equally preferable and
both of them give him same level of satisfaction.

This approach does not use cardinal values like 1, 2, 3, 4, etc. Rather, it makes use of ordinal
numbers like 1st, 2nd, 3rd, 4th, etc. which can be used only for ranking. It means, if the
consumer likes apple more than banana, then he will give 1st rank to apple and 2ndrank to
banana. Such a method of ranking the preferences is known as ‘ordinal utility approach’.
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Before we proceed to determine the consumer’s equilibrium through this approach, let us
understand some useful concepts related to Indifference Curve Analysis.

Meaning of Indifference Curve:

When a consumer consumes various goods and services, then there are some combinations,
which give him exactly the same total satisfaction. The graphical representation of such
combinations is termed as indifference curve.

Indifference curve refers to the graphical representation of various alternative combinations

of bundles of two goods among which the consumer is indifferent. Alternately, indifference
curve is a locus of points that show such combinations of two commodities which give the
consumer same satisfaction. Let us understand this with the help of following indifference
schedule, which shows all the combinations giving equal satisfaction to the consumer.

Table 2.5: Indifference Schedule

Combination ofApples Bananas
Apples and(A) (B)
Bananas
P 1 15
Q 2 10
R 3 6
S 4 3
T 5 1

As seen in the schedule, consumer is indifferent between five combinations of apple and
banana. Combination ‘P’ (1A + 15B) gives the same utility as (2A + 10B), (3A + 6B) and so
on. When these combinations are represented graphically and joined together, we get an
indifference curve ‘IC1’ as shown in Fig. 2.4.
In the diagram, apples are measured along the X-axis and bananas on the Y-axis. All points
(P, Q, R, S and T) on the curve show different combinations of apples and bananas. These
points are joined with the help of a smooth curve, known as indifference curve (IC1). An
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indifference curve is the locus of all the points, representing different combinations, that are
equally satisfactory to the consumer.
Every point on IC1, represents an equal amount of satisfaction to the consumer. So, the
consumer is said to be indifferent between the combinations located on Indifference Curve
‘IC1’. The combinations P, Q, R, S and T give equal satisfaction to the consumer and
therefore he is indifferent among them. These combinations are together known as
‘Indifference Set’.

Monotonic Preferences:
Monotonic preference means that a rational consumer always prefers more of a commodity as
it offers him a higher level of satisfaction. In simple words, monotonic preferences imply that
as consumption increases total utility also increases. For instance, a consumer’s preferences
are monotonic only when between any two bundles, he prefers the bundle which has more of
at least one of the goods and no less of the other good as compared to the other bundle.

Example: Consider 2 goods:

Apples (A) and Bananas (B).

(a) Suppose two different bundles are: 1st: (10A, 10B); and 2nd: (7A, 7B).
Consumer’s preference of 1st bundle as compared to 2nd bundle will be called monotonic
preference as 1st bundle contains more of both apples and bananas.
(b) If 2 bundles are: 1st: (1 OA, 7B); 2nd: (9A, 7B).
Consumer’s preference of 1st bundle as compared to 2nd bundle will be called monotonic
preference as 1st bundle contains more of apples, although bananas are same.

Indifference Map:
Indifference Map refers to the family of indifference curves that represent consumer
preferences over all the bundles of the two goods. An indifference curve represents all the
combinations, which provide same level of satisfaction. However, every higher or lower level
of satisfaction can be shown on different indifference curves. It means, infinite number of
indifference curves can be drawn.

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In Fig. 2.5, IC1 represents the lowest satisfaction, IC2 shows satisfaction more than that of
IC1 and the highest level of satisfaction is depicted by indifference curve IC3. However, each
indifference curve shows the same level of satisfaction individually.
It must be noted that ‘Higher Indifference curves represent higher levels of satisfaction’ as
higher indifference curve represents larger bundle of goods, which means more utility
because of monotonic preference.

Marginal Rate of Substitution (MRS):

MRS refers to the rate at which the commodities can be substituted with each other, so that
total satisfaction of the consumer remains the same. For example, in the example of apples
(A) and bananas (B), MRS of ‘A’ for ‘B’, will be number of units of ‘B’, that the consumer is
willing to sacrifice for an additional unit of ‘A’, so as to maintain the same level of
satisfaction.

MRSAB = Units of Bananas (B) willing to Sacrifice / Units of Apples (A) willing to Gain
MRSAB = ∆B/∆A
MRSAB is the rate at which a consumer is willing to give up Bananas for one more unit of
Apple. It means, MRS measures the slope of indifference curve.
It must be noted that in mathematical terms, MRS should always be negative as numerator
(units to be sacrificed) will always have negative value. However, for analysis, absolute value
of MRS is always considered.

The concept of MRSAB is explained through Table 2.6 and Fig. 2.6
Table 2.6: MRS between Apple and Banana:
Apples Banana
(A) (B)
Combination MRSAB
P 1 15 –
Q 2 10 5B:1 A
R 3 6 4B:1A
S 4 3 3B:1A
T 5 1 2B:1 A

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As seen in the given schedule and diagram, when consumer moves from P to Q, he sacrifices
5 bananas for 1 apple. Thus, MRSAB comes out to be 5:1. Similarly, from Q to R, MRSAB is
4:1. In combination T, the sacrifice falls to 2 bananas for 1 apple. In other words, the MRS of
apples for bananas is diminishing.

Why MRS diminishes?

MRS falls because of the law of diminishing marginal utility. In the given example of apples
and bananas, Combination ‘P’ has only 1 apple and, therefore, apple is relatively more
important than bananas. Due to this, the consumer is willing to give up more bananas for an
additional apple. But as he consumes more and more of apples, his marginal utility from
apples keeps on declining. As a result, he is willing to give up less and less of bananas for
each apple.

Properties of Indifference Curve:

1. Indifference curves are always convex to the origin:

An indifference curve is convex to the origin because of diminishing MRS. MRS declines
continuously because of the law of diminishing marginal utility. As seen in Table 2.6, when
the consumer consumes more and more of apples, his marginal utility from apples keeps on
declining and he is willing to give up less and less of bananas for each apple. Therefore,
indifference curves are convex to the origin (see Fig. 2.6). It must be noted that MRS
indicates the slope of indifference curve.

2. Indifference curve slope downwards:

It implies that as a consumer consumes more of one good, he must consume less of the other
good. It happens because if the consumer decides to have more units of one good (say
apples), he will have to reduce the number of units of another good (say bananas), so that
total utility remains the same.

3. Higher Indifference curves represent higher levels of satisfaction:

Higher indifference curve represents large bundle of goods, which means more utility because
of monotonic preference. Consider point ‘A’ on ICX and point ‘B’ on IC2 in Fig. 2.5. At ‘A’,

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consumer gets the combination (OR, OP) of the two commodities X and Y. At ‘B’, consumer
gets the combination (OS, OP). As OS > OR, the consumer gets more satisfaction at IC2.
4. Indifference curves can never intersect each other:
As two indifference curves cannot represent the same level of satisfaction, they cannot
intersect each other. It means, only one indifference curve will pass through a given point on
an indifference map. In Fig. 2.7, satisfaction from point A and from B on IC1 will be the
same.
Similarly, points A and C on IC2 also give the same level of satisfaction. It means, points B
and C should also give the same level of satisfaction. However, this is not possible, as B and
C lie on two different indifference curves, IC1 and IC2 respectively and represent different
levels of satisfaction. Therefore, two indifference curves cannot intersect each other.

Assumptions of Indifference Curve

The various assumptions of indifference curve are:

1. Two commodities:
It is assumed that the consumer has a fixed amount of money, whole of which is to be spent
on the two goods, given constant prices of both the goods.

2. Non Satiety:
It is assumed that the consumer has not reached the point of saturation. Consumer always
prefer more of both commodities, i.e. he always tries to move to a higher indifference curve
to get higher and higher satisfaction.

3. Ordinal Utility:
Consumer can rank his preferences on the basis of the satisfaction from each bundle of goods.
19
4. Diminishing marginal rate of substitution:
Indifference curve analysis assumes diminishing marginal rate of substitution. Due to this
assumption, an indifference curve is convex to the origin.

5. Rational Consumer:
The consumer is assumed to behave in a rational manner, i.e. he aims to maximize his total
satisfaction.

Note2
INDIFFERENCE CURVES
Indifference curves are a graphical representation of how much value an individual receives
from various combinations of consumption. We measure value through the catch-all term
“utility”, an concept for the value, well-being, satisfaction, benefit, etc. that someone
receives. As I have expressed before, utility is a relatively abstract concept; people constantly
face trade-offs between current satisfaction and later success or happiness. We can examine
utility from a short or long-term perspective in most cases, pondering the existential question
of which happiness is the most important—the current, tangible feeling or that of later, but
not-assured, joy.

In this case, however, we will be sticking to the neo-classical interpretation of utility, where
we assume people are totally rational and weigh all their decisions fully, implying that they
will aim to make choices that are both responsible and maximize their utility in the long run.
With this definition of utility in mind, we can tackle the concept of an indifference curve.

An indifference curve aims to display all the various combinations of consumption for two
goods that will give an individual the same level of utility. Because the combinations all give
you the same level of satisfaction (utility), you won’t care which one you pick—that is,
consumers will be indifferent to the various combinations along the indifference curve.

20
This is what an indifference curve looks like. Along this line, the individual in question will
receive the same amount of satisfaction for any different combination of Item A and B.

An individual doesn't just have one indifference curve - they will have an identically shaped
curve at each different level of income. These different curves account for the fact that
incomes and budgets can change, and a new income may mean there is no "optimal" point on
the original indifference curve.

21
So, for a given person, a graph of indifference curves for different levels of income could
look like this:

The indifference curves pictured above are just one example of how indifference curves can
look. The slope of an indifference curve (how steep/flat it is) will be different depending on
the individual’s preferences. My favorite real-world example for this is the tradeoff between
hours worked and leisure time - depending on if a person loves or hates work, their curve will
be sloped differently.

22
The slope of the indifference curve is known as the marginal rate of substitution, or MRS.
This term seems a lot more complex than it is, really, the MRS documents the marginal utility
the individual will gain (or lose) from moving up or down on the indifference curve. Marginal
utility is simply the benefit the person gains from consuming an additional unit of a good.
You will recall the indifference curve plots 2 different goods, so the marginal rate of
substitution is telling us “how much does this person prefer good X to good Y? What is the
value they get from an additional unit of this good?”

The MRS is always negative for the same reason that indifference curves are convex:
diminishing marginal utility. For all goods, the amount of satisfaction you receive for each
additional until you consume is decreasing. A hungry person eating a cheeseburger finds the
first one amazing, the second one filling, the third one hard to eat, and the fourth one nausea-
inducing (trust me, I would know). The value they receive from each one goes down, and the
same idea applies to all goods. Even our example person who hates work will stop valuing
leisure after a while, when he has no money! So, you can see how the marginal rate of
substitution would be negative—the utility a person receives from each additional unit
is decreasing. The convexity of the curve is also due to this assumption—as you get further
out towards the extremes of consumption, the slope is skewed towards one variable. For
example:
It should be noted that all the scenarios laid out here for slope and typical shapes of curves are
just the straightforward scenarios in economics that aren’t very applicable to real life.
Indifference curves can be useful for modeling consumer reactions to income, welfare, or
wage changes (read: all labor-related) but are otherwise hard to create because most people
are spending their income or time on more than 2 things. The traditional methods of teaching
indifference curves rely on examples like “popcorn versus candy when you have $20 at the
movies”, or “spending your income on hot-dogs versus hamburgers”, both of which seem like

23
awful decisions. Nevertheless, the concepts of indifference curves, preferences, diminishing
marginal utility, and the marginal rate of substitution are important in theoretical economics.

Isocost Curves and Expansion Path!

Having studied the nature of isoquants which represent the output possibilities of a firm from
a given combination of two inputs, we pass on to the prices of the inputs as represented on the
isoquant map by the isocost curves. These curves are also known as outlay lines, price lines,
input-price lines, factor-cost lines, constant-outlay lines, etc.

Each isocost curve represents the different combinations of two inputs that a firm can buy for
a given sum of money at the given price of each input. In the words of Koutsoyiannis, ‘’The
isocost line is the locus of all combinations of factors the firm can purchase with a given
monetary outlay

Figure 6 (A) shows three isocost curves, each represents a total outlay of 50, 75 and 100
respectively. The firm can hire ОС of capital or OD of labour with Rs. 75. ОС is 2/3 of OD
which means that the price of a unit of labour is 11 /2 times less than that of a unit of capital.
The line CD represents the price ratio of capital and labour.

24
Prices of factors remaining the same, if the total outlay is raised, the isocost curve will shift
upward to the right as EF parallel to CD, and if the total outlay is reduced it will shift
downwards to the left as AB. The isocosts are straight lines because factor prices remain the
same whatever the outlay of the firm on the two factors.

The isocost curves represent the locus of а1Г combinations of the two input factors which
result in the same total cost. If the unit cost of labour (L) is w and the unit cost of capital (K)
is r, then the total cost: TC = wL + rK. The slope of the isocost line is the ratio of prices of
labour and capital, i.e., w/r. or PL/PK where P is price.

Expansion Path:
The point where the isocost line is tangent to an isoquant represents the least- cost
combination of the two factors for producing a given output. If all points of tangency like
LMN are joined by a line OP, it is the least-outlay curve or the expansion path of a firm. It
shows how the proportions of the two factors used might be changed as the firm expands.
According to Prof. Salvatore, “Expansion path is the locus of points of producer’s equilibrium
resulting from changes in total outlays while keeping factor prices constant.”

Iso-cost Lines
The extent to which a factor is combined to the other factor depends on the prices of factor
and the willingness of organization to spend money on factors.

Iso-cost line represents the price of factors along with the amount of money an organization is
willing to spend on factors.

In other words, it shows different combinations of factors that can be purchased at a certain
amount of money.

For example, a producer wants to spend Rs. 300 on the factors of production, namely X and
Y. The price of X in the market is Rs. 3 per unit and price of Y is Rs. 5 per unit.

25
In such a case, the iso-cost line is shown in Figure-10:

As shown in Figure-10, if the producer spends the whole amount of money to purchase X,
then he/she can purchase 100 units of X, which is represented by OL. On the other hand, if
the producer purchases Y with the whole amount, then he/she would be able to get 60 units,
which is represented by OH.

If points H and L are joined on X and Y axes respectively, a straight line is obtained, which is
called iso-cost line. All the combinations of X and Y that lie on this line, would have the same
amount of cost that is Rs. 300. Similarly, other iso-cost lines can be plotted by taking cost
more than Rs. 300, in case the producer is willing to spend more amount of money on
production factors.

With the help of isoquant and iso-cost lines, a producer can determine the point at which
inputs yield maximum profit by incurring minimum cost. Such a point is termed as producer’s
equilibrium.

Iso-Quant Curve: Definitions, Assumptions and Properties!

The term Iso-quant or Iso-product is composed of two words, Iso = equal, quant = quantity or
product = output.

Thus it means equal quantity or equal product. Different factors are needed to produce a
good. These factors may be substituted for one another.

A given quantity of output may be produced with different combinations of factors. Iso-quant
curves are also known as Equal-product or Iso-product or Production Indifference curves.
26
Since it is an extension of Indifference curve analysis from the theory of consumption to the
theory of production.

Thus, an Iso-product or Iso-quant curve is that curve which shows the different combinations
of two factors yielding the same total product. Like, indifference curves, Iso- quant curves
also slope downward from left to right. The slope of an Iso-quant curve expresses the
marginal rate of technical substitution (MRTS).

Definitions:
“The Iso-product curves show the different combinations of two resources with which a firm
can produce equal amount of product.” Bilas

“Iso-product curve shows the different input combinations that will produce a given output.”
Samuelson

“An Iso-quant curve may be defined as a curve showing the possible combinations of two
variable factors that can be used to produce the same total product.” Peterson

“An Iso-quant is a curve showing all possible combinations of inputs physically capable of
producing a given level of output.” Ferguson

Assumptions:
The main assumptions of Iso-quant curves are as follows:
1. Two Factors of Production:
Only two factors are used to produce a commodity.

2. Divisible Factor:
Factors of production can be divided into small parts.

3. Constant Technique:
Technique of production is constant or is known before hand.

4. Possibility of Technical Substitution:

The substitution between the two factors is technically possible. That is, production function
is of ‘variable proportion’ type rather than fixed proportion.

5. Efficient Combinations:
Under the given technique, factors of production can be used with maximum efficiency.

27
Iso-Product Schedule:
Let us suppose that there are two factor inputs—labour and capital. An Iso-product schedule
shows the different combination of these two inputs that yield the same level of output as
shown in table 1.

The table 1 shows that the five combinations of labour units and units of capital yield the
same level of output, i.e., 200 metres of cloth. Thus, 200 metre cloth can be produced by
combining.

(a) 1 units of labour and 15 units of capital

(b) 2 units of labour and 11 units of capital

(c) 3 units of labour and 8 units of capital

(d) 4 units of labour and 6 units of capital

(e) 5 units of labour and 5 units of capital

28
Iso-Product Curve:
From the above schedule iso-product curve can be drawn with the help of a diagram. An.
equal product curve represents all those combinations of two inputs which are capable of
producing the same level of output. The Fig. 1 shows the various combinations of labour and
capital which give the same amount of output. A, B, C, D and E.

Iso-Product Map or Equal Product Map:

An Iso-product map shows a set of iso-product curves. They are just like contour lines which
show the different levels of output. A higher iso-product curve represents a higher level of
output. In Fig. 2 we have family iso-product curves, each representing a particular level of
output.

The iso-product map looks like the indifference of consumer behaviour analysis. Each
indifference curve represents particular level of satisfaction which cannot be quantified. A
higher indifference curve represents a higher level of satisfaction but we cannot say by how
much the satisfaction is more or less. Satisfaction or utility cannot be measured.

An iso-product curve, on the other hand, represents a particular level of output. The level of
output being a physical magnitude is measurable. We can therefore know the distance
between two equal product curves. While indifference curves are labeled as IC1, IC2, IC3, etc.,
the iso-product curves are labelled by the units of output they represent -100 metres, 200
metres, 300 metres of cloth and so on.

29
Properties of Iso-Product Curves:
The properties of Iso-product curves are summarized below:

1. Iso-Product Curves Slope Downward from Left to Right:

They slope downward because MTRS of labour for capital diminishes. When we increase
labour, we have to decrease capital to produce a given level of output.

The downward sloping iso-product curve can be explained with the help of the following
figure:

The Fig. 3 shows that when the amount of labour is increased from OL to OL1, the amount of
capital has to be decreased from OK to OK1, The iso-product curve (IQ) is falling as shown in
the figure.

The possibilities of horizontal, vertical, upward sloping curves can be ruled out with the
help of the following figure 4:

(i) The figure (A) shows that the amounts of both the factors of production are increased-
labour from L to Li and capital from K to K1. When the amounts of both factors increase, the
output must increase. Hence the IQ curve cannot slope upward from left to right.
30
(ii) The figure (B) shows that the amount of labour is kept constant while the amount of
capital is increased. The amount of capital is increased from K to K1. Then the output must
increase. So IQ curve cannot be a vertical straight line.
(iii) The figure (C) shows a horizontal curve. If it is horizontal the quantity of labour
increases, although the quantity of capital remains constant. When the amount of capital is
increased, the level of output must increase. Thus, an IQ curve cannot be a horizontal line.

2. Isoquants are Convex to the Origin:

Like indifference curves, isoquants are convex to the origin. In order to understand this fact,
we have to understand the concept of diminishing marginal rate of technical substitution
(MRTS), because convexity of an isoquant implies that the MRTS diminishes along the
isoquant. The marginal rate of technical substitution between L and K is defined as the
quantity of K which can be given up in exchange for an additional unit of L. It can also be
defined as the slope of an isoquant.

It can be expressed as:

MRTSLK = – ∆K/∆L = dK/ dL
Where ∆K is the change in capital and AL is the change in labour.

Equation (1) states that for an increase in the use of labour, fewer units of capital will be used.
In other words, a declining MRTS refers to the falling marginal product of labour in relation
to capital. To put it differently, as more units of labour are used, and as certain units of capital
are given up, the marginal productivity of labour in relation to capital will decline.

This fact can be explained in Fig. 5. As we move from point A to B, from B to C and from C
to D along an isoquant, the marginal rate of technical substitution (MRTS) of capital for

31
labour diminishes. Everytime labour units are increasing by an equal amount (AL) but the
corresponding decrease in the units of capital (AK) decreases.

Thus it may be observed that due to falling MRTS, the isoquant is always convex to the
origin.
3. Two Iso-Product Curves Never Cut Each Other:
As two indifference curves cannot cut each other, two iso-product curves cannot cut each
other. In Fig. 6, two Iso-product curves intersect each other. Both curves IQ1 and IQ2
represent two levels of output. But they intersect each other at point A. Then combination A =
B and combination A= C. Therefore B must be equal to C. This is absurd. B and C lie on two
different iso-product curves. Therefore two curves which represent two levels of output
cannot intersect each other.

4. Higher Iso-Product Curves Represent Higher Level of Output:

A higher iso-product curve represents a higher level of output as shown in the figure 7
given below:

In the Fig. 7, units of labour have been taken on OX axis while on OY, units of capital.
IQ1 represents an output level of 100 units whereas IQ2 represents 200 units of output.

32
5. Isoquants Need Not be Parallel to Each Other:
It so happens because the rate of substitution in different isoquant schedules need not be
necessarily equal. Usually they are found different and, therefore, isoquants may not be
parallel as shown in Fig. 8. We may note that the isoquants Iq1 and Iq2 are parallel but the
isoquants Iq3 and Iq4 are not parallel to each other.

6. No Isoquant can Touch Either Axis:

If an isoquant touches X-axis, it would mean that the product is being produced with the help
of labour alone without using capital at all. These logical absurdities for OL units of labour
alone are unable to produce anything. Similarly, OC units of capital alone cannot produce
anything without the use of labour. Therefore as seen in figure 9, IQ and IQ1 cannot be
isoquants.

7. Each Isoquant is Oval-Shaped.

It means that at some point it begins to recede from each axis. This shape is a consequence of
the fact that if a producer uses more of capital or more of labour or more of both than is
necessary, the total product will eventually decline. The firm will produce only in those
segments of the isoquants which are convex to the origin and lie between the ridge lines. This
is the economic region of production. In Figure 10, oval shaped isoquants are shown.

33
Curves OA and OB are the ridge lines and in between them only feasible units of capital and
labour can be employed to produce 100, 200, 300 and 400 units of the product. For example,
OT units of labour and ST units of the capital can produce 100 units of the product, but the
same output can be obtained by using the same quantity of labour T and less quantity of
capital VT.

Thus only an unwise entrepreneur will produce in the dotted region of the iso-quant 100. The
dotted segments of an isoquant are the waste- bearing segments. They form the uneconomic
regions of production. In the up dotted portion, more capital and in the lower dotted portion
more labour than necessary is employed. Hence GH, JK, LM, and NP segments of the
elliptical curves are the isoquants.

Difference Between Monopoly and Monopolistic Competition

In economics, the market is not just a place whereby parties engage in an exchange of goods
or services for money but it refers to a system whereby there are many buyers and sellers for a
product or service, they have complete knowledge about market conditions, buyers and sellers
bargain and settle the price of the product to take place. The market is classified into various
categories like area, time, regulation, competition and so on. Based on competition, the
market is divided as perfect competition and imperfect competition. Further, there are three
types of imperfect competition, monopoly, oligopoly and monopolistic competition.

Many people have trouble in understanding the difference between monopoly and
monopolistic competition. Monopoly refers to a market structure where there is a single seller
dominates the whole market by selling his unique product. On the other hand, Monopolistic
competition refers to the competitive market, wherein few buyers and sellers in the market
offer near substitutes to the customers.

34
Content: Monopoly Vs Monopolistic Competition

Comparison Chart

Basis For
Monopoly Monopolistic Competition
Comparison

Meaning Monopoly refers to a market Monopolistic competition is a

structure where a single competitive market setting
seller produces/sells product wherein there are many sellers
to large number of buyers. who offer differentiated products
to a large number of buyers.

Number of players One Two to Ten or even more.

Product Extreme Slight

differentiation

Degree of control Considerable but very Some

over price regulated.

Competition Does not exist. Stiff competition exists between

firms.

Demand curve Steep Flat

Barriers to entry and Many No

exit

Difference between No Yes

firm and industry

Definition of Monopoly

A type of market structure, where the firm has absolute power to produce and sell a product
or service having no close substitutes. In simple terms, monopolised market is one where
there is a single seller, selling a product with no near substitutes to a large number of buyers.
As the firm and industry are one and the same thing in the monopoly market, so it is a single-
firm industry. There is zero or negative cross elasticity of demand for a monopoly product.
Monopoly can be found in public utility services such as telephone, electricity and so on.

Under this marketing setting, a firm is the price setter; however, the pricing of the product is
done taking into account the elasticity of demand for the product, so that the demand for the
product and profit will be maximum. Look at the diagram given below:
35
Where MR = Marginal Revenue
AR = Average Revenue
MC = Marginal Cost
AC = Average Cost

Definition of Monopolistic Competition

A market setting wherein scores of sellers sell a differentiated product is called monopolistic
competition. Products are differentiated, by their brand name, packaging, shape, size, design,
trademark, etc. Although the product sold by different firms in the industry remain close
substitutes for the rivals, as the products are not identical but similar. Monopolistic
competition is prevalent in the manufacturing industry, such as tea, shoes, refrigerators,
toothpaste, TV sets, etc. The salient features of monopolistic competition are given below:

 A large number of sellers.

 Differentiated products, yet close substitutes.
 Free entry into and exit from the industry.
 Perfect factor mobility
 Full knowledge of market conditions.

Under this setting, the consumers buy more when the prices of the product are lower than at
higher prices. By equating marginal revenue with marginal cost, the firm’s profit can be
maximised, which can be seen in the given below diagram:

36
Key Differences Between Monopoly and Monopolistic Competition:

The following points are noteworthy so far as the difference between monopoly and
monopolistic competition is concerned:

A market structure where a single seller produces/sells the product to a large number of
buyers is called a monopoly. A competitive market setting wherein many sellers offer
differentiated products to a large number of buyers, is called monopolistic competition.

There is a single sellers/producers in a monopoly market whereas there can be two to ten or
more players in the monopolistic competition.

In a monopoly market structure, a single product is offered by the seller and there is extreme
product differentiation. On the contrary, in a monopolistic competition, as the product offered
by different sellers are close substitutes, and so, there is slight product differentiation.

In a monopoly market, the degree of control over price is considerable but regulated. As
against this, in a monopolistic competition, there is some control over price.

No competition exist in a monopoly market while stiff competition due to non-price

competition exists between firms the monopolistically competitive market.

As there are no close substitutes of the product, demand for the product is elastic. As opposed
to monopolistic competition, as the products offered by the different sellers are not identical
but similar, hence its demand is highly elastic.

37
 Under monopoly, there are high entry and exit barriers, due to the economic, legal and
institutional causes. On the other hand, in monopolistic competition, there is an unrestricted
entry into and exit from the industry.

As a single firm regulates the whole market, there is no difference between firm and industry
in the monopoly. So, it is a single-firm industry. Unlike, monopolistic competition, the
difference between firm and industry exists, i.e. a firm is a single entity, and a group of firms
is called industry.

Conclusion

In a monopoly market, it is possible for a firm to charge distinct prices from various
customers, for the same product. So, the firm can adopt price discrimination policy. On the
other hand, as non-price competition is prevalent in the market, therefore, price
discrimination is not possible, so, no firm can charge different prices from different
customers.

BASIS FOR PERFECT

MONOPOLISTIC COMPETITION
COMPARISON COMPETITION

Meaning A market structure, Monopolistic Competition is a market structure,

where there are many where there are numerous sellers, selling close
sellers selling similar substitute goods to the buyers.
goods to the buyers, is
perfect competition.

Product Standardized Differentiated

Price Determined by demand Every firm offer products to customers at its own
and supply forces, for price.
the whole industry.

Entry and Exit No barrier Few barriers

Demand Curve slope Horizontal, perfectly Downward sloping, relatively elastic.

elastic.

Relation between AR = MR AR > MR

AR and MR

Situation Unrealistic Realistic

38
 Comparison Chart

Key Differences Between Perfect Competition and Monopolistic Competition

The basic differences between perfect competition and monopolistic competition are
indicated in the following points:

A market structure, where there are many sellers selling similar goods to the buyers, is perfect
competition. A market structure, where there are numerous sellers, selling close substitute
goods to the buyers, is monopolistic competition.

In perfect competition, the product offered is standardised whereas in monopolistic

competition product differentiation is there.

In perfect competition, the demand and supply forces determine the price for the whole
industry and every firm sells its product at that price. In monopolistic competition, every firm
offers products at its own price.

Entry and Exit are comparatively easy in perfect competition than in monopolistic
competition.

The slope of the demand curve is horizontal, which shows perfectly elastic demand. On the
other hand, in monopolistic competition, the demand curve is downward sloping which
represents the relatively elastic demand.

Average revenue (AR) and marginal revenue (MR) curve coincide with each other in perfect
competition. Conversely, in monopolistic competition, average revenue is greater than the
marginal revenue, i.e. to increase sales the firm has to lower down its price.

Perfect competition is an imaginary situation which does not exist in reality. Unlike,
monopolistic competition, that exists practically.

Conclusion

After reviewing the above points, it is quite clear that perfect competition and monopolistic
competition are different, where monopolistic competition has features of both monopoly and
perfect competition. The principal difference between these two is that in the case of perfect
competition the firms are price takers, whereas in monopolistic competition the firms are
price makers.

39
 Price Discrimination
This involves charging a different price to different groups of people for the same good. For
example: student discounts, off peak fares cheaper than peak fares.

Different Types of Price Discrimination

1. First Degree Price Discrimination

This involves charging consumers the maximum price that they are willing to pay. There will
be no consumer surplus.

2. Second Degree Price Discrimination

This involves charging different prices depending upon the quantity consumed.

E.g. after 10 minutes phone calls become cheaper.

3. Third Degree Price Discrimination

This involves charging different prices to different groups of people. E.g. students, OAPs and
peak travellers e.t.c.

More on third degree price discrimination

Conditions Necessary for Price Discrimination

1. The firm must operate in imperfect competition, it must be a price maker with a downwardly
sloping demand curve.

2. The firm must be able to separate markets and prevent resale. E.g. stopping an adults using a
child’s ticket.

3. Different consumer groups must have elasticities of demand. E.g. students with low income
will be more price elastic.

To maximise profits a firm sets output and price where MR=MC. If there are 2 sub markets
with different elasticities of demand. The firm will increase profits by setting different prices
depending upon the slope of the demand curve.

 Therefore for a group like adults, PED is inelastic – the price will be higher
 For groups like students prices will be lower because there demand is elastic

Profit Maximisation under Price Discrimination

40
 Profit is maximised where MR=MC. Because demand is more inelastic in market (A) it leads
to a higher price being set. In market (B) demand is price elastic, so profit maximising price is
lower.

Advantages of Price Discrimination

1. Firms will be able to increase revenue. This will enable some firms to stay in business who
otherwise would have made a loss. For example price discrimination is important for train
companies who offer different prices for peak and off peak.

2. Increased revenues can be used for research and development which benefit consumers

3. Some consumers will benefit from lower fares. E.G. old people benefit from lower train
companies, old people are more likely to be poor.

Disadvantages of Price Discrimination

1. Some consumers will end up paying higher prices. These higher prices are likely to be
allocatively inefficient because P > MC.

2. Decline in consumer surplus.

41
3. Those who pay higher prices may not be the poorest. E.g. adults could be unemployed, OAPs
well off.

4. There may be administration costs in separating the markets.

5. Profits from price discrimination could be used to finance predatory pricing.

Importance of Marginal Cost in Price Discrimination

In markets where the marginal cost of an extra passenger is very low. E.G. a bus traveller the
firm has an incentive to use price discrimination to sell all the tickets. This is why sometimes
prices for airlines can be very low just before their date. Once the company is due to fly the
MC of an extra passenger will be very low. Therefore this justifies selling the remaining
tickets at a low price.

Examples of price discrimination

1. Student discounts on trains

2. Discounts for buying train tickets in advance
3. Discounts for travelling at off peak time
4. Lower unit cost price for buying high quantity.

Concept Of Price Elasticity Of Demand

The price elasticity of demand measures the degree of responsiveness of quantity demanded
for a certain commodity to the change in its price. In other words, the price elasticity of
demand is defined as the 'ratio of percentage change in the quantity demanded to the
percentage change in price . It can be expressed as follows:

Price elasticity of demand (ep) = Percentage change in quantity of demand / Percentage

change in price Where, ep = Coefficient of price elasticity of demand.

The price elasticity of demand is always negative due to the inverse relationship between the
price and quantity demanded. But for the sake of simplicity in understanding the magnitude
of response of quantity demanded to the change in the price we ignore the negative sign and
take into account only the numerical value of the price elasticity of demand.

Types Of Price Elasticity Of Demand

There are five types of price elasticity of demand. They are as follows:
1. Perfectly Elastic Demand
Demand is said to be perfectly elastic if negligible change in price would lead to infinite
change in the quantity demanded. Visibly, no change in price causes in infinite change in
demand.
42
2. Perfectly Inelastic Demand
When the demand for a commodity does not change despite change in price, the demand is
said to be perfectly inelastic.
3. Unitary Elastic Demand
When the percentage change in the quantity demanded is equal to the percentage change in
price, the demand for a commodity is said to be unitary elastic demand. For example, 10%
change in price causes 10% change in demand.
4. Relatively Elastic Demand
When the percentage change in the quantity demanded for a commodity is more than
percentage change in price, it is called relatively elastic demand. For example, if 10% change
in price results, 20% change in quantity demanded.
5. Relatively Inelastic Demand
When the percentage change in the quantity demanded of a commodity is less than percentage
change in the price, it is called relatively inelastic demand. For example, when 20% change in
price causes 10% change in demand.

Equilibrium of the Firm and Industry under Perfect Competition!

1. Meaning of Firm and Industry

2. Equilibrium of the Firm

3. Equilibrium of the Industry under Perfect Competition

Meaning of Firm and Industry:

It is essential to know the meanings of firm and industry before analysing the two. A firm is
an organisation which produces and supplies goods that are demanded by the people.
According to Prof. S.E. Lands-bury, “Firm is an organisation that produces and sells goods
with the goal of maximising its profits. In the words of Prof. R.L. Miller, “Firm is an
organisation that buys and hires resources and sells goods and services.”

Industry is a group of firms producing homogeneous products in a market. In the words of

Prof. Miller, “Industry is a group of firms that produces a homogeneous product.” For
example, Raymond, Maffatlal, Arvind, etc., are cloth manufacturing firms, whereas a group
of such firms is called the textile industry.

Equilibrium of the Firm:

Meaning:
A firm is in equilibrium when it has no tendency to change its level of output. It needs neither
expansion nor contraction. It wants to earn maximum profits. In the words of A.W. Stonier
and D.C. Hague, “A firm will be in equilibrium when it is earning maximum money profits.”

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Equilibrium of the firm can be analysed in both short-run and long-run periods. A firm can
earn the maximum profits in the short run or may incur the minimum loss. But in the long
run, it can earn only normal profit.

Short-run Equilibrium of the Firm:

The short run is a period of time in which the firm can vary its output by changing the
variable factors of production in order to earn maximum profits or to incur minimum losses.
The number of firms in the industry is fixed because neither the existing firms can leave nor
new firms can enter it.

It’s Conditions:
The firm is in equilibrium when it is earning maximum profits as the difference between its
total revenue and total cost.

For this, it essential that it must satisfy two conditions:

(1) MC = MR, and (2) the MC curve must cut the MR curve from below at the point of
equality and then rise upwards.

The price at which each firm sells its output is set by the market forces of demand and supply.
Each firm will be able to sell as much as it chooses at that price. But due to competition, it
will not be able to sell at all at a higher price than the market price. Thus the firm’s demand
curve will be horizontal at that price so that P = AR = MR for the firm.

1. Marginal Revenue and Marginal Cost Approach:

The short-run equilibrium of the firm can be explained with the help of the marginal analysis
as well as with total cost-total revenue analysis. We first take the marginal analysis under
identical cost conditions.

This analysis is based on the following assumptions:

1. All firms in an industry use homogeneous factors of production.

2. Their costs are equal. Therefore, all cost curves are uniform.

3. They use homogeneous plants so that their SAC curves are equal.

4. All firms are of equal efficiency.

5. All firms sell their products at the same price determined by demand and supply of the
industry so that the price of each firm is equal to AR = MR.

Determination of Equilibrium:
Given these assumptions, suppose that price OP in the competitive market for the product of
all the firms in the industry is determined by the equality of demand curve D and the supply
curve S at point E in Figure 1(A) so that their average revenue curve (AR) coincides with the
marginal revenue curve (MR).

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At this price, each firm is in equilibrium at point L in Panel (B) of the figure where (i) SMC
equals MR and AR, and (ii) the SMC curve cuts the MR curve from below. Each firm would
be producing OQ output and earning normal profits at the maximum average total costs QL.
A firm earns normal profits when the MR curve is tangent to the SAC curve at its minimum
point.

If the price is higher than these minimum average total costs, each firm will be earning
supernormal profits. Suppose the price rises to 0Рг where the SMC curve cuts the new
marginal revenue curve MR2 (=AR2) from below at point A which now becomes the
equilibrium point. In this situation, each firm produces OQ2 output and earns supernormal
profits equal to the area of the rectangle P2 ABC.

If the price falls below OP1the firm would make a loss because the SAC would be higher than
the price. In the short-run, it would continue to produce and sell OQ1 output at OP1price so
long as it covers its AVC. S is thus the shut-down point at which the firm is incurring the
maximum loss equal to SK per unit of output. If the price falls below OP1 the firm will close
down because it would fail to cover even the minimum average variable cost. OP1 is thus the
shut-down price.

We may conclude from the above discussion that in the short-run each firm may be making
either supernormal profits, or normal profits or losses depending upon the price of the
product.

2. Total Cost Revenue Analysis:

The short-run equilibrium of the firm can also be shown with the help of total cost and total
revenue curves. The firm is able to maximize its profits at that level of output where the
difference between total revenue and total cost is the maximum. This is shown in Figure 2
where TR is the total revenue curve and TC total cost curve.

The total revenue curve is an upward sloping straight line curve starting from O. This is
because the firm sells small or large quantities of its product at a constant price under perfect
competition. If the firm produces nothing, total revenue will be zero. The more it produces,
the larger is the increase in total revenue. Hence the TR curve is linear and slopes upward.
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The firm will maximize its profits at that level of output where the gap between the TR curve
and the 1C curve is the maximum. Geometrically, it is that level at which the slope of a
tangent drawn to the total cost curve equals the slope of the total revenue curve. In Figure 2,
the maximum amount of profit is measured by TP at OQ output. At outputs smaller or larger
than OQ between A and В points, the firm’s profits shrink. If the firm produces OQ1 output,
its losses are the maximum because the TC curve is i above the TR curve. At Q1 its profits are
zero. Similar situation prevails at Q2.

Since the marginal revenue equals the slope of the total о revenue curve and the marginal cost
equals the slope of the tangent to the total cost curve, it follows that where the slopes of the
total cost and revenue curves are equal as at P and T, the marginal cost equals the marginal
revenue. It should be clear of that the point of maximum profits lies in the region of rising
marginal cost (when TC is below TR) and of maximum loss in the falling marginal cost
region (where TC is above TR).

The explanation of the equilibrium of the firm by using total cost-revenue curves does not
throw more light than is provided by the marginal cost-marginal revenue analysis. It is useful
only in the case of certain marginal decisions where the total cost curve is also linear over a
certain range of output.

But it makes the equilibrium of the firm a cumbersome and difficult analysis particularly
when one has to compare the change in cost and revenue resulting from a change in the
volume of output. Further, maximum profits cannot be known at once. For this, a number of
tangents are required to be drawn which is a real difficulty.

Long-run Equilibrium of the Firm:

In the long-run, it is possible to make more adjustments than in the short-run. The firm can
adjust its plant capacity and scale of operations to the changed circumstances. Therefore, all
costs are variable. Firms must earn only normal profits. In case the price is above the long-run
AC curve firms will be earning supernormal profits.

Attracted by them, new firms will enter the industry and supernormal profits will be
competed away. If the price is below the LAC curve firms will be incurring losses. As a
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result, some of the firms will leave the industry so that no firm earns more than normal
profits. Thus “in the long-run firms are in equilibrium when they have adjusted their plant so
as to produce at the minimum point of their long-run AC curve, which is tangent (at this
point) to the demand (AR) curve defined by the market price” so that they earn normal
profits.

It’s Assumptions:
This analysis is based on the following assumptions:
1. Firms are free to enter into or leave the industry.

2. All firms are of equal efficiency.

3. All factors are homogeneous. They can be obtained at constant and uniform prices.

4. Cost curves of firms are uniform.

5. The plants of firm: are equal having given technology.

6. All firms have perfect knowledge about price and output.

Determination:
Given these assumptions, each firm of the industry will be in the following two conditions.

(1) In equilibrium, its short-run marginal cost (SMC) must equal to its long-run marginal cost
(LMC) as well as its short-run average cost (SAC) and its long-run average cost (LAC) and
both should be equal to MR=AR=P. Thus the first equilibrium condition is:

SMC = LMC = MR = AR = P = SAC = LAC at its minimum point, and

(2) LMC curve must cut MR curve from below.

Both these conditions of equilibrium are satisfied at point E in Figure 3 where SMC and LMC
curves cut from below SAC and LAC curves at their minimum point E and SMC and LMC
curves cut AR = MR curve from below. All curves meet at this point E and the firm produces
OQ optimum quantity and sell it at OP price.

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Since we assume equal costs of all the firms of industry, all firms will be in equilibrium m the
long-run. At OP price a firm will have neither a tendency to leave nor enter the industry and
all firms will earn normal profit.

Equilibrium of the Industry under Perfect Competition:

Conditions of Equilibrium of the Industry:

An industry is in equilibrium:
(i) When there is no tendency for the firms either to leave or enter the industry, and (ii) when
each firm is also in equilibrium. The first condition implies that the average cost curves
coincide with the average revenue curve of all the firms in the industry. They are earning only
normal profits, which are supposed to be included in the average cost curves of the firms. The
second condition implies the equality of MC and MR. Under a perfectly competitive industry,
these two conditions must be satisfied at the point of equilibrium, i.e.,

SMC = MR

SAC = AR

P = AR = MR

SMC = SAC = AR = P

Such a situation represents full equilibrium of the industry.

Short-Run Equilibrium of the Industry:

An industry is in equilibrium in the short run when its total output remains steady, there being
no tendency to expand or contract its output. If all firms are in equilibrium, the industry is
also in equilibrium. For full equilibrium of the industry in the short run, all firms must be
earning only normal profits. The condition for this is SMC = MR = AR = SAC. But full
equilibrium of the industry is by sheer accident because in the short run some firms may be
earning supernormal profits and some incurring losses.

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Even then, the industry is in short- run equilibrium when its quantity demanded and quantity
supplied are equal at the price which clears the market. This is illustrated in Figure 4, where
in Panel (A), the industry is in equilibrium at point E where its demand curve D and supply
curve S intersect which determine OP price at which its total output OQ is cleared. But at the
prevailing price OP some firms are earning supernormal profits PE1ST as shown in Panel (B),
while some other firms are incurring FGE2P losses as shown in Panel (C) of the figure.

Long-Run Equilibrium of the Industry:

The industry is in equilibrium in the long run when all firms earn normal profits. There is no
incentive for firms to leave the industry or for new firms to enter it. With all factors
homogeneous and given their prices and the same technology, each firm and industry as a
whole are in full equilibrium where LMC = MR =AR(=p) =LAC at its minimum. Such an
equilibrium position is attained when the long-run price for the industry is determined by the
equality of total demand and supply of the industry.

The long-run equilibrium of the industry is illustrated in Figure 5(A) where the long-run price
op and OQ output are determined by the intersection of the demand curve d and the supply
curve s at point E. At this price op, the firms are in equilibrium at point A in Panel (B) at OM
level of output where LMC =SMC= MR= p (=AR) =SAC= LAC at its minimum. At this
level, the firms are earning normal profits and have no incentive to enter or leave the industry.
It follows that when the industry is in long-run equilibrium, each firm in the industry is also in
long-run equilibrium. If both the industry and the firms are in long-run equilibrium, they are
also in short-run equilibrium.

Even though all firms in a perfectly competitive industry in the long run have the same cost
curves, the firms can be of different efficiency. Firms using superior resources or inputs such
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as superior management must pay them higher rewards, otherwise they will shift to new firms
which offer them higher prices.

So the forces of competition will force the more efficient firms to pay superior resources
higher prices at their opportunity cost. As a result, the lac curve of the more efficient firms
will shift upwards and they will benefit in the form of higher output at the higher long-run
equilibrium price set by the industry.

Unable to pay higher prices to resources or inputs, less efficient firms will be competed away.
New firms which are able to pay more and attracted by the new higher market price will enter
the industry. But at the new long-run equilibrium price of the industry, all firms will be
producing at the minimum LAC.

This is illustrated in Figure 6 where the industry is in initial equilibrium at point E with price
OP m Panel (A) and the more efficient firms like all other firms are in equilibrium at point A
in Panel (B). As the industry is in equilibrium, the new firms do not exist as they are not in a
position to cover their costs at OP price.

When the more efficient firms pay higher prices to resources or inputs, their LAC curve rises
to LAC1 At the new long-run equilibrium price of the industry set at OP 1 the more efficient
firms are in equilibrium where P1 = LAC1 at its minimum point A1 in Panel (B). They are
now producing larger output OM1 even though they earn normal profits. The new firms also
earn normal profits at point A2, as shown in Panel (C). But they produce less output OM2 than
OM1 produced by the more efficient firms.

Determining the Shutdown Point of a Firm

This continues a previous post on profit maximization. The question we want to continue with
is when should a firm shutdown? Then answer is when P (price) = AVC (average
variable cost).
This is the output where firms are indifferent between producing the profit-maximizing
quantity (ie. loss-minimizing quantity) and shutting down operations. Take a look at this
graph to help you understand the when and where.

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While we’re on the topic, what is the supply curve for each firm? Looking at the graph you’ll
note the MC curve. The supply curve for each firm is simply its marginal cost (MC) curve
above the minimum point on the average variable cost (AVC) curve.
The supply curve for the industry is just the (horizontal) summation of each individual firm’s
supply curve. Carrying on, what about the items that dictate and influence long run decision
making?

Long-Run Decisions:
Forces in a competitive industry ensure that firms earn zero economic profits in the long-run.
Competitive industries will adjust in two ways: 1. Entry and exit, 2. Changes in plant size

Entry and Exit:

The prospect of persistent profit of loss causes firms to enter or exit an industry. If firms are
making economic profits, other firms enter the industry. This graph shows how where there is
room for new entrants in the market and how it eliminates industry profits in the long run.

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If firms are making economic losses, some of the existing firms exit the industry. This entry
and exit of firms influences prices, quantities, and economic profits. This graph depicts
economic losses in the industry.

Important points: as new firms enter an industry, the price falls and the economic profit of
each existing firm decreases. As firms leave an industry, the price rises and the economic loss
of each remaining firm decreases. [See graphs above]
Changes in Plant Size: When a firm changes its plant size, it can lower its costs and increase
its economic profit. Let’s see in this graph how a firm can increase its profit by increasing its
plant size.

Long-Run Equilibrium: Therefore, in the long-run equilibrium for a competitive industry,

all firms must be:

1. Maximizing profits (P = MR = MC)

2. Earning zero economic profits (P = SRATC)
3. Unable to increase profits by altering its scale of operations.

And that concludes our intro into profit maximization and shut down points for firms.

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 The Short Run and Long Run Production Function:

In the Market Structures

The production function provides information about the quantity of factor inputs as to the
result of the quantity of outputs and this is measured by total product; average product; and
marginal product

1. The total product is generated from the total output from the factors of production
employed by the firm. It is the quantity of output produced per time period given the inputs.
The total product can easily be determined when applied to manufacturing industries for the
production of cars, appliances, cellphones and other products because of clear cut measure as
to the volume of production as to the tangible costs on labor and capital inputs.

2. The average product is computed through the total output divided by the number of units of
the variables of the factor of production. For example, the 10 factory workers produce 1000
units of electronic components of a computer, therefore the average product of labor is 10
units of electronic components per worker. This example is generated by the output per
worker employed in the factory.

3. The marginal product is the change of the total product when there is an additional unit of
the input in the factors of production. The additional labor (increased in the number of
workers) as an input product may increase the total product. For example, the factory intends
to hire two additional workers then the 10 workers with a product of 1000 units may now
increase to 1200 units. Therefore , the marginal product is computed by the one unit change
may result to the increase of the total product.

The Period of Production

1. Short Run Production

The short run is a period in which at least one input of the factors of production is fixed. It
should be noted that usually factory facilities, equipment and machinery including land are
fixed, however, the supply can be altered by changing the demand for labor, raw material,
factory components and etc. Usually a firm or producers have to pay certain production cost
form the expenses such as the construction of building for the management office,
manufacturing facilities, salaries or wages of the labor and other overhead costs. In the short
run, the firm cost
structure has to consider the fixed costs (FC) in a given period of time regardless of
production level. The variable cost is associated with the production cost.

1. Fixed Costs The cost of production of the investment utilized by the firm. The fixed cost
does not vary regardless of the production output. These are overhead cost, rent of offices and
buildings, property tax, amortization and interest.

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1. Variable Cost This indicates cost of the direct labor, raw materials, supplies and materials.
The variable cost is associated in the production of goods. It must be noted that the Total
Costs (TC) presents the sum of the Total Variable Costs (TVC) and Total Variable Costs
(TVC). This is the economic calculation of this presentation and the average cost with that of
the Total Costs:

AC = (TFC + TVC)/Q = AFC + AVC

AC: average costs
TFC: total fixed costs
TVC: total variable costs
AFC: average fixed costs
AVC: average variable costs

In the short run, the total product usually responds to the increase on the use of a variable
input. However, you cannot simply add factory workers just to increase the production output.
There is a certain point when the marginal product could no longer increase the production
output because there are too many workers to work on a fixed capital input just like
machinery, equipment and facilities.

This is the reason why the Law of Diminishing Returns is present in the study of production
function because the additional units of a variable inputs such as labor and raw material with
a fixed land and capital may have consequence on the initial change in total output will at first
rise and then fall. The marginal product of labor starts to fall when there are already so many
workers producing products with fixed land, capital, equipment and etc. It can reduce the
diminishing returns once there is an expansion of the land, equipment, machinery and even
the increase of capital, however, we must always consider the average product and marginal
product with the standard workers needed in a given number of production output.

The concept of law of diminishing returns is shown above with the production function
variables of capital outlay, labor input, total output, marginal product and average product of
labor. Let us assume that the fixed capital input in the short run analysis is 30 units available
for the production of certain product. There is a certain point of the capital input that could
maximized the marginal product, however, once it reaches the peak point the marginal
product falls which may show the sign of diminishing return. Let us take this example in the
production function, the fixed capital input of 30 units may need a labor input of 6 workers
that may produce 233 for the total output with a marginal product of 60 and average product
of labor of 39. The marginal product of 60 is the maximize change of product for 6 workers,
however, an additional workers may result to diminishing return to marginal product and
eventually to the average product output.

2. Long Run Production

The period of production in the long run shows the production operation of a certain period of
time. Normally, the firm expansion on the average cost of production may result the increase
of production inputs. However, there are some conditions that:
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a) If the firm increases or expand its production operation, is it always increases its
production output.

b) Is it possible that the average cost of production may follow the same increase (to let say
5050%) in the production input and output?

c) If the firm increases by its production input, however, the production output decreases.
The long run production for the expansion of the firm through the economies of scale
illustrates the importance of capital intensive ( more equipment per worker) in mass
production; increased specialization and division of labor .

Three (3) Possible Cases in Long Run Period of Production

The long run period of production usually analyzes the economies of scale which studies the
increasing returns to scale or economies of mass production. It tends to provided information about
the unit cost and the size of operation in the production of goods. The economies of scale primarily
directed to reduce the unit costs from the increasing size of the operation. That is why the larger firms
are more economically viable in the long run production as it diminishes the production cost. Take
note that the economies of scale tends to increase in specialization and division of labor. This may
lead to increase production inputs and expands the production output.

1. Decreasing Returns to Scale (Increasing Cost)

When the firm becomes large it is likely to encounter problem in the production of a particular
product because of the increase average cost of operation. This is the problem of management when
increase of production input by 60% the production output reaches only to 40%. In this notion the
production is less cheap at a certain scale when it is already large in scale. It requires large scale
machinery or division of labor to produce greater production output. Hence, the Decreasing Returns
to scale occur when the percent change in output is greater in percent for the change in inputs.

2. Constant Returns to Scale (Constant Cost)

There is a time for a firm to enjoy a long range of production output for which the average cost is the
same proportion to both production input and output. If there is an increase of the number of
machines by 50% then there is also an increase of the number of units produced by 50%. This is a
constant returns in machinery production. Hence, the Constant Returns to scale occur when the
average cost do not increase as a result of diseconomies of scale.

3. Increasing Return to Scale (Decreasing Cost)

This is known as the economies of scale wherein the firm’s increase in all production inputs and
outputs. Supposing a firm increases the inputs by 50% the return of scale increases to 60%.The
economies scale expands productive capacity in the long run as it operated by machines and other
sophisticated technology that may reduce the overhead cost in producing the products. This is more
on capital intensive production wherein there are more equipment utilize than workers in the
production process. In the long run, the manufacturing sectors with high capital investment of
equipment results to higher production output that expands the profitability of the firms. The
economies of scale are the reduction of unit cost in the long run of operation. The expansion of the
firm through a mass production provides greater units of output.

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