PRODUCTION

Production is the process of creating various goods and services, which are
consumed by the people of a country. Things utilized in the production process
are called inputs or factors of production and the things obtained from the
process are called outputs.
WHAT IS PRODUCTION FUNCTION?
The production function of an enterprise is an association between inputs utilized
and output manufactured by an enterprise. For various quantities of inputs
utilized, it gives the utmost quantity of output that can be manufactured.

Let us presume that the farmer utilizes only 2 inputs to manufacture rice: labor
and land. A production function explains us the utmost quantity of rice he can
manufacture for a provided amount of land that he utilizes and a given number of
hours of labor that he performs. Suppose that he uses 2 hours of labor per day
and 1 hectare of land to manufacture an utmost of 2 tons of rice. Then, a function
that explains this association is called a ‘Production Function’. One feasible
instance of the form this could take is: q = K × L, Whereas, q is the amount of rice
manufactured, K is the area of land in hectares, L is the number of hours of work

performed in a day.

Law of Variable Proportions or Returns to a Factor

The Law of Variable Proportions or Returns to a Factor plays an important role in

the study of the Theory of Production. We will understand the meaning,
explanation, stages, and reasons behind the operation of the Law of Variable
Proportions. This law exhibits the short-run production functions in which one
factor varies while the others are fixed.

STATEMENT OF THE LAW-The law states that keeping other factors constant, when
you increase the variable factor, then the total product initially increases at an
increases rate, then increases at a diminishing rate, and eventually starts declining.

IN TERMS OF TOTAL PRODUCT-In the short run keeping first factor input fixed as we
increase the units of second variable input, initially increases at an increasing rate,
then increases at a diminishing rate and then decreases. Total amount of output that
a firm produces within a given period, utilizing the given inputs.

TP= Sum of Marginal product

TP= AP x Variable input

IN TERMS OF MARGINAL PRODUCT- In the short run keeping first factor input fixed
as we increase the units of second variable input, its MP initially increases then
decreases and finally becomes negative. It denotes the addition of variable factor to
the total product.

MP=

MP=TPn-TPn-1

AVERAGE PRODUCT-It is output per unit of inputs of variable factor.

AP=TP/VI

SCHEDULE:
DIAGRAM

EXPLANATION:
Relation between TP and MP –
Phase I (IRF) – Increasing Returns to Factor - At 0 units of variable input, MP is
undefined and TP is 0.
At unit 1, TP equals MP. In this phase MP increases and becomes maximum while
TP product increases at an increasing rate giving the curve a downward bend.

Phase II (DRF) – Diminishing returns to a factor - MP decreases and becomes zero;

TP increases at a diminishing rate giving the curve an upward bend. When MP is
zero TP is maximum and constant.

Phase III (NRF) – Negative Returns to Factor - In this phase MP becomes negative
and total product begins to decrease.
Relation between MP and AP - MP and AP are undefined at 0 units. AP equals MP
at unit 1. MP and AP increase in Phase I. MP increases and becomes maximum.
The value of AP is always less than MP.
In phase II, MP decreases while AP continues to increase till finally it is intersected
by the MP curve from above. After this AP begins to decrease but its value
remains greater than MP. Hence AP is intersected by MP at its maximum. At the
end of phase II MP is 0 while AP is positive.
In Phase III, MP becomes negative. AP continues to decline but is still positive.
Reasons for Increasing, Decreasing and Negative returns OR
Why is the MP curve inverted U in shape?
In phase 1 as more units of variable factor is introduced, there is division of labor.
Such favorable factor combinations enable specialization and increase efficiency
of the variable factor. This leads to increase in Marginal productivity, and the MP
curve rises.
In Phase II, with excess units of variable factor being used along with fixed factor
of production, the production process becomes crowded. Due to unfavorable
factor combinations and increasing difficulty in supervision and management,
Marginal productivity of the variable factor decreases and MP curve slopes
downwards.
In phase III, overcrowding of the production process leads to adverse factor
combinations and Marginal productivity becomes Negative.
Hence the MP curve is inverted U in shape.
Q. Which out of the 3 phases is the best for a firm to function in?
Q. Calculate MP & AP from the given information: -
Units 1 2 3 4 5 6 7
TP 40 80 110 130 140 140 130
Q. Calculate TP & AP from the given information: -
Units 1 2 3 4 5 6 7
MP 24 20 16 12 8 0 -8

Long run theory / Long run production function / Law of returns to scale - (not in
syllabus but important for cost curve)
In the long run both the factors of production are increased simultaneously and
proportionately leading to increasing returns to scale in the initial phase followed
by constant and diminishing returns to scale as the production increases.
 COSTS
Definition: - Costs refer to the expenditure incurred for the hire or use of a factor
of production.
Cost Function: - Refers to the functional relation between units of output
produced and the cost of producing them.
Short run costs and long run costs –
Short run costs – In the short run there is a fixed factor and a variable factor of
production. Fixed costs refer to the costs which are incurred to employ the fixed
factor of production, it remains fixed irrespective to the level of output. E.g., rent
of factory building, depreciation on machinery, salary to office staff, guard,
supervisor, insurance premiums, etc.
Variable costs are the cost incurred to employ the variable factors of production.
It varies directly with the level of output. E.g., costs of raw materials, wages of
laborers, etc.
Total fixed cost – The cost of employing the fixed factor of production is also
called the total fixed cost.
Total variable cost – The cost of employing the variable factor of production is
also called the total variable cost.
Total cost is the sum of total fixed cost and the total variable cost.
TC = TFC + TVC
Cost Schedule: -

1 2 3 4 5 6 7 8
OUTPU TFC TVC TC SMC AFC AVC SAC
T
TC = SMC = TFC TVC TC/q
TFC + ∆TC
q q q OR
TVC
∆q
AFC+AV
C
0 20 0 20 - - - -
1 20 10 30 10 20 10 30
2 20 18 38 8 10 9 19
3 20 24 44 6 6.67 8 14.67
4 20 29 49 5 5 7.25 12.25
5 20 33 53 4 4 6.6 10.6
6 20 39 59 6 3.3 6.5 9.8
7 20 47 67 8 2.8 6.7 9.5
8 20 60 80 13 2.5 7.5 10.0
9 20 75 95 15 2.2 8.3 10.5
10 20 95 115 20 2 9.5 11.5
Diagram: - TC, TVC, TFC
Q. Why is the TVC zero, at zero units’ output?
A. If one of the two factors of production is zero, output is zero. Since, the TFC is a
positive value (20) the fixed factor of production exists. This means there is no
variable factor and hence TVC is zero.
Q. Why does TVC increase with the level of output? OR Why is the TVC curve
upward / positively sloped?
A. In the short run, fixed factor cannot be changed; hence to increase the level of
output variable factor needs to be increased. Increase in variable factor leads to
increase in the TV cost.
Q. Why does TC = TFC at zero units of output?
A. TC = TFC + TVC. At zero units of output, TVC is zero at zero Hence at zero units
of output TC = TFC.
Q. Why does TC increase with the level of output? OR Why is the TC curve upward
/ positively sloped?
A. TC = TFC + TVC. TFC is constant for all levels of output. As TVC increases with
the level of output the behavior of TVC is reflected on TC curve.
Q. Why is TC - TVC always a constant value? OR Why are TC and TVC parallel?
A. Since TC = TFC + TVC, TC – TVC = TFC. TFC is constant irrespective of the level of
output; hence the gap between TVC and TFC is constant making the 2 curves
parallel.
Q. Why is the sum of marginal costs = TVC?
A. In the short run, the fixed cost remains constant. Any change in the TC is due to
the change in the TVC. Thus, the marginal cost which measures the change in TC
per unit change in output can also be calculated by the per unit change in TVC.
Hence sum of MCs = TVC.
Average Fixed Cost curve (AFC) –
Definition – AFC is the total fixed cost per unit of output, i.e., TFC/q.The average
fixed cost is undefined at zero units of output. As the output increases the AFC
goes on increasing but never becomes zero. Hence the AFC curve is downward
sloping but never touches the x-axis or y-axis and is thus called a rectangular
hyperbola.
Q. Explain the nature of AFC? OR Why does AFC never become zero? OR Why is
AFC curve a rectangular hyperbola?
A. If the TFC is 20, AFC = TFC
q

OUTPUT TFC AFC = TFC/q

0 20 20/0 = ∞ (infinity)
(undefined)
1 20 20/1 = 20
2 20 20/2 = 10
3 20 20/3 = 6.67
4 20 20/4 = 5

Since at zero units of output the AFC is undefined (∞). It does not touch the
y–axis. As the output goes on increasing, the TFC which is a constant value gets
divided by larger unit of outputs. Hence AFC decreases. Since the numerator
never equals zero (0 divided by any number equals to 0), TFC being a constant
value divided by any amount/quantity of output, its value may become negligible
but never zero. Thus, the AFC never touches the x-axis and becomes a rectangular
hyperbola in shape.
Diagram: - AFC curve

Diagram: - SMC, AVC, SAC

Relation between SMC, SAC and AVC –
*We plot output on x-axis and SMC, AVC and SAC on y-axis. They are U in shape.
*They are undefined at zero units of output.
*At unit 1 of output SMC = AVC while SAC is greater than them.
*Initially as the output increases all three decrease.
*After a certain level of output, SMC begins to increase. SMC cuts AVC from
below.
*As long as SMC is less than AVC, AVC is decreasing.
*When SMC is greater than AVC, AVC begins to increase. Hence SMC cuts AVC
from below at its minimum.
*But as long as the value of SMC is less than SAC, value of SAC continues to
decrease.
*When SMC has risen enough, it intersects SAC from below and continues to
increase.
*When SMC is greater than SAC, SAC also begins to rise. Hence SMC cuts SAC
from below at its minimum.
*The value of SAC is always greater than AVC i.e., the SAC lies above AVC curve.
*As the level of output increases the gap between SAC and AVC decreases but
they never intersect.
*The minimum point of AVC lies at a level of output before the minimum point of
SAC.
Q. Why is the SMC curve U in shape?
The behavior of SMC depends on the marginal product curve. Initially in Phase I
(IRF), Marginal product (MP) increases due to the division of work, specialization
and increase in efficiently of the variable factor (labor). This leads to reduction in
the cost of production and the Marginal cost (MC) which is the cost incurred to
produce an additional unit of output goes on decreasing.
At the end of phase I where MP is maximum the MC is minimum.
In phase II due to unfavorable factor combinations and difficulties in management
and supervision, the Marginal productivity of variable factor decreases leading to
a decrease in efficiently and increase in wastage. Hence the MP decreases the
cost of producing an additional unit of output increases i.e., MC increases. Hence
the MC curve is U shaped.
Q. Why in AVC curve U-shaped?
A. The behavior of AVC depends on the behavior of marginal cost (MC). AVC is the
average of TVC. But the TVC is nothing but a sum of MC up to a certain level of
output. Hence, we conclude that AVC is an average of the sum of the MC.

AVC = TVC
Q
Where TVC = MC1 + MC2 +MC3.
Hence the AVC reflects the behavior of the MC.
Initially, as the MC decreases, AVC also decreases. However, since it is an average,
the decrease in AVC is at a lesser rate than the decrease in MC which is an
independent value. (This is why the downward sloping section of AVC curve
remains above the SMC curve)
As output increases, MP begins to increase and its value becomes greater than
AVC. The effect of the behavior of MC begins to reflect on the AVC which also
starts rising. (AVC however remains below SMC.) Hence the AVC curve is U
shaped.
Q. Relation between SAC and AVC. OR Why does the gap between SAC and AVC
go on decreasing? Do they intersect? OR Why is SAC always > AVC?
A. TC = TFC + TVC
TC = TFC + TVC
q q q (dividing both side by q)
 i.e., SAC = AFC + AVC – (1)
Thus SAC – AVC = AFC – (2)
This means that the distance between SAC and AVC exists because of AFC.
The AFC is a rectangular hyperbola i.e., it is maximum at unit 1 but goes on
decreasing, however it never becomes zero.
Thus, the distance between is SAC and AVC is maximum at unit 1and goes on
decreasing as the level of output increases. As AVC is never zero, there exists a
negligible gap between SAC and AVC and they never intersect. (This is also the
reason why SAC curve always lies above AVC.)
Q. Why does the minimum point of AVC lies before minimum point of SAC?
A. The behavior of SAC depends on AFC and AVC. During the initial stage of output
both AFC and AVC start decreasing. Hence SAC also decreases. As more output is
produced SMC cuts AVC at its minimum after which AVC begins to increase.
However, SAC continues to decrease from output level from Oq0 to Oq1. This is
because in this duration AFC and AVC work as two opposite forces of which AFC
which is decreasing at a faster rate in comparison to AVC which is increasing
gradually (at slower rate), becomes the stronger force and manages to pull SAC
downwards. After q1 units of output SMC has risen enough and AVC increases at
a faster rate while AFC begins to decrease gradually. Now AVC emerges as the
stronger force and manages to pull SAC upwards. Hence, the minimum point of
AVC lies before the minimum point of SAC.
Long Run cost curve – (LR)
In the Long Run there are no fixed factors of production and hence there is no
fixed cost of production. In such a case the behavior of MC and AC curves is
guided by the Long Run production function. In the Long Run when both factors
vary simultaneously and proportionately as per the law of returns of scale the
firm first experiences Increasing, then Constant and finally Diminishing returns to
the scale. Hence in the long run the LRMC and LRAC or LRAVC cost curve are also
U shaped with MC curve intersecting LRAC at its minimum.
NOTE – There is only 1 average cost curve.
Implicit and Explicit costs
Production of a commodity involves contribution of all 4 factors of production i.e.,
land, labor, capital and entrepreneur (businessman). The remuneration paid to
these factors is also called factor costs. E.g., Rent, wages, interest and profit.
Explicit Cost / Accounting Cost: - Factors of production, which are not owned by
the producer and are hired from outside need to be paid a remuneration which
also enters into the books of accounts. Hence the cost incurred to pay for a factor
not owned by a businessman is called an Explicit Cost / Accounting Cost. E.g.,
costs like wages paid to the laborers, rent paid for hiring factory building.
Implicit Costs: - Factors which are owned by the producer for which no
remuneration may be paid explicitly are called as Implicit Costs. They do not enter
the books of accounts.
E.g., cost like interest on capital contributed by the producer, rent of factory
building owned by the producer.
Economic Costs: - Both explicit and implicit costs together are called Economic
Costs. Hence the Economic costs / TC = Explicit + Implicit cost.
Shut down point / Breakeven point / Normal profits
*Total Revenue (TR) = Price (p) x Quantity (q).
Comparison between TR and TC –
1. When TR = TC, the firm is said to be at a Break-even point where at least the
firm is able to cover its costs of production. It is called as Zero Economic Profits.
Since TC includes normal profits the business man continues to do business even
at the Break Even Point (BEP)
2. When TR > TC, the firm earns super normal profits or positive economic
profits.
3. When TR < TC, the firm incurs a loss. It is unable to recover even its costs of
production. The producer does not even earn normal profits and would prefer to
move to the next best alternative by shutting down the firm.
Opportunity Cost (OC): - It is the cost of next best alternative foregone. OC is used
to ascertain /calculate the value of implicit costs in business. E.g., If a
businessman earns a profit of Rs. 10,000 from his business but would earn Rs.
8000 by doing a job, Rs. 8000 is the cost of his next best alternative i.e., OC of
doing a business.
Shut Down Point – It is the last price-output combination on the MC curve where
the firm is willing to supply a positive level of output.
Diagrams: - Shut down Point and Break-even Point in Short and L
 Market Structures
Perfect Competition –
(PC) It is a market structure where there are many buyers and sellers as there are
no restrictions on entry or exit, they sell a homogenous product and earn only
nominal profit (no super profit).
Features of Perfect Competition –
1. Many buyers and sellers – The term ‘many’ does not specify any number. It
means that the number of firms / buyers is large enough to render the share of a
single seller / buyer in the total market supply / demand insignificant. The term
insignificant means that the buyer / seller cannot influence the market price by
changing the quantity supplied / demanded. Hence having to accept the market
determined price, making each seller / buyer a price taker.
2. Freedom of entry and exit – In a perfect competition, there is no restriction on
entry and exit for firms. Such restrictions may be natural or artificial. Natural
restrictions could be control / ownership of crucial raw materials or huge capital
investment. Artificial barriers may be in the form of patents, trademarks, rules
and regulations, franchisee, restrictions of exit in the form of govt. interventions,
labor laws, and trade unions. Since there are no restrictions, firms can enter or
exit whenever they find it suitable. It is because of this reason that perfect
competition firms earn only normal profits (zero economic profits) in the long run.
Q. Why do perfect competition firms earn only normal profits (zero economic
profits) in the long run?
Since there are no restrictions on entry or exist of firms in a perfect competition
market, whenever existing firms in the market make super normal profits, new
firms attracted by the supernormal profits new enter the market. This leads to an
increase in the supply of the commodity and decreases the market price. This
continues till the market price becomes equal to the minimum average cost
where super normal profits disappear and all firms earn only normal profit.
When existing firms make losses, some firms who cannot withstand the loss exit.
Supply decreases and market price increases, till ultimately all the firms start
earning at least normal profit.
3. Homogeneous products – It means the products sold in the market are
identical in all respects i.e., they are similar in color, shape, size, flavor, odors,
quality etc.
Since all sellers sell a homogenous product and each buyer / seller has perfect
market knowledge, no seller can charge a price higher than the market
determined price. Nor will he be willing to sell at a price less than the market
price. Hence in a PC, one and only one price exists i.e., market price. Thus, all
buyers and sellers are price takers because of homogenous product.
4. Perfect market knowledge – The feature perfect market knowledge has 2
aspects:
a. Perfect knowledge of commodity market –It means that both buyers and sellers
are aware of the prices at which commodities are sold in the market. Hence all
sellers and buyers accept the market determined price. Thus, only one market
price prevails and buyers and sellers are ‘Price takers.
b. Perfect knowledge of factor market – It means that the producers are aware of
the prices of the factors of production. Sellers end up paying the same costs for
raw materials, wages, interest on capital, rent and hence each firm in the PC
market has the same cost of production.
From a and b we conclude that, since each firm has the same cost structure and
sells at the same price, every firm in the PC market earns the same profit which
equals normal profit in the long run. (No super profit)

REVENUE CURVES
TOTAL REVENUE- the total revenue refers to the amount of money realized by a firm
on the sale of a commodity. Total revenue is expressed as follows:

TR = P x Q … where TR – Total Revenue, P – Price, and Q – Quantity of the

commodity sold.
MARGINAL REVENUE- Marginal revenue (MR) is the change in total revenue resulting
from the sale of an additional unit of a commodity.

MR= TR/ or

TR=TRn-TRn-1

AVERAGE REVENUE- Average revenue is simply the revenue earned per unit of the
output. In simpler words, it is the price of one unit of the output. Average revenue is
expressed as follows:

AR=TR/Q, where AR – Average Revenue,

TR – Total Revenue, and Q – Quantity of the commodity sold.

For perfect competition: -

In a perfect competition market, each unit of commodity is sold at a constant
price equal to minimum average costs. If a perfect competition firm wants to
increase its revenue it has to supply more units at the same price.

Quantity Price Total revenue Marginal revenue Average

revenue
TR = p x q MR = TR / q
AR = TR / q
Or TRn-TRn-1
0 10 0 - -
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
Diagram: - TR, MR and AR of perfect competition: -

TR curve is upward sloping / positive sloped straight line bisecting the origin. It
has a constant slope. MR / AR / P coincide; it is a horizontal straight line parallel to
x – axis.
MARKET EQUILIBRIUM (PERFECT COMPETITION)

Market equilibrium refers to that point which has come to be established under a
given condition of demand and supply and has a tendency to stick to that level,
i.e., where Demand = Supply.
If due to some disturbance we divert from our position the economic forces will
work in such a manner that it could be driven back to its original position, i.e.,
where Demand = Supply. In short it is the position of rest.
It can be explained with the help of the schedule and diagram:
(a) (i) In the given schedule market equilibrium is determined at Price Rs. 3 where
Market demand is equal to Market Supply.
(ii) At price 1 and 2, there is excess demand, which leads to rise in price, resulting
tendency is expansion in supply.
(iii) Similarly, at price 4 and 5, there is excess supply, which leads to fall in price,
tendency is Contraction in supply.
b) (i) In the given diagram, price is measured on vertical axis, whereas quantity:
demanded and supply is measured on horizontal axis.
(ii) Suppose that initially the price in the market is P . At this price, the consumer
1

demand P B and the producer supply P A, i.e., consumers want more than what
1 1

the producer are willing to supply. There is excess demand equal to AB. So, price
cannot stay on P as excess demand will create competition among the buyers and
1

push the price up till, we reach equilibrium.

)
Suppose that initially the price in the market is P . At this price, the consumer Due
1

to rise in price from P to P there is upward movement along the supply curve
1 2
(expansion in supply) from A to E and upward movement along the demand curve
(contraction in demand) from B to E.
(iii) Similarly, at price supplied P L. There is excess supply, equal to KL, which will
2

create competition among the sellers and lower the price. The price will keep
falling as long as there is an excess supply.
Due to fall in price from P to P there is downward movement along the supply
2

curve (contraction in supply) from L to E and downward movement along the

demand curve (expansion in demand) from K to E.
(iv) The situation of zero excess demand and zero excess supply defines market
equilibrium (E). Alternatively, it is defined by the equality between quantity
demanded and quantity supplied. The price P is called equilibrium price and
quantity Q is called equilibrium quantity.
Effect of Change in Equilibrium due to Increase and Decrease in Demand and
Supply.
 INDIVIDUAL SHIFT IN DEMAND AND SUPPLY
Case I: Increase in Demand
1. An increase in demand leads to rightward shift of demand curve as shown in
the figure below:
You Must Know When demand increases, then shifting should be such that initial
price remains constant. It is so because increase in demand is the part of the shift
in demand in which other factor changes and price remains constant.
Changes in Demand
(1) A to B because of increase in demand (shift in demand)
(2) B to C as price rises because of excess demand which leads to upward
movement along the demand curve.

A to C as price rises because of excess demand which leads to upward movement

along the supply curve.
2. We assume that initial price is OP and equilibrium quantity is OQ as shown
above:
(a) In the above figure price is on vertical axis and quantity demanded and
supplied is on horizontal axis. But due to increase in demand due to the following
reasons the demand curve shifts rightward from DD to D D .1 1

(i) Price of substitute goods rises.

(ii) Price of complementary goods falls.
(iii) Income of a consumer rises in case of normal goods.
(iv) Income of a consumer falls in case of inferior goods.
(v) When preferences are favorable.
(b) With new demand curve D D , there is excess demand at initial price OP
1 1

because at price OP demand is PB and supply is PA, so there is excess demand of

1

AB at price OP.
(c) Due to this excess demand, competition among the consumer will rise the
price. With the rise in price, there is upward movement along the demand curve
(contraction in demand) from B to C and similarly, there is upward movement
along the supply curve (expansion in supply) from A to C. So, finally equilibrium
price rises from OP to OP , and equilibrium quantity also rises from OQ to OQ
1 1

Conclusion
Due to increase in demand,
(i) Equilibrium price rises from OP to OP
1

(ii) Equilibrium quantity also rises from OQ to OQ

1

Case II: Decrease in Demand

1. A decrease in demand leads to leftward shift of demand curve as shown in the
below figure:
You Must Know
When demand decreases, then shifting should be such that initial price remains
constant. It is so because decrease in demand is the part of the shift in demand in
which other factor changes and price remains constant.
Changes in Demand
(1) A to B because of decrease in demand (shift in demand)
(2) B to C as price fall because of excess supply which leads to downward
movement along the demand curve.
2. (a)A to C as price fall because of excess supply which leads to downward
movement along the supply curve.
(i) Price of substitute goods fall.
(ii) Price of complementary goods rise.
(iii) Income of a consumer falls in case of normal goods.
(iv) – Income of a consumer rises in case of inferior goods.
(v) When a preference becomes unfavorable.
(b) With new demand curve D D , there is excess supply at initial price OP because
1 1

at price OP demand is Pre and supply is PA so there is excess supply of AB at price

OP.
(c) Due to this excess supply, competition among the producer will make the price
fall. Due to fall in price there is downward movement along the demand curve
(Expansion in demand) from B to C and similarly there is downward movement
along the supply curve (contraction in supply) from A to C. So, finally, the
equilibrium price falls from OP to OP and equilibrium quantity also falls from OQ
1

to OQ .
1

Conclusion
Due to decrease in demand,
(i) Equilibrium price falls from OP to OP .
1

(ii) Equilibrium quantity also falls from OQ to OQ .

1

Case III: Increase in Supply

1. An increase in supply leads to rightward shift of supply curve as shown in the
below figure:
You Must Know
When supply increases, then shifting should be such that initial price remains
constant. It is so because increase in supply is the part of the shift in supply in
which other factor changes and price remains constant.
Changes in Supply
(1) A to B because of increase in supply (shift in supply)
(2) B to C as price falls because of excess supply which leads to downward
movement along the supply curve.
A to C as price falls because of excess supply which leads to downward movement
along the demand curve.
We assume that initial price is OP and equilibrium quantity is OQ as shown above:
(a) In the above figure price is on vertical axis and quantity demanded and
supplied is on horizontal axis. But due to increase in supply due to the following
reasons:
(i) Fall in the prices of remuneration of factors of production.
(ii) Fall in the prices of other commodities.
(iii) Improvement in technology.
(iv) Change in objective of producer (inducing them to increase supply at the
same price.)
(v) Taxation policy of government falls.
(b) The supply curve shifts rightward from SS to S S .With new supply curve S,
1 1

S, there is excess supply at initial price OP because at price OP supply is PB and

1

demand is PA, so there is excess supply of AB at price OP.

(c) Due to this excess supply competition among the producer will make the price
fall. Due to this fall in price, there is downward movement along the supply curve
(Contraction in supply) from B to C and similarly, there is downward movement
along the demand curve (Expansion in demand) from A to C. So, finally,
equilibrium price falls from OP to OP and equilibrium quantity rises from OQ to
1

OQ 1

Conclusion
D i) Equilibrium price falls from OP to OP .
1

(ii) Equilibrium quantity rises from OQ to OQ .

1

Case IV: Decrease in Supply

A decrease in supply leads to leftward shift of supply curve as shown in the below
figure:
You Must Know
When supply decreases, then shifting should be such that initial price remains
constant. It is so because decrease in supply is the part of the shift in supply in
which other factor changes and price remains constant.
Changes in Supply
(1) A to B because of decrease in supply (shift in supply)
(2) B to C as price rises because of excess demand which leads to upward
movement along the supply curve. ue to increase in supply. Changes in Demand
A to C as price rises because of excess demand which leads to upward movement
along the demand curve.

2. We assume that initial price is OP and equilibrium quantity is OQ as shown

above:
(a) In the above figure price is on vertical axis and quantity demanded and
supplied is on horizontal axis. But due to decrease in supply due to the following
reasons the supply curve shifts leftward from SS to S S .
1 1

(i) Rise in the prices of remuneration of factors of production.

(ii) Rise in the prices of other goods.
(iii) When the technology becomes outdated.
(iv) Change in objective of producer (inducing them to decrease supply at the
same price).
(v) Taxation policy of government rises.
(b) With new supply curve S S , there is excess demand at initial price OP because
1 1
at price OP, supply is PB and demand is PA, so there is excess demand of AB at
price OP.
(c) Due to this excess demand competition among the consumer will rise the
price. Due to this rise in price, there is upward movement along the supply curve
(Expansion in supply) from B to C and similarly, there is upward movement along
the demand curve (Contraction in demand) from A to C. So, finally, equilibrium
price rises from OP to OP and equilibrium quantity falls from OQ to OQ .
1 1

Conclusion
Due to decrease in supply,
(i) Equilibrium price rises from OP to OP 1

(ii) Equilibrium quantity falls from OQ to OQ 1

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Simple Applications of Tools of Demand and Supply

Price Ceiling (Maximum Price Ceiling)
1. When the government imposes upper limit on the price (maximum
price) of a good or service which is lower than equilibrium price is
called price ceiling.

2. Price ceiling is generally imposed on necessary items like wheat, rice,

kerosene etc.
3. It can be explained with the help of given diagram:
(a) In the given diagram, DD is the market demand curve and SS is the
market supply curve of Wheat.
(b) Suppose, equilibrium price OP is very high for many individuals and
they are unable to afford at this price.
(c) As wheat is necessary product, government has to intervene and
impose price ceiling of Pt, which is below the equilibrium level.
(d) When the government fixes the price of a commodity at a level
lower than the equilibrium price (say it fixes the price at OP , there
1

would be a shortage of the commodity in the market. Because at this

price demand exceeds supply. Quantity demanded is P S, while quantity
1

supplied is only P R. There is, thus, a shortage of RS quantity at this

1

price (i.e., OP ). In free market, this excess demand of RS would have

1

raised the price to the equilibrium level of OP. But, under government
price-control consumers’ demand would remain unsatisfied.
(e) Though the intension of the government was to help the consumers,
it would end up creating shortage of wheat.
(f) To meet this excess demand, government may use Rationing system.
(g) Under rationing system, a certain part of demand of the consumers
is met at a price lower than the equilibrium price. Under this system,
consumers are given ration coupons/ Cards to buy an essential
commodity at a price lower than the equilibrium price from Fair
price/Ration Shop.
(h) Rationing system can create the problem of black market, under
which the commodity is bought and sold at a price higher than the
maximum price fixed by the government.
Price Floor (Minimum Price Ceiling)
1. When the government imposes lower limit on the price (minimum
price) that may be charged for a good or service which is higher than
equilibrium price is called price floor.
2. Price Floor is generally imposed on agricultural price support
programs and the
minimum wage legislation.
(a) Agricultural price support programs: Through an agricultural price
support programme, the government imposes a lower limit on the
purchase price for some of the agricultural goods and the floor is
normally set at a level higher than the market—determined price for
these good.
(b) Minimum wage legislation: Through the minimum wage legislation,
the government ensures that the wage rate of the laborer’s does not
fall below a particular level and here again the minimum wage rate is
set above the equilibrium wage rate.
3. It can be explained with the help of given diagram:
(a) In the given diagram, DD is the market demand curve and SS is the
market supply curve of Wheat.
(b) Suppose, equilibrium price OP is not so profitable for farmers, who
have suppose just faced Drought.

(c) To help farmers government must intervene and impose price floor
of P ; which is above than equilibrium price.
1

(d) Since, the price P is above the equilibrium price P the quantity
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supplied P B exceeds the quantity Demanded and demanded P A. There

1 1

is excess supply. Supplied of Wheat

(e) In case of excess supply, farmers of these commodities need not sell
at prices lower than the minimum price fixed by the government.
(f) The surplus quantity will be purchased by the government. If the
government does not procure the excess supply, competition among its
sellers would bring down the price to the level of equilibrium price.