Q1.

LAW OF DEMAND

The law of demand shows a functional relationship between price and quantity demanded of a
commodity. The law of demand explains the behaviour of consumers, either a single
consumer/household or all the consumers collectively. It is used together with the law of
supply to determine the efficient allocation of resources in an economy and finding the optimal
price and quantity of goods.

STATEMENT OF LAW OF DEMAND

The law of demand states that,” Other things being equal (CETRIS PARABUS), the quantity
demanded of a commodity increases when its price falls and decrease when its price rises.”

Thus, the law of demand indicates an inverse relationship between price and quantity demanded
of a commodity. That is, with a rise in price demand will fall and with the fall in price demand
will rise. The concept of demand generally refers to the quantity demanded at a given time,
which may be a point of time, a day or a week. The term ―Ceteris parables associated with the
law of demand, implies that taste and preferences, income, the prices of related goods, and social
status, all remain constant over the period in which the impact of price variation on the quantity
demanded. The law of demand is a partial analysis of the relationship between demand and
price, in the sense that it relates to the demand for only one commodity, say X, at a time or over a
period of time.

Assumptions

Every law will have limitation or exceptions.This law operates when the commodity’s price
changes and all other prices and conditions do not change. The main assumptions are:

 Habits, tastes and fashions remain constant.

 Size of the population remains the same.
 Income of the consumer remains unchanged.
 Prices of related goods remain unchanged.
 Government’s policies remain unchanged.
 There is no change in the expectations about the future.

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EXPLANATION OF THE LAW OF DEMAND:-

The law of demand can be well explained with the help of a ―Demand schedule and a
―Demand curve. The Demand schedule and a Demand curve can be drawn for an individual
consumer, for a particular firm, as also for the entire industry.

DEMAND SCHEDULE:- Demand schedule shows the list of prices and the corresponding
quantities of a commodity. It is the tabular representation of the different combinations of price
and the corresponding quantity demanded of a commodity. While preparing the Demand
schedule, it is assumed that the marginal utility of money is constant and that the quantity
demanded depends only on the price.

The following table gives one hypothetical Demand schedule for an individual consumerA,
showing different price levels of a commodity that A is interested in and their corresponding
quantities demanded by A, ceteris paribus.

The law of demand can be explained with the help of the following demand schedule:

Price of Commodity (X) Quantity Demanded of X

(Rs) (Units)

5 100

10 75

15 50

20 25

The schedule shows that as the price of commodity X increases from Rs 10 to Rs 15, the quantity
demanded for X falls from 75 units to 50 units. Thus, there is a negative relationship between
demand and price.

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DEMAND CURVE:- The graphical presentation of the Demand schedule of any commodity is
known as the Demand curve. The Demand schedule of any commodity can be converted into a
demand curve when the various price-quantity combinations are graphically plotted. The graph
in fig.1 uses the numbers from the table-1 to illustrate the law of demand. The Demand Curve is
a graphic representation of quantities of a good which will be demanded by the consumer at
various possible prices in a given period of time.

On the x-axis, we represent the quantity demanded; and on the y-axis, we represent the price of
the good. Joining the different combinations of price and quantity demanded, we get a curve DD.
This curve is the demand curve showing the inverse relationship between the price and the
quantity demanded.

Exceptions to law of demand

In certain cases, the demand curve slopes up from left to right, i.e., it has a positive slope. Under
certain circumstances, consumers buy more when the price of a commodity rises, and less when
price falls, as shown by the D curve in Figure 8. Many causes are attributed to an upward sloping
demand curve.

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1. Giffen goods: These are those inferior goods on which the consumer spends a large part of his
income and the demand for which falls with a fall in their price. The demand curve for these has
a positive slope. The consumers of such goods are mostly the poor. a rise in their price drains
their resources and the poor have to shift their consumption from the more expensive goods to
the giffen goods, while a fall in the price would spare the household some money for more
expensive goods which still remain cheaper. These goods have no closely related substitutes;
hence income effect is higher than substitution effect. In the case of an underdeveloped
economy, with the fall in the price of an inferior commodity like maize, consumers will start
consuming more of the superior commodity like wheat.

2. Commodities which are used as status symbols: Some consumers measure the utility of a
commodity entirely by its price i.e., for them, the greater the price of a commodity, the greater its
utility.Some expensive commodities like diamonds, air conditioned cars, etc., are used as status
symbols to display one’s wealth. The more expensive these commodities become, the higher
their value as a status symbol and hence, the greater the demand for them. The amount demanded
of these commodities increase with an increase in their price and decrease with a decrease in
their price. Also known as a Veblen good. (In economics, Veblen goods are a group of
commodities for which people's preference for buying them increases as their price increases, as
greater price confers greater status, instead of decreasing according to the law of demand).

3. Expectations regarding future prices: If the price of a commodity is rising and is expected to
rise in future the demand for the commodity will increase.

4. Emergency: At times of war, famine etc. consumers have an abnormal behaviour. If they
expect shortage in goods they would buy and hoard goods even at higher prices. In depression
they will buy less at even low prices.

5. Quality-price relationship: some people assume that expensive goods are of a higher quality
then the low priced goods. In this case more goods are demanded at higher prices.

6. Demonstration Effect: If consumers are affected by the principle of conspicuous consumption

or demonstration effect, they will like to buy more of those commodities which confer
distinction on the possessor, when their prices rise. On the other hand, with the fall in the prices
of such articles, their demand falls, as is the case with diamonds.

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6. Ignorance Effect: Consumers buy more at a higher price under the influence of the “ignorance
effect”, where a commodity may be mistaken for some other commodity, due to deceptive
packing, label, etc.

7. Necessities of Life: Normally, the law of demand does not apply on necessities of life such as
food, cloth etc. Even the price of these goods increases, the consumer does not reduce their
demand. Rather, he purchases them even the prices of these goods increase often by reducing the
demand for comfortable goods. This is also a reason that the demand curve slopes upwards to the
right.

Q2.DEMAND AND ITS DETERMINANTS

Demand refers to the desire backed by the ability and willingness to pay for a particular
commodity at a given point in time or over a period in time .

Demand schedule and law of demand state the relationship between price and quantity demanded
by assuming “other things remaining the same “. When there is a change in these other things,
the whole demand schedule or demand curve undergoes a change.

In other words, these other things determine the position and level of the demand curve. If these
other things or the determinants of demand change, the whole demand schedule or the demand
curve will change. As a result of the changes in these factors or determinants, a demand curve
will shift above or below as the case may be.

Demand for a commodity is influenced by a number of factors. Some of the factors that
influence the demand for a commodity are:

 Price of the commodity- Demand for a commodity shares a negative relationship with
price. As the price of the commodity increases, the demand for it falls and vice versa.
 Size of the population- Greater the size of population, greater is the total number of
consumers, greater is the demand for the commodity and vice versa.
 Tastes and Preferences of the Consumers: A good for which consumers’ tastes and
preferences are greater, its demand would be large and its demand curve will lie at a
higher level. People’s tastes and preferences for various goods often change and as a
result there is change in demand for them. The changes in demand for various goods
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 occur due to the changes in fashion and also due to the pressure of advertisements by the
manufacturers and sellers of different products. On the contrary when any good goes out
of fashion or people’s tastes and preferences no longer remain favourable to it the
demand for it decreases. In economics we say that the demand curve for these goods will
shift downward.
 Incomes of the People: The demand for goods also depends upon incomes of the people.
When as a result of the rise in incomes of the people, the demand increases, the whole of
the demand curve shifts upward and vice versa. The greater income means the greater
purchasing power. Therefore, when incomes of the people increase, they can afford to
buy more. It is because of this reason that the increase in income has a positive effect on
the demand for a good. When the incomes of the people fall they would demand less of
the goods and as a result the demand curve will shift below.
 Changes in the Prices of the Related Goods: The demand for a good is also affected by
the prices of other goods, especially those which are related to it as substitutes or
complements. When price of a substitute for a good falls, the demand for that good will
decline and when the price of the substitute rises, the demand for that good will increase.
For example, when price of the tea as well as the incomes of the people remains the same
but price of the coffee falls, the consumers would demand less of tea than before. Tea and
coffee are very close substitutes, therefore when coffee becomes cheaper, the consumers
substitute coffee for tea and as a result the demand for tea declines.
 Population: Another Important cause for the increase in the number of consumers is the
growth in population. For instance, in India the demand for many essential goods,
especially food-grains, has increased because of the increase in the population of the
country and the resultant increase in the number of consumers for them.
 Changes in Propensity to Consume: People’s propensity to consume also affects the
demand for them. The income of the people remaining constant, if their propensity to
consume rises, then out of the given income they would spend a greater part of it with the
result that the demand for goods will increase. On the other hand, if propensity to save of
the people increases, that is, if propensity to consume declines, then the consumers would
spend a smaller part of their income on goods with the result that the demand for goods
will decrease.

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  Consumers’ Expectations with regard to Future Prices: If due to some reason, consumers
expect that in the near future prices of the goods would rise, then in the present they
would demand greater quantities of the goods so that in the future they should not have to
pay higher prices. Similarly, when the consumers hope that in the future they will have
good income, then in the present they will spend greater part of their incomes with the
result that their present demand for goods will increase.
 Income Distribution: Distribution of income in a society also affects the demand for
goods. If distribution of income is more equal, then the propensity to consume of the
society as a whole will be relatively high which means greater demand for goods. On the
other hand, if distribution of income is more unequal, then propensity to consume of the
society will be relatively less, for the propensity to consume of the rich people is less than
that of the poor people.

Q3.SCOPE OF MANAGERIAL ECONOMICS

Managerial economics refers to those aspects of economic theory and application which are
directly relevant to the practice of management and the decision making process within the
enterprise. Managerial economics is a discipline that combines economic theory with managerial
practice. It helps in covering the gap between the problems of logic and the problems of policy.
The subject offers powerful tools and techniques for managerial policy making.

Managerial Economics − Definition

To quote Mansfield, “Managerial economics is concerned with the application of economic

concepts and economic analysis to the problems of formulating rational managerial decisions.

Spencer and Siegelman have defined the subject as “the integration of economic theory with
business practice for the purpose of facilitating decision making and forward planning by
management.”

SCOPE

The scope of managerial economics refers to its area of study. Managerial economics has its
roots in economic theory. The empirical nature of managerial economics makes its scope wider.
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Managerial economics provides management with strategic planning tools that can be used to get
a clear perspective of the way the business world works and what can be done to maintain
profitability in an ever changing environment.

It enables the business executive to assume and analyse things. Every firm tries to get
satisfactory profit even though economics emphasises maximizing of profit. Hence, it becomes
necessary to redesign economic ideas to the practical world. This function is being done by
managerial economics.

All the economic theories, tools, and concepts are covered under the scope of managerial
economics to analyze the business environment. The scope of managerial economics is a
continual process, as it is a developing science. Demand analysis and forecasting, profit
management, and capital management are also considered under the scope of managerial
economics.

1. Demand Analysis and Forecasting:

A business firm is an economic unit which transforms productive resources into saleable goods.
Since all output is meant to be sold, accurate estimates of demand help a firm in minimizing its
costs of production and storage.

A firm must decide its total output before preparing its production schedule and deciding on the
resources to be employed. Demand forecasts serves as a guide to the management for
maintaining its market share in competition with its rivals, thereby securing its profit. Thus,
demand analysis facilitates the identification of the various factors affecting the demand for a
firm’s product. This, in turn helps the firm in manipulating the demand for its output.

In fact, demand forecasts are the starting point for a firm’s planning and decision-making. This
deals with the basic tools of demand analysis i.e.; Demand Determinants, Demand Distinctions
and Demand Forecasting, etc.

2. Cost and Production Analysis:

A firm’s profitability depends much on its costs of production. A wise manager would prepare
cost estimates of a range of output, identify the factors causing variations in costs and choose the

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cost-minimising output level, taking also into consideration the degree of uncertainty in
production and cost calculations. Production processes are under the charge of engineers but the
business manager works to carry out the production function analysis in order to avoid wastages
of materials and time. Sound pricing policies depend much on cost control.

The main topics discussed under cost and production analysis are:Cost concepts, cost-output
relationships, Economies and Diseconomies of scale and cost control.

3. Pricing Decisions, Policies and Practices:

Another task before a business manager is the pricing of a product. Since a firm’s income and
profit depend mainly on the price decision, the pricing policies and all such decisions are to be
taken after careful analysis of the nature of the market in which the firm operates. The important
topics covered in this field of study are: Market Structure Analysis, Pricing Practices and Price
Forecasting.

4. Profit Management:

Success of a firm depends on its primary measure and that is profit. Firms are operated to earn
long term profit which is generally the reward for risk taking. Appropriate planning and
measuring profit is the most important and challenging area of managerial economics.

Each and every business firms are tended for earning profit; it is profit which provides the chief
measure of success of a firm in the long period. Economists tell us that profits are the reward for
uncertainty bearing and risk taking. A successful business manager is one who can form more or
less correct estimates of costs and revenues at different levels of output. The more successful a
manager is in reducing uncertainty, the higher are the profits earned by him. It is therefore,
profit-planning and profit measurement that constitutes the most challenging area of business
economics. The important aspects covered under this area are: nature and measurement of profit,
profit policies, and techniques of profit planning like break-even analysis, cost-volume-profit
analysis, etc.

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5. Capital Management:

Still another most challenging problem for a modern business manager is of planning capital
investment. Investments are made in the plant and machinery and buildings which are very high.
Therefore, capital management requires top-level decisions. It means capital management i.e.,
planning and control of capital expenditure. It deals with Cost of capital, Rate of Return and
Selection of projects. Capital management implies planning and control of capital expenditure
because it involves a large sum and moreover the problems in disposing the capital assets of arc
so complex that they require considerable time and labour. Capital management involves
planning and controlling of expenses.

The demand for managerial economics has increased post liberalization and globalization period
primarily because of increasing use of economic logic, concepts, tools and theories in the
decision making process of large multinationals.

6.Competition

Study of markets is one of the important aspects of the work of a managerial economist. A
manager should have clear knowledge of different markets existing in the environment. The
environment is not constant and goes on changing. Thus, the manager should know clearly about
perfect and imperfect markets so as to introduce the product in such markets where he can
increase the sales revenue. The main aspects are perfect market, monopoly market, monopolistic
market, oligopoly market, and price fixation under different market conditions.

6. Analysis of business environment:

The environmental factors influence the working and performance of a business undertaking.
Therefore, the managers will have to consider the environmental factors in the process of
decision-making. Decisions taken in isolation of environmental factors would prove harmful to
the firm. Therefore, the management must be fully aware of economic environment, particularly
those economic factors which constitute the business climate. Also the main factors that affect
the business climate are : general trend in national income and consumption expenditure, general
price trends, trading relations with other countries, trends in world market, economic and
business policies of the government, industrial relations etc. Analysis of monetary policy, fiscal

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policy, industrial policy, foreign trade policy and other direct controls also help in forecasting
business climate. Therefore, macro- economic theory and government policies arc also included
in the scope of managerial economics.

Q4.CONSUMER SURPLUS

A clear understanding of the concept helps to take business decisions associated with value
pricing, price-output setting and price discrimination under the umbrella of marketing strategies.

MEANING

The excess of, which a customer wants to pay for a product/service, over what she pays
constitutes consumer surplus. It means, it’s the difference between two price levels; the buyer’s
willingness to pay and the market price. A few critical definitions are given below:

“Consumer surplus is defined as the difference between the consumers' willingness to pay for a
commodity and the actual price paid by them” – Economic Times

“A consumer surplus occurs when the consumer is willing to pay more for a given product than
the current market price” – Investopedia

“It is the amount above the actual price of a commodity a purchaser would pay in order not to go
without the commodity” – Merriam Webster

Consumer surplus is the difference between the maximum price a consumer is willing to pay and
the actual price they do pay. If a consumer would be willing to pay more than the current asking
price, then they are getting more benefit from the purchased product than they spent to buy it.
Consumer surplus plus producer surplus equals the total economic surplus in the market .

DIAGRAMATIC REPRESENTATION

It is is a triangular area in the diagram, bordered by the demand curve, the price axis, and the
price level as shown in the figure:

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Generally, the lower the price, the greater the consumer surplus.

“Willingness to pay” is the maximum amount that a buyer is ready to pay for a product/service.

Suppose you are an electronic gadgets manufacturer, you charge $30 for each headphone you
manufacture, while a customer is willing to pay $40 for it. The customer gets $10 as consumer-
surplus!

Naturally, he likes it and values the headphone, more than the price you charge! He perceives,
your product is worthy enough to spend $40 for it. The consumer always like to buy the
products/services if they think, they are getting a good deal on them and consumer-surplus is
merely an economic measure of this satisfaction or welfare. Consumer surplus is quite related to
the demand curve for a product/service.

Another way to define consumer surplus in less quantitative terms is as a measure of a

consumer’s well-being. Some goods, like water, are valuable to everyone because it is a
necessity for survival. But the utility, or “usefulness,” of most goods vary depending on a
person’s individual preferences. Since the utility a person gets from a good defines her demand
for it, utility also defines the consumer surplus an individual might get from purchasing that
item. If a person has no use for a good, there is no consumer’s surplus for that person in
purchasing the good no matter the price. However, if a person finds a good incredibly useful,
consumer surplus will be significant even if the price is high. An individual’s customer surplus
for a product is based on the individual’s utility of that product.

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The Basics of a Consumer Surplus
The concept of consumer surplus was developed in 1844 to measure the social benefits of public
goods such as national highways, canals, and bridges. It has been an important tool in the field
of welfare economics and the formulation of tax policies by governments.

Consumer surplus is based on the economic theory of marginal utility, which is the additional
satisfaction a consumer gains from one more unit of a good or service. The utility a good or
service provides varies from individual to individual based on their personal preference.
Typically, the more of a good or service that consumers have, the less they're willing to spend for
more of it, due to the diminishing marginal utility or additional benefit they receive.

Distribution of benefits when price falls

When supply of a good expands, the price falls (assuming the demand curve is downward
sloping) and consumer surplus increases. This benefits two groups of people: consumers who
were already willing to buy at the initial price benefit from a price reduction, and they may buy
more and receive even more consumer surplus; and additional consumers who were unwilling to
buy at the initial price will buy at the new price and also receive some consumer surplus.

Measuring Consumer Surplus With a Demand Curve

The demand curve is a graphic representation used to calculate consumer surplus. It shows the
relationship between the price of a product and the quantity of the product demanded at that
price, with price drawn on the y-axis of the graph and quantity demanded, drawn on the x-axis.
Because of the law of diminishing marginal utility, the demand curve is downward sloping.

Consumer surplus is measured as the area below the downward-sloping demand curve, or the
amount a consumer is willing to spend for given quantities of a good, and above the actual
market price of the good, depicted with a horizontal line drawn between the y-axis and demand
curve.

Consumer surplus can be calculated on either an individual or aggregate basis, depending on if

the demand curve is individual or aggregated. Consumer surplus always increases as the price of
a good falls and decreases as the price of a good rises.

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For example, suppose consumers are willing to pay $50 for the first unit of product A and $20
for the 50th unit. If 50 of the units are sold at $20 each, then 49 of the units were sold at a
consumer surplus, assuming the demand curve is constant.

Q5.Circular Flow of National Income in a Two Sector Economy or Circular

Flow Model:

Definition of Circular Flow Model:

A simple circular flow model of the macro economics containing two sectors (business and
household) and two markets (product and factor) that illustrates the continuous movement of the
payments for goods and services between producers and consumers. The payment flow between
the two sectors and two markets is conveniently divided into four segments representing
consumption expenditures, gross domestic product, factor payments, and national income. The
state of equilibrium in the two-sector economy is defined as a situation in which no change
occurs in the levels of income (Y), expenditure (E), and output (O).

i.e. Y=E=O

The modern economy is a monetary economy. In the modern economy, money is used as a
medium of exchange. While analyzing the circular flow of income in a two sector model of the
economy, we assume:

Assumptions of Circular Flow Model:

(i) There are only two sectors in the economy, household sector and business sector.

(ii) The business sector (or the firms) hires factors of production owned by the household sector
and it is the sole producer of goods and services in the economy.

(iii) The household sector (or the households) is the sole buyer of goods and services. It spends
its entire income on the goods and services produced by the business sector. They are also
suppliers of labor and various of other factors of production.

(iv) The business sector sells the entire output to households. It does not store. There are,
therefore, no inventories.

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(v) There are no savings and investment in the economy.

(vi) The household sector receives income by selling or renting the factors of production owned
by it.

(vii) Government does, not exist for all such practical purposes (No public expenditures, no
taxes, no subsidies, no social insurance contribution, etc.).

(viii) The economy is closed one having no international trade relations.

In this hypothetical economy stated above, we explain the circular flow of economic life.

Principles of Circular Flow of National Income:

In the simple circular flow of income and product, there are two principles which are involved.

First: In the business transactions, the sellers of goods receive exactly the same amount which
the buyers spend on them.

Second: The goods and services flow in one direction and money payment flow in the other
direction.

Explanation of Circular Flow of National Income:

In a two sector economy, there are business firms which produce goods and services. The other
sector is households which supplies their factors services to the firms and also buy goods and
services produced by them. The households supply the economic resources to the firms and
receive payments in terms of money. There is, thus, a flow of money corresponding to the flow
of economic resources. These money incomes are spent by households on goods and services
produced by the firms. With this the money comes back to the firms. This circular flow of
income in fact is the mutual dependence of the two sectors of modern economy.

Diagram of Circular Flow of Income:

The circular flow of income in a two sector economy is explained with the help of figure 23.1.

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In this figure, it is shown that the economy consists of two sectors (1) households and business.
In the upper top of this figure, the resources such as land, capital, labor and entrepreneurial
ability flow from households to business firms as indicated by the arrow mark. In opposite
direction to this, money flows from business firms to the households as factors payments such as
rent, wages, interest and profit.

In the lower pipe line, money flows from households to firms as consumption expenditure made
by the households on the goods and services produced by the firms. The flow of goods and
services is in opposite direction from business firms to households. We, thus, find that money
flows from business firms to households as factor payments and then it flows back from
households to firms. Thus there is in fact a circular flow of income. This circular flow of money
or income continues year after year. This is how the economy functions.

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5.MONOPOLY AND ITS CHARACTERISTICS

A monopoly is an economic market structure where a specific person or enterprise is the only
supplier of a particular good.

A monopoly is a specific type of economic market structure. A monopoly exists when a specific
person or enterprise is the only supplier of a particular good. As a result, monopolies are
characterized by a lack of competition within the market producing a good or service.

The word monopoly has been derived from the combination of two words i.e., ‘Mono’ and
‘Poly’. Mono refers to a single and poly to control.

In this way, monopoly refers to a market situation in which there is only one seller of a
commodity.

Definitions:

“Pure monopoly is represented by a market situation in which there is a single seller of a product
for which there are no substitutes; this single seller is unaffected by and does not affect the prices
and outputs of other products sold in the economy.” Bilas

“Monopoly is a market situation in which there is a single seller. There are no close substitutes of
the commodity it produces, there are barriers to entry”. -Koutsoyiannis

Characteristics of a Monopoly

A monopoly can be recognized by certain characteristics that set it aside from the other market
structures:

Profit maximizer: A monopoly maximizes profits. Due to the lack of competition a firm can
charge a set price above what would be charged in a competitive market, thereby maximizing its
revenue.

High barriers to entry: In a monopoly market, factors like government license, ownership of
resources, copyright and patent and high starting cost make an entity a single seller of goods. All
these factors restrict the entry of other sellers in the market. Monopolies also possess some
information that is not known to other sellers.

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Single seller: in a monopoly one seller produces all of the output for a good or service. The
entire market is served by a single firm. For practical purposes the firm is the same as the
industry.

Price discrimination: in a monopoly the firm can change the price and quantity of the good or
service. In an elastic market the firm will sell a high quantity of the good if the price is less. If
the price is high, the firm will sell a reduced quantity in an elastic market.

No Close Substitutes: There shall not be any close substitutes for the product sold by the
monopolist. The cross elasticity of demand between the product of the monopolist and others
must be negligible or zero.

Price Maker: Under monopoly, monopolist has full control over the supply of the commodity.
But due to large number of buyers, demand of any one buyer constitutes an infinitely small part
of the total demand. Therefore, buyers have to pay the price fixed by the monopolist.

ABNORMAL PROFITS UNDER MONOPOLY

 Supernormal profit is all the excess profit a firm makes above the minimum return
necessary to keep a firm in business.
 Supernormal profit is calculated by Total Revenue – Total Costs (where total cost
includes all fixed and variable costs, plus minimum income necessary for the owner to be
happy in that business.).It is a condition where AR>AC.
 Supernormal profit is defined as extra profit above that level of normal profit.

Supernormal profit is also known as abnormal profit. Abnormal profit means there is an
incentive for other firms to enter the industry. However, most markets don’t have these features
of perfect information and freedom of entry and exit. Most markets have a degree of barriers to
entry and exit. There are sunk costs which deter entry. Therefore, even if firms are making
supernormal profit, new firms may not be able to enter and compete.

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NORMAL PROFIT

Normal profit is defined as the minimum level of profit necessary to keep a firm in that line of
business. This level of normal profit enables the firm to pay a reasonable salary to its workers
and managers. The definition of normal profit occurs when AR=ATC (average revenue =
average total cost)

Short-run Equilibrium in Monopoly

 In the short-run, a monopolist firm cannot vary all its factors of production as its cost curves
are similar to a firm operating in perfect competition. Also, in the short-run, a monopolist
might incur losses but will shut down only if the losses exceed its fixed costs. Further, if the
demand for his product is high, then the monopolist can also make super-normal profits.
 In the short period, the monopolist behaves like any other firm. A monopolist will
maximize profit or minimize losses by producing that output for which marginal cost
(MC) equals marginal revenue (MR). Whether a profit or loss is made or not depends
upon the relation between price and average total cost (ATC). It may be made clear here
that a monopolist does not necessarily makes profit. He may earn super profit or normal
profit or even produce at a loss in the short ran.

Conditions for the Equilibrium of a Monopoly Firm:

There are two basic conditions for the equilibrium of the monopoly firm.

 First Order Condition: MC = MR.

 Second Order Condition: MC curve cuts MR curve from below.

Normal Profits

A firm earns normal profits when the average cost of production is equal to the average revenue for
the corresponding output.

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In the figure above, you can see that the MC curve cuts the MR curve at the equilibrium point E.
Also, the AC curve touches the AR curve at a point corresponding to the same point. Therefore, the
firm earns normal profits.

Super-normal Profits

A firm earns super-normal profits when the average cost of production is less than the average
revenue for the corresponding output.

In the figure above, you can see that the price per unit = OP = QA. Also, the cost per unit = OP’.
Therefore, the firm is earning more and incurring a lesser cost. In this case, the per unit profit is

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OP – OP’ = PP’.Also, the total profit earned by the monopolist is PP’BA.

Losses

A firm earns losses when the average cost of production is higher than the average revenue for the
corresponding output.

In the figure above, you can see that the average cost curve lies above the average revenue curve for
the same quantity. The average revenue = OP and the average cost = OP’. Therefore, the firm is
incurring an average loss of PP’ and the total loss is PP’BA. In the short-run, a monopolist
sometimes sets a lower price and incurs losses to keep new firms away.

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A Firm’s Long-run Equilibrium in Monopoly

In the long-run, a monopolist can vary all the inputs. Therefore, to determine the equilibrium of the
firm, we need only two cost curves – the AC and the MC. Further, since the monopolist exits
the market if he is operating at a loss, the demand curve must be tangent to the AC curve or lie to
the right and intersect it twice.

As you can see above, there are two alternative cases for the determination of Equilibrium in
Monopoly:

 With normal profits

 With super-normal profits

We have not taken the loss scenario here because if the monopolist incurs losses in the long-run, he
will stop operating.

Case 1

The demand curve AR1 is tangent to AC or LAC at point E. Remember, if the demand curve lies to
the left of the AC curve, then the monopolist is unable to recover his costs and closes down.

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However, if the AR curve is tangent to the AC curve, then the monopolist can recover his costs and
stay in the market.

Further, note that the perpendicular drawn from point E to the X-axis, the MC curve, and the MR
curve are concurrent at point A.

Therefore, all the conditions of equilibrium are satisfied. The monopolist produces OM quantity and
sells it at a price of EM per unit which covers its average costs + normal profits.

Case 2

The marginal revenue curve MR2 cuts the MC curve from below at point B. The corresponding
height of the AR2 curve is E’M1.

Hence, the monopolist produces OM1 quantity and sells it at E’M1 per unit to earn an extra profit of
E’B per unit. Being a monopoly, this extra profit is not lost to competition or newer firms entering
the industry.

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