What is Inflation?

Inflation can be defined as the persistent increase in the price level of goods and services in
an economy over a period of time.
If the rise in prices exceeds the rise in output, the situation is called inflationary situation.
Inflation can take place due to various reasons. One of the major reason is a rapid increase in
money supply which leads to a decrease in interest rate.

Inflation Definition
Some of the important inflation definitions are:
Inflation is a rise in the general level of prices. Samuleson Nordhaus
Inflation can be defined as, “too much money chasing too few goods. Coulborn
Inflation is an upward movement in the average level of prices. Its opposite is deflation, a downward movement
in the average level of prices. The boundary between inflation and deflation is price stability. Parkin and Bade
The word inflation in the broadest possible sense refers to any increase in the general price-level which is
sustained and non-seasonal in character.Peterson
inflation is an increase in the quantity of money faster than real national output is expanding .Johnson

Inflation Causes
So what exactly causes inflation in an economy? 

Causes of inflation are:
1. Demand Pull Inflation
2. Cost Push Inflation
3. Built In Inflation
Inflation Causes

Demand Pull Inflation

 Arises when aggregate demand in an economy outpaces aggregate supply.

 It involves inflation rising as real gross domestic product rises and unemployment falls. This is
commonly described as “too much money chasing too few goods”.

 Possible causes of demand pull inflation:

 Excessive investment expenditures
 Excessive growth of consumption expenditures
 Low-cost loans
 Tax cutting
 Augmentation of government expenditures

Cost Push Inflation

 is a type of inflation caused by large increases in the cost of important goods or services where no
suitable alternative is available.
 Possible causes of cost-push inflation:
 Imperfect competition
 Increased taxes
 Rising wages
 Political incidents (like oil crises)

Built In Inflation
 Induced by adaptive expectations, often linked to the “price/wage spiral

 It involves workers trying to keep their wages up with prices and then employers passing higher costs
on to consumers as higher prices as part of a “vicious circle.

 Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

Characteristics of Inflation
Inflation is desirable in a country at moderate levels. However, there is no universally
acceptable limit of inflation. Depending on the contribution, a country decides the acceptable
limit of inflation.

Characteristics of Inflation are:

 Inflation is followed by the price rise.

 The cause behind inflation is increase in the money supply. Thus, it is a monetary phenomenon.
 Due to interaction among various economic forces, inflation is also an economic phenomenon.
 Inflation occurs in a dynamic environment over a period of time.
 Inflation is always scarcity oriented and occurs in a disequilibrium state of economy.
 The rise in prices in inflation cannot be reversed.
 Inflation is persistent in nature. Generally, inflation is categorised on the basis of its rate.

Types of inflation
Let us discuss these three types of inflation in detail.
3 Types of inflation are:
1. Moderate inflation
2. Galloping inflation
3. Hyperinflation

Types of inflation

Moderate Inflation
Moderate Inflation is a type of inflation that takes place when there is a rise in the prices of
goods and services at a single rate annually. Moderate inflation is also known as creeping
inflation.
At the time of moderate inflation in an economy, the prices of goods and services increase
only at a moderate rate. However, the rate of increase in prices differs in different countries.
It is easy to anticipate moderate inflation; therefore, individuals hold money as a store of
value.

Galloping Inflation
Galloping Inflation is a type of inflation that takes place at the time of the rise in the prices of
goods and services at a two-digit or three-digit rate per annum. Another name for galloping
inflation is as jumping inflation.
In the words of Baumol and Blinder, “Galloping inflation refers to inflation that proceeds at
an exceptionally high.”

The worst sufferers of galloping information are middle and lower class individuals. Due to
this, people are unable to save money for the future. This kind of situation requires strict
measures to control inflation.

Hyperinflation
Hyperinflation is a type of inflation that takes place when the rate of increase in prices is
extremely high or out of control. In other words, hyperinflation occurs when the increase in
prices is more than a three-digit rate annually.
The cause behind hyperinflation is the unrestricted increase in the supply of money in the
market. This results in a situation of imbalance in the supply and demand for money.
Consequently, money loses its real worth at a rapid speed.

Effects of Inflation
1. Redistribution effect of inflation
2. Social impact of inflation
3. Impact on economy balance
Redistribution effect of inflation
 Inflation affects recipients of fixed income firstly (nominal incomes remain same but the real value of
income drop)
 Inflation affects the purchasing power of wages that don’t follow the rise of prices
 Inflation causes diminishing value of loans and savings
Social impact of inflation
 Socially poor persons suffer from inflation more then rich
Impact on economy balance
 Fall of real product bellow potential product
 Changes in the structure of consumption (consumers are buying cheaper goods)
 In case of fixed currency exchange rate higher exports are incited
 Inflation deforms prices
 Inflation causes higher costs and makes the economy less efficient
 Creeping and anticipated inflation has a positive effect on the economy and stimulates economic growth
 High inflation and not anticipated inflation are serious problems in the economy.
Business Cycle

What is the Business Cycle?

Business Cycle, also known as the economic cycle or trade cycle, is the fluctuations in economic activities or
rise and fall movement of gross domestic product (GDP) around its long-term growth trend.
No era can stay forever. The economy too does not enjoy same periods all the time. Due to its dynamic nature,
it moves through various phases.

The change in business activities due to fluctuations in economic activities over a period of time is known as
a business cycle. Business cycle are also called trade cycle or economic cycle. Business Cycle can also help
you make better financial decisions. 
The economic activities of a country include total output, income level, prices of products and services,
employment, and rate of consumption. All these activities are interrelated; if one activity changes, the rest of
them also change.

Business Cycle Definition

Business cycle are a type of fluctuation found in the aggregate economic activity of nations that organize their work
mainly in business enterprises: a cycle consists of expansions occurring at about the same time in many economic
activities, followed by similarly general recessions, contractions, and revivals which merge into the expansion phase of
the next cycle; in duration, business cycle vary from more than one year to ten or twelve years; they are not divisible into
shorter cycle of similar characteristics with amplitudes approximating their own.Arthur F. Burns & Wesley C. Mitchel

Phases of Business Cycle

4 Phases of Business Cycle are:
1. Expansion
2. Peak
3. Contraction
4. Trough
 Business
Cycle

Let us discuss 4 phases of business cycle in detail:

Expansion
Expansion is the first phase of a business cycle. It is often referred to as the growth phase.

In the expansion phase, there is an increase in various economic factors, such as production, employment,
output, wages, profits, demand and supply of products, and sales. During this phase, the focus of Organizations
remains on increasing the demand for their products/services in the market.

The expansion phase is characterised by:

 Increase in demand
 Growth in income
 Rise in competition
 Rise in advertising
 Creation of new policies
 Development of brand loyalty
In this phase, debtors are generally in a good financial condition to repay their debts; therefore, creditors lend
money at higher interest rates. This leads to an increase in the flow of money.

In the expansion phase, due to increase in investment opportunities, idle funds of Organizations or individuals
are utilised for various investment purposes. The expansion phase continues till economic conditions are
favourable.

Peak
Peak is the next phase after expansion. In this phase, a business reaches at the highest level and the profits are
stable. Moreover, Organizations make plans for further expansion.

Peak phase is marked by the following features:

 High demand and supply

 High revenue and market share
 Reduced advertising
 Strong brand image
In the peak phase, the economic factors, such as production, profit, sales, and employment, are higher but do
not increase further.

Contraction
An organization after being at the peak for a period of time begins to decline and enters the phase of
contraction. This phase is also known as a recession.
An organization can be in this phase due to various reasons, such as a change in government policies, rise in the
level of competition, unfavorable economic conditions, and labour problems. Due to these problems, the
organization begins to experience a loss of market share.

The important features of the contraction phase are:

 Reduced demand
 Loss in sales and revenue
 Reduced market share
 Increased competition


Trough
In Trough phase, an organization suffers heavy losses and falls at the lowest point. At this stage, both profits
and demand reduce. The organization also loses its competitive position.

The main features of this phase are:

 Lowest income
 Loss of customers
 Adoption of measures for cost-cutting and reduction
 Heavy fall in market share
In this phase, the growth rate of an economy becomes negative. In addition, in trough phase, there is a rapid
decline in national income and expenditure.

After studying the business cycle, it is important to study the nature of business cycle.
Nature of Business Cycle
The nature of business cycle helps the Organization to be prepared for facing uncertainties of the business
environment.

Nature of Business Cycle

Let us discuss the nature of business cycle in detail.

Cyclical nature
This is the periodic nature of a business cycle. Periodicity signifies the occurrence of business cycle at regular
intervals of time. However, periods of intervals are different for different business cycle. There is a general
consensus that a normal business cycle can take 7 to 10 years to complete.
General nature
The general nature of a business cycle states that any change in an Organization affects all other Organizations
too in the industry. Thus, general nature regards the business world as a single economic unit.
For example, depression moves from one Organization to the other and spread throughout the industry. The
general nature is also known as synchronism.

Types of Business Cycle

Following the writings of Prof .James Arthur and Schumpeter, we can classify business cycle into three types
based on the underlying time period of existence of the cycle as follows:
1. Short Kitchin Cycle (very short or minor period of the cycle, approximately 40 months duration)

2. Longer Juglar cycle (major cycles, composed of three minor cycles and of the duration of 10 years or so)

3. Very long Kondratief Wave (very long waves of cycle, made up of six major cycles and takes more than 60
years to run its course of duration)

Business Cycle Theory

A business cycle is a complex phenomenon which is common to every economic system. Several theories of
business cycle have been propounded from time to time to explain the causes of business cycle.
Business Cycle Theory are:
1. Hawtrey Monetary Theory
2. Innovation Theory
3. Keynesian theory
4. Hicks Theory
5. Samuelson theory

Business Cycle Theory

Hawtrey Monetary Theory

Hawtray was of opinion that in depression monetary factors play a critical role. The main factor affecting the
flow of money and money supply is the credit position by the bank. He made the classical quantity theory of
money as the basis of his trade cycle theory.
According to him, both monetary and non-monetary factors also affect trade. His theory is basically the product
of the supply of money and expansion of credit. This expansion of credit and other money supply instrument
create a cumulative process of expansion which in return increase aggregate demand.

According to this theory the only cause of fluctuations in business is due to instability of bank credit. So it can
be concluded that Hawtray’s theory of business cycle is basically depend upon the money supply, bank credits
and rate of interests.

Criticism of this Business Cycle theory

 Hawtray neglected the role of non-monetary factors like prosperous agriculture, inventions, rate of profit and
stock of capital.
 It only concentrates on the supply of money.
 Increase in interest rates is not only due to economic prosperity but also due to other factors.
 Over-emphasis on the role of wholesalers.
 Too much confidence in monetary policy. vi. Neglect the role of expectations. vii. Incomplete theory of trade
cycles.

Innovation Theory
The innovation theory of business cycle is invented by an American Economist Joseph Schumpeter. According
to this theory, the main causes of business cycle are over-innovations.
He takes the meaning of innovation as the introduction and application of such techniques which can help in
increasing production by exploiting the existing resources, not by discoveries or inventions. Innovations are
always inspired by profits. Whenever innovations are introduced it results into profitability then shared by other
producers and result in a decline in profitability.

Criticism of this Business Cycle theory

 Innovation fails to explain the period of boom and depression.

 Innovation may be major factor of investment and economic activities but not the complete process of trade
cycle.

 This theory is based on the assumption that every new innovation is financed by the banks and other credit
institutions but this cannot be taken as granted because banks finance only short term loans and investments.

Keynesian Theory
The theory suggests that fluctuations in business cycle can be explained by the perceptions on expected rate of
profit of the investors. In other words, the downswing in business cycle is caused by the collapse in the
marginal efficiency of capital, while revival of the economy is attributed to the optimistic perceptions on the
expected rate of profit.
Moreover, Keynesian multiplier theory establishes linkages between change in investment and change in
income and employment. However, the theory fails to explain the cumulative character both in the upswing and
downswing phases of business cycle and cyclical fluctuations in economic activity with the passage of time.

Hicks Theory
Hicks extended the earlier multiplier-accelerator interaction theory by considering real world situation. In
reality, income and output do not tend to explode; rather they are located at a range specified by the upper
ceiling and lower floor determined by the autonomous investment.

In the theory, it is assumed that autonomous investment tends to grow at a constant percentage rate over the
long run, the acceleration co-efficient and multiplier co-efficient remain constant throughout the different
phases of the trade cycle, saving and investment co-efficient are such that upward movements take away from
equilibrium.

The actual output fails to adjust with the equilibrium growth path overtime. In fact it has a tendency to run
above it and then below it, and thereby, constitute cyclical fluctuations overtime. This basic intuition can be
shown with the help of the following figure.

Criticism of this Business Cycle theory

 Wrong assumption of constant multiplier and acceleration co-efficient.
 Highly mechanical and mathematical device.
 Wrong assumption of no-excess capacity.
 Full-employment ceiling is not independent
Samuelson theory
According to this theory process of multiplier starts working when autonomous investment takes place in the
economy. With the autonomous investment income of the people rises and there is increase in the demand of
consumer goods. It directly affected the marginal propensity to consume.

If there is no excess production capacity in the existing industry then existing stock of capital would not be
adequate to produce consumer goods to meet the rising demand. Now in order to meet the consumer’s
requirements, producers will make new investment which is derived investment and the process of acceleration
principle comes into operation.

Then there is rise in income again which in the same manner continue the process of income propagation. So in
this way multiplier and acceleration interact and make the income grow at faster rate than expected. After
reaching its peak, income comes down to bottom and again start rising.

Autonomous investment is incurred by the government with the objective of social welfare. It is also called
public investment. The autonomous investment is the investment which is done for the sake of new inventions
in techniques of production.
Derived investment is the investment undertaken in capital equipment which is induced by increase in
consumption.

Criticism of this Business Cycle theory

 This model only concentrates on the impact of the multiplier and acceleration and it ignored the role of
producer’s expectations, changing business requirements and consumers preferences etc.

 It is not practically possible to compute the fact of multiplier and acceleration principle.

 It has wrong assumption of constant capital output ratio.

What is Business Economics?

Business Economics is playing an important role in our daily economic life and business practices. Organizations face
many problems on a day to day basis. For example, Organizations are always concerned with producing maximum output
in the most economical way.

To solve problems of such nature, managers are required to apply various economic concepts and theories. The
application of economic concepts, theories, and tools in business decision making is called business economics
or managerial economics.

What is Business Economics?

Business Economics is the integration of economic theory with business practice for the purpose of facilitating
decision making and forward planning by management
Business Economics, also referred to as Managerial Economics, generally refers to the integration of
economic theory with business practice.
While the theories of Economics provide the tools, which explain various concepts such as demand, supply,
costs, price, competition etc., Business Economics applies these tools in the process of business decision
making.

Business Economics Definition

Definition of economics by different economists have a different point of view, but the essence is the same.
The following are some popular definition of business economics.
Managerial economics is concerned with the application of economic concepts and economics to the problems of
formulating rational decision making Mansfield
Managerial economics is concerned with the application of economic principles and methodologies to the decision-
making process within the firm or organization. It seeks to establish rules and principles to facilitate the attainment of the
desired economic goals of management. Douglas
Managerial economics applies the principles and methods of economics to analyze problems faced by the management of
a business, or other types of organizations and to help find solutions that advance the best interests of such organization.
Davis and Chang

From the above-mentioned business economics definitions, it can be concluded that business economics is

a link between two disciplines, which are management and economics.
The management discipline focuses on a number of principles that aid the decision-making process of
Organizations.

On the other hand, economics is related to the optimum allocation of limited resources for attaining the set
objectives of Organizations.
Characteristics of Business Economics
Characteristics of business economics are

1. Microeconomics: Business economics is microeconomic in character. This is so because it studies the problems
of an individual business unit. It does not study the problems of the entire economy.

2. Normative science: Managerial economics is a normative science. It is concerned with what management should
do under particular circumstances. It determines the goals of the enterprise. Then it develops the ways to achieve these
goals.

3. Pragmatic: Business economics is pragmatic. It concentrates on making economic theory more application-
oriented. It tries to solve the managerial problems in their day-to-day functioning.

4. Prescriptive: Managerial economics is prescriptive rather than descriptive. It prescribes solutions to various
business problems.
5. Uses macroeconomics: Macroeconomics is also useful to business economics. Macro-economics provides an
intelligent understanding of the environment in which the business operates.

6. Management oriented: The main aim of managerial economics is to help the management in taking correct
decisions and preparing plans and policies for the future.

Scope of Business Economics

The scope of business economics is quite wide. Business economics involves the application of various
economic tools, theories, and methodologies for analyzing solving different business problems.

Two Categories

There are two categories of business issues to which economic theories can be directly applied, namely:

1. Microeconomics applied to internal or operational issues

2. Macroeconomics applied to external or environmental issues
Therefore, the scope of Business Economics may be discussed under the above two heads.

Microeconomics applied to internal issues

Operational issues include all those issues that arise within the Organization and fall within the purview and
control of the management.

The following Microeconomic theories deal with most of these issues.

 Demand analysis and forecasting: Demand analysis is a process of identifying potential consumers, the amount
of goods they want to purchase, and the price they are willing to pay for it.

This process is important for an Organization to analyse the demand for its products, and to produce accordingly and
helping Organizations in business planning and deciding on strategic issues.

 Cost and benefit analysis (CBA): By analyzing costs, management can estimate costs required for running the
Organization successfully.

Cost analysis helps firms in determining hidden and uncontrollable costs and taking measures for effective cost
control. Also, help in determine the return on investment (ROI).

 Pricing decisions, policies, and practices: Pricing is one of the key areas of business economics. It is a process
of finding the value of a product or service that an Organization receives in exchange for its product/service.

The profit of an Organization depends a great deal on its pricing strategies and policies. Business economics includes
various pricing-related concepts, such as pricing methods, product-line pricing, and price forecasting.

 Profit maximization: Profit generation and maximization is the main aim of every Organization (except for non-
profit Organizations).

In order to maximize profit, Organizations need to have complete knowledge about various economic concepts, such
as profit policies and techniques, and break-even analysis.
 Capital management: Organizations often find it difficult to make decisions related to capital investment. These
decisions require sound knowledge and expertise in various economic aspects.

To make sound capital investment decisions, an Organization needs to determine various aspects, such as the cost of
capital and rate of return.

 Risk and Uncertainty Analysis: Business rms generally operate under conditions of risk and uncertainty.

Analysis of risks and uncertainties helps the business firm in arriving at efficient decisions and in formulating plans on
the basis of past data, current information and future prediction.
Macroeconomics applied to external issues
Environmental factors have signicant influence upon the functioning and performance of the business.

The major scope of business macroeconomic factors relate to:

 The type of economic system stage of business cycle is the general trends in national income, employment,
prices, saving and investment.

 Government’s economic policies like industrial policy, competition policy, monetary and scal policy, price
policy, foreign trade policy and globalization policies.

 Working of financial sector and capital market

 Socio-economic Organizations like trade unions, producer and consumer unions and cooperatives.

 Social and political environment: Business decisions cannot be taken without considering these present and future
environmental factors.

 Business decisions cannot be taken without considering these present and future environmental factors. As the
management of the firm has no control over these factors, it should ne-tune its policies to minimize their adverse
effects

Importance of Business Economics

Business economics plays an important role in decision making in an Organization. Decision making is a
process of selecting the best course of action from the available alternatives.

The following points explain the importance of business economics:

 Business economics covers various important concepts, such as Demand and Supply analysis; Short run
cost and Long run costs; and Law of Diminishing Marginal Utility. These concepts support managers in identifying
and analyzing problems and finding solutions.

 It helps managers to identify and analyze various internal and external business factors and their impact on
the functioning of the Organization.

 Business economics helps managers in framing various policies, such as pricing policies and cost policies, on
the basis of economic study and findings.

 By studying various economic variables, such as cost production and business capital, Organizations can predict
the future.

 Business economics helps in establishing relationships between different economic factors, such as income,

profits, losses, and market structure. This helps in guiding managers in effective decision making and running the
Organization.
Difference Between Economics and Business
Economics
ECONOMICS BUSINESS ECONOMICS

Economics is a traditional subject that has prevailed from a Business economics is a modern concept and is still
long time. developing.

Economics mainly covers theoretical aspects. Business economics covers practical aspects.

In economics, the problems of individuals and societies are In Business economics, the main area of study is the
studied. problems of Organizations.

In economics, only economic factors are considered. In business economic, both economic and no-economic
factors are considered.

Both microeconomics and macroeconomics fall under the Only microeconomics falls under the scope of business
scope of economics. economics.

Economics has a wider scope and covers the economic Business economics is a part of economics and is limited
issues of nations. to the economic problems of Organizations

Summary of Business Economics

Business Economics comprises of that part of economic knowledge, logic, theories and analytical tools that are
used for rational business decision making. In brief, it is Applied Economics that fills the gap between
economic theory and business practice.

The scope of business economics is quite wide. It covers most of the practical problems a manager or a firm
faces.
It can be concluded that Business Economics is a link between two disciplines, which are management and
economics.
 The management discipline focuses on a number of principles that aid the decision-making process of
Organizations.

 On the other hand, economics is related to the optimum allocation of limited resources for attaining the set
objectives of Organizations.
Therefore, it can be said that business economics is a special discipline of economics that can be applied in
business decision making of Organizations. Also, the Importance of business Economics plays a crucial role in
decision making in an Organization.

Microeconomics vs Macroeconomics
Economics is divided into two branches, namely: microeconomics and macroeconomics.
Microeconomics deals with the economic problems of a single industry or Organization,
while macroeconomics deals with the problems of an economy as a whole.

Both of these branches contribute a major part in business analysis and decision-making
directly or indirectly.

Let us discuss two branches of economics in detail as follows:

What is Microeconomic?
Microeconomics is a branch of economics that deals with the study of the economic behaviour
of individual Organizations or consumers in an economy. Moreover, microeconomics focuses
on the supply and demand patterns and price and output determination of individual
markets.
Microeconomics lays emphasis on decisions related to the selection of resources, the amount
of output to be produced, and the price of products of an Organization. hus, it can be said that
the focus of microeconomics is always at the individual level.

Importance of Microeconomics
The importance of microeconomics is explained as follows:
 Microeconomics helps in understanding the mechanism of individual markets.
 It suggests ways for making full utilisation of resources.
 It facilitates the formation of economic models that can be further be used to understand the real
economic phenomenon.

What is Macroeconomics?
Macroeconomics is a branch of economics that mainly deals with the economic behaviour of
various units combined together.
Macroeconomics focuses on the growth of an economy as a whole by undertaking the study of
various economic aggregates, such as aggregate supply and demand, changes in employment,
gross domestic product (GDP), overall price levels, and inflation.
Importance of Microeconomics
The following points explain the importance of macroeconomics:
 Macroeconomics helps in understanding the functioning of an economic system and provides a better
view of the world’s economy

 It enables nations to formulate various economic policies.

 It helps economists in finding solutions to economic problems by providing various economic theories.

 It helps in bringing stability in prices by supporting detailed analysis of fluctuations in business

activities.

 It helps in identifying the causes of the shortage in the balance of payment and determining remedial
measures.

What is Economics?
Economics is the science that deals with production, exchange and consumption of various commodities in
economic systems. It shows how scarce resources can be used to increase wealth and human welfare. The
central focus of economics is on the scarcity of resources and choices among their alternative uses.

Economics is broadly classified into two types

1. Microeconomics is a branch of economics that studies the behavior of individual consumers and Organizations
in the market. It focuses on the demand and supply, pricing, and output of individual Organizations.

2. Macroeconomics examines the economy as a whole and deals with issues related to national income,
employment pattern, inflation, recession, and economic growth.
Managers should have a clear understanding of different economic concepts, theories, and tools. Business
economics or managerial economics is a specialized discipline of economics that undertakes a study of
various economic theories, logics, and tools used in business decision making.

Meaning of Economics
In the meaning of economics, the term ‘Economics’ owes its origin to the Greek word ‘Oikonomia’, which
can be divided into two parts: oikos means home and nomos means management.

Thus, in earlier times, economics was referred to as home management where the head of a family managed the
needs of family members from his limited income.

Till the 19th century, Economics was known as ‘Political Economy.’ The book named ‘An Inquiry into the
Nature and Causes of the Wealth of Nations’ (1776) usually abbreviated as ‘The Wealth of Nations’, by
Adam Smith is considered as the first modern work of Economics.
Economics Definition
Defining economics has always been a controversial issue since time immemorial. Definition of economics by
different economists have different viewpoints. Some economists had a viewpoint that economics deals with
problems, such as inflation and unemployment while others believed that economics is a study of money,
Therefore, a simple definition of economics is defined by taking four definition

Wealth Definition of Economics

This is a classical definition of economics by Adam Smith, who is also considered as the father of modern
economics.
Economics is the study of the nature and causes of nations’ wealth or simply as the study of wealth.

Adam Smith

Key Features of Wealth economics definition

1. The main objective of Economics is to gain maximum wealth as possible
2. The core of economic activity: are production, distribution and consumption.
3. It deals with the causes of the creation of wealth in an economy.
4. The term ‘wealth’ used in this definition referred to material wealth.

Welfare Definition of Economics

It is a neo-classical definition of economics by Alfred Marshall.
It is the study of mankind in the ordinary business of life. It enquires how he gets his income and how he uses
it. In one view, it is a study of wealth and on other hand it is part of study of man.

Alfred Marshall

Key features of Welfare economics definition

1. It defines Economics as the study of activities related to a human being and their material welfare.
2. Marshall clarified that Economics is related to incomes of individuals and its uses for creating material welfare.
3. Collectively incomes of a group of individuals form the wealth of a nation and ultimate goal is to increase welfare
of individual by their routine activities.
Scarcity Definition of Economics
It is a pre-Keynesian definition of economics by robbins in his book ‘Essays on the Nature and Significance
of the Economic Science’ (1932).
Economics is a science which studies human behaviour as a relationship between ends and scarce means
which have alternative uses.

Lionel Charles Robbins

Key features of Scarcity economics definition

1. It recognized that Economics is a science deal with the economic behaviours of a human being.
2. It also focuses on optimum utilisation of scarce resources.
3. It provides three basic features of human existence, which are unlimited wants, limited resources, and alternative
uses of limited resources
4. There is a need for efficient use of scarce resources, and the primary objective of Economics is to ensure
efficiency in the use of resources with a purpose to satisfy human wants.
Growth Definition of Economics
This is the modern perspective definition of economics by Samuelson. He provided the growth-oriented
definition of economics.
Economics is the study of how man and society choose with or without the use of money to employ the scarce
productive resources, which have alternative uses, to produce various commodities over time and distributing
them for consumption, how or in the future among various person or groups in society.

Paul Samuelson

Key features of Growth economics definition

1. It deals with the allocation of scarce resource to be used in productive purposes.
2. The selection of the most efficient use of the resources from alternative ways.
3. The growth of economies will depend upon the consumption and production in the economy.
4. This definition also points towards Economics as a study of an economic system.
Economics have different definition of economics by different economists and social thinkers with different
objectives and contexts. All these definitions are correct and none can be taken as universally acceptable.

Scope of economics
The scope of economics has been broadened to many and some area are mentioned below:
 Microeconomics
 Macroeconomics
 International arena
 Public finance
 Welfare
 Health
 Environmental studies
 Urban and rural development
Scope of economics

Nature of Economics
There are a number of controversial issues related to its nature. Let us now understand the true nature of
economics.
Nature of Economics
 Economics as a Science
 Economics as an Art
 Economics as a social science

Assumptions in Economics
There are certain assumptions in economics about an economic situation to happen in the future. Economists
use assumptions to break down complex economic processes and advocate different theories to understand
economic variables.
Three important assumptions in economics, are as follows:
 Consumers have rational preferences: This assumption states that consumers act in a rational manner and focus
on satisfying their needs.

It is also assumed that the tastes of consumers remain constant for a long period. For instance, a consumer who is
 vegetarian may not change his/her preferences in the near future.

 Existence of perfect competition: According to this assumption, there is perfect competition in an economy,
wherein there are numerous buyers and sellers.

It is assumed that homogenous products exist in the market and both buyers and sellers cannot affect prices.

 Existence of equilibrium: As per this assumption, equilibrium exists wherein both consumers and entrepreneurs
achieve maximum satisfaction.

In a market, there can be two types of equilibrium: industry equilibrium and firm’s equilibrium. An industry is at
equilibrium if profits achieved are normal. On the other hand, a firm is at the state of equilibrium if its profits are
maximum.

Difference Between Economics and Business

Economics
ECONOMICS BUSINESS ECONOMICS

Economics is a traditional subject that has prevailed from a Business economics is a modern concept and is still
long time. developing.

Economics mainly covers theoretical aspects. Business economics covers practical aspects.

In economics, the problems of individuals and societies are In Business economics, the main area of study is the
studied. problems of Organizations.

In economics, only economic factors are considered. In business economic, both economic and no-economic
factors are considered.

Both microeconomics and macroeconomics fall under the Only microeconomics falls under the scope of business
scope of economics. economics.

Economics has a wider scope and covers the economic Business economics is a part of economics and is limited
issues of nations. to the economic problems of Organizations
Nature of Economics
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Nature of economics is broadly categories into 3 types: Economics as a science, Economics as an

art and Economics as a social science.

Nature of Economics
Similar to the economics definition, there are a number of controversial issues related to its nature of
economics. Some economists consider economics as a science, or economics as a social science while others
have a believe economics as an art.
1. Economics as a Science
2. Economics as an Art
3. Economics as a social science

Nature of Economics

Economics as a Science
A subject is considered science if:

 It is a study of the relationship between cause and effect.

 It is capable of measurable and based on facts.
 It has its own methodological apparatus.
 It should have the ability to forecast.
After being analyzed, economics has all the features of science.
 Like science, it has a cause and effect relationship between economic phenomena.

For instance, Law of demand explains the cause and effect relationship between price and quantity demanded a
commodity.

 Similarly, the outcomes are measurable in terms of money.

 It has its own methodology of study (induction and deduction).

 It forecasts the future market condition with the help of various statistical and non-statistical tools.
Thus, a majority of economic laws are of this type and therefore, economics as a science.

Critics
Economics as a science but not a perfect science like physical science. The fact is that we cannot rely upon the
accuracy of the economic laws. The predictions made on the basis of economic laws can easily go wrong.
In other words, the subject matter of economics is the economic behaviour of man which is highly
unpredictable.

The next question arises as to whether Economics is positive or normative in nature.

Two nature of economics as a science

Economics as a science can be of two nature of economics

1. Positive Economics
2. Normative Economics
Positive Economics
A Positive Economics or science that is based on cause and effect relationship between variables but it does not
pass value judgment. In other words, it states “what is”.
Positive statements are about facts. They state what the reality is. Economics should be neutral between ends. It
is not for economists to pass value judgments and make pronouncements on the goodness or otherwise of
human decisions.

Normative Economics
As normative economics or science, economics involves value judgments. It is prescriptive in nature and
describes ‘what ought to be’ or ‘what should be the things’.

Normative economics is concerned with normative statements. In this case, economics is not concerned with
facts rather it is concerned with how things should be.
For example, the questions like what should be the level of national income, what should be the wage rate,
how much of national product be distributed among people – all fall within the scope of normative economics.
Thus, normative economics is concerned with welfare propositions.
The above discussion shows that Economics is both positive as well as normative in nature.

Economics as an Art
Art is a branch of study that deals with expressing or applying the creative skills and imagination of humans to
perform a certain activity.

Similarly, economics also requires human imagination for the practical application of scientific laws,
principles, and theories to perform a particular activity.

Art is a system of rules for the achievement of a given end. We know that in practice, economics is used for
achieving a variety of goals.

Every individual economic unit has an economic goal to achieve. It decides its course of action by keeping in
mind the end to be achieved and the situation faced by it. Therefore, economic laws are widely used and relied
upon at all levels of our economic activities. And that makes economics an art.

Economics as a social science

Economics is also considered as social science as it deals with studying the behaviour of human beings and
their relationships in society. This is because of the exchange of goods takes place within the society and
among different societies to satisfy the needs and wants of people.

Conclusion
From the above discussion about the nature of economics, we can say that, economics as a science, economics
as an art as well as economics as a social science. economics has science in its methodology and art in its
application.
Scope of Economics
Earlier, the scope of economics was limited to the utilisation of scarce resources to meet the needs and wants of
people and society.
Over the years, the scope of economics has been broadened to many areas, which are shown in Figure

Scope of Economics
1. Micro Economics
2. Macro Economics
3. International Economics
4. Public finance
5. Welfare Economics
6. Health Economics
7. Environmental Economics
8. Urban and rural Economics
Scope of Economics

Micro Economics
This is considered to be basic economics. Microeconomics may be defined as that branch of economic analysis
which studies the economic behaviour of the individual unit, maybe a person, a particular household, or a
particular firm.

Macro Economics
Macroeconomics may be defined as that branch of economic analysis which studies the behavior of not one
particular unit, but of all the units combined together. Macroeconomics is a study in aggregates.

International Economics
With the advent of globalization and cross-border integration, economic concepts are applied in order to
conduct successful business dealings between countries. Economic concepts can be used in areas, such as
foreign trade (exports and imports), foreign exchange (trading currency), the balance of payments, and balance
of trade.

Public finance
Economic concepts are also applied to assess the government’s collection of taxes from the users of public
goods as well as expenditure on production and distribution of these goods to the general public.
Welfare Economics
Economic theories and concepts are used to analyze the growth and development of low-income countries. This
helps in improving the living standard of people in less developed and developing societies by understanding
their needs for various facilities and utilities, such as health and education facilities and good working
conditions.
Health Economics
Economic concepts are also applicable in assessing the problems faced in promoting health in different
countries. These concepts help the government in making decisions for defining appropriate health packages
and programs for the general public.
Environmental Economics
Economic concepts are used to analyze the utilization and depletion of natural resources. Moreover, they are
applied to study the impact of increasing ecological imbalance on society.

Urban and rural Economics

In urban development, the scope of economics covers the analysis of different urban issues such as crime,
education, public transit, housing, and local government finance. On the other hand, in rural development,
economics can be used to analyze the shortage of natural resources, obtain the best price for production, study
constraints of productivity, adapt to climate change, etc.

Laws of Economics
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What is Laws of Economics?

Marshall gave laws of economics definition as Laws of Economics or statements of economic
tendencies, are those social laws, which relate to branches of conduct in which the strength of
the motives chiefly concerned can be measured by money price.
Laws of economics are based on a set of generalizations assumed to govern economic activity.
In economics, there are two basic laws.

Laws of Economics
Two type of Laws of Economics are:
1. Law of demand
2. Law of supply

Laws of Economics

Law of demand
Law of demand is one of the basic laws of economics, according to which demand rises in
response to a fall in prices while other factors remain constant, such as consumer preferences
and level of income of consumers.

In other words, customers buy a high quantity of products at lower prices and vice versa.

Law of supply
Law of Supply states that supply diminishes when there is a fall in prices and increases with the
rise in prices while other factors are unchanged.
This means that if the price of a product X rises, there will be more products to offer to
customers by sellers and vice versa.

Nature of Laws of Economics

In order to understand the importance of laws of economics and their utility in daily business
practices, it is required to comprehend the nature of these laws.

While studying the law of economics, it is important to note that all economic laws are based on
certain assumptions.
The following points describe the nature of economic laws:
1. Lack of exactness: In comparison to the laws of natural sciences, the law of economics are not exact. An
economist can only state the events that are likely to happen in the future but cannot be assured of their occurrence.

There are three reasons for the lack of exactness in economic laws.

• Firstly, these laws are concerned with human behavior which is dynamic. The uncertainty of human behavior makes
it difficult to predict the actual course of action for the future.

• Secondly, due to changes in human attitudes, perceptions, and preferences, factual data is difficult to be collected,
which is the base of economic laws.

• Thirdly, the business environment is so dynamic that any change in it will simply falsify the economic prediction.

2. Hypothetical: Law of economics is always based on the fulfilment of specific conditions, which means these
laws are subject to the hypothesis.

For example, the rise in demand for a product is subject to a condition, i.e. reduction in price and other factors are
constant. Moreover, the supply must not reduce during that period.

3. Statement of propensity: As discussed, economic laws require certain conditions to be fulfilled to be true.
However, these conditions cannot be exactly predicted.

For example, an increase in demand for a product tends to increase in its rice. However, the price may not rise as it is
dependent on supply too.
Application of Economic Laws
As mentioned earlier, laws of economics concepts have a scope in various sectors.

Let us now study the application of economic laws:

 Formulation of economic policies of countries: The economic climate changes from one country to the other
depending on various factors, such as standard of living of people, level of national income, and composition of the
population.

Every country requires certain policies to run its economy successfully. Economic laws provide a strong base for the
formation of economic policies of different countries.

 Formulation of economic policies of Organizations: In microenvironment, Organizations differ from each

other. To run successfully, organizations apply economic laws to form their policies.

Economic laws help Organizations to plan their business strategies related to production, costs, and pricing.

Demand in Economics

What is Demand in Economics?

Demand is an economic principle can be defined as the quantity of a product that a consumer desires to
purchase goods and services at a specific price and time.
Factors such as the price of the product, the standard of living of people and change in customers’ preferences
influence the demand. The demand for a product in the market is governed by the Laws of Economics
A market is a place where individuals, households, and businesses are engaged in the buying and selling of
products and services through various modes.

The working of a market is governed by two forces, which are demand and supply. These two forces play a
crucial role in determining the price of a product or service and size of the market.

Introduction of Demand
Demand in economics is a relationship between various possible prices of a product and the quantities
purchased by the buyer at each price. In this relationship, price is an independent variable and the quantity
demanded is the dependent variable.

In a market, the behavior of consumer can be analysed by using the concept of demand.

Meaning of Demand
In economics by demand, we mean the various quantities of a given good or service which buyer would
purchase in one market during a given period of time, at various prices, or at various incomes, or at various
prices of related goods.
Demand Definition
Economist has given different demand definition but essence is same.
Frederic Charles Courtenay Benham defines demand as “The demand for anything i.e; goods and service, at a
given price, is the amount of it, which will be bought per unit of time, at that price.

Demand Example
1. Demand is always referred to in terms of price and bears no meaning if it is not expressed in relation to price.

For example, an individual may be willing to purchase a shirt at a price of ` 500 but may not be willing to purchase
the same shirt if it is valued at ` 1000. In addition, different quantities of a commodity are demanded at different
prices.

2. Demand is always referred in terms of a time period and bears no meaning if it is not expressed in relation to a
time period.

For example, a garment manufacturer has a demand for 200 metres of cloth in a month or 2400 metres of cloth in a
year. a statement referring to demand for a commodity or service must include the following three key factors: The
quantity to be purchased. The price at which the commodity is to be purchased. The time period when the commodity
is purchased.

Types of Demand
7 Types of Demand in Economics are:

1. Price demand: It is a demand for different quantities of a product or service that consumers intend to purchase at
a given price and time period assuming other factors, such as prices of the related goods, level of income of
consumers, and consumer preferences, remain unchanged.

2. Income demand: It is a demand for different quantities of a commodity or service that consumers intend to
purchase at different levels of income assuming other factors remain the same.

3. Cross demand: It refers to the demand for different quantities of a commodity or service whose demand depends
not only on its own price but also the price of other related commodities or services.

4. Individual demand and market demand: This is the classification of demand based on the number of
consumers in the market. In dividual demand refers to the quantity of a commodity or service demanded by an
individual consumer at a given price at a given time period.

5. Joint demand: It is the quantity demanded for two or more commodities or services that are used jointly and are,
thus demanded together.
6. Composite demand: It is the demand for commodities or services that have multiple uses. For example, the
demand for steel is a result of its use for various purposes like making utensils, car bodies, pipes, cans, etc.

7. Direct and derived demand: Direct demand is the demand for commodities or services meant for final
consumption. This demand arises out of the natural desire of an individual to consume a particular product.

Determinants of demand
1. Price of a commodity
2. Price of related goods
3. The income of consumers
4. Tastes and preferences of consumers
5. Consumers’ expectations
6. Credit policy
7. Size and composition of the population
8. Income distribution
9. Climatic factors
10. Government policy

Importance of Demand
Demand is considered the basis of the entire process of economic development, hence demand plays an
important role in the economic, social and political fields. The importance of demand may be studied under the
following heads :

 Importance in Consumption: Demand implies the schedule of quantities to be purchased over a specific period
of time at various prices. A consumer determines the quantity of various commodities to be consumed on the basis of
his demand.

 Advantageous to producers: Producers maximize the profit by determining the nature, variety, quantity and cost
of production on the basis of demand of various commodities and controlling the supply at appropriate time.

 Importance in Exchange: Quantity demanded is the purchase of a commodity in certain quantity at a certain
price, therefore it is exchange. This means that production, purchase and sale of a particular commodity of a particular
quality and quantity takes place in demand and it is the process of exchange.

 Importance in distribution: Aggregate social production is determined on the basis of social demand.
Production scale is increased with an increase in demand. Resources from various sources are procured to fulfil this
increased demand. The share in the national product of a factor of production depends upon its demand.

 Importance in Public Finance: Maximization of social welfare is the prime objective of the process of public
finance. Sources of public revenue (inflows) and items of public expenditure (outflows) are determined to achieve this
objective.

 Importance of the Law of demand and Elasticity of Demand: The Law of Demand and Elasticity of

demand is the most important concepts in economics.

 Importance in Religion, Culture and Politics: Demand of various commodities in the society at various points
of time is also very important from the religious, cultural and political point of view. Efforts are made to fulfil the
demand of various commodities which arises at the time of various social or religious festivals.
Types of Demand in Economics

What is Demand? Demand refers to the willingness or effective desire of individuals to buy a product supported by
their purchasing power.

In economics, Demand is generally classified based on various factors, such as the number of consumers for a
given product, the nature of products, the utility of products, and the interdependence of different demands.

Types of Demand
7 types of demand are:
1. Price demand
2. Income demand
3. Cross demand
4. Individual demand and Market demand
5. Joint demand
6. Composite demand
7. Direct and Derived demand
Types of Demand

Price demand
It is a demand for different quantities of a product or service that consumers intend to purchase at a given price
and time period assuming other factors, such as prices of the related goods, level of income of consumers, and
consumer preferences, remain unchanged.

Price demand is inversely proportional to the price of a product or service. As the price of a product or service
rises, its demand falls and vice versa. Therefore, price demand indicates the functional relationship between the
price of a product or service and the quantity demanded.

Price demand can be mathematically expressed as follows:

DA = f (PA) where,
DA = Demand for product A
f = Function
PA =Price of product A

Income demand
It is a demand for different quantities of a commodity or service that consumers intend to purchase at different
levels of income assuming other factors remain the same.

Generally, the demand for a commodity or service increases with an increase in the level of income of
individuals except for inferior goods. Therefore, demand and income are directly proportional to normal goods
whereas the demand and income are inversely proportional to inferior goods.

Relationship between demand and income can be mathematically expressed as follows:

DA = f (YA), where,
DA = Demand for commodity A
f = Function
YA = Income of consumer A

Cross demand
It refers to the demand for different quantities of a commodity or service whose demand depends not only on its
own price but also the price of other related commodities or services.

For example, tea and coffee are considered to be the substitutes of each other. Thus, when the price of coffee
increases, people switch to tea. Consequently, the demand for tea increases. Thus, it can be said that tea and
coffee have cross demand.

Mathematically, cross demand can be expressed as follows:

DA = f (PB), where,
DA = Demand for commodity A
f = Function
PB = Price of commodity B

Individual demand and Market demand

This is the classification of demand based on the number of consumers in the market. In dividual demand refers
to the quantity of a commodity or service demanded by an individual consumer at a given price at a given time
period.

For example, the quantity of sugar that an individual or household purchases in a month is the individual or
household demand. The individual demand of a product is influenced by the price of a product, income of
customers, and their tastes and preferences.
On the other hand, Market demand is the aggregate of individual demands of all the consumers of a product
over a period of time at a specific price while other factors are constant.
For example, there are four consumers of sugar (having a certain price). These four consumers consume 30
kilograms, 40 kilograms, 50 kilograms, and 60 kilograms of sugar respectively in a month. Thus, the market
demand for sugar is 180 kilograms in a month.
Joint demand
It is the quantity demanded for two or more commodities or services that are used jointly and are, thus
demanded together.

For example, car and petrol, bread and butter, pen and refill, etc. are commodities that are used jointly and are
demanded together. The demand for such commodities changes proportionately. For example, a rise in the
demand for cars results in a proportionate rise in the demand for petrol.
However, in the case of joint demand, rise in the price of one commodity results in the fall of demand for the
other commodity. In the above example, an increase in the price of cars will cause a fall in the demand of not
only of cars but also of petrol.

Composite demand
It is the demand for commodities or services that have multiple uses. For example, the demand for steel is a
result of its use for various purposes like making utensils, car bodies, pipes, cans, etc.

In the case of a commodity or service having composite demand, a change in price results in a large change in
the demand. This is because the demand for the commodity or service would change across its various usages.
In the above example, if the price of steel increases, the price of other products made of steel also increases. In
such a case, people may restrict their consumption of products made of steel.

Direct and Derived demand

Direct demand is the demand for commodities or services meant for final consumption. This demand arises
out of the natural desire of an individual to consume a particular product.
For example, the demand for food, shelter, clothes, and vehicles is direct demand as it arises out of the
biological, physical, and other personal needs of consumers.
Derived demand refers to the demand for a product that arises due to the demand for other products. For
example, the demand for cotton to produce cotton fabrics is derived demand.
Derived demand is applicable to manufacturers’ goods, such as raw materials, intermediate goods, or machines
and equipment. Apart from this, the factors of production (land, labour, capital, and enterprise) also have a
derived demand. For example, the demand for labour in the construction of buildings is a derived demand.

Determinants of Demand
Determinants of demand are the factors that influence the decision of consumers to purchase a product or service.

It is essential for Organizations to understand the relationship between the demand and its each determinant to
analyse and estimate the individual and market demand for a commodity or service.

What is Demand in Economics?

Demand is an economic principle can be defined as the quantity of a product that a consumer desires to
purchase goods and services at a specific price and time.

Determinants of Demand
What drives demand? In economics, there are 10 determinants of demand for individual and market.
1. Price of a commodity
2. Price of related goods
3. Income of consumers
4. Tastes and preferences of consumers
5. Consumers expectations
6. Credit policy
7. Size and composition of the population
8. Income distribution
9. Climatic factors
10. Government policy
Determinants of Demand

Factors Influencing Individual Demand

When an individual intends to purchase a particular product, he/she may take into consideration various factors,
such as the price of the product, the price of substitutes, level of income, tastes and preferences, and the
features of the product.

These considerations determine the individual demand of the product. Let us now discuss the factors that
influence individual demand as follows:
Price of a commodity
The price of a commodity or service is generally inversely proportional to the quantity demanded while other
factors are constant. As per the law of demand, it implies that when the price of the commodity or service
rises, its demand falls and vice versa.
Price of related goods
The demand for a good or service not only depends on its own price but also on the price of related goods. Two
items are said to be related to each other if the change in price of one item affects the demand for the other
item. Related goods can be categorized as follow

 Substitute or competitive goods: These goods can be used interchangeably as they serve the same purpose;
thus, are the competitors of each other.

For example, tea and coffee, cold drink and juice, etc. The demand for a good or service is directly proportional to the
price of its substitute.

 Complementary goods: Complementary goods are used jointly; for example, car and petrol.

There is an inverse relationship between the demand and price of complementary goods. This implies that an increase
in the price of one good will result in fall in the demand of the other good.

For example, an increase in the price of mobile phones not only would lead to fall in the quantity demanded but also
lower the demand for mobile cover or scratch guards.
Income of consumers
The level of income of individuals determines their purchasing power. Generally, income and demand are
directly proportional to each other. This implies that rise in the consumers’ income results in rise in the demand
for a commodity.
However, the relationship depends on the type of commodities, which are listed below:

Let us discuss different types of commodities in detail.

 Normal goods: These are goods whose demand rises with an increase in the level of income of consumers.

For example, the demand for clothes, furniture, cars, mobiles, etc. rises with an increase in individuals’ income.

 Inferior goods: These are goods whose demand falls with an increase in consumers’ income.

For example, the demand for cheaper grains, such as maize and barley, falls when individuals’ income increases as
they prefer to purchase higher quality grains. These goods are known as Giffen goods in economic parlance,

 Inexpensive goods or necessities of life: These are basic necessities in an individual’s life, such as salt,
matchbox, soap, and detergent. The demand for inexpensive goods rises with an increase in consumers’ income until a
certain level after that it becomes constant.
Tastes and preferences of consumers
The demand for commodity changes with changes in the tastes and preferences of consumers (which depend on
customers’ customs, traditions, beliefs, habits, and lifestyles).
For example, the demand for burqas is high in gulf countries. In such countries, there may be less or no
demand for short skirts.
Consumers expectations
Demand for commodities also depends on the consumers’ expectations regarding the future price of a
commodity, availability of the commodity, changes in income, etc. Such expectations usually cause rise in
demand for a product.

For example, if a consumer expects a rise in the price of a commodity in the future, he/she may purchase larger
quantities of the commodity in order to stock it. Similarly, if a consumer expects a rise in his/her income,
he/she may purchase a commodity that was relatively unaffordable earlier.

Credit policy
It refers to terms and conditions for supplying various commodities on credit. The credit policy of suppliers or
banks also affects the demand for a commodity. This is because favourable credit policies generally result in
the purchase of commodities that consumers may not have purchased otherwise.

Favorable credit policies generally increase the demand for expensive durable goods such as cars and houses.

For example, easy home and car loans offered by banks have led to a steep rise in the demand for homes and
cars respectively.

Factors Influencing Market Demand

Market demand is the sum total of all household (individual) demands. Therefore, all the factors that affect
individual demand also affect market demand as well. However, there are certain other factors that affect
market demand, which is as follows:

Size and composition of the population

Population size refers to the actual number of individuals in a population. An increase in the size of a
population increases the demand for commodities as the number of consumers would increase.

Population composition refers to the structure of the population based on characteristics, such as age, sex, and
race. The composition of a population affects the demand for commodities as different individuals would have
different demands.

For example, a population with more youngsters will have higher demand for commodities like t-shirts, jeans,
guitars, bikes, etc. compared to the population with more elderly people.
Income distribution
Income distribution shows how the national income is divided among groups of individuals, households, social
classes, or factors of production. Unequal distribution of income results in differences in the income status of
different individuals in a nation.

For example, luxury goods will have higher demand. On the other hand, nations having evenly distributed
income would have higher demand for essential goods.
Climatic factors
The demand for commodities depends on the climatic conditions of a region such as cold, hot, humid, and dry.

For example, the demand for air coolers and air conditioners is higher during summer while the demand for
umbrellas tends to rise during monsoon.
Government policy
This includes the actions taken by the government to determine the fiscal policy and monetary policy such as
taxation levels, budgets, money supply, and interest rates. Government policies have direct impact on the
demand for various commodities.

For example, if the government imposes high taxes (sales tax, VAT, etc.) on commodities, their prices would
increase, which would lead to a fall in their demand.

On the contrary, if the government invests in building of roads, bridges, schools, and hospitals, the demand for
bricks, cement, labour, etc., would rise.

What is the Law of Demand?

The law of demand is given as, “If the price of a product falls, its quantity demanded increases
and if the price of the commodity rises, its quantity demanded falls, other things remaining
constant.”
Law of Demand

Law of Demand Example

Demand Example: Take the example of an individual, who needs to purchase soft drinks. In the
market, a pack of three soft drinks is priced at 120 and the individual purchases the pack. In
the next week, the price of the pack is reduced to 105. This time the individual purchases two
packs of soft drinks. In the third week, the price of the pack has risen to 130.
This time the individual does not purchase the pack at all. It is a common observation that
consumers purchase a commodity in greater quantities when its price is low and vice versa.

This inverse relationship between the demand and price of a commodity is called the law of
demand

Law of Demand Definition

The following are some popular definitions of the law of demand given by experts:
Robertson defines the law of demand as “Other things being equal, the lower the price at which a
thing is offered, the more a man will be prepared to buy it.”
Marshall defines the law of demand as “The greater the amount to be sold, the smaller must be
the price at which it is offered in order that it may find purchasers; or in other words, the
amount demanded increases with a fall in price and diminishes with a rise in price.”
Ferguson defines the law of demand as “Law of Demand, the quantity demanded varies inversely
with price.”

Meaning of Law of Demand

The law of demand represents a functional relationship between the price and quantity
demanded of a commodity or service.
The law states that the quantity demanded of a commodity increase with a fall in the price of
the commodity and vice versa while other factors like consumers’ preferences, level of
income, population size, etc. are constant.

Demand is a dependent variable, while the price is an independent variable.

Therefore, demand is a function of price and can be expressed as follows:

D= f (P) Where
D= Demand
P= Price
f = Functional Relationship

Assumptions of Law of Demand

The law of demand follows the assumption of ceteris paribus, which means that the other factors
remain unchanged or constant.
As mentioned earlier, the demand for a commodity or service not only depends on its price
but also on several other factors such as price of related goods, income, and consumer tastes
and preferences.

In the law of demand, other factors are assumed to remain constant while only the price of
the commodity changes.

The law of demand is based on the following assumptions:

 The income of the consumer remains constant.
 Consumer tastes and preferences remain constant.
 Price of related goods remains unchanged.
 Population size remains constant.
 Consumer expectations do not change.
 Credit policies remain unchanged.
 Income distribution remains constant.
 Government policies remain unchanged.
 The commodity is a normal commodity.
The law of demand can be understood with the help of certain concepts, such as demand
schedule, demand curve, and demand function.

Exceptions To The Law Of Demand

There are certain exceptions to the law of demand that with a fall in price, the demand also
falls and there is an increase in demand with an increase in price.

In case of exceptions, the demand curve shows an upward slope and referred to as exceptional
demand curve. Figure shows an exceptional demand curve:
 Exceptional Demand Curve

Definition: Exception to the law of demand refers to conditions where the law of demand is not
applicable.
1. Giffen goods
2. Articles of distinction goods
3. Consumers ignorance
4. Situations of crisis
5. Future price expectations

Exceptions To The Law Of Demand

Giffen goods
Giffen good is a commodity that is unexpectedly consumed more as its price increases. Thus,
it is an exception to the law of demand. In the case of Giffen goods, the income effect
dominates over the substitution effect.

After the Irish Famine (1845), the potato crop failed due to plant disease, late blight, which
destroys both the leaves and the edible roots, or tubers, of the potato plant. Due to this, the
price of potatoes increased tremendously.

Despite the fact that the price increase made people to find substitutes of potatoes, they
moved away from luxury products so that their overall consumption of potatoes increased.

Articles of distinction goods

Named after economist, Thorstein Veblen, these commodities satisfy the desires of the upper-
class people in society. Veblen goods include those commodities whose demand is
proportional to their price and thus, they are exceptions to the law of demand.

These articles are purchased only by a few rich people to feel superior to the rest. For
example, diamonds, rare paintings, vintage cars, and antique goods are examples of Veblen
goods.

Consumers ignorance
Consumer ignorance is another factor that motivates people to purchase a commodity at a
higher price, which violates the law of demand. This results out of the consumer biases that a
high-priced commodity is better in quality than a low-priced commodity.

Situations of crisis
Crisis such as war and famine negate the law of demand. During crisis, consumers tend to
purchase in larger quantities with the purpose of stocking, which further accentuates the
prices of commodities in the market. They fear that goods would not be available in the
future.

On the other hand, at the time of depression, a fall in the price of commodities does not
induce consumers to demand more.

Future price expectations

When consumers expect a rise in the prices of commodities, they tend to purchase
commodities at existing high prices. For example, speculation of market strategists on an
increase in gold prices in the future induces consumers to purchase higher quantities in order
to stock gold.

On the contrary, if consumers expect a fall in the price of a commodity, they postpone the
purchase for the future.

Characteristics of Law of Demand

The following are the main characteristics of law of demand:
 Inverse Relationship: According to this law there is an inverse relationship between the quantity demanded and
the price of a commodity. If the price of a commodity increases the quantity demanded decreases and if the price
decreases the quantity demanded increases.

 Price independent and Demand dependent variable: Price of a commodity is an independent variable. The law
of demand explains the change in demand of a commodity due to change in its price. In mathematical terms price is an
independent variable and demand is a dependent variable.

 Other things being equal: This law holds good only when the other things remain the same. This ‘other things
remaining the same’ is called the assumptions of the law of demand.

 Qualitative statement: The law of demand is a qualitative statement which tells us that a fall in the price of a
commodity will lead to an increase in the quantity demanded and a rise in price will lead to a fall in the quantity
 demanded. But it does not tell us how much change in price will bring how much change in quantity demanded.

 Concerned with certain period of time: The law of demand is related with a particular period of time, for
example weekly, monthly, annually etc.

Demand Schedule rkM

What is Demand Schedule?

Demand schedule is a tabular representation of different quantities of commodities that consumers are willing
to purchase at a specific price and time while other factors are constant.

Demand Schedule Definition

A full account of the demand, or perhaps we can say, the state of demand for any goods in a given market at a given time
should state what the volume (weekly) of sales would be at each of a series of prices. Such an account, taking the form of
a tabular statement, is known as a demand schedule. Benham

Types of Demand Schedule

Two types of demand schedule are:

1. Individual Demand Schedule

2. Market Demand Schedule
Individual demand schedule
Individual demand schedule definition: It is a tabular representation of quantities of a commodity demanded
by an individual at a particular price and time, provided all other factors remain constant.
Market demand schedule
Market demand schedule definition: There is more than one consumer of a commodity in the market. Each
consumer has his/her own individual demand schedule. If the quantities of all individual demand schedules are
consolidated, it is called market demand schedule.

Demand Schedule Example

Let us understand the concept demand schedule with the help of a demand schedule example:
Assume that there are two individuals A and B in the market. They have a particular individual demand for
Apple. The individual demand schedules for A and B and the consequent market demand are shown in Table

QUANTITY QUANTITY TOTAL MARKET

PRICE PER
DEMANDED BY A DEMANDED BY B DEMAND (A + B)
DOZEN (IN ₹ PER
(IN DOZENS PER (IN DOZENS PER (IN DOZENS PER
DOZEN)
WEEK) WEEK) WEEK)

(1) (2) (3) (4)

80 2 4 2+4=6
 QUANTITY QUANTITY TOTAL MARKET
PRICE PER
DEMANDED BY A DEMANDED BY B DEMAND (A + B)
DOZEN (IN ₹ PER
(IN DOZENS PER (IN DOZENS PER (IN DOZENS PER
DOZEN)
WEEK) WEEK) WEEK)

70 4 6 4 + 6 = 10

60 6 10 6 + 10 = 16

50 9 15 9 + 15 = 24

40 14 22 14 + 22 = 36

In Table, the individual demand schedule of A and B are depicted in the columns (2) and (3) at different price
levels shown in column (1). Column (4) depicts the market demand schedule, which is the sum total of the
individual demands of A and B. As shown in Table, at a price level of ₹ 80 per dozen of apple, individual
demand by A and B are 2 dozens per week and 4 dozens per week respectively.

The market demand (assuming there are only two individuals in the market) is the sum total of individual
demands i.e. 6 dozens a week.

The law of demand can also be represented graphically with the help of a Demand Curve.

Definition: Demand Function is the relationship between the quantity demanded and the price
of the commodity.
Mathematically, a function is a symbolic representation of the relationship between dependent
and independent variables.

What is Demand Function?

Demand function represents the relationship between the quantity demanded for a commodity
(dependent variable) and the price of the commodity (independent variable).
Let us assume that the quantity demanded of a commodity X is Dx, which depends only on its
price Px, while other factors are constant. It can be mathematically represented as:
Dx = f (Px)

However, the quantitative relationship between Dx and Px is expressed as:

Dx = a – bPx
Where, a (intercept) and b (relationship between Dx and Px) are constants.

Types of Demand Function

2 types of demand function are:
1. Linear demand function
2. Non linear demand function
Linear demand function
In the linear demand function, the slope of the demand curve remains constant throughout its
length. A linear demand equation is mathematically expressed as:
Dx = a – bPx
In this equation, a denotes the total demand at zero price.

b = slope or the relationship between Dx and Px

b can also be denoted by change in Dx for change in Px
If the values of a and b are known, the demand for a commodity at any given price can be
computed using the equation given above.

For example, let us assume a = 50, b = 2.5, and Px= 10: Demand function is:
Dx = 50 – 2.5 (Px) Therefore, Dx = 50 – 2.5 (10) or Dx= 25 units
Price Levels of Quantity Demanded of
Commodity X Commodity X
18 5
16 10
14 15

12 20

Demand Curve in Linear Demand Function

Non linear demand function

In the non linear or curvilinear demand function, the slope of the demand curve (ΔP/ΔQ) changes
along the demand curve. Instead of a demand line, non-linear demand function yields a
demand curve. A non-linear demand equation is mathematically expressed as:
Dx = a (Px) – b
Dx = a/Px + c
where a, b, c> 0

Exponent –b of price in the non-linear demand function refers to the coefficient of the price
elasticity of demand.
Figure, represents a non-linear demand function:

Non linear Demand Function

Demand Curve

What is Demand Curve?

Demand curve definition: In economics, a demand curve is a graphical presentation of the demand schedule.
It is obtained by plotting a demand schedule.
The demand schedule can be converted into a demand curve by graphically plotting the different combinations
of price and quantity demanded of a product.

Types of Demand Curve

Similar to demand schedule, there are two types of demand curve.
2 Types of Demand Curve are:

1. Individual demand curve

2. Market demand curve
Individual demand curve
Individual demand curve definition: It is the curve that shows different quantities of a commodity which
an individual is willing to purchase at all possible prices in a given time period with an assumption that other
factors are constant.
An individual demand curve slopes downwards to the right, indicating an inverse relationship between the
price and quantity demanded of a commodity.
Market demand curve
Market demand curve definition: This curve is the graphical representation of the market demand schedule.
A market demand curve shows different quantities of a commodity which all consumers in a market are
willing to purchase at different price levels at a given time period, while other factors remaining constant.
A market demand curve can be plotted by consolidating individual demand curves. Therefore, market demand
curve is the horizontal summation of individual demand curves.

A market demand curve, just like the individual demand curves, slopes downwards to the right, indicating an
inverse relationship between the price and quantity demanded of a commodity.

The negative slope of a demand curve is a reflection of the law of demand

However, it is important to understand the reasons why the demand curve slopes downward to the right.

Why the demand curve slopes downward?

Generally, the demand curves slope downwards. It signifies that consumers buy more at lower prices. We
shall now try to understand why the demand curve slopes downward?
Different explanations have been given different economists for the operation of the law of demand. These are
explained below:

Factors that cause a demand curve shifts are:

1. Law of diminishing marginal utility
2. Income effect
3. Substitution effect
4. Change in the number of consumers
5. Multiple uses of a commodity
Law of diminishing marginal utility
Consumers purchase commodities to derive utility out of them.

The law of diminishing marginal utility states that as consumption increases, the utility that a consumer
derives from the additional units (marginal utility) of a commodity diminishes constantly.
Therefore, a consumer would purchase a larger amount of a commodity when it is priced low as the marginal
utility of the additional units decreases.

Income effect
A change in the demand arising due to change in the real income of a consumer owing to change in the price of
a commodity is called income effect.
A change in the price of a commodity affects the purchasing power of a consumer.

For example, if an individual buys two dozens of apples at 40 per kg, he/she spends 80. When the price of
apples falls to 30 per kg, he/she spends 60 for purchasing two kg of apples. This results in a saving of 20 for the
individual, which implies that the real income of the individual has increased by 20
The amount saved may be utilized by the individual in purchasing additional units of apples. Thus, the demand
for apples increased due to a change in real income.

Substitution effect
The change in demand due to change in the relative price of a commodity is called the substitution effect.
The relative price of a commodity refers to its price in relation to the prices of other commodities.
Consumers always switch to lower-priced commodities that are substitutes of higher-priced commodities in
order to maintain their standard of living.

Therefore, the demand for relatively cheaper commodities increases.

For example, if the price of pizzas comes down, while the price of burgers remains the same, pizzas will
become relatively (burgers) cheaper. The demand for pizzas will increase as compared to burgers.
Change in the number of consumers
When the price of a commodity decreases, the number of consumers of the commodity increases. This leads to
a rise in the demand for the commodity.

For example, when the price of apples is 120 per kg, only a few people purchase it. However, when the price
of apples falls down to 60 per kg, more number of people can afford it.
Multiple uses of a commodity
There are certain commodities that can serve more than one purpose. For example, milk, steel, oil, etc.
However, some uses are more important over others. When the price of such a commodity is high, it will be
used to serve important purposes. Thus, the demand will be low.

On the other hand, when the price of the commodity falls, it will be used for less important purposes as well.
Thus, the demand will increase.

For example, when the price of electricity is high, it is used only for lighting purposes, whereas when the price
of electricity goes down, it is also used for cooking, heating, etc.

Movement and Shift In Demand Curve

Movement along Demand Curve
Movement along Demand Curve is when the commodity experience change in both the quantity demanded
and price, causing the curve to move in a specific direction.
Shift In Demand Curve
The shift in demand curve is when, the price of the commodity remains constant, but there is a change in
quantity demanded due to some other factors, causing the curve to shift to a particular side.

Shift and Movement along Demand Curve

In economics, change in quantity demanded and change in demand are two different concepts.

Change in quantity demanded refers to change in the quantity purchased due to rise or fall in product prices
while other factors are constant.

 It can be measured by the movement along the demand curve.

 The terms, change in quantity demanded refers to expansion or contraction of demand.
Change in demand refers to increase or decrease in demand for a product due to various determinants of
demand other than price (in this case, price is constant).
 It is measured by shifts in the demand curve.
 The terms, change in demand means to increase or decrease in demand.
Expansion and Contraction of Demand
The change in the quantity demanded of a product with change in its price, while other factors are at constant,
is called expansion or contraction of demand.
Expansion and contraction are represented by the movement along the same demand curve. Let us discuss the
expansion and contraction of demand as follows:

Expansion or extension of demand

Expansion or extension of demand: It is an increase in the demand of a commodity due to decrease in its
prices, while other factors are constant.
For example, in Table, when the price of apple falls from 60 per dozen to 50 per dozen, its quantity demanded
rises from 6 dozens to 9 dozens by individual A. Therefore, the demand for apple is expanded or extended.

Contraction of demand
Contraction of demand: It is a decrease in the demand of a commodity due to increase in its price, while other
factors remain unchanged.
For example, in Table(View Here), when the price of apple rises from 60 per dozen to 80 per dozen, its
quantity demanded falls from 6 dozens to 2 dozens by individual A. Therefore, the demand for apple is
contracted.
Let us consider the graph shown in Figure

Movement along the Demand Curve

In the demand curve, when the price of commodity X is OP1, quantity demanded is OQ1. If the price of
commodity X decreases to OP2, the quantity demanded increases to OQ2.

The movement of the demand curve from A1 to A2 in the downward direction is called the extension of the
demand curve.
On the other hand, if the price of the commodity X rises from OP1 to OP3, the quantity demanded of
commodity X falls from OQ1 to OQ3. This movement along the demand curve in the upward direction is called
the contraction of demand.

Increase and decrease in demand

Increase and decrease in demand takes place due to changes in other factors, such as change in income,
distribution of income, change in consumer’s tastes and preferences, change in the price of related goods. In
this case, the price factor remains unchanged.
Increase in demand
Increase in demand refers to the rise in demand for a product at a specific price,
Decrease in demand
Decrease in demand is the fall in demand for a product at a given price.
When other factors change, the demand curve changes its position which is referred to as a shift along the
demand curve, which is shown in Figure.

Demand Curve Shift

Demand curve D2 is the original demand curve of commodity X. At price OP2, the demand is OQ2 units of
commodity X.

When the consumer’s income decreases owing to high income tax, he/she is able to purchase only OQ1 unit of
commodity X at the same price OP2. Therefore, the demand curve, D2 shifts downwards to D1.

Similarly, when the consumer’s disposable income increases due to a reduction in taxes, he/she is able to
purchase OQ3 units of commodity X at the price OP2. Therefore, the demand curve, D2 shifts upwards to D3.
Such changes in the position of the demand curve from its original position are referred to as a shift in the
demand curve.

Factors that cause a demand curve shifts

Why the demand curve slopes downward? There are several factors that cause a demand curve shift. Some
of them are given as follows:
 A fall in consumers income due to which they can purchase fewer units of a commodity (income effect).

 A fall in the price of a related commodity due to which consumers prefer to purchase the substitute commodity
(substitution effect).
 Changes in the tastes and preferences of consumers due to which they may replace the original commodity
with a new one.

 Increase in the price of complementary goods due to which consumers can afford to buy fewer units of the
original commodity.

 Change in fashion, season, technology, or quality due to which consumers may purchase fewer units of the
original commodity.

Movement and Shift In Demand Curve

Movement along Demand Curve
Movement along Demand Curve is when the commodity experience change in both the quantity demanded
and price, causing the curve to move in a specific direction.
Shift In Demand Curve
The shift in demand curve is when, the price of the commodity remains constant, but there is a change in
quantity demanded due to some other factors, causing the curve to shift to a particular side.

Shift and Movement along Demand Curve

In economics, change in quantity demanded and change in demand are two different concepts.

Change in quantity demanded refers to change in the quantity purchased due to rise or fall in product prices
while other factors are constant.
 It can be measured by the movement along the demand curve.
 The terms, change in quantity demanded refers to expansion or contraction of demand.
Change in demand refers to increase or decrease in demand for a product due to various determinants of
demand other than price (in this case, price is constant).
 It is measured by shifts in the demand curve.
 The terms, change in demand means to increase or decrease in demand.

Expansion and Contraction of Demand

The change in the quantity demanded of a product with change in its price, while other factors are at constant,
is called expansion or contraction of demand.
Expansion and contraction are represented by the movement along the same demand curve. Let us discuss the
expansion and contraction of demand as follows:

Expansion or extension of demand

Expansion or extension of demand: It is an increase in the demand of a commodity due to decrease in its
prices, while other factors are constant.

For example, in Table, when the price of apple falls from 60 per dozen to 50 per dozen, its quantity demanded
rises from 6 dozens to 9 dozens by individual A. Therefore, the demand for apple is expanded or extended.

Contraction of demand
Contraction of demand: It is a decrease in the demand of a commodity due to increase in its price, while other
factors remain unchanged.
For example, in Table(View Here), when the price of apple rises from 60 per dozen to 80 per dozen, its
quantity demanded falls from 6 dozens to 2 dozens by individual A. Therefore, the demand for apple is
contracted.
Let us consider the graph shown in Figure

Movement along the Demand Curve

In the demand curve, when the price of commodity X is OP1, quantity demanded is OQ1. If the price of
commodity X decreases to OP2, the quantity demanded increases to OQ2.

The movement of the demand curve from A1 to A2 in the downward direction is called the extension of the
demand curve.
On the other hand, if the price of the commodity X rises from OP1 to OP3, the quantity demanded of
commodity X falls from OQ1 to OQ3. This movement along the demand curve in the upward direction is called
the contraction of demand.

Increase and decrease in demand

Increase and decrease in demand takes place due to changes in other factors, such as change in income,
distribution of income, change in consumer’s tastes and preferences, change in the price of related goods. In
this case, the price factor remains unchanged.
Increase in demand
Increase in demand refers to the rise in demand for a product at a specific price,
Decrease in demand
Decrease in demand is the fall in demand for a product at a given price.
When other factors change, the demand curve changes its position which is referred to as a shift along the
demand curve, which is shown in Figure.
Demand Curve Shift

Demand curve D2 is the original demand curve of commodity X. At price OP2, the demand is OQ2 units of
commodity X.

When the consumer’s income decreases owing to high income tax, he/she is able to purchase only OQ1 unit of
commodity X at the same price OP2. Therefore, the demand curve, D2 shifts downwards to D1.

Similarly, when the consumer’s disposable income increases due to a reduction in taxes, he/she is able to
purchase OQ3 units of commodity X at the price OP2. Therefore, the demand curve, D2 shifts upwards to D3.
Such changes in the position of the demand curve from its original position are referred to as a shift in the
demand curve.

Factors that cause a demand curve shifts

Why the demand curve slopes downward? There are several factors that cause a demand curve shift. Some
of them are given as follows:
 A fall in consumers income due to which they can purchase fewer units of a commodity (income effect).

 A fall in the price of a related commodity due to which consumers prefer to purchase the substitute commodity
(substitution effect).

 Changes in the tastes and preferences of consumers due to which they may replace the original commodity
with a new one.

 Increase in the price of complementary goods due to which consumers can afford to buy fewer units of the
original commodity.

 Change in fashion, season, technology, or quality due to which consumers may purchase fewer units of the
original commodity.
What is Supply?
Supply is an economic principle can be defined as the quantity of a product that a seller is willing to offer in
the market at a particular price within specific time.
The supply of a product is influenced by various determinants, such as price, cost of production, government
policies, and technology. It is governed by the law of supply, which states a direct relationship between the
supply and price of a product, while other factors remaining the same.
A market is a place where buyers and sellers are engaged in exchanging products at certain prices.

In a market, the two forces demand and supply play a major role in influencing the decisions of consumers and
producers.

The behaviour of buyers is understood with the help of the concept of demand. On the other hand,
the behaviour of sellers is analysed using the concept of supply.

Concept of Supply
What is Supply Concept? In economics, supply refers to the quantity of a product available in the market for
sale at a specified price and time.
In other words, supply can be defined as the willingness of a seller to sell the specified quantity of a product
within a particular price and time period. Here, it should be noted that demand is the willingness of a buyer,
while supply is the willingness of a supplier.

Meaning of Supply
What is Supply Meaning? Supply has three important aspects, which are as follows:

1. Supply is always referred in terms of price

The price at which quantities are supplied differs from one location to the other.
For example, fast moving consumer goods (FMCG) are usually supplied at different prices in different prices.

2. Supply is referred in terms of time

This means that supply is the amount that suppliers are willing to offer during a specific period of time (per day, per
week, per month, bi-annually, etc.)

3. Supply considers the stock and market price of the product

Both stock and market price of a product affect its supply to a greater extent. If the market price of a product is more
than its cost price, the seller would increase the supply of the product in the market. However, a decrease in the
market price as compared to the cost price would reduce the supply of product in the market.

Supply Definition
What is Supply Definition? Economist has given different supply definition but the essence is same.
Supply may be defined as a schedule which shows the various amounts of a product which a particular seller is willing
and able to produce and make available for sale in the market at each specific price in a set of possible prices during a
given period.McConnell
Supply refers to the quantity of a commodity offered for sale at a given price, in a given market, at given time.Anatol
Murad

Supply Example
What is Supply? Let us understand the concept of supply with an example.

r example, a seller offers a commodity at 100 per piece in the market. In this case, only commodity and price
are specified; thus, it cannot be considered as supply.
However, there is another seller who offers the same commodity at 110 per piece in the market for the next six
months from now on. In this case, commodity, price, and time are specified, thus it is supply.

Classification of supply
What is Supply Classification? Supply can be classified into two categories, which are individual supply and
market supply.
1. Individual supply is the quantity of goods a single producer is willing to supply at a particular price and time in
the market. In economics, a single producer is known as a firm.

2. Market supply is the quantity of goods supplied by all firms in the market during a specific time period and at a
particular price. Market supply is also known as industry supply as firms collectively constitute an industry.

Types of Supply
 Market Supply
 Short-term Supply
 Long-term Supply
 Joint Supply

Determinants of Supply
9 Determinants of supply are:
1. Price of a product
2. Cost of production
3. Natural conditions
4. Transportation conditions
5. Taxation policies
6. Production techniques
7. Factor prices and their availability
8. Price of related goods
9. Industry structure
Determinants of Supply

Price of a product
The major determinants of the supply of a product is its price. An increase in the price of a product increases its
supply and vice versa while other factors remain the same.

Cost of production
It is the cost incurred on the manufacturing of goods that are to be offered to consumers. Cost of production and
supply are inversely proportional to each other.

Natural conditions
The supply of certain products is directly influenced by climatic conditions. For instance, the supply of
agricultural products increases when the monsoon comes well on time.

Transportation conditions
Better transport facilities result in an increase in the supply of goods. Transport is always a constraint to the
supply of goods. This is because goods are not available on time due to poor transport facilities.

Taxation policies
Government’s tax policies also act as a regulating force in supply. If the rates of taxes levied on goods are high,
the supply will decrease. This is because high tax rates increase overall productions costs, which will make it
difficult for suppliers to offer products in the market.

Production techniques
The supply of goods also depends on the type of techniques used for production. Obsolete techniques result in
low production, which further decreases the supply of goods.

Factor prices and their availability

The production of goods is dependent on the factors of production, such as raw material, machines and
equipment, and labour.

Price of related goods

The prices of substitutes and complementary goods also influence the supply of a product to a large extent.

Industry structure
The supply of goods is also dependent on the structure of the industry in which a firm is operating. If there is
monopoly in the industry, the manufacturer may restrict the supply of his/her goods with an aim to raise the
prices of goods and increase profits.

Supply Function
Supply function is the mathematical expression of law of supply. In other words, supply function quantifies the
relationship between quantity supplied and price of a product, while keeping the other factors at constant.
The law of supply expresses the nature of the relationship between quantity supplied and price of a product,
while the supply function measures that relationship.
The supply function can be expressed as:

Qs = f (Pa, Pb, Pc, T, Tp)

Where,

Qs = Supply
Pa = Price of the good supplied
Pb = Price of other goods
Pc = Price of factor input
T = Technology
Tp = Time Period

According to the supply function, the quantity supplied of a good (Qs) varies
with the price of that good (Pa), the price of other goods (Pb), the price
of factor input (Pc), the technology used for production (T), and time period
(Tp)

Determinants of Supply are the factors that influence producer supply cause the market supply curve to shift.

What is Determinants of Supply?

Supply does not remain constant all the time in the market. There are many factors that influence the supply of
a product. Generally, the supply of a product depends on its price and cost of production.

Thus, it can be said that supply is the function of price and cost of production. These factors that influence the
supply are called the determinants of supply.

Determinants of Supply
What drives supply? In economics, there are 9 determinants of supply discussed below:

9 Determinants of supply are:

1. Price of a product
2. Cost of production
3. Natural conditions
4. Transportation conditions
5. Taxation policies
6. Production techniques
7. Factor prices and their availability
8. Price of related goods
9. Industry structure
Determinants of Supply

Price of a product
The major determinants of the supply of a product is its price. An increase in the price of a product increases its
supply and vice versa while other factors remain the same.
Producers increase the supply of the product at higher prices due to the expectation of receiving increased
profits. Thus, price and supply have a direct relationship.

Cost of production
It is the cost incurred on the manufacturing of goods that are to be offered to consumers. Cost of production and
supply are inversely proportional to each other.

This implies that suppliers do not supply products in the market when the cost of manufacturing is more than
their market price. In this case, sellers would wait for a rise in price in the future.

The cost of production increases due to several factors, such as loss of fertility of land; high wage rates of
labour; and increase in the prices of raw material, transportation cost, and tax rate.

Natural conditions
The supply of certain products is directly influenced by climatic conditions. For instance, the supply of
agricultural products increases when the monsoon comes well on time.

On the contrary, the supply of these products decreases at the time of drought. Some of the crops are climate
specific and their growth purely depends on climatic conditions.

For example, Kharif crops are well grown at the time of summer, while Rabi crops are produced well in the
winter season.

Transportation conditions
Better transport facilities result in an increase in the supply of goods. Transport is always a constraint to the
supply of goods. This is because goods are not available on time due to poor transport facilities.

Therefore, even if the price of a product increases, the supply would not increase.

Taxation policies
Government’s tax policies also act as a regulating force in supply. If the rates of taxes levied on goods are high,
the supply will decrease. This is because high tax rates increase overall productions costs, which will make it
difficult for suppliers to offer products in the market.

Similarly, reduction in taxes on goods will lead to an increase in their supply in the market.

Production techniques
The supply of goods also depends on the type of techniques used for production. Obsolete techniques result in
low production, which further decreases the supply of goods.

Over the years, there has been tremendous improvement in production techniques, which has led to increase in
the supply of goods.

Factor prices and their availability

The production of goods is dependent on the factors of production, such as raw material, machines and
equipment, and labour.

An increase in the prices of the factors of production increases the cost of production. This will make difficult
for firms to supply large quantities in the market.

Price of related goods

The prices of substitutes and complementary goods also influence the supply of a product to a large extent.

For example, if the price of tea increases, farmers would tend to grow more tea than coffee. This would
decrease the supply of tea in the market.
Industry structure
The supply of goods is also dependent on the structure of the industry in which a firm is operating. If there is
monopoly in the industry, the manufacturer may restrict the supply of his/her goods with an aim to raise the
prices of goods and increase profits.

On the other hand, in case of a perfectly competitive market structure, there would be a large of number of
sellers in the market. Consequently, the supply of a product would increase.

What is the Law of Supply?

The law of supply states that the relationship between price and supply of a product.
According to the law of supply, the quantity supplied increases with a rise in the price of a product and vice
versa while other factors are constant. The other factors may include customer preferences, size of the market,
size of population, etc.
The law of supply can be explained through a supply schedule and a supply curve.

Law of Supply Example

For example, in the case of rise in a product’s price, sellers would prefer to increase the production of the
product to earn high profits, which would automatically lead to an increase in supply.
Similarly, if the price of the product decreases, the supplier would decrease the supply of the product in the
market as he/ she would wait for a rise in the price of the product in the future.

Thus, the law of supply states a direct relationship between the price of a product and its supply. Therefore,
both price and supply moves in the same direction.

Law of Supply definition

The law of supply defined as: “Other things remaining unchanged, the supply of a good produced and offered
for sale will increase as the price of the good rises and decrease as the price falls.”
To understand the law of supply, it is important to discuss the concepts of demand schedule and demand curve.

Assumptions of Law of Supply

Like the law of demand, the law of supply also follows the assumption of ceteris paribus, which means that
‘other things remain unchanged or constant’.
As mentioned earlier, the supply of a commodity is dependent on many factors other than price, such as
consumers’ income and tastes, price of substitutes, natural factors, etc.
All the factors other than the price are assumed to be constant. The law of supply works on certain
assumptions which are given as follows:

Assumptions of Law of Supply are:

 The income of buyers and sellers remains unchanged.
 The commodity is measurable and available in small units.
 The tastes and preferences of buyers remain unchanged.
 The cost of all factors of production does not change over a period of time.
 The time period under consideration is short.
 The technology used remains constant.
 The producer is rational.
 Natural factors remain stable.
 Expectations of producers and the government policy do not change over time.

Exceptions of Law of Supply

According to the law of supply, if the price of a product rises, the supply of the product also rises and vice
versa.

However, there are certain conditions where the law of supply is not applicable. These conditions are known as
exceptions to the law of supply. In such cases, the supply of a product falls with the increase in the price of a
product at a particular point of time.

For example, there would be a decrease in the supply of labour in an Organization when the rate of wages is
high.
The exception to the law of supply is represented on the regressive supply curve or backward sloping curve. It
is also known as an exceptional supply curve.
Exceptions of Law of Supply are:
1. Agricultural products
2. Goods for auction
3. Expectation of change in prices
4. Supply of labour

Let us discuss important exceptions to the law of supply in detail.

Agricultural products
The law of exception is not applicable to agricultural products. The production of these products is dependent
on so many factors which are uncontrollable, such as climate and availability of fertile land.

Thus, the production of agricultural products cannot be increased beyond a limit. Therefore, even a rise in price
cannot increase the supply of these products beyond a limit.

Goods for auction

Auctions goods are offered for sale through bidding. Auction can take place due to various reasons, for
instance, a bank may auction the assets of a customer in case of his failure in paying off the debts over a period
of time.
Thus, supply of these goods cannot increase or decrease beyond a limit. In case of these goods, a rise or fall in
price does not impact the supply.

Expectation of change in prices

Law of supply is not applicable under the circumstances when there is an expectation of change in the prices of
a product in the near future.

For instance, if the price of wheat rises and is expected to increase further in the next few months, sellers may
not increase supply and store huge quantities in the hope of achieving profits at the time of a price rise.

Supply of labour
The law of supply fails in the case of labour. After a certain point, the rise in wages does not increase the
supply of labour. At higher wages, labour prefers to work for lesser hours. This happens due to change in
preference of labour for leisure hours.

What is Supply Schedule?

In economics, a Supply schedule is defined as a tabular representation of the law of supply. It represents the
quantities of a product supplied by a supplier at different prices and time periods, keeping all other factors
constant.

Types of Supply Schedule

There can be two types of supply schedules and those are explained below:
1. Individual supply schedule
2. Market supply schedule
Individual Supply Schedule
Individual supply schedule definition: This schedule represents the quantities of a product supplied by an
individual firm or supplier at different prices during a specific period of time, assuming other factors remain
unchanged.
Example
Let us understand the individual supply schedule with the help of an example. Table shows the supply schedule
of a firm supplying commodity A:

Price of the Product Quantity Supplied of Commodity A (Kg per Week)

(₹ per Kg)
5 3,000
10 8,000
15 12,000
20 15,000

From Table 3.1, it is clear that the firm is supplying 3,000 kg per week of commodity A at the price of 5 per kg.
As the price rises from 5 to 10 per kg, the firm also increased the supply to 8,000 per kg. Therefore, the
individual supply schedule shown in Table 3.1 indicates that the quantity supplied increases with a rise in price.
Market supply schedule
Market supply schedule definition: This schedule represents the quantities of a product supplied by all firms
or suppliers in the market at different prices during a specific period of time, while other factors are constant.
In other words, market supply schedule can be defined as the summation of all individual supply schedules.
Table 3.2 shows the market supply schedule of two firms X and Y for the commodity A:

Example
QUANTITY QUANTITY
PRICE OF MARKET SUPPLY
SUPPLIED BY SUPPLIED BY
PRODUCT A (₹ (1000 KG PER
FIRM X (1000 KG FIRM Y (1000 KG
PER KG) WEEK)
PER WEEK) PER WEEK)

5 3 7 10

10 8 12 20

15 12 15 27

20 15 17 32

In Table 3.2, market supply is calculated by combining the quantities supplied by firm X and Y. It also shows
when the commodity is priced at ₹5 per kg, the market supply of commodity A is 10,000 kg per week. When
the price rises to ₹10 per kg, the market supply also increases to 20,000 per kg. So it can be observed, that a
rise in price of the commodity A increases the market supply.

What is Supply Curve?

Supply Curve definition: In economics, supply curve is a graphical representation of supply
schedule is called supply curve.
In a graph, the price of a product is represented on Y-axis and quantity supplied is
represented on X-axis.

Types of Supply Curve

In, economics, Supply curve can be of two types, individual supply curve and market supply
curve. These two types of supply curves are explained as follows:
Types of Supply Curve are:

1. Individual supply curve

2. Market Supply curve

Individual supply curve

Individual supply curve definition: It is the graphical representation of individual supply
schedule.
The individual supply schedule of commodity A represented in Table when plotted on a graph
will provide the individual supply curve, which is shown in Figure.

Individual Supply Curve

The slope moving upwards to the right in individual supply curve shows the direct
relationship between supply and price, i.e. increase in supply along with the rise in prices.

Market Supply curve

Market Supply curve definition: It is the graphical representation of market supply schedule.
The market supply schedule of commodity A (supplied by Firm X and Firm Y) represented
in Table, when plotted on the graph will provide the market supply curve, which is shown in
Figure.

Market Supply Curve

Supply Curve Shifts

Movement and Shift In Supply Curve

Movement In Supply Curve
Movement in the supply curve is when the commodity experience change in both the quantity
supply and price, causing the curve to move in a specific direction.
Shift in Supply Curve
The shift in the supply curve is when, the price of the commodity remains constant, but there is
a change in quantity supply due to some other factors, causing the curve to shift to a
particular side.

Shifts and Movement along Supply Curve

In economics, like demand, change in quantity supplied and change in supply are two
different concepts.

Change in quantity supplied occurs due to rise or fall in product prices while other factors are
constant.
 It can be measured by the movement of the supply curve.
 The term, Change in quantity supplied refers to expansion or contraction of supply.
Change in supply refers to increase or decrease in the supply of a product due to various
determinants of supply other than price (in this case, price is constant).
 It is measured by shifts in the supply curve.
 The terms, while a change in supply means an increase or decrease in supply.

Expansion and Contraction of Supply

Expansion or Extension of Supply
Expansion or extension of Supply: When there are large quantities of a good supplied at higher
prices, it is known as expansion or extension of supply.
Figure shows the movement of the supply curve:
Expansion and Contraction of supply

In Figure, quantity supplied at price OP1 is OQ1. When the price rises to OP2, the quantity
supplied also increases to OQ2, which is shown by the upward movement from A1 to A2 (it is
pointed by the direction of the arrow between A1 to A2). This upward movement is known as
the expansion of supply.

Contraction Of Supply
Contraction of supply occurs when smaller quantities of goods are supplied even at reduced
prices.
On the contrary, a fall in price from OP1 to OP3 results in a decrease in supply from OQ1 to
OQ2. This movement from A1 to A3 shown by the arrow pointed downwards is known as the
contraction of supply. Thus, the movement from A1 to A3 is the representation of the
expansion and contraction of the quantity supplied.

Increase and Decrease In Supply

Increase In Supply
An increase in supply takes place when a supplier is willing to offer large quantities of products
in the market at the same price due to various reasons, such as improvement in production
techniques, fall in prices of factors of production, and reduction in taxes.
Decrease In Supply
A decrease in supply occurs when a supplier is willing to offer small quantities of products in
the market at the same price due to increase in taxes, low agricultural production, high costs
of labour, unfavourable weather conditions, etc.

Supply curve shifts

A shift takes place in supply curve due to the increase or decrease in supply, which is shown
in Figure.

Increase and Decrease in Supply

In Figure, an increase in supply in indicated by the shift of the supply curve from S1 to S2.
Because of an increase in supply, there is a shift at the given price OP, from A1 on supply
curve S1 to A2 on supply curve S2. At this point, large quantities (i.e. Q2 instead of Q1) are
offered at the given price OP.
On the contrary, there is a shift in the supply curve from S1 to S3 when there is a decrease in
supply. The amount supplied at OP is decreased from OQ1 to OQ3 due to a shift from A1 on
supply curve S1 to A3 on supply curve S3.
However, a decrease in supply also occurs when producers sell the same quantity at a higher
price (which is shown in Figure 3.6) as OQ1 is supplied at a higher price OP2.

What is Elasticity of Demand?

In economics, the elasticity of demand is a degree of change in the quantity demanded of a
product in response to its determinants, such as the price of the product, price of substitutes,
and income of consumers.
In economics, elasticity can be defined as the responsiveness of a variable (demand or supply)
with respect to its various determinants.

Elasticity of Demand Definition
The concept of elasticity was first introduced by Dr. Alfred Marshall, who is regarded as the
major contributor of the theory of demand, in his book “Principles of Economics.”
According to him, “The elasticity (or responsiveness) of demand in a market is great or small
according as the amount demanded increases much or little for a given fall in price, and
diminishes much or little for a given rise in price.”

Elasticity of demand may be defined as the ratio of percentage change in demand to the percentage change in
the price

Lipsey

The elasticity of demand is the proportionate change of amount purchased in response to a small change in
price, divided by the proportionate change in price.

Mrs. Jone Robinson

The elasticity of demand may be defined as the percentage change in the quantity demanded which would
result from one percent change in price.

Prof. Boulding

Types of Elasticity of Demand

Economists have divided the elasticity of demand in three main categories. Three types of
elasticity of demand is mentioned below:
1. Price Elasticity of Demand
2. Income Elasticity of Demand
3. Cross-Elasticity of Demand

Price Elasticity of Demand

Definition: Price elasticity of demand is a measure of a change in the quantity demanded of a
product due to change in the price of the product in the market.
Types of Price Elasticity of Demand
There are basically 5 types of price elasticity of demand:
1. Perfectly Elastic Demand
2. Perfectly Inelastic demand
3. Relatively Elastic Demand
4. Relatively Inelastic Demand
5. Unitary Elastic Demand
Types of Price Elasticity of Demand

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Factors Affecting Price Elasticity of Demand

1. Relative Need for the Product
2. Availability of Substitute Goods
3. Impact of Income
4. Time under Consideration
5. Perishability of the Product
6. Addiction

Factors Affecting Price Elasticity of Demand

Importance of Price Elasticity of Demand

1. Price determination under Monopoly
2. Price discrimination
3. Formulation of taxation policies
4. International trade
5. Formulation of agricultural policies

Importance of Price Elasticity of Demand

Income Elasticity of Demand

Definition: In Income elasticity of demand, the responsiveness of demand to change in income.
Types of Income Elasticity of Demand
1. Positive income elasticity of demand
2. Negative income elasticity of demand
3. Zero income elasticity of demand

Factors Affecting Income Elasticity of Demand

1. Income of Consumers in a Country
2. Nature of Products
3. Consumption Pattern

Cross Elasticity of Demand

Definition: Cross elasticity of demand can be defined as a measure of a proportionate change in
the demand for goods as a result of change in the price of related goods.
Types of Cross Elasticity of Demand
1. Positive cross elasticity of demand
2. Negative cross elasticity of demand
3. Zero cross elasticity of demand

What is Elasticity of Supply?

Definition: The elasticity of supply is a measure of change in the quantity supplied of a product
in response to a change in its price.

Types of Elasticity of Supply

1. Perfectly elastic supply
2. Perfectly Inelastic Supply
3. Relatively Elastic Supply
4. Relatively Inelastic Supply
5. Unitary Elastic Supply

Determinants of Elasticity of Supply

1. Nature of a product
2. Production techniques
3. Time period
4. Agriculture products

What is Price Elasticity of Demand?

Definition: Price elasticity of demand is a measure of a change in the quantity demanded of a product due to
change in the price of the product in the market.
In other words, Price elasticity of demand can be defined as the ratio of the percentage change in quantity
demanded to the percentage change in price.

Price Elasticity of Demand Formula

It can be mathematically expressed as:

A percentage change in demand and price is denoted with a symbol Δ.

Thus, the formula for calculating the price elasticity of demand is as follows:

Where,
ep = Price elasticity of demand
P = Initial price
ΔP = Change in price
Q = Initial quantity demanded
ΔQ = Change in quantity demanded

Price Elasticity of Demand Example

Let us understand the concept of price elasticity of demand with the help of an example.
Example: Assume that a business firm sells a product at the price of 450. The firm has decided to reduce the
price of the product to 350. Consequently, the demand for the product is raised from 25,000 units to 35,000
units. In this case, the price elasticity of demand is calculated as follows:
Here,
P = 450 DP = 100 (a fall in price; 450 – 350 = 100)
Q = 25,000 units
ΔQ = 10,000 (35,000 – 25,000)
By substituting these values in the above formula, ep = 1.8
Thus, the elasticity of demand is greater than 1.

Types of Price Elasticity of Demand

There are 5 types of price elasticity of demand as mentioned below:
1. Perfectly Elastic Demand
2. Perfectly Inelastic demand
3. Relatively Elastic Demand
4. Relatively Inelastic Demand
5. Unitary Elastic Demand

Types of Price Elasticity

Perfectly Elastic Demand

Definition: When a small change (rise or fall) in the price results in a large change (fall or rise) in the quantity
demanded, it is known as perfectly elastic demand.
Perfectly Inelastic Demand
Definition: When a change (rise or fall) in the price of a product does not bring any change (fall or rise) in the
quantity demanded, the demand is called perfectly inelastic demand.
Relatively Elastic Demand
Definition: When a proportionate or percentage change (fall or rise) in price results in greater than the
proportionate or percentage change (rise or fall) in quantity demanded, the demand is said to be relatively
elastic demand.
Relatively Inelastic Demand
Definition: When a percentage or proportionate change (fall or rise) in price results in less than the percentage
or proportionate change (rise or fall) in demand, the demand is said to be relatively inelastic demand.
Unitary Elastic Demand
Definition: Unitary elastic demand occurs when a change (rise or fall) in price results in equivalent change (fall
or rise) in demand.

Measurement of Price Elasticity

An Organization needs to estimate the numerical value of change in demand with respect to change in the given
price for making various business decisions. The numerical value of elasticity of demand can only be estimated
by its measurement.

Organizations use various methods for measuring price elasticity of demand. The figure, shows some
commonly used methods of measuring price elasticity of demand:
1. Total Outlay Method
2. Percentage method
3. Point elasticity method
4. Arc elasticity method
Measurement of Price Elasticity
Let us discuss study these methods in detail.

Total Outlay Method

Definition Total outlay method: Price elasticity of a product is measured on the basis of the total amount of
money spent (total expenditure) by consumers on the consumption of that product.
Using this method, price elasticity is determined by comparing consumers’ expenditure or outlay before the
change in the price with that of after change in the price. By comparing so, the.

In the total outlay method, three cases are considered, which are:

 If the total outlay remains unchanged after there is a change in the price of the good, the price elasticity equals
one (ep = 1).

 When a fall in the price of the good results in a small increase in the quantity demanded leading to a decline in
total outlay, the elasticity of demand is less than one (e p < 1).

 When a fall in the price of the good brings a large increase in the quantity demanded resulting in the rise of total
expenditure, elasticity of demand is greater than one (e p >1).
Percentage method
Definition: Percentage method is also known as the ratio method. Using this method, a ratio of proportionate
change in quantity demanded to the price of the product is calculated to determine the price elasticity.
ep = Q2 – Q1 / Q1 ÷ P2 – P1/ P1
Where,
Q1 = Original quantity demanded
Q2 = New quantity demanded
P1 = Original price
P2 = New price
Point elasticity method
Definition: In this method, different points are taken on the demand curve to find the price elasticity of demand
at different prices. The points at which elasticity is measured are lower and upper segments of the curve.
ep = L / U

L is a lower segment of the demand curve

U is the upper segment of the demand curve.
The point price elasticity of demand is measured on linear curves and non-linear curves.

This method is used to measure the elasticity at a specific point on a demand curve. The point elasticity method
is also known as geometric method or slope method.

Arc elasticity method

Definition: Arc elasticity method is used to calculate the elasticity of demand at the midpoint of an arc on the
demand curve. In this method, the average of prices and quantities are calculated for finding elasticity.
It is assumed that the elasticity would be same over a range of values of variables considered.

The formula of the arc elasticity method is:

ep= ΔQ/ ΔP ÷ P+ P1 / Q+Q1

Where,
ΔQ is change in quantity (Q1– Q)
ΔP is change in price (P1 – P)
Q is original quantity demanded
Q1 is new quantity demanded
P is original price
P1 is the new price

Factors Affecting Price Elasticity of Demand

Some of the important factors affecting price elasticity of demand are mentioned below:
1. Relative need for the product
2. Availability of substitute goods
3. Impact of income
4. Time under consideration
5. Perishability of the product
6. Addiction

Importance of Price Elasticity of Demand

The concept of price elasticity of demand plays a vital role in the functioning economies by having a significant
contribution in the field of industry, trade, and commerce. The major importance of price elasticity of
demand are mentioned below:
1. Price determination under Monopoly
2. Price discrimination
3. Formulation of taxation policies
4. International trade
5. Formulation of agricultural policies

Types of Price Elasticity of Demand

There are 5 types of price elasticity of demand, mentioned in the figure below:
1. Perfectly Elastic Demand
2. Perfectly Inelastic Demand
3. Relatively Elastic Demand
4. Relatively Inelastic Demand
5. Unitary Elastic Demand
Types of Price Elasticity of Demand

Let us study these different types of price elasticity of demand.

Perfectly Elastic Demand

Perfectly Elastic Demand Definition: When a small change (rise or fall) in the price results in a
large change (fall or rise) in the quantity demanded, it is known as perfectly elastic demand.
Under such type of elasticity of demand, a small rise in price results in a fall in demand to
zero, while a small fall in price causes an increase in demand to infinity. In such a case, the
demand is perfectly elastic or ep =∞.

The extent or degree of elasticity of demand defines the shape and slope of the demand curve.
Therefore, the elasticity of demand can be determined by the slope of the demand curve.
Flatter the slope of the demand curve, higher the elasticity of demand. In perfectly elastic
demand, the demand curve is represented as a horizontal straight line (in parallel to X-axis),
which is shown in Figure.

Figure: Perfectly Elastic Demand

In Figure, DD is the demand curve. Thus, demand rises from OQ to OQ1 and so on, if the price
remains at OD. A slight fall in price will increase the demand to OX, whereas a slight rise in
price will bring demand to zero.

Example of perfectly elastic demand

Example: The demand schedule for bread is given below

Price of Bread (per packet) Quantity Demanded (per month)

23 100
23.4 70
Calculate the price elasticity of demand and determine the type of price elasticity.

Solution:
P= 23
Q = 100
P1= 23.04
Q1 =70

Therefore, change in the price of milk is:

ΔP = P1 – P
ΔP = 23.04 – 23
ΔP = 0.04
A change of Rs 0.04 is a negligible change; thus, can be considered as zero.
Similarly, change in quantity demanded of bread is:
ΔQ = Q1–Q
ΔQ = 70–100
ΔQ = –30

In the above calculation, a change in demand shows a negative sign, which is ignored. This is
because price and demand are inversely related which can yield a negative value of demand
(or price).

Price elasticity of demand for bread is:

ep = ΔQ/ ΔP × P/ Q
ep = 30/0 × 23/100
ep = ∞
The price elasticity of demand for bread is ∞. Therefore, in such a case, the demand for bread
is perfectly elastic.

Perfectly Inelastic Demand

Perfectly Inelastic Demand Definition: When a change (rise or fall) in the price of a product does
not bring any change (fall or rise) in the quantity demanded, the demand is called perfectly
inelastic demand.
In this case, the elasticity of demand is zero and represented as ep = 0. Graphically, perfectly
inelastic demand curve is represented as a vertical straight line (parallel to Y-axis). Figure
shows the perfectly inelastic demand curve.

Figure: Perfectly Inelastic Demand

In Figure, DD is the demand curve. Thus, it can be observed that even when there is a change
in the price from OP1 to OP2, quantity demanded remains the same at OQ1.
Example of Perfectly Inelastic Demand
Example: The demand schedule for notebooks is given below:

Price of Notebook (Rs.per notebook) Quantity Demanded

40 100
30 100
Calculate the price elasticity of demand and determine the type of price elasticity.

Solution:
P= 40
Q = 100
P1= 30
Q1 =100

Therefore, a change in the price of notebooks is:

ΔP = P1 – P
ΔP = 30 – 40
ΔP = –10

In the above calculation, the change in price shows a negative sign, which is ignored. This is
because price and demand are inversely related which can yield a negative value of price (or
demand).

Similarly, a change in quantity demanded of notebooks is:

ΔQ = Q1 – Q
ΔQ = 100 – 100
ΔQ =0

Price elasticity of demand for notebook is:

ep = ΔQ/ ΔP × P/ Q
ep = 0/10 ×40/100
ep = 0
The price elasticity of demand for notebook is 0. Therefore, in such a case, the demand for a
notebook is perfectly inelastic.

Relatively Elastic Demand

Relatively Elastic Demand Definition: When a proportionate or percentage change (fall or rise) in
price results in greater than the proportionate or percentage change (rise or fall) in quantity
demanded, the demand is said to be relatively elastic demand.
In other words, a change in demand is greater than the change in price. Therefore, in this
case, elasticity of demand is greater than 1 and represented as ep > 1. The demand curve of
relatively elastic demand is gradually sloping, which is shown in Figure.
Figure: Relatively Elastic Demand

In Figure, DD is the demand curve that slopes gradually down with a fall in price. When price
falls from OP to OP1, demand rises from OQ to OQ1. However, the rise in demand QQ1 is
greater than the fall in price PP1.

Example of Relatively Elastic Demand

Example: The demand schedule for pens is given below:

Price of Pen (Rs.per pen) Quantity Demanded

25 50
20 100

Calculate the price elasticity of demand and determine the type of price elasticity.

Solution:
P= 25
Q = 50
P1= 20
Q1 =100

Therefore, a change in the price of pens is:

ΔP = P1 – P
ΔP = 20– 25
ΔP = – 5
In the above calculation, a change in price shows a negative sign, which is ignored. This is
because price and demand are inversely related which can yield a negative value of price (or
demand).

Similarly, a change in quantity demanded of pens is:

ΔQ = Q1–Q
ΔQ = 100–50
ΔQ = 50

Price elasticity of demand for pens is:

ep = ΔQ/ ΔP * P/ Q
ep = 50/5 * 25/50
ep = 5
The price elasticity of demand for bread is 5, which is greater than one. Therefore, in such a
case, the demand for pens is relatively elastic.

Relatively Inelastic Demand

Relatively Inelastic Demand Definition: When a percentage or proportionate change (fall or rise)
in price results in less than the percentage or proportionate change (rise or fall) in demand,
the demand is said to be relatively inelastic demand.
In other words, a change in demand is less than the change in price. Therefore, the elasticity
of demand is less than 1 and represented as ep < 1. The demand curve of relatively inelastic
demand is rapidly sloping, which is shown in Figure.

Figure: Relatively Inelastic Demand

In Figure, DD is the demand curve that slopes steeply with a fall in price. When price falls
from OP to OP1, the demand rises from OQ to OQ1. However, the rise in demand QQ1 is less
than the fall in price PP1.

Example of Relatively Inelastic Demand

Example: The demand schedule for milk is given below:
Price of Milk(Rs.per liter) Quantity Demanded (liters)
15 90
20 85

Calculate the price elasticity of demand and determine the type of price elasticity.

Solution: P= 15
Q = 90
P1= 20
Q1 =85

Therefore, a change in the price of milk is:

ΔP = P1 – P
ΔP = 20 – 15
ΔP = 5

Similarly, a change in quantity demanded of milk is:

ΔQ = Q1 – Q
ΔQ = 85 – 90
ΔQ = –5

In the above calculation, a change in demand shows a negative sign, which is ignored. This is
because price and demand are inversely related which can yield a negative value of demand
(or price).

Price elasticity of demand for milk is:

ep =DQ/DP × P/ Q
ep = 5/5 × 15/90
ep = 0.2
The price elasticity of demand for milk is 0.2, which is less than one. Therefore, in such a case,
the demand for milk is relatively inelastic.

Unitary Elastic Demand

Unitary Elastic Demand Definition: Unitary elastic demand occurs when a change (rise or fall) in
price results in equivalent change (fall or rise) in demand.
The numerical value for unitary elastic demand is equal to one, i.e., ep =1. The demand curve
for unitary elastic demand is a rectangular hyperbola, which is shown in Figure.
Figure: Unitary Elastic Demand

In Figure, DD is the unitary elastic demand curve sloping uniformly from left to the right.
Here, the demand falls from OQ to OQ2 when the price rises from OP to OP2. On the contrary,
when price falls from OP to OP1, demand rises from OQ to OQ1.

Example of Unitary Elastic Demand

Example: The demand schedule for cloth is given as follows:

Price of cloth(Rs. per metre) Quantity Demanded (in metres)

30 100
15 150
Calculate the price elasticity of demand and determine the type of price elasticity.

Solution:
P= 30
Q = 100
P1 = 15
Q1 = 150

Therefore, change in the price of cloth is:

ΔP = P1 – P
ΔP = 15 – 30
ΔP = –15

In the above calculation, a change in price shows a negative sign, which is ignored. This is
because price and demand are inversely related which can yield a negative value of price (or
demand).
Similarly, change in quantity demanded of cloth is:
ΔQ = Q1 – Q
ΔQ = 150 –100
ΔQ = 50

Price elasticity of demand for cloth is:

ep = ΔQ/ ΔP × P/ Q
ep = 50/15 × 30/100
ep = 1
The price elasticity of demand for cloth is 1. Therefore, in such a case, the demand for milk is
unitary elastic.

Factors Affecting Price Elasticity of Demand

As discussed earlier, the price elasticity of demand of a product reflects the change in the quantity demanded
as a result of a change in price. However, the price elasticity differs for different products as it depends on
various factors.
Some of these factors affecting price elasticity of demand are mentioned below:

Factors Affecting Price Elasticity of Demand

1. Relative need for the product
2. Availability of substitute goods
3. Impact of income
4. Time under consideration
5. Perishability of the product
6. Addiction

Relative need for the product

The need of every individual is not the same for the same product. A product that is luxury for an individual
may be a necessity for another person.

For example, a laptop may be a luxury product for an ordinary individual, while a necessity for a computer
engineer. Thus, price elasticity differs across people due to their different needs.

Availability of substitute goods

As discussed in the previous chapters, the availability of substitutes has major impact on the demand for a
product. If substitutes are easily available at relatively low prices, the demand for the product would be more
elastic and vice versa.

For example, if the price of tea rises, people may opt for coffee.
Impact of income
The amount of income that consumers spend on purchasing a particular product also influences the price
elasticity of demand. If consumers spend a large sum on a product, the demand for the product would be elastic.

For example, if the price of salt is raised by 50%, the demand would still be inelastic as consumers would keep
on purchasing. Conversely, if the price of a home theatre system is raised by 25%, the demand for the system
would be more elastic.
Time under consideration
It majorly influences the price elasticity of demand. Demand for a product remains inelastic in the short run due
to failure to postpone demand.

For example, if the price of electricity goes up, people may find it difficult to cut its consumption; thus, the
demand would remain less elastic. However, in case of a continuous increase in the price, people would
gradually reduce the consumption of electricity by finding various ways, such as using CFL bulbs. In such a
case, the demand would be more elastic.
Perishability of the product
If products are perishable in nature, the demand for such products would be inelastic as their consumption
cannot be postponed.

For example, if the prices of vegetables that are used regularly are raised, the consumption would not decrease.
Thus, the demand would be inelastic. Similarly, if products such as medicines are to be used in an emergency,
the demand for them would not decrease.
Addiction
Some products, such as cigarettes and other tobacco-based products, have inelastic demand.

For instance, smokers may be willing to pay extra for cigarettes even in case of a price rise. Thus, the demand
would remain the same.

FAQ – Price Elasticity of Demand

What are the factors affecting PED?

Factors affecting price elasticity of demand (PED) are: Relative Need for the Product, Availability of Substitute
Goods, Impact of Income, Time under Consideration, Perishability of the Product, Addiction.

What are the 4 determinants of Price Elasticity of Demand?

Four Determinants of Price Elasticity of Demand are Substitutability, Proportion of Income, Luxuries vs
Necessities, Time.

Importance of Price Elasticity of Demand

The concept of price elasticity of demand plays an important role in the functioning economies by having a
significant contribution in the field of industry, trade, and commerce. Not only this, it helps Organizations in
analysing economic problems and making appropriate business decisions. The figure, shows the importance of
price elasticity of demand:

Importance of Price Elasticity of Demand

Let us discuss the importance of price elasticity of demand in detail.
1. Price determination
2. Price discrimination
3. Formulation of taxation policies
4. International trade
5. Formulation of agricultural policies

Price determination
The concept of price elasticity of demand is used by Organizations in determining prices under various
situations.

For instance, under monopolistic market conditions, an Organization sets a low price per unit of the product in
case of elastic demand. As a result, the demand for the product rises. On the other hand, when the demand for
the product is inelastic, the price is set very high. This helps in generating large revenues for Organizations due
to the high price of a product while demand remains constant.
Price discrimination
This is another area where price elasticity of demand plays an important role. Price discrimination refers to
charging different prices from various customers for the same product.

The common example of price variation is petrol. Its demand is inelastic as the change in the price does not
affect consumption. Thus, the price of petrol is charged differently in different states of India.
Formulation of taxation policies
The government takes under consideration the price elasticity of demand before formulating taxation policies.
Generally, government levies high taxes on products (for producers) whose demand is elastic. On the contrary,
it levies high taxes on products (for customers) having inelastic demand as the consumption remains
unaffected.

International trade
The concept of price elasticity has a significant role in international trade. This is because successful trade
transactions between the two countries are dependent on the price elasticity of demand. This is because the
price elasticity of demand is used in deciding the level of imports and exports.

For instance, if the demand for the product is inelastic in the international market, the seller country will have
an upper hand in exports.
Formulation of agricultural policies
The price elasticity of demand also helps the government in formulating agricultural policies by providing
insight into the paradox of poverty. The prices of farm products whose demand is inelastic fall due to large
supplies as a result of bumper crops. This results in a fall in prices, which leads to low income for farmers.

Consequently, poverty among farmers increases. Thus, government sets a minimum suitable price for inelastic
farm products so that farmers can generate adequate revenues.
What is Income Elasticity of Demand?
An increase in the income of consumers increases the demand for the product even if the price remains
constant. The responsiveness of quantity demanded with respect to the income of consumers is called
the income elasticity of demand.
Similar to the price elasticity of demand, the income of consumers is also an important determinant of the
demand for the product.

Income Elasticity of Demand Definition

The following are some important popular definitions of income elasticity of demand:

Income elasticity of demand means the ratio of the percentage change in the quantity demanded to the
percentage in income.
Watson

The responsiveness of demand to change in income is termed as income elasticity of demand.

Richard G. Lipsey

Income Elasticity of Demand Formula

Mathematically, the income elasticity of demand can be stated as:

Where,
Percentage change in quantity demanded =

Percentage change in income =

Thus, the formula for calculating the price elasticity of demand is as follows:

Where,
Q is original quantity demanded
Q1 is new quantity demanded
∆Q = Q1–Q
Y is original income
Y1 is new income
∆Y = Y1 – Y
Income Elasticity of Demand Example
Let us understand the concept of income elasticity of demand with the help of an example.

Example: Suppose the monthly income of an individual increases from 5,000 to 15,000. Now, his demand for
clothes increases from 35 units to 70 units. Calculate the income elasticity of demand.
Solution: Given that:

Y = 5,000 Y1= 15,000

∆Y = 15,000-5,000 = 10,000
Q = 35 units
Q1 = 70 units
∆Q = 70 – 35 = 35

The formula for calculating the income elasticity of demand is:

Substituting the values,

Types of Income Elasticity of Demand

Similar to the types of price elasticity of demand, the degree of responsiveness of demand with a change in
consumer’s income is not always the same.
Types of Income Elasticity of Demand
1. Positive income elasticity of demand
2. Negative income elasticity of demand
3. Zero income elasticity of demand
Positive income elasticity of demand
When a proportionate change in the income of a consumer increases the demand for a product and vice versa,
income elasticity of demand is said to be positive. In case of normal goods, the income elasticity of demand is
generally found positive, which is shown in Figure.
Positive Income Elasticity of Demand

In Figure, DYDY is the curve representing positive income elasticity of demand. The curve is sloping upwards
from left to the right, which shows an increase in demand (OQ to OQ1) as a result of rise in income (OB to
OA).

Three types of positive income elasticity of demand

There are three types of positive income elasticity of demand, namely unitary income elasticity of demand, less
than unitary income elasticity of demand, and more than income elasticity of demand. Let us discuss them as
follows:

 Unitary income elasticity of demand: The income elasticity of demand is said to be unitary when a
proportionate change in a (increase) for a product. For example, if there is 25% increase in the income of a consumer,
the demand for milk consumption would also be increased by 25%. Thus e y = 25/25 =1.

 Less than unitary income elasticity of demand: The income elasticity of demand is said to be less than unitary
when a proportionate change in a consumer’s income causes comparatively less increase in the demand for a product.
For example, if there is an increase of 25% in consumer’s income, the demand for milk is increased by only 10%.
Thus ey = 10/100 = 0.1 < 1.

 More than unitary income elasticity of demand: The income elasticity of demand is said to be more than
unitary when a proportionate change in a consumer’s income causes a comparatively large increase in the demand for
a product. For example, if there is an increase of 25% in consumer’s income, the demand for milk is increased by only
35%. Thus ey = 35/25 = 1.4 > 1.
Negative income elasticity of demand
When a proportionate change in the income of consumer results in a fall in the demand for a product and vice
versa, the income elasticity of demand is said to be positive. It generally happens in the case of inferior goods.

For example, consumers may prefer small cars with a limited income. However, with a rise in income, they
may prefer using luxury cars.

Figure shows the negative income elasticity of demand

Negative Income Elasticity of Demand

In Figure, DYDY is the curve representing negative income elasticity of demand. The curve is sloping
downwards from left to the right, which shows a decrease in the demand as a result of a rise in income. As
shown in Figure, with a rise in income from 10 to 30, the demand falls from 3 to 2.

Zero income elasticity of demand

When a proportionate change in the income of a consumer does not bring any change in the demand for a
product, income elasticity of demand is said to be zero. It generally occurs for utility goods such as salt,
kerosene, electricity. Figure 5.15 shows the zero income elasticity of demand:

Zero Income Elasticity

In Figure, DYDY is the curve representing zero income elasticity of demand. The curve is parallel to Y-axis
that shows no change in the demand as a result of a rise in income. As shown in Figure 5.14, with a rise of
income from 10 to 20, the demand remains the same i.e. 4.

Factors Affecting Income Elasticity of Demand

As discussed earlier, the income elasticity of demand for a product reflects the change in the quantity demanded
as a result of change in consumer’s income. However, the income elasticity differs for different products as it
depends on various factors. Some of these factors are listed in Figure.

Factors Affecting Income Elasticity of Demand

1. Income of consumers in a country
2. Nature of products
3. Consumption pattern
Income of consumers in a country
In any country, the income level of consumers is not the same. Therefore, consumers spend on the basis of not
only on their need but also their purchasing capacity. The purchasing capacity of consumers increases with a
rise in their income.

For example, a consumer with a low income may prefer using public transport for commuting. However, with
a rise in income, he/she may buy a two-wheeler for the same purpose.
Nature of products
The nature of products being consumed by consumers also has an important influence on income elasticity.

For example, basic goods used on a day to day basis, such as salt, sugar, and cooking oil, is elastic. Even with
a rise in the income of a consumer, the demand for such products does not change and remain inelastic.
Consumption pattern
With a rise in income, people quickly change their consumption patterns. For example, people may start buying
high priced products with an increase in their income. This leads to an increase in the demand for the products
in the market. However, once the consumption pattern is established, it becomes difficult to lower the demand
in case of a decrease in income.

For example, a consumer may buy a two-wheeler that runs on petrol as a result of a rise in his/her income.
However, over a period of time, in case his/her income falls, it will be difficult for him to reduce the
consumption of petrol.

What is Cross Elasticity of Demand?

The cross elasticity of demand can be defined as a measure of a proportionate change in the demand for goods
as a result of a change in the price of related goods.

Cross Price Elasticity of Demand Definition

The cross elasticity of demand is the proportional change in the quantity demanded of good X divided by the
proportional change in the price of the related good Y.

Cross Elasticity of Demand Formula

The cross elasticity of demand can be measured as:

Cross Elasticity of Demand Example

Let us understand the concept of cross elasticity of demand with the help of an example.

Example: Assume that the quantity demanded for detergent cakes has increased from 500 units to 600 units
with an increase in the price of detergent powder from 150 to 200. Calculate the cross elasticity of demand
between two products.

Solution: Given that

X = Detergent cakes
Y = Detergent powders
Qx = 500
ΔQx = 100(600-500)
Py = 150
ΔPy = 50

Types of Cross Elasticity of Demand

Cross elasticity of demand can be categorised into three types, which are as follows:

1. Positive cross elasticity of demand

2. Negative cross elasticity of demand
3. Zero cross elasticity of demand
Positive cross elasticity of demand
When an increase in the price of a related product results in an increase in the demand for the main product and
vice versa, the cross elasticity of demand is said to be positive. Cross-elasticity of demand is positive in the
case of substitute goods.

For example, the quantity demanded tea has increased from 200 units to 300 units with an increase in the price
of coffee from 25 to 30. In this case, the cross elasticity would be:

Negative cross elasticity of demand

When an increase in the price of a related product results in the decrease of the demand of the main product and
vice versa, the negative elasticity of demand is said to be negative. In complementary goods, cross elasticity of
goods is negative.

For example, if the price of butter is increased from 20 to 25, the demand for bread is decreased from 200 units
to 125 units. In such a case, cross elasticity will be calculated as:

Zero cross elasticity of demand

When a proportionate change in the price of a related product does not bring any change in the demand for the
main product, the negative elasticity of demand is said to be negative. In simple words, cross elasticity is zero
in case of independent goods. In this case, it becomes zero.

By studying the concept of cross elasticity of demand, Organizations can forecast the effect of change in the
price of a good on the demand for its substitutes and complementary goods. Thus, it helps Organizations in
making pricing decisions by determining the expected change in the demand for its substitutes and
complementary goods. Moreover, it helps an Organization to anticipate the degree of competition in the market.
What is Elasticity of Supply?
According to Prof. Thomas, “The supply of a commodity is said to be elastic when as a result of a change in
price, the supply changes sufficiently as a quick response. Contrarily, if there is no change or negligible change
in supply or supply pays no response, it is elastic.”

Thus, the elasticity of supply is a measure of the degree of change in the quantity supplied of a product in
response to a change in its price.
As discussed previously, the law of supply states that the quantity supplied of a product increases with a rise in
the price of the product and vice versa, while keeping all other factors constant.
However, an Organization needs to determine the impact of change in the price of a product on its supply in
numerical terms. The concept of elasticity of supply helps Organizations to estimate the impact of change in the
supply of a product with respect to its price.

Elasticity of Supply Formula

Mathematically, the elasticity of supply is expressed as:

Percentage change in quantity supplied =

Percentage change in quantity supplied =

The elasticity of supply can be calculated with the help of the following formula:

Where,
ΔS = S1 – S
ΔP = P1 – P

Elasticity of Supply Example

Let us understand how to calculate the elasticity of supply with the help of an example.
Example: Assume that a business firm supplied 450 units at the price of 4500. The firm has decided to increase
the price of the product to> 5500. Consequently, the supply of the product is increased to 600 units. Calculate
the elasticity of supply.
Solution: Here,
P = 4500 ΔP = 1000 (a fall in price; 5500– 4500 = 1000)
S = 450 units
ΔS = 150 (600 – 450)

By substituting these values in the above formula, we get:

es = 150/1000 x 4500/450 = 1.5

Types of Elasticity of Supply

Similar to elasticity of demand, elasticity of supply also does not remain same. The degree of change in the
quantity supplied of a product with respect to a change in its price varies under different situations.
Based on the rate of change, the types of price elasticity of supply is grouped into five main categories, which
are explained as follows:
1. Perfectly elastic supply
2. Perfectly Inelastic Supply
3. Relatively Elastic Supply
4. Relatively Inelastic Supply
5. Unitary Elastic Supply
Perfectly elastic supply
Definition: When a proportionate change (increase/ decrease) in the price of a product results in an
increase/decrease of quantity supplied, it is called a perfectly elastic supply.
In such a case, the numerical value of elasticity of supply would be infinite (es =∞). This situation is imaginary
as there is no such product whose supply is perfectly elastic. Therefore, this situation does not have any
practical implication.
Perfectly elastic supply example
Let us understand the concept of a perfectly elastic supply with the help of an example.

Example: The supply schedule of product X is given as follows:

Price (Rs.Per Kg.) Quantity Supplied (Kgs. in thous.)
100 60
100 40
100 80
Draw a supply curve for the supply schedule and find the type of elasticity of supply using the curve.
Solution: The supply curve for product X is shown in Figure.
Perfectly elastic supply curve
Perfectly elastic supply curve

Figure shows that the price of product X remains constant at ₹100 per kg. However, the quantity supplied
changes from 40,000 kgs to 80,000 kgs at the same price. Therefore, the supply of product X is perfectly elastic
( es =∞).
Perfectly Inelastic Supply
Definition: In this situation, the quantity supplied does not change with respect to a proportionate change in the
price of a product. In other words, the quantity supplied remains constant at the change in price when supply is
perfectly inelastic.
Thus, the elasticity of supply is equal to zero ( es =0). However, this situation is imaginary as there can be no
product whose supply could be perfectly inelastic.
Perfectly inelastic supply example
Let us understand the concept of perfectly inelastic supply with the help of an example.

Example: The quantity supplied and the price of product A are given as follows:
Price (Rs.Per Kg.) Quantity Supplied (Kgs. in thou.)
45 50
55 50
65 50
Draw a supply curve for the supply schedule and find the type of elasticity of supply using the curve.

Solution: The supply curve for product A is shown in Figure

Perfectly inelastic supply curve

Perfectly inelastic supply curve

Figure, shows that the supply of product A remains constant at 50,000 kgs. However, the price changes from 45
to 65 at the same supply rate. Therefore, the supply of product X is perfectly inelastic (e = 0).

Relatively Elastic Supply

Definition: When a percentage change in the quantity supplied is more than a percentage change in the price of
a product, it is called relatively elastic supply. In this case, the elasticity of supply is less than 1, i.e. es < 1.
Relatively elastic supply example
Let us understand the concept of relatively elastic supply with the help of an example.
Example: The quantity supplied and the price of product P are given as follows:
Price (Rs.Per Kg.) Quantity Supplied (Kgs. in thous.)
50 35
53 40
55 45
Draw a supply curve for the supply schedule of product P and find the type of the elasticity of supply using the
curve.

Solution: The supply curve for product P is shown in Figure

Relatively Elastic supply curve

Relatively Elastic supply curve

In Figure, SS is the supply curve. When the price of product P is 50, the quantity supplied is 35,000 kgs.
However, when the price increases to 53, supply reaches to 40,000 kgs. Similarly, when the price further
increases to 55, the supply increases to 45,000 kgs. This shows that the change in price is only 2 while the
change in supply is 5,000 kgs.

In other words, the proportionate change in quantity supplied is more than the proportionate change in the price
of product P. Therefore, the supply of product P is highly elastic (es>1).

Unitary Elastic Supply

Definition: When the proportionate change in the quantity supplied is equal to the proportionate change in the
price of a product, the supply is unitary elastic. In this case, elastic supply is equal to one ( es =1).
Unitary elastic supply example
Let us understand the concept of relatively elastic supply with the help of an example.

Example: The quantity supplied and the price of product Z are given below:
Price (Rs.Per Kg.) Quantity Supplied (Kgs. in thous.)
50 30
55 35
Solution: The supply curve for product Z is shown in Figure
Unitary elastic supply curve

Unitary elastic supply curve

In Figure, when the price of product Z is 50, the quantity supplied is 30,000 kgs. When price increases to 55,
supply reaches to 35,000 kgs. This shows that the proportionate change in quantity supplied is equal to the
change in the price of product Y. Therefore, the supply of product B is unit elastic ( es =1).

Measurement of Elasticity of Supply

An Organization is required to estimate the elasticity of supply for making various business decisions under
different situations, such as deciding the supply of products. Apart from this, the concept of elasticity of supply
is helpful for the government in deciding taxation policies.

For instance, high taxes are levied on goods whose supply is inelastic to generate large revenues. Thus, a
numerical value is required to measure the elasticity of supply.
There are two most commonly used methods for measuring the elasticity of supply, which are explained as
follows:

Proportionate method
It is an important method of measuring the elasticity of supply. In this method, the elasticity of supply is
calculated by dividing the percentage change in quantity supplied with the percentage change in the price of a
product. Thus, the elasticity of supply is calculated as follows:

Percentage change in quantity supplied =

Percentage change in price = Change in price (ΔS) / Original price (P)

Where
ΔS = S1–S
ΔP = P1–P

Point method
In this method, the elasticity of supply is measured at a particular point on the supply curve. For that, a tangent
needs to be drawn along with the demand curve. Let us understand the estimation of elasticity of supply on the
demand curve using the point method.

In Figure, TF is a tangent drawn from point P to measure the elasticity of supply. This tangent intersects X-axis
at point T. Another vertical line from P is intersecting X-axis at point B. Thus, the elasticity of supply at point P
is calculated as:

Point Elasticity of Supply

In Figure, TF is a tangent drawn from point P to measure the elasticity of supply. This tangent intersects X-axis
at point T. Another vertical line from P is intersecting X-axis at point B. Thus, the elasticity of supply at point P
is calculated as:

es = TB/OB

Thus, it presents three conditions. If

TB > OB, es > 1
TB < OB, es <1
TB = OB, es = 1
Let us understand these three conditions with the help of the following diagrams:

1. When TB < OB
 Condition 1: TB < OB

In Figure, SS is the supply curve and at point P the elasticity of the supply is measured. When SS curve is
extended, it intersects OX axis at point T. Now es is represented as TB/OB
By seeing the Figure, it is apparent that TB < OB. Therefore, es < 1, a representative that the supply is less
inelastic:
2. When TB = OB

Condition 2: TB = OB

In Figure, SS is the supply curve and at point P the elasticity of the supply is measured. As SS curve is
extended, passes through the point of origin. Now es is represented as

By seeing Figure, it is apparent that TB = OB. Therefore, es = 1, implying that the supply is elastic:
3. When TB > OB
 Condition 3: TB > OB

In Figure, SS is the supply curve and at point P the elasticity of the supply is measured. As SS curve is
extended, it meets OY axis at point T. Now es is represented as

By seeing Figure, it is apparent that TB>OB. Therefore, es > 1, implying that the supply is highly elastic.

Determinants of Elasticity of Supply

The elasticity of supply cannot be the same under all circumstances. This is because it is influenced by a
number of factors. Some of the important factors affecting elasticity of supply are explained as follows:
Determinants of Elasticity of Supply
1. Nature of a product
2. Production techniques
3. Time period
4. Agriculture products
Nature of a product
The product’s nature is an important factor that influences the elasticity of supply. For instance, products that
are perishable in nature have inelastic supply as their supply cannot be increased or decreased in a short span of
time. On the other hand, products, such as antiques and old wines, which cannot be reproduced in the same
form, have a constant supply.

Production techniques
Production techniques used by Organizations also have a great influence on the supply of their products. If
Organizations use the latest techniques of production, the supply can be faster with respect to the change in the
price of products.

Time period
It affects the elasticity of supply to a great extent. For instance, in the short run, elasticity of supply is low due
to various factors, such as obsolete production techniques. Therefore, changes in prices do not affect the supply
of products immediately. If the price remains high for a longer period, the supply of products is increased.

Agriculture products
The production of agriculture products cannot be increased or decreased easily as they depend on natural
factors, including rain, humidity, and sunlight. This affects the supply of such products to a great extent;
thereby making the supply relatively inelastic.

What is Utility?
The level of satisfaction derived by a consumer after consuming a good or service is
called utility.
In economics, utility can be defined as a measure of consumer satisfaction received on the
consumption of a good or service.
The concept of utility is used in neo classical Economics to explain the operation of the law of
demand.
A consumer is willing to buy a particular good to satisfy his/her various needs and wants.
Thus, it can be said that the demand for a good is closely related to the level of satisfaction
that the consumer derives from that good.

For instance, if the level of consumer satisfaction after the consumption of a good is high, the
demand for that good rises and vice versa.

Utility Definition
Utility is the power of commodity to satisfy human wants.Prof. Waugh
On the whole in recent years the wider definition is preferred and utility is identified, with desireness rather than with
satisfyingness.Fraser

Meaning of Utility
The utility is want satisfying power of a good or service. It is also defined as the property of a
good or service to satisfy the want of the consumer. The utility is subjective.

It depends upon the mental assessment of the consumer and is determined by several factors
which influence the consumer’s judgment.

Formula for Utility

Mathematically, utility can be expressed as a function of the quantities of different
commodities consumed by an individual.
If an individual consumes quantity m1 of a commodity M, quantity n1 of a commodity N, and
quantity r1 of a commodity R, the utility U of the consumer can be measured as follows:

U = f (m1, n1, r1)

Utility Analysis
Utility analysis is a systematic process of measuring utility derived by a consumer after the
consumption of a good. It involves analysing factors that influence consumer behaviour for a
particular good.

There are two approaches to the measurement of utility, namely cardinal utility approach

and ordinal utility approach.

Characteristics of Utility
1. Utility is that invisible quality of anything which resorts to satisfying any human want. The utility may neither be
seen, i.e. it is invisible, nor may it be touched. It is there in the things in abstract or invisible form.

2. Utility is not concerned with the ‘morality’. Whether the consumption of a thing is useful or harmful, if it serves
to fulfill the wants of anyone, it possesses ‘utility’.

3. Utility emerges out of the human needs or wants. Thus it is Individual and relative in nature. It is a subjective
concept, not objective or concrete which could be uniformly applicable in all cases.

Types of Utility
There are four different types of utility. Those are:
 Form utility
 Place utility
 Time utility
 Possession utility

Concept of Utility
1. Total Utility
2. Marginal Utility
Total Utility
Definition: Total utility is defined as the sum of the utility derived by a consumer from the
different units of a commodity or service consumed at a given period of time.
Assume that an individual consumes five units of a commodity X at a given period of time and
derives utility out of the consumption of each unit as u1, u2, u3, u4, and u5.

The total utility is measured as follows:

TU = U1 + U2 + U3 + U4 + U5

If the individual consumes n number of commodities, his/her total utility, TUn, will be the
sum of the utility derived from each commodity. For example, an individual consumes
commodities X, Y, and Z and their respective utilities are Ux, Uy, and Uz, then total utility is
expressed as follows:
TUn = Ux + Uy + Uz

Marginal Utility
Definition: Marginal utility is defined as the utility derived from the marginal or additional unit
of a commodity consumed by an individual.
It can also be defined as the addition to the total utility of a commodity resulting from the
consumption of an additional unit.

Therefore, marginal utility, MU of a commodity X, is the change in the total utility, ∆ TU,
attained from the consumption of an additional unit of commodity X.

Mathematically, it can be expressed as:

MUx = ∆ TUx / ∆ Qx

Where TUx = Total utility, ∆Qx = Change in quantity consumed by one additional unit

When total number of unit consumed is n, a marginal utility can also be expressed as: MU of
nth unit = TUn – TUn – 1

What is Consumer Demand?

Consumers consider various factors before making purchases. For example, a particular
brand, price range, size, features, etc. These factors differ from one individual to the other
depending on their income level, standard of living, age, sex, customs, socio-economic
backgrounds, tastes and preferences, etc. These factors form the basis for consumer buying
behaviour.

Manufacturers are always interested to gain insight into consumer buying behaviour. For
this, they need to analyse consumer demand for their products and services.

Consumer Demand Analysis

Consumer demand analysis is a process of assessing consumer behaviour based on the satisfaction
of wants and needs generated by a consumer from the consumption of various goods.
The satisfaction that consumers gain out of the consumption of a commodity or service is
called utility.

Assumptions of Consumer Demand

The study and analysis of consumer behaviour is based on three main assumptions, which
are listed
Let us discuss these assumptions in detail.

1. Decisiveness: It is assumed that a consumer is able to state his/ her own preference or indifference for two
different commodities.

Therefore, consumers are least ambiguous or confused about deciding between different commodities. This is referred
to as decisiveness of consumers.

For example, an individual goes to a fast food restaurant and is asked to opt between pizza and burger.

According to the assumption of decisiveness, the individual would act in one of the following ways: Opt for pizza,
Opt for burger, Opt for none of the two and walk out

2. Transitivity: In consumer demand, it is assumed that the preferences of an individual consumer are always
consistent. An individual’s preference or indifference for one commodity over another can be applied to another
related commodity. This is referred to as transitivity.

In the above example, if the individual chooses pizza over burger, burger over pasta, then the individual would prefer
pizza over pasta too as per the assumption of transitivity.

3. Non-satiation: It is assumed that a consumer is never completely satisfied. If a consumer prefers a commodity,
he/she would continue to demand it. This is referred to as non-satiation.

For example, a larger pizza is preferred over a smaller pizza; two dresses are preferred over one; etc. However, non-
satiation is not a fundamental assumption as rational consumers get satiated after a certain limit.
.

What is Law of Diminishing Marginal Utility?

Definition: The law of diminishing marginal utility states that as the quantity consumed of a
commodity continues to increase, the utility obtained from each successive unit goes on
diminishing, assuming that the consumption of all other commodities remains the same.
To put simply, when an individual continues to consume more and more units of a
commodity per unit of time, the utility that he/she obtains from each successive unit
continues to diminish.

Law of diminishing marginal utility example

For example, the utility derived from the first glass of water is high, but with successive glasses
of water, the utility would keep diminishing. The law of diminishing marginal utility is
applicable to all kinds of goods such as consumer goods, durable goods, and non-durable
goods.
Let us understand the law of diminishing marginal utility with the help of an example.

An individual consumes only one commodity X and its utility is measured quantitatively. The
total utility and marginal utility schedules are as shown in Table

Number of Units of Commodity X Consumed Per Unit of Time

 TOTAL UTILITY MARGINAL UTILITY
UNITS OF COMMODITY X
(TUX) (MUX)

1 30 30

2 50 30

3 60 20

4 65 10

5 60 5

6 45 -5

Table shows that as the number of units of commodity X consumed per unit of time increases,
TUx increases but at a diminishing rate while marginal utility MUx decreases consistently.
The rate of increase in TUx as a result of increase in the number of units consumed has been
depicted through the MUx curve in the graph shown in Figure

Total and Diminishing Marginal Utility of Commodity X

In Figure, the downward sloping MUx curve shows that the marginal utility of a commodity
consistently decreases as its consumption increases. When the consumption reaches to 4 units
of commodity X, TUx reaches its maximum level (the point of saturation) marked as M.

Beyond the point of saturation, MUx becomes negative and TUx begins to decline consistently.
The downward slope of MUx explains the law of diminishing marginal utility. Therefore,
according to the law of diminishing marginal utility, the utility gained from a unit of a
commodity is dependent on the consumer’s desire for the commodity.

When an individual continues to consume additional units of a commodity, the satisfaction

that he/she derives from the consumption keeps decreasing. This is because his/ her need gets
satisfied in the process of consumption. Therefore, the utility derived from successive units of
the commodity decreases.

Assumptions of law of diminishing marginal utility

Assumptions of law of diminishing marginal utility are as follows:
 Rationality: The law of marginal utility assumes that a consumer is a rational being who aims at maximising
his/her utility at the given income level and the market price.
 Measurement of utility: The utility of a commodity can be measured using quantifiable standards like a cup of
tea, a bag of sugar, a pair of socks, etc.
 Constant marginal utility of money: The marginal utility of consumer’s income is constant.
 Homogeneity of commodity: The successive units of a commodity consumed are homogenous or identical in
shape, size, colour, taste, quality, etc.
 Continuity: The consumption of successive units of a commodity should be continuous without intervals.
 Ceteris paribus: Factors, such as the income, tastes and preferences of consumers; price of related goods; etc.
remain unchanged.

Exceptions of law of diminishing marginal utility

Following are the exceptions of law of diminishing marginal utility:
1. Drunkard – Utility from each additional peg of wine increases for the drunkard. The law does not operate in his
case.
2. Money – The law docs hold good in case of money. The utility of money does not diminish.
3. Hobbies– Hobbies like stamp collection is an exception. A man who has hobby of collecting stamps feels more
satisfied with every successive stamp he is able to collect.
4. Rare collections
5. Money
6. Knowledge and Innovation
7. Precious goods
8. Utility increases due to a demonstration

Importance of law of diminishing marginal utility

Importance of law of diminishing marginal utility are as follow:
1. Basis for law of demand: The law of diminishing marginal utility is one of the fundamental laws of Economics.
The basic law of demand is, in fact, totally based on the law of diminishing marginal utility.

2. Basis of the Progressive Tax-policy: The government can formulate a progressive tax-policy on the basis of the
law of diminishing marginal utilIty.

3. Basis for Re-Distribution of Wealth Policy: The government’s public expenditure policy is also based on the
law of diminishing marginal utility.

4. Determining optimum level of consumption: This law helps in the determination of the optimum level of
consumption. it is attained at a point where the marginal utility of a commodity equals its price.

5. Forms basis for production of things: According to Taussing, only due to this very law, are the various things
produced or manufactured.

What is Indifference Curve?

Definition: An indifference curve can be defined as the locus of points each representing a
different combination of two good, which yield the same level of utility and satisfaction to a
consumer.
Therefore, the consumer is indifferent to any combination of two commodities if he/she has to
make a choice between them. This is because an individual consumes a variety of goods over
time and realises that one good can be substituted with another without compromising on the
satisfaction level.
When these combinations are plotted on the graph, the resulting curve is called indifference
curve. This curve is also called the iso-utility curve or equal utility curve.

Indifference Curve Analysis

Let us learn the indifference curve through a schedule. Assume that a consumer consumes two
commodities X and Y and makes five combinations for the two commodities a, b, c, d, and e,
which is shown in Table 4.2:
UNITS OF UNITS OF TOTAL
COMBINATION
COMMODITY Y COMMODITY X UTILITY

a 25 3 U

b 15 5 U

c 8 9 U

d 4 17 U

e 2 30 U

When the indifference schedule for X and Y is plotted on a graph, a curve is obtained, which
is shown in Figure.

On the indifference curve (IC), there can be several other points in between the points a, b, c,
d, and e, which would yield the same level of satisfaction to the consumer. Therefore, the
consumer remains indifferent towards any combinations of two substitutes yielding the same
level of satisfaction.
Indifference Curve Properties
The indifference curve (IC) has certain definite properties or characteristics, which are as
follows:

Indifference Curve Properties are:

1. Indifference Curves are negatively sloped
2. Higher IC represents a higher satisfaction level
3. Indifference Curves are convex to the origin
4. Indifference Curves do not intersect
Indifference Curves are negatively sloped
The indifference curves are sloped downwards to the right. The reason for the negative slope
is that as a consumer increases the consumption of commodity X, he/ she sacrifices some units
of commodity Y in order to maintain the same level of satisfaction.

Higher IC represents a higher satisfaction level

A higher IC lying above and to the right of another IC implies a higher level of satisfaction and
vice versa. In simple words, the combination of commodities on the higher IC is preferred by
a consumer to the combination that lies on a lower IC.

Indifference Curves are convex to the origin

ICs are curved inwards; thus they are convex to the origin. This implies that as the consumer
continues to substitute commodity X for commodity Y, MRS of X for Y diminishes along the IC.

Indifference Curves do not intersect

This can be explained by considering a hypothetical situation where two indifference curves
intersect. The point of intersection would then imply that a combination of commodities on
the higher curve would offer the same level of satisfaction as that on the lower indifference
curve, which violates the basic assumption of ICs.

Assumptions of Indifference Curve

Assumptions of Indifference Curve are:
1. Rationality
2. Ordinal Utility
3. Diminishing Marginal Rate of Substitution
4. Consistency and Transitivity of Choice
5. Non-Satiety
 Rationality: We have assumed our consumer a rational consumer he always aims at getting the maximum
satisfaction (utility) out of his income taking the prices and other relevant information into account.
 Ordinal Utility: The consumer ranks his preference according to the satisfaction of each combination. He does
not know actually his satisfaction but he always expresses his preferences for the various bundles of commodities.
Hence ordinal utility measurement is necessary and not cardinal measurement.
 Diminishing Marginal Rate of Substitution: Indifference curves are assumed to be convex to the origin. It
denotes that indifference curve technique is based on the axiom of diminishing marginal rate of substitution.

 Consistency and Transitivity of Choice: It is assumed that the consumer’s behavior is consistent over the
period. It means if a consumer, 1ooses combination A over combination B, at a given time, he will not choose
combination B over combination A at some other time provided both the combinations are available to him.

 Non-Satiety: It is assumed in the analysis that a consumer always prefers a large number of a good to smaller
amount of that good provided that the amount of other goods at his disposal remains unchanged. It implies that the
consumer never reaches at satiety point. This assumption is known as non-satiety assumption.

Application of Indifference Curve

The technique of indifference curves has assumed special significance because of its application in
almost every sphere of economic activity. A few such applications can be mentioned as
follows:
Application of Indifference Curve are:
1. Theory of Production
2. Theory of Exchange
3. Field of Rationing
4. Measurement of Consumer Surplus
5. Field of Taxation

Theory of Production
In the Theory of Production: The basic aim of a producer is to attain a low-cost combination.
Indifference curves are useful in the realization of this objective. When we use these curves
in the theory of production, they are called iso-product curves.
Theory of Exchange
In the Theory of Exchange: Prof. Edgeworth used the technique of indifference curves to show
the mutual gains from the exchange of two goods between two consumers. Exchange makes
11, possible for both the consumers to reach a higher level of satisfaction.
Field of Rationing
In the field of Rationing: This technique can also be mad use of in the field of rationing.
Ordinarily two commodities are rationed out to different individuals, irrespective of their
preferences. But if their respective preferences are considered and the amounts of the two
commodities be distributed among consumers in accordance with their scale of preferences,
each of them shall be in a position to reach a higher indifference curve and satisfaction.

Measurement of Consumer Surplus

In the measurement of Consumer’s Surplus: Indifference curve technique has rehabilitated the
old Marshallian concept of consumer’s surplus that has lain buried almost for decades under
the weight of unrealistic and illusory assumptions. Consumer’s surplus can be measured with
the help of this technique without any need for making unrealistic assumptions.
Field of Taxation
In the field of Taxation: The technique is also applied to test preference between a direct and
indirect tax. With the help of indifference curves it can be shown that a direct tax is
preferable to an indirect tax as regards its effects on consumption and satisfaction of the
taxpayer.

Criticism of Indifference Curve

Although the concept of IC is vital to explain the ordinal approach, it is criticised on various
grounds. The main points of criticism against IC are given below:

Let us discuss these points of of Indifference curve in detail:

Criticism of Indifference Curve

 Ignorance towards market behaviour: IC analysis considers only two commodities in the market. However,
the market is full of a large number of commodities. Thus, it does not consider market behaviour in the analysis of
consumer behaviour.

For example, a change in the price of other commodities in the market may affect the purchase of the commodities
being considered.

 Two commodities model: IC analysis is based on the combinations of two commodities. Considering more than
two commodities in IC analysis makes the calculations more complex. This may further make it difficult to predict
consumer behaviour.

 Ignorance towards demonstration effect: The demonstration effect states that an individual’s consumption
pattern is affected by the level of consumption of other individuals. This is ignored by IC analysis limiting its use to
understand consumer behaviour.

 Indifference towards risks and uncertainties: Risks and uncertainties in the market and individual’s life are
inevitable.

 Unrealistic assumptions: IC is based on an assumption that a consumer is fully aware of his/her preference for
various commodities. However, this is an unrealistic assumption as humans have their limitations.

What is Demand Forecasting?
Demand forecasting is a process of predicting the demand for an Organization’s products or
services in a specified time period in the future. Demand forecasting is helpful for both new
as well as existing Organizations in the market
For example, a new Organization needs to anticipate demand to expand its scale of production.
On the other hand, an existing Organization requires demand forecasts to avoid problems,
such as overproduction and underproduction.
Demand forecasting enables an Organization to arrange for the required inputs as per the
predicted demand, without any wastage of materials and time.

Organizations forecast demand in short term or long term depending on

their requirements.
Short-term forecasting is done for coordinating routine activities, such as scheduling production
activities, formulating pricing policy, and developing an appropriate sales strategy.
On the contrary, long-term forecasting is performed for planning a new project, expansion, and
upgradation of production plant, etc.
There are a number of techniques for forecasting demand. Some of the popular techniques of
demand forecasting are survey methods and statistical methods.

Concept of Demand Forecasting

In order to mitigate risks, it is of paramount importance for Organizations to determine the
future prospects of their products and services in the market. This knowledge of the future
demand for a product or service in the market is gained through the process of demand
forecasting.

Demand forecasting can be defined as a process of predicting the future demand for an

Organization’s goods or services.
It is also referred to as sales forecasting as it involves anticipating the future sales figures of an
Organization.

Demand Forecasting Definition

Some of the popular definitions of demand forecasting are as follows:

Demand estimation (forecasting) may be defined as a process of finding values for demand in future time periods.Evan J.
Douglas
Demand forecasting is an estimate of sales during a specified future period based on proposed marketing plan and a set
of particular uncontrollable and competitive forces.Cundiff and Still

Demand forecasting helps an Organization to take various business decisions, such as

planning the production process, purchasing raw materials, managing funds, and deciding
the price of its products.

Demand can be forecasted by Organizations either internally by making estimates called guess

estimate or externally through specialised consultants or market research agencies.

Components of a Demand Forecasting

Let us discuss the basis components of demand forecasting in detail:
1. Level of forecasting
2. Time period involved
3. Nature of products
Level of forecasting
Demand forecasting can be done at the firm level, industry level, or economy level. At the
firm level, the demand is forecasted for the products and services of an individual
Organization in the future. At the industry level, the collective demand for the products and
services of all Organizations in a particular industry is forecasted. On the other hand, at the
economy level, the aggregate demand for products and services in the economy as a whole is
anticipated.

Time period involved

On the basis of the duration, demand is forecasted in the short run and long term, which is
explained as follows:

 Short-term forecasting: It involves anticipating demand for a period not exceeding one year. It is focused on the
shortterm decisions (for example, arranging finance, formulating production policy, making promotional strategies,
etc.) of an Organization.

 Long-term forecasting: It involves predicting demand for a period of 5-7 years and may extend for a period of
10 to 20 years. It is focused on the long-term decisions (for example, deciding the production capacity, replacing
machinery, etc.) of an Organization.
Nature of products
Products can be categorised into consumer goods or capital goods on the basis of their nature.
Demand forecasting differs for these two types of products, which is discussed as follows:

 Consumer goods: The goods that are meant for final consumption by end users are called consumer goods.
These goods have a direct demand. Generally, demand forecasting for these goods is done while introducing a new
product or replacing the existing product with an improved one.

 Capital goods: These goods are required to produce consumer goods; for example, raw material. Thus, these
goods have a derived demand. The demand forecasting of capital goods depends on the demand for consumer goods.
For example, prediction of higher demand for consumer goods would result in the anticipation of higher demand for
capital goods too.

Importance of Demand forecasting

Demand forecasting is vital to the management of every business. It enables an Organization
to mitigate business risks and make effective business decisions. Moreover, demand
forecasting provides insight into the Organization’s capital investment and expansion
decisions.

Importance of Demand forecasting are:

1. Producing the desired output
2. Assessing the probable demand
3. Forecasting sales figures
4. Better control
5. Controlling inventory
6. Assessing manpower requirement
7. Ensuring stability
8. Planning import and export policies

Producing the desired output

Demand forecasting enables an Organization to produce the pre-determined output. It also
helps the Organization to arrange for the various factors of production (land, labour, capital,
and enterprise) beforehand so that the desired quantity can be produced without any
hindrance.

Assessing the probable demand

Demand forecasting enables an Organization to assess the possible demand for its products
and services in a given period and plan production accordingly. In this way, demand
forecasting avoids dependence on merely making assumptions for demand.

Forecasting sales figures

Sales forecasting refers to the estimation of sales figures of an Organization for a given
period. Demand forecasting helps in predicting the sales figures by considering historical
sales data and current trends in the market.

Better control
In order to have better control on business activities, it is important to have a proper
understanding of cost budgets, profit analysis, which can be achieved through demand
forecasting.

Controlling inventory
As discussed earlier, demand forecasting helps in estimating the future demand for an
Organization’s products or services. This, in turn, helps the Organization to accurately assess
its requirement for raw material, semi-finished goods, spare parts, etc.

Assessing manpower requirement

Demand forecasting helps inaccurate estimation of the manpower required to produce the
desired output, thereby avoiding the situations of under-employment or over-employment.

Ensuring stability
Demand forecasting helps an Organization to stabilise their operations by initiating the
development of suitable business policies to meet cyclical and seasonal fluctuations of an
economy.

Planning import and export policies

At the macro level, demand forecasting serves as an effective tool for the government in
determining the import and export policies for the nation. It helps in assessing whether
import is required to meet the possible deficit in domestic supply.

Factors Influencing Demand Forecasting

There are a number of factors that affect the process of demand forecasting. Figure 6.2 lists
down various factors influencing demand forecasting:

Factors Influencing Demand Forecasting

Let us discuss these factors in detail.

Prevailing economic conditions

Demand forecasting can be affected by the changing price levels, national and per capita
income, consumption pattern of consumers, saving and investment practices, employment
level, etc. of an economy. Thus, it is important that existing economic conditions should be
assessed in order to align demand forecasting with current economic trends.

Existing conditions of the industry

The assessment of demand for an Organization’s products and services is also affected by the
overall conditions of the industry in which the Organization operates. For example,
concentration of an industry increases the level of competition, which directly affects the
demand for products and services of different Organizations in the industry. In such a case,
demand forecasted by Organizations may falter.

Existing condition of an Organization

Apart from industry conditions, the internal state of an Organization also affects demand
forecasting. Within the Organization, demand forecasting is affected by various factors, such
as plant capacity, product quality, product price, advertising and distribution policies,
financial policies, etc.

Prevailing market conditions

in market conditions, such as change in the prices of goods; change in consumers’
expectations, tastes and preferences; change in the prices of related goods; and change in the
income level of consumers also influence the demand for an Organization’s products and
services.

Sociological conditions
Sociological factors, such as size and density of population, age group, size of family, family
life cycle, education level, family income, social awareness, etc. largely impact demand
forecasts of an Organization. For example, markets having a large population of youngsters
would have a higher demand for lifestyle products, electronic gadgets, etc.

Psychological conditions
Psychological factors, such as changes in consumer attitude, habits, fashion, lifestyle,
perception, cultural and religious beliefs, etc. affect demand forecast of an Organization to a
large extent.

Competitive conditions
A market consists of several Organizations offering similar products. This gives rise to
competition in the market, which affects demand forecasted by Organizations. For example,
reduction in trade barriers increases the number of new entrants in a market, which affects
the demand for products and services of existing Organizations.

Import-export policies
The demand for export-import goods gets directly affected by changes in factors, such as
import and export control, terms and conditions of import and export, import/export policies,
import/export conditions, etc.

Steps in Demand Forecasting

To achieve the desired results, it is important that demand forecasting is done systematically.
Demand forecasting involves a number of steps, which are shown in Figure 6.3:

1. Specifying the objective

2. Determining the time perspective
3. Selecting the method for forecasting
4. Collecting and analysing data
5. Interpreting outcomes

Let us discuss these steps in detail.

Specifying the objective

The purpose of demand forecasting needs to be specified before starting the process. The
objective can be specified on the following basis:

 Short-term or long-term demand for a product

 Industry demand or demand specific to an Organization
 Whole market demand or demand specific to a market segment
Determining the time perspective
Depending on the objective, the demand can be forecasted for a short period (2-3 years) or
long period (beyond 10 years). If an Organization performs long-term demand forecasting, it
needs to take into consideration constant changes in the market as well the economy.

Selecting the method for forecasting

There are various methods of demand forecasting, which have been discussed later in the
chapter. However, not all methods are suitable for all types of demand forecasting. Depending
on the objective, time period, and availability of data, the Organization needs to select the
most suitable forecasting method. The selection of demand forecasting method also depends
on the experience and expertise of the demand forecaster.

Collecting and analyzing data

After selecting the demand forecasting method, the data needs to be collected. Data can be
gathered either from primary sources or secondary sources or both. As data is collected in the
raw form, it needs to be analyzed in order to derive meaningful information out of it.

Interpreting outcomes
After the data is analyzed, it is used to estimate demand for the predetermined years.
Generally, the results obtained are in the form of equations, which need to be presented in a
comprehensible format.

Limitations of Demand Forecasting

Limitations of Demand Forecasting are:

1. Lack of historical sales data

2. Unrealistic assumptions
3. Cost incurred
4. Change in fashion
5. Lack of expertise
6. Psychological factors

Lack of historical sales data

Past sales figures may not always be available with an Organization. For example, in case of a
new commodity, there is unavailability of historical sales data. In such cases, new data is
required to be collected for demand forecasting, which can be cumbersome and challenging
for an Organization.

Unrealistic assumptions
Demand forecasting is based on various assumptions, which may not always be consistent
with the present market conditions. In such a case, relying on these assumptions may
produce incorrect forecasts for the future.

Cost incurred
Demand forecasting incurs different costs for an Organization, such as implementation cost,
labour cost, and administrative cost. These costs may be very high depending on the
complexity of the forecasting method selected and the resources utilized. Owing to limited
means, it becomes difficult for new startups and small-scale Organizations to perform
demand forecasting.

Change in fashion
Consumers’ tastes and preferences continue to change with a change in fashion. This limits
the use of demand forecasting as it is generally based on historical trend analysis.

Lack of expertise
Demand forecasting requires effective skills, knowledge and experience of personnel making
forecasts. In the absence of trained experts, demand forecasting becomes a challenge for an
Organization. This is because if the responsibility of demand forecasting is assigned to
untrained personnel, it could bring huge losses to the Organization.

Psychological factors
Consumers usually prefer a particular type of product over others. However, factors, such as
fear of war and changes in economic policy, could affect consumers’ psychology. In such
cases, the outcomes of forecasting may no longer remain relevant for the time period.

Techniques of Demand Forecasting

Methods of demand forecasting are broadly categorized into two types. Let us discuss these
techniques & methods of demand forecasting in detail:

Qualitative Techniques
 Survey Methods
Quantitative Techniques
 Time Series Analysis
 Smoothing Techniques
 Barometric Methods
 Econometric Methods

What is Demand forecasting?

Definition: Demand forecasting is a process of predicting the demand for an Organization’s products or
services in a specified time period in the future. 

Techniques & Methods of Demand Forecasting

Different Organizations rely on different techniques to forecast demand for their products or services for a
future time period depending on their requirements and budget.

Methods of demand forecasting are broadly categorised into two types. Let us discuss these techniques &
methods of demand forecasting in detail:
 Methods of
Demand Forecasting

Qualitative Techniques
Qualitative techniques rely on collecting data on the buying behaviour of consumers from experts or through
conducting surveys in order to forecast demand.These techniques are generally used to make shortterm
forecasts of demand.
Qualitative techniques are especially useful in situations when historical data is not available; for example,
introduction of a new product or service. These techniques are based on experience, judgment, intuition,
conjecture, etc.

Survey Methods
Survey methods are the most commonly used methods of forecasting demand in the short run. This method
relies on the future purchase plans of consumers and their intentions to anticipate demand.
Thus, in this method, an organization conducts surveys with consumers to determine the demand for their
existing products and services and anticipate the future demand accordingly. The two types of survey methods
are explained as follows:

 Complete enumeration survey: This method is also referred to as the census method of demand forecasting. In
this method, almost all potential users of the product are contacted and surveyed about their purchasing plans.

Based on these surveys, demand forecasts are made. The aggregate demand forecasts are attained by totaling the
probable demands of all individual consumers in the market.

 Sample survey: In this method, only a few potential consumers (called sample) are selected from the market and
surveyed. In this method, the average demand is calculated based on the information gathered from the sample.
Opinion poll methods involve taking the opinion of those who possess knowledge of market trends, such as
sales representatives, marketing experts, and consultants. The most commonly used opinion polls methods are
explained as follows:
 Expert opinion method: In this method, sales representatives of different Organizations get in touch with
consumers in specific areas. They gather information related to consumers’ buying behaviour, their reactions and
responses to market changes, their opinion about new products, etc.
 Delphi method: In this method, market experts are provided with the estimates and assumptions of forecasts
made by other experts in the industry. Experts may reconsider and revise their own estimates and assumptions based
on the information provided by other experts.

 Market studies and experiments: This method is also referred to as market experiment method. In this method,
Organizations initially select certain aspects of a market such as population, income levels, cultural and social
background, occupational distribution, and consumers’ tastes and preferences.

Among all these aspects, one aspect is selected and its effect on demand is determined while keeping all other aspects
constant.
Quantitative Techniques
Quantitative techniques for demand forecasting usually make use of statistical tools. In these techniques,
demand is forecasted based on historical data.
These methods are generally used to make long-term forecasts of demand. Unlike survey methods, statistical
methods are cost effective and reliable as the element of subjectivity is minimum in these methods. Let us
discuss different types of quantitative methods:

Time Series Analysis

Time series analysis or trend projection method is one of the most popular methods used by Organizations for
the prediction of demand in the long run. The term time series refers to a sequential order of values of a
variable (called trend) at equal time intervals.
Using trends, an Organization can predict the demand for its products and services for the projected time. There
are four main components of time series analysis that an Organization must take into consideration while
forecasting the demand for its products and services. These components are:

 Trend component: The trend component in time series analysis accounts for the gradual shift in the time series
to a relatively higher or lower value over a long period of time.
 Cyclical component: The cyclical component in time series analysis accounts for the regular pattern of
sequences of values above and below the trend line lasting more than one year.
 Seasonal component: The seasonal component in time series analysis accounts for regular patterns of variability
within certain time periods, such as a year.
 Irregular component: The irregular component in time series analysis accounts for a short term, unanticipated
and non-recurring factors that affect the values of the time series.
Smoothing Techniques
In cases where the time series lacks significant trends, smoothing techniques can be used for demand
forecasting. Smoothing techniques are used to eliminate a random variation from the historical demand.

This helps in identifying demand patterns and demand levels that can be used to estimate future demand. The
most common methods used in smoothing techniques of demand forecasting are simple moving average
method and weighted moving average method.

The simple moving average method is used to calculate the mean of average prices over a period of time and
plot these mean prices on a graph which acts as a scale.

For example, a five-day simple moving average is the sum of values of all five days divided by five.
The weighted moving average method uses a predefined number of time periods to calculate the average, all
of which have the same importance.

For example, in a four-month moving average, each month represents 25% of the moving average.
Barometric Methods
Barometric methods are used to speculate the future trends based on current developments. This method is
also referred to as the leading indicators approach to demand forecasting.
Many economists use barometric methods to forecast trends in business activities. The basic approach followed
in barometric methods of demand analysis is to prepare an index of relevant economic indicators and forecast
future trends based on the movements shown in the index.

The barometric methods make use of the following indicators:

 Leading indicators: When an event that has already occurred is considered to predict the future event, the past
event would act as a leading indicator.

For example, the data relating to working women would act as a leading indicator for the demand of working women
hostels.

 Coincident indicators: These indicators move simultaneously with the current event.

For example, a number of employees in the non-agricultural sector, rate of unemployment, per capita income, etc., act
as indicators for the current state of a nation’s economy.

 Lagging indicators: These indicators include events that follow a change. Lagging indicators are critical to
interpret how the economy would shape up in the future. These indicators are useful in predicting the future economic
events.

For example, inflation, unemployment levels, etc. are the indicators of the performance of a country’s economy.
Econometric Methods
Econometric methods make use of statistical tools combined with economic theories to assess various
economic variables (for example, price change, income level of consumers, changes in economic policies, and
so on) for forecasting demand.
The forecasts made using econometric methods are much more reliable than any other demand forecasting
method. An econometric model for demand forecasting could be single equation regression analysis or a system
of simultaneous equations. A detailed explanation of regression analysis is given in the next section.

 Regression Analysis: The regression analysis method for demand forecasting measures the relationship between
two variables. Using regression analysis, a relationship is established between the dependent (quantity demanded) and
independent variable (income of the consumer, price of related goods, advertisements, etc.).
For example, regression analysis may be used to establish a relationship between the income of consumers and
their demand for a luxury product. In other words, regression analysis is a statistical tool to estimate the
unknown value of a variable when the value of the other variable is known.

After establishing the relationship, the regression equation is derived assuming the relationship between
variables is linear.

The formula for a simple linear regression is as follows:

Y =a + bX
Where Y is the dependent variable for which the demand needs to be forecasted; b is the slope of the regression
curve; X is the independent variable; and a is the Y-intercept. The intercept a will be equal to Y if the value of
X is zero.

Criteria for Good Demand Forecasting

Demand forecasting can be effective if the predicted demand is equal to the actual demand. The
effectiveness of demand forecasting depends on the selection of an appropriate forecasting
technique. Each technique serves a specific purpose; thus an Organization should be careful
while selecting a forecasting technique for a particular problem.
The following points explain the criteria for the selection of demand forecasting technique:

Criteria for Good Demand Forecasting

1. Accuracy
2. Timeliness
3. Affordability
4. Ease of interpretation

Accuracy
Almost all the methods of demand forecasting yield accurate results under different
circumstances. However, not all methods are appropriate to be used for all kinds of
forecasting.

For example, a lack of statistical data limits the use of regression analysis in order to predict
demand. Therefore, an appropriate selection of forecasting technique would ensure the
accuracy of results.

Timeliness
As discussed earlier, demand forecasting can be short term or long term. The demand
forecasting methods used for both the time periods vary.

For example, the demand for a new product, which needs to be introduced in a month’s time,
cannot be assessed using the time series analysis method. This is because this method
requires data collected over long periods.

Affordability
The cost for different demand forecasting methods varies based on its implementation,
expertise required, the time period involved, etc. Thus, Organizations should select a method
that suits their budget and requirements without compromising on the outcome.

For example, the complete enumeration method of demand forecasting yields accurate
results but could prove expensive for small-scale Organizations.

Ease of interpretation
Outcomes generated using demand forecasting methods are generally represented in the
form of statistical or mathematical equations. Therefore, it should be ensured that personnel
carrying out forecasting are trained and efficient to use forecasting methods and interpret the
results.
Production in Economics
Production in Economics is a very important economic activity. As we are aware, the survival of
any firm in a competitive market depends upon its ability to produce goods and services at a
competitive cost.
One of the principal concerns of business managers is the achievement of optimum efficiency
in production by minimising the cost of production.

What is Production?
In economics, Production is a process of transforming tangible and intangible inputs into
goods or services.
Raw materials, land, labour and capital are the tangible inputs, whereas ideas, information
and knowledge are the intangible inputs. These inputs are also known as factors of
production.

Production Definition
Production in Economics  can be defined as an organised activity of transforming physical inputs (resources)
into outputs (finished products), which will satisfy the products’ needs of the society.
James Bates and J.R. Parkinson

Production in Economics  is an activity whether physical or mental, which is directed to the satisfaction of
other people’s wants through exchange.
J.R. Hicks

Concept of Production
Production in Economics can be defined as the process of converting the inputs into outputs.
Inputs include land, labour and capital, whereas output includes finished goods and services.
In other words, Production in Economics is an act of creating value that satisfies the wants of the
individuals.
O rganizations engage in production for earning maximum profit, which is the difference
between the cost and revenue. Therefore, their production decisions depend on the cost and
revenue. The main aim of production is to produce maximum output with given inputs.

Importance of Production
Production in Economics is considered very important by Organizations.
Importance of Production are as follow:
 Helps in creating value by applying labour on land and capital
 Improves welfare as more commodities mean more utility
 Generates employment and income, which develops the economy.
 Helps in understanding the relation between cost and output
Factors of Production
Factors of Production in Economics are the inputs that are used for producing the final output
with the main aim of earning an economic profit.
Land, labour, capital and entrepreneur are the main factors of production. Eachand every factor
is important and plays a distinctive role in the Organization.

Factors of Production are:
1. Land
2. Labour
3. Capital
4. Entrepreneur
Land
Land is the gift of nature and includes the dry surface of the earth and the natural resources
on or under the earth’s surface, such as forests, rivers, sunlight, etc.

Land is utilised to produce income called rent. Land is available in fixed quantity; thus, does
not have a supply price. This implies that the change in price of land does not affect its supply.
The return for land is called rent.

Characteristics which would qualify a given factor to be called land

 Land is a free gift of nature

 Land is a free gift of nature
 Land is permanent and has indestructible powers
 Land is a passive factor
 Land is immobile
 Land has multiple uses
 Land is heterogeneous
Labour
Labour is the physical and mental efforts of human beings that undertake
the production process.
It includes unskilled, semi-skilled and highly skilled labour. The supply of labour is affected
by the change in its prices. It increases with an increase in wages. The return for labour is
called wages and salary.

Characteristics of labour:

 Human Effort
 Labour is perishable
 Labour is an active factor
 Labour is inseparable from the labourer
 Labour power differs from labourer to labourer
 All labour may not be productive
 Labour has poor bargaining power
 Labour is mobile
 There is no rapid adjustment of supply of labour to the demand for it
 Choice between hours of labour and hours of leisure
Capital
Capital is the wealth created by human beings. It is one of the important factor of production of
any kind of goods and services, as production cannot take place without the involvement of
capital.
Capital is an output of a production process that goes into another production process as an
input. Capital as a factor of production is divided into two parts, namely, physical capital and
human capital.
Physical capital includes tangible resources, such as buildings, machines, tools and equipment,
etc.
Human capital includes knowledge and skills of human resource, which is gained by education,
training and experience. Return for capital is termed as interest.
Types of Capital

 Fixed capital
 Circulating capital
 Real capital
 Human capital
 Tangible capital
 Individual capital
 Social Capital
Entrepreneur
Entrepreneurship consists of three major functions, viz., coordination, management and
supervision. An entrepreneur is a person who creates an enterprise. The success or failure
depends on the efficiency of the entrepreneur.

An enterprise is an Organization that undertakes commercial purposes or business ventures

and focuses on providing goods and services. An enterprise is composed of individuals and
physical assets with a common goal of generating profits.

Functions of an entrepreneur

 Initiating business enterprise and resource co-ordination

 Risk bearing or uncertainty bearing
 Innovations

What is Production Possibility Curve?

In economics, the Production Possibility Curve provides an overview of the maximum output of
a good that can be produced in an economy by using available resources with respect to
quantities of other goods produced. It is also known as Production Possibility Frontier (PPF) or
transformation curve.
 Production Possibility Curve Example
Let us learn Production Possibility Curve with the help of an example.
Suppose an Organization decided to produce two goods A and B with its available resources.
If all the resources are used in producing A, then 100 lakh units of A can be produced,
whereas if all the resources are used in producing B, then 4000 units of B can be produced. If
both the goods are produced, then there is possibility of various combinations as shown in
Table:

Production Possibilities
A ( in lakhs) B (in thousands)
100 0
90 1
70 2
40 3
0 4

Let us draw the PPC from Table, as shown in Figure

Production Possibility Curve

As shown in Figure, the attainable combinations are A, B, C, D and E from the given resources.
A and E are the combinations that produce only one good at a time. The unattainable
combination is F as it is outside the PPC. G is the inefficient combination, which is inside the
PPC. It implies that the resources are underutilised.
From Figure, it can be noticed that PPC is concave to origin. It is because the increase in
production of one unit of good is accompanied by the sacrifice of units of the other good. The
rate at which an amount of product is sacrificed for producing the amount of another product
is called Marginal Rate of Transformation (MRT).

For example, in case of A and B, the amount of product B that is sacrificed to produce the
amount of product A is termed as MRT. The slope of PPC is also MRT. Increasing MRT implies
increasing slope of PPC.

Uses of Production Possibility Curve

Let us discuss some important Uses of Production Possibility Curve:
 It enables the planning authority of a developed nation to divert the usage of its resources for the production of
necessary goods to the production of luxury goods and from consumer goods to producer’s goods, after a certain point
of time.

 It helps a democratic nation to focus and shift a major amount of resources in the production of public sector
goods instead of private sector goods. The public sector goods are supplied and financed by government, such as
public utilities, free education and medical facilities.

On the other hand, private sector goods are manufactured by privately owned Organizations and are purchased by
individuals at a certain price.

 It helps in guiding the movement of resources from producer goods to capital goods, such as machines, which, in
turn, increases the productive resources of a country for achieving a high production level.

What is Production Function?

Production function can be defined as a technological relationship between the physical inputs
and physical output of the Organization.

Meaning of Production Function

The production function is a statement of the relationship between a firm’s scarce resources (i.e.
its inputs) and the output that results from the use of these resources.
Inputs include the factors of production, such as land, labour, capital, whereas physical
output includes quantities of finished products produced. The long-run production function
(Q) is usually expressed as follows:

Q= f (LB, L, K, M, T, t)

Where, LB= land and building

L = labour
K = capital
M = raw material
T = technology
t = time

Production Function Definition

Production function is the name given to the relationship between the rates of input of productive services and
the rate of output.

Stigler

Production Function is the technological relationship, which explains the quantity of production that can be
produced by a certain group of inputs. It is related with a given state of technological change.

Samuelson

The relation between a firm’s physical production (output) and the material factors of production (input) is
referred to as production function.

Watson

Uses of Production Function

In economics, the uses of production function are as follows:
 Helps in making short-term decisions, such as optimum level of output.
 Helps in making long-term decisions, such as deciding the production level.
 Helps in calculating the least cost combination of various factor inputs at a given level of output.
 Gives logical reasons for making decisions. For example, if price of one input falls, one can easily shift to other
inputs.

Assumptions of Production Function

Assumptions of production function are as follow:
 Production function is related to a specific time period.
 The state of technology is fixed during this period of time.
 The factors of production are divisible into the most viable units.
 There are only two factors of production, labour and capital.
 Inelastic supply of factors in the short-run period.

Limitations of Production Function

Apart from the advantages, production function also suffers from some limitations.

Limitations of Production Function are:

 Restricts itself to the case of two inputs and one output.
 Assumes a smooth and continuous curve, which is not possible in the real world, as there are always
discontinuities in production.
 Assumes technology as fixed, which is not possible in the real world.
 Assumes a perfectly competitive market, which is rare in the real world.

Cobb-Douglas Production Function

A cobb-douglas production function is one of the famous statistical production function. In its
original form, this production function applies not to an individual firm but to the whole of
manufacturing in the United States. In this case, the output is manufacturing production and
inputs used are labour and capital.

Cobb-Douglas production function is stated as: Q = KLa C (1-a)

where ‘Q’ is output, ‘L’ the quantity of labour and ‘C’ the quantity of capital. ‘K’ and ‘a’ are
positive constants.

The conclusion drawn from this famous statistical study is that labour contributed about
3/4th and capital about 1/4th of the increase in the manufacturing production. Although, the
Cobb-Douglas production function suffers from many shortcomings, it is extensively used in
Economics as an approximation.

3 Types of Production Functions are:

1. Cobb Douglas production function
2. Leontief Production Function
3. CES Production Function
There are different types of production functions that can be classified according to the degree of
substitution of one input by the other.
Figure illustrates different types of production functions:

Cobb Douglas production function

The Cobb Douglas production function, given by American economists, Charles W. Cobb and
Paul. H Douglas, studies the relation between the input and the output.
The cobb douglas production function is that type of production function wherein an input can be
substituted by others to a limited extent.

For example, capital and labour can be used as a substitute of each other, however to a
limited extent only. Cobb Douglas production function can be expressed as follows:

Q = AKa Lb
Where, A = positive constant
a and b = positive fractions
b = 1–a

Cobb Douglas production function Properties

The main attributes of the Cobb Douglas production function are discussed as follows:
 It enables the conversion of the algebraic form into log linear form, represented as follows: log Q = log A + a log
K + b log L This production function has been estimated with the help of linear regression analysis.

 It acts as a homogeneous production function, whose degree can be calculated by the value obtained after adding
values of a and b. If the resultant value of a+b is 1, it implies that the degree of homogeneity is 1 and indicates the
constant returns to scale.

 It makes use of parameters a and b, which signifies the elasticity coefficients of output for inputs, labour and
capital, respectively. Output elasticity coefficient is the change in output that occurs due to adjustment in capital while
 keeping labour at constant.

 It depicts the non-existence of production at zero cost.

Leontief Production Function

Leontief production function, evolved by W. Wassily Leontif, uses fixed proportion of inputs
having no substitutability between them.
It implies that if the input-output ratio is independent of the scale of production, there is
existence of Leontief production function. It assumes strict complementarity of factors of
production. Leontief production function is also called as fixed proportion production
function.

This production function can be expressed as follows:

q= min (z1/a, z2/b)

where, q = quantity of output produced
z1 = utilised quantity of input 1
z2 = utilised quantity of input 2
a and b = constants

Minimum implies that the total output depends upon the smaller of the two ratios.

CES Production Function

CES stands for constant elasticity substitution. CES production function displays a constant
change produced in the output due to change in input of production.
It is expressed as:

Q = A [aK–β + (1–a) L–β]–1/β

CES has the homogeneity degree of 1 that implies that output would be increased with the
increase in inputs. For example, labour and capital has increased by constant factor m.

Properties of CES Production Function

The properties of CES function are as follows:
 The value of elasticity of substitution depends upon the value of a.
 The marginal products are positive and slope downwards.
Merits of CES Production Function
The merits of CES production are as follows:
 Covers a number of parameters, such as efficiency and substitutability
 Easy to estimate
 Free from unrealistic assumptions, such as fixed technology, etc.
Demerits of CES function
The demerits of CES production system are as follows:
 Fails to fit for manufacturing industries
 Cannot be generalised in case of n factors of production
 Fails to give correct economic implications
Types of Costs
While computing the total cost of production, there are several types of costs that an Organization needs to consider apart
from those involved in the procurement of raw material, labour and capital.

Different circumstances give way to different types of costs. For effective decision making, it is essential to
distinguish between and interpret the various cost concepts that affect an Organization’s overall profit.

Types of Costs
In Economics there are 10 Types of Costs. These are explained below:

1. Opportunity costs
2. Explicit costs
3. Implicit costs
4. Accounting costs
5. Economic costs
6. Business costs
7. Full costs
8. Fixed costs
9. Variable costs
10. Incremental costs

Opportunity Costs
Opportunity cost is also referred to as alternative cost. Organizations tend to utilise their limited resources for
the most productive alternative and forgo the income expected from the second-best use of these resources.

Opportunity cost may be defined as the return from the second-best use of the firm’s limited resources, which
it forgoes in order to benefit from the best use of these resources.
Example: Let us assume that an Organization has a capital resource of 1,00,000 and two alternative courses to
choose from. It can either purchase a printing machine or photo copier, both having a productive life span of 12
years.
The printing machine would yield an income of 30,000 per annum while the photocopier would yield an
income of 20, 000 per annum. An Organization that aims to maximise its profit would use the available amount
to purchase the printing machine and forgo the income expected from the photo copier. Therefore, the
opportunity cost in this case is the income forgone by the Organization, i.e., 20, 000 per annum.

Explicit costs
Explicit costs, also referred to as actual costs, include those payments that the employer makes to purchase or
own the factors of production. These costs comprise payments for raw materials, interest paid on loans, rent
paid for leased building or machinery and taxes paid to the government.
An explicit cost is one that has occurred and is clearly reported in accounting books as a separate cost.
Example: if an Organization borrows a sum of 70,00,000 at an interest rate of 4% per year, the interest cost of
2,80,000 per year would be an explicit cost for the Organization.
Implicit costs
Unlike explicit costs, there are certain other costs that cannot be reported as cash outlays in accounting books.
These costs are referred to as implicit costs. Opportunity costs are examples of implicit cost borne by an
Organization.

Example: An employee in an Organization takes a vacation to travel to his relative’s place. In this case, the
implicit costs borne by the employee would be the salary that the employee could have earned if he/she had not
taken the leave. Implicit costs are added to the explicit cost to establish a true estimate of the cost of production.
Implicit costs are also referred to as imputed costs, implied costs or notional costs.
Accounting costs
Accounting costs include the financial expenditure incurred by a firm in acquiring inputs for the production of a
commodity. These expenditures include salaries/wages of labour, payment for the purchase of raw materials
and machinery, etc.

Accounting costs are recorded in the books of accounts of a firm and appear on the firm’s income statement.
Accounting costs include all explicit costs along with certain implicit costs of an Organization.

Example: depreciation expenses (implicit cost) are included in the books of account as a firm’s accounting
costs.
Economic costs
Economic costs include the total cost of opting for one alternative over another.

The concept of economic costs is similar that of opportunity costs or implicit costs with the only difference that
economic costs include the accounting cost (or explicit cost) as well as the opportunity cost (or implicit cost)
incurred to carry out an action over the forgone action.

Example: if the economic cost of the employee in the above example would include his/her week’s pay as well
as the expense incurred on the vacation.
Business costs
Business costs include all the expenditures incurred to carry out a business. The concept of business cost is
similar to the explicit costs.

Business costs comprise all the payments and contractual obligations made by a business, added to the book
cost of depreciation of plant and equipment. These costs are used to calculate the profit or loss made by a
business, filing for income tax returns and other legal procedures.

Full costs
The full costs include business costs, opportunity costs, and normal profit. Full costs of an Organization include
cost of materials, labour and both variable and fixed manufacturing overheads that are required to produce a
commodity.

Fixed costs
Fixed costs refer to the costs borne by a firm that do not change with changes in the output level. Even if the
firm does not produce anything, its fixed costs would still remain the same.
Example: depreciation, administrative costs, rent of land and buildings, taxes, etc. are fixed costs of a firm that
remain unchanged even though the firm’s output changes. However, if the time period under consideration is
long enough to make alterations in the firm’s capacity, the fixed costs may also vary.
Variable costs
Variable costs refer to the costs that are directly dependent on the output level of the firm. In other words,
variable costs vary with the changes in the volume or level of output.

Example: if an Organization increases its level of output, it would require more raw materials. Cost of raw
material is a variable cost for the firm.
Other examples of variable costs are labour expenses, maintenance costs of fixed assets, routine maintenance
expenditure, etc. However, the change in variable costs with changes in output level may not necessarily be in
the same proportion.

Incremental costs
Incremental costs involve the additional costs resulting due to a change in the nature of level of business
activity.

It characterises the additional cost that would have not been incurred if an additional unit was not produced. As
these costs may be avoided by avoiding the possible variation in the production, they are also referred to as
avoidable costs or escapable costs.

Example: if a production house has to run for additional two hours, the electricity consumed during the extra
hours is an additional cost to the production house. The incremental cost comprises the variable costs.

What is Short Run Cost?

Definition: Short Run Cost refers to a certain period of time where at least one input is fixed while others are
variable.
In the short-run period, an Organization cannot change the fixed factors of production, such as capital, factory
buildings, plant and equipment, etc. However, the variable costs, such as raw material, employee wages, etc.,
change with the level of output.

Example: If a firm intends to increase its output in the short run, it would need to hire more workers and
purchase more raw materials. The firm cannot expand its plant size or increase the plant capacity in the short
run.
Similarly, when demand falls, the firm would reduce the work hours or output, but cannot downsize its plant.
Therefore, in the short run only variable factors are changed, while the fixed factors remain unchanged. Let us
discuss the cost-output relations in the short run

Type of Short Run Cost

What is Short Run Cost Types? There are basically three types of short run costs:
1. Short Run Total Cost
2. Short Run Average Cost
3. Short Run Marginal Cost
Short Run Total Cost
The total cost refers to the actual cost that is incurred by an Organization to produce a given level of output.
The Short-Run Total Cost (SRTC) of an Organization consists of two main elements:
Total Fixed Cost (TFC): These costs do not change with the change in output. TFC remains constant even
when the output is zero. TFC is represented by a straight line horizontal to the x-axis (output).
Total Variable Cost (TVC): These costs are directly proportional to the output of a firm. This implies that
when the output increases, TVC also increases and when the output decreases, TVC decreases as well.
SRTC is obtained by adding the total fixed cost and the total variable cost.

SRTC = TFC + TVC

As the TFC remains constant, the changes in SRTC are entirely due to variations in TVC.

Figure depicts the short run cost curve of a firm:

Short Run Total Cost

Short Run Average Cost

The average cost is calculated by dividing total cost by the number of units a firm has produced. The short-run
average cost (SRAC) of a firm refers to per unit cost of output at different levels of production. To calculate
SRAC, short-run total cost is divided by the output.

SRAC = SRTC/Q = TFC + TVC/Q

Where, TFC/Q =Average Fixed Cost (AFC) and
TVC/Q =Average Variable Cost (AVC)

Therefore, SRAC = AFC + AVC

SRAC of a firm is U-shaped. It declines in the beginning, reaches to a minimum and starts to rise.

Figure depicts the short run average cost curve of a firm

U Shaped Short Run Average Cost

The SRAC curve represents the average cost in the short run for producing a given quantity of output. The
downward-slope of the SRAC curve indicates that as the output increases, average costs decrease. However, the
SRAC curve begins to slope upwards, indicating that at output levels above Q1, average costs start to increase.

Short Run Marginal Cost

Marginal cost (MC) can be defined as the change in the total cost of a firm divided by the change in the total
output. Short-run marginal cost refers to the change in short-run total cost due to a change in the firm’s output.
SRMC = ∅SRTC / ∅Q

In the marginal cost concept, Δ Q = 1. Therefore, SRMC = TVC

Short-run marginal cost on a graph is the slope of the short-run total cost and depicts the rate of change in total
cost as output changes. The marginal cost of a firm is used to determine whether additional units need to be
produced or not. If a firm could sell the additional unit at a price greater than the cost incurred to produce the
additional unit (marginal cost), the firm may decide to produce the additional unit.

The figure depicts the Short Run Marginal Cost curve of a firm:

The short-run marginal cost (SRMC), short-run average cost (SRAC) and average variable cost (AVC) are U-
shaped due to increasing returns in the beginning followed by diminishing returns. SRMC curve intersects
SRAC curve and the AVC curve at their lowest points.
What is Long Run Cost?
Definition: Long run cost refers to the time period in which all factors of production are variable. Long-run
costs are incurred by a firm when production levels change over time.
In the long run, the factors of production may be utilised in changing proportions to produce a higher level of
output. In such a case, the firm may not only hire more workers, but also expand its plant size, or set up a new
plant to produce the desired output.

Example: downsizing or expanding an Organization, entering or leaving a market, etc., involve long-run costs.
To understand the long run cost-output relations, it can be assumed that a long-run cost curve is composed of a
series of short-run cost curves.

Type of Long Run Cost

What is Long Run Cost Type? There are basically three types of long run costs:
1.
2. Long Run Total Cost
3. Long Run Average Cost
4. Long Run Marginal Cost

Long Run Total Cost

Long-run total cost (LRTC) refers to the total cost incurred by an Organization for the production of a given
level of output when all factors of production are variable.
Example: Long run total cost is the per unit cost incurred by a firm when it expands the scale of its operations
not just by hiring more workers, but also by building a larger factory or setting up a new plant.
The shape of the long-run total cost curve is S-shaped, much similar to a short-run total cost curve. For
relatively small quantities of output, the slope begins to flatten. Then, for larger quantities the slope makes a
turn-around and becomes steeper.

The figure depicts the long-run total cost curve of a firm:

Long Run Total Cost

Long Run Average Cost
Long-run average cost (LRAC) refers to per unit cost incurred by a firm in the production of a desired level of
output when all the inputs are variable.
Example: long-run average cost curve of a firm depicts the minimum average cost at which the firm can
produce any given level of output in the long run. The LRAC of a firm can be obtained from its individual
short-run average cost curves.
Each SRAC curve represents the firm’s short-run cost of production when different amounts of capital are used.
The shape of the LRAC curve is similar to the SRAC curve although the U-shape of the LRAC is not due to
increasing, and later diminishing marginal.

The negative slope of the LRAC curve depicts economies of scale and increasing returns to scale. On the
other hand, the positive slope of the LRAC curve represents diseconomies of scale or decreasing returns to
scale. The economies and diseconomies of scale have been discussed later in the chapter.

Figure depicts the long-run average cost curve of a firm:

Long Run Average Cost

In Figure, there are five alternative scales of a plant SRAC1, SRAC2, SRAC3, SRAC4 and SRAC5. However,
in the long run, the firm will operate the scale LRAC, which is the most profitable to it.

Long Run Marginal Cost

Long-run marginal cost (LRMC) refers to the incremental cost incurred by an Organization for producing a
given output level when none of the input is constant.
Example: long-run marginal cost is the additional cost that the firm incurs when it expands the scale of its
operations not just by hiring additional workers, but also by increasing the plant capacity.
The LRMC is the slope of the Long run marginal cost curve. The shape of the LRMC curve is similar to the
SRMC curve although the U-shape of the LRMC is not due to increasing, and later diminishing marginal.
The negative slope of the LRMC curve depicts economies of scale and increasing returns to scale. On the
other hand, the positive slope of the LRMC curve represents diseconomies of scale or decreasing returns to
scale.
LRMC curve can be derived from the LRAC curve. In Figure, at output OM1, SRMC1 = LRMC. At SRMC2,
LRMC = SRAC2 = LRAC. SRAC1 = LRAC (at tangency) and SRMC1 = LRMC (at intersection).
Long Run Marginal Cost

What are Economies of scale?

Definition: Economies of scale, As a firm expands its production capacity, the efficiency of production also
increases. It is able to draw more output per unit of input, leading to low average total costs. This condition is
termed as economies of scale.
Economies of scale result in cost-saving for a firm as the same level of inputs yields a higher level of output. A
higher level of output results in lower average costs as the total costs are shared over the increased output.

Types of Economies of Scale

There are two types of economies of scale:
1. Internal economies of scale
2. External economies of scale
Types of Economies of Scale

Internal economies of scale

Definition: Internal Economies of Scale refers to the economies that a firm achieves due to the growth of the
firm itself. When an Organization reduces costs and increases the production, internal economies of scale are
achieved.
Internal economies of scale refer to the lower per-unit cost that a firm obtains by increasing its capacity.

Internal economies of scale example, large companies have the aptitude to buy in size, thus lowering the cost
per unit of the resources they need to create their products. They can also use the savings to augment profits, or
pass the investments to consumers and fight on price.
Types of Internal Economies of Scale
There are five types of internal economies of scale:
1. Bulk-buying economies
2. Technical economies
3. Financial economies
4. Marketing economies
5. Managerial economies
Let us discuss the different types of internal economies of scale in detail:
1. Bulk-buying economies: As a firm grows in size, it requires larger quantities of production inputs, such as raw
materials. With increase in the order size, the firm attains bargaining power over the suppliers. It is able to purchase
inputs at a discount, which results in lower average cost of production.

2. Technical economies: As a firm increases its scale of production, it may use advanced machinery or better
techniques for production purposes.

For example, the firm may use mass-production techniques, which provide a more efficient form of production.
Similarly, a bigger firm may invest in research and development to increase the efficiency of production.

3. Financial economies: Often small businesses are perceived as being riskier than larger businesses that develop a
credible track record. Therefore, while the smaller firms find it hard to obtain finance at reasonable interest rates,
larger firms easily find potential lenders to raise money at lower interest rates. This capital is further used to expand
the production scale resulting in low average total costs.

4. Marketing economies: The marketing function of a firm incurs a certain cost, such as costs involved in
advertising and promotion, hiring sales agents, etc. Many of these costs are fixed and as the firm expands its capacity,
it is able to spread the marketing costs over a wider range of products. This results in low-average total costs.

5. Managerial economies: As a firm grows, managerial activities become more specialised. For example, a larger
firm can further divide its management into smaller departments that specialise in specific areas of business.

Specialist managers are likely to be more efficient as they possess a high level of expertise, experience and
qualifications. This reduces the managerial costs in proportion to the scale of production in the firm. Therefore,
economies of scale can be achieved with efficient management.
External economies of scale
Definition: External economies of scale refer to the economies in production that a firm achieves due to the
growth of the overall industry in which the firm operates.
External economies of scale transpire outside a firm, within an industry. Therefore, when an industry’s scope of
operations expands, external economies of scale are said to have been achieved.

For example, the creation of a better transportation network, which results in a subsequent fall in the
transportation cost of a firm operating within that industry, leads to external economies of scale.
Factors of external economies of scale
 Improvement in transport and communication network
 Focus on training and education within the industry
 Support of other industries

What is Diseconomies of Scale?

Definition: Diseconomies of scale refer to the disadvantages that arise due to the expansion of a firm’s
capacity leading to a rise in the average cost of production. Similar to the economies of scale, diseconomies of
scale can also be categorized into internal and external diseconomies of scale.

Types of Diseconomies of Scale

There are two types of economies of scale:
1. Internal diseconomies
2. External diseconomies
Internal diseconomies
Definition: Internal diseconomies refer to the diseconomies that a firm incurs due to the growth of the firm
itself. These diseconomies of scale result in a decrease in the firm’s output and increase in the long-run average
cost.
Type of Internal diseconomies
The two main reasons for internal diseconomies of scale are as follows:

1. Managerial inefficiency: When a firm expands its production capacity, control and planning also need to be
increased. This requires the administration to be more efficient. Often due to the challenge of managing a bigger firm,
managerial responsibilities are delegated to the lower level personnel. As these personnel may lack the required
experience to undertake the challenge, it may result in low output at a higher cost.

2. Labour inefficiency: When a firm expands its production capacity, work areas may become more crowded
leaving little space for each worker to work efficiently.

Moreover, over-specialisation and division of labour in a bigger firm create over-dependence on workers. In such
situations, labour absenteeism, lethargy, discontinuation of services, etc., become common, which increase the long-
run average cost of production.
External diseconomies
Definition: External diseconomies of scale refer to the disadvantages that arise due to an increase in the
number of firms in an industry-leading to overproduction.
Factors of external diseconomies of scale
 The concentration of firms within an industry increases the demand for raw materials. This leads to an increase in
the prices of raw materials consequently increasing the cost of production in the industry.

 The concentration of firms within an industry increases the demand for skilled labour. This leads to an increase in
the wages of the skilled workers consequently increasing the cost of production in the industry.

 The concentration of firms within an industry may lead to problems of waste disposal. Firms are bound to employ
expensive waste disposal or recycling methods, which increases the long-run cost of production.

 The concentration of firms within an industry may lead to excessive need for advertising and promotion,
consequently increasing the cost of production in the industry.

FAQ – Economies of scale and Diseconomies of Scale

What is the difference between economies of scale and diseconomies of scale? ✅
Economies of scale may be defined as a reduction in the firms per unit cost i.e. average cost of production
which is associated with the use of large plants to produce a large volume of output. whereas, diseconomies of
scale refer to the disadvantages that arise due to the expansion of a firm’s capacity leading to a rise in the
average cost of production.
What is an example of economies of scale? ✅
Internal economies of scale example: Large companies have the aptitude to buy in size, thus lowering the cost
per unit of the resources they need to create their products. They can also use the savings to augment profits, or
pass the investments to consumers and fight on price.

What is Revenue?
Definition: Revenue is the total amount of money received by an Organization in return of the goods sold or
services provided during a given time period.
In other words, revenue of a firm refers to the amount received by the firm from the sale of a given quantity of
a commodity in the market.

For example, if a firm obtains 2, 50,000 from the sale of 10 computers, the received amount of 2, 50,000 is its
revenue earned during the time period.

Types of Revenue
What is Revenue Types? There are mainly three types of revenue:

1. Total Revenue
2. Average Revenue
3. Marginal Revenue

Total Revenue
Definition: Total Revenue (TR) of a firm refers to total receipts from the sale of a given quantity of a
commodity. In other words, total revenue is the total income of a firm. Total revenue is calculated by
multiplying the quantity of the commodity sold with the price of the commodity.
Formula: Total Revenue = Quantity × Price
Total Revenue Example
For example, if a firm sells 10 fans at a price of ₹ 2,000 per fan, then the total revenue would be calculated as
follows: 10 fans × ₹ 2,000 = ₹ 20, 000

Average Revenue
Definition: Average Revenue (AR) of a firm refers to the revenue earned per unit of output sold. It is
calculated by dividing the total revenue of the firm by the total number of units sold.
Formula: Average Revenue = Total revenue / Total number of unit sold
Average Revenue Example
For example, if total revenue from the sale of 10 fans at the rate of 2000 per fan is ₹ 20, 000, then:

Average Revenue = 20000 / 10 = ₹ 2,000

Here, it is important to note that AR and price of a commodity are equal in value. This can be explained as
follows

TR = Quantity × Price……………………..(1)
AR = TR / Q ………………………………………….(2)
Substituting the value of TR from equation (1) in equation (2),
AR = Quantity Price / Quantity
Therefore, AR = Price

Marginal Revenue
Marginal Revenue (MR) of a firm refers to the revenue earned by selling an additional unit of the commodity.
In other words, the change in total revenue resulting from the sale of an additional unit is called marginal
revenue.

MRn = TRn – TRn-1

Where MRn = marginal revenue of nth unit (additional unit), TRn = total revenue from n units, TRn-1 = Total
revenue from (n – 1) units and n = number of units sold.
Marginal Revenue Example
if the total revenue realised from the sale of 10 fans is 2,000 and that from sale of 11 fans is ₹ 2,500, then MR
of the 11th fan will be calculated as follows:

MR11 = TR11 – TR10

MR11 = ₹ 2,500 – ₹ 2,000 = ₹ 500

What is Market Power?

Market power define as the ability of an Organization to raise the market price of a good or service over
marginal cost to achieve profits. It can also be defined as the degree of control an Organization has over the
price and output of a product in the market.
A firm with total market power is in a position to raise the prices without any loss of customers. This type of
control generally occurs in imperfect competition.

Organizations having total market power are also known as price makers. On the contrary, Organizations have
no market power in perfectly competitive markets. Such Organizations are known as price takers.

Market Power Definition

Market power can be defined as an Organization’s ability to increase the market price of a good or service
over marginal cost to achieve profits. It is also considered as a measure of the degree of control an Organization
has over the price and output of a product in the market.

Measurement of Market Power

In the market, the share of an Organization can be determined by measuring its market power. The most
common measure for determining market power is concentration ratios. These ratios are used to determine the
degree of control of firms in the market.

Concentration Ratios
Concentration ratios can be defined as a measure of market power in relation to the size of the business firm
with that of the product’s size.
There are two types of concentration ratios: four-firm concentration ratio and eight firm concentration ratio.

 Four firm concentration ratio: It can be defined as the fraction of output produced by the top four
Organizations in an industry.
 Eight firm concentration ratio: It can be defined as the fraction of output produced by the top eight
Organizations in an industry.
Both these ratios are used to provide a clear view of industry concentration in the market.

For example, in the case of cigarettes, the four biggest Organizations have 98 percent share in the US market.
These concentration ratios may range from 0 to 100 percent, where a 0 percent concentration ratio is an
indication of a highly competitive market and a 100 percent concentration ratio indicates a highly oligopolistic
market that is imperfectly competitive.

Types of Concentration
The concentration ratios fall under three types of concentration, discussed as follows:

 Low concentration: An industry is considered to be under low concentration ratio if its concentration ratio falls
bewteen 0 and 50 percent. Monopolistic competition falls into the bottom of this with oligopoly emerging near the
upper end.

 Medium concentration: An industry is considered to be under medium concentration if its concentration ratio is
from 50 to 80 percent. Example of such industries are very much oligopoly.

 High concentration: An industry is considered to be highly concentrated if its concentration ratio falls between
80 and 100 percent. Government regulators generally fall under this category.
In addition to Concentration ratios, there is another method that is used to determine the market power,
i.e., Herfindahl-Hirschman Index (HHI).
Herfindahl-Hirschman Index: This index is used as an indicator of competition among Organizations in an
industry. Thus, it helps in determining if the industry is competitive or moving towards monopoly.
The HHI is calculated by squaring the market share for each firm (up to 50 firms) and then summing the
squares. HHI comes close to zero in a perfectly competitive market, whereas in a monopoly, HHI nears 10,000.
Let us understand the estimation of market share using HHI.

Determinants of Market Power

The market power of Organizations is threatened, when there is a new entrant in the market. Thus, as long as
there are barriers to entry, the market power of the existing Organizations remains strong. These barriers often
act as the determinants of market power of Organizations.

For example, retail stores have generally very low market power as it is easy for a new participant to enter the
market. There are various determinants of market power that explain the existence of Organizations’ control in
the market. Some of the important determinants of market power are shown in Figure.
There are 4 major determinants of market power:
1. Economies of scale
2. Governmental regulations
3. Control of raw materials
4. Customer loyalty

Let us discuss these determinants of market power in detail, as follows:

Economies of scale
It often occurs that the Organization that has a fair amount of the share in the market produces large quantities
to maximise its profit. Thus, when a new Organization decides to enter the market, it has to produce in large
quantities to keep its cost low in comparison to the market rulers. Thus, economies of scale actually indicate the
market power of an Organization in the market.
Governmental regulations
Governmental regulations also act as a major determinant of market power. In the market, where these
regulations are strict and numerous, there is a strong control of the existing Organizations.

For instance, by licensing and franchising monopolies are created along with government decree. In such a
scenario, starting up a new venture becomes difficult due to the high market power of the leaders.
Control of raw materials
An important determinant of market power is the control of raw material supplies in the market.

For instance, an Organization that controls the supply of all the raw materials required for a product in the
market may refuse to sell the raw materials at low prices to make the manufacturing Organizations compete.
Customer loyalty
With time, an Organization builds its reputation in the market. In the eyes of customers too, these Organizations
hold a great image. Thus, customers find it difficult to switch to other products, even at a low price. Due to
brand establishment in the market, the market power of the Organization remains high making it difficult for
new entrants to gain share in the market.

What is Market Structures?

Definition: Market structure can be defined as a group of industries characterised by number of buyers and
sellers in the market, level and type of competition, degree of differentiation in products and entry and exit of
Organizations from the market.
The study of market structure helps Organizations in understanding the functioning of different firms under
different circumstances. Based on the study, Organizations can make effective business decisions.

Types of Market Structures

1. Pure Competition
2. Perfect Competition
3. Imperfect Competition

Pure Competition
Definition: Pure competition exists in a market when there is large number of sellers offering homogenous
products to equal population of buyers. Due to presence of high population of producers, price does not get
affected so as to cause inflation.

Thus, buyers can purchase products from any seller as there is no difference in the price and quality of products
of different sellers. This is because the market sets the price for the market, making sellers as price takers.

Moreover, in a purely competitive market, all the products are considered as substitutes of one another.
Therefore, if there is a rise in the price of a product from one producer, buyers can easily purchase the similar
product from the other seller.

In a purely competitive market, due to the absence of legal, technological, financial or other barriers, it is easy
for a new Organization to enter or exit the market. However, the existence of pure competition is not possible
in the real world. In pure competition, the homogeneity of the products with a fixed market price is shown by
the average revenue curve or the demand curve as a horizontal straight line.
Average Revenue Curve under Pure Competition

In Figure, OP is the price level at which a seller can sell any quantity of products.

Perfect Competition
Definition: Perfect competition is a market in which there are many firms selling identical products with no
firm large enough relative to the entire market to be able to influence the market price. Perfect competition is a
type of market structures which is extension of pure market subject to a wider scope.

Perfect Competition Characteristics

The main perfect competition characteristics are discussed below in details:
 Large number of buyers and sellers: In perfect competition, a large number of buyers and sellers exist.
However, the high population of buyers and sellers fails to affect the prices, and the output produced by a seller or
purchases made by a buyer are very less in comparison to the total output or total purchase in an economy.

 Homogenous product: Another important characteristic of perfect competition is the existence of homogenous
product for buying and selling. This makes it possible for buyers to choose the product from any seller in the market.
Due to the presence of large number of sellers, the market price remains same throughout the market.

 Ease of entry and exit from the market: In perfect competition, there are hardly any barriers, such as
government regulations and policies, to enter or exit the market. Consequently, firms find it easy to enter the markets
as all the Organizations earn normal profits. Similarly, Organizations also easily exit the market as they are not bound
by any rules and regulations.

 Perfect knowledge: In the perfectly competitive scenario, both buyers and sellers are completely aware of the
product price prevailing in the market. Thus, no seller would try to sell the product at a higher price. However, this
also leaves no scope for bargaining for buyers too.

 No transportation costs: In perfect competition, the existence of the same price is because of zero transportation
costs. Due to the absence of transportation costs, there is no scope of price variation in all sectors of the market.
Imperfect Competition
Definition: Imperfect competition is a competitive market where a large number of sellers are engaged in
selling heterogeneous (dissimilar) goods as opposed to the perfectly competitive market.
The concept of imperfect competition was first explained by an English economist, Joan Robinson. Under
imperfect competition, both buyers and sellers are unaware of the prices. Therefore, producers can influence the
price of the product they are offering for sale.

Types of Imperfect Competition

There are 3 types of Imperfect competition:
1. Monopolistic competition
2. Monopoly
3. Oligopoly

Monopolistic competition
Definition: Monopolistic competition is a type of market structures where there are a large number of small
sellers, selling differentiated, but close substitute products.
Monopolistic competition is a type of imperfect competition, wherein a large number of sellers are engaged in
offering heterogeneous products for sale to buyers.
The term monopolistic competition was given by Prof. Edward H. Chamberlin of Harvard University in 1933 in
his book, Theory of Monopolistic Competition. Monopolistic competition is the most realistic situation that
exists in the market.

Monopolistic Competition Characteristics

The main monopolistic competition characteristics are discussed below in details:
 Large number of sellers and buyers: The presence of large number of sellers offering different products to
equal number of buyers is a primary characteristic of monopolistic competition.

 Product differentiation: Another important characteristic of monopolistic competition is product differentiation;

wherein products that are sold in the market vary in style, quality standards, trademarks and brands. This helps buyers
in differentiating among the available products in more than one way. However, under monopolistic competition,
products are close substitutes of each other.

 Ease of entry and exit: Similar to perfect competition, under monopolistic competition, Organizations are free to
enter or exit the market due to the limited number of restrictions imposed by the government.
 Restricted mobility: Dissimilar to perfect competition, the factors of production are not perfectly mobile in
monopolistic competition. This is due to Organization’s willingness to pay heavy transportation costs to move the
factors of production or goods and services. This results in difference in the prices of products of Organizations.

 Price control policy: Under monopolistic competition, Organizations do not have much control over the price of
the product. If the prices of products are higher, then the buyers would switch to other sellers due to close
substitutability of products. Therefore, the price policy of competitors greatly influences the price policy of an
Organization.

Oligopoly
Definition: Oligopoly is a market situation in which a firm determines its marketing policies on the basis of the
expected behaviour of close competitors. Oligopoly is a type of imperfect competition, wherein there are few
sellers dealing either in homogenous or differentiated products.
The term oligopoly has been derived from the two Greek words, oligoi means few and poly means control.
Thus, it means the control of the few Organizations in the market.
Example, oligopoly in India exists in the aviation industry where there are just few players, such as Kingfisher,
Air India, Spice JetIndigo, etc. All these airlines depend on each other for setting their pricing policies. This is
because the prices are affected by the prices of the competitors’ products.
Oligopoly characteristics
 Existence of few sellers: One of the primary features of oligopoly is the existence of a few sellers who dominate
the entire industry and influence the prices of each other, greatly. In addition, the number of buyers is also large.
Moreover, in oligopoly, there are a large number of buyers.

 Identical or differentiated products: An important characteristic of oligopoly is the production of identical

products or differentiated products. This implies that Organizations may either produce homogenous products, such as
cement, asphalt, concrete and bricks, or differentiated products, such as an automobile. If Organizations produce
homogenous products, it is said to be pure oligopoly.

 Impediments in entry: Another important characteristic of oligopolistic competition is that Organizations cannot
easily enter the market; nor can they make an exit from the market. The reasons for difficult entry in the market are
various legal, social and technological barriers. This also implies that the existing Organizations have a complete
control over the market.

 Enhanced role of government: Under oligopolistic market structure, the government has a greater role as it acts
as a guard to anti-competitive behaviours of oligopolists. It is often observed that oligopolists may engage in the
illegal practice of collusion, where they together make production and pricing decisions. Oligopolists may start acting
as a single Organization and further increase prices and profits. Thus in such an environment, the government requires
to keep a watch on such activities to curb the illegal practices.

 Mutual interdependence: Under oligopoly market structure, mutual interdependence refers to the influence that
Organizations create on each other’s decisions, such as pricing and output decisions. In oligopoly, a few numbers of
sellers compete with each other. Therefore, the sale of an Organization is dependent on its own price of products, as
well as the price of its competitor’s products. Thus, in oligopoly, no Organization can make an independent decision.

 Existence of price rigidity: Under oligopolistic market, Organizations do not prefer to change the prices of their
products as this can adversely affect the profits of the Organization. For instance, if an Organization reduces its price,
its competitors may reduce the prices too, which would bring a reduction in the profits of the Organization. On the
other hand, the increase in prices by an Organization will lead to loss of buyers.

Monopoly
Definition: Monopoly can be defined as a type of market structures, wherein a single producer or seller has a
control on the entire market.
The term monopoly has been derived from a Greek word Monopolian, which means a single seller. Thus, in
monopoly, a single seller deals in the products that have no close substitutes in the market.
Monopoly characteristics
 Existence of a single seller: Under the monopoly type of market structure, there is always a single seller
producing large quantities of the products. Due to the availability of only one seller, buyers are forced to purchase
from the only seller. This results in total control on the supply of products by the seller in the market. Moreover, the
seller has complete power to decide the price of products.

 Absence of substitutes: Another important characteristic of a monopoly is the absence of substitutes of the
products in the market. In addition, differentiated products are absent in the case of a monopoly market.

 Barriers to entry: The reason behind the existence of monopoly is the various barriers that restrict the entry of
new Organizations in the market. These barriers can be in the form of exclusive resource ownership, copyrights, high
initial investment and other restrictions by the government.

 Limited information: Under monopoly, information cannot be disseminated in the market and is restricted to the
Organization and its employees. Such information is not easily available to public or other Organizations. This type of
information generally comes in the form of patents, copyrights or trademarks.
Price Discrimination Under Monopoly
Definition: It is generally observed that different prices are charged from various users by a monopolist to
achieve more profits. This policy of charging different prices by a monopolist is known as price
discrimination.
Three types of Price discrimination under monopoly are discussed below:
 Geographical price discrimination: In this type of price discrimination, a monopolist charges different prices
for the products in different areas. Generally, if the demand of a product is inelastic in an area, the monopolist charges
higher price and vice versa.

For example, rice is sold at different prices by Food Corporation of India in Kashmir and Himachal Pradesh.

 Personal price discrimination: In this type of price discrimination, a monopolist charges different prices from
different users or buyers. Personal price discrimination occurs mainly due to ignorance among buyers related to the
prices of the products.

For example, a grocery seller may charge different prices for similar vegetables from different customers depending
on the negotiation power of customers. If a customer is aware of the prices and is able to bargain, the seller may
become willing to sell the product at a lower price. On the other hand, the seller may sell the same product at a higher
price if the customer is ignorant and unaware of prevailing prices in the market.

 Utility based price discrimination: In this type of price discrimination, the seller charges different prices from
buyers in accordance with the use of the products.

For example, the price of electricity differs on the basis of consumption, i.e., rate per unit for commercial use is higher
than that for the domestic use.

Price regulations
Definition: Price regulations are governmental measures dictating the quantities of a commodity to be sold at a
specified price both in the retail marketplace and at other stages in the production process. These regulations act
as control measures or emergency economic measures in the case of imperfect competition to prevent probable
market failures.
Price regulations Example
For example, in monopolies, sellers have complete market power of controlling the pricing decisions and
setting prices higher than in competitive markets. In such a case, demand for the product does not lower down,
which can lead to market failure.

Thus, the government is required to intervene in the scenario to prevent market failures. By using price
regulations, the government not only controls the functioning of the market, rather protects consumer welfare.

There are various price mechanism used by the government to regulate the prices in the market. The most
commonly used price regulations are Price Ceiling and Price Floor.

What is Price Ceiling?

Definition: A price ceiling can be defined as the price that has been set by the government below the
equilibrium price and cannot be soared up above that.
Price Ceiling Example
For example, price ceiling occurs in rent controls in many cities, where the rent is decided by the governmental
agencies. The rent is allowed to rise at a specific rate each year to keep up with inflation. However, the rent
must remain below equilibrium.

It is observed that a shortage occurs by setting price ceiling. This is due to more demand than there is at the
equilibrium price at which the price of the ceiling is defined. Moreover, supply is also reduced than the supply
at the equilibrium price. This results in increased demand of the commodity than the quantity supplied.
Consequently, marginal costs are exceeded by marginal benefits resulting in inefficiencies equivalent to the
deadweight welfare loss.
Price Ceiling

Way to Resolve Price Ceiling Shortage

The shortages created by price ceilings can be resolved in many ways without increasing the price. Following
are the ways that can be used to resolve shortages:

 First come first serve: This is the most common way of resolving the shortage, wherein, the person who comes
first gets to buy the product.

A common example of this is the people standing in line at the counter of a cinema hall to buy the tickets to a movie.

 Lottery: It is a type of lucky draw, where one lucky person who picks the right numbers is allowed to make the
purchase. The lottery system is could be a way to dole out a product that is facing a shortage.

For example, some chargers may use this system to determine the persons who could buy the limited tickets to a
special game of football.

 Sellers’ selection: Another way of resolving the shortage due to price ceiling is allowing sellers to select the
buyers to whom they want to sell their products.

For example, many landlords select renters to rent based on certain criteria (such as preference for the married couple
and without pets).

 Choice of government: On many occasions it is left to the government to make the selection of buyers.

For example, to deal with the shortage of gasoline in 1979, the California government allowed the sale of gasoline to
those who had license plates of their vehicles ending in an odd number on the odd days of the month.
What is Price Floor?
Definition: A price floor is said to exist when the price is set above the equilibrium price and is not allowed to
fall. It is used by the government to prevent the prices from hitting a bottom low.
Price Floor Example
The most common example of a price floor is the setting of minimum daily wages of a labour worker, where
the minimum price that can be paid to labour is established. This is mostly done to protect the farmers.

Price Floor

A predominant condition for price floor to be effective is to place the price floor above the equilibrium price. If
the price is not set above equilibrium, the market does not sell below the equilibrium price and the price floor
will become inappropriate.

Way to Resolve Price Floor Shortage

There are some problems due to the surplus (quantity in demand is lesser than the quantity in supply) created
through the price floor. If the surplus exists in the market for a long period, the price floor begins to fall below
the price of equilibrium, which can result in market failure. Thus, the government is required to intervene to
avoid the occurrence of surplus. Some of the measures that can be adopted by the government to deal with the
surplus are:
 Purchase of all surplus goods: A way to deal with the surplus is the purchase of all the surplus goods by the
government. The surplus can be sold to other countries. For example, the US government had bought all the surplus
grain in the US and sold it to Africa.

 Control of production by the government: Another way to control the surplus is the government’s control over
the production. The government can offer rights of production to some of the selected suppliers. If the government
gives out the rights for production to some suppliers (selected on a specific criterion) or compensates them for not
making any additional supply, then the unnecessary production of goods can be eliminated.

 Sponsorship of consumption: The government can also sponsor the buyers by paying a part of the cost. This
would help the buyers to buy more of the surplus

Economists believe that in an economy, actual inflationary process contains some elements of both demand pull
inflation and cost push inflation. They state that both the forces operate simultaneously and independently in an
inflationary process. Thus, mixed inflation is when change in price level is a result of change in both aggregate
demand and aggregate supply functions.
But, economists also argue that both demand pull and cost push inflations do not occur simultaneously. The
inflationary process may begin with either excess of demand or an increase in costs of production.

When inflation begins with excess demand with no cost push forces, prices rise and consequently leads to rise
in wage rates (rise in cost of production). Here, wages do not increases because of cost push inflation but
because of rise in prices. This is because, when the price of commodities increase, individuals would want a
raise in their income in order to keep up with the economy. Thus, mixed inflation takes place.

On the other hand, when inflationary process starts with cost push inflation, prices rise but output declines.
Subsequently, problem of unemployment occurs in the economy. In order to avoid economic recession,
government adopts expansionary monetary and fiscal policies. Increase in government’s expenditures give rise
to employment opportunities which further increases income level and purchasing power of people. As a result,
demand for commodities increase, causing a price rise and thus, leading to demand pull inflation.

The diagram below clearly explains the concept of mix inflation:

As seen in the diagram, forces that affect aggregate demand and aggregate supply simultaneously affect each
other. The initial point of equilibrium is E0 where, aggregate demand curve ADo intersects aggregate supply
curve AS0, and the equilibrium price is P0 and output is Y0.
Suppose, wage rates rise due to the activities of the trade union. Rise in wage shifts the AS curve to AS1 and the
new equilibrium point is E1. At this point, the higher price level is at P1 and the reduced level of output is at Y1.
This is cost push inflation.
As the government takes measures to increase employment level in the economy, income level rises and causes
a shift in the demand curve from AD0 to AD1. The new equilibrium point is E2 where the rise in price is P2. This
is demand pull inflation resulted due to cost push inflation.
Taking another economic scenario, suppose government expenditures increase in the economy, which increases
the level of income of the people. This shifts the AD curve from AD0 to AD1. The new equilibrium point with
higher price level (P1) and output (Y1) is point E1. This is demand pull inflation.
When prices rise, real income of workers fall. So, workers demand more wages to keep up with the increasing
prices. This causes the aggregate supply curve AS to shift from AS0 to AS1. The new point of equilibrium is
E2 where price rose to P2 and output declined to Y0. Consequently, demand pull inflation gave rise to cost push
inflation.
Thus, demand pull and cost push inflations operate simultaneously in the economy and cause a
sustained rise in prices from P0 to P2.

Meaning of Inflation
The price of goods and services are always changing. The chocolate one could buy for $1 a year
back now costs $1.5. This is because of the increase in the price of commodities.
The phenomena when the prices of goods and services rise is known as inflation. It was first brought
into light by the neo-classical economists, after which it has undergone modifications and it still
remains a debatable term even today.
Neo-classical economists defined inflation as increase in price level of commodities. They believed
that the economy is always at full employment, which means that all the available resources are fully
utilized to meet the demand of the economy. Thus, inflation was a result of extra flow of money
within the economy.

However, Keynes opposed to the neo-classical view of inflation. He stated since unemployment
exists in the economy, the excess supply of money leads to a rise in total demand, output and
employment. As the money supply increase, the level of output increase at the same level. But, when
there is further rise in total demand, output, and employment, price of commodities starts rising
further. This happens because of the effect of diminishing returns.

The prices that rise until the level of full employment is termed as semi-inflation. When the money
supply increases even after full employment has been attained, output remains same, and only the
prices rise.
Thus, inflation is defined as a state of continuous rise in general price of all commodities.
Specifically, it is a situation of rising prices in which a unit of money will buy less quantity of goods
and services. This means that with the rise in the supply of money, the price of commodities
increase, while the purchasing power of money decreases.
According to Arthur Cecil Pigou, inflation takes place ‘when money is expanding relatively to the
output of work done by the productive agents for which it is the payment’.

John Maynard Keynes defines, ‘Inflation is the result if excess aggregate demand over the aggregate
supply and the true inflation starts after full employment.’ According to him, the rise in price level
before full employment is semi-inflation.
On the basis of the scholarly definitions provided by various economists, inflation can be stated as a
continuous rise in price levels of most goods and services during which the quantity of money
increases but the value of money decreases.

Types of Inflation
The types of inflation have been classified on the basis of their varying nature. Generally, the basis of
its classification is the rate of speed, cause, government reaction, and employment levels.

I. On the basis of speed

The different types of inflation on the basis of speed are explained below:

 Creeping/Mild inflation
When the rise in price level is less than 3 percent per annum, it is termed as creeping or mild inflation.
The price of goods and services rise moderately and it is usually considered helpful for the
development of the economy. However, some economists consider it as a signal towards the rising
prices.
 Walking inflation
A sustainable rise in price level within the range of 3 percent to 6 percent or less than 10 percent is
called as walking inflation. It occurs when mild inflation is not considered or is let to fan out by the
government.

Both creeping inflation and walking inflation are one digit figures and are considered as moderate
inflation in the economy.

 Running inflation
When the rise in prices increase rapidly at a rate of 10 percent or 20 percent per annum is known as
running inflation. As the inflation rate crosses two digit figure, economic problems arise. Running
inflation adversely affects the poor and middle class families and households in the economy.
 Hyperinflation
Hyperinflation or galloping inflation is a rise in price level by 50 percent or more annually. It occurs
when running inflation is left uncontrolled in the economy. When the economy faces hyperinflation,
the preference of people shifts from money to the traditional barter system.

For instance, between 2007 and 2009, Zimbabwe faced severe economic problems due to political
changes and harsh climatic conditions. As a solution to this, the leaders of the country printed
billions of money, which led the country into hyperinflation. The rate of inflation reached 79 billion%
per month.

II. On the basis of employment level

 Semi-inflation
The rise in general price level below the level of full employment is termed as semi-inflation.
According to Keynes, general prices do not rise as long as there are unemployed resources in the
economy. However, when aggregate expenditure increases by a large portion, costs for some
resources may rise eventually leading to increase in price. This phenomenon is known as semi-
inflation.

 Pure inflation
The inflation that occurs when the economy is at full employment level is known as pure inflation. As
Keynes states, at full employment levels, output cannot be increased any further. Due to this, price
level rises in relation to the rise in demand for commodities. This is termed as pure inflation.
III. On the basis of government reaction
 Open inflation
When the government has no control over the price rise and there are no barriers to price rise, it is
termed as open inflation. In this case, markets for commodities or factors or production are allowed
to function freely with no intervention from the central authority.

 Suppressed inflation
When the government makes efforts to check the price rise through price control mechanisms, it is
called as suppressed inflation. The government imposes various physical and monetary controls in
order to suppress the extensive increase in price levels. Although control over price rise helps to keep
inflation under check, it leads to price rise in uncontrolled resources, consequently resulting in
diversion of productive resources. It may also lead to economic problems like hoarding of goods,
black marketing, corruption, and so on.

IV. On the basis of cause

 Demand pull inflation
The rise in price due to excess demand for goods and commodities in comparison to their supply is
termed as demand pull inflation. Classical economists state that the reason behind the rise in
demand is because of the increased supply of money.

 Cost push inflation

The rise in the price level as a result of increase in the cost involved in the production of goods and
services in known as cost push inflation. Cost of production may be caused due to the rise in price of
raw materials, wages of workers, and so on.

For instance, the cost bread that costs $1 has risen to $1.5 in a month. This may have occurred
because of the increase in the price of wheat or because of the higher wages demanded by workers
in a baking company.
 Deficit-induced inflation
An economy faces deficit balance when its expenditures exceed revenue. In order to meet the gap,
the government prints more money through central bank. So, any price rise in the economy due to the
government’s effort to level of the deficit balance is called as deficit-induced inflation.
  Credit inflation
When financial institutions and commercial banks provide more loan to the public with a view to earn
more profit, the expansion amount of money in the economy exceeds more than what is required.
The of credit leads to rise in price level and is termed as credit inflation.

The cross-price elasticity of demand is the degree of responsiveness of quantity demanded of a

commodity due to the change in price of another commodity.
Mathematical Formula for Cross Elasticity of Demand
Cross elasticity of demand is the percentage change in the quantity demanded of good X due to
certain percent change in the price of good Y.

Numerical Example to Explain Cross Elasticity of Demand

Tea and coffee are substitutes to each other. If the price of coffee rises from Rs.10 per 100 grams to Rs.15 per
100 grams and as a result, consumer demand for tea increases from 30/100 grams to 40/100 grams, find out the
cross elasticity of demand between tea and coffee.
Here, If we suppose tea as good x and coffee as good y.

Thus, the coefficient of cross elasticity is 2/3 which shows that the quantity demanded for tea
increases 2% when the price of coffee rises by 3%.

Types of Cross Elasticity of Demand

Positive cross elasticity of demand (EC>0)
If rise in price of one good leads to rise in quantity demanded of other good of a similar nature and
vice versa, it is known as positive cross elasticity of demand. Positive cross elasticity exists between
two goods which are substitutes of each other.

 
In the above figure, quantity demanded for Coke and price of Pepsi are measured along X-axis and Y-
axis respectively. When the price of Pepsi increases from OP to OP1, quantity demanded for coke
rises from OQ to OQ1 and vice versa. Thus, the demand curve DD shows positive cross elasticity of
demand.
Negative cross elasticity of demand (EC<0)
Two goods which are complementary have negative cross elasticity of demand. If the rise in price of
one good leads to fall in quantity demanded of its complementary good and vice versa, it is known as
negative cross elasticity of demand.

 
In the above figure, quantity demanded for Tea and price of Sugar are measured along X-axis and Y-
axis respectively. When the price of Sugar increases from OP to OP1, quantity demanded for Tea falls
from OQ to OQ1 and vice versa. Thus, the demand curve DD shows negative cross elasticity of
demand.

Marginal Rate of Substitution

Marginal rate of substitution (MRS) may be defined as the rate at which the consumer is willing to
substitute one commodity for anothe r without changing the level of satisfaction.
In other words, MRS can also be defined as the amount of a commodity that a consumer is willing to
trade off for another commodity, as long as the second commodity provides same level of utility as
the first one.

If we denote two commodities as X and Y, then MRS between X and Y can be expressed as the
amount of Y a consumer is willing to give up so as obtaining one more unit of commodity X.

Mathematically, MRS is represented as

MRS=ΔY/ΔX
 Table 1: Indifference schedule

Combination Cigarette Coffee (cups) MRS

A 1 12 –

B 2 8 4

C 3 5 3

D 4 3 2

E 5 2 1

In the above indifference schedule are given 5 different combinations of two goods (cigarette and
coffee), all of which produce same level of satisfaction.
We can see, combination A consists of 1 cigarette and 12 cups of coffee. When the consumer moves
to combination B from A, he has to give up 4 cups of coffee in order to add 1 unit of cigarette,
maintaining same level of satisfaction. Hence the marginal rate of substitution of cigarette for coffee
is 4.

In the same way, when the consumer moves to combination C, he has to give up 3 more cups of
coffee in order to add one more unit of cigarette and maintain the same utility level. Hence, marginal
rate of substitution of cigarette for coffee here is 3.
Likewise, when the consumer moves to combination D and E, marginal rate of substitution is 2 and 1,
respectively.

Principle of Marginal Rate of Substitution

Marginal rate of substitution (MRS) is based on an important economic principle, i.e. MRS of X for Y
diminishes more and more with each successive substitution of X for Y. This principle is known as
diminishing marginal rate of substitution.

According to MRS, a consumer can let go off some of one commodity, say Y, in order to gain more of
the other commodity X. However, as the consumer starts getting more and more of commodity X, he
tends to forego less and less of good Y.

The rate at which the consumer substitutes X for Y is greater at the beginning. But, as he continues
the substitution process, the rate of substitution begins to fall.
The diminishing marginal rate of substitution is also apparent from the table 1.
Initially, when the consumer moved to combination B from A, the MRS was calculated to be 4. In the
same way, when he moved to combination C, the MRS was calculated to be 3. Likewise from
combination C to D, MRS was 2. And, from D to E, MRS was 1.
Clearly, marginal rate of substitution diminished more and more as the consumer kept on
substituting more and more cigarette for coffee.

The diminishing marginal rate of substitution can also be clearly visualized from the graphical
representation of the indifference schedule.

Causes for diminishing marginal rate of substitution

Marginal rate of substitution is diminishing because of following reasons.
Goods are not perfectly substitutable
Goods can never be perfectly substitutable. If one good can perfectly substitute another good, both
the goods are regarded as same. And, thus, increase or decrease in amount of any good will not
cause effect in marginal substitution.

Increase in one good does not increase the want satisfying power of another good
Since two goods cannot be perfectly substitutable, an increase in one good cannot fully satisfy the
consumer as the other good.
For an instance, cigarette and coffee cannot be perfect substitutes to each other. Thus, giving up 4
cups of coffee increases cigarette consumption by only 1 unit, rather than 4 units.
The want for a particular commodity can be satiable
According to marginal rate of substitution, a person can sacrifice certain amount of one commodity
(y) in order to increase the stock of other commodity (X). He keeps on sacrificing Y for X until the
point of satiety, after which his demand for X starts declining.

Also, trading off Y more and more causes decrease in stock of Y, to maintain which he is now willing
to forego lesser and lesser of that good with each successive increment of X.

Since two goods cannot be perfectly substitutable, an increase in one good cannot fully satisfy the
consumer as the other good.
For an instance, cigarette and coffee cannot be perfect substitutes to each other. Thus, giving up 4
cups of coffee increases cigarette consumption by only 1 unit, rather than 4 units.

The want for a particular commodity can be satiable

According to marginal rate of substitution, a person can sacrifice certain amount of one commodity
(y) in order to increase the stock of other commodity (X). He keeps on sacrificing Y for X until the
point of satiety, after which his demand for X starts declining.

Also, trading off Y more and more causes decrease in stock of Y, to maintain which he is now willing
to forego lesser and lesser of that good with each successive increment of X.

Inflation is measured in percentage which is obtained by calculating the change in percentage of

current price index over the previous one. The price index is developed by carrying out a survey on
costs of a number of goods and services that comprise the economy. These goods and services are
put together into what is known as ‘market basket’. The cost of identical market basket today is
compared to the cost of identical basket in the previous year or a base year in order to determine the
rate of inflation.

Consumer Price Index (CPI)

Consumer Price Index or CPI is an internationally comparable measure of inflation which measures
changes in price from the purchasers’ perspective. It is a measure of price changes in consumer
goods and services such as food, clothing, gasoline and automobiles but excludes housing costs and
mortgage interest payments. It reflects changes in the prices of a market basket of goods and
services purchased by consumers (individuals and households). CPI helps in the measurement of
cost of living of urban consumers.

As defined by the U.S. Bureau of labor statistics, ‘CPI is a measure of the average change over time in
the prices paid by urban consumers for a market basket of consumer goods and services.’

CPI is a statistical estimate constructed with the help of prices of items that represent the economy,
whose prices are collected periodically. The annual percentage change in CPI is taken as a measure
of inflation.

Thus,

Where,
CPI1 = CPI in previous year
CPI2 = CPI in current year
Calculating CPI
Calculation of CPI and inflation requires data on prices of goods and services in large scale. But, for
the simple understanding, let us consider a simple economy in which consumer goods include bread
and egg.

A step-wise calculation on CPI and inflation is explained below:

Step 1: Determination of basket of goods and services
Suppose, the market basket of a typical consumer contains 4 breads and 2 eggs.

Step 2: Determination of prices

Year Per unit price of Bread ($) Per unit price of Egg ($)

2005 1 2

2006 2 3

2007 3 4
Step 3: Computation of cost of basket of goods in each year
The costs of market basket is calculated with the help of individual prices and relative quantity of
goods.

Year 2005: ($1 per bread x 4 breads) + ($2 per egg x 2 eggs) = $8 per basket.
Year 2006: ($2 per bread x 4 breads) + ($3 per egg x 2 eggs) = $14 per basket.

Year 2007: ($3 per bread x 4 breads) + ($4 per egg x 2 eggs) = $20 per basket.
Step 4: Selection of base year (year 2005 in this case) and computation of CPI
Taking 2005 as the base year, and using the formula of CPI, we compute CPI for each given year as

Year 2005: ($8 / $8) x 100 = 100

Year 2006: ($14 / $8) x 100 = 175

Year 2007: ($20 / $8) x 100 = 250

Step 5: Computation of inflation rate using CPI

Using CPI from the above calculation and the formula of inflation, we derive inflation rate for each
year

Inflation in 2006: (175 – 100) / 100 x 100 = 75%

Inflation in 2007: (250 – 175) / 175 x 100 = 43%

Product Price Index (PPI)

Product Price Index (PPI), also referred to as Wholesale Price Index (WPI), measures the average
price changes of goods and services over time at wholesale level. In other words, PPI measures price
change from the viewpoint of domestic producers.

PPI or WPI is an index of prices paid by retailers for the products that they would resale to the final
consumers. It monitors the price changes made by manufacturers and wholesalers before the
products reach the final consumers.
GDP Deflator
GDP deflator measures the changes in the overall prices of newly produced goods and services that
are ready for consumption. It is an important economic metric that helps to determine the rate of
inflation by converting output measured at current market prices into constant base year prices.

In other words, GDP deflator measures the relationship between nominal GDP (total output measured
at current prices) and real GDP (total output measured at constant base year prices). It measures the
current level of prices relative to the level of prices in the base year.

Since the GDP deflator is not based on a fixed market basket of products, it takes into account the
change in consumption patterns of consumers as a result of newly manufactured products and
services.

The GDP deflator is simply nominal GDP in a year divided by real GDP in that year, multiplied by 100.
Thus,

Calculating GDP Deflator

A step-wise explanation of the GDP deflator is given below:
Step 1: Determination of basket of goods and services
Suppose, the market basket of a typical consumer contains bread and egg.

Step 2: Determination of prices

Per unit price of Per unit price of

Year Bread ($) Quantity of Bread Egg ($) Quantity of Egg

2005 1 100 2 50

2006 2 150 3 100

2007 3 200 4 150

Step 3: Computation of Nominal GDP
Year 2005: ($1 per bread x 100 breads) + ($2 per egg x 50 eggs) = $200

Year 2006: ($2 per bread x 150 breads) + ($3 per egg x 100 eggs) = $600

Year 2007: ($3 per bread x 200 breads) + ($4 per egg x 150 eggs) = $1200

Step 4: Computation of Real GDP

Taking 2005 as the base year, we calculate real GDP as

Year 2005: ($1 per bread x 100 breads) + ($2 per egg x 50 eggs) = $200

Year 2006: ($2 per bread x 150 breads) + ($2 per egg x 100 eggs) = $350

Year 2007: ($3 per bread x 200 breads) + ($2 per egg x 150 eggs) = $500

Step 5: Computation of the GDP Deflator

Using the above mentioned formula of GDP Deflator, we derive

Rate of Inflation in 2006: (171 – 100) / 100 x 100 = 71%

Rate of Inflation in 2007: (240 – 171) / 171 x 100 = 40.35%

After computation of various price indices, rate of inflation is calculated using the following formula:

Where,

Pt = Price index in current (t) period

Pt – 1 = Price index of previous (t – 1) period

Cobb-Douglas Production Function:

The general form of C-D function is expressed as Q = ALαKβ where A, α and β are
constants that, when estimated, describe the quantitative relationship between the inputs (K and
L) and output (Q). The sum of the constant (α +β) can be used to determine Returns to Scale.
That is
α +β =1  Constant returns to scale

α +β>1  Increasing returns to scale

α +β<1  Decreasing returns to scale

In a C–D function the exponent of a factor gives the ratio between the marginal product and
average product. Given the production function

αβ
Q= AL K

MP Q
L
=
L

=

AL
-1 
K   
= α AL K  L
-1

=   Q
L =  APL

MP

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 = L


APK

Where, APL and MPL are the average and marginal products of labour respectively.

Similarly we find that MPK = β. Q

K

 β = MPK

APK

α and β represent the labour and capital shares of output respectively. The C–D function
is a power function which can be converted into a linear form by taking it in a logarithmic form:

αβ
Q= AL K

Log Q = log A + α log L + β log K

In a C-D production function if one of the inputs is zero, output is also zero. If we look at the
form of the C-D production function, we find that it‘s a multiplicative in nature. In such a
function, if one input takes the value zero, the output becomes zero. It implies that all the inputs
considered in the function are necessary for the production process to take place.

Importance of Cobb-Douglas production function –

C.D production function is most popular in imperial research. The reasons for this are

1) The C-D function is convenient for international and inter-industry comparisons. Since α
and β are pure numbers, (i.e. independent of units of measurements) they can be easily
used for comparing results of different samples having varied units of measurement.
2) Another advantage is that this function captures the essential non-linearities of production
process and also has the benefit of the simplification of calculation by transforming the
function into a linear form with the help of logarithms. The log-linear function becomes

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linear its parameters, which is quite useful to a managerial economist for his analysis.
3) In addition to being elasticities, the parameters of C-D function also possess other
attributes. For example, the sum of (α+β) shows the returns to scale in the production
process. α and β represent the labour share and capital share of output respectively and so
on.
4) This function can be used to investigate the nature of long-run production function, viz –
increasing, constant and decreasing returns to scale.
5) Although in its original form, C–D production function limits itself to handing just two
inputs (e.g. L and K), it can be easily generalized for more than two inputs, like
a bc Q         Xnp
= AX1 X2 X3
Where
X1 X 2 X 3         Xn
are different inputs.

 Phillips Curve: Another important model following Keynes’s publications is the Phillips Curve,
put forward by William Phillips in 1958. The idea here was also largely Keynesian, revolving
around the relationship between inflation and unemployment (see ).This implies a trade off
between inflation rates and the creation of employment, which governments could consider in
policy making. Stagflation (economic stagnation and inflation simultaneously) created issues
with this however, necessitating New Keynesian ideas (as discussed briefly above).

Synthesis

 MANAGERIAL ECONOMICS
Managerial Economics (also called Business Economics) a subject first introduced by Joel
Dean in 1951, is essentially concerned with the economic decisions of business managers. It is a branch
of Economics that applies microeconomic analysis to specific business decisions (i.e. Economics
applied in business decision-making). Managerial Economics may be viewed as Economics applied to
problem solving at the level of the firm. The problems of course relate to choices and allocation of
resources, which are basically economic in nature and are faced by managers all the time. It is that
branch of Economics, which serves as a link between abstract theory and managerial practice. It is
based on economic analysis for identifying problems, organizing information and evaluating
alternatives. In other words Managerial Economics involves analysis of allocation of the resources
available to a firm or a unit of management among the activities of that unit. It is thus concerned with
choice or selection among alternatives. Managerial Economics is by nature goal-oriented and
prescriptive, and it aims at maximum achievement of objectives.
Managerial Economics help managers to learn the economic principles which are relevant to
decision-making in such areas as production, personnel, marketing and finance. A clear understanding
of economic principles will help the manager in his activities. For example, XYZ Ltd. has limited
financial, human, and physical resources. XYZ Ltd. managers seek to maximize the financial return
from these limited resources. They should apply Managerial Economics to develop pricing and
advertising strategies, design their organizations, and manage purchasing.
Managerial Economics applies economic theory and methods to business and administrative
decision-making. Managerial Economics prescribes rules for improving managerial decisions.
 
Managerial Economics also helps managers to recognize how economic forces affect
organizations and describes the economic consequences of managerial behaviour. It links traditional
Economics with the decision sciences to develop vital tools for managerial decision making. This
process is illustrated in Fig. 
Managerial Economics Definitions
Definitions
In the words of TJ. Webster, "Managerial economics is the synthesis of microeconomic theory and
quantitative methods to find optimal solutions to managerial decision-making problems?
In the words of Hirschey and Pappas, "Managerial economics applies economic theory and methods
to business and administrative decision making"
According to Mansfield, "Managerial economics provides a link between economic theory and decision
sciences in the analysis of managerial decision making?
Brigham and Poppas believe that managerial economics is "the application of economic theory and
methodology to business administration practice."
Hague on the other hand, considers managerial economics as "a fundamental academic subject which
seeks to understand and to analyse the problems of business decision-making."

According to McNair and Meriam, “Managerial economics is the use of economic modes of thought
to analyse business situations.”
 
According to Prof. Evan J Douglas, ‘Managerial economics’ is concerned with the application of
economic principles and methodologies to the decision making process within the firm or organisation
under the conditions of uncertainty”. Spencer and Siegelman define it as “The integration of economic
theory with business practices for the purpose of facilitating decision making and forward planning by
management.”

According to Hailstones and Rothwel, “Managerial economics is the application of economic theory

and analysis to practice of business firms and other institutions.” A common thread runs through all
these descriptions of managerial economics which is using a framework of analysis to arrive at informed
decisions to maximize the firm’s objectives, often in an environment of uncertainty. It is important to
recognize that decisions taken while employing a framework of analysis are likely to be more successful
than decisions that are knee jerk or gut feel decision s. 
Almost any business decision can be analyzed with managerial economics techniques, but
it is most commonly applied to:
1. Risk analysis - various models are used to quantify risk and asymmetric information and to
employ them in decision rules to manage risk.
2. Production analysis - microeconomic techniques are used to analyze production efficiency,
optimum factor allocation, costs, economies of scale and to estimate the firm's cost function.
3. Pricing analysis - microeconomic techniques are used to analyze various pricing decisions
including transfer pricing, joint product pricing, price discrimination, price elasticity
estimations, and choosing the optimum pricing method.
4. Capital budgeting - Investment theory is used to examine a firm's capital purchasing decisions.

Scope of Managerial Economics

Scope of Managerial Economics                                    
Demand analysis and forecasting
When a business manager decides to venture into a business, the very first thing he needs to
find out is the nature and amount of demand for the product, both at present and in the future. A
firm's performance and profitability depends upon accurate estimates of demand. The firm will
prepare its production schedule on the basis of demand forecast. Demand analysis helps to identify
the factors influencing the demand for a firm's product and thus helps a manager in business
planning. Demand analysis and forecasting thus help him in the choice of the product and in planning
output levels. The main topics covered under demand analysis and forecasting are the concepts of
demand, demand determinants, law of demand, its assumptions, elasticity of demand (price, income
and cross elasticity), demand forecasting, etc.
Cost and production analysis
 Estimation of the cost in production.
 Recognizing the factors, which are causing cost to firm.
 Suggests cost should be reduced for making good profits.
 Production analysis deals with,   Minimum cost should be spend on raw materials and
maximum production should be obtained
Pricing decisions, policies and practices
Once a particular quantity of output is ready for sale, the firm has to fix its price given the conditions
in the market. Pricing is a very important aspect of Managerial Economics as a firm's revenue
earnings largely depend on its pricing policy. A correct pricing policy makes a firm successful, while
incorrect pricing may lead to its elimination. The topics covered under this area are: price
determination in various market forms such as perfect market, monopoly, oligopoly, etc., pricing
methods such as differential pricing and product-line pricing, and price forecasting.
Profit management
Business firms are established with the objective of making profits and it is thus the chief measure of
success. For maximizing profits the firm needs to take care of pricing, cost aspects and long-range
decisions, i.e., it has to evaluate its investment decisions and carry out the best policy of capital
budgeting for the firm under a given set of conditions. If we know the future, profit analysis would be
an easy task. However, in a world of uncertainty our expectations are not always realized, so that
profit planning and measurement constitute a difficult area of Managerial 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.
 Capital Management
                Large amount of money is invested in the business and that amounts should be managed
efficiently.
 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.
 

Application of M E

The application of managerial economics is these examples. Tools of managerial economics

can be used to achieve all the goals of a business organization in an efficient manner. Typical
managerial decision making may involve one of the following issues:

1. Deciding the price of a product and the quantity of the commodity to be produced.
2. Deciding whether to manufacture a product or to buy from another manufacturer.
3. Choosing the production technique to be employed in the production of a given
product.
4. Deciding on the level of inventory a firm will maintain of a product or raw material.
5. Deciding on the advertising media and the intensity of the advertising campaign
6. Making employment and training decisions.
7. Making decisions regarding further business investment.
It should be noted that the application of managerial economics is not
limited to profit-seeking business organizations. Tools of managerial economics
can be applied equally well to decision problems of nonprofit organizations. While
a nonprofit hospital is not like a typical firm seeking to maximize its profits, a
hospital does strive to provide its patients the best medical care possible given its
limited staff (doctors, nurses, and support staff), equipment, space, and other
resources. The hospital administrator can use the concepts and tools of
managerial economics to determine the optimal allocation of the limited resources
available to the hospital. In addition to nonprofit business organizations,
government agencies and other nonprofit organizations (such as cooperatives,
schools, and museums) can use the techniques of managerial decision making to
achieve goals in the most efficient manner.
ECONOMIC CONCEPTS USED IN MANAGERIAL ECONOMICS
Managerial economics uses a wide variety of economic concepts, tools, and
techniques in the decision-making process. These concepts can be placed in three
broad categories:
1)      The theory of the firm, which describes how businesses make a
variety of decisions
2)      The theory of consumer behavior, which describes decision making
by consumers
3)      The theory of market structure and pricing, which describes the
structure and   characteristics of different market forms under which
business firms operate.

Role of Managerial Economics

Managerial economics, or business economics, is a division of microeconomics
that focuses on applying economic theory directly to businesses. The application
of economic theory through statistical methods helps businesses make decisions
and determine strategy on pricing, operations, risk, investments and production.
The overall role of managerial economics is to increase the efficiency of decision
making in businesses to increase profit.
Pricing
Managerial economics assists businesses in determining pricing strategies
and appropriate pricing levels for their products and services. Some
common analysis methods are price discrimination, value-based pricing
and cost-plus pricing.
 
Elastic vs. Inelastic Goods
Economists can determine price sensitivity of products through a price
elasticity analysis. Some products, such as milk, are consider a necessity
rather than a luxury and will purchase at most price points. This type of
product is considered inelastic. When a business knows they are selling an
inelastic good, they can make marketing and pricing decisions easier.
 
Operations and Production
Managerial economics uses quantitative methods to analyze production
and operational efficiency through schedule optimization, economies of
scale and resource analyses. Additional analysis methods include marginal
cost, marginal revenue and operating leverage. Through tweaking the
operations and production of a company, profits rise as costs decline.
 
Investments
Many managerial economic tools and analysis models are used to help
make investing decisions both for corporations and savvy individual
investors. These tools are use to make stock market investing decisions
and decisions on capital investments for a business. For example,
managerial economic theory can be used to help a company decide
between purchasing, building or leasing operational equipment.
 
·Risk
Uncertainty exits in every business and managerial economics can help
reduce risk through uncertainty model analysis and decision-theory
analysis. Heavy use of statistical probability theory helps provide potential
scenarios for businesses to use when making decisions.

Relationship with other subjects

Macro Economics, Statistics, Mathematics, Accounts etc., have contributed a lot in the growth
of Managerial Economics. D.C. Hague has stated, "Managerial Economics uses the logic of
Economics, Mathematics and Statistics to provide effective ways of thinking about business
decision problems."
Economics has two main divisions: micro-economics and macro-economics. Micro-economics
has been defined as that branch where the unit of study is an individual or a firm. Macro-
economics, on the other hand, is aggregative in character and has the entire economy as a
unit of study.
MANAGERIAL ECONOMICS AND TRADITIONAL ECONOMICS Relationship
Another useful method throwing light upon the nature and scope of managerial economics is
to examine its relationship with other subjects. In this connection, Economics, Statistics,
Mathematics and Accounting deserve special mention. Prof. D.C. Hague has described
managerial Economics  uas using the logic of Economics, Mathematics and Statistics to provide
effective ways of thinking about business decision problems."
1. Managerial Economics and Traditional Economics: Managerial Economics has been
described as economics applied to decision-making. It may be viewed as a special branch
of economics bridging the gulf between pure economic theory and managerial practice. The
relation between Managerial Economics and Economics is as close as is Engineering to
Physics and Medicines to Biology.
Traditional Economics has two main divisions: microeconomics and macroeconomics.
Microeconomics; also known as price theory, is the main source of concepts and analytical
tools for managerial economics. To illustrate, various microeconomic concepts such as
elasticity of demand, marginal cost, the short and long runs, opportunity cost, various
market forms, etc., are all of great significance to managerial economics. The chief
contribution of macroeconomics is in the area of forecasting. The modern theory of
income, employment, trade cycles, etc. has implications for forecasting general business
conditions. As the prospects of an individual firm often depend greedy on general business
conditions, individual firm forecasts depend on general business forecasts.
2.Managerial Economics and Accounting: Managerial economics and accounting are
closely interrelated. Accounting can be defined as the recording of financial operations of a
business firm. A business manager needs a lot of accounting information data for logical
analysis in decision-making and policy formulation at the level of firm. The accounting data
and information has to be presented in a methodological manner worthy of analysis and
interpretation for decision-making and future planning. This is why a new branch of
accounting known as 'management accounting' has developed to help correct managerial
decision-making. The main task of management accounting is to provide the sort of data
which managers need to solve some business problems accurately.
 
3. Managerial Economics and Operational Research: Operational Research is closely
related to managerial economics. Operational research is the application of mathematical
techniques to solving business problems. It provides all the data required for business
decisions and forward planning. Techniques such as linear programming, game theory, etc.
are due to the works of operational research, linear programming is extensively used in
decision-making. Managerial economics is concerned with efficient use of scarce resources.
Operational research is also concerned with efficient use of scarce resources. There is close
affinity between managerial economics and operational research. Managerial economics
gives special emphasis to the problems involving maximisation of profits and minimisation
of costs, while operational research focuses attention on the concept of optimisation.
Managerial economics has made much use of optimisation concept but initially started with
marginal analysis taken from economics. Managerial economics uses the logic of
Economics, Mathematics and Statistics for undertaking effective decisions, while
operational research techniques based on these ways of thinking are being used to solve
decision-making problems in business. Again, both operational research and managerial
economics are concerned with taking effective decisions.
Operational research is a tool in the hands of managerial economics to solve day-to-day
business problems. Managerial economics is an academic subject which aims at
understanding and analysing problems and decision-making by a firm. Thus, operational
research is a functional activity pursued by specialists within the firm. Though it is
expensive and a slow process, it helps managers make accurate solutions by means of
providing necessary data.
4. Managerial Economics and Marketing: Managerial Economics helps marketing in two
ways. First, as a basic discipline, providing tools and concepts of analysis and second, as
an integrating area, providing its judgement on the optimum sales volume under the given
cost function of a firm, market structure, and the objective function to be optimized. How
much to sell under given circumstances is answered by an economist and how to sell the
desired amount of output is the domain of the marketing manager. Sometimes, selling
more than what is desired may harm the interest of the firm. It has, however, the sanction
neither of Economics nor of marketing principles as both stresses on the protection of long
run interests of the firm.
Economics is of a great help to marketing in the sphere of pricing. Of the three basic
aspects of pricing viz. value theory, price theory, and pricing techniques, the first two are
the exclusive domain of Economics, while the third one forms part of both Managerial
Economics and marketing. In the case of pricing techniques, there are varying practices in
different organizations. In many pricing is handled by the accounts staff such as chartered
accountants and company secretaries. There are several areas of marketing which are
totally or heavily dependent on economic theory. These are:
1.       Theory of the Firm
2.       Concepts of goals and goal formulation
3.       Market structures
4.       Pricing
 5. Managerial Economics and Production Management: Production is defined as the
creation of utility by transforming input into output. It usually refers to manufacturing
activity and the term operations are used to denote a wider meaning, encompassing all
economic activity which creates economic utility. Operations personnel have four basic
responsibilities to fulfill while producing a firm's products or services: [Raymond R. Mayor,
1975 p. 3]
1.       Supply of quantities,
2.       Maintenance of time-bound deliveries,
3.       Fulfillment of quality requirement, and
4.       Economizing production operations.
For this, the personnel have to deal with a number of inter-related areas including production
planning, production control, quality control, methods analysis, materials handling, plant
layout, inventory control, work management, and wage incentives. A knowledge of Economics
would help operations personnel not only to economize their production operations but also
help them
a) To monitor and analyse the input market,
b) To monitor market maturity, technical maturity, and competitive maturity of
products being produced,
c) To have better coordination with the R & D department with respect to product and
process innovation, and
d)  To take decisions on production targets.
6. Managerial Economics and Personnel Management: A human resource manager
has to concern himself with two types of problems: (i) an effective utilization of human
resources in terms of costs and productivity and (ii) improvement in the terms and
conditions of employment as an adjunct to employee satisfaction. Manpower planning, at
the micro level, is another important function of an HRD manager wherein a firm ensures
that it has the right number and the right kind of people, at the right places, at the right
time, doing work for which they are economically most useful.
Managerial economics can help personnel management by analysing the economic and
financial aspects of personnel problems both in relation to the economic welfare of the firm
and to the prevailing environment of the economy as a whole. It explains the economic
implications of policies and strategies and judges their consistency with respect to
organizational objectives as well as internal and external constraints. It can provide a
safety range for wage negotiations with trade unions. Business forecasting could provide
information for devising employment norms of the sales force

MANAGERIAL THEORIES OF THE FIRM

MANAGERIAL THEORIES OF THE FIRM

Managerial theories of the firm place emphasis on various incentive mechanisms in explaining the
behaviour of managers and the implications of this conduct for their companies and the wider
economy.

According to traditional theories, the firm is controlled by its owners and thus wishes to maximise
short run profits. The more contemporary managerial theories of the firm examine the possibility
that the firm is controlled not by its owners, but by its managers, and therefore does not aim to
maximise profits. Although profit plays an important role in these theories as well, it is no longer
seen as the sole or dominating goal of the firm. The other possible aims might be sales revenue
maximisation or growth.

Baumol's Theory of Sales Revenue Maximisation

Prof. Baumol, in his book 'Business behaviour, Value and Growth' has propounded a theory of Sales
Maximisation. Main aim of a firm is to maximise sales. By sales he meant total revenue earned by the
sale of goods. That is why this goal is also referred to as Sales Maximisation Goal. According to this
theory, once profits reach acceptable levels, the goal of the firms become maximisation of sales revenue
rather than maximisation of profits.

In the words of Baumoul, 'The sales maximisation goal says that managers of firms seek to maximise
their sales revenue subject to the constraint of earning a satisfactory profits. "

The above definition maintains that when the profits of firms reach a level considered satisfactory by the
shareholders then the efforts of the managers are directed to maximise revenue by promoting sales
instead of maximising profit. While studying this theory. K must be kept in view that firms do not Ignore
profit altogether. They do aspire to attain a general level of profit. But once an acceptable level of profit
is obtained their goal shifts to sales maximisation in place of profit maximisation.

Baumol raised serious questions on the validity of profit maximisation as an objective of the firm. He
stressed that in competitive markets, firms would rather aim at maximising revenue, through
maximisation of sales. According to him, sales volumes, and not profit volumes, determine market
leadership in competition. He further stressed that in large organisations, management is separate from
owners. Hence there would always be a dichotomy of managers' goals and owners' goals. Manager's
salary and other benefits are largely linked with sales volumes, rather than profits.

Baumol hypothesised that managers often attach their personal prestige to the company's revenue or
sales; therefore they would rather attempt to maximise the firm's total revenue, instead of profits.
Moreover, sales volumes are better indicator of firm's position in the market, and growing sales
strengthen the competitive spirit of the firm. Since operations of the firm are in the hands of managers,
and managers' performance is measured in terms of achieving sales targets, therefore it follows that
management is more interested in maximising sales, with a constraint of minimum profit. Hence the
objective is not to maximise profit, but to maximise sales revenue, along with which, firms need to
maintain a minimum level of profit to keep shareholder satisfied. This minimum level of profit is
regarded as the profit constraint.

However, empirical evidence to support above arguments of Baumol is not sufficient to draw any
definite conclusion. Whatever research has been done is based on inadequate data; hence the results are
inconclusive.

Arguments in favour of Maximisation of Sales Goal

Following arguments are given in favour of maximisation of sales goal:

i. More Realistic: Goal of maximisation of sales is a more realistic goal- In fact, firms accord more
importance to the goal of sales maximisation than profit maximisation. It is so because success of a firm
is generally judged from its total sales. According to Ferguson and Krupps, 'Among the various
alternatives advanced, Baumoul’s thesis has great advantage — it raises the other models in the direction
of reality and plausibility while still permitting a rather general theoretical analysis."

ii. More Practical: Revenue maximisation thesis of Baumol is more practical. It is so because goal of
revenue (Sales) maximisation leads to more production which, in turn, leads to fall in price. As a result,
consumers' welfare is promoted. They also endorse this goal of the firms.

iii. More Availability of Loans: At the time of sanctioning loan to a firm, financial institutions mainly
consider its sales. Prospects of loans are bright for such firms as have large total sales.
iv. Strong Position in the Market: Maximum sales of a firm symbolize its strong position in the market.
Sales of a firm will be large only in that situation when consumers like its production, firm has more
competitive power and has been expanding. All these features are indicative of the progress of the firm.

v. More Advantageous to the Managers: It is more to the advantage of the managers that the firm should
aim at sates maximisation. This way their credibility enhances in the market. Maximum sales is a
reflection of the competence of the managers It has a favorable effect on their wages. Firm is in a
position to offer higher wages to the employees. Consequently, employer-employee relations become
more cordial. II is the constant endeavour of the managers to maximize the sales of the firm after
attaining a given level of profit.

Marris Growth Maximization Model:

Working on the principle of segregation of managers from owners, Marris proposed that owners
(shareholders) aim at profits and market share, whereas managers aim at better salary, job security and
growth. These two sets of goals can be achieved by maximising balanced growth of the firm (G),
which is dependent on ihe growth rate of demand for the firm's products (GD) and growth rate of
capital supply to the firm (GC). Hence growth rate of the firm is balanced when the demand for its
product and the capital supply to the firm grow at the same rate.

Marris further said that firms face two constraints in the objective of maximisation of balanced
growth, which are explained below:

i. Managerial Constraint

Among managerial constraints, Marris stressed on the importance of the role of human resource in
achieving organisational objectives. According to him, skills, expertise, efficiency and sincerity of
team managers are vital to the growth of the firm. Non availability of managerial skill sets in required
size creates constraints for growth: organisations on their high levels of growth may face constraint of
skill ceiling among the existing employees. New recruitments may be used to increase the size of the
managerial pool with desired skills; however new recruits lack experience to make quick decisions,
which may pose as another constraint.

ii. Financial Constraint

This relates to the prudence needed in managing financial resources. Marris suggested that a prudent
financial policy will be based on at least three financial ratios, which in turn set the limit for the
growth of the firm. In order to prove their discretion managers will normally create a tradeoff and
prefer a moderate debt equity ratio (rj), moderate liquidity ratio (r2) and moderate retained profit ratio
(r3). (Let us mention here that the ratios used in the financial constraint are dealt with in detail in any
standard text book on Financial Management and are beyond the scope of this book). However a brief
description is given hereunder:

(a) Debt equity ratio (r1) This is the ratio between borrowed capital and owners* capital. High value
of debt equity ratio may cause insolvency; hence a low value of this ratio is usually preferred by
managers to avoid insolvency. However, a low value of r, may create a constraint to the growth of the
firm in terms of dependence on high cost capital, i.e., equity.

(b) Liquidity ratio (r2) This is the ratio between current assets and current liabilities and is an indicator
of coverage provided by current assets to current liabilities. According to Marris, a manager would try
to operate in a region where there is sufficient liquidity and safety and hence would prefer a high
liquidity ratio. But a high r2 would imply low yielding assets, since liquid assets either do not earn at
all (like cash and inventory), or earn low returns (like short term securities).

(c) Retention ratio (r3) This is the ratio between retained profits and total profits. In other words, it is
the inverse of dividend payout ratio, i.e., the retained profits are that portion of net profit which is not
distributed among shareholders. A high retention ratio is good for growth, as retained profits provide
internal source of funds. However, a higher r3 would imply greater volume of retained profits, which
may antagonise the shareholders. Hence managers cannot afford to keep a very high value of retention
ratio.

Williamson’s Managerial Discretionary Theory:

The theory of Managerial Utility Maximisation was developed separately by Berle-Means-Galbralth

and Williamson. It is also known as Managerial Discretion Theory. The Theory is based on the
concept that shareholders or owners of the firm and managers are (two separate groups. The owners
or the shareholders want high dividends and are. therefore, interested In maximising profits, the
managers, on the other hand, have different motives other than profit maximisation. Once the
managers have achieved a level of profit that will pay satisfactory dividends to shareholders and still
ensure growth.

they are free to increase their own emoluments and also the size of their staff and expenditure on
them. In the words of Williamson, "7b the extent that the pressure from the capital market and
competition in the product market is imperfect, the manager, therefore, has discretion to pursue goals
other than profits." Further Berle and Means suggested that "The lack of corporate democracy leaues
owners or shareholders with little or no power to change corporation policy."

According to Williamson, "Managerial Utility function may be expressed as follows:

U = f(S, M. ID)

It will be read: Managerial utility is a function (f) of additional expenditure on staff, managerial
emoluments and discretionary investment.

(Here, U = managerial utility; S = additional expenditure on staff; M = managerial emoluments and

ID = discretionary investment).

Managerial utility function maximises the utility of the managers rather than profits of the firm. The
manager is expected to follow policies which maximise the following components of his utility
function.

i. Expansion of Staff: The manager will like to increase the quality and number of staff reporting to
him. This will lead to an increase in the salary of the staff. More staff are valued because they lead to
the manager getting more salary, more prestige and more security.

ii. Increase in Managerial Emoluments: Managerial Utility also depends on managerial

emoluments. It includes facilities like entertainment allowance, luxurious office, staff car, company
phone, etc. Expenditure of this nature reflects to a large extent the prestige, power and status of the
manager.

iii. Discretionary Power of Investment: Managerial utility also depends on the discretion of the
manager to undertake investment beyond those required for normal operations. The manager is in a
position to invest in advanced technology and modem plants. Such investments may or may not be
 economically efficient. These investments may be undertaken for the self-satisfaction of the manager.

According to the theory, in a firm, shareholders and managers are two separate groups. The firm tries
to get maximum returns on investment and get maximum profit, whereas managers try to maximize
profit in their satisfying function.

At last, Williamson’s managerial discretion theory shows the utility function of a manager. In this
theory, the firm will try to get maximum returns or maximum profit where as manager try to
maximum utility satisfying function. They are in equilibrium when the utility has maximum amount.

Producer Surplus

Market Power
Market power is a measure of a firm’s economic strength that affects its pricing and supply decisions.
LEARNING OBJECTIVES

Summarize the relationship between market power and a firm’s supply decision

KEY TAKEAWAYS

Key Points

 Firms with market power are said to be “price makers.” They can raise prices and change the
quantity supplied of goods and services without hurting profits. Market power often exists when
there is a monopoly or oligopoly.
 Firms with limited to no market power are said to be “price takers.” They cannot raise their
prices or change the quantity supplied of goods and services without hurting profits. Perfectly
competitive firms are examples of price takers with no market power.
 Market power is determined by the number of producers in the market, the size of each firm,
barriers to entry in the market, and availability of substitute goods. Firm size and market size
alone do not dictate market power.
 Market power is often measured with concentration ratios or the Herfindahl-Hirschman Index,
but these are not perfect measures.

Key Terms

 Herfindahl-Hirschman Index: A measure of the size of firms in relation to the industry and an
indicator of the amount of competition among them.
 concentration ratio: The proportion of total industry output produced by the largest firms
(usually the four largest).
 contestable market: An imperfectly competitive industry subject to potential entry if prices or
profits increase.
  market power: The ability of a firm to profitably raise the market price of a good or service
over marginal cost. A firm with total market power can raise prices without losing any customers
to competitors.
Market power is a measure of the economic strength of a firm. It is the ability of a firm to influence the
quantity or price of goods and services in a market. A firm is said to have significant market power
when price exceeds marginal cost and long run average cost, so the firm makes economic profits.
Such firms are often referred to as “price makers.” In contrast, firms with limited to no market power
are referred to as “price takers.”

Determinants of Market Power

A firm usually has market power by virtue of controlling a large portion of the market. However,
market size alone is not the only indicator of market power. Other factors that affect a firm’s market
power include:
 Number of producers
 Size of firms in the market
The numbers and size of firms determine the extent that firms can withstand pressures and threats to
change prices or product flows. However, being a large firm does not necessarily equal market
power. For example, while conglomerates may be very large, they may play only small roles in many
different markets and have no ability to influence prices in any of them.
 Barriers to entry
Barriers to entry determine how contestable the market is. Even highly concentrated markets may be
contestable markets if there are no barriers to entry or exit, which limits a firm’s ability to raise its
price above competitive levels.
Common barriers to entry include control of a scarce resource, increasing returns to scale,
technological superiority, and government-imposed barriers.
 Availability of substitute goods
Greater availability of substitute goods will weaken a firm’s market power.

Relationship between Market Power and Firm Behavior

A firm’s market power influences its behavior. For example, market power gives firms the ability to
engage in unilateral anti-competitive behavior. Some of the behaviors that firms with market power
are accused of engaging in include predatory pricing, product tying, and creation of overcapacity or
other barriers to entry. If no individual participant in the market has significant market power, then
anti-competitive behavior can take place only through collusion, or the exercise of a group of
participants’ collective market power.

Google Logo: In 2012, the U.S. Federal Trade Commission opened an antitrust probe against Google’s search practices.
Google allegedly used its market dominance to promote its own products over competitors’ products in web searches.
A monopoly, a price maker with market power, can raise prices and retain customers because the
monopoly has no competitors. If a customer has no other place to go to obtain the goods or services,
they either pay the increased price or do without.
An oligopoly may also be a price maker with market power, as firms may be able to collude and
control the market price or quantity demanded.
A perfectly competitive firm, a price taker with no market power, cannot raise its price without losing
its customers.

Measurement of Market Power

Measurement of market power is often accomplished with concentration ratios or the Herfindahl-
Hirschman Index (HHI).

Concentration Ratios

The concentration ratio is the proportion of total industry output produced by the largest firms (usually
the four largest). This measure of market power relates the size of firms to the size of the market. For
monopolies, the four firm concentration ratio is 100 percent, while the ratio is zero for perfect
competition.

Herfindahl-Hirschman Index (HHI)

The Herfindahl-Hirschman Index (HHI) is a measure of the size of firms in relation to the industry,
and an indicator of the amount of competition among them. The HHI is calculated by summing the
squares of the percentage market shares of all participants in the market. The HHI for perfect
competition is zero; for a monopoly, it is 10,000.
For example, if a market consists of five firms with market shares of 40, 20, 20, 15, and 5 percent
each, the HHI is 2650 (402+202+202+152+52=2650402+202+202+152+52=2650).

Measurement Problems

The use of the concentration ratio or the HHI to measure market power is not perfect. A high
concentration ratio or large firm size is not the only way to achieve market power. Many smaller firms
acting in unison can achieve the same result. Additionally, the measurements do not convey the
extent to which market power may be concentrated in a local market.

Defining Producer Surplus

Producer surplus is the difference between the amount producers get for selling a good and the
amount they want to accept for that good.
LEARNING OBJECTIVES

Define producer surplus

KEY TAKEAWAYS

Key Points

 Producer surplus can be thought of as the extra money, utility, or benefits the producer
receives by selling a product at a price that is higher than its minimum acceptable price.
 The minimum acceptable price for producers is represented by the supply curve.
  Graphically, producer surplus is the shaded region just above the supply curve, but below the
equilibrium price level.

Key Terms

 producer surplus: The amount that producers benefit by selling at a market price that is
higher than the lowest price at which they would be willing to sell.
Producer surplus is the difference between what price producers are willing and able to supply a
good for and what price they actually receive from consumers. It is the extra money, benefit, and/or
utility producers get from selling a product at a price that is higher than their minimum accepted price,
as shown by the supply curve.
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Introduction to Theory of Factor Pricing

Introduction:

The theory of factor pricing deals with the prices paid for factor services (land, labour,

capital, entrepreneur) and received by the sellers of factor services. It deals with wage rate,
interest rate specific rent and profit.
 In short theory of factor pricing studies how rent of land, wages of labour interest on capital
and profit of entrepreneur is determined.
Why factor pricing is not studied along with product pricing:

 Theory of factor pricing deals with determination of prices of services of different factors of
production, whereas theory of value deals with the determination of prices of goods
produced. In both the theories prices are determined by the intersection of demand
and supply curves. Therefore a question arises that why a separate study of factor pricing?
 This is because of the fact that the nature of demand and supply of factors and that of
commodities. The difference in nature of demand and supply are as follows:
Difference in demand of factors and commodities: There are three main differences in the demand for
factors and commodities.
These are:

 Derived Demand:Factors are demanded to produce commodities to satisfy consumer’s

demand. Thus demand for factors is derived demand which is derived from the demand of
commodities in the production of which it is used. For example demand for bricks, cement
iron etc. is derived from the demand for a building.
 Joint Demand: Demand for factors is joint demand i.e. more than one factor is needed
jointly to produce the commodity. For example one factor (labour) alone cannot produce
apple. It is the outcome of efforts of Land, labour, capital and entrepreneur jointly.
 Dependability: The demand for factors depends upon their marginal productivities, while
the demand for commodities depends upon their marginal utilities
Difference in supply of factors and commodities: There are two factors of difference between supply of
factors and commodities:
Cost of production:

 Supply of commodities depends on its cost of production. But land has no cost of production
to an economy. Also it is not possible to estimate the cost of production of labour.
 According to Modern economists supply of factors depend on their opportunity cost.
Relationship between price and supply
  There is positive relationship between price and supply of commodities, but there is no
definite relation between price and supply of factors. Thus due to these differences, there is
need for a separate theory for factor pricing.
Aspects of Marginal Productivity:
The three different aspects of marginal productivity are:

1. Marginal Physical Productivity (MPP)

2. Marginal Revenue Productivity (MRP)
3. Value of Marginal Productivity (VMP)
1. Marginal Physical Productivity (MPP): In the words of M. J. Ulmer,” Marginal Physical
Productivity may be defined as the addition to total production resulting from the employment of one
more unit of a factor of production, all other things being constant.”It means marginal physical
productivity measures productivity in physical terms. Suppose 5 labourer produce 20 meters of cloth and
6 labourer produce 24 meters of cloth. Thus, the marginal physical productivity of 6th labourer is 4 (24-
20) meters. Marginal Physical Productivity can be expressed through the following formula:

MPP=TPP n – TPP n-1

Where :
MPP =1 Marginal Physical Productivity
TPP n =Total physical productivity of ‘n’ units of factor
TPP n-1= Total physical productivity of ‘n-1’ units of factor
2. Marginal Revenue Productivity (MRP) :
In the words of M. J. Ulmer,” Marginal Revenue Productivity may be defined as the addition to total
revenue resulting from the employment of one more unit of a factor of production, all other things being
constant.” It measures productivity in monetary terms. It can be expressed as the product of marginal
physical product (MPP) and marginal revenue (MR). It can be written as:
MRP a = MPP a * MP x
Where, a is a factor and x is a commodity
Suppose an additional labourer produces 4 meters of cloth and an additional meter of cloth fetches the
additional revenue of Rs. 20. Then, the marginal revenue productivity is Rs. 80 (20 *4).
3. Value of Marginal Productivity (VMP):

 In the words of Ferguson,” the value of marginal product of a variable factor is equal to its
marginal product multiplied by the market price of the commodity in question.”Thus the
value of marginal physical productivity is the product of marginal physical product and
average revenue (price).
VMP a =MPP a XAR x
Suppose an additional labourer produce 4 metre of cloth and the market price of cloth is Rs 25, then VMP
is 4x25=100.
 Since the firm can sell any amount of commodities at the given market price under perfect
competition, average revenue is equal to marginal revenue. Thus under perfect competition,
MRP is equal to VMP. While under monopoly and monopolistic completion, average
revenue is greater than marginal revenue. Thus VMP is greater than MRP under these two
market conditions.
Marginal Productivity Theory:
The marginal productivity theory contends that in equilibrium each productive agent will be rewarded in
accordance with marginal productivity.
Assumptions:

1. There is perfect competition in the commodity and factor market

2. All units of a factor are homogeneous
3. The proportion in which factor are combined can be changed
4. Each firm is guided by the objective of profit maximization
  Given the assumption that firm is guided by the objective of profit maximization, it will
employ additional units of factor as long as addition made by it to the total product is more
than its price. Thus firm will employ additional units of a factor as long as its marginal
revenue product is greater than the price. Therefore the equilibrium of the profit making
firm will be establish at the point where MRP = Price.
 As each firm wants to maximize its profit, it will produce its output with least cost
combination. It occurs when the isoquant is tangent to iso cost line. Thus firm will employ
factors where Slope of iso quant = Slope of iso cost line
 Slope of the iso quant is the marginal rate of technical substitution and slope of iso cost line
is equal to the ratio of the price paid to the factors.
MRTPS =Pa/ Pb
MPa/MPb =Pa/Pb
Where MRTPS= Marginal rate of technical substitution
MPa =Marginal productivity of factor a
MPb = Marginal productivity of factor b
Pa = price of factor a
Pb =Price of factor b
Thus the profit maximizing firm will employ factors of production in such a way that the ratio of marginal
productivity of all factor to their prices are equal.
 Under perfect competition, wage rate is determined by the industry or the combined forces
of demand and supply. The only decision that a firm can take is about the number of
labourers that it employ at the given wage rate.
 According to this theory a firm under perfect competition will employ that number at which
price is equal to the value of its marginal product (VMP). Other things remaining the same,
a firm will employ more and more labourers, their marginal physical productivity goes on
diminishing. As price(AR=MR)of the product under perfect competition is constant, so
when marginal physical productivity of labour go on diminishing ,marginal revenue product
will also go on diminishing.
 In order to achieve the objective of profit maximization, a firm will employ labourer up to
the point where their MRP is equal to wage rate (price). This can be explained with the
following example.
No of MPP Price of the product MRP=MPPXMR Wage
labourer (AR=MR) Rate(Rs)

1 10 2 10X2=20 8

2 8 2 16 8

3 6 2 12 8

4 4 2 8 8

5 2 2 4 8

It can be seen from the table that firm will employ 4 units of labour as at this point marginal revenue
productivity is equal to wage rate of Rs 8.

Criticism of the theory: This theory has been criticized on the following grounds.

1. It is based on unrealistic assumption of perfect competition

2. Theory assumes that all the units of factor are homogeneous which is wrong. In reality
different units of factor are heterogeneous.
3. The measurement of marginal productivity of any factor is not possible in practical life.
4. It ignores the influence of other factors on the productivity.
 5. As per theory if wage rate is higher, a firm will employ less ,however in reality, while
employing labourer, a firm does not only take into consideration the wage rate alone but
also consider many other factors such as amount of profit, demand of the product etc.
6. According to Keynes, it holds good only under static condition when there is no change.

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1
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Explain the concept of oligopoly

An oligopoly is an industry dominated by just a few firms. Oligopolists are said to be

interdependent since each one must consider the effect of its own actions on competitors‘
behavior. The formation of an oligopoly can often be traced to some form of barrier to entry,
such as economies of scale, legal restrictions, brand names built up by years of advertising, or
control over an essential resource.
2
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Describe models of oligopoly Explain the concept of oligopoly

An oligopoly is an industry dominated by just a few firms. Oligopolists are said to be

interdependent since each one must consider the effect of its own actions on competitors‘
behavior. The formation of an oligopoly can often be traced to some form of barrier to entry,
such as economies of scale, legal restrictions, brand names built up by years of advertising, or
control over an essential resource.

6. Structures) Determine whether each of the following is a characteristic of perfect

competition, (monopolistic competition, oligopoly, and/or monopoly:
 a. A large number of sellers Market
b. Product is a commodity
c. Advertising by firms
d. Barriers to entry
e. Firms that are price makers

a. Perfect competition and monopolistic competition

b. Perfect competition
c. Monopolistic competition and oligopolies with differentiated products; some
monopolies
d. Oligopoly and monopoly
e. Monopolistic competition, oligopoly, and monopoly

PRICING STRATEGIES:-

Pricing decisions are equally important for a new product and an existing product, for
entering into a new market or a new market segment and are affected by a host of

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factors like objective of the firm, cost of production, market structure, competitor‘s
strategy, elasticity of demand, government policy, etc.

COST BASED PRICING:-

Under cost plus pricing, price of the product is the sum of cost plus a profit margin.

i. Cost plus or Mark up pricing

Price= AC+ m, where AC=TC/Q, m is the percentage of mark up

ii. Marginal cost pricing

This is used when demand is slack and market is highly competitive. Under
marginal cost pricing price of the product is the sum of variable cost plus a
profit margin. This method is used by firms to enter into a new market as well
as to beat competitors. As this method ignores the element of fixed cost, it
cannot be adopted as a long term strategy.

iii. Target Return Pricing

This method of pricing is the same as the previous ones but for the fact that
margin is decided on the basis of target rate of return, determined on the
company‘s experience, consumer‘s paying capacity, risk involved, and
similar other factors.
PRICING BASED ON FIRM‘S OBJECTIVES:-

If we consider pricing in the light of objectives of a firm, a profit maximizing firm

considers total cost of production for determination of price and hence will adopt Mark
up pricing. Those which maximize sales would adopt competitive pricing like Marginal
cost pricing.

COMPETITION BASED PRICING:-

(A) PENETRATION PRICING

When a firm plans to enter a new market which is dominated by existing players,
its only option is to charge a low price, even lower than the ongoing price. This
price is called Penetration price. The principle of marginal costing may be used
to determine penetration price. This method is short term in perspective and its
success largely depends upon the price elasticity of demand of the product

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because in the long run ultimately factors other than price may become
important.

(B) ENTRY DETERRING PRICING

Under this method of pricing the price is kept low, thus making the market
unattractive for other players. Success of entry deterring pricing strategy depends
on the fact that the firm earns economies of scale and hence can afford to charge
low price. This practice is also known as Limit Pricing.

(C) GOING RATE PRICING

Going rate pricing strategy is adopted when most of the players do not indulge in
separate pricing but follow the prevailing market price. This pricing strategy is
popular in monopolistic and oligopoly markets where product differentiation is
minimal or only cosmetic, and consumer‘s switching cost is almost negligible. It
is mostly adopted when the product has reached maturity and has become
generic to the extent that consumers ask for a good soap or soft tooth brush
instead of a particular brand.

PRODUCT LIFE CYCLE BASED PRICING:-

Product life cycle pricing refers to different pricing for a product at different
stages of its life cycle (viz. introduction, growth, maturity, saturation, and
decline).
(A) PRICE SKIMMING:-

Under price skimming producers charge a very high price in the beginning to
skim the market and earn super margins on sales. As the market is small in
the introduction stage, a firm tries to popularize its product among the niche
consumers and may charge a high price and skim the market by creating high
value perception on account of the novelty factor of the product. Nokia has
been using this strategy successfully for its products.

(B) PRODUCT BUNDLING:-

Under product bundling two or more products are bundled together for a
single price. This strategy is often used as a double edged weapon, for
propagating a new product, as well as for selling a product in its stage of
decline. It may be adopted at the time of introduction as well as during
growth and maturity.

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(C) PERCEIVED VALUE PRICING:-

According to this pricing, value of goods for different consumers depends

upon their perception of utility of the good. The underlying philosophy of
this pricing is that a product is as good as a consumer finds it. Such pricing is
normally adopted during the growth and maturity stage so as to differentiate
the product from that of competitors‘ and retain the quality conscious
customers. Here the price of the good is not at all governed by the cost of
production.

CYCLICAL PRICING:-

(A) RIGID PRICING:-

Rigid pricing suggests that firms should follow a stable pricing policy
irrespective of the phase of the economic cycle (i.e. inflation and
recession)

(B) FLEXIBLE PRICING:-

Under flexible pricing firms keep their prices flexible to meet the
challenges of change in demand.

MULTI PRODUCT PRICING:-

(A) LOSS LEADER PRICING

 Under loss leader pricing multi product firms sell
one product at a low price and compensate the loss
by other products.

(B) TRANSFER PRICING:-

Transfer prices are the charges made when a

company supplies goods, services or financials to its
subsidiary or sister concern. Transfer pricing is used
in large organizations for transaction between
various divisions, i.e., internal pricing as opposed to
external market.

RETAIL PRICING:-

(A) EVERY DAY LOW PRICING(EDLP):-

Under EDLP a low price is charged throughout

the year and none or very few special discounts

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are given on special occasions. This method can
be successful only when the retailer is very large
in size to avail of economies of scale and has
very low overhead expenses.

(B) HIGH-LOW PRICING:-

This method involves high prices on a regular

basis, coupled with temporary (or occasional)
discounts as promotional activity. On all days the
price is higher than EDLP, but on discount days
it is lower than EDLP. This method is adopted by
those firms which have high overhead expenses
and cannot afford everyday low pricing.

(C) VALUE PRICING:-

Under value pricing sellers try to create a high

value of the product and charge a low price. This
 is a strategy suitable for the maturity and
saturation stage when demand can be maintained
by keeping focus on higher quality and lower
cost.

3
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Explain the concept of oligopoly

An oligopoly is an industry dominated by just a few firms. Oligopolists are said to

be interdependent since each one must consider the effect of its own actions on
competitors‘ behavior. The formation of an oligopoly can often be traced to some
form of barrier to entry, such as economies of scale, legal restrictions, brand
names built up by years of advertising, or control over an essential resource.

Key Points

 Positive economics is a branch of economics that focuses on the description and

explanation of phenomena, as well as their casual relationships.
 Positive economics clearly states an economic issue and normative economics
provides the value-based solution for the issue.
 Normative economics is a branch of economics that expresses value or
normative judgments about economic fairness. It focuses on what the outcome of
the economy or goals of public policy should be.
 Positive economics does impact normative economics because it ranks
economic polices or outcomes based on acceptability (normative economics).
Key Terms

 normative economics: Economic thought in which one applies moral beliefs, or

judgment, claiming that an outcome is “good” or “bad”.
 positive economics: The description and explanation of economic phenomena
and their causal relationships.
Positive and normative economic thought are two specific branches of economic
reasoning. Although they are associated with one another, positive and normative
economic thought have different focuses when analyzing economic scenarios.

Positive Economics

Positive economics is a branch of economics that focuses on the description and

explanation of phenomena, as well as their casual relationships. It focuses primarily on
facts and cause-and-effect behavioral relationships, including developing and testing
economic theories. As a science, positive economics focuses on analyzing economic
behavior. It avoids economic value judgments. For example, positive economic theory
would describe how money supply growth impacts inflation, but it does not provide any
guidance on what policy should be followed. “The unemployment rate in France is
higher than that in the United States” is a positive economic statement. It gives an
overview of an economic situation without providing any guidance for necessary actions
to address the issue.

Normative Economics

Normative economics is a branch of economics that expresses value or normative

judgments about economic fairness. It focuses on what the outcome of the economy or
goals of public policy should be. Many normative judgments are conditional. They are
given up if facts or knowledge of facts change. In this instance, a change in values is
seen as being purely scientific. Welfare economist Amartya Sen explained that basic
(normative) judgments rely on knowledge of facts.
An example of a normative economic statement is “The price of milk should be $6 a
gallon to give dairy farmers a higher living standard and to save the family farm. ” It is a
normative statement because it reflects value judgments. It states facts, but also
explains what should be done. Normative economics has subfields that provide further
scientific study including social choice theory, cooperative game theory, and mechanism
design.

Relationship Between Positive and Normative Economics

Positive economics does impact normative economics because it ranks economic

policies or outcomes based on acceptability (normative economics). Positive economics
is defined as the “what is” of economics, while normative economics focuses on the
“what ought to be. ” Positive economics is utilized as a practical tool for achieving
normative objectives. In other words, positive economics clearly states an economic
issue and normative economics provides the value-based solution for the issue.

What is price elasticity of supply?

In Economics, elasticity is defined as the degree of change in demand and supply of
consumers and producers with respect to the change in income or price of the
commodity.
Particularly, price elasticity of supply is a measure of the degree of change in the
supplied amount of commodity in response to the change in the commodity’s price. In
simple words, it can be defined as the rate of change in supply in response to a price
change. It is denoted as PES or Es.
Mathematically, price elasticity of supply is expressed as

Degrees or Types of Price Elasticity of Supply

The degree of elasticity of supply can be of five types. They are described below in brief
with figure.
Relatively elastic supply
When percentage change in quantity supplied is greater than percentage change in
price, the condition is known as relatively elastic supply. This situation when plotted in
graph makes an upward slope which intersects positive Y-axis.
Fig. i: relatively elastic supply curve
In figure i, we can see that ratio of change in quantity supplied is greater than the ratio
of change in price. As a result, when we put their values in the above mathematical
expression, we get PES>1.

Elasticity tends to be greater than 1 in case of products which are not necessary to
sustain our lives. Luxury goods such as expensive smart phone, gold, etc. show this
kind of price elasticity.

Relatively inelastic supply

When the percentage change in quantity supplied is lesser than percentage change in
price, the condition is known as relatively inelastic supply. This situation when plotted in
graph makes highly inclined upward slope which intersects positive X-axis.

Fig. ii: relatively inelastic supply curve

In the above figure, it is clearly shown that ratio of change in price is greater than ratio
of change in quantity, whose value when substituted in the given expression, we get
PES<1.

Such kind of price elasticity can be observed in goods which are necessary in our day to
day lives. Clothes, foods, etc. are good examples of these kinds of goods.

Unitary elastic supply

When percentage change in quantity supplied is exactly equal to percentage change in
price, the situation is known as unitary elastic supply. This situation is graph is
represented by an upward slope which intersects the origin.

Fig. iii: unitary elastic supply

In the above figure, the ratio of change in quantity supplied is equal to the ratio of
change in price. Consequently, when the value of these variables are substituted in the
given expression, we get PES=1. This behavior between price and quantity supplied of
commodity is also known as lock-step movement.
Infinite/perfectly elastic supply
When a slight or minimal change in price causes infinite change in quantity supplied, it
is said to be infinite or perfectly elastic supply. In a graph, such situation is represented
by a straight line which is parallel to X-axis.

Fig. iv: perfectly elastic supply curve

In the above figure, we can see that quantity supplied has varied significantly even at the
same price level. This kind of price elasticity is expected to occur in highly luxurious
goods. However, perfectness of anything, including perfectly inelastic supply is
considered to be rare or impractical in economy.

Zero /perfectly inelastic supply

When quantity supplied remains unchanged with change in price, it is said to be zero or
perfectly inelastic supply. Such situation in graph is represented by a straight line which
is parallel to Y-axis.
Fig. v: perfectly inelastic supply
In figure v, we can see that the amount of commodity supplied has remained unchanged
even when the price has greatly changed. This type of price elasticity is expected to be
observed in highly essential goods such as medicines. However, as mentioned earlier,
perfectness of anything in economy is rare or impractical.

A supply curve is a graphical representation of the relationship between the amount of a

commodity that a producer or supplier is willing to offer and the price of the commodity,
at any given time. In other words, a supply curve can also be defined as the graphical
representation of a supply schedule.
In a graph, the price of the commodity is shown on the vertical axis (Y-axis) and the
quantity supplied is shown on the horizontal axis (X-axis) of the graph. It is an upward
slope, which means higher the price, higher will be the quantity supplied, and lower the
price, lesser will be the quantity supplied.

Given below are two figures –I and II. Figure I is an example of supply schedule and
figure II is its graphical illustration.

Fig. I: Individual supply schedule

Price of milk per liter (in Rs.) Quantity supplied per day in liters (*1000)

10 10
 20 20

30 30

40 40

Fig. II: Supply curve

Movement along a supply curve

The amount of commodity supplied changes with rise and fall of the price while other
determinants of supply remain constant. This change, when shown in the graph, is
known as movement along a supply curve.
In simple words, movement along a supply curve represents the variation in quantity
supplied of the commodity with a change in its price and other factors remaining
unchanged.

The movement in supply curve can be of two types – extension and contraction.
Extension in a supply curve is caused when there is an increase in the price or quantity
supplied of the commodity while contraction is caused due to a decrease in the price or
quantity supplied of the commodity.
In the above fig. II, let us suppose Rs. 20 is the original price of milk per liter and 20,000
liters is the original quantity of supply. When the price rises from Rs. 20 to Rs. 30, the
amount of quantity supplied rises from 20,000 liters to 30,000 liters, and there is a
movement in the supply curve from point B to point C. This movement is known as an
extension of the supply curve.
Similarly, when the price falls from Rs. 20 to Rs. 10, the amount of quantity supplied
falls from 20,000 liters to 10,000 liters, and there is another movement in the supply
curve from point B to point A. This movement is known as a contraction of the supply
curve.

Shift in supply curve

The amount of commodity that the producers or suppliers are willing to offer at the
marketplace can change even in cases when factors other than the price of the
commodity change. Such non-price factors can be the cost of factors of production, tax
rate, state of technology, natural factors, etc.

When the quantity of the commodity supplied changes due to change in non-price
factors, the supply curve does not extend or contract but shifts entirely. For an instance,
the introduction of improved technology in industries helps in reducing the cost of
production and induces production of more units of a commodity at the same price. As
a result, the quantity of commodity supplied increases but the price of the commodity
remains as it is.
Fig. III: Shift in supply curve

The shift in supply curve can also be of two types – rightward shift and leftward shift.
The rightward shift occurs in supply curve when the quantity of supplied commodity
increases at same price due to favorable changes in non-price factors of production of
the commodity. Similarly, a leftward shift occurs when the quantity of supplied
commodity decreases at the same price.
In the above fig. III, let us suppose that SS is the original supply curve where Q amount
of commodity has been supplied at price P. Due to favorable changes in non-price
factors, the production of the commodity has increased and its supply has been
increased by Q2 – Q amount, at the same price. This has caused the supply curve
rightwards and new supply curve S2S2 has formed.
In the same, due to unfavorable changes in non-price factors of the commodity, the
production and supply have fallen to Q1 amount. Accordingly, the supply curve has
shifted leftwards and new supply curve S1S1 has formed.

Reasons for rightward shift of supply curve

 Improvement in technology
 Decrease in tax
 Decrease in cost of factor of production
 Favorable weather condition
 Seller’s expectation of fall in price in future

Reasons for leftward shift of supply curve

 Use of old or outdated technology
 Increase in tax
 Increase in cost of factor of production
 Unfavorable weather condition
 Seller’s expectation of rise in price in future
price elasticity of demand?
What is price elasticity of supply?
In Economics, elasticity is defined as the degree of change in demand and supply of
consumers and producers with respect to the change in income or price of the
commodity.
Particularly, price elasticity of supply is a measure of the degree of change in the
supplied amount of commodity in response to the change in the commodity’s price. In
simple words, it can be defined as the rate of change in supply in response to a price
change. It is denoted as PES or Es.
Mathematically, price elasticity of supply is expressed as

Degrees or Types of Price Elasticity of Supply

The degree of elasticity of supply can be of five types. They are described below in brief
with figure.
Relatively elastic supply
When percentage change in quantity supplied is greater than percentage change in
price, the condition is known as relatively elastic supply. This situation when plotted in
graph makes an upward slope which intersects positive Y-axis.
Fig. i: relatively elastic supply curve
In figure i, we can see that ratio of change in quantity supplied is greater than the ratio
of change in price. As a result, when we put their values in the above mathematical
expression, we get PES>1.

Elasticity tends to be greater than 1 in case of products which are not necessary to
sustain our lives. Luxury goods such as expensive smart phone, gold, etc. show this
kind of price elasticity.

Relatively inelastic supply

When the percentage change in quantity supplied is lesser than percentage change in
price, the condition is known as relatively inelastic supply. This situation when plotted in
graph makes highly inclined upward slope which intersects positive X-axis.

Fig. ii: relatively inelastic supply curve

In the above figure, it is clearly shown that ratio of change in price is greater than ratio
of change in quantity, whose value when substituted in the given expression, we get
PES<1.

Such kind of price elasticity can be observed in goods which are necessary in our day to
day lives. Clothes, foods, etc. are good examples of these kinds of goods.

Unitary elastic supply

When percentage change in quantity supplied is exactly equal to percentage change in
price, the situation is known as unitary elastic supply. This situation is graph is
represented by an upward slope which intersects the origin.

Fig. iii: unitary elastic supply

In the above figure, the ratio of change in quantity supplied is equal to the ratio of
change in price. Consequently, when the value of these variables are substituted in the
given expression, we get PES=1. This behavior between price and quantity supplied of
commodity is also known as lock-step movement.
Infinite/perfectly elastic supply
When a slight or minimal change in price causes infinite change in quantity supplied, it
is said to be infinite or perfectly elastic supply. In a graph, such situation is represented
by a straight line which is parallel to X-axis.

Fig. iv: perfectly elastic supply curve

In the above figure, we can see that quantity supplied has varied significantly even at the
same price level. This kind of price elasticity is expected to occur in highly luxurious
goods. However, perfectness of anything, including perfectly inelastic supply is
considered to be rare or impractical in economy.

Zero /perfectly inelastic supply

When quantity supplied remains unchanged with change in price, it is said to be zero or
perfectly inelastic supply. Such situation in graph is represented by a straight line which
is parallel to Y-axis.
Fig. v: perfectly inelastic supply
In figure v, we can see that the amount of commodity supplied has remained unchanged
even when the price has greatly changed. This type of price elasticity is expected to be
observed in highly essential goods such as medicines. However, as mentioned earlier,
perfectness of anything in economy is rare or impractical.

A supply curve is a graphical representation of the relationship between the amount of a

commodity that a producer or supplier is willing to offer and the price of the commodity,
at any given time. In other words, a supply curve can also be defined as the graphical
representation of a supply schedule.
In a graph, the price of the commodity is shown on the vertical axis (Y-axis) and the
quantity supplied is shown on the horizontal axis (X-axis) of the graph. It is an upward
slope, which means higher the price, higher will be the quantity supplied, and lower the
price, lesser will be the quantity supplied.

Given below are two figures –I and II. Figure I is an example of supply schedule and
figure II is its graphical illustration.

Fig. I: Individual supply schedule

Price of milk per liter (in Rs.) Quantity supplied per day in liters (*1000)

10 10
 20 20

30 30

40 40

Fig. II: Supply curve

Movement along a supply curve

The amount of commodity supplied changes with rise and fall of the price while other
determinants of supply remain constant. This change, when shown in the graph, is
known as movement along a supply curve.
In simple words, movement along a supply curve represents the variation in quantity
supplied of the commodity with a change in its price and other factors remaining
unchanged.

The movement in supply curve can be of two types – extension and contraction.
Extension in a supply curve is caused when there is an increase in the price or quantity
supplied of the commodity while contraction is caused due to a decrease in the price or
quantity supplied of the commodity.
In the above fig. II, let us suppose Rs. 20 is the original price of milk per liter and 20,000
liters is the original quantity of supply. When the price rises from Rs. 20 to Rs. 30, the
amount of quantity supplied rises from 20,000 liters to 30,000 liters, and there is a
movement in the supply curve from point B to point C. This movement is known as an
extension of the supply curve.
Similarly, when the price falls from Rs. 20 to Rs. 10, the amount of quantity supplied
falls from 20,000 liters to 10,000 liters, and there is another movement in the supply
curve from point B to point A. This movement is known as a contraction of the supply
curve.

Shift in supply curve

The amount of commodity that the producers or suppliers are willing to offer at the
marketplace can change even in cases when factors other than the price of the
commodity change. Such non-price factors can be the cost of factors of production, tax
rate, state of technology, natural factors, etc.

When the quantity of the commodity supplied changes due to change in non-price
factors, the supply curve does not extend or contract but shifts entirely. For an instance,
the introduction of improved technology in industries helps in reducing the cost of
production and induces production of more units of a commodity at the same price. As
a result, the quantity of commodity supplied increases but the price of the commodity
remains as it is.
Fig. III: Shift in supply curve

The shift in supply curve can also be of two types – rightward shift and leftward shift.
The rightward shift occurs in supply curve when the quantity of supplied commodity
increases at same price due to favorable changes in non-price factors of production of
the commodity. Similarly, a leftward shift occurs when the quantity of supplied
commodity decreases at the same price.
In the above fig. III, let us suppose that SS is the original supply curve where Q amount
of commodity has been supplied at price P. Due to favorable changes in non-price
factors, the production of the commodity has increased and its supply has been
increased by Q2 – Q amount, at the same price. This has caused the supply curve
rightwards and new supply curve S2S2 has formed.
In the same, due to unfavorable changes in non-price factors of the commodity, the
production and supply have fallen to Q1 amount. Accordingly, the supply curve has
shifted leftwards and new supply curve S1S1 has formed.

Reasons for rightward shift of supply curve

 Improvement in technology
 Decrease in tax
 Decrease in cost of factor of production
 Favorable weather condition
 Seller’s expectation of fall in price in future

Reasons for leftward shift of supply curve

 Use of old or outdated technology
 Increase in tax
 Increase in cost of factor of production
 Unfavorable weather condition
 Seller’s expectation of rise in price in future
price elasticity of demand?
What is Market?
Meaning
"Market refers to an arrangement, whereby buyers and sellers come in contact with each other directly
or indirectly, to buy or sell goods."
Thus, above statement indicates that face to face contact of buyer and seller is not necessary for market.
E.g. In stock or share market, the buyer and seller can carry on their transactions through internet. So
internet, here forms an arrangement and such arrangement also is included in the market.
Characteristics of Market
1. Existence of commodity which is to be bought and sold.
2. The existence of buyers and sellers.
3. A place, be it a certain region, a country or the entire world.
4. Communication between buyers and sellers that only one price should prevail for the same
commodity at the same time.
Classification or Types of Market
The classification or types of market are depicted in the following chart.
Generally, the market is classified on the basis of:
1. Place,
2. Time and
3. Competition.
On the basis of Place, the market is classified into:
1. Local Market or Regional Market.
2. National Market or Countrywide Market.
3. International Market or Global Market.
On the basis of Time, the market is classified into:
1. Very Short Period Market.
2. Short Period Market.
3. Long Period Market.
4. Very Long Period Market.
On the basis of Competition/Market Structure, the market is classified into:
1. Perfectly Competitive Market Structure.
2. Imperfectly Competitive Market Structure.
(Market structure refers to number and types of firms operating in the industry.)
Both these market structures widely differ from each other in respect of their features, price, etc. Under
imperfect competition, there are different forms of markets like monopoly, duopoly, oligopoly
and monopolistic competition.
1. A monopoly has only one or a single (mono) seller.
2. Duopoly has two (duo) sellers.
3. Oligopoly has little or fewer (oligo) number of sellers.
4. Monopolistic competition has many or several numbers of sellers.

The suffix pozly has its origin from Greek word Polus which means many or more than o

Explain the concept of microeconomic analysis?

Ans. Microeconomic analysis is that part of economic analysis which studies the following
individual economic variables-
1. Individual consumer ‘
2. Input price
3. Individual producer
4. Individual firm
5. Commodity price

Microeconomic analysis is also called:

1. Price theory
2. Theory of value
3. Price system and revenue allocation

The term ―micro‖ has been borrowed from the Greek word ―Mikros‖ meaning small.
Scope of Microeconomic Analysis
Following studies are made in microeconomic analysis-
(I) Allocation of resources in the production of goods and services. In this we study
1. Theory of product pricing
a) Theory of demand
b) Theory of cost of production

2. Theory of factor pricing

a) Determination of price (remuneration) of factors of production.

Factors of Production price/remuneration

1. Land rent
2. Labor Wages
3. Capital Interest
4. Entrepreneur Profit

(II) Allocative Efficiency

Allocating efficiency in welfare economics include-
Related to individual welfare:
1. Efficiency in production
2. Efficiency in Consumption

Related to social welfare

1. Optimum efficiency

Role of microeconomic analysis in formulation of business policies and business decision

making
i. Used in understanding the functioning and working of an economy.
ii. Useful in analyzing environmental policies.
iii. Used in welfare economics
iv. Helpful in managerial decision making.
v. Helps in solving internal problems of operations.
vi. Helpful in determining prices
vii. Useful in analysis of taxation problems.
viii. Useful in demand forecasting and prediction.
ix. Helpful in cost and production analysis.
x. Used in profit planning and control.
xi. Helpful in building Microeconomic models.
xii. Measures managerial efficiency of a firm

Show by chart the relation between different concepts/ components of National Income/ Concepts of National
Product.
Ans. Relation between Different concepts of National Income
Gross domestic product at market price
= Market value of all final goods and services produced within the domestic territory. +Net factor Income from
Abroad (NFIA)
= Gross domestic national product at market price
-Depreciation or consumption of fixed capital
= Net national product at market price
- Net factor Income from Abroad (NFIA)
= Net Domestic Product at Market Price
-Indirect Taxes
+Subsidies
= Net Domestic Product at Factor Cost or Domestic Income
+depreciation
=Gross Domestic Product at Factor Cost
+ Net factor Income from Abroad (NFIA)
=Gross National Product at Factor Cost
-Depreciation
=Net National Product at Factor Cost
-Property and entrepreneurial income of the government
-Saving of Non-departmental enterprise
- Net factor Income from Abroad (NFIA)
=Factor income from Net Domestic Product accruing to Private Sector
+interest rate on National debt
+Net current transfer payments from the government
+Net current transfer payments from Abroad
+ Net factor Income from Abroad (NFIA)
=Private Income-Corporate Scetor
-Saving of Corporation ( Less Net retained earnings of foreign companies)
=Personal Income
-Direct Taxes
-Miscellaneous receipts of government administratin departments i.e. fees, fines etc.
=Disposable Income
=Consumption +Saving

What do you mean by Money?

Ans Money is anything that is accepted as the medium of exchange i.e. Whenever an article is generally
acceptable in exchange in a community so that B will take it from A in exchange for what A wants, not
because B desires the article but because he knows that practically all other persons will take it from him in
exchange for the things which they have and which he wants, that article is known as money.
Q2. Explain the functions of Money.
Ans Money performs five important functions: Medium of exchange: Purchase of goods and services can be
made i.e. goods and services are exchanged for money. Measure of value: Exchange value of commodity can
be expressed in terms of money. For e.g. we can say that 10 metres of Cotton Cloth cost $220 dollars or Rs.10,
000 rupees only. Store of value: Money being generally acceptable and its value being more or less stable, it is
ideal for use as a store of value. Standard or Deferred payment: Future transactions can be carried on in terms
of money. The loans, which are taken at present, can be repaid in money in the future. The value of the future
payments is regulated by money. Transfer of value: Value of any asset can be transferred from one person to
another or to any institution or to any place by transferring money. Transfer of purchasing power, which is
necessary in commerce and other transactions, has become available because of money.

Explain the classical approach to the Quantity Theory of Money and give its
assumptions.
Ans. The Quantity Theory of money was first developed by Irving Fisher in the inter-war
years to explain the theoretical explanation for the link between money and the general
price level. This is sometimes known as the Fisher identity or the equation of exchange.
This is an identity which relates total aggregate demand to the total value of output (GDP).
MxV=PxY
Where
M is the money supply
V is the velocity of circulation of money i.e. the no. of times a unit of currency changes
hands
P is the general price level
Y is the real value of national output (i.e. real GDP)

Assumptions:
1. Velocity of money is treated to be constant as it is predictable.
2. It is assumed that real value of GDP is not affected by monetary variables.

Hence, assuming V and Y to be constant, changes in supply of money will be equated by

changes in general price level.
We can further modify this relationship by dividing both sides by V:
M = (1/V) x PY
Since V is constant we can replace (1/V) with some constant, k, and when the money
market is in equilibrium, Md = M. So our equation becomes
Md = k x PY
So under the quantity theory of money, money demand is a function of income and does
not depend on interest rates.
Q3. What are the three motives of holding money

What are the functions of Central Bank?

Ans. The entity responsible for overseeing the monetary system for a nation is known as the Central Bank of
that nation. Central banks have a wide range of responsibilities, from overseeing monetary policy to
implementing specific goals such as currency stability, low inflation and full employment.
.
Functions of the Central Bank:
1. Monopoly of Note-Issue:
Note-issue primarily is the main function of a central bank in every country. These days, in all the countries
where there is a central bank generally it has got the monopoly or the sole right of note-issue.
2. Banker, Agent & Adviser to the Government:
As banker to the government, central bank performs following functions: It operates the accounts of the public
enterprises. It manages government departmental undertakings and government funds and when there is a need
gives loans to the government. It looks after the management of public debt. It accepts the payment of taxes
from the public on behalf of the government and makes payment for the cheques issued by the government. It
also undertakes transactions relating to foreign currencies on behalf of the government.
3
. Custodian of Cash Reserves of Commercial Bank:
Central bank is the bank of banks. It regulates commercial banks by provides security to their cash reserves,
gives them loan at the times of need, gives them advice on financial and economic matters and works as
clearing house among various member banks.

4. Custodian of Nation's Reserves of International Currencies:

Central bank is the custodian of the foreign currency obtained from various countries in order to stabilize the
external value of the currency.
5. Lender of the Last Resort:
Central bank works as lender of the last resort for commercial banks because in tthe times of need it provides
them financial assistance and accommodation by discounting their bills and securities.
6. Clearing House Function:
All the commercial banks have their accounts with the central bank. Therefore, central bank settles the mutual
transactions of banks.
7. Credit Control:
The most important function of central bank is to control the volume of credit for bringing about stability in the
general price level and accomplishing various other socio-economic objectives. There are number of methods
which a central bank may use for controlling the volume of credit such as bank rate, open market operations,
change in reserve ratio and various selective controls.
Q2. What do you mean by Commercial banks and state their functions?

Ans. A commercial bank is a profit-seeking business firm which deals in money and credit by accepting
deposits of money from the public to keep them in its custody for safety. This can be explained
diagrammatically as follows:
Savings Commercial banks Loans
(Earn interest rate)
Q.3. How does banks create money?
Ans. Credit creation is one of the important functions of a commercial bank. Other financial institutions
transfer money from the lenders to the borrowers. Commercial banks while performing the same function, they
create credit or bank money also. Professor Sayers says, "Banks are not merely purveyors of money, but in an
important sense, they are the manufacturers of money". The process of credit creation occurs when banks
accepts deposits and provide loans and advances. When the customer deposits money with the bank, they are
called primary deposits. This money will not be withdrawn immediately by them. Hence banks keeps a certain
amount of deposits as reserves which is known as cash reserve ratio and provide the balance amount as loans
and advances. Thus, every deposit creates a loan. Commercial banks give loans and advances against some
security to the public. But the bank does not give the loan amount directly. It open an account in the name of
the borrower and deposits the amount in that account. Thus, every loan creates a deposit. The loan amount can
be withdrawn by means of checks. They create a deposits while lending money also. These deposits created by
banks with the help of primary deposits are called derivative deposits.
Customers use these loans to make payments. While paying they issue a checks against these deposits. The
person who receives the checks, deposit it in another bank. For that bank, this will be the primary deposit. A
part of the deposit will be kept as a reserve and the balance will be used for giving loans and advances. This
process is repeated by other banks. When all the banks involve in this process, it is called Multiple
Credit Creation

Nature of Macro Economics

1) Macro economics studies the concept of national income and its different elements and the method of
measurement.
2) It studies problems relating to employment and unemployment. It studies different factors determining the
level of employment.
3) Determination of general price level is also studied under macro economics. Problems relating to inflation
and deflation are an important component of macro economics.
4) Change in demand and supply of money have an important impact on the level of employment.
Macroeconomics studies function of money & theories relating to it.
5) Problems relating to economic growth is another important component of macro economics like plans for
overall increase in national income, output, employment are framed so the economic development of economy
as a whole.
6) It also studies issues relating to international trade, export, import exchange rate and balance of payments
are the principal issue in this context.
Importance of Macro Economics
1) Macro economics is helpful for getting us an idea of the functioning of an economic system it is very
essential for a proper and adequate knowledge of behavior pattern of the aggregative variable, as the
description of a large and complex economic system.
2) It says about the study of national income and social accounts. It is the study of national income which
enables us to know that three fourth of the world is living in object poverty without proper national difficult to
formulate proper economic policies.
3) Macroeconomic approaches are of almost importance to analyze and understand the effect of inflation and
deflation different sections of society are affected differently as a result of charges in the value of money.
4) Economic fluctuation is a characteristics features of the capitalist form of economy. The economic booms
and depression in the level of income and employment follow one another in cyclical fashion.
5) The study of macro economics is essential for the proper understanding of Micro economics. No micro
economics law could be framed without a prior study of the aggregate.
Microeconomics v/s Macroeconomics
S.No.
Points
Microeconomics
Macroeconomics
1
Study
It studies individual unit
It studies aggregate or group of individual units.
2
Assumption
At micro level full employment is assumed which is never found in an economy. Hence this is an unreal
assumption
At macro level, full employment is not assumed. Instead equilibrium employment is assumed which is a real
assumption.
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3
3
Subject Matter
We study demand supply, consumer behavior production, types of market, theory of cost & revenue etc.
We study national income, theory of wage, interest & employment. Theory of money, theory of international
trade etc.
4
Applicability
It is useful in analysis of an individual unit like cost of an individual good, demand of a single good, price of a
single good.
It is useful in analysis of aggregate units such as aggregate demand, aggregate prices or inflation-deflation,
aggregate or national income etc.
5
Usefulness to Govt.
It is less useful to Govt. in formulating economic policies.
It is more useful to Govt. in formulating economic policies.
Limitations of Macroeconomics
1) Individual unit is ignored: While studying macroeconomics, individual unit is ignored, one cannot think of
increasing national saving at the expense of individual welfare.
2) It overlooks individual differences: Macro analysis overlooks individual differences for e.g.: overall prices
in the economy may b stable but price of petrol is increasing day by day. This puts a burden on common man.
3) Too much stress on macro analysis: Too much stress on macro analysis is also one of the limitations of
macro economics. For e.g. An economy may be growing due to yearly over year rise in GDP but if the wealth
is concentrated in the hands of few rich people. From developmental point of view this is not an ideal
condition.
DEFINITIONS OF NATIONAL INCOME
Marshall’s Definition
"The labour and capital of a country acting on its natural resources produce annually a certain net aggregate of
commodities, material and immaterial, including services of all kinds. This is the true net annual income or
revenue of the country or national dividend." The main defects of marshall's definition are as under 1. A
country produces a number of commodities and services whose correct evolution becomes difficult. Thus ,we
cannot get an accurate estimate of the national income of a country. 2. There are some commodities which are
used more than once. Thus, there is a possibility that the product of such commodities may be counted twice.
This will give a wrong estimate of the national income. 3. There are some commodities which do not appear in
the market and they are consumed directly by the producers. This normally happens in the case of agricultural
commodities. Marshall's definition fails to provide a measure for such items.
Pigou’s Definition
"National income is that part of the objective income of the community, including of course income derived
from abroad, which can be measured in money." The limitations of this definition are as following: 1. While
calculating national income, Pigou includes only those goods and services which are exchanged for money.
Thus, the services which a person renders to himself ,and those which he performs for the sake of his family or
friends should not be regarded as part of national dividend. Thus, the definition does not provide a correct
picture of the national income of a country. 2. This definition is applicable only to developed countries of the
world where barter system is not found. It cannot be used to calculate of the national income of the backward
and less developed countries where the barter system still occupies an important place in the economy.
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4
CONCEPTS OF NATIONAL INCOME There are different concepts of National Income, namely; GNP, GDP,
NNP, Personal Income and Disposable Income. 1) Gross Domestic Product (GDP): GDP at market price is
sum total of all the goods and services produced in a country during a year within the domestic territory 2)
Gross National Product (GNP): GNP at market price is sum total of all the goods and services produced in a
country during a year and net income from abroad. GNP is the sum of Gross Domestic Product at Market Price
and Net Factor Income from abroad 3) GDP at Market Price: If we multiply the total output produced in one
year within the domestic territory , by their ‘Market Prices’, we get GDP at market price. 4) GNP at Market
Price : If we multiply the total output produced in one year within the domestic territory as well as outside the
country , by their ‘Market Prices’, we get GNP at market price. 5) Gross Domestic Product at Factor Cost : The
gross domestic product at factor cost is the difference between gross domestic product at market price and net
indirect taxes. 6) Gross National Product at Factor Cost : The gross national product at factor cost is the
difference between gross national product at market prices and net indirect taxes. Private Income Central
Statistical Organization defines Private Income as “the total of factor income from all sources and current
transfers from the government and rest of the world accruing to private sector” or in other words the private
income refers to the income from socially accepted source including retained income of corporation. NI+
Transfer payment + Interest on public debt +Social security + Profit and Surplus of public enterprises = Private
Income Personal Income Prof. Peterson defines Personal Income

The ‘Nash Equilibrium’

The famous mathematician John Nash showed the following: in non-
cooperative games there exists an equilibrium at which no side has any
rational incentive to change the chosen strategy even after running through all
the choices available to the opponent(s).
The movie ‘A Beautiful Mind’ is based on his life and if the movie is to believed
— the insight for game theory struck him when he observed that all his friends
hit on the most pretty girl around, and he decided that he should hit on the
second or the third prettiest to improve his chances (also to the benefit of
everyone involved). A less pretty girl is indeed better than no girl at all!
[Please note how all the boys will automatically gravitate towards girls
according to their own ‘social order’, and also the side-fact that they have no
incentive to change their strategy after knowing what their ‘competitors’
planned to do. An efficient and elegant solution indeed!]
By mathematically proving that an equilibrium point exists, John Nash
showed that important economic, political or social interactions can be hinged
on desirable outcomes without the need for any contracts.
 

Introduction to Macroeconomics
 

Macroecono
mics is the branch of economics studying the behavior of the aggregate
economy – at the regional, national or international level.
While microeconomics is concerned primarily with the decisions made by an
individual within the usual economic constraints of scarcity, macroeconomics
(Greek makro = ‘big) is the field of study that is concerned with the indicators
that reflect the performance of the broader economy- gross domestic product,
inflation levels, unemployment, growth rate, fiscal deficit etc.
If you are trying to gain a better appreciation of the macroeconomics problems
of the Indian economy that get covered in newspapers and TV channels, this
post should help you get the basic principles of macroeconomics.
 
What is macroeconomics?
The aim of studying macroeconomics is to understand how an economy
works, and identifying the levers that can be pulled to put the overall economy
on the right path of growth. The system that is a result of different economic
agents coming into contact is much more complex than the sum of its
independent and often disjoint parts.
Moreover, it is strictly “non-experimental” as we do not have the luxury of
conducting controlled experiments like in the field of science. We can just wait
and observe the effects of broader policy measures with a certain level of
accuracy and a tinge of hope.
It usually deals with goals that are conflicting; ensuring growth, taming
inflation, full employment and fair income distribution at the same time!
 

Introduction to Macroeconomics – Basic

concepts
 Currency
Before the advent of money and modern economic systems, barter was
prevalent to facilitate the exchange of goods and services. Money has many
advantages over the barter system and serves multiple functions: it is
faster, convenient, holds value over time and both parties are not obligated
to want what the other is offering ensuring freedom of choice through a
neutral medium of exchange.
There is no scope for confusion as everyone knows the current value of one
unit of a currency (atleast they think they know!). Interest rate is the cost
of borrowing money, which in turn is dependent upon the current demand
of money in the economy.
An exchange rate signifies the rate at which one currency will be exchanged for
another. The two primary types of exchange rate systems are
– fixed and floating. In fixed rate systems, the participating countries agree
upon the relative value of their currencies and maintain the same rate by
buying/selling their foreign reserves in the case of demand fluctuations for
their currency.
Fixed exchange rate system was mostly prevalent in the 19 th and 20th centuries,
and currencies were backed by gold in the good old days (now it is not the
case, read about fiat money). In floating exchange rate systems, the value of
the currency is determined by the market forces, just like any other good.
 Inflation
Simply put, inflation is the erosion in value of a currency, as its buying
capacity diminishes over time. Alternatively, it can also be defined as a
significant increase in the prices of goods/services in an economy for
considerable time duration. Consumer Price Index (CPI) and Wholesale
Price Index (WPI) are the measures of inflation used in India.
There is no broad consensus upon the right rate of inflation in the
economy, but majority believe that a slightly positive rate of inflation
signifies growth and is best for the economy.
Wild variation in inflation is the major source of headache for economists
and can lead to a variety of problems in the economy: the saving sentiment
of the populace erodes due to uncertainty in the value of deposits and the
long-term investments may dry up due to significant risk associated with
final returns.

 Business cycles
Business cycles are the patterns of expansions & contractions in the
economy. During a phase of expansion, gross domestic product (GDP)
rises and the unemployment rate falls. While recession has found its place
in the pop culture and now usually means any downturn in the economy,
the definition of recession usually requires the real GDP to decline for two
consecutive quarters.
There is no set consensus among the economists as to what decides the
extent of these cycles, and the role government should play in influencing
these cycles. Lowering taxes and increasing spending usually provide the
required stimulus to the economy during downturns. Some see this cycles
as totally irregular phenomenon, while some believe that overall
technological throughput of the economy drive these cycles.

 Unemployment
: Good rate of employment within an economy is important for a couple of
reasons – unemployed workforce is pure wasted potential, plus it leads to
lowering in consumer spending as they’ve got nothing to spend!
There are three sub-categories of unemployment:
 Cyclical unemployment: Result of business cycles, not harmful to the
economy in general
 Frictional unemployment: Result of lags in information dissemination and
imperfect matching of jobs and skilled workers
 Structural unemployment: Result of workers not being equipped for the
jobs that are available, can be detrimental to the economy
While a very low rate of unemployment is desirable, absolute zero
unemployment is neither desirable nor practically possible. The general
relationship that exists between inflation and employment – higher the rate of
employment, higher is the rate of inflation. Balancing it all does require some
serious effort after all.
 

Economic growth
Gross Domestic Product: What is GDP?
GDP full-form: Gross domestic product. GDP is the total value of the final
goods/services produced in an economy and is the most commonly employed
measure of a country’s economic capacity. GDP in effect is a measure of ‘value
added’, the value added is more if an entity produces more output with every
unit of available input.
‘Real GDP’ measures economic output after adjusting for price changes, i.e.
inflation or deflation. The ultimate goal of any economic growth is to translate
into a higher standard of living, and measuring GDP per capita is an
approximate way to do that. A sweet side effect: it serves as a barometer to
gauge the success (or lack thereof) of major economic policy changes.
There are some drawbacks to the use of GDP though: –

 The GDP calculations exclude any form of unpaid/illegal activity. In a

country like India where a significant portion of economy is
“underground”, the real GDP can be grossly underestimated.
 It fails to take into account the losses that happen due to natural or
man-made disasters, but the rebuilding activity after a war or a natural
disaster will cause the GDP figures to shoot up.
 It also fails to capture the improvements in quality of life due to
increased affordability of goods over time;also ignores transactions where
no money comes into picture (think of NGOs) and does not take into
account the value of all assets in the economy.
 The sustainability factor also does not come into picture as the high
GDP can be a result of over-utilizing the nation’s natural resources.
 Last but not the least, it does not take into account the distribution of
wealth (a few wealthy individuals can hold a very significant amount of
money in an economy). It is generally measured through Gini coefficient.
For instance, “Gini” tells that the income distribution is fairly skewed
(screwed?) in South Africa whereas Scandinavian countries are egalitarian
havens.
 
A gap exists between the potential GDP that an economy could generate
through optimum utilization of labor and capital, and the actual GDP that is
generated which is called the output gap.
 
International Trade
Liberalization, Privatization and Globalization are the factors which have been
responsible for the spurt in economic activity in India for the past two
decades. Without international trade, the world suddenly becomes a very large
and disconnected place.
The consumers have to compromise on the available choices (getting a
landline connection before 90’s was a luxury in India and a thriving black
market for regular commodities was the norm). Specialization is the backbone
of all modern economic activity, and a nation can maximize its welfare (and
that of the world) by making goods which it produces most efficiently—
competitive advantage.
Balance of payment tracks the financial flow, the components being the flow of
goods/services and/or the investments. To make the payments exactly
balanced with a trading nation, the earnings from selling goods/services and
the return on investments should be equal to the spending on goods/services
and the outgoing investment income.
While we are increasingly moving towards free international trade, the
governments can introduce barriers to trading which can come in various
forms such as tariffs or quotas, primarily to save local industries from foreign
competition as a temporary measure or to impose sanctions on a trading
partner.
Tariffs cause the imported goods/services to be artificially expensive as
compared to the domestically produced goods. Similarly subsidies can be
provided to the local manufacturers which artificially make local
goods/services cheaper as compared to the foreign counterparts.
 

Macroeconomic policy
The macroeconomic policy of a nation is implemented with two
levers: fiscal and monetary.
 The money supply in the economy can be altered through several means
by the central bank. The usual action is to increase the money supply by
offering bonds which lowers interest rates, or selling bonds to take some
money out of circulation. Inflation is another beast that has to be tamed
while ensuring a steady and high growth rate in the economy.
When the interest rates are already near zero, the conventional approaches
do not work. Quantitative easing is an unconventional technique which
was adopted by the US Federal Reserve to stimulate the economy which
was in doldrums due to the worldwide financial crisis. In QE the
government purchases assets from private institutions, commercial banks
etc.,instead of the usual government bonds.
 Fiscal policy involves governments’ lawful tinkering of balance sheets,
i.e. decisions related to changes in revenue and expenditure to take hold of
the overall economy. Let us take the case of a nation which is currently in a
state of recession. If the tax rates are lowered, people have more
disposable income which will fuel the economic activity. Another way is to
increase spending, say by initiating an infrastructure project. This will
create jobs, lowers the unemployment rate and boosts consumer spending
which will be a positive stimulus for the overall economy.
Generally, monetary intervention is preferred over fiscal as the average lag in
the case of implementing monetary policies is far lesser than fiscal; a central
bank is involved for implementing monetary policies which is usually a strong
non-political institution.
 

Macroeconomic schools of thought

 Classical economics is a school of thought that’s generally regarded as the
first school of economic thought and is widely associated with Adam
Smith, the father of modern economics. The central idea behind the
ideology is that markets work best when they are left alone and role of the
government be as minimal as possible. The ‘invisible hand’ in the free
 markets automatically assigns resources to places where they are best
utilized.
 Neo-classical economics is hinged on the premise of rationality in
behavior, and that the consumers are looking for maximum “utility” and
the firms are looking for maximum profits. This fundamental conflict gives
rise to the current demand and supply theory.
 Keynesian economics derives its roots from the ideas of the British
economist John Maynard Keynes (widely regarded as the most important
economist of the 20th century). It is a theory which relies on government
intervention to manipulate aggregate demand through changes in fiscal
policy.It also posits that free markets rarely move towards full-
employment equilibrium.
 Monetarist economics is a school of thought largely attributed to the
contributions of Milton Friedman. The central belief is: The role of the
government is to control inflation through manipulating money supply.
They believe that attempts to manage demand in an artificial way (the
Keynesian way) can be destabilizing to the overall economy and can lead to
inflation.
 
Through tracking major macro-economic indicators, an investor can expect to
make better investing decisions, a salaried individual can plan
savings/investments in a better way and a businessmen can take more
informed decisions about raw materials or labor.
The knowledge of macroeconomics is an important tool in the arsenal of every
individual, and the future might lie dormant in the government’s stance on a
few key policies.
 

Game Theory in Economics

As an introduction to Game Theory, an important concept in Economics, let’s
take an example.
Put yourself in the shoes of Walter White from Breaking Bad (a professor-
turned-drug-lord) and you have an accomplice (Jesse!) in your sweet little
crime.
You are under investigation by the DEA (Drug Enforcement Administration)
after they managed to trace the whole gamut of illegal activities you were
involved in over the period of last two years. But they have insufficient proof
and hence they require a testimony from either of you to go ahead with the
prosecution.
Both of you are interrogated separately and do not come in any kind of contact
whatsoever. You don’t want to end up rotting in jail, obviously. Now here are
the rules of the game decided behind your back:
 

1. If you plead not guilty and Jesse confesses (defects), Jesse will be

released and you might have to stay in the jail for twenty years.
2. Similarly, if Jesse pleads not guilty and you confess, you will be released
and Jesse might have to stay in the jail for twenty years.
3. If nobody makes any implications and hold their ground (i.e. both co-
operate), both might receive the maximum sentence of six months (good!)
4. If both of you decide to plead guilty and implicate the other (i.e. both
defect), both will receive a sentence of eight years (not so good).
The complicated situation cited above is an example of a game analyzed in
game theory, called the prisoner’s dilemma.
 
What is Game Theory?
Game theory attempts to take into consideration the interactions between the
participants and their behavior to study the strategic decision-making between
rational individuals. It tries to find out the actions that a “player” should
perform which would maximize his chances of success mathematically and
logically.
Actions by everyone involved directly alter dynamics of the game, and hence
the players are all interdependent. The games can be broadly classified into
two categories: zero-sum and non-zero-sum. In zero-sum games, the loss of one
is gain of another. It is not the case in non-zero-sum games, there can be a net
gain or net loss.
‘Game’ is defined in a way that ensures feedback from the surroundings — if
you are preparing for a stellar MBA interview, the response from the
AdComs should be factored into your preparations. There might be chances of
both cooperation and conflict! Another important feature is — you will learn
from the experience and modify your strategy accordingly for the next one.
John von Neumann is the pioneer of the field of game theory. It is distantly
related to the rational-agent model in traditional Economics and gave an
impetus to Bernoulli’s theory of utility. There are two main branches of game
theory: cooperative and non-cooperative.
As the name suggests, in the cooperative branch a coalition is present between
players and the competition is between coalitions of players. Non-cooperative
branch of game theory deals with purely rational (and selfish) behavior, in an
effort to achieve one’s goals.
 
The ‘Nash Equilibrium’
The famous mathematician John Nash showed the following: in non-
cooperative games there exists an equilibrium at which no side has any
rational incentive to change the chosen strategy even after running through all
the choices available to the opponent(s).
The movie ‘A Beautiful Mind’ is based on his life and if the movie is to believed
— the insight for game theory struck him when he observed that all his friends
hit on the most pretty girl around, and he decided that he should hit on the
second or the third prettiest to improve his chances (also to the benefit of
everyone involved). A less pretty girl is indeed better than no girl at all!
[Please note how all the boys will automatically gravitate towards girls
according to their own ‘social order’, and also the side-fact that they have no
incentive to change their strategy after knowing what their ‘competitors’
planned to do. An efficient and elegant solution indeed!]
By mathematically proving that an equilibrium point exists, John Nash
showed that important economic, political or social interactions can be hinged
on desirable outcomes without the need for any contracts.
 
Examples of Game Theory
There are multiple real-life examples for understanding the basic concept of
game theory. Let us take up a simple one: Apple and Samsung involved in a
‘game of advertising’. As both firms have a stable market reputation, the
advertising costs are a direct drain on the net corporate profits.
If both do not advertise, their profits will remain the same (with many
simplistic assumptions, including that there are no other competitors).
But advertising budgets are assigned in both the firms so that they do not lose
market share to the competitor (spending on advertising is a good strategy for
both irrespective of the decision taken by the competitor).
The same analogy can be comfortably replicated for the US-USSR cold war, in
which both the nations seemed to be hell bent on adding more nukes in their
arsenal.
Another common example that we see in everyday life is related to public
goods: if all the residents of a society decide to become good citizens and
decide not to throw trash in the open— the society benefits as a whole (even the
property rates might go up!).
But an individual might behave in a rogue way (selfish?) by throwing trash in
the open— the cost of cleaning is borne by the whole society. This also extends
to the free-rider problem and tragedy of commons.
 
Game theory has a variety of applications in diverse fields — economics,
business, political science, biology, computer science and even philosophy. It
has helped and is currently helping strategists of every kind all over the world
to better design their environments, to suit their overall needs.
We are constantly ‘in the game’ — our life is impacted by the actions and
decisions made by others. And here is a thought that might as well be the
ultimate philosophical rhetoric originating from game theory: “We can create
a better world by becoming better human beings ourselves”.
 
KEYNESIAN PSYCHOLOGICAL LAW OF CONSUMPT ION - LAW
Keynes introduced the law of consumption which is popularly known as the Keynesian Law of Consumption.
According to the law, As income increases consumption also increases but at a lesser rate than the increase in
income.
With minimum income we fulfill our basic needs however even with zero income our basic necessities are
fulfilled either by
borrowing or using our saving, this consumption is called Autonomous consumption.
When the income of a person increases, consumption also increases but at a lesser rate and a part of the income
is saved.
So simply as income increases rate of saving increases.
Let us understand this with an example:
Aggregate income (Y)Consumption (C)Saving (S) Y-C
0 500 -
1000 1300 - 300
2000 2000 0
3000 2600 400
4000 3400 600
5000 4100 900
In the above example we see that at 0 income there is some level of consumption (Autonomous consumption)
however
savings are negative.
As income increases to 1000, consumption increases but savings are negative.
At further increase in income consumption and income are equal and there is no saving.
However we see that as income increases by (1000 at every stage) consumption increases but less than the
increase in
income and savings also increases.
Initially there is negative savings but as income increases, savings also increases.
T he two important properties of this law is that:
As income increases consumption increases but at a lesser rate than increase in income.
As income increases savings increase and an increasing rate.