Business Economics - SUCM103

SUCM103 / SUBT103 /
SUCC103
UNDERGRADUATE COURSE
B.Com.,
FIRST YEAR
FIRST SEMESTER
ALLIED PAPER - I
BUSINESS ECONOMICS
INSTITUTE OF DISTANCE EDUCATION

UNIVERSITY OF MADRAS
B.Com., ALLIED PAPER - I
FIRST YEAR - FIRST SEMESTER BUSINESS ECONOMICS
WELCOME
Warm Greetings.
It is with a great pleasure to welcome you as a student of Institute of Distance

Education, University of Madras. It is a proud moment for the Institute of Distance education
as you are entering into a cafeteria system of learning process as envisaged by the University
Grants Commission. Yes, we have framed and introduced Choice Based Credit
System(CBCS) in Semester pattern from the academic year 2018-19. You are free to
choose courses, as per the Regulations, to attain the target of total number of credits set
for each course and also each degree programme. What is a credit? To earn one credit in
a semester you have to spend 30 hours of learning process. Each course has a weightage
in terms of credits. Credits are assigned by taking into account of its level of subject content.
For instance, if one particular course or paper has 4 credits then you have to spend 120
hours of self-learning in a semester. You are advised to plan the strategy to devote hours of
self-study in the learning process. You will be assessed periodically by means of tests,
assignments and quizzes either in class room or laboratory or field work. In the case of PG
(UG), Continuous Internal Assessment for 20(25) percentage and End Semester University
Examination for 80 (75) percentage of the maximum score for a course / paper. The theory
paper in the end semester examination will bring out your various skills: namely basic
knowledge about subject, memory recall, application, analysis, comprehension and
descriptive writing. We will always have in mind while training you in conducting experiments,
analyzing the performance during laboratory work, and observing the outcomes to bring
out the truth from the experiment, and we measure these skills in the end semester
examination. You will be guided by well experienced faculty.
I invite you to join the CBCS in Semester System to gain rich knowledge leisurely at
your will and wish. Choose the right courses at right times so as to erect your flag of
success. We always encourage and enlighten to excel and empower. We are the cross
bearers to make you a torch bearer to have a bright future.
With best wishes from mind and heart,
DIRECTOR
(i)
B.Com., ALLIED PAPER - I
FIRST YEAR - FIRST SEMESTER BUSINESS ECONOMICS
COURSE WRITER AND EDITING
Dr. R. Rajkumar
Former Professor of Economics
Institute of Distance Education
University of Madras,
Chennai - 600 005.
Dr. S. Thenmozhi
Associate Professor
Department of Psychology
Institute of Distance Education
University of Madras
Chepauk Chennnai - 600 005.
© UNIVERSITY OF MADRAS, CHENNAI 600 005.
(ii)
B.Com.,
FIRST YEAR
FIRST SEMESTER
Allied Paper - I
BUSINESS ECONOMICS
SYLLABUS
UNIT 1
Introduction to Economics – Wealth, Welfare and Scarcity Views on Economics – Positive
and Normative Economics -Definition – Scope and Importance of Business Economics
Concepts: Production Possibility frontiers – Opportunity Cost – Accounting Profit and
Economic Profit – Incremental and Marginal Concepts – Time and Discounting Principles
– Concept of Efficiency
UNIT II
Demand and Supply Functions - Meaning of Demand – Determinants and Distinctions of
demand – Law of Demand – Elasticity of Demand – Demand Forecasting – Supply concept
and Equilibrium
UNIT III
Consumer Behaviour: Law of Diminishing Marginal utility – Equimarginal Utility – Indifference
Curve – Definition, Properties and equilibrium
UNIT IV
Production: Law of Variable Proportion – Laws of Returns to Scale – Producer’s equilibrium
– Economies of Scale - Cost Classification – Break Even Analysis
UNIT V
Product Pricing: Price and Output Determination under Perfect Competition, Monopoly –
Discrimination monopoly – Monopolistic Competition – Oligopoly – Pricing objectives and
ethods
(iii)
Recommended Texts
1. S.Shankaran, Business Economics - Margham Publications - Ch -17

2. P.L. Mehta, Managerial Economics – Analysis Problems & Cases - Sultan Chand &
Sons - New Delhi – 02.
3. Francis Cherunilam, Business Environment - Himalaya Publishing House -Mumbai
– 04.
4. Peter Mitchelson and Andrew Mann, Economics for Business - Thomas Nelson
Australia - Can -004603454.
5. C.M.Chaudhary, Business Economics - RBSA Publishers - Jaipur - 03.
6. H.L. Ahuja, Business Economics – Micro & Macro - Sultan Chand & Sons - New
Delhi – 55.
B.Com.,
FIRST YEAR
FIRST SEMESTER
Allied Paper - I
BUSINESS ECONOMICS
SCHEME OF LESSONS
Sl.No. Title Page
1 Introduction to Economics 1
2 Nature, Scope and Importance of Business Economics 20
3 Business Concepts 30
4 Demand Functions 39
5 Supply Functions 57
6 Consumer Behaviour 65
7 Production 98
8 Cost Analysis 126
9 Product Pricing & Market Structure 139
10 Canons of Taxation 171
(iv)
1
LESSON -1
INTRODUCTION TO ECONOMICS
Learning Objectives
· After having read this lesson, you will be able to
· Define the subject matter in Economics
· Understand the various aspects dealt in definitions
· Know the basic concepts used and recognize the use of economic concepts in
businesses.
UNIT STRUCTURE
1.1 Introduction
1.2 Definition of Economics
1.2.1 Wealth Definition
1.2.2 Welfare Definition
1.2.3. Scarcity Definition
1.2.4 Growth-Oriented Definitions
1.3 Positive and Normative Economics
1.4 Summary
1.5 Key Words
1.6 Check Your Progress
1.7 Reference Books
1.1 Introduction
Economics is the study of how economic agents or societies choose to use scarce
productive resources that have attractive uses to satisfy wants which are unlimited and of varying
degrees of importance.
The main concern of economics is economic problem: its identification, description,

explanation and solution, if possible. The source of any economic problem is scarcity. Scarcity
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of resources forces economic agents to choose among alternatives. Therefore, economic

problem can be said to be a problem of choice and valuation of alternatives. The problem of
choice arises because limited resources with alternative uses are to be utilized to satisfy unlimited
wants, which are of varying degrees of importance. The resources like human, natural, capital,
etc. not been scare, there would have been no problem of choice and hence no economic
problem at all. Therefore, the root cause of all economic problems is scarcity.
Scarcity is a relative concept. It can be defined as excess demand. (i.e), demand more
than the supply. For example, unemployment is essentially the scarcity of jobs. Inflation is
essentially scarcity of goods.
Economics assumes rationality on the part of its subjects like consumer, producer and
seller. Rationality implies acting objectively, keeping in view the ends and means, the objectives
and constraints.
1.2 Definition of Economics

A Adam Smith’s “Wealth definition”
B. Marshall’s “Welfare definition”
C. Lionel Robbin’s “Scarcity definition”
D. Samuelson’s “Growth-oriented definition”.
1.2.1 Wealth definition
Adam Smith, the founder of the classical school of economics, in his famous book ‘An
Inquiry into the Nature and Causes of wealth of Nations’ in the year 1776, defined economics
as “the science of wealth”. This means that economics studies wealth. It deals with the acquisition,
accumulation and expenditure of wealth. It examines how people earn wealth and spend wealth.
According to Adam Smith, economics is concerned with “an inquiry into the nature and
causes of wealth of nations” and it is related to the laws of production, exchange, distribution
and consumption.
N.W. Senior observed that “the subject treated by political economy is not happiness but
wealth”.
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J.S. Mill defined Economics as “the practical science of production and distribution of
wealth”.
J.B. Say defined Economics as “political economy makes known the nature of wealth’
Prof. Waller has said, “Economics is that body of knowledge which relates to wealth”
These definitions have, thus, made wealth as the subject matter and the central point of
economics. To them, the only important thing was wealth. Thus, they used the word wealth in a
narrow sense. It is for this reason, the definition is called wealth definition.
Features of wealth Definition : The main features of Adam Smith’s definition are us under:
1. Study of wealth: According to wealth definitions given by various Economists,

Economics is the study of wealth only. Therefore, it deals with the activities of man
related to production, consumption, exchange and distribution.
2. Only material commodities: This definition conveys the feeling that economics
constitutes only material commodities while it ignores non-material good as air and
water.
3. Causes of wealth: Economics is considered as study of causes of wealth

accumulation which brings economic development. In order to increase wealth,
production of material goods will have to be increased.
4. Much stress on wealth: The main aim of the political economy is to increase the
riches of the economy. Thus, it gives more stress to wealth accumulation.
5. Economic man: These definitions are basically based on the individual who is
always aware of his ‘self-interest’. Self interest leads to material gains. Therefore,
such a creature is called Economic Man.
Merits
I. The merits of the definition is that it separates economics from politics and thereby
makes it an independent subject and science. Earlier economics was called only
Political Economy which made no distinction between Economics and Politics. The
Credit of making Economics a separate subject and a science goes to Adam Smith.
For this reason he is rightly called the father of Economics”.
II. Wealth definition seeks to examine the causes which lead to increase wealth.
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III. Wealth definition is used to signify the material goods which are scarce.
IV. This definition has a clear cut idea of economic man who is fully aware of his self
interest and makes efforts to achieve his needs to the maximum.
Criticism
The wealth definition is not free from defects. The economists like Carlyle and Maurice
Ruskin called it useless science. Some others called it is a dismal science. Thus, this definition
has been criticized on the following grounds.
1. Totally materialistic definition: This definition explains that wealth is the sole end
of all human beings, but in reality wealth is not an end in itself. It is only mean and
that too one of the many means for mans happiness and welfare contrary to this the
definition goes to the extent of preaching the worship of Mannon the God of wealth
at the cost of all spiritual values.
2. Only a mean science: The definition makes wealth as the only subject matter of
economics. It would become a sordid and mean science. That is why Ruskin Carlyle
criticized “Economics as a dark and dismal science”.
3. Ambiguous: The term wealth which forms the subject matter of economics is
ambiguous as the meaning of the term is not very clear. In old days wealth means
only material goods like money, gold, silver, land, cattle etc., which are visible. It
ignores non-material goods such as services of doctors, teachers and artists in the
category of wealth. The immaterial goods are as good a wealth as material goods.
4. Narrow view: The definition places wealth in the forefront and means in the
background ignoring the most fundamental aspect of economics viz. welfare. The
definition is, therefore, incomplete as it takes into account wealth for study and
omits man and welfare from the preview of economics.
5. Concept of economic man: Adam Smith’s wealth definition is based on the concept
of economic man. Marshall and Pigou believed that economic man who works or
selfish ends alone is not found in real life. In real practice, man’s activities are not
only influenced by selfish motives but also by moral, social and religious factors.
Thus, economics studies a common man not an economic man.
6. It ignores the problem of scarcity and choice: The definition has ignored the
study of economic activities namely scarcity choice. In fact, economic activities
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take place because not of goods and services satisfying human wants which are
scarce but they have several uses. This gives s birth to the question of choice. In
this way, this definition neglects both aspects.
7. Secondary place to man: This gives under stress on wealth while secondary place
has been given to human beings. Wealth does not remain a social science.
8. Static: According to some critics wealth definition is static which is based on deductive
method”.
1.2.2 Welfare Definition
Welfare definition of economics was first of all propounded by Alfred Marshall and supported
by A.C. Pigou and Cannon. Marshall, in his book, “Principles of Economics”, defined “Economics
is a study of man in the ordinary business of life, it examine that part of individual and social
action which is most closely connected with the attainment and with the use of material requisites
of well-being. Thus, it is on one side a study of wealth; on the other and more important side a
part of the study of man”.
This definition implies three important aspects. Economics is a study of mankind in the
ordinary business of life, (b) It examines the economic aspect of an individual and his social
actions. (c) The attainment of material welfare as the end of economics. Let us explain each
aspect in detail.
a) Study of Ordinary Business of Life
Ordinary business of life means earning a living. It consists in earning material means
and using it for the satisfaction of the most common human wants of food, clothing and shelter.
This ordinary business of life is something fundamental and common to mankind In other words,
it is fundamental and the primary concern of everybody. Even the saints and philosophies who
stand for noble ideals can first for their bread and butter be one the pursuit of their philosophy.
Thus, it includes the income earning and income spending activities of all human beings.
b) Study of Individual and Social Action
Economics examines the individual and social actions of the people that are conducive to
material welfare only. This means that Economics will study only those actions that promote
welfare. There may be other activities that do not promote welfare. These may be other activities
such as political, religious, social and cultural, which do not come under that preview. In this
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way, Marshall restricts the scope to these economic activities which are measurable with monetary
standards.
c) Only Welfare Aspect
In explaining the subject matter of Economics, Marshall has shifted the emphasis from
wealth to the welfare. Wealth as he says, is only a means for the attainment of material welfare.
So he gave primary importance to man and welfare and secondary place to wealth. Thus, the
study is confined to acquisition of wealth as well as to promote human welfare.
From the above discussion it is clear that Marshall has made material welfare as the
subject matter of economics. This is well supported by Prof. Pigou, who observed “the range of
our enquiry becomes restricted to that part of social welfare that can be brought directly or
indirectly into relation with measuring rod of money”. Similarly Prof. Cannon says, “the aim of
political economy is the explanation of the general causes on which the material welfare of
human beings depends”. According to Renson, “economics is the science of material welfare”.
Thus Marshall has made economics the science of welfare.
Features of Welfare Definition
The main features of material welfare definition are as follows
I. Study of mankind: Economics is the study of mankind than wealth. Wealth is only
a mean to satisfy human wants.
II. Study of ordinary mans: It studies the activities of a man who earns wealth and
spends it to get the maximum satisfaction. Thus, it studies an ordinary and not
extra-ordinary man like sadhus.
III. Study of real man: Economics does not study a man who is selfish but studies a
real man who possesses several qualities and is influenced by economic and non-
economic factors in society.
IV. Study of industrial man: Economics studies the individual and social man who is
always concerned with material gains.
V. Promotion of welfare: It studies the material means which promote human welfare.
VI. Study of Science and Art: Material definition deals with economics both as a
science and an art
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VII. Use of money: This definition considers material or economic welfare as a

part c social welfare which can be easily measured with the measuring rod
of money.
Merits
The proponents of welfare economics, favoured Marshall’s welfare definition, pointing

out the following merits:-
I. It deals with welfare: Welfare definition completes Adam Smith’s wealth definition
by adding man and welfare to wealth as the subject matter of economics.
II. Study of social science: This definition has dearly mentioned economics as a
social Science. It is not a pure science bit one among the social sciences.
III. Proper relationship of welfare and wealth: Marshall defines economics as a

noble science. In the hands of Adam Smith, economics has science of wealth
remained only a dismal science. But Marshall explained the proper relation between
wealth and welfare.
IV. Classification of activities: The definition makes economics not only a science
but also a social and Normative science. This definition clearly classifies economic
activities.
V. More scientific: This definition clearly classifies economic activities into two parts,
as material welfare and non-material welfare. Thus, it is more scientific,
Criticism
Marshall’s welfare definition, no doubt, is superior to Adam Smith’s wealth definition Prof.
Lionel Robbins attached Marshall’s welfare definition on the following grounds
I. Impracticable: In his discussion, Marshall classifies the action into those which are
not conducive to material welfare. In other words, he divides the activities into
economic and non-economic. But such a classification is not sound because all
activities in one way or the other are economic. Prof. Robbins considers the distinction
in economic and non-economic as invalid.
II. Unscientific: According to Prof. Robbins, this definition is unscientific. Marshall

explains one kind of behaviour as district from another in a haphazard manner. This
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makes the subject matter highly variable, indefinite and uncertain. Further the lack
of analytical study renders the definition throughly unscientific.
III. Term welfare is very vague: Generally by welfare, people refer to the National
happiness. But in reality welfare is a mental make-up of a person which depends
much upon his psychological feelings. Thus, it is highly subjective. It cannot be
defined measured and compared at all.
IV. Only materialist aspect: According to Marshall welfare is attainable only by material
means. But Robbins observes that it is not proper to say that material means alone
promote welfare because the services of doctors, teachers, lawyers domestic
servants etc., also do promote welfare. These services have nothing material in
them So, they may be called immaterial welfare.
V. Uncertain concept of welfare: According to some affair, all material means do not
always promote welfare. For example, poison, poisonous goods, intoxicants etc.,
are definite material means, but they do not promote welfare. They, on the other
hand, positively are harmful to human welfare.
VI. Limited scope: Marshall narrows down the scope of economics by making it a
more study of material means of welfare. If economists were to study the material
means of welfare to the exclusion of non-material means, economics would definitely
become narrow in its scope.
VII. Economics is not concerned with ends: Assuming economics as a normative

science, Marshall made welfare as the end of economics. This implies that economics
is concerned with ends and as such it makes judgement whether an end is noble or
ignoble, desirable or undesirable and so on.
VIII. No proper explanation: This definition fails to explain the main economic problem
of how to satisfy the unlimited wants with limited means which have alternative
uses.
IX. Only social science: As a social science economics studies all the individuals,
who are the members of the society. Strictly speaking economics, should be
considered more as a human science than as a social science.
X. No analytical: This definition has only made classification by dividing human activities
like material, non-material, economic and non-economic. This base is unscientific
and narrow. In short, Marshall failed to give an analytical definition of economics.
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XI. Impractical: This definition is of a theoretical nature, ignoring the practical aspect
of human like. In real lifts there is no distinction between economic and non-economic
activities.
Comparison between Adam Smith and Marshall’s Definition
There are some dis-similarities between the definitions given by Adam Smith and Marshall.
Dissimilarities
1. Adam Smith’s definition is the study of economic man while Marshall sources on
the study of a real man.
2. The main stress has been given by Adam Smith on wealth and Marshall followed
about human welfare.
3. In Marshall’s definition, man is more significant while in Adam Smith’s view, it is

wealth as means and human welfare as an end.
4. According to Adam Smith’s wealth is both mean and end while Marshall considered
wealth as means and human welfare as an end.
5. Adam Smith has laid much emphasis on production of wealth while Marshall has
given stress on the consumption of wealth.
1.2.3 Scarcity Definition
Challenging Marshall’s welfare definition, Lionel Robbins formulated a new definition in

his book, ‘Essay on the Nature and Significance of Economic Science’, published in the year
1923.
Robbins defined economics as follows, “Economics is a science which studies human

behaviour as a relationship between ends and scarce means which have alternative uses”.
In the words of stories and Hague “Economics is fundamentally a study of scarcity and
the problems which scarcity give rise”.
According to Scitovosky, “Economics is a science concerned with the administration of

scarce resources”.
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Features of Scarcity Definition
Prof. Robbins definition has the following main features:
I. Multiplicity of ends of unlimited wants: By ends, Prof. Robbbins means human

wants. These human wants are various and numerous. When one want is satisfied,
another want crops up in place and so on in endless succession. They grow in
number with an advancement of cirilisation and material progress. Since human
wants are unlimited, man is compelled to select the most urgent wants for immediate
satisfaction.
II. Scarcity of means: Human wants are unlimited and means to satisfy them are
limited. The means refer to goods and services which we use to satisfy our wants.
They are the material and non-material goods like time, money, services, resources,
etc., that are at our disposal. These means are scarce if these means are abundant
like free goods, there would be then no economic problem. But they are scarce and
one is forced to postpone some of one’s wants. Here we must remember the term
scarcity is used not in the absolute sense but in the relative sense (i.e) in relation to
demand. A commodity may be available in small quantity but if nobody demands,
then it is not scarce. It is therefore, the scarcity of the means which is the basis for
all economic problems.
III. Alternative use of means: The scarce means are capable of alternative uses.
They can be used for several purposes. For example, land which is scarce can be
used for cultivation, house construction, playground etc. similarly all the economic
means and resources may be put to alternative uses of varying importance. In
other words, Robbins, explains any human behaviour that is concerned with utilization
of scarce means with alternative uses for the satisfaction of given ends.
IV. Economic problem: The multiplicity of wants, the scarcity of means and the
application of scarce means for the alternative uses impose an economic problem.
The problem is how to satisfy the unlimited wants with limited means which have
alternative uses. Robbins describes this problem as the problem of economizing
scarce resources. In other words, it is the choice of making of an economic activity.
Prof. Cassel says, ‘Economics is the science of scarcity.” Economics is thus a study
of certain kind of economics that is economizing the resources.
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V. Science of choice: The problem of economizing resources leads to another problem

viz., the problem of choice. Since wants are numerous and means are scarce, we
have to choose the most urgent wants from the numerous, dropping of course,
other wants which we can satisfy later and choose some of the means from scarce
ones to satisfy the selected wants. In a sense the scarcity of means makes the
choice necessary That is why Economics is described as a ‘Science of choice”.
Superiority / Merits of the Definition
Robbins definition is superior to welfare definition on the basis of the following arguments.
1. More scientific than Marshall’s welfare definition: Since Marshall explains are
kind of behaviour as distinct from another in economics, so his definition is criticized
as unscientific. But the scarcity definition analyzing human behaviour explains any
behaviour under one aspect. In this way, definition is more scientific.
2. Scarcity definition is more wider: Marshall in his definition limits the scope of
economics to the material means of welfare. But Robbins on the other hand by
studying any behaviour connected with the problem of scarcity widens the scope of
economics from the boundaries of National welfare.
3. Free from all confusion: As Marshall claims, economics will involve value judgment.
This will lead to difference of opinions and endless controversy among economists.
‘Economics then would become indefinite and fecitless. But when economics is
natural between ends it becomes from all these controversies and confusion.
4. Universal: Robbins definition is considered universal. It is applicable to all individuals,

groups and society. Moreover it deals with the problem of unlimited wants and scarce
means.
5. Study of human behaviours: This definition gives clear cut view of human
behaviour. It studies the human behaviors of an individual as well as of a society.
6. More logical explanation of economic problem: Robbins definition is more logical

in explaining the economic problem. According to this, economic problem arises
due to scarcity of means in relation to their demand. It is not concerned with material
well beings.
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Criticism
Though scarcity definition is more scientific than welfare definition, it has its own limitations.
Robbin’s definition has the following drawbacks.
1. Robbin’s definition is too wide: It does not confine the scope of economics either
to the study of wealth or welfare. It extends the scope of economics to all activities
of mankind that are related to the problem of choice. The problem of choice as such
is found not only with social beings but also with non-social beings like sadhus. So,
their problem of choice has neither the social significance nor social implications.
2. Scarcity definition makes economics meaningless: If economics is neutral

between ends, as Lionel Robbins claims economics becomes a more theoretical
science or a more value theory.
3. It is colourless and Important: Robbin’s definition makes human and realistic

tough which characterize as Marshall’s welfare definition. Explaining economics as
neutral ends, Robbin makes economics a pure science devoid or all humanism.
4. Only abstract: when economics is not concerned with ends, economics becomes
both theoretical abstract.
5. Economic problem not always arises from scarcity: Some critics of the opinion
that economic problem also arises from the abundance of goods as well for example,
during the great depression of 1930’s it was not the scarcity but abundance of
goods in U.S.A that created the economic problem to the world.
6. Link with welfare: Prof. Robbins criticized Marshall’s definition based on welfare.
Limited means are generally used to satisfy unlimited wants. Evidently it means
maximizing satisfaction which leads to more welfare. Thus Robbins definition has
indirect link with welfare of the individual or society.
7. Impractical: Following Robbins version, economics becomes merely an intellectual

exercise. But in practical life, man is always interested to solve many problems. In
this way, Robbins definition is a departure from reality.
8. Not applicable to rich counties: It is also argued that Robbins definitions is not
applicable in highly rich countries who have plentiful resources. In other words,
there is no scarcity of resources.
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9. Inapplicable in Socialist countries: Prof. Maurice has criticized Robbin’s definition

on the ground that in socialist countries, this definition is not applicable. In socialist
set up, Government is responsible for providing basic necessities to do people.
10. Confusion: Robbins failed to make a clear cut difference between ends and means.
In a sense, ends become means for satisfying some other ends in the later stage.
For example, production of steel is an end for a steel mill while it is a mean for
building railway lines or bridges. Therefore, this view point is totally confusing and
complex.
11. Static definition: According to some critics, Robbins definition is static as he studies
present means. He, on the other hand, forgets the future where both ends and
means are subject to change. Thus, Robbins ignores growth economics properly.
12. Only deductive method: Prof. Robbins used the deductive method to study and
not relies on inductive and historical methods which are more scientific.
Comparison between Marshall’s and Robbins Definition
After making a detailed analysis of Marshal and Robbins definitions, let us make a
comparative study stating the similar points as well as different points of both.
Similarities:- Similarities between both definitions are described as under;
1. Main focus on man: Marshall and Robbins have given main focus on the study of
man. Marshall says that it is on the one side a study of wealth and on the other, it is
more important study of a man. Similarly Robbins studied human behaviour as a
relationship between ends and scarce means which have alternative use. Thus,
both these definitions focuses on the study of a man.
2. Rational behaviour of the man: Both definitions are based on the assumption of
rational behaviour of the man. Marshall assumed that the man always aims at
maximizing his welfare while Robbins is of the opinion that rational man tries to
maximise his satisfaction.
3. Wealth and Scarce means: Marshall considered wealth as material welfare whereas
Robbins used scarce means in place of wealth. However, both the words convey
the same meaning. So both definitions are similar from this point of view.
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4. Normative and Positive science: Marshall considers economics as normative

science and Robbins gives it the name of positive science. Thus, one thing is there,
both economists consider economics as a science.
Dis-Similarities:- The main point of difference in both definitions are given as under:
1. Distinction between Social and Human science: In the opinion of Marshall,

economics is a science which studies normal social human beings. But according
to Robbins, it is a human science aiming at the economic activities of all men (i.e.),
ordinary or extra-ordinary. Every man faces economic problems.
2. Difference between Economic and Non-Economic activities: According to

Marshall’s view, economic activities are those which are related to material goods
and those promoting welfare are economic activities. Robbins, on the other hand is
of the view that all human activities are economic activities where there is a problem
of choice (alternative) as source means are limited. In this way, Robbin’s definition
is more wider in scope as it includes all material and non-material goods in economic
activities.
3. Normative and Positive science: Marshall clearly states that economics is a

normative science as it values the welfare of human beings. But to Robbins
economics is appositive science. He remarked that the function of an economist is
to explore and explain not to advocate and condemn. In this way, there is a sharp
difference in two opinions.
4. Classificatory and Analytical: According to Marshall, human activities can be

classified into ordinary special; material non material and welfare– non –welfare.
But Robbins consider it analytical as it deals with analyzing why does economic
problem rise? In this regard, Robbins definition is certainly superior to Marshall’s.
5. Economic welfare: Marshall hold the view that economic welfare may be increased
in the society but according to Robbins, economics has nothing to do with welfare.
Therefore, former definition has the human touch.
6. Practical and Theoretical: Marshall’s definition is more real and faithful for making
economic policies while in contrast, Robbins is more technical and of an abstract
nature.
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7. Nature of applicability: Marshall’s definition is relevant is capitalist monetary

economy where individual choice is free and market-oriented. On the contrary,
Robbins definition is applicable to all types of economics whether primitive or
moderate or advanced.
1.2.4 Growth - Oriented Definitions
Modem economist have also defined the concept of economists as follows:-
According to Prof. Samuelson, ‘Economics is the study of how people and society and
choosing with or without the use of money, to empty scarce productive resources that could
have alternative uses to produce various commodities overtime and distributing them far
consumption now or in the future, among various persons and groups in society. It analyses
costs and benefits of improving patterns of resource allocation”.
C.E. Ferguson has defined economics, “Economics is a study of the economic allocation
of scarce physical and human means among competing ends, an allocation that achieves a
stipulated optimizing or maximizing objective.
According to Benham, “Economics is the study of the factors affecting employment and
standard of living”.
Main Features:- The growth oriented definitions of economics have the under mentioned
features.
I. Economic resources: These definitions deal with the economic resources which
are natural, human or physical. They are used to satisfy human wants. They are
scarce but have alternative uses.
II. Efficient allocation of resources: As the resources have alternative uses, the
main problem lies in choice making. Thus resources should be efficiently utilized for
maximum welfare.
III. Full utilization of resources: This definition does not acknowledge only allocation
of resources but they must also be fully utilized.
IV. Increase in productivity: Anther feature of this definition is that it must increase
productivity resulting in an increase in economic growth, employment and higher
standard of living.
16
Merits of Growth Oriented Definition

I. Realistic explanation of economic problems: The growth oriented definitions
provide realistic explanation of economic problems. Economic problems arise
because wants (ends) are unlimited but means to satisfy them are not only scarce,
but have alternative uses also. This gives rise to the problem of choice-making (i.e).
efficient allocation of scarce resources which accelerates the rate of economic
growth. Thus, these definitions offer realistic explanation to economic problems.
II. Science and Art: According to Samuelson, economics is oldest among arts and
newest among the groups of sciences. In fact, it is the Queen of social sciences.
These definitions corner with the statement that economics studies both its theoretical
and practical aspects.
III. Not neutral as regards ends: Economic welfare forms part of the study of
economics according to these definitions. Economic welfare is that part of general
welfare which is measured in terms of money. Economics studies both material and
non-material means of economic welfare. These definitions are therefore wider in
scope than the definition of Marshall and Robbins.
IV. Practical: These definitions have made economics more practical. Economics does
not analyse economic problems only rather it suggests measures to solve them.
Thus, these definitions are more practical.
V. Dynamic: These definitions have imparted dynamism to economics. Study of

economics is not restricted to the present day problems relating to the consumption,
production, distribution etc. but it studies their future problems as well. Economics,
therefore, is concerned with the dynamic aspect of economic development.
VI. Universal: Growth oriented definitions are universal. These are concerned with the
economic problems of all types of economics, developed or under-developed. In
developed economics the problem is to maintain full employment. On the other
hand, in under-developed economies the problem is to achieve the level of full
employment and raise the standard of living of the people. Economics is thus
concerned with all these issues which makes it universal.
VII. Study of economic quantities: Prof. Boulding hold the view that growth oriented
definitions makes a study of the forces determining the quantities and their mutual
relations. On this ground, these definitions are called more scientific and definite.
17
In short, growth oriented definitions are superior to earlier definitions of economics. Besides,
these definitions includes all merits of Marshall and Robbins definitions. Thus, these definitions
are logical, dynamic and practical
Which Definition is the best?
Different economists have given different definitions of economics. Boulding is of the

opinion that any single concise definition of economics will be inadequate of course, to define,
it is a study of mankind in the ordinary business of life is to give a very wide definition. To refer
it as a science of natural wealth is a very narrow view of economics. If it is defined as study of
human valuation and choice making then it will be too narrow wide definition and it is defined as
a study of that part of man’s actions which are measured in terms of money then it will be too
narrow a definition. The subjects which economics study at one time may fall outside its scope
at any other particular time. Thus, definitions of economics are liable to undergo change with
changing times and conditions. It is so because the subject matter of economics is ever changing.
So, by taking the term of wealth from Adam Smith’s definition, welfare from Marshall,
scarcity from Robbins, economic growth from Samuelson a concrete definition of economics
can be constructed as “Economics is a subject which studies those activities of man which are
concerned with maximum satisfication of wants or with the provision of welfare and economic
growth by the efficient consumption, production and exchange of scarce means having alternative
uses.
1.3 Positive and Normative Science

A positive science is concerned with “what is’ and a normative science with ‘what’ ought to
be. According to J.M.Keynes, a positive science may be defined as a body of systematised
knowledge concerning ‘what is’. A normative science is a body of systematised body of knowledge
relating to ‘what ought to be and concerned with the ideal distinguished from the actual. Keynes
further says that the object of positive science is the establishment of uniformities and the
object of normative science is the determination of ideals. In short, positive science remains
neutral between ends. But normative science discusses the end result.
According to Watson, “When it confines itself to statements about causes and their effects
and to statement of functional relation, theory is said to be positive. When, in contract, it embraces
norms and standards, mixing them with cause effect analyses theory is said to be normative”.
18
According to Milton Friedman, “Positive economies deals with how economic problem is
solved” Richard G.Lipsey, explains it as “positive statements may be simple or they may be very
complex but they are basically about what they can. Disagreements over positive statements
are appropriately handled by an appeal to the facts. Normative statements concern what ought
to be. They depend upon our judgements about what is good and what is bad; they are thus
inextricably bound up with our philosophical, cultural and religious position”.
As pointed out, the English classical school wanted to divorce economic analysis from
ethical considerations. The German historical school insists upon associating ethics with
economics.
Thus it may be said? that economics is both a positive and a normative science. It not
only tells us why certain things tends to happen: it also says whether it is the right to happen. It
not only investigates fact arid discovers truth but it also prescribes, rules of the life and passes
judgement as to what is right and what is wrong. We may thus conclude that economics is not
only a positive science but also a normative science.
1.4 Summary
The study about allocation & Resources is ordinary business of mankind is the subject
economics. it helps to know the need, taste & preference people and how society employs its
limited resources in order to satisfy their wants. The subject has great significance for
academicians, producers, consumer, price, planners, etc. The study about allocation of resources
in ordinary business of mankind is the subject economics. it helps in understanding the
functioning of an economy and formulating appropriate policies and strategies which will enhance
growth and development.
1.5 Key Words

Economics : Economics is a study of man in the ordinary business
of life, it examine that part of individual and social
action which is most closely connected with the
attainment and with the use of material requisites of
well-being.
19
Robins Scarcity : Economics is a science which studies human

behaviour as a relationship between ends and scarce
means which have alternative uses.
Positive & Normative : A positive science is concerned with “what is’ and a
Science normative science with ‘what’ ought to be. According
to J.M.Keynes, a positive science may be defined as
a body of systematised knowledge concerning ‘what
is’. A normative science is a body of systematised
body of knowledge elating to ‘what ought to be.
Economic Model : It is a mathematical or Geometrical or Logical

statement which simplifies a complicated real life
economic situation.
1.6 Check your Progress

(1) Define Economics ?
(2) Enumerate the Merits & Demerits of Welfare Definitions
(3) Compare Adam Smith's and Marshall's definition on Economics.
(4) Describe Positive and Normative Economics
1.7 Reference Books

1. M.L. Jhingan Micro Economic Theory
2. S.Sankaran Micro Economics
3. Ferguson,C.E.(1968), Micro Economic Theory, Cambridge University Press, London
4. H.L. Ahuja ( Principles of Micro Economics)

20
LESSON - 2
NATURE, SCOPE AND IMPORTANCE OF
BUSINESS ECONOMICS
Learning Objectives
To know the nature and importance of Business Economics
To understand the concepts and outcome of Business Decisions.
Scope of Business Economics
Unit Structure
2.1 Introduction of Business Economics
2.2 Definition of Business Economics
2.3 Business Decisions
2.4 Fundamental Concepts and Methods
2.5 Decision Making
2.6 Characteristics of Business Economics
2.7 Scope of Business Economics
2.7.1 Demand Analysis and Forecasting.
2.7.2 Cost and Production Analysis.
2.7.3 Pricing Decisions, Policies and Practices.
2.7.4 Profit Management.
2.7.5 Capital Management.
2.7.6 Advertising.
2.7.7 Resource Allocations.
2.8 Summary
2.9 Key words
2.10 Check your progress
2.11 Reference Books.

21
2.1 Introduction
Economics is the study of the optimal use of scarce resources to satisfy human wants.
Social economy requires that business enterprises to be well located and alert with the demands
of consumers, efficient resource allocation and so on. A good deal of economic analysis is
therefore in need to use them in the business practice.
2.2 Definition
In the words of Milton H. Spencer and Siegelman “ Business Economics ... is the integration
of economic theory with business practice for the purpose of facilitating decision-making and
forward planning by management”
According to Mcnair and Meriam, Business Economics is “the use of economic modes of
thought to analyse business situations”.
Thus, the following are the common features of Business economics:
§ It is concerned with the decision making of economic nature.
§ It is goal oriented and prescriptive.
§ It is pragmatic, as it is concerned with analytical tools, which are useful in improved

decision-making.
§ It had metrical dimension and provides necessary conceptual tools to achieve the
objectives of business.
§ It provides a link between traditional economics and the decision sciences for
managerial decision — making as shown below:
22
DECISION PROBLEM
Chart 2.1
2.3 Business Decisions

Generally ‘business decisions are classified into categories depending upon the managerial
function to which they relate. From this standpoint, we can divide the same into five parts as
given below:
I. Financial Decisions: Such decisions consist of costing, budgeting, accounting,

auditing, tax-planning, portfolio composition, capital structure, dividend distribution
and the like.
II. Production Decisions : Such decisions implies to quantity and quality of product,
choice of technology, product mix, plant location and layout, production scheduling,
maintenance, pollution control etc.
III. Personal Decisions: Such decisions may relate to recruitment, selection, induction,
training, placement, promotion, transfer, retirement or retrenchment of staff.
23
IV. Marketing Decisions: This category may relate to sales volume, sales force, sales
promotion, market research, customer service, packaging, advertisement, new
product positioning etc.
V. Miscellaneous Decisions: Such decisions includes to all residuary items like

purchasing, inventory control, information system, data processing and public
relations etc.
2.4 Fundamental Concepts and Methods

We have studied that ‘decision-making’ forms the core of Managerial economics. An
enlightened business management will take scientific decisions after thorough study of pros
and cons of a particular decision. The quality of the decision made by the management
determines the success or failure of the ventures.
2.5 Decision-making
Decision-making is the process of selecting a particular course of action from among the
various alternatives. Every Business Manager has to work on uncertainties and the future cannot
be precisely predicted by anyone. If everything could be predicted accurately, then decision-
making would become a very simple process. Because of the presence of uncertainty, the
decision maker must be very careful in choosing a particular course of action in order to realise
the objectives. The result may lead to either non-realisation of objective or complete realisation
of objective or partial realisation of objective.
The following diagram depicts the process of decision-making :

24
Chart 2.2
Now the problem is how to take decisions. Since the knowledge of the future is uncertain,
the managements have to make decisions daily and also formulate plans for the future. Is
decision-making a mere guess-work born out of experiences of the past, or is there any specific
method to be followed in order to arrive at fairly correct decision?
There are certain fundamental concepts that aid decision making in the management of
the business.
2.6 Characteristics of Business Economics

Business economics has certain characteristics which distinguish it from business
management and economics both. They are discussed below:
1. Micro in nature: Business economics is micro-economic in nature. This is due to

the study of business economics mainly at the level of the firm. Generally a business
manager is concerned with problems of his own business unit. He does not study
the economic problems of an economy as a whole.
25
2. Basis of theory of markets and private enterprises: Business economics largely

uses the theory of markets and private enterprise. It uses the theory of the firm and
resource allocation of private enterprise economy.
3. Pragmatic in approach: Business economics is pragmatic in its approach. It does

not involve itself with the theoretical controversies. Yet it does not relegate the realities
of business decision-making to the background by bringing in abstract assumptions.
While economic theory abstracts from realities of the individual business units to
build up its theories. Managerial economic takes proper note of the particular
economic environment in which a firm works.
4. Normative in nature: Business economics is also called normative economics

which prescribes standards or norms for policy making. Business economics is
prescriptive rather than descriptive in nature.
In economic theory, we try to explain economic behaviour: in business economics, we try

to prescribe policies for a business manager which is most likely applied to achieve his objectives.
In a economic theory, we build ‘laws’ such as the Law of Demand and the Law of Diminishing
Returns. In business economics we apply these laws for policy planning at the level of a firm.
5. Macro analysis: Macro economics which deals with the principles of economic
behaviour for the economy as a whole is also useful for business economics. A
business unit operates within some economic environment which is in turn shaped
by the behaviour of the economy as a whole. Therefore, business manager must
know the external forces working over his business environment. He has to adjust
himself to the uncertainties of his business in a wise manner. The important aspects
of macro economics of special interest to business economist are national income
accounting, business cycles, economic policies of the government in relation to
business activities.
6. Positive vs. Normative analysis: In positive economic analysis, we analysed the

problem in objective terms based on principles and theories. On the contrary, in
normative economic analysis, the problem is analysed based on value judgement
(norms).
26
2.7 Scope of Business Economics

Business economics is a developing science which generates the countless problems to
determine its scope in a clearcut way. From the following fields, we can examine the scope of
business by economics.
1. Demand Analysis and Forecasting.
2. Cost and Production Analysis.
3. Pricing Decisions, Policies and Practices.
4. Profit Management.
5. Capital Management.
6. Advertising.
7. Resource Allocations.
2.7.1 Demand analysis and forecasting
The foremost aspect regarding scope in demand analysis and forecasting. A business
firm is an economic unit which transforms productive resources into saleable goods. Since all
output is meant to be sold, accurate estimates of demand help a firm in minimising its costs of
production and storage. A firm must decide its total output before preparing its production schedule
and deciding on the resources to be employed. Demand forecasts serves as a guide to the
management for maintaining its market share in competition with its rivals, thereby securing its
profit. Thus, demand analysis facilities the identification of the various factors affecting the
demand for a firm’s product. This, in turn helps the firm in manipulating the demand for its
output. In fact, demand forecasts are the starting point for a firm’s planning and decision-
making. This deals with the basic tools of demand analysis i.e.: Demand Determinants, Demand
Distinctions and Demand Forecasting etc.
2.7.2 Cost and production analysis
A firm’s profitability depends much on its costs of production. A wise manager would
prepare cost estimates of a range of output, identify the factors causing variations in costs and
choose the cost-minimising output level, taking also into consideration the degree of uncertainty
in production and cost calculations. Production process are under the charge of engineers but
the business manager works to carry out the production function analysis in order to avoid
27
wastages of materials and time. Sound pricing policies depend much on cost control. The main
topics discussed under cost and production analysis are Cost concepts, cost-output relationships,
Economies and Diseconomies of scale and cost control.
2.7.3 Pricing decisions, policies and practices
Another important aspect of a business manager is the pricing of a product. Since income
and profit depend mainly on the price decision, the policies and all such decisions are to be
taken after careful, of the nature of the market in which the firm operates. The important topics
covered in this field of study are: Market Structure Analysis, Pricing Practices and Price
Forecasting.
The central functions of an enterprise are not only production but pricing as well. While
the cost of production has to be taken into account when pricing a commodity, a complete
knowledge of the price system is quite essential to the determination of the price.
Pricing is actually guided by considerations of cost plus pricing and the policies of public
enterprises. Finally, there is such a thing as price-leadership and non-price competition.
Therefore it is clear that the price system touches upon several aspects of managerial
economics and aids or-guides the manager to take valid and profitable decisions.
2.7.4 Profit management
Each and every business firm tended for earning profit, it is profit which provides the chief
measure of success of a firm in the long period. Economists tell us that profits are the reward
for uncertainty bearing and risk taking. A successful business manager is one who can form
more or less correct estimates of costs and revenues at different of output. The more successful
a manager is in re uncertainty, the higher are the profits earned by him therefore, profit-planning
and profit measurement constitute most challenging area of business economics.
2.7.5 Capital management
Still another most challenging problem for a modern business manager is of planning
capital investment. Investments are made in the plant and machinery and buildings which are
very high. Therefore, capital management requires top- level decisions. It means capital
management i.e., planning and control of capital expenditure. It deals with; Cost of capital, Rate
of Return and Selection of projects.
28
Capital is scarce and it has a price. So the manager has to utilise scarce capital in the
best manner possible, so as to get the best out of it. The manager must be capable of arriving
at investment decisions under conditions of uncertainty and also to effect a cost benefit analysis.
From the above analysis, we understand that Business economics is applied economics.
Business economics, therefore, plays a very important role in the successful business operations
of a firm.
2.7.5 Advertising
To produce a commodity is one thing; to market it is another. Yet, the message about the
product should reach the consumer before he thinks of buying it. Therefore, advertising firm is
an integral part of decision making and forward planning.
2.7.6 Resource Allocations
Resources are not only limited but also capable of alternative uses. The aim is to achieve
optimisation. For the purpose, some advanced trends, such as linear programming, etc. are
used to arrive at the best course of action for a particular period.
Generally speaking, the main concern of the manager is to combine productive resources
in such a way to get the least cost combination of factors or optimum combination of factors.
2.8 Summary
Business Economics concerned with firm’s decision - making of economic nature. it
provides a link between traditional economics and decision making. Business Economics use
various economic theory to find out of suitable solution faced by the entrepreneur of course
there may be some gap in the theory. but many theories were reformulated and incorporated
when the user find problem while applying the theory. Many models have undergone changes.
new theories were developed many statistical and quantitative methods were incorporated is
the managerial economics. these techniques were used to solve the problem.
2.9 Key Words

Decision Making: it is the process of selecting a particular course of action from among
the various alternatives.
29
Micro Economic Analysis: It deals with the behaviour of individual economic units which
include consumers, firms, investors, etc.,
Equi Marginal Principle: An input must be so allocated between various uses that the
value added by the last unit of the input is the same in all its uses.

1. What is the nature of Business Economics?
2. Explain the role of Business Economist
3. Depict the process of Decision Making.
2.11 Reference Books

1. Essentials of Business Economics by D.N. Dwivedi
2. Business Economics : Theory & Applications by D. D. Chaturvedi (Author), S. L.

Gupta (Author
30
UNIT – 3
BUSINESS CONCEPTS
Learning Objectives
To understand the fundamental concepts used in the business.
To understand the concept of opportunity cost.
To understand and use the discounting principle and time perspectives.
Unit Structure:
3.1 Fundamental concepts used in Business
3.2 Incremental concept
3.3 Concept of Time perspective
3.4 Discounting principle
3.5 Concept of Opportunity Cost
3.6 Equi-Marginal Principle
3.7 Summary
3.8 Key words
3.10 Reference Books.
3.1 Fundamental concepts used in Business

Mainly there are five fundamental concepts that are basic in the study of Business
economics that aid decisions. They are :
1. Incremental concept
2. Concept of Time perspective
3. Discounting principle
4. Concept of Opportunity Cost
5. Equi-Marginal Principle
31
3.2 Incremental Concept

The incremental Concept involves the estimation of the impact of decision alternatives on
costs and revenues that result from changes in prices, products, procedures, investments, etc.,
or whatever may be at stake in the decision. The two fundamental concepts in this analysis are
Incremental Cost and Incremental Revenue. Incremental cost is defined as the change in total
cost consequent upon a decision. Similarly, incremental revenue is defined as the change in
total revenue resulting from a decision.
A decision is profitable only if (a) it increases revenue more than costs; (b) it decreases
some costs more than it increases others; (c) it increases some revenues more than ii decreases
others,; and (d) it reduces costs more than revenue.
Significance of Incremental Reasoning
Generally, businessmen hold the view that they ‘must make a profit on every job’ in order
to make an overall profit. With this concept, the businessmen may often refuse orders that do
not cover full cost, i.e., variable and fixed costs plus some provision for profit. But this view is
not wholly correct and it is inconsistent with the principle of incremental reason i W and profit
maximisation.
The following example will illustrate that a refusal to accept business below full cost may
mean a rejection of a possibility of adding more to revenue than to cost.
Illustration
Suppose for a firm an order may bring in an additional revenue of Rs. 7,000. The full cost
to execute the ‘order’ as estimated by resultant revel the Company’s Accountant will be as
follows:
Material costs …. Rs. 4,000

Labour costs …. Rs. 3,000
Overhead charges at 10% of labour cost …. Rs. 300
Selling and advertisement expenses at
20% of labour and material costs …. Rs. 1,400
____________
Full Cost Rs 8,700
____________
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From the estimate furnished by the Accountant, the above ‘order’ bringing in just Rs.
7,000 appears to be unprofitable. Suppose there exists some idle capacity with which this
‘order could be met. Further suppose that the acceptance of this order will add only Rs 100 of
overhead charges being the incremental overhead limited to the added use of energy, wear and
tear of unit of output the machinery and added cost of supervision, etc. This ‘order’ does not
require any additional selling or administrative expenses, as the only requirement is the
acceptance of the order. Further, only part of the labour cost is incremental, since some idle
workers will be put to work without any additional pay.
On the basis of above assumptions, the incremental cost of accepting the above ‘order’
will be as follows :
Material costs …. Rs. 4,000
Labour costs …. Rs. 2,000
Overhead charges …. Rs. 100
Selling and advertisement expenses …. Rs. Nil

____________
Total incremental cost …. Rs. 6,100
____________
According to Accountant’s estimate, the order, if accepted, will result in a loss of Rs.
1,700/-. But, from the concept of incremental cost, as given above, the order will fetch an
addition of Rs.9001- in profit. On this basis of incremental reasoning, the ‘order’ can be accepted
and executed with profit. But this concept assumes the following :
(i) The existence of idle capacity which would otherwise go unused; and (ii) Absence of
more profitable alternatives.
Incremental reasoning does not mean that a firm should accept all orders that cover
merely their incremental costs. In fact, ional revenue “charging what the market will bear” is
consistent with incrementalism for it implies increasing rates as long as the resultant revenues
increase. The basic purport of incremental reasoning is that a decision is sound if it increases
revenue more than costs, or reduces costs more than revenue.
33
Incrementalism and Marginalism
Students may be familiar with concept of Marginal revenue and Marginal Cost discussed
in Economic Theory. Incremental revenue concept is akin to the marginal revenue concept; but
there exist some differences between the incremental revenue and marginal revenue.
In marginal analysis, marginal revenue means the addition made to the total revenue by
selling an additional or extra unit of the output. Marginal revenue is the addition to the total
revenue per unit of output change.
It is derived by the following formula :
MR = R2 – R1 = ΔR
Q2 – Q1 ΔQ
where : MR stands for Marginal Revenue; R, indicates new total cost of revenue; R1
represents old total revenue; Q2 measures new quantity of output sold; Q1 shows old quantity
of 4,000 output sold; R denotes Revenue and Q denotes output; it measures the impact of
decision alternatives on the total revenue. The formula for incremental revenue is:
IR = R2 – R1 = ΔR
where : IR stands for incremental revenue ; R2 denotes new total revenue; R, indicates
old total revenue; and A means ‘change in’.
Suppose a firm manufacturing fountain pens and selling it at a price of Rs.5/- decides to
reduce the price to Rs.4/-. As a result, sales increase from 1000 pens to 1500 pens. In this
case, incremental and marginal revenues can be calculated as under
IR = R2 – R1
= ( Rs .4 x 1500 Units) - (Rs.5 x 1000 Units)
= Rs.6000 - Rs.5000
= Rs.1000 / -
Incremental costs are additional costs incurred due to a change in the nature of activity.
These costs refer to any type of change: adding a new product, changing distribution channels,
34
installing a new machine, expanding the market area and so on. Incremental cost measures
the difference between the old and new total costs. It measures the impact of decision alternatives
on the total costs. On the other hand, Marginal cost denotes the extra cost incurred in adding an
unit of output. It is the per unit cost of the added units. Marginal cost as limited meaning.
Incremental cost is very flexible referring to any kind of change, while marginal costs are
calculated for unit changes in output. Incremental costs are r ore’ relevant in decision-making at
the firmal level.
The incremental cost may be calculated as follows :
where : IC stands for Incremental cost; C2 represents new total cost and Cl
denotes old total cost.
Similarly, marginal cost may be worked out by using the formula :
IC = C2 – C1 = ΔC
where : MC is Marginal cost; C, stands for new total costs; C1 shows old total costs; 0,
indicates new total output; and Q1 shows old total output.
Incremental analysis of Managerial Economics and Marginal analysis of economic theory

are closely related. There are similarities as well as differences between the two. The main
differences are :
(i) MC and MR are always defined in terms of unit changes in output. But, incremental
costs and revenues are not necessarily restricted to unit changes.
(ii) Generally, MC and MR are restricted to the effects of changes in output. But in
Managerial economics, decision-making, may not be confined to changed output at all. The
problem may be one of substituting one process for another to produce the same output. The
problem may be one of comparing the cost of the first process with that of the alternative. The
marginalist language is not suited to this kind of decision.
3.3 Concept of Time. Perspective

‘Time’ plays a decisive role in economic theory, particularly in the field of ‘Pricing’. It was
Marshall who introduced the element of ‘Time’ in value theory. He conceived four market forms
35
based on time, viz., very short period, short period; long period and very low period or secular
period.
According to Marshall, very short period is a time interval in which the market supply is
almost fixed and it cannot be changed because skilled labour, capital and organization are
fixed. Commodities like vegetables, fish, eggs, fruits, milk, etc., are perishable and the supply
cannot be changed in the very short period and they are classified under this category of very
short period. Since supply cannot be changed, demand plays a decisive role in determining the
price,
In short period, the commodity is non-perishable and also reproducible. Short-run period
refers to a period of time which is long enough to allow the variable factors of production to be
used in different amounts in order to ensure that maximum profits are earned, but during which
period, the fixed factors cannot be altered.
Long period refers to a period of time which is long enough to bring about possible variations
in all inputs. It is the time in which an entirely new plant can be erected.
Managerial Economist is concerned with short-run and long-run effects of decisions on

costs and revenues. “A decision should take into account both the short-run and long-run effects
on revenues and costs, giving appropriate weight to the most relevant time periods.” A decision
made on the basis of short-run considerations may, in the long run, prove less profitable than at
first seemed. The firm should take into consideration the short and long run effects on cost and
revenues, customers’ reactions and also the image of the company,
3.4 Discounting Principle

Another important fundamental concept used in Managerial economics is the discounting
principle. This principle has its genesis in valuing the money received at different points of time.
For example, a rupee to be received tomorrow is worth less than a rupee today, even though,
you are sure of receiving one rupee tomorrow. Whenever we make comparison between the
present in and the future values of money, we always discount future value to make it comparable
with the present value. This can be illustrated as follows Suppose there is a choice between
receiving a gift of Rs.1000/- today and Rs.1000/- next year, naturally everyone would prefer
Rs.10001- today. Even though if there is a certainty of receiving Rs.1000/- next year, we choose
to get Rs.1000/- today, as it can yield some interest during one year by investing. Suppose it
36
earns an interest of Rs.100/-, after a year, the amount would be Rs.1100/-. Therefore, Rs.1000/
- at a future date (next year) is to all be discounted at the rate of 10 per cent.
If a sum of Rs.’X’ is invested at an interest rate of ‘r’ per cent per annum, the capital will
have accrued by year end to Rs.X(1 + r). Interest on this amount is then charged during the
second year at a rate of ‘r’ per cent per annum, so that at the year end the capital has grown to
Rs.X(1 + r) (1+r) Rs.X(1 + r)2. To generalise and make it a formula, we may say that the future
worth of Rs.’X’ at ‘r’ per cent interest for ‘n’ years is:
Rs. X(1+r)n
The other way of explaining the discounting principle is to ask how much money today
would be equivalent to Rs.1000 a year from now. Assuming the rates of interest at 10 per cent,
we must discount the Rs.1000 at 10 per cent which means that we divide it by 1.10.
Thus : V = Rs.100 = Rs.1000 = Rs. 909.90

1+r 1+ 0.10
where : V = present value and r = rate of interest.
To put it in a formula, the present value of Rs.X, ‘n’ years hence, at ‘r’ percent interest is
X (1 + r)”
The discounting concept is very useful in Managerial Economics in making investment

decisions. It has profound relevance in capital budgeting.
3.5 Concept of Opportunity Cost

The principle involved in ‘Opportunity Cost’ is not the pain or the strain involved in making
a product, but the sacrifice of alternative product that could have been produced. This means
that the “cost of using something in a particular venture is the benefit foregone (or opportunity
lost) by not using it in its best alternative use.”
The opportunity cost of any goods is the next best alternative goods sacrificed. In
Managerial economics, opportunity costs are the costs of displaced alternatives. They represent
only sacrificed alternatives. They involve the measurement of sacrifices made in taking- a
particular decision. For example, in a textile mill that spins its own yarn, the cost of yarn is. really
the price at which the yarn could be sold if it were not woven into cloth.
37
3.6 Equi-Marginal Principle

Another important concept used in Economics is the equi-marginal principle. According
to this concept, an input should be allocated in such a way that the value added by the last unit
is the same in all cases. Suppose a firm is involved in four activities, namely, activity A, activity
B, activity C and activity D. All these activities require the services of labour. Imagine that the
firm has 100 units of labour at its command arid this is fixed so that the total payroll is
predetermined.
Now the firm can increase any one of the activities by employing more labour, but this can
be done only at the cost of other activities. If the firm adds an unit of labour to activity B,
increase in output will result this is termed as marginal product in other activities namely A, C
and D. If the firm finds that the value of the marginal product in one activity is greater than in
another, then, it is evident that it would be profitable to shift labour from the low marginal activity
to high marginal value activity and thereby increase the total value of all products taken together.
For example: suppose the value of the marginal product of labour in activity ‘B’ is Rs.40/
- while in activity A it is Rs.50/-. Then it is profitable to shift labour from activity B to A. The
optimum will be attained when the value of the marginal product is equal in all activities. The
formula for this is :
VmP1A = VmP1c = VmP1D

where : VmP denotes the value of marginal product
I denotes labour; and
ABCD stand for activities
In this concept, one important thing to be borne in mind is that the marginal products in
the formula above mentioned are net of incremental costs. For instance, in activity A, the addition
of one unit of labour may result in an increase of physical output of 25 units. Each unit may sell
at Rs.2/- and the 25 units will fetch Rs.50/- which is the value of the marginal product. But this
increased production may be the result of additional raw materials and other inputs and other
variable costs in the activity A, not counting labour cost. Suppose that the incremental cost is
Rs.20/-. This leaves a net addition of Rs.30/-. The value of the marginal product which is relevant
for our study is only Rs.30/-.
38
It may be pointed out that the concept of equi-marginal principle is used in ‘Capital
budgeting’ where the limited resources of the firm have to be allocated in a rational manner.
The equi-marginal principle holds good only in cases where the law of diminishing returns
operates.
3.7 Summary
The subject matter of economics consists of demand analysis and forecasting, production
and cost, market structure, pricing and output, profit, capital budgeting, product policy and
market strategy, macro - economic environment and government policy. The main concepts,
which can be considered as the cornerstone of business economics, are incremental reasoning,
opportunity cost, time perspective, discounting principle and equi - marginal principle.
3.8 Key Words

Incremental Cost: It is additional costs incurred due to a change in the nature of activity.
Marginal cost denoted the extra cost incurred in adding a units of output.
Opportunity cost: It represents the benefits foregone by pursuing the best course of
action rather than the next best course of action. it includes both explicit and implicit cost.

1. Critically explain the definitions of economists.
2. What are problems of all economy?
3. Explain scarcity or choice.
4. Business Economics is economics applied in Decision - making. Discuss
5. Discuss the nature and scope of Business Economics.

1. Essentials of Business Economics by D.N. Dwivedi
2. Business Economics : Theory & Applications by D. D. Chaturvedi (Author), S. L.

Gupta (Author
39
LESSON - 4
DEMAND FUNCTIONS
Learning objectives
After having read this Lesson you will be able to
· To understand the concept of demand and its determents
· Describe the demand & concept
· Disucss the importance of demand forecasting
UNIT STRUCTURE
4.1 Introduction
4.2 Meaning of Demand
4.3 Characteristics of the “Law of Demand’
4.4 Demand Schedule
4.5 Demand Curve
4.6 Factors Influencing Changes in Demand
4.7 Elasticity of Demand:
4.7.1 Introduction
4.7.2 Elasticity of demand
4.7.3 Factors Determining Elasticity of Demand
4.7.4 Practical Importance of Elasticity of Demand
4.8 Demand Forecasting
4.9 Types of Forecasting
4.10 Durable Consumer Goods
4.10.1 Forecasting Demand for Capital Goods:
4.10.2 Forecasting Demand for New Products:
4.11 Keywords

40
4.1 Introduction
In economics the term demand occupies a very significance place. According to Benham
“the demand for anything at a given price, is the amount of it which will be bought per unit of
time at that price” for example, a consumer may demand Rs.4/- per dozen and so on. So a
person’s demand for any commodity refers to different quantities which he would be prepared
to buy at different prices.
4.2 Meaning of Demand

Demand for any commodity is based on
a. The desire of a consumer for a product
b. The willingness to buy it, and
c. The purchasing power of the consumer
Demand does not mean mere desire. A poor teacher may desire to have a bungalow but
male desire does not bring the bungalow. He must have sufficient money to pay the price of the
bungalow, so demand means desire backed up by ability and willingness to pay the price.
Law of Demand: the law of demand explains the inverse relationship between the demand
and price. Arise in the price of a commodity and service is followed by a reduction in the demand
for it, and a fall in price is followed by an increase in demand, if conditions of demand remain
constant”. This is the law of demand it simply says that, if price falls demand increase: in
Marshall’s words the amount demanded increases with a fall in price and diminishes with a rise
in price”
In the statement of law of demand and phrase “if conditions of demand remain constant”
is very important. Conditions of demand refer to fashion, taste, price of other related goods,
change in population and income of the consumer etc. at any given time these conditions
remain the same. The law will operate only if the above things remain unchanged.
The relationship between the variation in price and quantity demanded is known as the
Law of Demand
41
4.3 Characteristics of the “Law of Demand’

a. There is inverse relationship between the price and the quantity demanded (i.e) if
the price rises the demand falls and if the price falls the demand rises.
b. The price is an independent variable and the demand is a dependent variable. It is

the effect of price in demand that is examined and not the effect of demand in price.
c. The law assumes that there is no change with the consumers income, price of
related goods, consumer taste and preferences, expected future increase in the
demand and vice versa
d. The inverse relationship between the price and the quantity demanded rests in
these considerations.
1. Income effect
2. Substitution effect
3. Law of Diminishing Margin utility
4. Entry or Exit of Buyers.
4.4 Demand Schedule

Demand schedule is the table or statement showing how much of a commodity is demand
in a particular market at different prices. According to Benham, “a full account of the demand for
any given good in a given market at a given time should state that what the (weekly) volume of
sales would be at each of a series of prices. Such as account, taking the form of a tabular
statement is known as a demand schedule.
A demand schedule may be an individual demand schedule or market demand schedule.

An individual demand schedule shows the quantities demanded by an individual consumer at
different prices. A demand schedule for a market can be constructed by adding up demand
schedules of the consumers in the market.
For instance, if the price of apples rises from Rs.6/- to Rs.8/- dozen, amount demanded
may tend to decline from 4,000 to 2,000 dozen. If the price of apples falls from Rs.8/- to Rs.6/
- per dozen, amounts demanded may tend to rise from 2,000 to 4,000 dozen
42
Table 4.1 Demand Schedule
Price of Apples(per dozen)Rs Quantity demanded(in dozen)
108642 1,0002,0004,0006,0008,000
From the demand schedule it is clear that the quantity demanded rises as price falls, and
the quantity demanded falls as price rises.
4.5 Demand Curve

Demand curve can be drawn from the demand schedule. The demand curve is the curve
which represents the market.
Figure 4.1
In the diagram, DD is the demand curve. Any profit on, the demand curve DD refers to
both price and quantity of apple. The demand curve DD is downward sloping to the right. The
downward slope of the curve indicates that the quantity demanded rises as price falls.
If the income of the consumer decreases, demand for certain goods may also decrease.
A decrease in demand indicates a shift to the left to the original demand curve increase and
decrease in demand involves the shifting of the demand curve itself.
The following diagram illustrates the increase and decrease in demand.

43
Quantity
Figure 4.2
Extension and contraction of demand are quite different from increase and decrease in
demand. Extension and contraction of demand take place in response to changes in price,
while increase and decrease of demand take place in response — to other factors. Extension
and contraction of demand involve movements along the demand curve while increase and
decrease in demand involve the shifting of the demand curve itself.
4.6 Factors Influencing Changes in Demand

Besides prices many other factors influence the demand, some of the important factors
given below,-
1. Changes in income.
2. Changes in taste or fashion
3. Changes in price of substitutes.
4. Discovery of new substitutes.
5. Changes in population.
S. Changes in weather.
7. Changes in distribution of income.
8. Expectation of future trade.
When changes takes place in the above factors, the demand curve shifts to the right or
the left.
44
4.7 Elasticity of Demand

4.7.1 Introduction
The concept of elasticity of demand is associated with the name of Marshall. Elasticity of
demand refers to the responsiveness of demand to change in price.
Elastic Demand: Demand is said to be elastic when it is responsive to changes in price.

When there is a small change in price, if the quantity demanded changes very much, the
demand is said to be elastic. For example, if the price of radio fall a little and demand increases
very much, demand for radio is said to be elastic.
Inelastic Demand: when the demand for a commodity changes little when there is a
change in its price, the demand for it is inelastic. For example the price of salt falls much,
amount demanded may not increase. The demand for salt is inelastic.
Marshall defines the concept as follows: “The elasticity 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”.
In short, demand is elastic when a small change in price leads to a great change in
demand. It is inelastic when a big change in once is followed by a small change in demand.
Price Elasticity of Demand: The rate at which the quantity demanded change s due to
a change in price is known as price elasticity of demand. The formula for calculating price
elasticity is:
Ed = Percentage change in amount demanded
Percentage change in Price
4.7.2 Elasticity of Demand
The responsiveness of demand to changes in price differs from product to product. There
are five different kinds of price elasticity of demand. They are:
1. Perfectly Elastic Demand: It refers to a situation when a small fall in price leads to
an unlimited extension of demand and a small rise in the price cause the demand to
fall to zero. The demand is perfectly Elastic or the elasticity of demand is infinity.
45
Figure 4.3
Figure shows an infinitely elastic demand curve DD. It is horizontal line parallel to the X-
axis.
2. Perfectly Inelastic Demand: It refers to a situation when the quantity demanded

remains unchanged irrespective of any rise or fall in the price of a commodity. The
demand is perfectly inelastic; the elasticity of demand is zero. (E = 0).
Figure shows a perfectly inelastic demand curve DD It demanded OR both at the price
OP and at the price P.
Figure 4.4
3. Relatively Inelastic Demand or less than unity: It refers to a condition when a big
change in the quantity demand brings small change in demand. The demand is
relatively inelastic, the elasticity of demand is less than unity E < 1.
46
Figure 4.5
Figure shows a relatively inelastic demand curve DD. As the price falls from N to N1 the
quantity demanded expands from OM to OM1. Here the increase in quantity demanded is less
than proportionate to the fall in price.
4. Unitary Elastic Demand: when proportionate change in price brings about an equal
proportionate change in the demand, the demand has unitary elasticity.
Figure shows a unitary elastic demand. As the price falls from Rs.3 to 1, the quantity
demanded increases from Rs.1 to 3. A demand curve which is having unitary elasticity is called
rectangular hyperbola. Here consumer’s outlay is constant.
Figure 4.6
5. Relatively Elastic Demand : it refers to a situation when a small change in leads to

great change in the quantity demanded. The elasticity of demand is greater than
unity E>.
47
Figure 4.7
Figure shows a relatively elastic demand curve DD. As the price falls from N to N1 the
demand extends from M to M1. Here the increase in demand is more than proportionate to the
fall in price.
Of these five kinds of elasticity’s, both inelastic demand and infinitely elastic demand are
seldom met within real like. In real life elasticity of demand is somewhere between two limits. It
is more than zero and less than infinity.
4.7.3 Factors Determining Elasticity of Demand

1. Necessaries Inelastic: For necessaries and conventional necessaries, the demand
is inelastic, Example: salt, Tobacco.
2. Luxuries-Elastic: For luxuries, demand is comparatively elastic. Example: Radio.
3. Substitutes- Elastic: For substitutes the demand is elastic: The demand for a
commodity is said to be elastic if the commodity has substitutes. Example: Coffee
and Tea.
4. Goods with several Uses- Elastic: Demand for goods having several uses in
elastic. Example: Coal.
5. Postponable Uses — Elastic: Demand for goods use of which can be postponed
is elastic. Example: Umbrella.
48
6. Level of prices: Elasticity also depends on the level of prices. If the price is either
too high or too low, the demand will be inelastic. Examples: Diamonds, safety pins.
7. Proportion of consumes Income spent on the commodity: The proportion of

total expenditure devoted, to a commodity is small; the demand for it tends to be
inelastic. Example: Proportion of expenditure on ink is quite small and consequently
the demand for this is inelastic.
8. Habit and Fashion: Demand for these goods which are habitually consumed or
which are in fashion is inelastic. Example: Particular brand of a cigarette.
9. Time: Elasticity varies with the length of time periods. In the larger period of time
demand is more elastic. In the short period of time, demand is less elastic or inelastic.
4.7.4 Practical Importance of Elasticity of Demand

1. It guides the businessman in fixing the prices of his goods. If the demand for a
commodity is elastic, he can rise the price. If it is elastic he has to bring down the
price.
2. The Finance Minister has to keep in mind the elasticity of demand for a commodity
before imposing a tax. The finance Minister must levy tax on such commodities for
which the demand is less elastic.
3. The Government has to take into account the elasticity of demand for a product,
before imposing price control on it.
4. In the case of joint products, separate cost of production of the two commodities is
not ascertainable. In such cases, price of each will depend on the elasticity of demand
of each. Example: Paddy & Straw.
5. The transport authorities also fix the prices for their various services after considering
their elasticity of demand.
6. It is used in the calculation of terms of trade. It is possible into account the elasticity
of demand.
7. Elasticity can influence wages. If demand for a particular type of labour is inelastic
the trade unions can easily get their wages raised.
8. The rates of exchange between currencies are fixed depending on the elasticity cal
demand for currencies in the exchange market
49
4.8 Demand Forecasting

Meaning
Forecasts are becoming the lifetime of business in a world, where the tidal waves of
change are sweeping the most established of structures, inherited by human society. Commerce
just happens to the one of the first casualties. Survival in this age of economic predators,
requires the tact, talent and technique of predicting the future.
Forecast is becoming the sign of survival and the language of business. All requirements
of the business sector need the technique of accurate and practical reading into the future.
Forecasts are, therefore, very essential requirement for the survival of business. Management
requires forecasting information when making a wide range of decisions.
The sales forecast is particularly important as it is the foundation upon which all company
plans are built in terms of markets and revenue. Management would be a simple matter if
business was not in a continual state of change, the pace of which has quickened in recent
years.
It is becoming increasingly important and necessary for business to predict their future
prospects in terms of sales, cost and profits. The value of future sales is crucial as it affects
costs profits, so the prediction of future sales is the logical starting point of all business planning.
A forecast is a prediction or estimation of future situation. It is an objective assessment of

future course of action. Since future is uncertain, no forecast can be percent correct. Forecasts
can be both physical as well as financial in nature. The more realistic the forecasts, the more
effective decisions can be taken for tomorrow.
In the words of Cundiff and Still, “Demand forecasting is an estimate of sales during a
specified future period which is tied to a proposed marketing plan and which assumes a particular
set of uncontrollable and competitive forces”. Therefore, demand forecasting is a projection of
firm’s expected level of sales based on a chosen marketing plan and environment.
Procedure to Prepare Sales Forecast
Companies commonly use a three-stage procedure to prepare a sales forecast. They

make an environmental forecast, followed by an industry forecast, and followed by a company’s
sales forecast, the environmental forecast calls for projecting inflation, unemployment, interest
50
rate, consumer spending, and saving, business investment, government expenditure, net exports
and other environmental magnitudes and events of importance to the company.
The industry forecast is based on surveys of consumers’ intention and analysis of

statistical trends is made available by trade associations or chamber of commerce. It can give
indication to a firm regarding tine direction in which the whole industry will be moving. The
company derives its sales forecast by assuming that it will win a certain market share.
All forecasts are built on one of the three information bases:
What people say?
What people do?
What people have done?
4.9 Types of Forecasting

Forecasts can be broadly classified into:
(i) Passive Forecast and
(ii) Active Forecast.
Under passive forecast prediction about future is based on the assumption that the firm
does not change the course of its action. Under active forecast, prediction is done under the
condition of likely future changes in the actions by the firms.
From the view point of ‘time span’, forecasting may be classified into two, viz.,:
(i) Short term demand forecasting and (ii) long term demand forecasting. In a short run
forecast, seasonal patterns are of much importance. It may cover a period of three months, six
months or one year. It is one which provides information for tactical decisions.
Which period is chosen depends upon the nature of business. Such a forecast helps in
preparing suitable sales policy. Long term forecasts are helpful in suitable capital planning. It is
one which provides information for major strategic decisions. It helps in saving the wastages in
material, man hours, machine time and capacity. Planning of a new unit must start with an
analysis of the long term demand potential of the products of the firm.
51
There are basically two types of forecast, viz.,:
(i) External or national group of forecast, and
(ii) Internal or company group forecast.
External forecast deals with trends in general business. It is usually prepared by a

company’s research wing or by outside consultants. Internal forecast includes all those that are
related to the operation of a particular enterprise such as sales group, production group, and
financial group. The structure of internal forecast includes forecast of annual sales, forecast of
products cost, forecast of operating profit, forecast of taxable income, forecast of cash resources,
forecast of the number of employees, etc.
At different levels forecasting may be classified into:
(i) Macro-level forecasting,
(ii) Industry- level forecasting,
(iii) Firm- level forecasting and
(iv) Product-line forecasting.
Macro-level forecasting is concerned with business conditions over the whole economy.
It is measured by an appropriate index of industrial production, national income or expenditure.
Industry-level forecasting is prepared by different trade associations.
This is based on survey of consumers’ intention and analysis of statistical trends. Firm-
level forecasting is related to an individual firm. It is most important from managerial view point.
Product-line forecasting helps the firm to decide which of the product or products should have
priority in the allocation of firm’s limited resources.
Forecast may be classified into (i) general and (ii) specific. The general forecast may
generally be useful to the firm. Many firms require separate forecasts for specific products and
specific areas, for this general forecast is broken down into specific forecasts.
There are different forecasts for different types of products like:
(i) Forecasting demand for nondurable consumer goods,
(ii) Forecasting demand for durable consumer goods,
(iii) Forecasting demand for capital goods, and

52
(iv) Forecasting demand for new-products.
Non-Durable Consumer Goods:
These are also known as ‘single-use consumer goods’ or perishable consumer goods.
These vanish after a single act of consumption. These include goods like food, milk, medicine,
fruits, etc. Demand for these goods depends upon household disposable income, price of the
commodity and the related goods and population and characteristics. Symbolically,
Dc =f(y, s, p, pr) where

Dc = the demand for commodity ñ
ó = the household disposable income
s = population
p = price of the commodity ñ
pr = price of its related goods
(i) Disposable income expressed as Dc = f (y) i.e. other things being equal, the demand
for commodity ñ depends upon the disposable income of the household. Disposable income of
the household is estimated after the deduction of personal taxes from the personal income.
Disposable income gives an idea about the purchasing power of the household.
(ii) Price, expressed as Dc = f (p, pr) i.e. other things being equal, demand for commodity
ñ depends upon its own price and the price of related goods. While the demand for a commodity
is inversely related to its own price of its complements. It is positively related to its substitutes.’
Price elasticities and cross elasticities of non-durable consumer goods help in their demand
forecasting.
(iii) Population, expressed as Dc= f (5) i.e. other things being equal, demand for commodity
ñ depends upon the size of population and its composition. Besides, population can also be
classified on the basis of sex, income, literacy and social status. Demand for non-durable
consumer goods is influenced by all these factors. For the general demand forecasting
population as a whole is considered, but for specific demand forecasting division of population
according to different characteristics proves to be more useful.
53
4.10 Durable Consumer Goods

These goods can be consumed a number of times or repeatedly used without much loss
to their utility. These include goods like car, T.V., air-conditioners, furniture etc. After their long
use, consumers have a choice either these could be consumed in future or could be disposed
of.
The choice depends upon the following factors:
(i) Whether a consumer will go for the replacement of a durable good or keep on using it
after necessary repairs depends upon his social status, level of money income, taste and fashion,
etc. Replacement demand tends to grow with increase in the stock of the commodity with the
consumers. The firm can estimate the average replacement cost with the help of life expectancy
table.
(ii) Most consumer durables are consumed in common by the members of a family. For
instance, T.V., refrigerator, etc. are used in common by households. Demand forecasts for
goods commonly used should take into account the number of households rather than the total
size of population. While estimating the number of households, the income of the household,
the number of children and sex- composition, etc. should be taken into account.
(iii) Demand for consumer durables depends upon the availability of allied facilities. For
example, the use of T.V., refrigerator needs regular supply of power, the use of car needs
availability of fuel, etc. While forecasting demand for consumer durables, the provision of allied
services and their cost should also be taken into account.
(iv) Demand for consumer durables is very much influenced by their prices and their
credit facilities. Consumer durables are very much sensitive to price changes. A small fall in
their price may bring large increase in demand.
4.10.1 Forecasting Demand for Capital Goods:
Capital goods are used for further production. The demand for capital good is a derived
one. It will depend upon the profitability of industries. The demand for capital goods is a case of
derived demand. In the case of particular capital goods, demand will depend on the specific
markets they serve and the end uses for which they are bought.
54
The demand for textile machinery will, for instance, be determined by the expansion of
textile industry in terms of new units and replacement of existing machinery. Estimation of new
demand as well as replacement demand is thus necessary.
Three types of data are required in estimating the demand for capital goods:
(a) The growth prospects of the user industries must be known,
(b) the norm of consumption of the capital goods per unit of each end-use product must
be known, and
(c) the velocity of their use.
4.10.2 Forecasting Demand for New Products:
The methods of forecasting demand for new products are in many ways different from
those for established products. Since the product is new to the consumers, an intensive study
of the product and its likely impact upon other products of the same group provides a key to an
intelligent projection of demand.
Joel Dean has classified a number of possible approaches as follows:
(a) Evolutionary Approach:
It consists of projecting the demand for a new product as an outgrowth and evolution of
an existing old product.
(b) Substitute Approach:
According to this approach the new product is treated as a substitute for the existing
product or service.
(c) Growth Curve Approach:
It estimates the rate of growth and potential demand for the new product as the basis of
some growth pattern of an established product.
55
(d) Opinion-Poll Approach:
Under this approach the demand is estimated by direct enquiries from the ultimate
consumers.
(e) Sales Experience Approach:
According to this method the demand for the new product is estimated by offering the
new product for sale in a sample market.
(f) Vicarious Approach:
By this method, the consumers’ reactions for a new product are found out indirectly through
the specialised dealers who are able to judge the consumers’ needs, tastes and preferences.
The various steps involved in forecasting the demand for non-durable consumer goods
are the following:
(a) First identify the variables affecting the demand for the product and express them in
appropriate forms, (b) gather relevant data or approximation to relevant data to represent the
variables, and (c) use methods of statistical analysis to determine the most probable relationship
between the dependent and independent variables.
Summary:
The demand for a commodity is the quantity of the commodity which is demanded at a
certain price during any particular point of time. the law of demand states that there is an
inverse relationship between price and quantity brought of a commodity. Elasticity of demand
measures percentage change in the quantity demanded of a good due to percentage change
with price.
4.11 Keywords
Demand: Desire backed by purchasing power and willingness to pay
Types & Demand: Price Demand, Cross Demand, Income Demand.
Equilibrium Price: The interaction between quantity demanded of quantity supplied.

56
Forecasts: An estimation of future situation under given condition.
Company Demand Forecasting: Forecasting of sales of a firm independent of the rest

of the firm in the industry.
Complete Enumeration: When every consumer is contacted is, census is taken.

1. Explain the concept of change in demand
2. What is demand?
3. What is demand forecasting?
4. Explain the types of Elasticity.

1 Baumol.W.J - Economic Theory And Operations Analysis.
2 Cohen.K.J And Cyret R.M, Theory Of The Firm, Prentice Hall Of India.
3. H.L. Ahuja, Principles of Micro Economics
4. M.L. Jhingan, Micro Economic Theory
5. S.Sankaran, Micro Economics

57
LESSON - 5
SUPPLY FUNCTIONS
Learning Objectives:
To understand the meaning of supply.
To outline the supply schedule and supply curve.
To understand the factors influencing supply.
Unit Structure:
5.1 Meaning of Supply
5.2 Law of Supply
5.3 Supply schedule
5.4 Supply Curve
5.5 Factors Influencing Supply
5.6 Demand - Supply Equilibrium
5.7 Equilibrium price
5.8 Summary
5.9 Keywords
5.1 Meaning of Supply

In ordinary conversation the word ‘supply’ often signifies some definite amount. For
example, the number of bags of wheat produced last year. Supply in Economics means supply
at a price. The farmers in Tamil Nadu may be willing to supply 1 million quintal of paddy at Rs.7
per quintal and 2 million quintals of paddy at Rs.80 and so on. Thus the supply of a product
refers to the various amounts which are offered for sale at a particular reference to price.
According to Harvey, supply is defined as, ‘how much of goods will be offered for sale at
a given time”.
58
“Supply may be defined as a schedule which shows the various amounts of a product
which a producer is willing to and able to produce and make available during some given
period”.
Supply is not the same as stock. The term stock indicates a fired quantity while the term
supply implies that the amount offered can be increased or decreased. If the price is high,
producer will offer a large in quantity for sale. If the price is low, they will offer to sell only less.
The amount of the commodity which a seller is willing to sell at a particular price is known as his
supply at that price. Though he may have in his stock a larger quantity of commodity be may not
supply the whole of his stock at a particular price. Hence there is a difference between the stock
of a commodity and its supply at any particular time.
The market supply refers to the total quantity of commodity which all the different sellers
together offer to sell at particular price in the market.
5.2 Law of Supply

Other things remaining the same; the supply of a commodity changes directly with its
price. This is according to the law of supply which explains in a given market, at any given time,
the quantity of any goods which people are ready to offer for sale generally varies directly with
price.
The law of supply may also be stated as follows: “Other things remaining the same if the
price of a commodity rises, the supply is expanded, and as the price falls, its supply is contracted.
In other words, the quantity offered for sale varies directly it price.
For example, when price of paddy rises from Rs.70- to Rs:120- per bag amount supplied
may increase from 1,000 to 5,000 bags. When price falls from Rs.100 to Rs. 80 per bag amount
supplied may also fall from 4,000 bags to 2,000 bags, From this, it is clear there is a direct
relationship between price and supply. We call this direct relationship between price and supply
by the name - of law of supply.
5.3 Supply Schedule

The direct relationship price and supply can be presented in the form of a table. The
following is an example of an imaginary supply schedule relating to paddy.
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Table 5.1 Supply Schedule
Price per bag Rs Amount supplied (Bags)
708090100110 1,0002,0003,0004,0005,000
If you look at the supply schedule, it is clear that when the price clear that when the price
of paddy falls, the supply of paddy also rises. Whereas when the price of paddy falls the supply
of paddy also falls. It shows the direct relationship between price of Supply.
Figure 5.2
5.4 Supply Curve

Like demand curve supply can also be drawn to present the relation between price and
supply. If the above supply schedule can be put in form of a supply curve.
On the basis of the supply schedule, supply curve is drawn. OX-axis measures amount of
supply and OY-axis measures the price. By marking points on the basis of the supply schedule,
we get supply curve SS. The supply curve SS slopes upwards from left to right showing large
supply at higher price. This is the general shape of the supply curve. The supply curve is the
diagrammatic representation of the law of supply. It has a great practical utility for the
manufacturer to guide him in the course of production.
60
Exceptions
1. The law does not apply to sales of the auction because whatever the price a result
of the bid the goods must be sold out.
2. When it is feared that prices are going to fall still further, the businessman even at
a loss. Similarly when the prices are expected to raise still further exceptions to the
law of supply.
5.5 Factors Influencing Supply

The following factors determine supply:
1. Number of firms of sellers: The supply of a production depends upon the number
of firms and rate of production. The larger the number of firms the more will be the
supply of the product. Any change in the assumption will raise or lower the supply
curve.
2. Level of technology: It is assumed that the level of technology remains constant.

Any improvement in the technology will reduce cost and price and increase the
supply.
3. Cost of production: The cost of production remains constant. Wages, rate of

interest, price of machinery, raw material etc, remain unchanged. If cost of production
is reduced, the supply curve will come down.
4. Price of related goods: It is assumed that the supply of the product depends upon
the price of that commodity only and not of other commodities.
5. Natural Causes: It is assumed that there is no change in natural factor like floods,
drought etc. This applies most to agricultural products.
6. Government policy: Any change in Government policy will affect the supply. A new
tax or duty may also affect the price and as a result the supply. Hence it is assumed
that there is no change in the Government policy.
These are the determinates of supply which is assumed as constant. In order to study the
supply in relation to price only, we keep all the above factor as constant or other things remain
the same.
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Changes in supply: Other things being equal, the supply of a commodity will expand at
higher prices and contract at lower prices. This is expansion and contraction of supply due to
change in price. The points on the curve show the price and its corresponding supply.
Suppose the assumption change, a new supply curve will have to be drawn either upward
or downward. If the new supply curve is drawn to the right of the old curve the supply has
increased. If the new curve is drawn to the left of the old curve the supply has decreased. These
changes can be shown with the help of a diagram.
Figure 5.3
Supply curve SS is the original supply curve. Any movement on this curve is expansion or
contraction of supply. Supply curve S1 S2 indicates that the supply increased. Supply curve S2 -
S2 indicates the supply has decreased. This change in supply is not due to rise in price but due
to other factors. In such cases there is shift in the position of the supply curve itself. Here we
use the terms increase and decrease to denote the change in supply.
Supply in the short period: The supply of a commodity can be studied with reference to
time. The supply of a commodity will be small in the short period, but the supply will be large
period. This is total the market. It is given and as such its supply cannot be increased much with
the existing factors of production. Long period supply can be expanded. The existing factors of
production can be changed. This leads to change in the total supply. Supply can be changed
permanently only in the long-run.
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5.6 Demand Supply Equilibrium

Prof. Marshall compared demand and supply to the two blades of a pair of scissors. A
moment of reflection will show that it is not demand or supply alone that determines the pair of
a commodity. Together though interaction they determine the equilibrium of a commodity.
The process of determination of equilibrium price has to be studied under:
1. Demand
2. Supply and equilibrium between demand of supply.
The chapter brought you the explanation of the concepts of demand and supply. So, this
section explains to you the equilibrium between demand & supply.
The forces of demand and supply determine the price of a commodity. There is a conflict
in the aim of producers and consumers. Producer’s wants sell the goods at the highest price to
maximize profit and consumers want to buy the goods at the lower price to maximize satisfaction.
Equilibrium price will be determined where quantity demanded is equal to quantity supplied.
This is called Market price.
Table 5.4 Demand — Supply Schedule
PriceRs / Kg Demand(Kg / Month) Supply(Kg / Months)
87654 12345 54321
Figure 5.5
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5.7 Equilibrium price

In table demand and supply of salt at different prices are shown. Equilibrium price is fixed
at Rs 6 where quantity demanded and the quantity supplied are equal. i.e, equal to 3 units. The
figure above shows the quantity demanded and supplied measured in X axis and price on the
Y axis. DD is the demand curve sloping downwards and SS is the upward sloping supply curve.
Both these curves intersect each other at point E which is the equilibrium point and it implies
that at price of Rs.6, demand is 3 units and supply is also 3 units. Thus, equilibrium price is
Rs.6/-.
5.8 Summary
Supply may be defined as how much of goods will be offered for sale at a given time.
Supply is not the same as stock. the term stock indicates a fired quantity while the term supply
implies that the amount offered can be increased or decreased. The law of supply states “ other
things remaning the same if the price of a commodity rises, the supply is expanded, and as the
price falls, its supply is contracted. In other words, the quantity offered for sale varies directly
with price.
5.9 Keywords
Supply: Quantity of goods offered for sale at a given point of time.
Equilibrium Price: The interaction between quantity demanded of quantity supplied.
Law of supply: “Other things remaining the same if the price of a commodity rises, the
supply is expanded, and as the price falls, its supply is contracted. In other words, the quantity
offered for sale varies directly it price
Elasticity of Supply: The responsiveness of Quantity supplied of a good to changes in its

own price.
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1. Explain Law of Supply
2. What is supply and types of Supply
3. What are the factors Influence Supply
4. Explain the method of measuring elasticity of supply.

2. Green,H.A.J(1964), Consumer Theory,2nd Edition, Macmillan.
3 Jack Hirschleifer (1980), Price Theory And Applications, 2nd Edition Macmillan.
4. K.E. Boulding ( A reconstruction of Economics)
5. Abba.P. Lerner – Micro Economic Theory.

65
LESSON - 6
CONSUMER BEHAVIOUR
Learning Objectives
 After having read this lesson you will be able to understand the concept of consumer
behaviour,
 Will know the theories of consumer behaviour and clearly understand the scale of
preference and IC Curve
UNIT STRUCTURE
6.1 Introduction
6.2. Law of Diminishing Marginal Utility
6.3. Law of Equi-Marginal Utility
6.4 Consumer Equilibrium with Utility Analysis
6.5 Meaning of Indifference Curve
6.6 Indifference Map
6.7 Marginal Rate of Substitution
6.8 Properties of Indifference Curves
6.9 Consumer’s Equilibrium with indifference Curve Approach
6.10 Price line or Budget line
6.11 Summary
6.12 Key words
6.13 Check your progress.
6.14 Books for References

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6.1 Introduction
There are two approaches to consumer behaviour (i.e):
(a) Cardinal Approach — Marshallian View
(b) Ordinal Approach — Hicksian View
Let us explain these two approaches in detail.
1. Cardinal Approach: Under cardinal approach there are two main laws (i.e) (i) Law of
Diminishing Marginal Utility (ii) Law of Equi — Marginal utility.
6.2 Law of Diminishing Marginal Utility

This law was first of all given by French Engineer, Gossen. According to this law as one
individual go on consuming a commodity, the marginal utility obtained from its additional units
goes on diminishing. For example, when one man is hungry and starts to get the roti. The utility
maximum at first unit of Roti. At the second time by eating second Roti, one gets less utility.
This process goes on and utility at every step goes on diminishing. Then it is called Gossen’s
First Law. Dr Marshall explained the law in a better way. He says that “the additional benefit
which a person derives from a given increase of his stock of thing diminishes with every increase
in the stock that he already has’.
Definitions of the Law
The law of diminishing marginal utility has been differently defined by economists as
under:
1. According to champion: The more we have of thing, the less we want additional
increments of it or the more we want not to have additional increment of it”.
2. According to Anatol Musad : “The law states that other things being equal, the
marginal utility of a stock decreases, as the quantity of the stock increases”.
3. According to Samuelson: As the amount consumed of a good increases, the marginal

utility of the good leads to decrease”.
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Assumptions:
The main assumption of the law are stated as:
1. Utility can be Measured in cardinal number like 1, 2, 3,……n units
2. The utility of a commodity depends on its own quantity rather than the quantities of
other commodities.
3. The law applies only when the commodity is continuously consumed.
4. All units consumed by the consumer are same in all respect (le), same color, and
state etc.
5. Marginal utility of money remains constant.
6. There is no change in the price of the commodity and its substitute.
7. There is no change in the taste, habits, fashion of the consumer.
Explanation of the Law
The law of Diminishing Marginal utility can be explained with the help of table and diagram.
Table 6.1
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Table 3.1 shows that total utility is 12 from first unit and as more units are consumed and
bought total utility increases and further 20, 26, 30, 32……up to Sn unit at a diminishing rate. At
6th unit, total utility is constant and after, it total utility goes on diminishing. On the other hand,
Marginal utility refers to the successive increment in total utility. As is clear from the table that
the first unit yields 12 of marginal utility. This will satisfy the want of the customer to some extent
and the intensity of want will go down. At the second unit, one gets less marginal utility than the
first unit. Similarly, at the 3rd unit, one gets less marginal utility as compared to second unit.
This process will go up to fourth and fifth unit. Now, if the consumer is forced to take seventh
unit, it will upset the entire system and the consumer gets zero utility. In order words, the
consumer will get the negative marginal utility. At seventh unit, one gets negative (i.e) -2 and
followed by -4 marginal utility. In short, we may conclude from the above analysis that as the
consumer buys more and more units of a commodity, the marginal utility from each successive
unit will go on decreasing.
Diagrammatic Representation of the Law
In the figure units of commodity are measured on X-axis whereas utility on Y-axis. MU is
the marginal utility curve which slopes downward from left to right. It shows that the first unit of
the commodity yields 12 units, second 8 units of marginal utility and so on. At sixth unit, one
gets zero marginal utility. Here the MU curve touches the X-axis at point E. At seventh unit, one
gets negative marginal utility and, therefore, the MU curve goes below the X-axis. It proves that
marginal utility from an additional unit goes on decreasing and so on.
Figure 6.1
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Exception of the Law
The law is universally applicable if all assumptions are fully net worth. Put in practical life.
It is not so. Therefore, there are exceptions which are briefly discussed below:
1. Rare things: The foremost exception of the law is that it does not apply in the case
of certain rare things like stamps, coins etc. But this exception cannot be regarded
genuine because the assumption of homogeneity is violated.
2. Initial stages: When initial -units of commodity are used in less than appropriate
quantity, the marginal utility from additional unit’s increases.
3. Public goods: In case of public utility goods, marginal utility from additional units
increases. But this assumption is contrary to the law of diminishing marginal utility.
4. Music and Poetry: It is said that by hearing music or poetry for the second true, we
get more satisfaction than the first learning. Thus, the learning of music and poetry
is another exception to the law.
5. Misers: It is stated that as the stock of money with a miser increase, the greed for
acquiring more and more money increases. It means the law of diminishing marginal
utility does not apply in case of misers.
6. Discontinuous consumption: The law of diminishing marginal utility does not apply
if there is a time lag between the use of commodity. It requires the continuous
consumption for its application.
7. Things of display: The present law is also not applicable in case of display for
instance, in case of fashion and taste, the law is not properly applicable.
8. Drunkards: This law is not applicable in case of drunkards. A drunkard always

demand more and more wine. So drunkard is considered to be another exception
to this law.
Importance of the law
The law of diminishing marginal utility has a great theoretical and practical significance.
The main points of its merits are explained as under.
1. Variety in production and consumption: It is only due to the law of diminishing

marginal Utility that the variety in production and consumption is found. As it is well
known when more and more units of a commodity are consumed, every additional
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unit yields lesser satisfaction. Thus, the consumer is forced to use another commodity.
The producer will have to produce different variety of goods.
2. Basis of socialism: Socialism refers to that economic system in which income and
wealth is equally distributed among the people. The reason is that rich people enjoys
a high level of income, therefore, the marginal utility for them is low. On the contrary
poor people have low income have less marginal utility guide us that if money is
taken from rich people and given to poor, then the marginal utility of money will
increase.
3. Progressive taxation The law of diminishing marginal utility has a great importance
for the Finance Minister of a country. The Finance Minister while framing suitable
taxation policy keeps in mind the application of this law. Progressive taxation refers
to that system of taxation under which rate of taxation increases as the income of
the person increases and vice-versa. It is only due to the reason that with an increase
in income, the marginal utility of money goes on diminishing.
4. Basis of the law of consumption: The law of diminishing marginal utility provides
basics for the laws of consumption. According to this law, a consumer does not
spend all his income on one commodity because every additional unit of a commodity
yields less satisfaction. Therefore the consumer, in order to get maximum satisfaction
spends different commodities may yield equal satisfaction.
5. Price determination: price of every commodity is determined by its demand and

supply. The demand for a commodity depends upon its marginal utility. If a consumer
wants to sell more units of a commodity, then he will have to reduce its price. It is so
because, as the quality of a commodity increase the marginal utility falls.
6. Advantage to consumers: The above law has a great significance to all parts of
consumers. According to this law, a consumer in order to get maximum satisfaction
from a commodity buys those units whose marginal utility is equal to its price.
6.3 Law of Equi-Marginal Utility

The law of Equi-marginal utility was propounded in 19th century by a French Engineer
named Gossen. The law of diminishing marginal utility applies in case of single commodity. In
reality, the consumer does not consume one commodity but a number of commodities at a
given time. Therefore, for this purpose, we have to extend the law of diminishing marginal utility
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to which we call the Law of Equi-Marginal Utility. It is also called the Gossen’s law. Moreover,
different economists have called it differently. Dr. Marshall has called it “Law of Maximum
Satisfaction”. Similarly, Prof. Hibdon named it “Law of Rational Consumers” and Lord Robbins
“Law of Economics” etc.
Statement of the Law: The law of equi-marginal may be defined which he can put on
several uses and he will distribute it among these uses in such a way that it has the same
marginal utility in all.
MUa = MUb =……….MUn
Pa Pb Pn
According to Samuelson: “A consumer gets maximum satisfaction when the ratio of

marginal utilities of all commodities and their prices are equal”.
According to Lipsey “The household maximizing its utility will allocate its expenditure
between commodities that the utility of the last penny spent on each is equal”.
According to Hicks: “Utility will be maximized when the marginal unit of expenditure in
each direction beings the same increment of utility”. It means
MU1 = MU2 = MU3
Assumptions
1. The law of equi - marginal utility is based on the following assumptions:
2. Every consumer wants to maximize his satisfaction.
3. Price of the commodity remains constant. No change in the prices of substitutes or

complementary goods.
4. Income of the consumer remains constant.
5. Commodities can be divide and sub-divided into the required commodities.
6. Consumer has a rational behaviour
8. No change in income, taste, fashion, habits and customs of the consumer.

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Explanation of the Law
First Method
Let us suppose that the consumer has to spend Rs.5 on two different commodities viz.
mangoes and oranges. Further, we assume that price of each of the commodities is Rs.1.
Marginal utilities of different units, of mangoes and oranges are shown in the table.
Table. 6.2
Let us assume that at one time, the consumer spends his income on one commodity. The
consumer spends first rupee on oranges which yields him 10 units of marginal utility. From the
second rupee, he gets utility equal to 8 units. Now as one goes on spending more and more,
the marginal utility goes on falling. On the other hand, if the consumer spends first rupee on
mangoes, he gets 8 units of utility. But as one goes on spending more and more on oranges,
the marginal utility of oranges goes on diminishing. Moreover, if the consumer spends Rs.5 on
oranges then he will buy only oranges which gives 30 units of utility (10+8+6+4+2=30). Thus,
as the consumer wants to buy two commodities, he will spend first rupee on oranges and
second on mangoes, again third on oranges. Similarly, the consumer will spend fourth and fifth
on mangoes and oranges respectively. In this way the consumer will enjoy maximum satisfaction.
Second method
Let us suppose that a consumer has Rs. 5 with him and wants to spend on two Commodities
(i.e) mangoes and oranges. The utility shall be measured as under.
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i. If consumer spends Rs.3 on oranges and Rs.2 on mangoes then total utility shall
be 10+8+6+8+6=38.
ii. If consumer spends Rs.3 on mangoes and Rs.2 on oranges then total utility shall
be 8+6+4+10+8=36.
iii. If consumer spends Rs.4 on mangoes and Rs.1 on oranges, then total utility shall
be 8+6+4+2+10=30
iv. If consumer spends Rs.1 on mangoes and Rs.4 on oranges then total utility shall
be 8+10+8+6+4=36.
Therefore, the consumer gets maximum satisfaction if he spends Rs.3 on oranges and
Rs.2 on mangoes. Any other arrangement provides less utility than the first case.
Diagrammatic Representation
In the figure, units of money have been taken on X-axis and marginal utility of both
commodities on Y-axis the figure depicts that at a given level of income (Le) Rs.5, the consumer
would spend Rs.3 on oranges, and Rs.2 on mangoes, In case of mangoes, the consumer is in
equilibrium at point E while F in case of oranges. The consumer finds that when Mum = MUO
he gets maximum satisfaction. Moreover, if the ‘consumer spends Rs.3 on oranges, the utility
gained is equal to the shaded area E’ P &C. On the other hand, if the consumer spends Rs.2 on
oranges, the loss in utility will be equal to E*GF. So, it is clear that loss in utility is greater than
the gain. Thus, it is not worthwhile to buy any proportions other than 3 units of oranges and 2
units of mangoes.
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Figure 6.2 Modern Statement of the Law
Modern economists have given a new name to this Law as “Law of Proportionality”.
According to them, a consumer yields maximum satisfaction only when the ratio of marginal
utilities derived from different goods and their prices is equal. For example, the price of commodity
x is paise 50 and the consumer buys 10 units. The consumer gets 10 units of marginal utility
from 10" unit. In the same way, if the price of the commodity - X is paise 25 and the consumer
buys 12 units, he gets 3 units from the 12th units. The formula to calculate the marginal utility
according to modern economists is as under:
MUa = MUb MUc = MUn
Pa Pb Pc Pn
Importance of the Law
Let us explain the significance of the law from the following points:
1. Consumption: Every consumer wants to get maximum satisfaction from one’s

limited income. The income of the consumer is limited while his wants are multiple.
Therefore, if a consumer spends his limited income on different commodities in
such a way that the last unit of the commodity yields equal marginal utility, then he
will get maximum satisfaction.
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2. Exchange: The law also applies to exchange. Exchange means replacing of goods
which gives him loss utility for another which yields more utility.
3. Public Finance: The law of substitution has also its importance in the sphere of
public finance. By public finance, we mean the revenue and expenditure activities
of the government. At the time of levying taxes, Finance Minister takes its help. He
levies taxes in such a way that the marginal social sacrifice (MSS) of each tax-
payer is equal. This will maximize the social welfare as:
MSSa. = MSSb= MSSc………….= MSSn
4. Production: Every producer in the market wants to get maximum profits. Therefore
in order to achieve this objective, the producer has to use several factors of production
The producer substitutes one commodity for another so as to serve most economical
combination.
5. Distribution: The law of equi-marginal utility gives us explanation about the

distribution of national income. Distribution is done in such a way that in the long
period every factor of production gets its share, according to its marginal productivity.
Therefore, in order to have such a distribution factors have to be substituted. This
process of distribution will go on till the marginal productivity of the factors is equal
to their remuneration and the marginal productivity of different factors becomes
equal to each others.
6. Guide to the individual: This law is the guide to the individual where he wants to
allocate his limited resources to get maximum satisfaction.
Limitations or Exceptions of the Law
The following are the limitations or exceptions of the law:
1. Irrational behaviour of the consumers: This law is based on the assumption that
every consumer is rational but in real sense, consumer acts in irrational number.
His behaviour is greatly influenced by habits, advertisements, fashions etc. Under
these cases, he fails to avail maximum satisfaction.
2. Utility is subjective: The law stands nowhere as consumer’s behaviour is based

on his psychology. It is difficult to measure one’s psychology or utility as it is possible
in case of heat or energy.
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3. Marginal utility of money is not constant: The law of equi-marginal utility is based
on the assumption that marginal utility is constant. In real life, it is not so. The utility
of money goes on decreasing with the passage of time, when there is a change in
the price of a commodity.
4. Unrealistic assumptions: This law is based on false unrealistic assumptions like

homogeneous products, constant fashion, taste, habits etc. But this is wrong as
they go on changing in a dynamic world.
5. Ignorance of the consumers: It is a fact a common consumer does not possess

complete knowledge of all commodities and their prices in the market. Moreover,
prices are subject to change. Therefore, ignorance of the consumer is a biggest
hindrance, so the law does not apply.
6. Consumer is not a computer: This law is only applicable when the consumer
keeps complete record of income and continuously goes on calculating the marginal
utility in daily life. But human mind is incapable to make such calculations. All
calculation works is possible with the help of a computer. Thus, the law is not
applicable at all.
7. Indivisible goods: Another limitation of the law is that is not applicable in case of
indivisible goods. There are certain goods such as fans, TV’s, car etc. which cannot
be divided or sub-divided. If these commodities are divided, they will lose their
utility. In such cases, this law is not applicable.
8. Durable goods: Still another limitation of the law persists as it is difficult to measure
the utility in respect of durable goods such as car and machinery. Moreover, it is not
desirable to compare the marginal utility of such goods with the marginal utility of
other goods.
9. Scarcity of goods: In the present world, there is acute shortage of some

commodities and the consumer is compelled to purchase an alternative or substitute
goods in the market. In such cases, it is very difficult to measure the utility of such
commodities.
10. Laziness of the consumers: There are some consumers who do not bother about
the maximum utility of commodity. So, it is also not applicable in such cases.
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6.4 Consumer Equilibrium with Utility Analysis

A consumer is said to in equilibrium wherein a consumer gets maximum satisfaction of
his limited income and has to tendency no make any change in the existing expenditure in other
words, the consumer would have no incentive to make any change in the quality of the commodity
purchased because any change in his preferences would reduce the given maximum level of
satisfaction. According to Scitovosky, “A consumer is in equilibrium when he regards his actual
behaviour as the best possible under the circumstances and feds no urge to change his behaviour
as long as circumstances remain unchanged.
Assumptions
Consumer’s equilibrium with utility analysis is based on the following assumptions:
1. Consumer acts rationally.
2. Utility is measured in cardinal numbers like 1,2, 3, 4, etc.
3. Consumer has complete knowledge.
5. Income of the consumer and price of the commodity remain fixed.
6. Tastes of the consumer also remain unchanged.
A Consumer Equilibrium with a Single Commodity with one Use
Consumer’s equilibrium with a single commodity having one use is explained with the law
of diminishing marginal utility. The consumer will go on purchasing additional units of commodity
so long as the marginal utility of the commodity becomes equal to price. If the price falls, he will
buy more of a commodity and therefore marginal utility gained from the commodity will also full
to become equal to price. In short, equality between marginal utility and price reflects the position
of consumer’s equilibrium.
MU = P
Suppose a consumer buys apples. His equilibrium will be reached at a point where the
price of apples is equal to the marginal utility of apples. In the above figure consumer gets
maximum satisfaction when he buys OQ apples. OP is the price which remains constant. At OQ
quantity, Price of apples is equal to marginal utility (i.e) OP=EQ. Here the consumer gets
maximum satisfaction which in the difference between total utility (OQ
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Figure 3.3
ED) and total price (OQEP) paid. Therefore, the total net satisfaction is equal to PED).
Now, if the consumer buys OQ, apples the price he pays MQ, is more than the marginal NQ.
Thus, his net satisfaction is reduced by triangle EMN. Contrary to this, if he buys OQ2 of apples
total satisfaction is still less buy triangle EKR. In this way, consumer gets maximum satisfaction
only when he buys OQ of apples at price OP.
Consumer’s Equilibrium with a single commodity with several uses
In case consumer buys a single commodity with several uses, then this equilibrium will be
determined by the law of equi-marginal utility. According to this law, consumer spends his limited
income on different goods in such a fashion that marginal utility from all commodities are equal.
MUa + MUb = MUc
Table 3.3
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We see from the table that a consumer has 5 units of a commodity as he can use it in two
forms. When consumer uses first unit he get MU equal to 20 units but if he uses it on B, he gets
marginal utility equal to 16 units. Therefore, the consumer uses first unit of commodity for A and
second unit for B and so on. By dividing so, he gets total satisfaction equal to
20+16+12+16+12=76.
In the figure given below marginal utility X commodity for A has been shown by AB line
and marginal utility of X for B commodity has been shown by EF line. Consumer has five units
of a commodity. If he uses three units for A, two units for B, he gets same satisfaction. As has
been shown by MN line, there the consumer will be in equilibrium.
Figure 3.4
Consumer’s Equilibrium with several commodities
In case of several commodities, the consumer would be in equilibrium when the marginal
utility from different commodities is the same.
MUx = MUy = MUz = = MUn.
The equation would hold good only if prices of all goods are same. If the prices of different
commodities differ, the equation would be.
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MUx MUy MUz = MUn
Px Py Pz Pn
The consumer spends a rupee on a commodity only if loss caused by rupee one yields
him satisfaction equal to that. In that way, marginal utility of money has also to be taken into
account (i.e)
MUn = MUx MUy MUz =……….. MUn
Px Py Pz Pn
6.5 Meaning of Indifference Curve

In simple words, an indifference curve may be defined as the low of the points of which
represents a collection of commodities such that Consumer is indifferent among, any of these
combinations.
The concept of indifference cue has been defined by orient economists as under:
1. According to Hicks: “It is the low of the points representing paths of quantities
between which the individual is indifferent and so it is termed as an indifference
curve”.
2. According to Meyers: “An indifference curve defined as a schedule of various

combination of goods which will be equally satisfactory to the consumer concerned”.
3. According to Ferguson: “An indifference curve is a combination of goods, each of

which yields the same level of total utility of which the consumer is indifferent”.
4. According to Leftwich “An single difference curve shows the different combinations
of X and Y yield equal satisfaction to the consumer”.
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Assumptions of Indifference Curve Analysis
The indifference curve analysis is based on the under mentioned assumptions:
1. Rationality: The consumer is assumed to be rational. He aims at marginalizing

utility given his income and market prices of goods.
2. Ordinal utility: It is assumed that consumer can has preferences (order the various
combinations of goods) according to satisfaction of each basket.
3. Diminishing marginal rate of substitution: The rate at which certain amount of

one commodity is substituted for another is called the marginal rate of substitution.
As a person acquires more and more units of commodity say Y, he is prepared to
give less and less amounts of X for one more unit of Y. It means that the marginal
rate of substitution of X for Y is diminishing.
4. Axiom of comparison: Any two combinations of X and Y commodities can be

compared in preference by an individual.
5. Consistency- It is assumed that the consumer is consistent in his choice. If in one

period he choose combination A over B, he will not chooses B over A in another
period when both combinations are presented to him. This assumption may be
symbolically written as A > B, then B > A.
6. Transitivity: it is assumed that consumer choices are characteristed by transitivity.

Symbolically we may write it as A>B and B>C, then A>C.
7. Weak ordering: Weak ordering implies that there is a possibility of consumer being
indifferent between two combinations weak order therefore recognizes the existence
of preferences and indifferences. The consumer may prefer A to B or B to A or he
may be indifferent
8. Scale of preferences independent of market price: The consumer is assumed

to build up his scale of preferences independently of market prices.
Consumer Behaviour
We have to explain consumer behaviour in the market place with the help of indifference
curves. We have to define the equilibrium of the consumer (that is, his choice of the combination
that maximizes his utility). For this we must introduce the concept of indifference curves and of
their slope (the marginal rate of substitution), and the concept of the budget of the price line.
These are the basic tools of indifference curve approach.
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Indifference Schedule: The indifference curve schedule, may be defined as a schedule

of various combinations of two goods that will be equally satisfactory to the individual concerned.
In other words, an indifference schedule is a list of combinations to which the consumer is

indifferent. Indifference schedule has been shown below:
Table 3.4
In table, all the combinations give same level of satisfaction to the consumer. The consumer
starts with 2 units of X and 18 units of Y. Now the consumer is asked to tell how much Y is
willing to give up to got the additional units of Good-X so that his level satisfaction may remain
the same. If the gain of two Unit of X compensates him fully for the loss of 5 units of Y, then the
Good Y (4X + 13Y) Will Provide him with the same level of satisfaction as that of the initial
combination (2X + 18Y) in the same way, by further asking to how much of Y he is ready to
forge to gain the successive increment of his stock of X so that his level of satisfaction remains
unaffected he gets the combination (6x + 9y) and (8x + 6y) Each of these combination give the
same level of satisfaction.
Indifference Curve: An indifference curve is the law of the combination of two goods that
are equally satisfactory to the consumer or to which the consumer is indifferent. In other words,
it is a graph of an indifferent schedule. At any point on the curve denotes a particular level of
satisfaction, so combination of commodities of X and Y that yields the same satisfaction when
joined gives a curve, known as indifference curve. Now, we can translate the above schedule
into a diagram and, thus, get an indifference curve.
In the figure below, quantity of Good-X has been measured on X-axis and on Y-axis, the
quantity of Good-Y. It is an indifference curve which has been drawn by plotting the various
combinations in the indifference schedule. All the combinations lying on indifference curve are
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equally, desirable because all these combinations give him the same level of satisfaction. If the
consumer resets at point J on the indifference curve with 2 units of X and 13 units of Y?, he
would be as satisfied as at point K with 4 units of X and 13 units of Y or at point L with 6 units of
X and 9 units of Y and so on. All these combinations provide him the same level of satisfaction.
If we join the points J, K. L, M, we get a continuous curve known as indifference curve.
Figure 3.5
6.6. Indifference Map

An indifference curves is which rank preferences of the consumer. These curves are like
contour lines on a map which shows all places in the same height above the sea level. Each
curve represents equal level of utility. In short, it is a device of ranking of consumer preference.
We can show different schedules graphically each with its own curve
Figure 3.6
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In figure 4.6, all points on IC2 and IC3 are preferred to all points on IC1 on the first instance,
all combinations on IC2 are preferred. They are more preferred to all combinations on IC1. It
needs no proof to say that the combination of P2 and P3 yield greater total satisfaction than the
combination of P1 and IC1 as it is a common knowledge that more of both the commodities yield
greater total satisfaction. Similarly any point on IC3 will yield higher satisfaction than the earlier
indifference curves.
6.7 Marginal Rate of Substitution

Prof. A Koutsiannis “the marginal rate of substitution of ‘Y for X (MRS yx) as the number
of units of commodity Y that must be given up in exchange for an extra unit of commodity X so
that the consumer maintains the same level of satisfaction”.
In the words of Prof. Bilas: ‘the marginal rate of substitution of Y for X (MRS yx) its
defined as the amount of Y the consumer is just willing to give up to get one additional units of
X and maintain the same level of satisfaction”
Thus, from the above, the marginal rate of substitution Y for X (MRS yx) is defined as the
amount of Y the consumer is just willing to give up to get one additional unit of X and maintain
the same level of satisfaction.
Let us explain the concept of MRS with the help of indifference curve approach as given
in the table
Table 3.5
From the above table, it is seen when the consumer moves from combination A to B, the
consumer foregoes 4 units of Y good for one unit gain of X good. Thus, marginal rate of
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substitution comes 4. In this way, when the consumer moves from B to C, the consumer foregoes
3 units of Y good for another unit of X good, the consumer is willing to a forego less units of Y
good as of 2 and 1. In E combination satisfaction of the consumer is 1:1.
Thus utility gained = utility lost
it can also be expressed as
MRSxy = Δy
Δx
In short, as the stock of X increases the amount Y in exchange will decreases: (for gaining
one more unit of X). In this way, the Marginal Rate of Substitution diminishes and slope of
indifference curve indicates the same.
Diagrammatic Representation
In figure at point A, consumer has 1 unit of Y commodity. At point B, he has 2 units of X-

Commodity and 11 units of Y-Commodity, According to the law of diminishing marginal utility,
MU of additional units of X-Commodities is diminishing and margin utility of Y commodity starts
increasing. Therefore, consumer will be willing to give up less and less of Y commodity for
every additional units of X commodity. In other words, marginal rate of substitution of X-
Commodity for Y commodity diminishes.
Figure 3.7
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Relationship between Marginal Rate of Substitution And Marginal Utility
To attain one unit gain of X commodity (i.e), ÄX, the consumer gives up ÄY and he gets
the same level of satisfaction. This means that the total loss in utility by giving up ÄY is equal to
the total gain in utility owing to the increase in X by ÄX.
Let the total loss in utility by surrendering ÄY = ÄY x MU of Y, and the gain in utility by
taking ÄX = ÄX x MU of X.
Since the loss in satisfaction is equal to gain in satisfaction, ÄY (MU of Y) = ÄX (MU of X).
By transporting, we shall get
Δy = MU of X
Δx MU of Y
In this way, the marginal rate of substitution between two goods is equal to the ratio
between the marginal utilities of two commodities. Hence, we must remember that in indifference
curve analysis, the marginal rate of substitution is obtained directly by asking the consumer
how much of the goods he would be willing to give up for a unit increase in another good. Thus,
Hicks-Allen concept of MRS does not involve any kind of measurement of marginal utilities.
Differences between Marginal Rate of Substitution and Diminishing

Marginal Utility
Generally, we are confused with marginal rate of substitution and diminishing marginal
utility. In fact, both concepts are totally different. The main points of difference are as under
mentioned.
1. MRS denotes the rate of commodity substitution. It has no subjective element in it.
It simply tells -us as to how much amount of one commodity the consumer loses to
attain amount of another commodity. In such a situation, the consumer still remains
on the same indifference curve.
2. It does not think of independent utilities. ‘It allows complementary and substitution.
In this sense, it is wider concept than diminishing marginal utility.
3. MRS does not require the assumption of constant marginal utility of money. It deals
with physical amounts of the commodity. On the other hand, the law of diminishing
marginal utility cannot do without this assumption.
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6.8 Properties of Indifference Curves

Before, we discuss the properties or attributes of the indifference curve, it would be crucial
to examine the assumption of an indifference curve, it would be crucial to examine the
assumptions of an indifference curve. The Main assumptions of indifference curve are as
following:
(a) Non-satisfy: It is assumed that the consumer will always prefer a large among of a
commodity to small amount of other commodity. Provided the amount of other good
at his disposal remains unchanged. This assumption implies that the consumer not
over supplied with any good. When he is over supplied or over satisfied with one
good, he will prefer a smaller quantity of that good to the large quantity of the other
good. This means that the consumer has yet not reached the point of satisfy in the
consumption of any good.
(b) Transitivity: This implies that the tastes of the consumer are quite consistent. Let
us suppose that there are three combinations of two goods (i.e) A, B and C, and the
consumer is indifferent between A and B, B and C, then obviously the consumer will
also be indifferent between A and C. Thus, if the consumer prefers A to B and B to
C, the consumer will also prefer A to C.
(c) Diminishing marginal rate of substitution: The consumer is to substitute more

and more units of Y for one unit of X. so the consumer will give up fewer units of Y
for each additional unit of X.
Properties
Indifference curves slope from Left Downward to Right: Indifference curves slope
from left downward to right means when the amount of one commodity in the combination
increases the amount of other commodity reduces. If for instance, the amount of commodity X
is increased in the combination and the amount of commodity Y remains unaltered, the consumer
will prefer new combinations to the original one and the two combinations will not lie on the
same indifference curve.
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Figure 3.8
In Figure A to C, A, B and C consumer has the points E, E1 on the same indifference

curve.
Three points reflect the two combination of commodity X and Y. The combinations
represented by E and El do not possess any loss of one commodity to fetch more of the other
commodity. In fig D at point A at consumer buys OX of commodity X and OY of commodity Y. As
he moves from A to B and further for attaining more X-commodity, he is ready to forego lesser
and lesser of commodity Y. it is only in this case that he can be indifferent between A and B
because increase in commodity – X leads to a decrease in commodity – Y.
Indifference Curves are Convex to the Origin: The other property of indifference curves
is that they are convex to the origin. It means, as we move from left down to the right along the
IC, the marginal rate of substitution between the two commodities goes on diminishing.
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Figure 6.9
In figure 3.9, combination A and D lie on indifference curve IC. As the consumer moves
from A to B, he gains a small increase of Good – X (X1 X2 = ÄA) but along with this he
foregoes (1/4 1/3 = ÄB) of Good-Y. The marginal rate of substitution of Y for X is ÄA / ÄB
now B If the consumer is allowed to some increment (X1 X2 = X2 X3) in commodity X, he is
prepared to part with (Y3 Y2) of Y than before. Thus, MRSxy goes diminishing along the IC.
In other words, in the figure on the left side, the marginal rate of Y-Commodity for X
commodity falls as ÄY ÄX. The indifference curve is convex to the origin, as ÄY becomes
smaller and smaller.
In figure B, the marginal rate of substitution of Y for X is constant ÄY = ÄX. The indifference
curve is a straight line.
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In figure C, on the right the marginal rate of substitution of X for Y is increasing, ÄY > ÄX.
The indifference curve is concave to the origin. Therefore, since the marginal rate of substitution
must diminish the indifference curve must be convex to the origin. If the indifference curve is a
straight line, the two commodities are perfect substitutes for one another. If they are perfect
substitutes, they are regarded, for all practical purposes, as the same commodity and there is
no basis to distinguish between them. Then the elasticity of substitution between them is infinite.
Indifference curve will not touch either X-axis or Y-axis.
Figure 6.10
The indifference curve will not touch either X-axis or Y-axis as we have assumed that the
individual is interested in different combinations of two commodities as seen in fig. 6. If it touches-
either of the axis, it will mean that the consumer is interested in one commodity only. In the
diagram 4.10, the indifference curve touches X axis of point A and the Y-axis at point B. Thus at
point A he will be satisfied with OA units of Y commodity, and has no preference for commodity
similarly, at point B, he will have OB units of Y commodity and non of X This normally does not
happen. However if one of the commodities is money and it is shown on the Y-axis, if would be
correct for an indifference curve to touch Y-axis at point-B. If would then mean that either the
consumer wants OB units of money only or some units of money and some units of the other
commodity, OB units of money will give him the same satisfaction as a combination of a few
units, of money and some units of the other commodity. Thus we can conclude that indifference
curve will not touch either X-axis or Y-axis.
4. Indifference curve neither touches nor intersect each other
Another property of indifference curve is that indifference curves can neither touch nor
intersect each other so that only one indifference curve can pass through any one point of the
indifference map.
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In figure 4:11 two indifference curves IC1 and IC2. Intersect each other at point P on
indifference curve IC2 combination M is preferable to combination N on indifference curve IC1
The reason for this preference is that combination M flies on the higher indifference curve .
Similarly, combination E is more preferred on IC, to combination F on IC2. But E = N

being points on the same curve IC, and F=M, points on IC2 curve. As combination M on IC2 it
preferred to combination N on ICI, thus, F should that F is preferred to F, E being on a higher
indifference curve. Therefore, no two indifference curves can intersect each other.
Figure 6.11
5. Higher Indifference curve represents higher level of Satisfaction:
Indifference curve which lies above the right to another indifference curve represent a
higher level of satisfaction. In other word the consumer will prefer the combination which lie on
a other indifference curve as compared to the combinations liying on a lower indifference curve.
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Figure 6.12
In fig 4.12 IC2 is a higher indifference curve than the IC1, thus combination K has been
taken on higher indifference curve and combination J on a lower indifference curve combination
O will provide more satisfaction to the consumer instead of combination J which lies on a lower
indifference curve. It is so because combination * represents more of two goods (i.e), good X
and good Y than the combination J. Therefore, the consumer must prefer K on IC2 instead of J
on IC1,.
6.9 Consumer’s Equilibrium with indifference curve Approach

The aim of the consumer is to get the maximum satisfaction from his limited resources
with the help of indifference curve analysis, a consumer can know how to he should spend his
limited income on the combination of various commodities that may provide him the maximum
satisfaction, When a consumer gets maximum satisfaction from his limited income he is said to
be in equilibrium. Thus, the consumer equilibrium refers to a situation when there is no tendency
on the part of the consumer to buy more or less of the commodity which has already been
consumed.
Assumptions: Consumer’s equilibrium through indifference curve technique has been

based on the following assumptions.
i. The consumer has an indifference map showing his scale preferences for
combinations of the goods in question and money.
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ii. The scale of preferences imprinted on his mind remains unchanged throughout the
analysis.
iii. He has limited money, income which, if he does not spend on the good in question,
will certainly spend on some other goods or goods.
iv. He is one of the many buyers and knows the prices of all goods. All prices remains
constant until a new equilibrium is to be attained.
v. All goods are homogenous and divisible.
vi. The consumer acts rationally and aim at maximizing his satisfaction.
vii. The condition of transistivity is satisfied. If combination A > B and B > C then A > C.
viii. The condition of non-satisfy holds. The consumer prefers more of one commodity
or of the other or of both,
6.10 Price line or Budget line

The price line of the consumer is given by his total money income that he would like to
spend on a combination of two goods. If it shows the limit of how much he can spend. It is also
known as the consumption possibility line, line of attainable combinations or opportunity line.
According to Ferguson: The price line shows the combinations of goods that can be
purchased if the entire money income is spent”.
According to Prof. Hibdon: “The budget line shows all the different combinations of the
two commodities that a consumer can purchase, given his money income and the price of two
commodities”.
Let us suppose that a consumer has limited money income of Rs.40 which he can spend
on two commodities. The price of commodity- X is Rs.30- and the price of commodity Y is Rs.20
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Table 3.6
It reveals from table that with Rs.40 as income and the price of X-Commodity being Rs
30/- and of Y-Commodity of Rs.20/- the initial combination is 0X+12%. The other possible
combinations are 2X+9Y, 4Y+6Y, 6X+3Y and 8X+0Y respectively. Now, if the consumer spends
his entire income on Y-Commodity he gets 12 units of Y-Commodity contrary to it, if he spends
the entire income on X-Commodity he gets 8 units of X-Commodity. There are other intermediate
combinations which are equally desirable. When all these combinations are plotted on a graph
and joined together with straight line, we get the price line or budget line as seen in fig.
Figure 3.13
In figure 3.13, different combinations of two goods have been shown by AB line. At different
prices, consumer buys different combinations, of commodity X and commodity-Y. For instance,
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when the consumer buys 2 units of commodity X then he will purchase 9 units of commodity Y
while 6 of X commodity, then 3 of Y commodity and so on. Therefore, from various combinations
we can easily draw a price line as AB
Therefore, Slope of price line Px

Py
Conditions of Equilibrium
Now, let us consider how a consumer reaches as equilibrium position with the help of
indifference curves. According to Prof. Kostsoyiannis there are two conditions of consumer’s
equilibrium.
1. Price line should be tangent to indifference curve.
2. Indifference curve should be convex to the origin.
A Condition of Tangency
The consumer is the equilibrium where the slope of the price level is equal to the slope of
the indifference curve. The scope of the price lines is the ratio of A price to B price. The indifference
curve shows the substitution ratio. So the consumer attains equilibrium when the substitution
ratio is just equal to the price ratio of X to Y In other words, the marginal ratio of substitution of
X and Y must become equal to price ratio between these two goods. Thus at point P, we get
MRSXY = Price of X
Price of Y
With the indifference curves of the usual shape, the equilibrium point possesses an element
of stability. If any one of the properties of indifference curves is violated, consumer equilibrium
would not occur at a point of a tangency
(i) If the slope of the indifference curves was not negative, there could be no point of
tangency with the negatively sloping price line. (ii) If indifference curves intersect each other, a
number of points of tangency might occur. (iii) If indifference curves were concave to the origin,
the point of tangency would yield the lowest indifference curve therefore, the highest indifference
curve would lie at one of the end points of the price line. Under these circumstances, consumer
will spend all his income on just one commodity.
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In figure 3.14 commodity-X has been measured on horizontal axis and commodity-Y on
the vertical axis. PL is the price line. The consumer can buy any combination of this price line.
The consumer will choose that combination on the price line which lies on the higher indifference
curve. The highest indifference curve to which price line is tangents would give maximum
satisfaction. Price line PL is tangent to indifference curve IC3 at point P. It gives us the condition
of consumer’s equilibrium. Since, indifference curves are convex to the origin, any other point
not lying on this price line cannot be a possible equilibrium point, because this present price-
income situation will not allow him to move on to that points. Actually, the consumer will be in
equilibrium at point P where he buys OX of X-Commodity and OY or Y-commodity. Any other
combination instead of P on the price will give him less satisfaction because they lie on the
lower or higher indifference curve. Thus, along all possible combinations on PL price line, P lies
on the higher indifference curve and would give the maximum satisfaction.
Figure 6.14
Although the consumer can get more satisfaction at indifference curves IC4 and IC5 get
the combinations on these indifference curves are beyond the reach of the consumer.
6.11 Summary
The logical basis of consumer behaviour has been explained by different theory. some
of the important ones are discussed in this chapter. The law of DMU states that as the consumer
has more and more units of a commodity, its MU falls. Marshall’s consumer surplus in hte
amount consumer in willing to pay units the amount be actually pays. IC curve shows different
combinations of goods that yield the same level of satisfaction to the consumer.
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6.12 Key Words

Consumer Surplus : The amount consumer is willing to pay. the amount be actually
pays.
Budget Line - Shows all the possible combinations of the two goods that can be bought
by a consumer given income and price of goods.
Elasticity of Substitution: Between two goods X & Y measure the case with which one
good can be substituted for the other.
Indifference Curve: Defined as the laws of points each of which represents a collection
of commodities such that the consumer is indifferent among any of these combinations.
Indifference Schedule: Is a list of combinations to which the consumer is different.

1. Explain law of diminishing marginal utility
2. What is mean by Indifference Curve
3. What is mean by Consumer Surplus
4. Explain assumptions of Indifference Curve?

1. Baumol.W.J(1978), Economic Theory And Operations Analysis.
2 Cohe.K.J And Cyret R.M.(1976), Theory Of The Firm, Prentice Hall Of India.
3. Ackley – Macro Economic Theory
4. Blackhouse. R. and A Salansi (Macro Economics and Real World)

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LESSON - 7
PRODUCTION
Learning Objectives
After having read this lesson, you will be able to describe the determinants of production,
analyse the laws of production, compare the aspects of production function, Cost classification,
etc.,
UNIT STRUCTURE
7.1 Introduction
7.2 Methods of Production
7.3 The Production Function
7.4 The Short-Run Production Function
7.5 The Long-Run Production Function
7.6. The Law of Variable Proportions
7.7. The Law of Returns to Scale
7.8 Economics of Scale
7.9. Diseconomics of Scale
7.10 Summary
7.11 Key Words
7.1 Introduction
Production is an activity that transforms inputs into output. In traditional production theory
resources used for the production of a product are known as factors of production. Factors of
production are now termed as inputs which may mean the use of the services of land, labour,
capital and organization in the process of production. The term output refers to the commodity
produced by the various inputs.
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Production theory concerns itself with the problems of combining various inputs, given
the state of technology, in order to produce a stipulated output. The technological relationships
between inputs and outputs are known as production functions.
Production:
Production in economic, terms is generally understood as the transformation of inputs

into outputs. The inputs are what the firm buys, namely productive resources, and outputs are
what it sells. Production is not the creation of matter but it is the creation of value. Production is
also defined as producing goods which satisfy some human want. Production is a sequence of
technical processes requiring either directly or indirectly the mental and physical skill of craftsman
and consists of changing the shape, size and properties of materials and ultimately converting
them into more useful articles.
7.2 Methods of Production

There are three methods of production:
a) Unit production
b) Mass production
c) Batch production
The unit production is otherwise known as job-order production. This type of production is
used for things which cannot be produced on large scale, things of high artistic nature, i.e.
production of exclusive goods. This is a method to meet the individual requirements of customers.
This type of production requires lot of flexibility in operation.
Mass production uses mechanical aids for material handling. This type of production
requires specially planned layout, special purpose machines, jigs and fixtures, automatic
machines, etc. Mass production is continuous production, i.e. it does not have any non-producing
time.
Batch production is generally adopted in medium size enterprises. It is a stage in-between

unit production and mass production. It is bigger in scale than unit production while it is smaller
than mass production. In this type of production, variety of products is manufactured in lots at
regular interval. Therefore, this is known as batch production. The theory of production centres
round the concept of production function which we explain now.
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7.3 The Production Function

The production function expresses a functional relationship between quantities of inputs
and outputs. It shows how and to what extent output changes with variations in inputs during a
specified period of time. In the words of Stigler, “The production function is the name given to
the relationship between rates of input of productive services and the rate of output of product.
It is the economist’s summary of technical knowledge.” Basically, the production function

is a technological or engineering concept which can be expressed in the form of a table, graph
and equation showing the amount of output obtained from various combinations of inputs used
in production, given the state of technology. Algebraically, it may be expressed in the form of an
equation as
Q =f (L, M, N, Ê, T)…………. (1)
where Q stands for the output of a good per unit of time, L for labour, M for management
(or organisation), N for land (or natural resources), Ê for capital and T for given technology,
and refers to the functional relationship.
The production function with many inputs cannot be depicted on a diagram. Moreover,
given the specific values of the various inputs, it becomes difficult to solve such a production
function mathematically. Economists, therefore, use a twoinput production function. If we take
two inputs, labour and capital, the production function assumes the form
Q = f (L, K) ….(2)
The production function as determined by technical conditions of production is of

two types:
It may be rigid ox flexible. The former relates to the short run and the latter to the long run.
The Nature of Production Function:
The production function depends upon the following factors:
(a) The quantities of inputs to be used.
(b) The state of technical knowledge.
(c) The possible processes of production.

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(d) The size of the firm.
(e) The prices of inputs.
Now if these factors change the production function automatically changes.
Attributes of Production Function:
The following are the important attributes of production function:
(i) The production function is a flow concept.
(ii) A production function is a technical relationship between inputs and outputs expressed
in physical terms.
(iii) The production function of a firm depends on the state of technology and inputs.
(iv) From the economic point of view, a rational firm is interested not in all the numerous
possible levels of output but only in that combination which yields maximum outputs.
(v) The short run production function pertains to the given scale of production. The long
run production function pertains to the changing scale of production.
7.4 The Short-Run Production Function

In the short run, the technical conditions of production are rigid so that the various
inputs used to produce a given output are in fixed proportions. However, in the short run, it is
possible to increase the quantities of one input while keeping the quantities of other inputs
constant in order to have more output. This aspect of the production function is known as the
Law of Variable Proportions. The short-run production function in the case of two inputs, labour
and capital, with capital as fixed and labour as the variable input can be expressed as
Q=f (L,K)
where K refers to the fixed input. … (3)
This production function is depicted in Figure 1 where the slope of the curve shows the
marginal product of labour. A movement along the production function shows the increase in
output as labour increases, given the amount of capital employed K;. If the amount of capital
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increases to K, at a point of time, the production function Q = f (L, K 1) shifts upwards to Q = f

(L,K2 ), as shown in the figure.
Figure - 7.1
On the other hand, if labour is taken as a fixed input and capital as the variable input, the
production function takes the form Q =f (KL) …(4)
Figure - 7.2
This production function is depicted in Figure 2 where the slope of the curve represents
the marginal product of capital. A movement along the production function shows the increase
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in output as capital increases, given the quantity of labour employed, L2 If the quantity of
labour increases to L2 at a point of time, the production function Q = f (K,L 1) shifts upwards to
Q=f(KL2).
7.5 The Long-Run Production Function

In the long run, all inputs are variable. Production can be increased by changing one or
more of the inputs. The firm can change its plants or scale of production. Equations (1) and (2)
represent the long-run production function. Given the level of technology, a combination of the
quantities of labour and capital produces a specified level of output.
The long-run production function is depicted in Figure 3 where the combination of OK of

capital and OL of labour produces 100 Q. With the increase in inputs of capital and labour to
OK1 and OL1, the output increases to 200 Q. The long-run production function is shown in
terms of an isoquant such as 100 Q.
Figure - 7.3
In the long run, it is possible for a firm to change all inputs up or down in accordance with
its scale. This is known as returns to scale. The returns to scale are constant when output
increases in the same proportion as the increase in the quantities of inputs. The returns to
scale are increasing when the increase in output is more than proportional to the increase in
inputs. They are decreasing if the increase in output is less than proportional to the increase
in inputs.
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Let us illustrate the case of constant returns to scale with the help of our production
function.
Q = (L, M, N, Ê, T)
Given T, if the quantities of all inputs L, M, N, K are increased n-fold, the output Q also
increases è-fold. Then the production function becomes nQ –f (nL, nM, nN, nK).
This is known as linear and homogeneous production function, or a homogeneous function

of the first degree. If the homogeneous function is of the Kth degree, the production function is
nk.Q = f (nL, nM, nN, nK) If k is equal to 1, it is a case of constant returns to scale; if it is greater
than 1, it is a case of increasing returns of scale; and if it is less than 1, it is a case of decreasing
returns to scale.
Thus a production function is of two types:
(i) Linear homogeneous of the first degree in which the output would change in exactly
the same proportion as the change in inputs. Doubling the inputs would exactly double the
output, and vice versa. Such a production function expresses constant returns to scale,
(ii) Non-homogeneous production function of a degree greater or less than one. The
former relates to increasing returns to scale and the latter to decreasing returns to scale.
Conclusion:
The production function exhibits technological relationships between physical inputs and
outputs and is thus said to belong to the domain of engineering. Prof. Stigler does not agree
with this commonly held view. The function of management is to sort out the right type of
combination of inputs for the quantity of output he desires.
For this, he has to know the prices of his inputs and the technique to be used for producing
a specified output within a specified period of time. All these technical possibilities
are derived from applied sciences, but cannot be worked out by technologists or engineers
alone. ‘The entrepreneurs also provide productive services and they are far from standardized.
Some men can get gang of workers to do their best, others are better at luring customers,
still others at borrowing money, and each will have a different production function. If we take
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account of activities such as selling, settling strikes and anticipating future styles of product, it
is clear that large segments of what we mean by technique are matters of business knowledge
and talents, not to be acquired in the best engineering schools.” The production function is, in
fact, “the economist’s summary of technological knowledge,” as pointed out by Prof. Stigler.
7.6. The Law of Variable Proportions.

If one input is variable and all other inputs are fixed the firm’s production function exhibits
the law of variable proportions. If the number of units of a variable factor is increased, keeping
other factors constant, how output changes is the concern of this law. Suppose land, plant and
equipment are the fixed factors, and labour the variable factor.
When the number of labourers is increased successively to have larger output, the
proportion between fixed and variable factors is altered and the law of variable proportions sets
in. The law states that as the quantity of a variable input is increased by equal doses keeping
the quantities of other inputs constant, total product will increase, but after a point at a diminishing
rate.
This principle can also be defined thus:
When more and more units of the variable factor are used, holding the quantities of fixed
factors constant, a point is reached beyond which the marginal product, then the average and
finally the total product will diminish. The law of variable proportions (or the law of non-proportional
returns) is also known as the law of diminishing returns. But, as we shall see below, the law of
diminishing returns is only one phase of the more comprehensive law of variable proportions.
Its Assumption:
The law of diminishing returns is based on the following assumptions:
(1) Only one factor is variable while others are held constant.
(2) All units of the variable factor are homogeneous.
(3) There is no change in technology.
(4) It is possible to vary the proportions in which different inputs are combined.
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(5) It assumes a short-run situation, for in the long-run all factors are variable.
(6) The product is measured in physical units, i.e., in quintals, tonnes, etc. The use of
money in measuring the product may show increasing rather than decreasing returns if the
price of the product rises, even though the output might have declined.
Its Explanation:
Given these assumptions, let us illustrate the law with the help of Table 1, where on the
fixed input land of 4 acres, units of the variable input labour are employed and the resultant
output is obtained. The production function is revealed in the first two columns. The average
product and marginal product columns are derived from the total product column.
The average product per worker is obtained by dividing column (2) by a corresponding
unit in column (1). The marginal product is the addition to total product by employing an extra
worker. 3 workers produce 36 units and 4 produce 48 units. Thus the marginal product is 12 i.e.,
(48-36) units.
Table 7.1
Output of Wheat in Physical Units (Quintals)
An analysis of the Table shows that the total, average and marginal products increase at
first, reach a maximum and then start declining. The total product reaches its maximum when 7
units of labour are used and then it declines. The average product continues to rise till the 4th
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unit while the marginal product reaches its maximum at the 3rd unit of labour, then they also
fall. It should be noted that the point of falling output is not the same for total, average and
marginal product.
The marginal product starts declining first, the average product following it and the total
product is the last to fall. This observation points out that the tendency to diminishing returns is
ultimately found in the three productivity concepts.
The law of variable proportions is presented diagrammatically in Figure 4. The TP curve

first rises at an increasing rate up to point A where its slope is the highest. From point A upwards,
the total product increases at a diminishing rate till it reaches its highest point Ñ and then it
starts falling.
Figure - 7.4
Point A where the tangent touches the TP curve is called the inflection point up to which
the total product increases at an increasing rate and from where it starts increasing at a
diminishing rate. The marginal product curve (MP) and the average product curve (AP) also
rise with TP. The MP curve reaches its maximum point D when the slope of the TP curve is the
maximum at point A.
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The maximum point on the AP curves is E where it coincides with the MP curve. This point
also coincides with point Â on TP curve from where the total product starts a gradual rise. When
the TP curve reaches its maximum point Ñ the MP curve becomes zero at point F. When TP
starts declining, the MP curve becomes negative. It is only when the total product is zero that
the average product also becomes zero. The rising, the falling and the negative phases of the
total, marginal and average products are in fact the different stages of the law of variable
proportions which are discussed below.
Three Stages of Production:
Stage-I: Increasing Returns:
In stage I the average product reaches the maximum and equals the marginal product
when 4 workers are employed, as shown in the Table 1. This stage is portrayed in the figure
from the origin to point E where the MP curve reaches its maximum and the AP curve is still
rising. In this stage, the TP curve also increases rapidly.
Thus this stage relates to increasing returns. Here land is too much in relation to the
workers employed. It is, therefore, profitable for a producer to increase more workers to produce
more and more output. It becomes cheaper to produce the additional output. Consequently, it
would be foolish to stop producing more in this stage. Thus the producer will always expand
through this stage I.
Causes of Increasing Returns:
1. The main reason for increasing returns in the first stage is that in the beginning the
fixed factors are larger in quantity than the variable factor. When more units of the variable
factor are applied to a fixed factor, the fixed factor is used more intensively and production
increases rapidly.
2. In the beginning, the fixed factor cannot be put to the maximum use due to the non-
applicability of sufficient units of the variable factor. But when units of the variable factor are
applied in sufficient quantities, division of labour and specialization lead to per unit increase in
production and the law of increasing returns operates.
3. Another reason for increasing returns is that the fixed factors are indivisible which
means that they must be used in a fixed minimum size. When more units of the variable factor
are applied on such a fixed factor, production increases more than proportionately. This points
towards the law of increasing returns.
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Stage-II: Diminishing Returns:
It is the most important stage of production. Stage II starts when at point E where the MP
curve intersects the AP curve which is at the maximum. Then both continue to decline with AP
above MP and the TP curve begins to increase at a decreasing rate till it reaches point C. At this
point the MP curve becomes negative when the TP curve begins to decline, table 1 shows this
stage when the workers are increased from 4 to 7 to cultivate the given land.
In figure 1, it lies between BE and CF. Here land is scarce and is used intensively. More
and more workers are employed in order to have larger output. Thus the total product increases
at a diminishing rate and the average and marginal product decline. This is the only stage in
which production is feasible and profitable because in this stage the marginal productivity of
labour, though positive, is diminishing but is non-negative.
Hence it is not correct to say that the law of variable proportions is another name for the
law of diminishing returns. In fact, the law of diminishing returns is only one phase of the law of
variable proportions.
The law of diminishing returns in this sense has been defined by Prof. Benham thus: “As
the proportion of one factor in a combination of factors is increased, after a point, the average
and marginal product of that factor will diminish.”
Its Causes: The Law in General Form:
But the law of diminishing returns is not applicable to agriculture alone; rather it is of
universal applicability. It is called the law in its general form, which states that if the proportion
in which the factors of production are combined, is disturbed, the average and marginal product
of that factor will diminish.
The distortion in the combination of factors may be either due to the increase in the
proportion of one factor in relation to others or due to the scarcity of one in relation to other
factors. In either case, diseconomies of production set in, which raise costs and reduce output.
For instance, if plant is expanded by installing more machines, it may become unwieldy.
Entrepreneurial control and supervision become lax, and diminishing returns set in. Or, there
may arise scarcity of trained labour or raw material that leads to diminution in output.
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In fact, it is the scarcity of one factor in relation to other factors which is the root cause of
the law of diminishing returns. The element of scarcity is found in factors because they cannot
be substituted for one another.
Mrs Joan Robinson explains it thus : “What the Law of Diminishing Returns really states
is that there is a limit to the extent to which one factor of production can be substituted for
another, or, in other words, that the elasticity of substitution between factors is not infinite.”
Suppose there is scarcity of jute, since no other fibre can be substituted for it perfectly, costs will
rise with production, and diminishing returns will operate.
This is because jute is not in perfectly elastic supply to the industry. If the scarce factor is
rigidly fixed and it cannot be substituted by any other factor at all, diminishing returns will at
once set in. If in a factory operated by electric power, there being no other substitute for it,
frequent power breakdowns occur, as is commonly the case in India, production will fall and
costs will rise in proportion as fixed costs will continue to be incurred even if the factory works
for less hours than before.
According to Wicksteed, the law of diminishing returns “is as universal as the law of life
itself.’ The universal applicability of this law has taken economics to the realm of science.
Stage-III: Negative Marginal Returns:
Production cannot take place in stage III either. For in this stage, total product starts
declining and the marginal product becomes negative. The employment of the 8th worker actually
causes a decrease in total output from 60 to 56 units and makes the marginal product minus 4.
In the figure, this stage starts from the dotted line CF where the MP curve is below the A’-axis.
Here the workers are too many in relation to the available land, making it absolutely impossible
to cultivate it.
The Best Stage:
In stage I, when production takes place to the left of point E, the fixed factor is excess in
relation to the variable factors which cannot be used optimally. To the right of point F, the
variable input is used excessively in Stage III. Therefore, no producer will produce in this stage
because the marginal production is negative.
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Thus the first and third stages are of economic absurdity or economic nonsense. So
production will always take place in the second stage in which total output of the firm increases
at a diminishing rate and MP and AP are the maximum, then they start decreasing and production
is optimum. This is the optimum and best stage of production.
7.7. The Law of Returns to Scale

The law of returns to scale describes the relationship between outputs and scale of
inputs in the long-run when all the inputs are increased in the same proportion. In the words of
Prof. Roger Miller, “Returns to scale refer to the relationship between changes in output and
proportionate changes in all factors of production. To meet a long-run change in demand, the
firm increases its scale of production by using more space, more machines and labourers in the
factory’.
Assumptions:
This law assumes that:
(1) All factors (inputs) are variable but enterprise is fixed.
(2) A worker works with given tools and implements.
(3) Technological changes are absent.
(4) There is perfect competition.
(5) The product is measured in quantities.
Explanation:
Given these assumptions, when all inputs are increased in unchanged proportions and
the scale of production is expanded, the effect on output shows three stages: increasing returns
to scale, constant returns to scale and diminishing returns to scale. They are explained with the
help of Table 4.2 and Fig. 4.5
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Table 4.2 - Returns to Scale in Physical Units
1. Increasing Returns to Scale:
Returns to scale increase because the increase in total output is more than proportional
to the increase in all inputs.
Figure - 7.5
The table reveals that in the beginning with the scale of production of (1 worker + 2 acres
of land), total output is 8. To increase output when the scale of production is doubled (2 workers
+ 4 acres of land), total returns are more than doubled. They become 17. Now if the scale is
trebled (3 workers + î acres of land), returns become more than three-fold, i.e., 27. It shows
increasing returns to scale. In the figure RS is the returns to scale curve where R to Ñ portion
indicates increasing returns.
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Causes of Increasing Returns to Scale:
Returns to scale increase due to the following reasons:
(i) Indivisibility of Factors:
Returns to scale increase because of the indivisibility of the factors of production.

Indivisibility means that machines, management, labour, finance, etc. cannot be available in
very small sizes. They are available only in certain minimum sizes. When a business unit expands,
the returns to scale increase because the indivisible factors are employed to their maximum
capacity.
(ii) Specialisation and Division of Labour:
Increasing returns to scale also result from specialisation and division of labour. When
the scale of the firm is expanded there is wide scope of specialization and division of labour.
Work can be divided into small tasks and workers can be concentrated to narrower range of
processes. For this, specialised equipment can be installed. Thus with specialisation, efficiency
increases and increasing returns to scale follow.
(iii) Internal Economies:
As the firm expands, it enjoys internal economies of production. It may be able to install
better machines, sell its products more easily, borrow money cheaply, procure the services of
more efficient manager and workers, etc. All these economies help in increasing the returns to
scale more than proportionately.
(iv) External Economies:
A firm also enjoys increasing returns to scale due to external economies. When the
industry itself expands to meet the increased long-run demand for its product, external economies
appear which are shared by all the firms in the industry.
When a large number of firms are concentrated at one place, skilled labour, credit and
transport facilities are easily available. Subsidiary industries crop up to help the main industry.
Trade journals, research and training centres appear which help in increasing the productive
efficiency of the firms. Thus these external economies are also the cause of increasing returns
to scale.
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2. Constant Returns to Scale:
Returns to scale become constant as the increase in total output is in exact proportion to
the increase in inputs. If the scale of production in increased further, total returns will increase
in such a way that the marginal returns become constant. In the table, for the 4th and 5th units
of the scale of production, marginal returns are 11, i.e., returns to scale are constant. In the
figure, the portion from Ñ to D of the RS curve is horizontal which depicts constant returns to
scale. It means that increments of each input are constant at all levels of output.
Causes of Constant Returns to Scale:
Returns to scale are constant due to:
(i) Internal Economies and Diseconomies:
But increasing returns to scale do not continue indefinitely. As the firm expands further,
internal economies are counterbalanced by internal diseconomies. Returns increase in the
same proportion so that there are constant returns to scale over a large range of output.
(ii) External Economies and Diseconomies:
The returns to scale are constant when external diseconomies and economies are
neutralised and output increases in the same proportion.
(iii) Divisible Factors. When factors of production are perfectly divisible, substitutable,
and homogeneous with perfectly elastic supplies at given prices, returns to scale are constant.
3. Diminishing Returns to Scale:
Returns to scale diminish because the increase in output is less than proportional to the
increase in inputs. The table shows that when output is increased from the 6th, 7th and 8th
units, the total returns increase at a lower rate than before so that the marginal returns start
diminishing successively to 10, 9 and 8. In the figure, the portion from D to S of the RS curve
shows diminishing returns.
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Causes of Diminishing Returns to Scale:
Constant returns to scale is only a passing phase, for ultimately returns to scale start
diminishing. Indivisible factors may become inefficient and less productive. Business may become
unwieldy and produce problems of supervision and coordination. Large management creates
difficulties of control and rigidities. To these internal diseconomies are added external
diseconomies of scale.
These arise from higher factor prices or from diminishing productivities of the factors. As
the industry continues to expand, the demand for skilled labour, land, capital, etc. rises. There
being perfect competition, intensive bidding raises wages, rent and interest. Prices of raw
materials also go up. Transport and marketing difficulties emerge. All these factors tend to raise
costs and the expansion of the firms leads to diminishing returns to scale so that doubling the
scale would not lead to doubling the output.
Conclusion:
For the management increasing, decreasing or constant returns to scale reflect changes
in production efficiency that result from scaling up productive inputs. But returns to scale is
strictly a production and cost concept. Management’s decision on what to produce and how
much to produce must be based upon the demand for the product. Therefore, demand and
other factors must also be considered in decision making.
7.8 Economics of Scale: Internal and External Economics

An economy of scale exists when larger output is associated with lower per unit cost.
Economies of scale have been classified by Marshall into Internal Economies and External
Economies. Internal Economies are internal to a firm when it expands its size or increases its
output.
They “are open to a single factory or a single firm independently of the action of other
firms. They result from an increase in the scale of output of the firm, and cannot be achieved
unless output increases. They are not the result of inventions of any kind, but are due to the use
of known methods of production which a small firm does not find worthwhile.” (A.K. Caimcross).
External Economies are external to a firm which is available to it when the output of the
whole industry expands. They are “shared by a number of firms or industries when the scale of
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production in any industry or group of industries increases. They are not mono-polised by a
single firm when it grows in size, but are conferred on it when some other firms grow larger”.
(A.K. Cairncross).
Modem economists distinguish economies of scale in terms of real and pecuniary internal
and external economies.
(A) Real Internal Economies:
Real internal economies are “associated with a reduction in the physical quantity of inputs,
raw materials, various types of labour and various types of capital (fixed or circulating) used by
a large firm.”
Real internal economies which arise from the expansion of a firm are the following:
1. Labour Economies:
As the firm expands, it achieves labour economies with increased division of labour and
specialisation. When a firm expands in size, this necessitates division of labour whereby each
worker is assigned one particular job, and the splitting of processes into sub-processes for
greater efficiency and productivity.
This, in turn, leads to the increase in the dexterity (skill) of every worker, the saving in time
to produce goods, and to the invention of large number of labour-saving machines, according
to Adam Smith. Thus division of labour and specialisation lead to greater productive efficiency
and reduction in per unit cost in a large firm.
2. Technical Economies:
Technical economies are associated with all types of machines and equipment’s used by
a large firm. They arise from the use of better machines and techniques of production which
increase output and reduce per unit cost of production.
Technical economies are classified as follows:
(i) Economies of Indivisibility:
Mrs. Joan Robinson refers to economies of factor indivisibility. Fixed capital is one such
factor. It is indivisible in the sense that a machine, an equipment or a plant must be used in a
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fixed minimum size or capacity to justify its use. Such machines can be most efficiently used at
a fairly large output than at small outputs because they cannot be divided into smaller units.
For example, an automated car assembly plant is not a viable proposition, if the number
of cars to be assembled is small because much of the plant would remain idle. But a large firm
assembling a large number of cars may be able to utilise the plant to its full capacity and
achieve lower per unit cost. Prof. Caimcross gives a five-fold classification of technical economies.
(ii) Economies of Superior Technique:
It is only a large firm which can afford to pay for costly machines and install them. Such
machines are more productive than small machines. The high cost of such machines can be
spread over a larger output which they help to produce. Thus the per unit cost of production
falls in a large firm which employs costly and superior plant and equipment and thereby enjoys
a technical superiority over a small firm.
(iii)Economies of Increased Dimensions:
The installation of large machines itself brings many advantages to a firm. The cost of
operating large machines is less than that of operating small machines. Even the cost of
construction is relatively lower for large machines than for small ones.
The cost of manufacture of a double-decker bus is lower as compared to the manufacture

of two single-decker buses. Moreover, a double-decker carries more passengers than a single-
decker and at the same time requires only a driver and a conductor like the latter. Thus its
operating costs are relatively lower.
(iv) Economies of Linked Processes:
A large firm is able to reduce it’s per unit cost of production by linking the various processes
of production. For instance, a large sugar manufacturing firm may own its sugarcane farms,
manufacture sugar, pack it in bags, transport and distribute sugar through its own transport and
distribution departments. Thus by linking the various processes of production and sale, a large
firm saves the expenses incurred on intermediaries thereby reducing unit cost of production.
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(v) Economies of the Use of By-products:
A large firm possesses greater resources than a small firm and is able to utilise its waste
material as a by-product. For example, the molasses left over after manufacturing sugar from
the surgarcane can be used for producing spirit by installing a plant for the purpose.
(vi) Economies in Power Consumption:
A large firm which operates large machines and runs them continuously, economises in
power consumption as compared to small machines.
3. Marketing Economies:
A large firm also reaps the economies of buying and selling. It buys its requirements of
various inputs in bulk and is, therefore, able to secure them at favourable terms in the form of
better quality inputs, prompt delivery, transport concessions, etc.
Because of its larger organisation, it produces quality products which are offered for sale
in attractive packing by its packing department. It may also have a sales department manned
by experts who carry on salesmanship, propaganda and advertisement through the various
media efficiently. Thus a large firm is able to reap the economies of marketing through its
superior bargaining power and efficient packing and sales organisation.
4. Managerial Economies:
A large firm can afford to put specialists to supervise and manage the various departments.
There may be a separate head for manufacturing, assembling, packing, marketing, general
administration, etc. This decentralisation leads to functional specialisation which increases the
productive efficiency of the firm. “Large firms apply techniques of management involving a high
degree of mechanisation, such as telephones, telex machines, television screens and computers.
These techniques save time in decision-making process and speed up the processing of
information, as well as increasing its amount and its accuracy.” These managerial economies
also reduce per unit cost of management because with expansion of the firm, the various
departmental managers will manage large output as efficiently as they were managing small
output at the same salary.
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5. Risk-Bearing Economies:
A large firm is in a better position than a small firm in spreading its risks. It can produce a
variety of products, and sell them in different areas. By the diversification of its products the
large firm is able to reduce risks by counter-balancing the loss of one product by the gain from
other products. By the diversification of markets, it can counter-balance the fall in demand in
one market by the increased demand in other markets. Even if the demand in the other markets
for the products of the firm is constant, the loss can be easily borne by it.
A firm undertakes great risk by depending exclusively on one source for its supply of
power and raw materials. It can avoid risks by having alternative sources of supply in the case
of power and different sources for the supply of raw materials. For instance, a large firm can
avoid the losses arising from failure of regular power supply by installing a generator of its own.
6. Economies of Research:
A large firm possesses larger resources than a small firm and can establish its own research
laboratory and employ trained research workers. When they invent new production techniques
or processes, the latter become the property of the firm which utilises them for increasing its
output and reducing costs.
7. Economies of Welfare:
All firms have to provide welfare facilities to their workers. But a large firm, with its large
resources, can provide better working conditions in and outside the factory. It may run subsidised
canteens, provide creches for the infants of women workers, and recreation rooms for the
workers within the factory premises.
It may also provide cheap houses, educational and medical facilities for the families of
workers and recreational clubs outside the factory. Though the expenses on such facilities are
very heavy, yet they tend to increase the productive efficiency of the workers which helps in
raising production and reducing costs.
(B) Pecuniary Internal Economies:
Pecuniary or monetary internal economies accrue to a large firm solely through reductions
in the market prices of its inputs.
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They arise when:
(i) It purchases raw materials in bulk at lower prices from its suppliers;
(ii) it gets loans from banks and other financial institutions at low interest rates because it
possesses large assets and good reputation; (iii) it raises capital by floating shares at a premium
and debentures at low interest rates in the capital market; (iv) it advertises at concessional
rates on a large scale in different media; (v) it transports large quantities of its commodity at
concessional transport rates. Thus pecuniary economies are “realised from paying lower prices
for the factors used in the production and distribution of the product, due to bulk-buying by the
firm as its size increases”.
(C) Real External Economies:
According to Prof. Viner, real external economies accrue to a firm in an industry due to
technological influences on its output which reduce its real cost of production. They represent
benefits to firms in an industry through technological interdependence of firms. Real external
economies arise when the industry is localised in a particular area, makes inventions and evolves
specialisation in production processes.
These external economies are discussed below:
1. Technical Economies:
Technical external economies arise from specialisation. When an industry expands in

size, firms start specialising in different processes and the industry benefits on the whole. For
example, in the cotton textile industry some firms may specialise in manufacturing thread,
others in printing, still others in dyeing, some in long cloth, some in dhotis, some in shirting, etc.
As a result, the productive efficiency of the firms specialising in different fields increases and
the unit cost of production falls.
Further, subsidiary industries develop to supply the localised industry with tools, equipment
and raw materials, and special services for repairs and maintenance of plants and equipments,
thereby lowering the unit cost of production of all the firms.
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2. Economies of Information:
As an industry expands, it specialises in collecting and disseminating market information,

in marketing the industry’s product and in supplying the firms with consultant services. An
industry is in a better position to set up research laboratories than a large firm because it is able
to pool larger resources.
It can employ highly paid and more experienced research personnel. The fruits of their
research in the form of new inventions are passed on to the firms through a scientific journal.
The industry can also set up an information centre which may publish a journal and pass on
information regarding the availability of raw materials, modern machines, export potentialities
of the products of the industry in various countries of the world and provide other information
needed by the firms. All this helps in raising the productive efficiency of the firms and reduction
in their costs.
3. Economies of By-products:
When an industry is localised, it turns out large quantities of waste materials, such as
molasses in sugar industry and iron scrap in steel industry. New firms enter the industry which
purchase these waste materials at reasonable prices and use them for manufacturing by
products.
The firms in the industry are able to reduce per unit cost in two ways: first, they do not
incur expenses in disposing of the waste materials, and second, they earn some amount by
selling them to manufacturers of by-products.
(D) Pecuniary External Economies:
Pecuniary external economies arise to firms in an industry from reductions in factor prices.
They reflect an interdependence among firms which is transmitted through factor price reductions
in the industry.
Such reductions in factor prices may arise from a number of sources:
(1) Local educational institutions may specialise in the type of courses needed by the
industry, thereby making available skilled labour to all the firms.
(2) Local management consultants can develop specialist expertise.

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(3) Firms with similar requirements can produce a pool of workers and managers with the
required skills to meet the needs of the local labour market.
(4) The transport and communications infrastructure can be developed to meet the special
needs of the industry. The industry may ask the railways for additional facilities for more wagons,
loading and unloading, etc. Road transporters may also provide special facilities to firms at
concessional rates.
(5) The Electricity Company or board may supply adequate and continuous power to the
firms at concessional rates.
(6) Banks, insurance companies and other financial institutions may open their offices in
the area and provide cheap and timely credit and insurance facilities.
(E) Relation between Internal and External Economies:
The relation between internal and external economies is only one of degree. For example,
firms may be enjoying external economies, but if they combine together, then all external
economies become internal for them.
Again, an internal economy reaped by a firm becomes external to some other firm if it
uses the same. To take an example, if molasses are used by the sugar factory itself for
manufacturing spirit, it is an internal economy. But if some other firm buys molasses for
manufacturing spirit, it is an external economy to the buying firm.
Often external economies lead to internal economies. As pointed out by Mrs Robinson,
“Economies of large scale industry are likely to have the effect of altering the optimum size of
the firm, and the reorganisation of the firm to adapt itself to the new optimum size may lead to
further economies. These have been described by Prof. Robertson as internal-external
economies. These have been demies, because they depend upon the size of the firm and
external economies because they depend upon the size of the industry.”
7.9 Diseconomies of Scale

A diseconomy of scale exists when larger output leads to higher per unit cost. The
economies of scale cannot continue indefinitely. A time comes in the life of a firm or an industry
when further expansion leads to diseconomies in place of economies. Internal and external
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diseconomies are, in fact, the limits to large scale production. We discuss below real and
pecuniary internal and external diseconomies.
(A) Real Internal Diseconomies:
When a firm expands beyond an optimum level, a number of problems arise such as
factor shortages, lack of coordination and management, marketing and technological difficulties,
etc. They tend to raise per unit cost of production.
Thus real internal diseconomies arise from the following:
(1) Managerial Diseconomies:
The check to the further expansion of a firm is put due to the failure on the part of the
management to supervise and control the business properly. There is a limit beyond which a
firm becomes unwieldy and hence unmanageable. Supervision becomes lax. Workers do not
work efficiently, wastages arise, decision-making becomes difficult, coordination between workers
and management disappears and per unit cost increases.
(2) Marketing Diseconomies:
The expansion of a firm beyond a certain limit may also involve marketing problems. Raw
materials may not be available in sufficient quantities due to their scarcities. The demand for
the products of the firm may fall as a result of changes in tastes of the people and the firm may
not be in a position to change accordingly in the short period. The market organisation may fail
to foresee changes in market conditions whereby the sales might fall.
(3) Technical Diseconomies:
A large scale firm often operates heavy capital equipment which is indivisible. As the firm
expands its size beyond the optimum level, there are repeated breakdowns in plants and
equipment’s and the firm may fail to operate its plant to its maximum capacity. It may have
excess capacity or idle capacity. As a result, per unit cost increases.
(4) Diseconomies of Risk Taking:
As the scale of production of a firm expands, risks also increase with it. An error of judgment
on the part of the sales manager or the production manager may adversely affect sales or
production which may lead to a great loss.
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(B) Pecuniary Internal Diseconomies:
Pecuniary internal diseconomies arise when the prices of factors used in the production
and distribution of the commodity increase. As a firm expands, it may need more labour, raw
materials, finance, etc. But trained and skilled labour may be available at higher wages.
There may arise shortages of raw materials which it may have to buy at higher prices.
More finance may be available at a high interest rate. Marketing, sales and transport expenses
may increase with the expansion of the firm. All these physical factors tend to raise per unit
cost.
(C) Pecuniary External Diseconomies:
Pecuniary external diseconomies arise solely through increases in the market prices of
inputs of an industry’. As an industry expands, pecuniary external diseconomies arise when the
prices of factors increase. When an industry expands, the demand for factors like labour, capital
equipment, raw materials, etc. increases on the part of firms which may eventually raise their
prices.
But the localisation of an industry and its overgrowth may lead to shortages of labour,
capital, equipment’s, raw materials, power, transport, etc. which tend to raise the prices of
these inputs and lead to the rise in per unit costs of firms. These diseconomies are external to
each firm in the industry because the increases in the prices of factors are not caused by the
expansion of any single firm but are the consequence of the expansion of the whole industry.
7.10 Summary
Production is an activity that transforms input into output. Creation of economic utilities
which can be from utility, time utility and place utility. Inputs can be divided into fixed and variable.
In short run some inputs are fixed while other are variable. in the long run, there are no fixed
inputs - all inputs are variable. Production function is a purely technical relationship between
inputs and outputs.
7.11 Key Words

Average Product: The total product divided by the number of units of a particular input
employed by the firm.
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Isoquants: A curve representing different combinations of two inputs that produce the
same level of output.
Long run production function: The maximum quantity of a good or a service that can
be produced by varying the amount of all inputs used in production.
Production Function: The maximum quantity of a good or service that can be produced
by a set of inputs. Production functions can be classified as short run and long run production
functions.
Short - run production function: The maximum quantity of a good or service that can
be produced by a set of inputs, assuming that the amount of at least one of the inputs used
remains unchanged as output varies.

1. Explain Production Function.
2. Write a brief note on Long run production function.
3. What is mean by economics of scale.
4. Explain Law of returns.

1. Dean, joel, Managerial Economics
2. Hague D.C, Managerial Economics
3. Mote, Paul & Gupta, Managerial Economics – Concepts & Cases

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LESSON - 8
COST ANALYSIS
Learning Objectives
This lesson will help us to understand the significance of cost analysis in Business
Economics. It outlines the break-even point of a business.
Unit Structure
8.1 Concept of Cost
8.2 Classification of Cost.
8.3 Break Even Analysis
8.4 Break-Even chart
8.5 Summary
8.6 Key words
8.8 Reference books
8.1 Concept of Cost

According to the Chartered Institute of Management Accountants, cost is “the amount of
expenditure (actual or notional) incurred on or attributable to a specified thing or activity.” Similarly,
according to Anthony and Wilsch “cost is a measurement in monetary terms of the amount of
resources used for some purposes.”
Cost has been defined by the Committee on Cost Terminology of the American Accounting
Association as “the foregoing, in monetary terms, incurred or potentially to be incurred in the
realisation of the objective of management which may be manufacturing of a product or rendering
of a service.”
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From the above, it may be stated that cost means the total of all expenses incurred for a
product or a service. Thus, cost of an article means the actual outgoings or ascertained changes
incurred in its production and sale activities. In short, it is the amount of resources used up in
exchange for some goods or services.
The so-called resources are expressed in terms of money or monetary units. What we
stated above will not be a meaningful one until the same is used with an adjective only, i.e.
when it communicates the meaning for which it is intended.
Thus, when we say Prime Cost or Works Cost or Fixed Cost etc., we want to explain a
particular meaning which is essential while computing, measuring or analysing the various
aspects of cost.
8.2 Classification of Cost

Classification of costs implies the process of grouping costs according to their common
characteristics. A proper classification of costs is absolutely necessary to mention the costs
with cost centres. Usually, costs are classified according to their nature, viz., material, labour,
over-head, among others. An identical cost figure may be classified in various ways according
to the needs of the firms.
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The above classification may be outlined as:
However, the classification of cost may be depicted as given:

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(a) According to Elements:
Under the circumstances, costs are classified into three broad categories Material, Labour
and Overhead. Now, further subdivision may also be made for each of them. For example,
Material may be subdivided into raw materials, packing materials, consumable stores etc. This
classification is very useful in order to ascertain the total cost and its components. Same
classification may also be made for labour and overhead.
(b) According to Functions:
The total costs are divided into different segments according to the purpose of the firm.
That is why costs are grouped as per the requirements of the firm in order to evaluate its
functions properly. In short, the total costs include all costs starting from cost of materials to the
cost of packing the product.
It takes the cost of direct material, direct labour and chargeable expenses and all indirect
expenses under the head Manufacturing/Production cost.
At the same time, administration cost (i.e. relating to office and administration) and Selling
and Distribution expenses (i.e. relating to sales) are to be classified separately and to be added
in order to find out the total cost of the product. If these functional classifications are not made
properly, true cost of the product cannot accurately be ascertained.
(c) According to Variability:
Practically, costs are classified according to their behaviour relating to the change (increase
or decrease) in their volume of activity.
These costs as per volume may be subdivided into:
(i) Fixed Cost;
(ii) Variable Cost;
(iii) Semi-variable Cost.
Fixed Costs are those which do not vary with the change in output, i.e., irrespective of the
quantity of output produced, it remains fixed (e.g., Salaries, Rent etc.) up to a certain limit. It is
interesting to note that if more units are product, fixed cost per unit will be reduced, and, if less
units are produced, obviously, fixed cost per unit will be increased.
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Variable Costs, on the other hand, are those which vary proportionately with the volume
of output. So the cost per unit will remain fixed irrespective of the quantity produced. That is,
there is no direct effect on the cost per unit if there is a change in the volume of output (e.g.
price of raw material, labour etc.,).
On the contrary, semi-variable costs are those which are partly fixed and partly variable
(e.g. Repairs of building).
(d) According to Controllability:
Costs may, again, be subdivided into two broad categories according to the performance
done by any member of the firm.
They are:
(i) Controllable Costs; and
(ii) Uncontrollable Costs.
Controllable Costs are those costs which may be influenced by the decision taken by a
specified member of the administration of the firm or, it may be stated, that the costs which at
least partly depend on the management and is controllable by them, e.g. all direct costs, direct
material, direct labour and chargeable expenses (components of Prime Cost) are controllable
by lower management level and is done accordingly.
Uncontrollable Costs are those which are not influenced by the actions taken by any
specific member of the management. For example, fixed costs, viz., rent of building, payment
for salaries etc.
(e) According to Normality:
Under this condition, costs are classified according to the normal needs for a given level
of output for a normal level of activity produced for such output.
They are divided into:
(i) Normal Costs; and
(ii) Abnormal Costs.

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Normal Costs are those costs which are normally required for a normal production at a
given level of output and which is a part of production.
Abnormal Costs, on the other hand, are those costs which are not normally required for a
given level of output to be produced normally, or which is not a part of cost of production.
(f) According to Time:
Costs may also be classified according to the time element in it. Accordingly, costs are
classified into:
(i) Historical Costs; and
(ii) Predetermined Costs.
Historical Costs are those costs which are taken into consideration after they have been
incurred. This is possible particularly when the production of a particular unit of output has
already been made. They have only historical value and cannot assist in controlling costs.
Predetermined Costs, on the other hand, are the estimated costs. Such costs are computed
in advanced on the basis of past experience and records. Needless to say here that it becomes
standard cost if it is determined on scientific basis. When such standard costs are compared
with the actual costs, the reasons of variance will come out which will help the management to
take proper steps for reconciliation.
(g) According to Traceability:
Costs can be identified with a particular product, process, department etc. They are divided
into:
(i) Direct (Traceable) Costs; and
(ii) Indirect (Non-Traceable) Costs.
Direct/Traceable Costs are those costs which can directly be traced or allocated to a
product, i.e. it includes all traceable costs, viz., all expenses relating to cost of raw materials,
labour and other service utilised which can be traced easily.
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Indirect/Non-Traceable Costs are those costs which cannot directly be traced or allocated
to a product, i.e. it includes all non-traceable costs, e.g. salary of store-keepers, general
administrative expenses, i.e. which cannot properly be allocated directly to a product.
(h) According to Planning and Control:
Costs may also be classified into:
(i) Budgeted Costs; and
(ii) Standard Costs.
Budgeted Costs refer to the expected cost of manufacture computed on the basis of
information available in advance of actual production or purchase. Practically, budgeted costs
include standard costs, both are predetermined costs and their amount may coincide but their
objectives are different.
Standard Costs, on the other hand, is a predetermination of what actual costs should be
under projected conditions serving as a basis of cost control and, as a measure of product
efficiency, when ultimately aligned actual cost. It supplies a medium by which the effectiveness
of current results can be measured and the responsibility for derivations can be placed.
Standard Costs are predetermined for each element, viz., material, labour and overhead.
Standard Costs include:
(i) The cost per unit is determined to make an estimated total output for the future period
for:
(a) Material;
(b) Labour; and
(c) Overhead.
(ii) The cost must depend on the past experience and experiments and specification of
the technic*al staff.
(iii) The cost must be expressed in terms of rupees.
(i) According to Management Decisions: Under this, costs may also be classified as:
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(a) Marginal Cost:
Marginal Cost is the cost for producing additional unit or units by segregation of fixed
costs (i.e., cost of capacity) from variable cost (i.e. cost of production) which helps to know the
profitability. Moreover, we know, in order to increase the production, certain expenses (fixed)
may not increase at all, only some expenses relating to materials, labour and variable expenses
are increased. Thus, the total cost so increased by the production of one unit or more is the cost
of marginal unit and the cost is known as marginal cost or incremental cost.
(b) Differential Cost:
Differential Cost is that portion of the cost of a function attributable to and identifiable with
an added feature, i.e. the change in costs as a result of change in the level of activity or method
of production.
(c) Opportunity Cost:
It is the prospective change in cost following the adoption of an alternative machine,

process, raw materials, specification or operation. In other words, it is the maximum possible
alternative earnings which might have been earned if the existing capacity had been changed
to some other alternative way.
(d) Replacement Cost:
It is the cost, at current prices, in a particular locality or market area, of replacing an item
of property or a group of assets.
(e) Implied Cost:
It is the cost used to indicate the presence of arbitrary or subjective elements of product
cost having more than usual significance. It is also called notional cost, e.g., interest on capital
—although no interest is paid. This is particularly useful while decisions are taken regarding
alternative capital investment projects.
(f) Sunk Cost:
It is the past cost arising out of a decision which cannot be revised now, and associated
with specialised equipment’s or other facilities not readily adaptable to present or future purposes.
Such cost is often regarded as constituting a minor factor in decisions affecting the future.
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8.3 Break Even Analysis

Break-even analysis is of vital importance in determining the practical application of cost
functions. It is a function of three factors, i.e. sales volume, cost and profit. It aims at classifying
the dynamic relationship existing between total cost and sale volume of a company.
Hence it is also known as “cost-volume-profit analysis”. It helps to know the operating

condition that exists when a company ‘breaks-even’, that is when sales reach a point equal to
all expenses incurred in attaining that level of sales. The break-even point may be defined as
that level of sales in which total revenues equal total costs and net income is equal to zero. This
is also known as no-profit no-loss point. This concept has been proved highly useful to the
company executives in profit forecasting and planning and also in examining the effect of
alternative business management decisions.
Break-Even Point
The break-even point (B.E.P.) of a firm can be found out in two ways. It may be determined
in terms of physical units, i.e., volume of output or it may be determined in terms of money
value, i.e., value of sales.
BEP in terms of Physical Units
This method is convenient for a firm producing a product. The ÂÅÐ is the number of units
of a product that should be sold to earn enough revenue just to cover all the expenses of
production, both fixed and variable. The firm does not earn any profit, nor does it incur any loss.
It is the meeting point of total revenue and total cost curve of the firm.
8.4 Break-Even Chart:

Break-Even charts are being used in recent years by the managerial economists, company
executives and government agencies in order to find out the breakeven point. In the break
even charts, the concepts like total fixed cost, total variable cost, and the total cost and total
revenue are shown separately. The break even chart shows the extent of profit or loss to the
firm at different levels of activity. The following figure illustrates the typical break-even chart.
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Figure - 8.2
In this diagram output is shown on the horizontal axis and costs and revenue on vertical
axis. Total revenue (TR) curve is shown as linear, as it is assumed that the price is constant,
irrespective of the output. This assumption is appropriate only if the firm is operating under
perfectly competitive conditions. Linearity of the total cost (TC) curve results from the assumption
of constant variable cost.
It should also be noted that the TR curve is drawn as a straight line through the origin (i.e.,
every unit of the output contributes a constant amount to total revenue), while the TC curve is a
straight line originating from the vertical axis because total cost comprises constant / fixed cost
plus variable cost which rise linearly. In the figure, Â is the break-even point at OQ level of
output.
In the preparation of the break-even chart we have to take the following considerations:
(a) Selection of the approach

(b) Output measurement
(c) Total cost curve
(d) Total revenue curve
(e) Break-even point and
(f) Margin of safety.
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2. Determination of Break-even Point:
The formula for calculating the break-even point is
BEP – Total Fixed Cost/Contribution Margin Per Unit
Contribution margin per unit can be found out by deducting the average variable cost
from the selling price. So the formula will be
BEP = Total Fixed Cost/Selling Pr ice – AVC
Assumptions of Break-Even Analysis:
The break-even analysis is based on the following set of assumptions:
(i) The total costs may be classified into fixed and variable costs. It ignores semi-variable
cost.
(ii) The cost and revenue functions remain linear.
(iii) The price of the product is assumed to be constant.
(iv) The volume of sales and volume of production are equal.
(v) The fixed costs remain constant over the volume under consideration.
(vi) It assumes constant rate of increase in variable cost.
(vii) It assumes constant technology and no improvement in labour efficiency.
(viii) The price of the product is assumed to be constant.
(ix) The factor price remains unaltered.
(x) Changes in input prices are ruled out.
(xi) In the case of multi-product firm, the product mix is stable.
Limitations:
We may now mention some important limitations which ought to be kept in mind while
using break-even analysis:
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1. In the break-even analysis, we keep everything constant. The selling price is assumed
to be constant and the cost function is linear. In practice, it will not be so.
2. In the break-even analysis since we keep the function constant, we project the future
with the help of past functions. This is not correct.
3. The assumption that the cost-revenue-output relationship is linear is true only over a
small range of output. It is not an effective tool for long-range use.
4. Profits are a function of not only output, but also of other factors like technological
change, improvement in the art of management, etc., which have been overlooked in this analysis.
5. When break-even analysis is based on accounting data, as it usually happens, it may

suffer from various limitations of such data as neglect of imputed costs, arbitrary depreciation
estimates and inappropriate allocation of overheads. It can be sound and useful only if the firm
in question maintains a good accounting system.
6. Selling costs are specially difficult to handle break-even analysis. This is because
changes in selling costs are a cause and not a result of changes in output and sales.
7. The simple form of a break-even chart makes no provisions for taxes, particularly
corporate income tax.
8. It usually assumes that the price of the output is given. In other words, it assumes a
horizontal demand curve that is realistic under the conditions of perfect competition.
9. Matching cost with output imposes another limitation on break-even analysis. Cost in a
particular period need not be the result of the output in that period.
10. Because of so many restrictive assumptions underlying the technique, computation

of a breakeven point is considered an approximation rather than a reality.
8.5 Summary
The opportunity cost is the return from the second best use of a resource, which the firm
foregoes when taking up the opportunity of its best use. The implicit costs are the earnings of
those resources which belong to the owner himself. for decision making both the explicit and
the implicit costs are important. The cost which do not vary with the nature or level of production
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are sunk costs, while the costs which vary with output are incremental costs. cost function
expresses the relationship between cost and its determinants like output level, plant size and
technology. The learning curve analysis is based on the assumption that efficiency of workers
improves with practice, so that per unit cost of additional output declines. Learning curve is
measured in terms of percentage fall in marginal labour cost when output doubles.
8.6 Key Words

Average Fixed Cost (AFC) - The fixed cost per unit of output.
Average Total Cost ( AC or ATC) - The total cost per unit of output.
Average variable cost (AVC) The variable cost per unit of output.
Marginal Cost (MC) - The cost to a firm of producing an additional unit of an output.
Learning Curve: The relationship between average cost of labour and the output produced
by is directly associated with the production process.
Total Variable cost: The toal cost associated with the level of output. This can be
considered the total cost to a firm of using its variable inputs.
Sunk Cost: A cost incurred in the past that is not affected by a current decision.

1. Define opportunity cost
2. show TVC with explanation graphically.
3. Differentiate social cost and private cost.
4 Explain the Various types of production function with their importance
5. Explain laws of variable proportions and returns to scale
6. What is mean by Break Even Analysis
7. Explain in detail with illustration the Break even analysis

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LESSON – 9
PRODUCT PRICING & MARKET STRUCTURE
MARKET STRUCTURE
Learning Objectives
After having read this lesson, you will be able to
· Understand the concept of Market and its classification
· Know how to determine equilibrium price and output under perfect competition &
monopoly
· Clearly define the use of time element.
UNIT STRUCTURE
9.1 Introduction
9.2 Classification of Market
9.3 Perfect Competition
9.4 Monopoly
9.5 Monopoly Equilibrium Price-Output Determination Under Monopoly
9.6 Monopoly and Perfect Competition
9.7 Discriminating Monopoly
9.8 Control and Regulation of Monopoly
9.9 Monopolistic Competition
9.10 Oligopoly
9.11 Price Leadership
9.12 Price Determination Under Oligopoly
9.13 Pricing Under Oligopoly with Product Differentiation
9.14 Summary
9.15 Key words

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9.1 Introduction
After knowing about the basic concepts of demand and supply on one hand and Production,
cost & Revenue on the other, there is a need to understand the types of market forces where
each market play a vital role. The equilibrium of a firm depends on all these forces through
which a firm attains profit. This lesson explains the classification of market forms. It also deals
with the price output determination in perfect competition and monopoly.
Size of the Market
In the ordinary language ‘market’ refers to a place where goods are bought and sold, e.g.
the Koyambedu market of Chennai. In economics, it refers to a particular commodity-transaction
and also buyers and sellers of the commodity, e.g. the wheat market and tea market. Market
morphology stands for the structure of markets. The key element in the structure of market is
the sellers, buyers and nature of competition. In short, market consists of the whole region in
which buyers and sellers are in close touch with one another, either directly or through dealers,
that prices obtainable in one part of the market affects the prices paid in other parts.”
9.2 Classification of Market

The basis of size, the market may be classified into local, national and international markets.
On the basis of competition, the market may be classified into perfect competition and imperfect
competition. Imperfect competition is further classified into monopoly, monopolistic competition,
etc.
Size or Extent of the market
The size of the market differs with different commodities. The following factors determine
the size of the market for a product:
1. The size of the market will depend upon the nature of demand for the product. A
commodity which has large demand will have wider market.
2. Durability of the commodity
3. Probability and possibility of sampling and grading has considerable influence on the
extent of the market.
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4. The quality of a product, speedy transportation and quick communication, efficient

banking system, peace and political stability are other general factors that affect the size of the
market for a product.
Thus the extent and size of the market for product depends on these factors.
Different Market Forms

The determination of price and output of various products depends upon the type of
market structure. Economists have classified the various market structures into:
1. Perfect competition or pure competition and
2. Imperfect competition.
Market forms of monopolistic competition, oligopoly, monopoly, etc. are generally grouped
under the general heading of imperfect competition. The following table illustrates the
characteristics of different market forms:
9.3 Perfect Competition

1. Large number of buyers and sellers: An important feature of perfect competition is the
existence of a very large number of buyers sellers in the market. The share of each one of them
in the market is too small that none has any influence on the market price.
2. There is no Control over price by individual buyers or sellers.
3. Homogeneous Product The products sold by the sellers are homogeneous or identical.
There is no difference between the product of one seller and another seller. Since the products
are homogeneous, the price will be uniform throughout the market.
4. Prevalence of uniform price.
5. Free entry and exit: The firms have the freedom to enter or leave the industry. Any
buyer or seller is free to enter or leave the market.
6. Perfect Knowledge on the part of buyers and sellers: All buyers and sellers have prefect
knowledge about the market for the commodity. It is assumed that the buyers know the nature
of the product as well as price at which it is said.
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7. Perfect mobility of the factors of production: Factors of production must be free to

move from one industry to another
8. Absence of transport cost: Under perfect competition it is assumed that transport costs
do not exist. The assumption is essential for uniform price throughout the market.
Pure and Perfect Competition
Distinguish often made between pure and perfect competition. Pure competition is said to
exist in the market where
(1)there is a large number of buyers and sellers,
(2)homogeneous product,
(3)there is freedom of entry and exit for firms. The essential feature of pure competition is
the absence of any monopoly element. As Chamberlain puts it, pure competition is a much
simpler and less inclusive concept than perfect competition. Perfect competition is much wider
than pure competition. Besides the above three conditions perfect competition requires,
(I)Perfect mobility of factors of production,
(ii) Full and unrestricted competition, and
(iii) Perfect knowledge and absence of transport cost
Thus there is distinction between pure and prefect competition Perfect competition has
more conditions than pure competition. However, the terms pure competition and prefect
competition are interchangeably used. While English economists attach great importance to
pure competition. American economists emphasise perfect competition. But for all practical
purposes both the terms are used inter changeably
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Table 9.1 Features of Different Market Forms

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These are the conditions necessary for the existence of perfect competition.
9.4 Monopoly
Meaning of Monopoly: The term ‘monopoly’ refers to that market situation in which there
is a single seller of a commodity which has. no close substitutes. ‘Mono’ means single and ‘poly’
means selling. So, literary monopoly means sale by a single person. Monopolist is defined as
the sole producer of a particular commodity Monopoly means absence of competition. It is an
extreme situation in imperfect competition.
Features of Monopoly: It is the situation of single control over the market. Commodity
produced by a monopolist has no substitutes There are no possibilities for any one to enter the
industry. A monopolist may be a single producer or joint stock organisation or any organisation
or government or quasi-government.
The monopolist has control over price, i.e., he can raise the price or lower the price. The
AR curve of the monopolist is downward sloping. The MR curve lies below the AR curve. This is
shown in diagram
Figure 5.1
But under perfect competition, the AR and MR curve will be horizontal straight line running
parallel to the X-axis.
Monopoly may be of different types. It may be a private monopoly, public monopoly, pure
monopoly, discriminating monopoly etc. In the real world, it is very difficult to see a complete
monopoly situation.
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9.5 Monopoly Equilibrium Price-Output Determination Under

Monopoly
The main objective of monopoly firm is to secure maximum profit. The Firm can achieve
its objective in two alternative ways. The firm can either fix the price or it can fix the quantity to
be sold to the customers. In other words, a firm can either fix the quantity or its price but it
cannot fix both quantity and price. Generally the firm fixes the price and leave the quantity to be
determined by market.
In fixing the price, the monopoly firm has to keep in mind two important things: (1) Nature
of demand, and (2) The cost of production.
As regards the nature of demand, the monopolist will have to study whether the demand
is elastic or inelastic. If demand is elastic, monopolist will gain if he fixes a low price and sells
more. On the other hand, if the demand is inelastic, the monopolist will fix a higher price.
The firm will also keep in mind the cost of production of that commodity. If the firm is
subject to the law of increasing costs, the firm will prefer to fix a high price and produce less.
Otherwise if it is subject to the law of diminishing costs, the firm will be fix a lower price and sell
a larger output.
From this, it may be concluded that if the demand is elastic and law of diminishing costs
operates, the price of the product will be low. On the other hand if the demand is inelastic and
the law of increasing cost operates, the price of the product will be high.
Monopoly Equilibrium
The monopoly firm will attain equilibrium when the MC becomes equal to the MR. The
demand curve or AR curve in a downward slopping curve. The MC curve lies below the AR
curve. The monopolist fixes his equilibrium output where his MR is equal to the MC.
The price output equilibrium of the monopolist can be illustrated with the help of a diagram.
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Figure 9.2
In Figure at the level of output OM, the MR = MC. This is the optimum level of output of a
firm. The output will be sold by the firm at TM price. At this price, the average revenue is greater
than AC. So the firm earn a profit of TS per unit. The total profit of the firm is QRST as shown in
the diagram. The shaded area represents the maximum profit which the firm can earn by selling
its output.
Thus, the monopolist will be in equilibrium at output OM, where MR = MC and the profits
are the greatest. The monopoly price determination in the long-run will be similar to that wider
short-period.
In the long-run the monopoly firm adjusts its capacity to changes in the long-run demand.
After these adjustments the monopoly firm will have a long-period equilibrium determined by
the equality between long-period marginal cost and marginal revenue.
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Figure 9.3
Figure shows the long-run equilibrium. The cost curves are L shaped and further except
the shape of the cost-curve, there is no difference between the two figures.
The monopolist earns super-normal profits in the short and in the long-run.
Monopoly Equilibrium under different cost condition: A monopoly firm can achieve
equilibrium wider different laws of returns or cost conditions. However two conditions must be
satisfied to achieve monopoly equilibrium.
1. Marginal revenue must equal the marginal cost.
2. The marginal cost must cut the marginal revenue curve from below.
The equilibrium of a monopoly firm with increasing, constant and decreasing cost curve
can be shown by means of diagram.
1. Increasing Cost or Diminishing Returns: The diagram illustrates monopoly equilibrium

assuming the operation of the law of increasing cost or diminishing returns.
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Figure 9.4
K = The point where MR = MC.
MO = Output
NPRQ = Abnormal profit.
From the diagram, it is clear that the monopoly firm is in equilibrium earning Abnormal
profits. It is equal to the shaded area NPRQ.
2. Constant Cost or Constant Returns: If the monopoly firm is subject to the laws of
constant returns are constant costs; the AC curve will be a horizontal straight line parallel to X-
axis, the marginal cost coincides with it. Monopoly equilibrium subject to constant returns is
illustrated below:
149
Figure 5.5
R = The point where MR = MC.
OM = Output
NPRQ = Abnormal profit.
The horizontal straight line shows AC and MC. The downward sloping AR curve and MR
curve. Then point where the ATR curve cuts the AC = MC lines write the letter R. From R drop
a line to the. X-axis and write the letter M, where it touches X axis. From R draw a straight
upwards to the AR curve and write it as Q. Then shade the area NPRQ., the abnormal profit.
3. Decreasing Cost or Increasing Returns: The diagram given below illustrates monopoly
equilibrium assuming the operation of the law of increasing returns or decreasing costs.
Figure 9.6
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K = The point where MR = MC.
OM = Output.
NPQR = Abnormal profit.
So, a monopolistic firm can be in equilibrium with rising, falling or constant marginal
costs. In other words it is in equilibrium earning super normal profits, when its costs are increasing,
constant or decreasing.
9.6 Monopoly and Perfect Competition

The usual assumption we make about firms, whether they are working wider competition
or monopoly, is that they try to maximise their profits. With profit maximisation the main objective,
they will try to equate Marginal cost and marginal revenue. But under perfect competition, no
single producer can influence the price. Hence each producer accepts the ruling price and he is
powerless to alter it. For him marginal revenue is the same as price, but for the monopolist,
marginal revenue is less than price, for we can control the whole supply and he can take
account of how changes in his output affect the price.
9.7 Discriminating Monopoly

A special feature of the monopoly is price discrimination. Price discrimination of differential
pricing or discriminating monopoly may be defined as the practice of changing different prices
from different buyers. Joan Robinson defines price discrimination as “the act of selling the
same article produced under a single control at different prices to different consumers”.
It may also be defined as, “the sales the technically similar products at prices which are
not proportional to marginal cost”. (Stigler, The Theory of Price). The monopolist can increase
his total profits by this method.
Forms or Degrees of Price Discrimination: Price discrimination may take place in different
ways. It is convention to distinguish three degrees of price discrimination.
First Degree Discrimination: The seller charges the same buyer a different price for each
unit bought (e.g.,) quantity discounts. Different prices may be charged according to the
transactions, whether wholesale or retail.
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Second Degree Discrimination: The seller charges different prices for different buyers
and different prices for different units of the same commodity (e.g. different rates charged by an
electricity for light, for domestic and for industrial use).
Third Degree Discrimination: Discrimination of third degree is the most common type in
practice. Here the monopoly firm charges different prices for different groups or markets. The
seller segregates buyers according to income, individual taste, kind of uses for the product, and
charges different prices to each group or market.
The size of the difference between MC and price is generally used to measure the extent
of the firms monopoly power.
Monopoly power = Price – Marginal cost

Price
The gap between MC and price will depend ultimately in the elasticity of demand (i.e.
Average revenue) of firms product.,
Since the monopolists MR curve will always lie below the AR curve.
Since at equilibrium the MR = MC, it follows that in equilibrium MC is less than price.
The monopoly power varies inversely with the elasticity of demand of the product.
The second indication of the monopoly power is the size of the net profit the monopolist
is able to earn.
Justification of Price Discrimination
Generally price discrimination is not considered a desirable policy on several grounds

whether price discrimination is economically justified or not will depend upon whether it is
advantageous or harmful to the welfare of the community.
1.There are services like the services of doctors in rural areas. It cannot be provided
satisfactory unless they are permitted to charge different charges. Since, these services are
essential to society, price discrimination is necessary and hence justified.
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2. Discriminating monopolist may charge two prices for the same commodity; some
consumers may be charged lower price while others may be asked to pay a higher price for the
same commodity. A higher price is generally charged from the rich customers and lower price is
charged from the poor customer. Here price discrimination is justified because, that the poor
customers would have gone without the commodity if the monopolist had charged a uniformity
high price from all customers.
3. Dumping is a type of price discrimination in which the monopoly firm may charged a
high price in home market and a lower price in foreign market. It can be justified economically.
According to Mrs. Joan Robinson dumping can be justified if the firm which resort to price
discrimination is subject to the operation of the law of increasing returns or law of decreasing
cost. In such a case, if there were no dumping in the foreign market the monopolist would
produce a limited output only for the home market. The average cost of production per unit will
tend to rise. Thus the home consumer will have to pay a high price so far the monopoly product.
Thus sometimes dumping is economically justified.
4. Price discrimination sometimes leads to large production. It is advantageous to the

society. But price discrimination adopted purposes of price-cutting and cut-throat competition is
unjustified.
In the provision of certain essential goods and services, price discrimination may prove
justifiable in the larger interests of the country. For example in railway electricity undertaking
price discrimination is even necessary to enable them to earn maximum profits. So under certain
circumstances, price discrimination is desirable and justifiable. Mrs. Joan Robinson has given
an account of such circumstances in her book “Economics of Imperfect Competition”’.
Price Under Discriminating Monopoly
The purpose of price discrimination is to maximise monopoly profits. The monopoly firm
can secure maximum profits only if it adjusts its price and output in each market in terms of
demand conditions of the market. It attempts to maximise its profits by producing and selling a
quantity at which its MC = MR in all markets. The condition of discriminating monopoly will be
MC = AMR = MR1 = MR2.
Price discrimination by the monopolist has been illustrated in Figure.

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Draw the X-axis and Y-axis in figure A, B and C. In figure A draw the downward sloping AR
and MR curve. Figure B show the AR and MR curves. In figure A demand curve must be steeper
and in figure B the demand curve must be relatively flatter. To find out the total output draw
marginal cost and marginal revenue curve in figure C. The AMR curve is the aggregate marginal
revenue. The point of intersection is K. From K, draw a horizontal line touching the figure B and
A.
Figure 9.7
From these figures it is clear that the monopolist has divided his total market into two sub-
markets. A, B on the basis of elasticity of demand. Elasticity of demand is greater in market B
than in market A. In market A, AR1 is the average revenue curve, MR1, is the marginal revenue
curve. Similarly AR2 and MR2 are the average revenue and marginal revenue curve in market
B. AMR is the aggregate marginal revenue curve. It is the sum of marginal revenue curves of
the individual markets. The monopolist will get maximum profit at output at which AMR = MC. it
is clear from the figure (C) that equilibrium stabilized at output OM at which MC cuts AMR. OM
is the profit maximising output.
Now the monopolist has to distribute the output OM between the two markets A and B.
The discriminating monopolist will sell OM1 output in market A and OM2 in market B. The prices
in the two markets are different in market A, the monopolist charges OP1 price while B, he
charges OP2 price. The discriminating monopolists total profit is shown by the area AKT in the
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figure (C). Price discrimination is profitable only if the price elasticity of demand is different in
different markets.
The price in the first market is higher than the price in the second market, the technique
of price discrimination is that the prices should be determined in such a way that the marginal
revenue in the different markets should be equal to marginal cost.
By practicing price discrimination, the monopolist attains maximum profit. For the viewpoint
of promoting welfare of the poorer classes, price discrimination is some times justified.
9.8 Control and Regulation of Monopoly

Under monopoly there is only one producer controlling the entire supply of a particular
commodity. So there may be an abuse of monopoly power. The abuse of monopoly power are;
1. High price and restriction of output.
2. Wrong allocation of economic resources.
3. It discourages technical progress.
4. Unfair business practices.
5. Lack of efforts to promote efficiency due to the absence of the competition.
6. Political corruption to achieve their ends and
7. Exploitation of worker.
It is for these reasons that monopoly is considered as a social evil and various measures
have been designed in all countries to control and regulate it. To check the abuse of monopoly
power, a permanent monopoly commission has been set up in India.
9.9 Monopolistic Competition

In the previous, we have studied about types of market situations, namely perfect
competition and Imperfect Competition. But these two types of market are rarely found in the
realistic world. in reality, there is only a market situation found in between the two expense
situations. It is imperfect competition which lies in between and we, in this lesson will understand
its forms and how price and output is determined under each form of imperfect market.
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Generally monopolistic competition is a term which is used interchangeably with imperfect

competition. But, both of them are different. Two eminent writers Prof. Chamberlin and Mrs.
Joan Robinson have made notable contribution to the theory of value. it was largely due to the
publication of the two important books namely Prof. Chamberlin’s “Theory of Monopolistic
Competition” and Mrs. Joan Robinsons “The Economics of imperfect Competition” Published in
1932, the study of markets that lie in between-perfect competition and Monopoly got its
importance.
For example take the case of soaps. There is not one type of soap, produced and sold by
soap producer but there are many varieties. Hamam, Lux, Lifebuoy, Rexona, Liril and many
more. Each producer has a monopoly control over his own variety, but competition exists between
the different varieties. So monopolistic competition is a blend of monopolistic competition. Prof.
Edward Chamberlin called it monopolistic competition, while Joan Robinson called the situation
as imperfect competition.
Features of Monopolistic Competition
Monopolistic Competition is characterised by the existence of several firm goods which

are closed substitutes of each other. Following are the important features of monopolistic
competition.
1. Existence of a large number of firms: The number of firms under monopolistic competition
is fairly large. It may vary from ten to thirty, since the number of firms is quite large.
(a) Each firm will be small sized firm controlling only small part of the total market it will
have only limited control over price.
(b) There is no possibility of any collusion or understanding; between the firms, and
(c)There is no question of interdependence of firms. Each firm follows an independent

price-output policy.
(d) All sellers and buyers are aware of all current opportunities. So one’s knowledge of
what others are doing is sufficient to prevent him from taking a lower or taking a higher price
than what others are doing.
(e)All buyers behave in the manner which maximise their utilities (i.e., satisfaction) and all
sellers behave in such a way as to maximise their profits.
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2.Product Differentiation: Product differentiation is the essence of monopolistic competition.

The products sold by different firms are not identical but only similar. For example, different
manufacturers produce tooth-paste under different brand names like Colgate, Binaca, Promise,
Signal and so on. Product differentiation can be brought about through differences in branding,
trademark, package, design, colour, etc.
3. Stoping Demand Curve: Another feature of monopolistic competition is that each firm
under this type has a demand or AR curve that slopes downward from left to right. The AR curve
is mare elastic than the MR or demand curve to a monopoly firm. The corresponding MR curve
lies below the AR curve.
Figure 9.8
4. Selling Costs: Another feature of monopolistic competition is selling costs incurred by

firms. The expenditure involved by advertisement in selling the product. The object of the selling
costs is to alter the demand curve or the product upwards.
5. Non price Competition: The competition by changing the price of the commodity by
each firm is called price competition. There are other methods by which a firm may offer
competition to other firms. That is by changing the size, shape, through advertisement,
salesmanship, window display etc., the firm may offer competition under monopolistic competition.
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6. Group of Firms: The term industry used to denote number of firms engaged in the
production of Identical products in monopolistic competition, the term “Group equilibrium is
used to denote the number of firms producing similar goods”.
7. Freedom of Entry and Exit of firms: Any firm can enter its own brand name and it has
the freedom to leave the industry at anytime.
9.11 Price Determination

Under monopolistic competition, different firms produce different varieties of product.
Each firm will fix price and output of its own product. As in other market forms, the firm under
monopolistic competition attempts to maximise its profits. The equilibrium is indicated by the
equality of marginal revenue and marginal cost. In the short-run, the firm A will be in equilibrium
when MR = MC.
Price determination can be shown through a diagram with the help of revenue and cost
curves.
In the diagram, AR is the average revenue curve, MR is the marginal revenue curve, SAC
is the short-run average cost curve. The firm is in equilibrium where MR = MC, OM is the
equilibrium output and OA is the profit-maximising price. The firm is earning super normal profit
as indicated by the shaded area ABCD”
Monopolistic competition consists of several firms. The cost of various firms may be
different. Therefore, in the short-run it is possible for some firms to earn abnormal profits, for
some to earn normal profits, while some may incur losses. When the average revenue is greater
than average cost, the firm is getting abnormal profits. When average revenue is equal to
average cost, the firm is getting normal profits. When average revenue is less than average
cost the firm may incur loss. This is shown in Figure
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Figure 9.9
C = Point of equilibrium with MR = MC.
PQRS = Total loss.
The firm incurs loss in the short-run because average cost higher than average revenue.
Long-run Equilibrium or Group Equilibrium
In the long-run, under monopolistic completion every firm will earn only normal profits
super normal profits or losses will be completed way, since there is free entry and exit of firms
Equilibrium is attained at MR = MC; AR = AC. This has been illustrated in diagram.
Figure 9.10
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In this diagram, LMC and LAC are long-period average and marginal revenue curves. AR
and MR are average and marginal revenue curves. in the figure AR is tangent to the AC curve
at point P. The equilibrium output is OM and the price is OP1. it is clear that the firms earn only
normal profit in the long-run, till the firms in the group are also in equilibrium. This is called
group equilibrium”.
Implications of Long-run Equilibrium
The implications of long-run equilibrium under monopolistic competitions are as follows:
1. It is case of group equilibrium.
2. Firms are not optimum firms. Output is not produced at least cost. Hence output is not
optimum. So firms under monopolistic competition in the long run are not optimum firms.
3. “There is excess capacity in or idle capacity in all the firms. Under monopolistic
competition in the long-run the equilibrium output is fixed within the diminishing cost phase of
the AC curve. This means presence of excess or idle capacity in all the firms.
4. It is a case of full equilibrium. According to Mrs. Joan Robinson equality of MR with MC

and equality of AR with AC denote that there is full equilibrium. Under monopolistic competition
at OM output MR.= MC on the one hand and AR = AC on the other hand. So it is a case of full
equilibrium.
Chamberlin’s ‘concept of monopolistic competition’ has revolutionised value theory. it is

considered as a realistic theory because in the actual world we find product differentiation,
advertisement expenditure and non-price competition.
Selling Costs
The firm under monopolistic competition, incurs certain expenditure on selling activity.
The expenditure has been referred to as selling cost. Selling costs may be defined as those
costs which are incurred by a firm to persuade customers to buy its products in preference to
those of others. Prof. Chamberlin has defined selling costs as, ‘costs incurred in order to alter
the position and shape of a demand curve for a product’.
Selling costs are incurred in several ways. They are advertisement expenditure, salaries
and allowances to salesmen, expenditure on display etc. Advertisement expenditure is the
most important form of selling costs.
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Production Costs and Selling Costs
Prof. Chamberlin distinguishes selling costs from production costs. Production costs may
be defined as those costs which are incurred by a firm on the. production of a given variety of a
product. These costs include cost of raw materials, wages to the workers, electricity charges,
expenditure on packing etc. The costs of transporting the product to the market is also part of
production.
In short, production costs include those expenses which are incurred on the manufacture
of a commodity and its transportation to the consuming centers. Selling costs are those costs
which are incurred in promoting the sale of a product.
Selling Costs and Demand
The main aim of the producer who in our selling costs, is to increase the demand for
his products. Selling cost are likely to induce old buyers to buy more and to attract new buyers.
This means an increase in demand. Selling cost shifts the demand curve of the firms, product
upward to the right.
Price output Equilibrium under selling costs
A producer can sell a larger output by spending money on advertisement and salesmanship.
A producer has to determine the output which yields him the maximum profit Net profit can be
found as follows: Net returns = (Price x Output) - (Production costs + Selling Costs).
Figure 9.11
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It is difficult to illustrate selling costs and its influence by means of a diagram. However, it
is possible to illustrate selling costs for anyone firm. The diagram is drawn on the assumption
that the seller has three alternative selling costs. (Rs.5,000/-, 7,000/-, 9,000/-)
In the diagram D1,D2 and D3 represent three demand curves when three alternative selling
costs are incurred ATC1, ATC2, ATC3 are the average total cost curves. It includes both production
costs and selling costs. For the sake of simplicity MR have been omitted. The total profit has
been maculated by taking the difference between demand and average cost curves.
The seller has three alternative selling cost (Rs. 5,000, 7,000 and 9,000). When the firm
spends Rs.5000/- on advertisement, its demand curve is D1 and its average total cost curve is
Arc. The maximum profit the firm can secure is given by the rectangle JKLP. The firm produces
OM output and fixes OJ price for the product. When the firm spends Rs.7000/- on advertisement
its demand curve is D2 and its averages total cost curve is TAC2. The maximum profit the firm
can secure is given by the rectangle EFGH .The firm produces ON output and fixes OE price for
the product. When the firm spends Rs. 9000/- on advertisement its demand curve is D2 and its
average total cost curve is ATC3. The maximum profit the firm can secure is given by the
rectangle ABCD. The firm produces OQ output and will fix OA price for the product.
It will be observed from the diagram that the firm secures the highest volume of profit
when it incurs an expenditure of Rs.7,000. Accordingly it will choose this amount of selling cost
and produce ON output and fix OE price for product.
The influence of selling cost on price and output is very difficult to measure. However,
selling cost are necessary to create, increase or maintain the demand for a firm’s product.
Wastes of Monopolistic Competition
Imperfect competition or monopolistic competition has been criticised for many of its
defects. The defects of imperfect competition are generally called as “wastes of competition”.
1. Excess Capacity: Under monopolistic competition firms will not produce optimum output.
Optimum output is that output which is produced at the lowest cost per unit. Every firm is
producing less its optimum capacity. According to Chamberlin’s monopolistic competition and
Mrs. Joan Robinson’s imperfect competition a firm in the long equilibrium produces an output
which is less than optimum output.
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The amount by which the actual long-run output of the monopolistic competitive firm short
of the ideal output is called the excess capacity. Excess capacity is regarded as waste in
monopolistic competition.
The concept of excess capacity is illustrated below with the help of a diagram.
Figure 9.12
The Figure shows equilibrium under monopolistic competition. The firm reaches equilibrium
at E where MR = MC. The long-run average cost is not minimum of this level of output ON. That
is there is scope for increasing the output to OQ. The optimum output is OQ but the actual
output is less at ON. NQ is unutilised capacity or excess capacity. The concept of excess
capacity is relevant only in the long-period.
1. The excess capacity under monopolistic competition is considered wasteful.
2. Unemployment: Monopolistic competition may aggravate the unemployment problem.
The productive capacity is not utilised fully and this will result in unemployment of
resources.
3. Multiplication of Varieties: The existence of large number of varieties of a product may

confuse the consumers It will result’ in consumer’s preference for inferior varieties.
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4. Cost Transport: The existence of cost transport is an important waste monopolistic

competition. The reason for cost transport is the irrational buyer’s preferences. it enable producers
of different areas to supply their goods all over the country.
5. Competitive Advertising: Advertisement is generally regarded as a waste of competition.

All the expenditure on advertisement is a waste so far as the community is concerned.
6. It encourages large number of inefficient firms.
This imperfect competition or monopolistic competition is said to posses many defects.

These defects are mainly due to the preferences of consumers for different varieties. These
defects of monopolistic competition In are considered as “Wastes of Competition .
9.10 Oligopoly
Oligopoly refers to a market situation in which there are a few sellers. Oligopoly is a term
derived from the word ‘oligos’, meaning a few and ‘polian’, meaning to sell. Prof Stigier defines
oligopoly as that situation in which a firm bases its market policy in part on the expected behaviour
of a few close rivals’. According to Prof Leftwich, An Oligopolist industry is one in which the
number of sellers is small enough for the activities of other firms to affect him.
Oligopoly is also termed as competition among the few. The best examples of oligopoly
are markets for petroleum, cigarettes, etc. Most writers considered duopoly and oligopoly as
the same Since the nature of oligopoly problem and the nature of duopoly problems are the
same, they have been considered together, Duopoly models can also be taken as oligopoly
models.
Types of Oligopoly
1. Pure and Differentiated Oligopoly: Oligopoly is said to be pure or perfect; on the basis
of product differentiation. In the case of pure oligopoly, all the producers produce identical
product. Stonier and Hague call pure oligopoly as oligopoly without product differentiation.
Oligopoly is imperfect or differentiated when the firms produce, products which are close
substitutes. The products are identical.
2. Collusive and non-Collusive Oligopoly: The collusive oligopoly refers to the market
situation where the firms combine together to fix the prices and output of the industry. A non-
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collusive oligopoly denotes lack of any understanding or agreement among firms. This
classification is done on the basis of agreement or understanding among the firms
3. Open and Closed Oligopoly: An open oligopoly refers to the market situation the new
firms are free to enter the industry. A closed oligopoly refers to the situation where the new firms
are not allowed to enter the industry. This classification is done on the basis of freedom to enter
the industry.
4.Partial and Full Oligopoly: Partial Oligopoly refers to the market situation where the
industry is dominated by one large firm, which is considered as the leader of the group. The
other firms would follow the leader in fixing prices of their products. Full Oligopoly is the situation
where price leadership is conspicuous by its absence.
5. Syndicated and Organised Oligopoly: Syndicate oligopoly refers to the situation where
the firms sell their products through a centralised syndicate. Organised oligopoly refers to a
situation where the sellers organise themselves into central association for fixing prices output,
quotas etc.
Characteristics of Oligopoly
(1) Few Sellers.
(2) Interdependence.
(3) Advertisement.
(4) Competition.
(5) Lack of uniformity.
(6) Indefinite and indeterminate price the demand curve is found to be kinked.
(7) No unique pattern of pricing behaviour.
(a) Oligopolists have a common objective of maximisation of their net profits.
(b)There is interdependence regarding their decision making. Since each one will react in
a different manner there are many models.
165
(C) it is very difficult to calculate the moves and counter moves. So a newly developed
game theory is also applied to guess the competitors optional moves, best possible strategies
so that one can prepare his own defences and confer measures.
(d) Sometimes they co.-operate but at times they are found with the conflicting attitudes.
(e) Other than the profit maiximisation, each one will have different objectives like sales
maximisation, risk mininisation, prestige seeking or power seeking etc., etc.
(F) Usually stick to the established price but change their design, concessions and
advertisements, free delivery guarantee and so on
(g) Strategies differ and vary according to the number of sellers.
Features of Oligopoly
Kinked Demand Curve: Price rigidity is a feature of oligopolistic market. Paul M. Sweeny
uses a peculiar demand curve, to illustrate price rigidity. it is popularly known as demand curve.
Figure 9.13
166
In the diagram, DD2, is a kinked demand curve. There are two portions in this curve. DP1
and D1D2. DD1 portion is relatively flatly sloped, in this DD1 portion the demand is generally
elastic. The seller will not tend to raise the price above OP. If he raises the price, there will be
decline in the volume of sales.
D1 D2 portion is relatively sloped, the demand is generally inelastic in the portion DI D2. So,
the seller will not tend to lower the price below, OP. If the seller lowers the price below this level
he may not gain much, because it is inelastic: So, OP price will tend to exist. The kinked
demand curve explains the price rigidity under oligopoly and it shows prices tend to be rigid.
9.11 Price Leadership

Price leadership means that in an industry one firm leads the other firms with respect to
price fixation. The firm Which takes the initiative in announcing its price changes is called the
‘price leader’. All other firms in the industry are termed as price followers. This is a very important
form of price fixation under conditions of oligopoly.
Price leadership is of two types: 1: Dominant price leadership and 2. Parametric price
leadership.
The dominant price leadership exists when one firm actually, dominates the industry. It
produces a significant portion of industry’s output. The dominant firm has the lowest costs and
assumes the position of a monopolist. It fixes the price and firm accept it.
The second type of price leadership is known as parametric price leadership. It takes
place when an experience firm assesses carefully demand, cost competition etc., and fixes a
price acceptable to all the firms in the industry. in this ease, the price leader perform the function
of the competitive market.
Conditions for Effective Price Leadership
The following are the conditions for effective price leadership:
1. The firms must be few in number, They should have strong feelings of interdependence
2. Entry to the industry must be restricted.
3. The products of firm must be homogeneous or close substitutes.
4. The demand for the product of the industry must be just elastic.
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5. The firms must have similar cost curves
6. Price leadership of the dominant firm is quite common in real life.
9.12 Price Determination Under Oligopoly

Price determination under oligopoly can be studied under two heads. ‘
1. pricing under pure oligopoly without produce differentiation.
2. Oligopoly with product differentiation : There is no one system of pricing in oligopoly

market. It is not easy to analyse the price system under oligopoly. in the case of pure competition,
monopoly and monopolistic competition the individual producer will fix his output at the point
where MR = MC. The price and output under pure competition, monopoly and monopolistic
competition are determinate.
But in the case of oligopoly, there is difficulty in the determination of the shape and slope
of the AR curve. We are not in a position to use the AR MR AC and MC. So, we are unable to
explain theoretically the output that an individual seller we produce under oligopoly
The best way to understand price output analysis under pure oligopoly is to approach it
through duopoly. The conclusions drawn from it are easily applicable to an oligopolistic situation.
Pricing Under Oligopoly without Product Differentiation
Oligopoly without product differentiation or pure oligopoly is a market situation in which

each seller sells the identical product. As stated earlier, the analysis of duopoly provides simplified
model for discussing the problems of oligopoly.
In duopoly it is assumed that each seller product identical products and that they have
identical costs. They are closely interdependent.
How does a firm under duopoly fix its price and output? There are two likely solutions of
the problem of price-output fixation. The first solution is that the two firms may collude together
to fix the price at the monopoly level.
The other solution is that they may compete against each other allowing the price to settle
itself at the competitive level.
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The simplest and most profitable solution for the duopolist will be to fix a single monopoly
price for their product. Here it is assumed that the duopolists are equally intelligent and recognise
mutual dependence and forms a collusion. They will be in the position of a monopoly. The
dupolists also fix their prices at the level of The monopolist and they would be surely maximising
their joint profits. The dupolists simultaneously fix the same price and output as the monopolist
and will share the market and profit equally. The price determined will be the same and the
output produced by each duopolist Will be half of the total output.
If the owners of the two firms are unintelligent, each will attempt gain at the expense of
the other. They will not recognise mutual dependence and there will be a price war as each
wants to earn more at the expense of another.
For instance, if firm A wants to earn more at the cost of the firm B, firm A makes a price-
cut. The result is that B loses his customers to A, because the products are identical.. Naturally
all customers will like to buy at a lower price. Now B retaliates by making a price-cut greater
than that done by A. As a result B may capture the entire market. Then A makes a counter
move. This may result in a price-war. in the bargain both will suffer. It is difficult to say where the
equilibrium price would be established. However the process of price-cuts stop at where the
price just equal to average cost and the duopolists would earn only normal profits. Thus, after a
price war, the duopolists will reach the equilibrium position when they earn normal profits.
The conclusions reached above with regard to duopoly pricing can extended to cover a
situation of pure oligopoly without product differentiation. Under pure oligopoly, there is greater
possibility’ of the price setting at the competitive level than at monopoly level. If the number of
firms happens to be larger than two. Thus, the price in oligopoly is indeterminate. According to
Stonier and Hague, with three producers the monopoly solution is less probable. In general, the
larger the number of firms the lower will be the price in the market.
9.13 Pricing Under Oligopoly with Product Differentiation

Oligopoly with product differentiation exist when there few sellers selling identical but
differentiated product. Under differentiated oligopoly, the number of firm is small and the products
are differentiated. The price-output analysis under differentiated oligopoly can also be studied
through duopoly. It is assumed that there are two firms will not indulge in price war. The products
being different it is not certain that a change in price on the part of one firm will provoke an
immediate retaliation from the other. It is possible for a firm to raise or lower its price without the
169
fear of other firm. it will be difficult for them to come to understanding or agreement in view of
the differentiated nature of the product.
These conclusions of duopoly analysis can be extended to the market situation of oligopoly
with product differentiation. In this market structure each oligopolist maximises his profits
independently. The reason is that each produces a differentiated product and has a group of
customers. Non-price competition takes place in differentiated oligopoly in the same way as in
monopolistic competition. In the long-run oligopolistic firm will earn normal profit as in monopolistic
competition. In short differentiated oligopoly is similar to that of monopolistic competition.
9.14 Summary
A market is a complex set of activities by which potential buyers and sellers interact to
determine the price and quantity of a good or service. Market can be classified on the basis of
time, area, nature of transaction, volume of business, status of sellers, basis of regulations and
basis of completion. Equilibrium price is that price at which demand and supply meet. Equilibrium
attains when MR = MC and MC cuts MR curve from below. Monopoly can be simple or
discriminating.
9.15 Key Words

Causes of monopoly - Control of resources of raw materials, control of process of
production, economics of scale and legal barriers.
Discriminating monopoly: It is a situation where the monopolist changes different prices

for the same commodity from different consumer, at the same time.
Dumping - It is a situation of monopoly discrimination where there is monopoly in home

market and perfect competition in the world market. in dumping, a nation sells a commodity
abroad at a lower rate than in its own home market.
Principle of Equilibrium: There are two basic principles which apply to all market conditions.
These are (1) A firm should produce only if its TR is equal or greater than its TVC (2) To
maximize profit, the firm should produce where MR = M and slope of MC is greater than slope
of MR.
170

1. What are the conditions of equilibrium of a firm
2. Distinguish between pure market and perfect market
3. Explain Price Discrimination
4. What are the features of oligopoly
5. Classify market structure.

1. Baumol.W.J(1978), Economic Theory And Operations Analysis.
2 Cohen.K.J And Cyret R.M.(1976), Theory Of The Firm, Prentice Hall Of India.
3. H.L. Ahuja ( Principles of Micro Economics)
4. M.L. Jhingan Micro Economic Theory
5. S.Sankaran Micro Economics
7. Green,H.A.J(1964), Consumer Theory,2nd Edition, Macmillan.
8. Jack Hirschleifer (1980), Price Theory And Applications, 2nd Edition Macmillan.
9. K.E. Boulding ( A reconstruction of Economics)

171
LESSON - 10
CANONS OF TAXATION
Learning Objectives
After having read this unit, you will be able to
 Write the principles of Taxation
 Determine how taxes are levied.
Unit Structure
10.1 Adamsmith’s Canon of Taxation
10.1.1 Canon of Ability
10.1.2 Canon of Certainty
10.1.3 Canon of Convenience
10.1.4 Canon of Economy
10.2 Other Canons of Taxation
10.2.1 Canon of Productivity
10.2.2 Canon of Elasticity
10.2.3 Canon of Simplicity
10.2.4 Canon of Diversity
10.3 Characteristics of Canons of Taxation
10.4 Summary
10.6 Key Words

172
Meaning of Canons of Taxation
By canons of taxation we simply mean the characteristics or qualities which a good tax
system should possess. In fact, canons of taxation are related to the administrative part of a
tax. Adam Smith first devised the principles or canons of taxation in 1776.
Even in the 21st century, Smithian canons of taxation are applied by the modern
governments while imposing and collecting taxes.
10.1 Types of Canons of Taxation

In this sense, his canons of taxation are, indeed, ‘classic’. His four canons of taxation are:
10.1.1 Canon of equality or equity
10.1.2 Canon of certainty
10.1.3 Canon of economy
10.1.4 Canon of convenience.
Modern economists have added more in the list of canons of taxation.
These are:
(v) Canon of productivity
(vi) Canon of elasticity
(vii) Canon of simplicity
(viii) Canon of diversity.
Now we explain all these canons of taxation:
10.1.1 Canon of Equality
Canon of equality states that the burden of taxation must be distributed equally or equitably
among the taxpayers. However, this sort of equality robs of justice because not all taxpayers
have the same ability to pay taxes. Rich people are capable of paying more taxes than poor
people. Thus, justice demands that a person having greater ability to pay must pay large taxes.
173
If everyone is asked to pay taxes according to his ability, then sacrifices of all taxpayers
become equal. This is the essence of canon of equality (of sacrifice). To establish equality in
sacrifice, taxes are to be imposed in accordance with the principle of ability to pay. In view of
this, canon of equality and canon of ability are the two sides of the same coin.
10.1.2 Canon of Certainty
The tax which an individual has to pay should be certain and not arbitrary. According to A.
Smith, the time of payment, the manner of payment, the quantity to be paid, i.e., tax liability,
ought all to be clear and plain to the contributor and to everyone. Thus, canon of certainty
embraces a lot of things. It must be certain to the taxpayer as well as to the tax-levying authority.
Not only taxpayers should know when, where and how much taxes are to be paid. In other
words, the certainty of liability must be known beforehand. Similarly, there must also be certainty
of revenue that the government intends to collect over the given time period. Any amount of
uncertainty in these respects may invite a lot of trouble.
10.1.3 Canon of Economy
This canon implies that the cost of collecting a tax should be as minimum as possible.
Any tax that involves high administrative cost and unusual delay in assessment and high collection
of taxes should be avoided altogether.
According to A. Smith: “Every tax ought to be contrived as both to take out and to keep out
of the pockets of the people as little as possible, over and above what it brings into the public
treasury of the State.”
10.1.4 Canon of Convenience
Taxes should be levied and collected in such a manner that it provides the greatest
convenience not only to the taxpayer but also to the government.
Thus, it should be painless and trouble-free as far as practicable. “Every tax”, stresses A.
Smith: “ought to be levied at time or the manner in which it is most likely to be convenient for the
contributor to pay it.” That is why, after the harvest, agricultural income tax is collected. Salaried
people are taxed at source at the time of receiving salaries.
174
These canons of taxation are observed, of course, not always faithfully, by modern
governments. Hence these are basic and classic canons of taxation.
We now discuss the other canons of taxation
10.2.1 Canon of Productivity
According to a well-known classical economist in the field of public finance, Charles F.

Bastable, taxes must be productive or cost-effective. This implies that the revenue yield from
any tax must be a sizable one. Further, this canon states that only those taxes should be
imposed that do not hamper productive effort of the community. A tax is said to be a productive
one only when it acts as an incentive to production.
10.2.2 Canon of Elasticity
Modern economists attach great importance to the canon of elasticity. This canon implies
that a tax should be flexible or elastic in yield.
It should be levied in such a way that the rate of taxes can be changed according to
exigencies of the situation. Whenever the government needs money, it must be able to extract
as much income as possible without generating any harmful consequences through raising tax
rates. Income tax satisfies this canon.
10.2.3 Canon of Simplicity
Every tax must be simple and intelligible to the people so that the taxpayer is able to
calculate it without taking the help of tax consultants. A complex as well as a complicated tax is
bound to yield undesirable side-effects. It may encourage taxpayers to evade taxes if the tax
system is found to be complicated.
A complicated tax system is expensive in the sense that even the most honest educated
taxpayers will have to seek advice of the tax consultants. Ultimately, such a tax system has the
potentiality of breeding corruption in the society.
10.2.4 Canon of Diversity
Taxation must be dynamic. This means that a country’s tax structure ought to be dynamic
or diverse in nature rather than having a single or two taxes. Diversification in a tax structure will
demand involvement of the majority of the sectors of the population.
175
If a single tax system is introduced, only a particular sector will be asked to pay to the
national exchequer leaving a large number of population untouched. Obviously, incidence of
such a tax system will be greatest on certain taxpayers. A dynamic or a diversified tax structure
will result in the allocation of burden of taxes among the vast population resulting in a low
degree of incidence of a tax in the aggregate.
The above canons of taxation are considered to be essential requirements of a good tax
policy. Unfortunately, such an ideal tax system is rarely observed in the real world. But a tax
authority must go on maintaining relentlessly the above canons of taxation so that a near- ideal
tax structure can be built-up.
10.3 Characteristics of Canons of Taxation

A good (may be a near-ideal) tax system has to fulfil the following characteristics:
i. The distribution of tax burden should be equitable such that every person is made to pay
his ‘fair share’.
This is known as the ‘fairness’ criterion which focuses on two principles:
Horizontal equity— equals should pay equal taxes; and vertical equity—un-equals should
pay unequal taxes. That is to say, rich people should pay more taxes.
ii. But equity must not hamper productive efficiency such that burdens should be provided
to correct inefficiencies. This ‘efficiency’ criterion says that it should raise revenue with the least
costs to the taxpayers so that tax system can allocate resources without distortion.
iii. The two other criteria are: ‘flexibility’ and ‘transparency’.
A good tax system demands changes in tax rates whenever circumstances change the
system. Further, a good tax must be transparent in the sense that taxpayers should know what
they are paying for the services they are getting.
iv. A good tax system is expected to facilitate the use of fiscal policy to achieve the goals
of
176
(a) stability
(b) economic growth.
For the attainment of these goals, there must be built-in-flexibility in the tax structure.
From the above discussion, it follows that taxation serves the following purposes:
(i) To raise revenue for the government
(ii) To redistribute income and wealth from the rich to the poor people
(iii) To protect domestic industries from foreign competition
(iv) To promote social welfare.
10.4 Summary
By canons of taxation we simply mean the characteristics or qualities which a good tax
system should possess. In fact, canons of taxation are related to the administrative part of a
tax. Adam Smith first devised the principles or canons of taxation in 1776. Even in the 21st
century, Smithian canons of taxation are applied by the modern governments while imposing
and collecting taxes. In this sense, his canons of taxation are, indeed, ‘classic’. His four canons
of taxation are: (i) Canon of equality or equity; (ii) Canon of certainty; (iii) Canon of economy;
(iv) Canon of convenience. Modern economists have added more in the list of canons of taxation,
these are: (v) Canon of productivity; (vi) Canon of elasticity; (vii) Canon of simplicity, (viii) Canon
of diversity.

1. Who first coined the term canons of taxation?
2. What are the characteristics of good tax?
3. What are the four canons of taxation?
4. Write a comment on modern economists view on canons of taxation?

177
10.6 Key Words

Canons of Taxation: Qualities which a good tax system should possess. In fact, canons
of taxation are related to the administrative part of a tax. Adam Smith first devised the principles
or canons of taxation in 1776
Canon of equality: States that the burden of taxation must be distributed equally or
equitably among the taxpayers
Canon of Certainty: The tax which an individual has to pay should be certain and not
arbitrary.
Canon of Economy: This canon implies that the cost of collecting a tax should be as
minimum as possible. Any tax that involves high administrative cost and unusual delay in
assessment and high collection of taxes should be avoided altogether.
Canon of Convenience: Taxes should be levied and collected in such a manner that it
provides the greatest convenience not only to the taxpayer but also to the government.
Canon of Diversity:
Taxation must be dynamic. This means that a country’s tax structure ought to be dynamic
or diverse in nature rather than having a single or two taxes. Diversification in a tax structure will
demand involvement of the majority of the sectors of the population.

1. Sundaram K.P.M, Fiscal Economics
2. Cauvery and others, Fiscal Economics
3. Bhargava .R.N, Indian Public Finance
4. Mithani .D.M, Public Finance

178
Model Question Paper

B.Com.,
First Year – First Semester
Allied Paper - I
BUSINESS ECONOMICS
Time : 3 Hours Maximum : 75 Marks
SECTION - A
Answer any TEN of the following in 50 words each (10 x 2 = 20 Marks)
1. Define Business Economics
2. Bring out the objectives of business firm
3. Define Law of Demand
4. What is meant by Utility?
5. Define Production Function
6. State Consumer Behaviour
7. Define Opportunity Cost
8. What is meant by Duopoly ?
9. Write a brief note on Incremental and Marginal Concepts.
10. Define the concept of Demand and Supply
11. State the four canons of taxation given by Adam Smith.
12. Explain the concept of Discounting Principle
SECTION - B
Answer any FIVE of the following in 250 words each ( 5 x 5 = 25 Marks)
13. What are the difference between economics and Business economics ?
14. Explain the features of indifference curve.

179
15. State the determinants of Demand
16. Explain law of variable Proportion
17. How price is determined under perfect competition
18. Explain law of returns to scale.
19. Examine Demand Forecasting.
SECTION - C
Answer any THREE questions in about 500 words each (3 x 10 = 30 Marks)
20. Explain the nature and scope of managerial economics
21. Explain Break - even analysis with diagram
22. Explain different types of Elasticity of Demand
23. How will you determine pricing and output under Monopolistic Competition ?
24. Give with suitable illustrations the various methods of forecasting demand.

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INSTITUTE OF DISTANCE EDUCATION

It is with a great pleasure to welcome you as a student of Institute of Distance

With best wishes from mind and heart,

COURSE WRITER AND EDITING

© UNIVERSITY OF MADRAS, CHENNAI 600 005.

1. S.Shankaran, Business Economics - Margham Publications - Ch -17

Sl.No. Title Page

2 Nature, Scope and Importance of Business Economics 20

8 Cost Analysis 126

9 Product Pricing & Market Structure 139

10 Canons of Taxation 171

· Define the subject matter in Economics

· Understand the various aspects dealt in definitions

1.2 Definition of Economics

1.2.1 Wealth Definition

1.2.2 Welfare Definition

1.2.3. Scarcity Definition

1.2.4 Growth-Oriented Definitions

1.3 Positive and Normative Economics

1.5 Key Words

1.6 Check Your Progress

1.7 Reference Books

The main concern of economics is economic problem: its identification, description,

of resources forces economic agents to choose among alternatives. Therefore, economic

1.2 Definition of Economics

B. Marshall’s “Welfare definition”

C. Lionel Robbin’s “Scarcity definition”

D. Samuelson’s “Growth-oriented definition”.

1.2.1 Wealth definition

1. Study of wealth: According to wealth definitions given by various Economists,

3. Causes of wealth: Economics is considered as study of causes of wealth

1.2.2 Welfare Definition

a) Study of Ordinary Business of Life

b) Study of Individual and Social Action

c) Only Welfare Aspect

Features of Welfare Definition

The main features of material welfare definition are as follows

VII. Use of money: This definition considers material or economic welfare as a

The proponents of welfare economics, favoured Marshall’s welfare definition, pointing

III. Proper relationship of welfare and wealth: Marshall defines economics as a

II. Unscientific: According to Prof. Robbins, this definition is unscientific. Marshall

VII. Economics is not concerned with ends: Assuming economics as a normative

Comparison between Adam Smith and Marshall’s Definition

3. In Marshall’s definition, man is more significant while in Adam Smith’s view, it is

1.2.3 Scarcity Definition

Challenging Marshall’s welfare definition, Lionel Robbins formulated a new definition in

Robbins defined economics as follows, “Economics is a science which studies human

According to Scitovosky, “Economics is a science concerned with the administration of

Features of Scarcity Definition

Prof. Robbins definition has the following main features:

I. Multiplicity of ends of unlimited wants: By ends, Prof. Robbbins means human

V. Science of choice: The problem of economizing resources leads to another problem

Superiority / Merits of the Definition

4. Universal: Robbins definition is considered universal. It is applicable to all individuals,

6. More logical explanation of economic problem: Robbins definition is more logical

2. Scarcity definition makes economics meaningless: If economics is neutral

3. It is colourless and Important: Robbin’s definition makes human and realistic

7. Impractical: Following Robbins version, economics becomes merely an intellectual

9. Inapplicable in Socialist countries: Prof. Maurice has criticized Robbin’s definition

Comparison between Marshall’s and Robbins Definition

Similarities:- Similarities between both definitions are described as under;

4. Normative and Positive science: Marshall considers economics as normative

1. Distinction between Social and Human science: In the opinion of Marshall,