D. N. Dwivedi - Microeconomics-I - (2012)

Microeconomics – I
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For University of Delhi
As per the syllabus of B.Com. (Hons) course
D. N. Dwivedi
Professor of Economics
Maharaja Agrasen Institute of Management Studies,
New Delhi

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Syllabus
B.Com. (Hons)
Paper – CH 1.3: Semester – I
Duration: 3 Hours Max. Marks: 100

Lectures: 75
Objective: Objective of the course is to acquaint the students with the concepts of microeconomics
dealing with consumer behaviour. The course also makes the students understand the supply side of the
market through the production and cost behaviour of firms.
Learning Outcomes: The students would be able to apply tools of consumer behaviour and firm theory
to business situations.
Course Contents
Unit – I
1. The concept of demand and the elasticity of demand and supply, Demand curves: individu-
al’s demand curve, market demand curve, Movements along versus shifts in the demand curve,
Elasticity of demand: price, income and cross. Concept of revenue: Marginal and Average: Revenue
and elasticity of demand. 11 lectures
Unit – II
Consumer Behaviour: Notion of indifference and preference. Indifference curve analysis of consumer
behaviour, Consumer’s equilibrium (necessary and sufficient conditions). Price elasticity and price
consumption curve, income consumption curve and Engel curve, price change and income and sub-
stitution effects. Consumer surplus. Indifference curve as an analytical tool (cash subsidy v/s kind sub-
sidy). Revealed preference. 22 lectures

vi Syllabus
Unit – III
2. Production: fixed and variable inputs, production function, total, average and marginal products,
law of variable proportions. Linear homogeneous production function. Production isoquants,
marginal rate of technical substitution, economic region of production, optimal combination of
resources, the expansion path, isoclines, returns to scale. 10 lectures
Unit – IV
3. Cost of Production: social and private costs of production, difference between economic and
accounting costs, long run and short run costs of production. Economies and diseconomies of
scale and the shape of the long run average cost. Learning curve. 10 lectures
Unit – V
4. Perfect Competition: assumptions, price and output decisions. Equilibrium of the firm and the
industry in the short and the long runs, including industry’s long run supply, difference between
accounting and economic profits, producer surplus. Stability analysis—Walrasian and Marshallian.
Demand-supply analysis. 22 lectures

Contents
Preface xvii
About the Author xix
Part I Introduction
1. Introduction to Microeconomics 3
What Is Economics?—3
Economics Is a Social Science 4
Why Economizing Behaviour? 4
Two Major Branches of Economics 5
What Is Microeconomics?—6
Is Microeconomics a Positive or a Normative Science?—7
Microeconomics As a Positive Science 7
Microeconomics As a Normative Science 8
Methodology of Positive Economics: Model Building and Theorization—8
The Uses and Limitations of Microeconomic Theories—10
The Uses of Microeconomic Theories 10
Limitations of Microeconomic Theories 11
Limitations Do Not Matter Much 12
Review Questions and Exercises 12
Endnotes 13
Further Readings 14
2. The Economy: Its Basic Problems

and Working System 15
What Is an Economy?—16
Economic Activities Are Interrelated and Interdependent 16
The Economic System Works Automatically 16
How an Economy Works?—17
The Circular Flow Model of a Simple Economy 17
The Basic Problems of an Economy—19
Problems in Maximizing Production and Optimizing Distribution 19
Problems in Achieving Growth, Full Employment and Stability 20

viii Contents
How Market Mechanism Solves the Basic Economic Problems?—21

Drawbacks of the Free Enterprise System—22
The Government and the Economy—24
The Mixed Economy System Is the Order of the Day 25
The Production Possibility Frontier—26
Some Implications of PPF 28
Shift in PPF 29
Endnotes 32
Further Readings 32
Part II Market Mechanism: How Markets Work
3. The Market Forces: Demand and Supply 35

The Concept of Market—36
The Demand Side of the Market—36
Meaning of Demand 36
The Law of Demand 37
The Demand Schedule 37
The Demand Curve 38
The Factors Behind the Law of Demand 38
Exceptions to the Law of Demand 40
The Market Demand 40
Determinants of Market Demand 42
Demand Function 47
Shift in Demand Curve 50
The Supply Side of the Market—52
Market Supply 52
The Law of Supply 52
The Supply Schedule and Supply Curve 52
Shift in the Supply Curve 53
Supply Function 55
The Market Equilibrium: The Equilibrium of Demand and Supply—55
Determination of Price in a Free Market 55
The Concept of Market Equilibrium 55
Determination of Market Price 56
Market Mechanism: How Market Brings About Balance 56
Graphical Illustration of Price Determination 57
Price Determination by Demand and Supply Functions 58
Shift in Demand and Supply Curves and Market Equilibrium—59
Shift in Demand Curve 59
Shift in Supply Curve 60
Parallel Shift in Demand and Supply Curves 60
Stability of Market Equilibrium—62
Market Equilibrium Under Dynamic Conditions 62

Contents ix
Conclusion—66
Endnotes 69
Further Readings 69
4. Elasticity of Demand and Supply 70

The Elasticity of Demand—71
Price Elasticity of Demand—71
The Arc and Point Elasticity 73
Measuring Arc Elasticity 73
Measuring Point Elasticity 75
Price Elasticity Varies Along the Demand Curve 78
The Slope of Demand Curve and Price Elasticity 80
Determinants of Price Elasticity of Demand—84
Measuring Price Elasticity from a Demand Function—85
Measuring Price Elasticity from a Linear Demand Function 86
Price Elasticity from a Non-linear Demand Function 87
Price Elasticity and Sales Revenue—88
Price Elasticity and Marginal Revenue 89
Relation Between MR and AR 90
Price Elasticity and Total Revenue 92
Price Elasticity and Consumption Expenditure—94
Other Elasticities of Demand—95
Cross-Elasticity of Demand 95
Income Elasticity of Demand 96
Application of Demand Elasticity—98
Price Elasticity of Supply—98
Definition and Measurement 98
Determinants of the Price Elasticity of Supply 100
Endnotes 104
Further Readings 104
5. Application of Market Laws and Elasticities 105

Excise Tax: Its Effects and Incidence—106
Lump-Sum and Ad Valorem Excise Tax 106
The Effects of Excise Tax on Production and Price 107
Who Bears the Tax Burden? 107
Production Subsidy and Its Effects—109
The Effect of Production Subsidy 110
Who Benefits from Production Subsidy? 111
Import Tariffs and Export Subsidies—111
Import Tariffs 111
Export Subsidy 112

x Contents
Review Questions 113

Endnotes 114
Part III Theory of Consumer Demand
6. Theory of Consumer Demand: Cardinal

Utility Approach 117
Introduction—117
Cardinal Utility Approach to Demand Analysis—118
The Concept of Cardinal Utility and Its Measurement 118
The Total and Marginal Utility 119
The Law of Diminishing Marginal Utility—119
Numerical Example 120
Graphical Illustration 120
Assumptions 120
Consumers’s Equilibrium: Cardinal Utility Approach—122
Assumptions 122
Consumer Equilibrium: A Single Commodity Case 122
Consumer Equilibrium: The Multiple Commodity 124
Derivation of Demand Curve—125
Drawbacks of Cardinal Utility Approach—127
Endnotes 128
7. Theory of Consumer Demand: Ordinal

Utility Approach 130
Ordinal Utility Concept and Its Assumptions—131
Assumptions of the Ordinal Utility Theory 131
Indifference Curve—132
Indifference Map 133
The Concept of Marginal Rate of Substitution (MRS) 134
Postulates of Diminishing MRS 135
Why the MRS Declines 136
Properties of Indifference Curves—137
Indifference Curves Have a Negative Slope 138
Indifference Curves Are Convex with Reference to the Origin 138
Indifference Curves Neither Intersect Nor Are Tangential to
One Another 138
Higher Indifference Curves Represent a Higher Level of Satisfaction
Than the Lower Ones 139
Other Types of Indifference Curves—140
Perfect Substitutes 140
Complementary goods 140

Contents xi
Goods, Bads and Neuters—141

What Are the Bads and the Neuters? 141
Indifference Maps for Goods, Bads and Neuters 142
Budgetary Constraint and the Budget Line—145
What Causes Shifts in the Budget Line 146
Slope of the Budget Line 146
Consumer Equilibrium: The Ordinal Utility Approach—148
Corner Solution: The Extreme Choice 150
Composite Goods Case 151
Changes in Income and Consumer Behaviour—152
Income Effects on Consumer Behaviour Towards Normal Goods 152
Inferior Goods 153
Income and Consumption: The Engel Curve 154
Engel and Demand Curves 155
Engel Curve and Income Elasticity of Demand 156
Changes in Prices and Consumer Behaviour—157
Changes in Price and Consumer Behaviour: Case of Normal Goods 157
Derivation of Consumer Demand Curve 158
Graphical Derivation of Demand Curve 160
Income and Substitution Effects of Price Change:
Normal Goods Case—161
Hicksian Approach 161
SIutskian Approach 164
Comparison of the Hicksian and Slutskian Methods 165
Measurability of Income and Substitution Effects 166
Income and Substitution Effects: Inferior Goods—167
Effect of Rise in Money Income 167
Case of Inferior Goods 167
Giffen Paradox 169
Comparison of Cardinal and Ordinal Utility Approaches—171
Similarity Between the Two Approaches 171
Superiority of the Indifference Curve Approach 171
Drawbacks of Indifference Curve Approach—172
Appendix 173
Endnotes 177
8. Application of Indifference Curve Analysis 180

Introduction—180
Measuring Welfare Effects of Income and
Excise Taxes—181
Choice Between Taxes 181
Measuring Effects of Excise and Income Subsidies—182

xii Contents
Measuring the Financial Cost of Excise Subsidy 182

Measuring the Financial Cost of Lump-Sum Income Subsidy 183
Making Choice of Policy 184
Measuring Welfare Effect of Commodity Exchange
Between Individuals—184
Derivation of Labour Supply Curve—186
Income–Leisure Choice 186
Wage–Labour Offer Curve and Labour Supply Curve 188
Evaluating Rationing of Consumer Good—190
Rationing of One Commodity 190
Rationing of More Commodities 191
Endnotes 194
9. Revealed Preference Theory 195

Introduction—195
Revealed Preference: Assumptions and Axioms—196
Assumptions 196
Revealed Preference Axiom 196
Decomposition of Substitution and Income Effects and
Derivation of Demand Curve—198
Derivation of Indifference Curve—199
Appraisal of Revealed Preference Theory—201
Endnotes 202
10. Consumer Surplus 203

Introduction—203
Marshallian Concept of Consumer Surplus
and Its Measurement—204
Assumptions 205
Critical Appraisal 205
Hicksian Method of Measuring Consumer Surplus—206
Measuring Consumer Surplus under Constant MU of Money 206
Measuring Consumer Surplus under Variable MU of Money 207
Extentions of Hicksian Approach to Consumer Surplus—208
Hicks’ Four Concepts of Consumer Surplus 208
Application of Consumer Surplus—211
The Deadweight Loss of Commodity Taxation 212
Deadweight Loss from Sales Tax: Tax on Consumers 212
Measuring Gains of Subsidy 215
Deadweight Loss of Price Control 216
Deadweight Loss of Trade Barriers 217

Contents xiii
Review Questions 219

Endnotes 219
Part IV Theory of Production and Analysis of Cost

11. Theory of Production: Laws of
Returns to a Variable Input 223
Introduction—223
Some Basic Concepts—224
Meaning of Production 224
Input and Output 224
Short Run and Long Run 225
Production Function—225
Short-run and Long-run Production Function 227
Assumptions 227
Production with One Variable Input: The Short-run
Laws of Production—228
The Laws of Returns to Variable Input (Labour) 228
Assumptions 228
Marginal Productivity of Labour 229
Average Productivity of Labour 230
The Three Stages in the Law of Diminishing Returns 230
Factors Behind the Laws of Returns 231
Applicability of the Law of Diminishing Returns 231
Graphical Derivation of Marginal and Average Product Curves—231
Derivation of Marginal Product Curve (MPL) 232
Derivation of Average Product Curve (APL) 233
The Three Stages of Production—233
The Three Stages of Production and Production Decisions—235
What About Stage II? 235
Endnotes 237
12. Theory of Production: Laws of Returns to

Two Variable Inputs 239
Introduction—239
The Isoquant Curve—240
Derivation of Isoquant Curve—240
Assumptions 240
Properties of Isoquant Curves—241
Isoquants Have a Negative Slope 242
Isoquants Are Convex to the Origin 242

xiv Contents
Isoquants Do Not Intersect or Are Tangent to Each Other 242

Upper Isoquants Represent a Higher Level of Output 243
Marginal Rate of Technical Substitution (MRTS)—244
Isoquant Map and Economic Region of Production—245
Isoquant Map 245
Economic Region of Production 246
Other Forms of Isoquants—247
Perfect Substitutes and Linear Isoquants 247
The Fixed Factor Technology and L-shaped lsoquant 248
The Kinked or Linear Programming Isoquants 249
Elasticity of Technical Substitution—251
The Laws of Returns to Scale—252
Three Laws of Return to Scale 252
The Law of Increasing Returns to Scale 253
The Law of Constant Returns to Scale 254
The Law of Decreasing Returns to Scale 255
Production Function and Returns to Scale—256
Cobb–Douglas Production Function and Returns to Scale 257
Laws of Variable Proportions and Returns to Scale Compared—258
Graphic Comparison 259
Are the Laws of Returns Compatible? 260
Can the Two Kinds of Laws Operate Simultaneously? 260
Appendix 260
Endnotes 264
13. Optimum Combination of Inputs 266

Introduction—266
Derivation of Isocost—267
The Least Cost Criteria of Optimum Input Combination—269
Criterion in Value Terms 270
Choice of Optimal Expansion path—271
Effects of Change in Input Prices—272
Change in Input Prices and Isocosts 272
Change in Input Prices and Expansion Path 273
Change in Relative Price of Inputs 273
Substitution and Resource Effects of Change in Input Prices—274
14. Theory of Cost 278

Introduction—278
Cost Concepts—279

Contents xv
Accounting Cost Concepts 279

Analytical Cost Concepts 280
Policy Related Cost Concepts: Private and Social Costs 281
Theory of Cost: An Overview—281
Theory of Short-run Cost—282
Short-run Cost Measures 282
The Short-run Cost–Output Relationship 283
Short-run Cost Function and Cost Curves—286
Numerical Example 286
Derivation of Behavioural Cost Equations 287
Long-run Cost–Output Relationship—290
Derivation of Total Long-run Cost (LTC) Curve 290
Derivation of Long-run Average Cost (LAC) curve 292
Derivation of Long-run Marginal Cost (LMC) Curve 293
Optimum Size of the Firm in the Long Run 293
Economies and Diseconomies of Scale: Factors
Behind Cost Behaviour—294
The Economies of Scale: Factors Causing Decrease in LAC 294
Diseconomies of Scale: Why LAC Increases 296
Modern Approach to the Theory of Cost—297
Modern Approach to Short-run Cost Behaviour 298
What Happens to the Average Variable Cost (AVC)? 299
The SAVC and SMC Curves 299
The Short-run Average Cost (SAC) Curves 300
Modern Approach to Long-run Cost Behaviour:
The L-shaped Scale Curve 301
Derivation of the LAC Curve 302
Endnotes 305
Part V Theory of Firm: Determination of Price and

Output
15. The Objectives of Business Firms and
Their Market Powers 311
The Objectives of Business Firms—311
Profit Maximization as Business Objective 312
Profit-Maximization Conditions 312
Numerical Illustration 314
Graphical Instruction 315
Controversy on Profit-Maximization Objective 317
Alternative Objectives of Business Firms 318
Conclusion 321
The Market Structure and Power of Firms—321

xvi Contents
Perfect Competition 322

Imperfect Competition 323
Monopoly 323
A Prelude to the Theory of Firm—324
Endnotes 325
16. Price and Output Determination under

Perfect Competition 327
Characteristics of Perfect Competition—328
Perfect versus Pure Competition 329
Role of a Firm in a Perfectly Competitive Market—329
What Are the Firm’s Options 330
Short-run Equilibrium of the Firm—330
Assumptions 330
Does a Firm Always Make Profit in the Short-run? 331
Shut-down or Close-down Point 332
Derivation of Supply Curve: A Digression—333
Derivation of Firm’s Supply Curve 333
Derivation of Industry Supply Curve 334
Short-run Equilibrium of Industry and Firm—334
Link Between Short-run Equilibrium of the Industry and the Firm 335
Long-run Equilibrium of the Firm and Industry—336
Equilibrium of the Firm in the Long-run 336
Equilibrium of Industry 337
Long-run Supply Curve of a Competitive Industry—338
Constant Cost Industry 338
Increasing Cost Industry 339
Decreasing Cost Industry 340
Whether Decreasing Cost 341
Conclusion—341
Endnotes 343
University Question Papers 345

Preface
The purpose of this book is to present a comprehensive and authentic text for the undergraduate students
of Microeconomics. It is based on the latest B.Com.(H) Microeconomics – I syllabus of the University
of Delhi.
An attempt has been made throughout the book to simplify the analytical treatment of the microeco-
nomic theories wherever necessary, without sacrificing the standard of the book. Besides this, several
examples and illustrations have been added to different chapters.
I am sure that this book would prove easily comprehensible to the undergraduate students. The tech-
nical treatments of some modern microeconomic theories have been shifted to the appendix of the
relevant chapter to complete the elaboration of the theories. Advanced topics falling outside the syllabus
have been excluded. Review questions and numerical problems have been added to each chapter.
I am confident that this book would fully meet the study requirements of the B.Com.(H) students of
Microeconomics – I of the University of Delhi. I express my gratitude to the teachers and my students
for their comments and suggestions. Last but not the least, I express my gratefulness to the editorial team
of Pearson Education, especially Dhiraj Pandey, for their suggestions and tremendous help in revising
the book.
Comments and suggestions from the teachers and students of the subject are most welcome.
D. N. Dwivedi


About the Author
Dr Dwivedi retired as Reader in Economics from Ramjas College, University of Delhi, in 2004. Since
his retirement, he has been working as Professor of Economics at Maharaja Agrasen Institute of
Management Studies, Delhi. He has taught undergraduate and postgraduate students of Economics over
the past four decades. He has been on the visiting faculty of several management institutes of Delhi.
Dr Dwivedi has also worked as Economic Consultant in the Center of Investment in Finance, Riyadh,
Saudi Arabia, for about a decade. He was also awarded Senior Fellowship by the Indian Council of Social
Science Research (ICSSR), New Delhi. He has published more than fifty research papers and articles on
different economic issues of the country in national and international journals, periodicals and books.
His research publications include Problems and Prospects of Agricultural Taxations in Uttar Pradesh and
Economic Concentration and Poverty in India. Dr Dwivedi has also authored some popular textbooks like
Managerial Economics, Macroeconomics and Principles of Economics and also edited the book Readings
in Indian Public Finance.


Part I
Introduction
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Chapter 1
Introduction to
Microeconomics
CHAPTER OBJECTIVES
The objective of this chapter is to introduce economics as a social science and microeconomics as
a branch of economics. This chapter discusses the following aspects:
The definition and scope of microeconomics as a branch of economics;
Whether microeconomics is a positive science or a normative science, i.e., whether micro-
economics is purely a theoretical science or a value-based science;
How economic models are built and how economic theories are formulated; and
Whether economic theories can be applied to solve economic problems and what are the limita-
tions of microeconomics.
The objective of this chapter is to introduce microeconomics as a subject of study. Because micro-
economics is a branch of economics, a broad knowledge of ‘what is economics’ would be helpful in
understanding ‘what is microeconomics’. Therefore, we begin this chapter with a brief introduction to
economics as a subject of study.
WHAT IS ECONOMICS?
Let it be noted at the outset that there is no universally accepted definition of economics. The eminent
economists of different generations—right from Adam Smith, the father of economics, down to mod-
ern economists—have defined economics differently as per their own perception of the central theme
of economics. For example, Adam Smith defined economics as ‘an inquiry into the nature and causes
of the wealth of the nations’. According to Alfred Marshall, a great economist of the 20th century,
‘Economics is the study of mankind in the ordinary business of life; it examines that part of individual
and social action which is most closely connected with the attainment and with the use of the material
requisites of well-being’. Robbins has defined economics more precisely, ‘Economics is the science which
studies human behaviour as relationship between ends and scarce means which have alternative uses’.
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4 Chapter 1
One may find many other definitions in the literature of economics. But no definition of economics is
universally acceptable. However, having a broad idea of ‘what economics is about’ would prove helpful
in understanding ‘what is microeconomics’.
Economics Is a Social Science

Economics as a social science studies economic behaviour of the people and economic problems of the
society. Economic behaviour is essentially economizing behaviour. Economizing behaviour means a
conscious effort of the people to derive maximum gains from the use of their limited resources (labour,
land, capital, time, etc.) and opportunities available to them. Economics is, fundamentally, the study of
how people allocate their limited resources to their alternative uses to produce and consume goods and
services to satisfy their endless wants and to maximize their gains. In other words, economics is the study
of how people try to make optimum utilization of their resources. Optimum utilization of resources
means maximizing gains given the cost or minimizing cost given the gains. In their efforts to optimize
the use of their limited resources, people (individuals, households, firms and the government) as produc-
ers and consumers have to make a number of choices regarding the use of their resources and spending
their earnings. A systematic study of the optimizing or economizing behaviour of human beings is the
central theme of economic science.
Why Economizing Behaviour?

The reason for economizing or optimizing behaviour of the people lies in certain basic economic facts of
human life. Briefly speaking, some basic economic facts of human life are as follows.
Human wants and desire are endless;
Resources available to satisfy human wants are scarce and limited;
People by nature want to maximize their gains or their economic welfare from their resources.
Let us look at these facts in some detail.
Human Wants Are Endless. Human wants, desire and needs are endless. Wants are endless in the
sense that they go on increasing with increase in people’s ability to satisfy their needs. Human wants
continue to increase without meeting their end because (i) people have insatiable desire to raise their
standard of living, comforts, and efficiency; (ii) human tendency is to accumulate things beyond their
present need; (iii) human wants increase with increase in knowledge, inventions and innovations;
(iv) satisfying one’s want (e.g., buying a car) creates want for many other things (e.g., petrol, driver,
parking place, safety locks, spare parts, insurance, etc.); (v) the moment one’s want is satisfied, other
wants come up from no where; (vi) biological needs (e.g., food, water, etc.) are repetitive; and (vii) in
modern times, advertisements influence consumer’s taste and preferences and create new kind of wants.
The end of wants of an individual comes only with the end of his or her life. Another equally important
feature of human wants is that they are not equally urgent and equally important. Satisfying some wants
gives more pleasure than satisfying some others wants. Therefore, gain maximizing consumers have to
make a choice between wants.
Resources Are Limited While human needs are unlimited, resources available to satisfy human
wants are limited. Resources can be classified as (i) natural resources (including land, space, water,
minerals, forest, climate, jointly called land); (ii) human resources (including manpower, its energy, talent,
professional skills, and innovative ability and organizational skill, jointly called labour); and (iii) man-
made resources (including machinery, equipments, tools, technology and building, jointly called capital).
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Introduction to Microeconomics 5
To this, economists add another category of resource called entrepreneurship, i.e., those who organize
the resources and assume risk in business. Time and information are two other kinds of resources, which
have economic value. All these resources have alternative uses yielding different benefits. The resources
available to a person, society, country—how so ever rich—at any point of time are limited. Resource
scarcity is a relative term. It implies that resources are scarce in relation to their demand. The scarcity
of resources is, in fact, the mother of all economic problems. Had resources been unlimited, like human
wants, there would be no economic problem and no economics. It is the scarcity of resources in relation
to human wants, which forces people to derive the maximum benefit from the available resources.
People Are Gain Maximizers by Nature In order to maximize their gains from limited resources,
people have to make numerous choices. The need of making choices arises basically due to two reasons.
(1) Although wants are unlimited, all are not equally important or necessary. While some wants can be
deferred, some cannot be. So the people have to make a choice between their wants. (2) The need for
choice arises also because resources have alternative uses and alternative uses yield different returns or
earnings. For example, an area of land in Delhi can be used to set-up a ‘public school’, a shopping centre
or for residential flats. But the rate of return varies from use to use. Therefore, a gain-maximizing land
owner has to make a choice from the alternative uses of land. Economics as a social science analyses
how people (individuals and society) make their choices for the economic goals they want to achieve,
between the goods and services they want to produce, and between the alternative uses of their resources
with the objective of maximizing their gains. The gain maximizers will have to evaluate the cost and
benefit of alternative options in making their choices. Economics studies the process of evaluation of
alternatives and how people find the optimum solution.
It may, thus, be concluded that economics as a science studies economizing behaviour of the people
and its consequences; it brings out cause-and-effect relationships between economic events; provides
the tools and techniques of analysing economic phenomena and for predicting the consequences of
economic decisions and economic events. Economics studies economic phenomena systematically and
methodically. This approach to economic inquiry imparts economics the status of a ‘social science’.
It may be added here that there is no precise and universally acceptable definition of economics. The
reason is that the subject matter of economics continues to grow and expand in scope, size and character
right from the days of its founder, Adam Smith, to date. Boundaries of economic science are not yet
precisely marked nor can it be. In the opinion of some economists, ‘Economics is still a very young
science and many problems in it are almost untouched’ (Charles Schultz) and ‘Economics is an unfin-
ished science’ (Zeuthen). Yet, economics is claimed to be ‘the oldest and best developed of the social
sciences’ and continues to grow in content and the level of analytical sophistication.
Two Major Branches of Economics

Although economics remains an undefined science, the mainstream economics is divided, though
imperfectly,1 into two major branches: Microeconomics and Macroeconomics.2 This division crystallized
after the Great Depression of 1930s. Until 1936,3 there was only one Economics which conformed to what
is now called ‘microeconomics’. In this book, we are concerned with Microeconomics.
The nature, scope and subject matter of microeconomics has been described elaborately in the fol-
lowing section. In brief, microeconomics analyses the economic behaviour of the people at micro level,
i.e., at the individual level of consumers, firms and resource owners. In effect, microeconomics analyses
how individual consumers and producers make their choices; how their decisions and choices affect the
demand and supply conditions; how consumers and producers interact to settle the prices of goods and
services in the market; how prices are determined in different market settings; and how total output is
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6 Chapter 1
distributed among those who contribute to production, i.e., between landlords, labour, capital supplier,
and the entrepreneurs. Briefly speaking, the subject matter of microeconomics consists of the theory of
consumer behaviour, theories of production and cost, theory of commodity pricing, theory of factor pricing,
and the most efficient allocation of output and factors of production called welfare economics. These theo-
ries make the main theme of microeconomics. We will look at the subject matter of microeconomics in
detail in the subsequent section.
Macroeconomics, on the other hand, studies the working and performance of the economy as a whole.
It analyses how the levels of the national economic aggregates including national income, aggregate
consumption, aggregate savings and investment, total employment, the general price level, and country’s
balance of payments are determined. Macroeconomics also analyses how these macroeconomic vari-
ables interact with one another and how they determine the aggregate national output. It also studies the
impact of changes in monetary policy and fiscal policy (including changes in public revenue and public
expenditure), government’s economic activities and other economic policies on the economy. An impor-
tant aspect of macroeconomic studies is the consequences of international trade and other economic
relations between the nations. The study of these aspects of macroeconomic aggregates constitutes the
major themes of macroeconomics.
Let us now turn to our main subject of study, the microeconomics.
WHAT IS MICROECONOMICS?
As mentioned above, microeconomics is fundamentally the study of how individual economic entities
including individual consumers, producers (firms) and resource owners find solution to the problem of
maximizing their gains from their limited resources and how their decisions affect market conditions,
prices and production. To maximize their gains, individuals have to make a number of choices between
the endless wants and alternative uses of their resources. Microeconomics studies how individuals make
their choices. How consumers make their choices as to ‘what to consume’ and ‘how much to consume’ to
maximize their total utility from their limited income? Similarly, it analyses how individual firms decide
‘what to produce’, ‘how to produce’, ‘for whom to produce’ and what price to charge so that their profit
is maximized from their limited resources. Microeconomics is the study of decision-making behaviour
at the micro level, i.e., at the level of individual decision makers. It makes a microscopic study of the
various elements of an economic system, not the system as a whole. As Lerner puts it, ‘Microeconomics
consists of looking at the economy through a microscope, as it were, to see how the millions of cells
in the body economic—the individuals or households as consumers, and the individuals or firms as
producers—play their part in the working of the whole economic organism’.4 From the microscopic
analysis point of view, decision makers are classified on the basis of their economic activity as con-
sumers, producers and resource owners. Microeconomics studies economic behaviour of consumers,
producers and factor owners at individual level—individual consumer, individual producer, and individ-
ual resource owner—owners of labour and capital. In addition, microeconomics studies how economic
behaviour of economic activities affect the production of goods and services and their prices.
A systematic study of economizing behaviour of consumers, producers and resource owners and
determination of the prices of goods and services make the central theme of microeconomics. The scope
of microeconomics can be broadly specified here. The study of consumer behaviour gives the theory of
consumer behaviour, theory of consumption or the theory of demand. The study of producer’s behaviour
constitutes the theory of production or the theory of supply including the cost theory. Theory of demand
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and theory of supply combined together form the theory of price determination or theory of price.
The study of the behaviour of factor owners (labour and capital owners) gives the theory of distribution
or the theory of factor-price determination. An extension of the distribution theory is the study of what
kind of allocation of productive resources for the production of goods and distribution of consumer goods
and services among the consumers makes the distribution most efficient. This aspect is studied under
economics of welfare. The study of these economic theories and their application to real-life conditions
constitute the subject matter of modern microeconomics.
IS MICROECONOMICS A POSITIVE OR A NORMATIVE

SCIENCE?
Before we answer the question whether microeconomics is a positive or a normative science, let us
understand what is a positive science and a normative science. According to J.N. Keynes, ‘… a positive
science is a body of systematized knowledge concerning what is [and] a normative or regulatory science
is a body of systematized knowledge relating to criteria of what ought to be and is concerned therefore
with ideal as distinguished from actual.’5 Friedman has defined ‘positive science’ more elaborately
and clearly. In his words, ‘The ultimate goal of a positive science is the development of a “theory” or
“hypothesis” that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet
observed.’6 Judged against these definitions, economics as a social science turns out to be both a positive
and a normative science as it deals with both positive and normative economic questions: ‘what is’ and
‘what ought to be’. Thus, microeconomics is both a positive and a normative science. The positive and
normative aspects of economic studies are described below.
Microeconomics As a Positive Science

Microeconomics as a positive science seeks to analyse and explain economic phenomena, i.e., economic
aspects, issues or matters, as they are. As a positive science, microeconomics seeks to answer such
questions as ‘what is’, ‘why it is’ and ‘what will be … ’ . For example, look at some questions of positive
nature. Why does a hungry person spend his or her first penny on food? When and why does he or she
stop spending on food? Why do people buy more of a commodity when it decreases? How does a firm
decide what and how much to produce? How does the firm determine the price of its product? How
does a labour decide what job to take up? Microeconomics as a positive science finds the answer to such
questions. These are some questions of positive nature.
Microeconomics as a positive science explains the economic behaviour of individual decision mak-
ers under given conditions; their response to change in economic conditions brings out the relationship
between the change in economic conditions and economic decision of the people. In fact, the main
function of microeconomics is to establish cause-and-effect relationship, if there is any, between two or more
economic variables at micro level and to provide the basis of prediction. Emphasizing the positive science
character of economics, Friedman says, ‘Economics as a positive science is a body of tentatively accepted
generalizations about economic phenomena that can be used to predict the consequences of change in
circumstances’.7 What Friedman said about economics is true for microeconomics. One of the main
tasks of microeconomics is ‘to provide a system of generalizations’, i.e., formulating microeconomic
theories capable of being used to predict economic phenomena at micro level. This makes microeco-
nomics a positive science.
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8 Chapter 1
Microeconomics As a Normative Science

Microeconomics as a normative science seeks to answer the normative question ‘what ought to be’ on
the basis of certain predetermined norms and social values. ‘What people do’ or ‘what happens in the
market’ may not be desirable for the society. For example, production and sale of harmful goods like
alcohol and cigarettes may be a very profitable business. But, a question arises here. ‘Is production
and sale of these goods desirable for the society?’ This is a normative question—a question in public
interest. Microeconomics as a social science examines this question from the angle of social desirability
of production and sale of such goods. It examines the social costs and benefits of production of goods
like alcohol and cigarettes and answers the question whether production and sales of such goods are
socially desirable.
Consider another microeconomic problem. Given the growth of population and the supply of
residential houses in India, house rents, if not controlled, will continue to increase and have, in fact,
increased exorbitantly. Here a question arises: ‘Should house rents be allowed to increase depending
on the market demand and supply conditions or be controlled and regulated to protect the interest of
tenants?’ This is a normative question—a question in public interest. Microeconomics as a normative sci-
ence examines the issue in the interest of both landlords and the tenants and prescribes the reasonable
rate of house rents.
Microeconomics, as a normative science, involves value judgement on ‘what is good’ and ‘what is
bad’ for the society. The values are drawn from the moral, ethical, social and political aspirations of the
society. Since microeconomics prescribes methods to correct undesirable economic happenings, it is
also called a prescriptive science.
To have a comparative view of positive and normative character of microeconomics, recall the issue
of high food grain prices in India in 2001 and in 2010. On one hand, there was surplus food grain pro-
duction8 in India, on the other hand, large-scale starvation and starvation deaths were reported from
different parts of the country. This was a paradoxical situation. Yet, the Food Corporation of India (FCI),
responsible for fixing the food grain price, did not take any steps to bring down the price of food grains.
This problem can be examined from both positive and normative angles. Examining ‘how price of food
grains is determined?’ is a question for positive microeconomics and ‘how should the prices of food
grains be determined to prevent starvation?’ is a question for normative microeconomics. It may, thus, be
concluded that microeconomics is both a positive and normative science.
However, it is important to note that microeconomics is, fundamentally, a positive science. It acquires
its normative character from the application of microeconomic theories to examine the economic phe-
nomena from their social desirability point of view; to show the need for a public policy action and; to
evaluate the policy actions of the government.
METHODOLOGY OF POSITIVE ECONOMICS: MODEL BUILDING

AND THEORIZATION
The economic theories that constitute the body of economic science are the result of scientific inves-
tigation of economic phenomena. Scientific method of investigation involves observation of economic
phenomena and collection and analysis of relevant facts with the purpose of establishing the relationship
between the related economic variables. When the relationship between the selected variables is estab-
lished with a high degree of confidence, it is presented in the form of a theory or a hypothesis. This
process is called theorization or formulation of theory.
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An important element of scientific method of inquiry is model building. An analytical model is an

abstraction of an economic phenomenon from the complex economic conditions of real life. It rep-
resents reality in a simplified form. An economic model is constructed in the form of mathematical
equations specifying the relationship between the interrelated economic variables. Models are used to
work out the implications of a theory, to deduce the consequences of the assumptions and to make
predictions. Economic variables are measurable quantities, e.g., consumer goods, output, inputs, money,
income, etc. The economic variables assumed to remain constant are called parameters. In this section,
we will discuss briefly the process of model building and theorization in economics in general.
Model Building and Economic Theorization. A scientific method of study or investigation consists
of the following steps:
Specifying the problem
Formulating hypothesis
Making assumptions
Building a relevant model
Collection and analysis of relevant data or facts
Deducing the testable predictions from data analysis
Testing the validity of predictions
Formulation of the theory
The first step in scientific method of study is to specify the problem—the economic phenomenon
chosen for the purpose of study. For example, the problem of a study may be specified as finding the
effect of increase in the price of petrol on the demand for cars or the reasons for exorbitant increase in
the price of onion in India, in December 2010 and its effect on food inflation.
The second step is to formulate a hypothesis. A hypothesis is a statement expressing the relationship
between the cause and effect. A hypothesis may be expressed in the form of a statement, e.g., ‘when price
of petrol increases, demand for cars decreases’. Here, increase in petrol prices is the cause and decrease in
the demand for cars is the effect. It may also be stated in the form of an equation, e.g., Qc = C − cPp (where
Qc = number of cars demanded; C = cars demanded at zero price of petrol; −c = a parameter showing the
effect of change in petrol price on the demand for car; and Pp = price of petrol.
The third step is to make necessary assumptions. Assumptions are made to simplify the problem, to
specify the variables and components of the model and to avoid the complexities that might arise due to
the change in extraneous factors—factors operating outside the model. For instance, in our petrol-price-
and-car-demand example, some general assumptions are made as (i) people’s income does not change
significantly, (ii) car prices are not likely to change significantly, and (iii) there is no demonstration effect,
etc. In general, in building an economic model, assumptions include (i) behavioural or motivational
assumptions pertaining to the behaviour of the decision makers and their motivation or the objective
that they set for themselves; (ii) institutional assumptions pertaining to the institutional set-up or market
conditions under which the economic players (consumers and producers) seek to achieve their goals;
(iii) technological assumptions relating to production technique; and (iv) input-related assumptions—
those pertaining to the supply position of the inputs.
Once the assumptions are specified, the fourth step is to build a model for testing the hypothesis.
A model is constructed by specifying the relationship between the chosen variables. The relationship
between the variables may be expressed in the form of mathematical equations or also in verbal terms.
The model so built forms the basis of data analysis and hypothesis testing.
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10 Chapter 1
The fifth step is to collect the relevant data and other facts related to the problem of study and their
analysis according to the model. After data are collected, assembled and analysed, the next or the fifth
step is to make the deduction/deductions, i.e., derive conclusions, about the relationship between the
causal factor and its effect. In our example, the deduction may be stated as ‘when petrol price increases,
demand for car decreases’. This deduction is the same as the hypothesis.
The sixth step is to test the validity of the model. The test of validity of a model is determined by its
power to predict. In our example, the test of validity of the model is to find whether it can be used to
predict the demand for car when the price of petrol increases (or decreases) by a certain percentage. If
the model predicts the car demand fairly accurately, it is taken to be a valid model. Otherwise, it is an
invalid model. In case a model turns out to be invalid, it needs to be modified by including other relevant
and explanatory variables that influence the demand for car and put to test again. When the model is
tested and retested and found to be valid, its outcome is stated in the form of a theory.
The final step is to state the findings of the study in the form of a theory. This leads to the formulation
of a theory.
THE USES AND LIMITATIONS OF MICROECONOMIC THEORIES

Economic laws have their uses and applications and also their limitations. The applicability and limi-
tations must be borne in mind while applying economic laws to find solution to real-life economic
problems. The uses and limitations of microeconomic theories in general are briefly described here.
The Uses of Microeconomic Theories

Microeconomics provides a theoretical framework for a systematic analysis of the economic behaviour
of the individual households, firms, industries and factor owners (the owners of factors of production—
land, labour and capital). Economic theories bring out the nature of relationship between the inter-
related economic variables and interdependence of the diverse elements of the economic system. The
application of economic theories, logic and tools of analysis proves helpful in business decision making
and in the formulation of economic policies of the government in many ways.
First, the study of economics contributes a great deal to the understanding of the complexity of
the economic system and its working. In the words of Lerner, ‘Microeconomic theory facilitates the
understanding of what would be a hopelessly complicated confusion of billions of facts by constructing
simplified models of behaviour which are sufficiently similar to the actual phenomena, to be of help
in understanding them. These models enable the economists to examine the degree to which actual
phenomena depart from certain ideal constructions that would most completely achieve individual and
social objective.’9 The clearer the understanding of the working of the economic system, the greater the
efficiency in control and management of the economy.
Second, microeconomic theories establish cause-and-effect relationship between two or more inter-
related and interdependent economic variables at micro level and, thereby, provide the basis for predict-
ing the future course of economic events. Economic predictions are of great importance in planning
the future course of economic activities by individuals, business firms and the government. Economic
predictions may be conditional and inaccurate. For example, prediction of future price of a commodity
may take the following form of a statement: If demand for a commodity increases, other things remaining
the same, its price will increase. Despite the fact that a prediction of this kind is conditional, future trend
of price is known more precisely than it would have been in the absence of any prediction. If one has
information regarding the demand trend of a commodity and other related factors, one can predict the
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future trend in price with a greater accuracy. Approximate predictions are also of great importance for
the consumers to make adjustment in their expenditure pattern; for the producers to plan their produc-
tion; and for the public policy makers to formulate policy regarding price of the commodity.
Third, microeconomic theories contribute a great deal also in formulating economic policies and in
examining the appropriateness and effectiveness of economic policies. Policy makers may, therefore,
apply relevant microeconomic theories to explain the problem at hand and analyse the implications of
alternative policies and select one which seems to be most appropriate. Public economic policies which
go against the economic laws may not only prove ineffective but may also create more problems than
they solve. For example, if the government increases the rate of excise duty for raising additional revenue
without analysing the nature of its demand and supply curves, the tax revenue may not increase, it may
instead decrease. Besides, it may reduce both production and consumption and impose extra burden on
the consumers. Microeconomic theories may be applied to examine the implications and effectiveness
of the policies adopted by the government.
Fourth, microeconomic theories, particularly price theory, can be and are, in fact, profitably used in
business decision making. Although microeconomic theories may not offer a practicable solution to a
problem of the real business world, they do help business decision makers in building analytical models
for projective future business scenario, which helps in specifying the nature of managerial problems and
in determining appropriate policy actions.
Last, one of the most important uses of microeconomic theories is to provide the basis for formulat-
ing propositions that maximize social welfare. Microeconomics examines how imperfect market con-
ditions distort the allocation of resources (money, men and material), create inefficiency and lead to
reduction in production, consumption and social welfare. The normative part of microeconomics, viz.,
welfare economics, suggests conditions for achieving ‘pareto-optimality’ in resource allocation with a
view to maximizing social welfare. It also suggests ways and means to correct inefficient allocation of
resources and to eliminate inefficiency. Although theoretical welfare propositions are of little practical
importance, their analytical value is not reduced by their impracticability.
Limitations of Microeconomic Theories

Microeconomics, like other social sciences, does not provide ready-made solution to the real-life eco-
nomic problems. It only provides tools and techniques for solving real-life problems. Microeconomics
has certain limitations that restrict its applicability. Most of the limitations of microeconomic theories
arise from the assumptions on which they are based. Some major assumptions and the resultant limita-
tions of microeconomic theories are as follows.
First, microeconomic theories assume a given level of macroeconomic variables, viz., national income,
employment, savings and investment, supply and demand for money and the general price level. In
reality, however, these variables are not constant; they are subject to change following the changes
in their determinants. As such, the validity of microeconomic theories is limited to their framework.
Second, microeconomic theories assume, in general, the existence of a free enterprise system in
which the ‘invisible hands’, i.e., market forces, are assumed to play their roles freely. Microeconomics
also assumes the absence of any government intervention in the economic activities of the society. In
practice, however, government controls and regulations of economic activities are the rules of the day
and are all pervasive. Therefore, microeconomic theories have only limited applicability—limited to the
conditions assumed in the microeconomic models.
Third, another limitation of microeconomics arises out of its very scope of study. It is concerned with
the behaviour of individual elements of the economic organism and not with the organism as a whole.
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12 Chapter 1
It provides only a partial analysis of economic phenomenon. Microeconomic theories, therefore, cannot
be applied to study the complex economic system treated as one unit. ‘Description of a large and com-
plex universe of facts like economic system is impossible in terms of individual items’10 and microeco-
nomics is concerned with only ‘individual items’.
Limitations Do Not Matter Much

These limitations of microeconomics, however, do not reduce its importance. There are many important
and practical reasons for studying and making use of microeconomic theory. Emphasizing the impor-
tance of ‘price theory’, a relatively older name of ‘microeconomics’, Liebhafsky said, ‘… there is a very
practical reason for acquiring a knowledge of price theory: the language and concepts of price theory perme-
ate the whole of economics, and in all fields of economic analysis they serve the practical purpose of economy
of effort and constitute a generally accepted method of organising and classifying ideas about economic
activities and magnitudes’.11
As Marshall has observed, ‘By the fundamental impulse of our nature, we all—high and low, learned
and unlearned—are in our several degrees constantly striving to understand the course of human action,
and to shape them for our purposes, whether selfish or unselfish, whether noble or ignoble’.12 Further-
more, the primary objective of economic analysis is not to formulate the exact and precise economic
laws but to provide a framework for logical economic thinking. In the words of Boulding, ‘The objective
of [economic] analysis is not to provide a machine or method of blind manipulation, which will furnish
an infalliable answer, but to provide ourselves with an organized and orderly method of thinking out
particular problem’.13
Apart from satisfying the human urge to understand the economic world, economic principles and
laws serve many useful purposes in our practical life in so far as they (i) provide logic and techniques
for predicting the possible consequences of economic activities and thus provide the basis for rational
decision making; (ii) provide rules for optimum allocation of resources and also the test for optimality;
and (iii) provide guidelines for formulating appropriate public policy actions to control and regulate
economic activities to achieve social goals.
REVIEW QUESTIONS AND EXERCISES

1. What is economics? What problem does economics deal with? Distinguish between microeco-
nomics and macroeconomics.
2. The origin of economics lies in endless human wants and scarcity of resources. Elaborate.
3. ‘Scarcity of resources is the mother of all economic problems.’ Discuss with examples.
4. Do you think your wants are unlimited at this moment? If your answer is ‘yes’, count your wants
and you will find they are limited. Then why do you accept the proposition that ‘human wants
are endless’?
5. Why one cannot buy anything one wants? What is one’s main consideration in deciding what
to buy and what not to?
6. Suppose time, money and labour are the only resources that you possess as a student, how do
you decide to use these resources?
7. What is microeconomics? Is microeconomics a positive or a normative science? Give argu-
ments for your answer.
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8. What is the purpose of model building in economics? What process is generally followed in
model building?
9. What is scientific method of investigation? What are the steps that are generally followed in
scientific study of economic problems? Use a suitable example to answer this question.
10. How will you define economic theory? What process is followed in economic theorization?
11. What kinds of assumptions are made in the analysis of microeconomic problem? What behav-
ioural assumptions are made in microeconomic theories?
12. Economic theories are not as exact and precise as the laws of natural sciences. Why are then
economic theories formulated? What purpose do they serve in practical life?
ENDNOTES
1. Some economists do not agree with the division of Economics into Microeconomics and
Macroeconomics. Fritz Machlup remarks, ‘… there is no agreement on the meaning and scope
of the concept of micro and macro theory’. (For details see his ‘Micro and macroeconom-
ics: Contested Boundaries and Claims of Superiority’ in Machlup (ed), Essays on Economic
Semantics (New York, NY: W.W. Norton, 1977), pp. 98–103. A.P. Lerner is of the opinion that the
division of economics between microeconomics and macroeconomics ‘often contributes more
to fuzzy confusion than to rigorous understanding’ (See his paper ‘Microeconomic Theory’ in
A.A. Brown, E. Neuberger and M. Palmatier (eds), Perspective in Economics—Economists Look
at Their Fields of Study (New York, NY: McGraw-Hill), p. 36.
2. The terms ‘Microeconomics’ and ‘Macroeconomics’ were first used by a Norwegian economist,
Ragnar Frisch in 1933 in his paper ‘Propagation Problems and Impulse Problems in Dynamic
Economics’, in Economic Essays in Honour of Gustav Cassel (London: Frank Cass & Co., 1933).
The prefixes ‘micro’ and ‘macro’ meaning ‘small’ and ‘large’, respectively, have been derived
from Greek language.
3. It was in this year that John Maynard Keynes published his revolutionary book, The General
Theory of Employment, Interest and Money. This book laid the foundation of Macroeconomics.
4. A.P. Lerner, ‘Microeconomic Theory’ in A.A. Brown, E. Neuberger and M. Palmatier (eds),
Perspectives in Economics—Economists Look at Their Fields of Study (New York: McGraw-Hill
1972), p. 37.
5. John Neville Keynes (1955), The Scope and Method of Political Science, 4th edn (New York, NY:
Kelley and Millman), pp. 34–45.
6. Milton Friedman (1953), ‘Methodology of Positive Economics’, in his Essays in Positive
Economics (Chicago, IL: University of Chicago Press).
7. ‘Methodology of Positive Economics’, op. cit.
8. As reported by the news media, production of wheat was so high that neither the farmers nor
the FCI had sufficient godown space to stock grains safely. Food grain bags were left in the open
to rot.
9. A.P. Lerner, ‘Microeconomic Theory’ in A.A. Brown, E. Neuberger and M. Palmatier (eds),
Perspectives in Economics—Economists Look at Their Field of Study (New York: McGraw-Hill
Book Company 1972), p. 36.
10. Boulding, K.E. (1995), Economic Analysis (New York, NY: Harper and Brose).
M01_DWIV9400_02_SE_C01.indd 13 04/07/11 7:58 PM

14 Chapter 1
11. Liebhafsky, H.H. (1963), The Nature of Price Theory (Illinois: Dorsey Press), p. 9.
12. Alfred Marshal (1959), Principles of Economics (London: Macmillan), p. 27.
13. Keynes, J.M. (1936), The General Theory of Employment, Interest and Money (New York, NY:
Harcourt Brace), p. 297.
FURTHER READINGS
Friedman, Milton (1953), ‘The Methodology of Positive Economics’, in his Essays in Positive Economics
(Chicago, ILL: University of Chicago Press), pp. 1–43.
Harrod, R.F. (1938), ‘Scope and Method of Economics’, Economic Journal, XL(VIII): 383–412.
Hutchinson, T.W. (1938), The Significance and Basic Postulates in Economic Theory (London: Macmillan).
Keynes, J.N. (1930), The Scope and Methods of Political Economy, 4th Edn. (London: Macmillan).
Knight, F.H. (1940), ‘What is Truth in Economics’, Journal of Political Economy, XL(VIII): 1–32.
Lange, O. (1945–46), ‘The Scope and Methods of Economics’, Review of Economic Studies, XIII: 19–32.
Machlup, Fritz (1955), ‘The Problem of Verification in Economics’, Southern Economic Journal,
XXII: 121.
Marshall, A. (1959), Principles of Economics (London: Macmillan), Chapters I, II, III and IV, Appendices
C and D.
Robbins, Lionel (1948), An Essay on the Nature and Significance of Economic Science (London, UK:
Macmillan).
Stewart, M.T. (1979), Reasoning and Method in Economics (London: McGraw-Hill, 1979).
M01_DWIV9400_02_SE_C01.indd 14 04/07/11 7:58 PM

Chapter 2
The Economy: Its Basic

Problems and Working
System
CHAPTER OBJECTIVES
The origin of economics began with the study of how an economic system works to provide solution to
economic problems. By going through this chapter, we can learn:
The functional set-up of an economy;
How economic system works;
What are the basic problems of an economy;
What are the economic problems faced by people in general;
How an economy works to provide solution to the economic problems of the people;
What are the failures of the market mechanism;
The role played by the government to resolve the problems;
How the production possibility of a country is determined.
In Chapter 1, we have discussed the nature, scope and methodology of microeconomics. We have noted
that microeconomics is the study of economic behavior of human beings in their individual capacity.
People do not carry out their economic activities in isolation. Gone are the days of Robinson Crusoe and
his economic system. In a modern economy, the people are a part of a social system and their economic
activities are a part of an economic system. In an economic system, economic activities of various eco-
nomic actors—consumers, producers and labour—are interrelated and interdependent. Therefore,
economic behavior of the people is determined and governed largely by their resourcefulness, economic
environment and the economic system in which they operate. Therefore, before we commence our study
of economic theories, it will be useful to have an idea of the functioning of the economic system and its
basic problems. In this chapter, we will briefly describe the functioning of a simplified economic system,
the basic problems of an economy, how problems are solved by the market system, what are the failures
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16 Chapter 2
of the market system and the role played by the government to resolve the problem. Finally, we will
discuss the production possibilities of an economy. Production possibilities of an economy determine
the scope of economic activities of the people.
WHAT IS AN ECONOMY?
An economy is a social organism through which people make their living. It is constituted of all the indi-
viduals, households, farms, firms, factories, banks and government who act and interact to produce and
consume goods and services. The interaction between the different groups as buyers and sellers creates
a market system. Individuals and households offer their resources (land, labour, capital and skill) for
sale in the factor market to make their living. Firms buy or hire factors of production from the factor
market and organize them in the process of production; produce goods and services; and offer them for
sale in the product market to make profits. Traders and shopkeepers work as intermediaries between
the producers and consumers to make their living. Financial institutions, e.g., commercial banks and
Life Insurance Corporation (LIC), and other financial institutions like IDBI, ICICI and mutual fund
companies, constitute the financial market. Financial institutions collect saving from the households and
firms and provide it to their prospective users. Transport companies transport goods from one place to
another and so on in the process, all those who contribute to these services make their living.
Economic Activities Are Interrelated and Interdependent

In a free market economy, economic activities of the people are interrelated and interdependent. For
example, if some individuals want to buy computers, there is a computer company (say IBM) to produce
and sell computers. Thus, the activities of computer users and computer producers are interrelated. Their
activities are interdependent in the sense that computer company will produce only as many comput-
ers as users demand, and users can use only as many computers as producers can produce and sell.
The interdependence and interrelatedness of the economic activities of the people is reflected in the
form of their interaction, cooperation and competition. The economic activities of people—individuals,
households and firms—affect economic interest and activities of one another, directly or indirectly, posi-
tively or negatively. Economic activities and interactions among the consumers, producers and resource
owners make the economy. An economy works through a complex mechanism.
The Economic System Works Automatically

The economic system works automatically and smoothly if nobody controls and regulates the economic
activities of the people. Consumers are able to get goods and services they want; producers are able to
produce goods and services they can sell; factors of production are able to find employment and so on.
The system is operated in an orderly manner by, what Adam Smith called, ‘invisible hands’, that is, the
market forces of demand and supply.
However, in modern times, the government is an important element in the modern economy. It taxes
people’s income and hires factors of production and produces certain goods and services for the people.
In addition, it intervenes with the economic activities of the people. It controls, regulates and guides
their economic activities with the purpose of achieving certain social and economic goals. The level
of intervention and participation of the government in overall economic activities of the people deter-
mines whether an economy is a capitalist or free enterprise economy, a socialist or command economy
or a mixed economy. In a free enterprise economy, government intervention in the form of control and
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The Economy: Its Basic Problems and Working System 17
regulation of economic activities of the people is minimal. The government control and regulation are
total and all pervasive in a command economy, also known as communist economy and it is partial in
a mixed economy.
HOW AN ECONOMY WORKS?

Working of a modern economy is extremely complex. Millions of people participate and contribute to
its working in different ways and in different capacities—as producers, traders, workers, financiers, and
consumers. Thousands of goods and services are produced and consumed and millions of people are
engaged in production and distribution of a single commodity. All those who are involved in economic
activities act and interact with different interests and motivations. The interdependence and interrelated-
ness of their economic activities add to the complexity of the economic system. To present a complete
picture of the economic system and showing the role of each individual participant in respect of each
commodity is an extremely difficult task, rather impossible. However, the economists have devised a
simplified circular model to show how real products (including productive resources) and money flow
in a circular manner between the different sectors or markets and how the economy continues to work.
The working of a simple economy is illustrated here by using a circular flow model.
The Circular Flow Model of a Simple Economy

In the simplified model, the economic players are classified under three functional categories or sectors:
(i) households; (ii) business firms and (iii) the government. These sectors make, what is called, a closed
economy model—a model excluding the foreign sector. The functions and the roles of these economic
entities in the model economy are described below.
(i) The Households participate in the economic system in two different capacities: (a) as suppliers
of productive resources (land, labour and capital) and (b) as consumers of all final goods and
services produced by the business firms.
(ii) Business Firms include all firms, farms, factories and shops operated by individual proprietors,
partnership firms and joint-stock companies engaged in production and distribution of goods
and services. Business firms perform two functions: (a) hiring productive resources from the
households and transforming them into final goods and services, and (b) selling their product
to the households, the consumers.
(iii) The Government collects taxes from the households and firms. It uses tax revenues to buy men
and material from households and firms to perform its economic and administrative functions
including providing public goods and services.
The functions of and the mode of transactions between the three kinds of economic sectors and
working of the economic system are exhibited in Figure 2.1. Households and firms interact in two
ways: (i) as sellers and buyers of inputs and (ii) buyers and sellers of output. The sale and purchase of
inputs makes factor market where factor prices are determined, and sale and purchase of final goods and
services creates product market where product prices are determined. The payment of taxes by the firms
and the households to the government and payments made by the government to these sector make the
government sector.
The transactions between the different sectors create two kinds of circular flows: (i) product flows and
(ii) money flows. Product and money flow in reverse directions.
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18 Chapter 2
Factor
market
Determination
of —
factor price
es Wa
m .
co , etc ge
s,
s t in
es, r in
e
—
er
Wag cto
ter
int
est,
Fa
etc.
es and salaries
Wag
Households: factors owners Government Business firms: factor

and product consumers Taxes and fees sector Taxes and fees uses and producers
Rec
c ts
du
eip
pro
ts
for
fro
nts
m
me pr
—
Pay od
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— Product
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Determination
of
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Figure 2.1 Working of the Economy: Real and Money Flows
As Figure 2.1 shows, factors of production (land, labour, capital, etc.) flow from the households to the
factor market. The transactions between households (the input suppliers) and business firms (the input
demanders) determine the factor prices. Once factor prices are determined, inputs move to business
firms. In return, factor payments (wages, rent, interest, etc.) flow to the households. The business firms
use the factor inputs to produce the goods and services, the finished products. Finished products flow
to the product market. The process of transactions between the business firms (the suppliers) and the
households (the buyers) determine the product prices and the volume of product flow to the households.
In return, the payments made by the households for their purchases flow to the firms. They use their
revenue to hire inputs again and the process continues infinitely.
As regard the transactions between the government and the two other sectors, the governments collect
taxes from households and firms. It uses the tax revenue to hire or to buy a part of social resources (land
and labour) to carry out its administrative and economic functions. It employs labour from households
and pays wages and makes payments for the purchases it makes from the firms. In addition, it makes
transfer payments to both households and business firms in the form of subsidies and grants.
The economic system works in an orderly manner. It meets the requirement of all those who partici-
pate in the system. Households are able to sell the services of their resources and to make their living—
earn their income. The income which they earn becomes the means of buying goods and services of their
need. Their purpose is well served. Similarly, this system also serves the interest of the business firms.
The basic objective of the firms is to make profit for their owners. In pursuit of their objective, business
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firms are able to procure the means of production which they transform into usable goods and services.
They are able to dispose of their product in the product market and make profit. The households and
business firms continue to interact with each other in pursuit of their respective objectives and thereby
make the economic system function continuously and in an orderly manner.
THE BASIC PROBLEMS OF AN ECONOMY

As mentioned in Chapter 1, human wants are endless as they go on increasing whereas resources
available to satisfy human wants are scarce at any point of time. Though resources also increase over
time—there is always a gap between demand for and supply of resources. In their effort to meet the
ever-growing needs using limited resources, economies aim at (i) achieving efficiency in production
and distribution of commodities; and (ii) achieving full employment, high growth in output and stabil-
ity in employment and growth. In their effort to achieve these goals, societies face certain problems.
For pedagogic reasons, the problems faced by the economies can be grouped under two categories:
(a) problems in achieving efficiency in production and distribution of goods and services; and (b) prob-
lems in achieving a reasonably high growth rate, full employment and stability in the economy. The
nature and origin of the two kinds of problems are discussed below.
Problems in Maximizing Production and Optimizing Distribution

The problems that arise in maximizing production and optimizing distribution of goods and services,
often referred to as the basic problems, are of three kinds:
(i) What to produce?
(ii) How much to produce?
(iii) How to produce?
Let us now discuss the nature and sources of these problems.
(i) What to Produce? The problem ‘what to produce?’ is the problem of choice between
commodities to be produced. This problem arises mainly for two reasons: (i) scarcity of
resources does not permit production of all the goods and services that people would like to
consume; and (ii) all the goods and services are not equally important in terms of their utility
for the consumers. Some commodities yield higher utility than the others. Since all the goods
and services cannot be produced for lack of resources, and all that is produced may not be
bought by the consumers, the problem of making choice between the commodities arises. The
problem ‘what to produce’ is essentially the problem of efficient allocation of scarce resources
so that the output is maximum and the output mix is optimum. The objective is to satisfy the
maximum needs of the maximum number of people.
(ii) How Much to Produce? The question ‘how much to produce?’ is the problem of determining the
quantity of each commodity and service to be produced. This problem too arises due to scar-
city of resources. For surplus production would mean wastage of scarce resources. Resource
wastage defeats the objective of maximizing production from the given resources.
(iii) How to Produce? The problem ‘how to produce?’ is the problem of choice of technology, i.e., the
production technique. Here the problem is how to determine optimum combination of inputs—
labour and capital—so that production of goods or services is maximized. This problem,
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20 Chapter 2
too, arises mainly because of scarcity of resources. If labour and capital were available in
unlimited quantities, any amount of labour and capital could be combined to produce a com-
modity. But resources are not available in unlimited quantity. Therefore, choosing a technology
that uses resources most economically becomes a necessity.
Another important factor that gives rise to this problem is that a given quantity of a commodity can
be produced with a number of alternative techniques, i.e., alternative input combinations. For example,
it is always technically possible to produce a given quantity of wheat with more of labour and less of
capital (i.e., with a labour-intensive technology) and with more of capital and less of labour (i.e., with
a capital-intensive technology). The same is true for most commodities. In case of some commodities,
however, choices are limited. For example, production of woollen carpets and other items of handicrafts
are by nature labour-intensive, while production of some other goods like machinery, aircraft, turbines,
etc. are by nature capital-intensive. In case of most commodities, however, alternative technologies are
available. But the alternative techniques of production involve different costs. Therefore, the problem of
choices of technology arises.
Problems in Achieving Growth, Full Employment and Stability

The economic problems discussed above are of micro nature. Apart from microeconomic problems,
there are certain macroeconomic problems of prime importance confronted by an economy includ-
ing the problems of growth, full employment and stability. Following Lipsey, these problems may be
specified as follows:
(i) How to Increase Production Capacity of the Economy? The need for increasing production
capacity of the economy arises for at least two reasons. First, most economies of the world have
realized by experience that their population has grown at a rate much higher than their pro-
ductive resources. This leads to the poverty of the nations. Poverty in itself is a cause of many
social evils. Besides, it has frequently jeopardized the sovereignty and integrity of the nations.
Colonization of poor nations by the richer and powerful imperialist nations during the pre-
20th century period is an evidence to this fact. Therefore, creating conditions for growth of
the economy and generating resources for defence purposes has become a necessity. Second,
some economies have grown over time faster than the others, while some others have remained
almost stagnant. The poor nations have been subjected to exploitation and economic discrimi-
nation by economically powerful nations. This has impelled the poor nations to make their
economies grow, to save themselves from exploitation and to give their people a respectable
place in the international community.
(ii) How to Stabilize the Economy? Economic fluctuation has been an important feature of free;
enterprise economies. Though economic ups and downs are not unknown in the controlled
economies, free enterprise economies have experienced it more frequently and more severely.
Economic fluctuations cause wastage of resources, e.g., idleness of manpower or involun-
tary unemployment, idle capital stock, etc., particularly during the periods of depression.
Economists have devoted a good deal of attention to explain this phenomenon and to suggest
measures to stabilize the economy. However, economic fluctuation, though of mild magnitude,
continues to remain a vexing problem. The global recession of 2008–2009, originating in the
United States, is the live example of economic fluctuation.
(iii) Other Problems of Macro Nature. In addition to the macroeconomic problems mentioned
above, there are many other economic problems of this nature, which economists have studied
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extensively and intensively. The major problems of this category are the problems of economic
growth, inflation, unemployment and foreign trade deficits. The major questions to which econ-
omists have devoted a good deal of their attention are how is national income determined? How
is the equilibrium between the product market and the money market determined? The mac-
roeconomic problems that arise in open economics are: What is the basis of trade between the
nations? How are the gains from trade shared between the nations? Why are there trade deficits
or trade surpluses? How is an economy affected by deficits in its balance of payments?
HOW MARKET MECHANISM SOLVES THE BASIC ECONOMIC

PROBLEMS?
The way the basic problems of an economy are solved depends on the nature of the economy. While
in a socialist economy they are solved by the government agencies like central planning authority, in
a free enterprise or mixed capitalist economy this task is performed by the price mechanism or market
mechanism. We discuss here how market mechanism solves the basic economic problems both in a free
entreprise and in a mixed capitalist economy. For other economic systems, a brief answer is provided in
the next section.
Pending a detailed discussion on the working of the market system, till the next chapter, market
mechanism can be described as a process through which market economy functions. A market economy
functions through the market forces of demand and supply. The demand and supply forces interact to
determine the price of goods and services. Thus, a price system is generated. Prices perform two func-
tions in the market system. First, prices serve as signals for the producers to decide ‘what to produce?’
and for the consumers to decide ‘what to consume?’ and ‘how much to consume?’. Second, prices force
the demand and supply conditions to adjust themselves to the prevailing prices. Let us now see how each
of the basic problems is solved by the market mechanism or price mechanism.
(i) What to Produce? The goods and services that are produced in a market economy are deter-
mined by consumer demand. The consumer is ‘sovereign’ in a free enterprise market economy.
Each penny a consumer spends on a commodity is treated as a vote for producing that com-
modity. Continuing demand is a continuous process of voting. Increasing demand for a good
causes increase in its price. Rise in price increases profit margin. The profit-seeking producers
will concentrate on the production of this commodity. If they produce a commodity that is not
in demand, it will go waste and their profit motive will be defeated. This solves the problem of
‘what to produce?’
(ii) How to Produce? ‘How to produce?’ is the question of choice of technology. The proportion of
labour and capital used to produce a commodity is also determined by the market forces, i.e., the
supply of and demand for labour and capital. Firms produce for profit and try to maximize it.
It requires, among other things, minimizing cost of production. Costs can be minimized using
more of a cheap factor and less of a costly factor. If labour is cheaper than capital then more of
labour and less of capital is used to produce a commodity. On the contrary, if capital is cheaper or
more productive, more of capital and less of labour is used. In fact, cost-minimizing firms com-
bine labour and capital in such a proportion that minimizes the cost of production for a given
output. This solves the problem of ‘how to produce?’
(iii) How Much to Produce? Market system solves not only the problems of ‘what to produce?’ but
also the problem ‘how much to produce?’ The market forces—demand and supply—determine
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22 Chapter 2
the quantity of a commodity that firms have to produce, given their objective of profit
maximization. If the firms produce less than the quantity demanded, they leave out the pros-
pect of selling more and making more profit. If firms produce more than the quantity demand,
supply exceeds the demand. As a result, the price of their product goes down. Decrease in price
reduces the profit margin (given the cost) or may even result in losses. So the firms cut down
their production to match with market demand. Thus, the market mechanism resolves the
problem of ‘how much to produce?’
DRAWBACKS OF THE FREE ENTERPRISE SYSTEM

In a perfectly competitive market economy, the whole system is supposed to function smoothly,
efficiently and in an orderly manner. Despite the fact that millions of people, often with conflicting
interests and motivations, participate in the working of the system at both individual and group levels,
the market system is supposed—at least theoretically—to work in an orderly manner. The market forces
organize the whole economic system to the benefit of majority of its participants. Consumers get what
they want to consume and producers produce goods and services that maximize their profits. This social
organism functions automatically—at least in theory.
Is all well with free enterprise economies? It may seem from the foregoing description of the market
system that all is well with the free enterprise economies but not quite so. A genuinely efficient free
enterprise system is supposed to ensure that (i) all those who are willing to work at the prevailing wage
rate must get employment; (ii) factor payments must be commensurate with their productivity; (iii) all
factors of production are optimally allocated; (iv) as Slitcher1 has suggested the goods must go to the
consumers who derive the highest utility from them; and (v) goods must be produced by the most effi-
cient producers, i.e., by those who can produce them at the minimum possible cost.
The free enterprise system has, however, not worked as efficiently as expected at least during the
post-World War I period. Goods and jobs are not distributed optimally. Goods go to the persons who
can pay the highest prices for them but may not necessarily derive the highest utility. It would be ‘ridicu-
lous to assert that ability to derive satisfaction from goods is proportionate to ability to pay for them’.
Although it is difficult to quantify the satisfaction derived from a good by rich or poor individuals,
it cannot be denied that a woollen coat hanging idle in the wardrobe of a rich individual would give
more satisfaction to his or her scantily dressed domestic servant during the winters. But the domestic
servant who needs it more does not get the coat because he or she does not have the adequate purchasing
power. Similarly, in a free enterprise system, jobs too are not distributed among the people on the least
pain basis. People are prepared to work for their living irrespective of pains and sacrifices they have to
make for a meagre income. Under the condition of prolonged unemployment, people would be willing
to work at an extremely low wage rate whatever might be their productivity. This is a general case when
there is excess supply of labour. Let us now look into the shortcomings of free enterprise system in detail.
The major shortcomings of free enterprise system, as experienced over time by the free enterprise
economies, are described below.
First, free enterprise system assumes the existence of perfect market conditions for its efficient
working. The necessary conditions for the efficient working of the market system are free competi-
tion, increasing cost in all markets, applicability of the exclusion principle in consumption, absence
of public goods, perfect knowledge and free factor mobility. But the existence of such a perfect mar-
ket system in the world economy is very rare—rather non-existent. Besides, mere existence of perfect
competition is not enough to ensure the efficient working of the system. As Scitovsky2 has remarked,
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perfect competition would not ensure perfect efficiency if there are differences between social and
private values and in social and private marginal products. It may not be possible to quantify the differ-
ence between social and private values and social and private costs, but the existence of such differences
cannot be denied.
Second, free enterprise system works on the principle that each individual is the best judge of his or
her own interest and, therefore, his choices and decisions would best serve his or her interest. But most
choices and decisions made by individuals, particularly in regard to consumer goods, are generally influ-
enced by ‘impulses, habits, prejudice, ignorance, or clever sales talks, and too little by reflection, inves-
tigation of facts and comparison of alternative opportunities’.3 If it is not so, a person would not spend
more on liquor and smoking and less on milk, education or health care; a couple would not produce
children whom they cannot bring up properly, people will not throw their household garbage on road;
factory owners will not cause air and environment pollution; drivers will not drive their automobiles
recklessly and violate traffic rules; ministers and politicians will not indulge in corrupt political practices;
and people will not vote for corrupt and criminal politicians.
Third, as mentioned above, the motivating force for private enterprise is profit. The private entre-
preneurs would, therefore, not like to invest their capital in the industries or sectors which have lower
profitability, even if the industries are of essential nature and of strategic importance for the national
economy. So is the case with regional distribution of industrial undertakings. Under free enterprise sys-
tem, the industries tend to concentrate on the production of goods and services that yield a rate of profit
rather than on goods and services that satisfy the maximum number of needs of the maximum number
of people. This leads to the growth of economic inequality and limits the size of the market economy.
Fourth, certain services, known as ‘public utilities’ like medical care, education, water, electricity,
sanitation, etc., are equally important for all the individuals—rich and poor. But the market system either
creates disincentive for the production of these services or leads to their production for only those who
can pay a high price. Transport and communication facilities (including roadways, railways, airways,
telephones, post and telegraph, etc.) are necessary for the overall growth of the economy. Private capital
normally does not flow into these sectors in adequate measures, at least for three reasons: (i) they require
huge initial investment; (ii) the rate of return in these sectors is very low and remote; and (iii) most pub-
lic utility services are in the nature of collective consumption to which the principle of exclusion cannot
be applied. Apart from this fact, the ‘public utilities’ and other essential services cannot be left to the
private sector. For the pricing system of free enterprise system is such that only the rich can afford these
services and hence there will be inequitable distribution of essential services.
Fifth, free enterprise system works efficiently only when there is perfect competition. Perfect com-
petition requires equality between the competitors. But two firms are hardly equal in efficiency. The
competition, therefore, becomes imperfect, which leads to the growth of monopolies with low supply
and high price and unequal distribution of income. This is one of the greatest drawbacks of the free
enterprise system.
Finally, free market mechanism does not function efficiently where the exclusion principle is not
applicable, especially where externalities are involved. Application of exclusion principle requires that
those who do not pay for a good are excluded from the benefit of that good, and those who do not derive
any benefit from a good are excluded from bearing the cost of that good. In a modern complex society,
there are numerous activities that impose disadvantage on those who do not benefit from them and
there are those who benefit even if they do not pay for such goods and services. For instance, smoke-
emitting factories, air-polluting automobiles and people using loudspeakers for marriage ceremonies
harm others who do not derive any benefit from their activities. Such costs borne by the people are
known as ‘spill-over costs’. Similarly, planting trees on roadsides, creation of parks and gardens, spread
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24 Chapter 2
of education etc. benefit the society by providing a beautiful landscape, spread of knowledge, etc. Such
benefits are known as ‘spill-over benefits’. Spill-over costs and spill-over benefits are jointly called exter-
nalities. The free enterprise system working on market principles does not compensate those who suffer
and does not charge those who benefit from externalities. This makes the market system inefficient and
leads to sub-optimal allocation of resources.
THE GOVERNMENT AND THE ECONOMY

Because of the drawbacks of the market mechanism, the free enterprise system has failed in achieving
optimum distribution on goods and services, optimum allocation of resources, maximum efficiency and
maximum social welfare. Failures apart, the free enterprise system is alleged to have caused the growth
of monopolies, unequal income distribution, unemployment and poverty. Besides, though free enter-
prise system is capable of bringing economic growth, it does not ensure a stable, sustained and balanced
growth. It becomes therefore inevitable for the government to intervene with the market mechanism
through fiscal measures to reduce market distortions, provide conditions for fair competition, and help
the economy in achieving efficiency, stability, growth and economic justice. The interference of the
government with the market system becomes inevitable because of the failure of the system. Now, the
question arises as to what should be the appropriate role of the government in economic management
of the country and what should be the form, nature and extent of government interference with market
mechanism. These questions have been discussed and debated for long, but no precise answer has been
provided by the economists. Nevertheless, the economic role of the government can be broadly catego-
rized on the basis of the three economic systems that currently prevail in the world, viz., capitalist system
or free enterprise system, socialist system and the mixed-economy system.
(i) Capitalist Economy. A capitalist economy works on the principles of free enterprise system or
what is also called a laissez faire system. In this system, most economic activities are undertaken
by the private sector business firms.4 The roles of the government are confined to (i) preserv-
ing and promoting free market mechanism wherever it is possible to ensure a workable com-
petition; (ii) removing all unnecessary restrictions on free working of a competitive market;
(iii) providing a level playground and rules of the market game through necessary interventions
of controls so that free competition can work effectively; (iv) producing and supplying goods
and services that free market mechanism cannot provide adequate supply at a socially reason-
able price; and (v) controlling and regulating monopolistic powers of large corporate concerns.
It may be inferred from the above discussed points that the government’s economic role in a capitalist
society is supposed to be limited to (a) restoration and promotion of necessary conditions for effi-
cient working of free market mechanism; and (b) enter those areas of production and distribution in
which private entrepreneurship is lacking or inefficient. Any economic planning by the government
is generally indicative and supplementary to the private plans for future economic activities.
(ii) Socialist Economy. In contrast with the capitalist system, the role of government in a socialist
economy is all pervasive. While in a free enterprise economy, the government is supposed to
play a limited role in the economic sphere, the government in a socialist economy exercises
comprehensive control on almost all economic activities. In the socialist system, not only is
there a complete disregard for free enterprise and market mechanism but also these systems
are abolished by law. The private ownership of factors of production is replaced by the state
ownership. All economic activities are centrally planned, controlled and regulated by the state.
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All decisions regarding production, resources allocation, employment, pricing, etc. are
centralized within the powers of government or the Central Planning Authority. The individual
freedom of choice and decision making in regard to economic activities is drastically curtailed.
This, however, does not mean that there is no scope for individual decisions. Individuals are
provided freedom to make their own choices about consumption, production and profession
but within the policy framework of the socialist economy. The Soviet economic system as it
was till 1990 was the most prominent example of socialist system of economic management.
Other countries which had adopted socialist economic system were China, Poland, Slovakia
and Yugoslavia. These economies are, however, liberalizing their economic system rapidly.
The social aims of the socialist economic system are the same as in free enterprise system,
viz., efficiency, growth, social justice and maximization of social welfare. However, while the
motivating force in a capitalist economy is private profit, in the socialist economy, it is maxi-
mization of social welfare. Socialist way of management of the economy eliminates many evils
of capitalist system, e.g., exploitation of labour by capitalists, recurrence of forces generating
economic fluctuations, large-scale unemployment and social, political and economic inequality.
However, the biggest drawback of socialist system is that, beyond a point, it turns out to be
anti-growth. That is why most socialist countries have given it up.
(iii) Mixed Economy. A mixed economy is an economic system that combines the features of both
free enterprise and socialist (or centrally planned) economic systems. Indian economy is a
good example of a mixed economy. In this system, the economy is divided into two sectors, viz.
(i) private sector and (ii) public sector. Private sector is allowed to function on the principles of
free enterprise system or free market mechanism within a broad political and economic policy
framework. The other part of the economy, the public sector, is organized, owned and man-
aged by the government along the socialist pattern. The public sector is created by reserving
certain industries, trade, services and activities for the government control and management.
The government prevents by law the entry of private capital into the industries reserved for the
public sector. Another way of creating or expanding the public sector is nationalization of pri-
vate industries in nation’s interest as India did by nationalizing commercial banks in 1969. The
promotion, control and management of the public sector industries is the sole responsibility of
the state.
Apart from controlling and managing the public sector industries, the government controls and regu-
lates the private sector through its industrial, monetary and fiscal policies. If necessary, direct controls
are also imposed.
The Mixed Economy System Is the Order of the Day

In today’s world, there is no pure capitalism or pure socialism. But the systems have gradually
disappeared because of their inherent drawbacks. It is noteworthy that most of the so-called free
enterprise economies are conceptually mixed economies, because in all such economies there co-exist
private and public sectors. A mixed economy is essentially a variant of the capitalist economy. The
mixed economies of free enterprise system can however be distinguished from the mixed econo-
mies of ‘socialist pattern’ on the basis of the rationale of public sector in the two systems. The public
sector in a free-enterprise system is a matter of pure economic necessity and is subservient to the free
market mechanism. It functions on the principles and with the objective of aiding, supplementing and
strengthening the free enterprise system.
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26 Chapter 2
However, the creation of public sector in a ‘socialist pattern of society’ like India, is a matter of
ideological and social choice. Its functioning is oriented towards the creation of a socialist pattern of
society. In this system, social justice and equal opportunity are intended to be achieved through state
policy measures rather than through market mechanism. Another point of distinction is that the public
sector of the socialist pattern of society has a comprehensive economic planning, whereas in a free enter-
prise system such plans are only indicative. The Indian economy had adopted a mixed economy system
based on the principles of the ‘socialist pattern of society’ after its Independence. However, since 1991
Indian economy has been oriented towards market mechanism by relaxing the government control on
the economy by putting an end to quota and ‘Licence raj’.
In the mixed economy of a socialist pattern of society, the roles and responsibilities of the government
are much wider than free enterprise system and much less than that in the socialist society. The govern-
ment, in this system, undertakes to perform all the functions that state performs in a free enterprise
economy. In addition, it assumes the responsibility of making and implementing the plans for economic
development of the country. The government has to also perform the task of coordinating private sector
activities with the public sector, and controlling and regulating the former to bring it in tune with the
public sector policies.
THE PRODUCTION POSSIBILITY FRONTIER

As noted earlier, one of the basic problems of an economy is how to expand the production capacity of
the economy to meet the ever-growing needs of the people. In reality, however, both human and non-
human resources available to a country keep increasing over time and the technology becomes more
and more productive. Availability of human resources increases due to a natural process of increase in
population, and non-human resources (especially capital goods and raw materials) increase due to the
creative nature of human beings. Non-human resources have been increasing due to human efforts to
create more and better capital goods, to discover new kinds and sources of raw materials and to create a
new and more efficient technique of production. Such factors change production possibilities and produc-
tion possibility frontier (PPF) of an economy.
In this section, we will define and describe the PPF and introduce the concept of opportunity cost. To
begin with, we assume a static model with the following assumptions: (i) a country’s resources consists
of only labour and capital; (ii) availability of labour and capital is given; (iii) the country produces only
two goods—food and clothing; and (iv) production technology for the goods is given.
The PPF. The PPF refers to the boundary line drawn by using the alternative combinations of goods
and services that a society is capable of producing with its given resources and state of technology. With
reference to our mode specified above, PPF would show the alternative combinations of maximum
food and clothing that the country can produce by making full use of its labour and capital, given the
technology.
For example, let us suppose that, given the availability of labour, capital and technology, the alterna-
tive production possibilities open to the country are given in Table 2.1. The production possibilities
given in Table 2.1 can be presented in the form of a diagram as shown in Figure 2.2. In this diagram,
vertical axis (y axis) measures food production and horizontal axis (x axis) measures production of
clothing. By analysing the alternative production possibilities given in Table 2.1, we locate points A,
B, C, D, E, and F as shown in Figure 2.2. A number of intermediate points can be located between any
two of these points. By joining these points, we get a curve PF. This curve is called PPF. The production
possibility frontier, AF, shows all possible alternative combinations of the two goods (food and clothing)
that can be produced by making full use of all the available resources (labour and capital), given the state
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Table 2.1 Alternative Production Possibilities

Point of Goods Alternative Combinations: Clothing
Combination Food and Clothing Food (million metres)
(thousand tons)
A 7 0
B 6 33
C 5 48
D 4 60
E 3 68
F 0 80
P Production
7 possibility
frontier
B
6
Food (thousand tons)
C H
5
4 D
G
3 E
1
33 48 68
F
O 10 20 30 40 50 60 70 80 90
Clothing (million meters)
Figure 2.2 The Production Possibility Frontier
of technology. Each point on the PPF shows a different combination of two goods. For example, produc-
tion possibility frontier PF shows that if the country chooses point P, it can produce 7 thousand tons of
food and no clothing.
Similarly, point F shows that the country can produce 80 million metres of clothing but no food.
A large number of other alternative combinations of food and clothing can be located on the curve PF
that the country can produce by making full use of its resources—labour and capital—given the tech-
nology. For example, point B shows a combination of 6 thousand tons of food and 33 million metres of
clothing and point C shows a combination of 5 thousand tons of food and 48 million metres of clothing,
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28 Chapter 2
and so on. Similarly, each point of the PPF indicates a different combination of food and clothing that
a society can produce.
Some Implications of PPF

Implications of Points Away from PFF
The PPF shows the alternative combinations of the two goods (food and clothing) under the conditions
that all the resources (labour and capital) are fully employed. Any point below the PPF, e.g., point G,
implies underutilization of resources, which results in underproduction—33 million metres of cloth-
ing and 4 thousand tons of food. This is underproduction because if resources are fully employed, an
additional 2 thousand tons of food or 15 million metres of clothing or an additional quantity of both
the goods can be produced. Any point that falls beyond the PPF, e.g., point H, represents a combination
of food and clothing that cannot be produced for lack of resources. The scarcity of resources does not
permit production of any combination of food and clothing indicated by a point outside the PPF.
The Opportunity Cost

Apart from showing the production possibility of alternative combinations of two goods, PPF also
indicates the opportunity cost of one commodity in terms of the other. Conceptually, opportunity cost
is the output of a commodity that is foregone to avail the output of another opportunity. In the present
context, ‘The opportunity cost of an increase in the output of some product is the value of the other goods
and services that must be foregone when inputs (resources) are taken away from production in order to
increase the output of the product in question’.5 In our example, opportunity cost of food production is
the quantity of clothing foregone to produce a certain additional quantity of food, and vice versa. The
concept of ‘opportunity cost’ can be exemplified with the help of alternative options given by the PPF. As
can be seen in Figure 2.2, the movement along the production possibilities frontier, PF, shows decrease in
the output of one commodity at the cost of the output of the other. For example, movement from point B
to point C shows decrease in food production from 6 thousand tons to 5 thousand tons and increase in
the production of clothing from 33 million metres to 48 million metres. It implies that 1 thousand tons
of food can be produced only by using 15 million metres of clothing. It means that opportunity cost of the
1 thousand tons of food is 15 million metres of clothing. Likewise, the backward movement from point C
to point B implies that opportunity cost of 15 million metres of clothing is one thousand tons of food.
Increasing Opportunity Cost and Concavity of PPF

The PPF reveals another important fact that opportunity cost changes along the PPF. In Figure 2.2,
movement from point P downwards to points B, C, D, E and F shows increasing opportunity cost of
clothing in terms of lost output of food. For example, movement from points A and B means trans-
ferring resources (labour and capital) from food production to clothing production. As a result, food
production is lost by 1 thousand tons for 33 million metres of clothing. It means that the opportunity
cost of 33 million metres of clothing is 1 thousand tons of food. A further movement from point B to C
means that the opportunity cost of 15 million metres of clothing, a much lower quantity, is the same one
thousand tons of food. It means that opportunity cost of clothing increases as we move downwards along
the PPF. It increases further between points C and D. Similarly, movement from point F towards point A
shows increasing opportunity cost of food production in terms of clothing.
Why Does Opportunity Cost Increase?

The opportunity cost increases due to an economic law, i.e., the law of diminishing returns to scale. The
law of diminishing returns to scale states that when more and more units of two inputs are used to
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produce a commodity, the return on the marginal units of inputs diminishes. The movement from one
point on the PPF to another means transfer of resources from the production of one commodity to that
of the other. For example, movement from point A towards point F implies transfer of resources from
food production to clothing production. As more and more resources are transferred to produce cloth-
ing, marginal productivity of resources in terms of clothing diminishes. The result is increase in the
opportunity cost.
Because of the law of diminishing returns to scale, the PPF takes a concave shape. However, if returns
to scale are constant, the PPF will be a straight line sloping downward.
Shift in PPF
The PPF for a country is not fixed for all times to come. In general, it keeps shifting upwards for two
reasons: (i) expansion of resources, i.e., increase in the availability of resources (labour and capital); and
(ii) technological improvements. The effects of resource expansion and technological improvements on
the PPF is explained and illustrated below.
(i) Resource Expansion and PPF. Increase in human and non-human resources of a country, tech-
nology remaining the same, causes a parallel shift in its PPF. In general, resources of a country
increase over time with increase in labour supply which in turn is because of increase in both
population and the supply of capital. The upward shift in the PPF because of the increase in
country’s resources (labour and capital) is illustrated in Figure 2.3, assuming a given technology.
Suppose that given the resources and technology of a country, its PPF is shown by the curve AB
in Figure 2.3.
F
A
Food (thousand tons)
E G
O B D
Clothing (million meters)
Figure 2.3 Shift in Production Possibility Frontier
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30 Chapter 2
Now, let the resources (labour and capital) of the country increase proportionately so that a
large quantity of labour and capital is available to produce food and clothing. With the increase
in resources, the country can increase its food production by AC or, alternatively, production
of clothing by BD, or a larger combination of both the goods. By joining the possible points,
we get a higher PPF as shown by the curve CD in Figure 2.3. This shows an upward shift in the
PPF from AB to CD because of the increase in resources. Each point on the PPF CD shows a
large combination of food and clothing. For example, suppose given its resources, the country
was at point E on the PPF marked by AB. When its resources increase, its PPF shifts upward
to CD. The country can then increase its production of food by EF or of clothing by EG or an
additional quantity of both the goods indicated by points between F and G. These kinds of
production possibilities show the economic growth of the country.
(ii) Technological Improvement and PPF. Technological improvement refers to change in produc-
tion techniques so that more of goods can be produced per unit of time using a given quantity
of resources. That is, technological improvement increases the productivity of resources, both
labour and capital. Technological improvement may be commodity specific and at different
points of time in different industries. In India, for example, technological break through in
food production was made during the 1970s, whereas technological improvement in clothing
industry had started much earlier. The PPF shift due to industry-wise technological improve-
ment is illustrated in panel (a) and (b) of Figure 2.4. Panel (a) illustrates shift in the PPF because
of technological improvement in food production, assuming no improvement in clothing tech-
nology, and panel (b) illustrates shift in the PPF because of technical improvement in clothing
industry, assuming no change in food technology.
It can be seen in panel (a) of Figure 2.4 that technological improvement in food production
makes an upwards shift in the PPF from AB to CB. The shift in PPF indicates that (i) total food
production can be increased with no change in clothing production, (ii) more of both the goods
can be produced. Similarly, panel (b) shows the shift in the PPF when there is technological
improvement in clothing industry and no such change in food industry. Due to technological
(a) (b)
C A
A
Food
Food
O O
B B D
Clothing Clothing
Figure 2.4 Technological Improvement and Shift in PPF
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improvement, total production of clothing can be increased by DB or more of both the goods
can be produced.
(iii) What if Changes in Resources in Technology Are Simultaneous? If technological improvements
take place along the resource expansion and if technological improvements take place in both
the industries simultaneously, then the shift in PPF is similar to that caused by resource expan-
sion, though the shift may not be parallel.

1. How will you define an economy and the economic system? What are the various constituents
of the economic system? How do they act and react?
2. Explain the working of a simple economy with the help of an appropriate diagram using a
simple model. How will the total real output be affected when households set aside a part of
their income?
3. Illustrate the circular flows of product and money in a simple economy. Why are the two kinds
of flows always equal in value terms? What will happen if one of the flows is reduced for some
reason?
4. What are the basic problems of an economy? Why do these problems arise? Do all kinds of
economies—rich and poor, developed and underdeveloped—face the same basic problems?
5. Scarcity is the mother of all kinds of economic problems. Do you agree with this statement?
Give reasons for your answer.
6. What is ‘market mechanism’? How does market mechanism work to solve the basic problems
in a free market economy? Under what market conditions does the market mechanism work
efficiently to solve the economic problems?
7. An efficient solution to the basic problems of an economy lies in that commodities go to those
who derive the highest utility from them and factors of production flow to the activities in
which their productivity is maximum. Does market mechanism provide solution to basic prob-
lems ‘what to produce’, ‘how to produce’ in the manner that the above condition is satisfied?
8. Discuss the major drawbacks and failures of the free market economy? What are the reasons for
failures of the market system in providing an efficient solution to the basic problems?
9. Why does government intervention in free market economy become often inevitable? What
roles does the government play in a free market economy? How is government role different in
free market economies from that in controlled economies?
10. What is meant by ‘production possibility frontier’? What factors determine the production
possibility frontier of an economy? How are the points below and above the production pos-
sibility frontier different from the points on the frontier curve?
11. Define opportunity cost. Why does opportunity cost increase along the production possibility
frontier? Explain with an appropriate example. Suppose a country produced only two goods—
cars and computers. When some of the resources are transferred from car production to
computer production, car output decreases by 1000 units and computer output increases by
50,000 units. Find the per unit opportunity cost of car production.
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32 Chapter 2
12. What are the factors that make production possibility frontier shift upwards? Illustrate and
explain an upwards shift in the production possibility frontier caused by (a) increase in the sup-
ply of resources, technology remaining the same; (b) technological improvements, resources
remaining the same; and (c) simultaneously change in resources and technology.
13. Which of the following statements is NOT correct?
(a) Scarcity is the cause of all economic problems;
(b) Market mechanism can solve all economic problems;
(c) Consumer is sovereign in a socialist economy;
(d) Opportunity cost equals cost of production.
14. Suppose the resources of a country increase and there is a simultaneous improvement in the
production of one of the products. Illustrate and explain the nature of shift in the production
possibility frontier.
15. Do you agree with the following statements? Give reason for your answer.
(a) Government is an important element of modern economies.
(b) Production possibilities frontier shows the combination of two goods that cannot
be produced.
(c) Production possibilities frontiers can shift upwards without any increase in resources.
(d) The basic economic problem, i.e., what to produce and how to produce, is the problem
of only poor countries.
ENDNOTES
1. Slitcher, S.M. (1928), Modern Economic Society (New York: Henry, Holt and Company),
reprinted in 1970 in Readings in Economics, P.A. Samuelson (ed.) (New York: McGraw-Hill
Company).
2. Scitovsky, T. (1968), Welfare and Competition (Unwin University Books), p. 144.
3. Slitcher, S., R, op. eit., pp. 35–36.
4. Meade, J.E. (1795), The Intelligent Radical’s Guide to Economic Policy (London: George Allen &
Unvvin Ltd.), pp. 13–14.
5. Baumol, W.J. and Blinder, A.S. (1988), Economics: Principles and Policies (London: Harcourt,
Jovanovich), 4th Edn., p. 632.
FURTHER READINGS
Lipsey, R.G. (1983), An Introduction to Positive Economics (London: ELBS), 6th Edn., Chapters 4 and 5.
Samuelson, P.A. and Nordhaus, W. (1995), Economics (New York: McGraw-Hill, Inc.), 15th Edn.,
Chapter 1.
Slitcher, S.H. (1928), Modern Economic Society (New York: Henry, Hold and Co.), reprinted in 1970 in
Readings in Modern Economics, P.A. Samuelson (ed.) (New York: McGraw-Hill, 1970).
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Part II
Market Mechanism:
How Markets Work
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Chapter 3
The Market Forces:

Demand and Supply
CHAPTER OBJECTIVES
The market system works through the market forces of demand and supply. In this chapter, we introduce
some fundamental economic laws. The two basic objectives of this chapter are to explain (i) the laws of
demand and supply and (ii) the market mechanism—how markets work. By going through this chapter
you learn:
The meaning of demand in economic sense of the term;
The law of demand and its basis;
The derivation of the demand curve;
The factors determining individual demand for a product;
The meaning and the law of supply;
Derivation of the supply curve for an individual product;
How demand and supply forces interact to determine the market equilibrium; and
How changes in demand and supply affect the market equilibrium.
We have noted in Chapter 2 that market mechanism plays a crucial role in solving the basic economic
problems in a free market economy and that the entire market system functions in an orderly manner,
though some aspects of it may not be desirable. The market system functions in an orderly manner
because it is governed by certain fundamental laws of market known as the law of demand and supply.
The forces of demand and supply interact to determine the price of goods and services brought to the
market. The laws of demand and supply are all so pervasive in economic analysis that Thomas Carlyle,
the famous 19th century historian remarked, ‘It is easy to train an economist; teach a parrot to say
Demand and Supply.’1 In fact, the most important function of microeconomics is to explain the laws
of demand and supply, market mechanism and working of the price determination system. Therefore,
before we process to discuss microeconomics theories in detail, it will be useful to have the basic under-
standing of the laws of demand and supply: how these laws make the market system work and how
market equilibrium is determined. This will give us a sound basis to launch our study of microeconomics.
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36 Chapter 3
Briefly speaking, we explain in this chapter the concept and the laws of demand and supply, price
determination and equilibrium of the commodity market.
THE CONCEPT OF MARKET

The word ‘market’ generally means a place or area where goods and services are bought and sold, e.g.,
Chandani Chowk, Karol Bagh, Connaught Place, Delhi Stock Exchange, Bombay Stock Exchange, Sabzi
Mandi. In economics, however, the word ‘market’ is used rather in an abstract sense. The market refers
to a system by which sellers and buyers of a commodity interact to settle its price and the quantity to
be bought and sold. According to Samuelson and Nordhaus (1995), ‘A market is a mechanism by which
buyers and sellers interact to determine the price and quantity of a good or service. The buyers and sell-
ers may be individuals, firms, factories, dealers and agents. Buyers constitute the demand side and sellers
constitute the supply side of the market’.
Following are some conceptual aspects in the market system:
1. A market need not be situated in a particular place or locality. The geographical area of a market
depends on the area over which the buyers and sellers are spread. It may be as small as a fish
market in a corner of the city or as large as the entire world, e.g., the global markets for arms,
cars, electronic goods, aeroplanes, computers, petroleum products, medicines.
2. Buyers and sellers need not come in personal contact with each other. The transactions can be
carried out through postal services, telephone, fax, agents, or e-mail, etc. People do buy many
goods and services directly from the producers by telephone calls or e-mails without having
seen them ever.
3. The word ‘market’ may refer to a commodity or service (e.g., fruit market, car market, share
market, money market, paper market, labour market) or to a geographical area (Bombay
market, Indian market, Asian market, etc.).
4. The economists distinguish between the markets also on the basis of (a) nature of goods and
services, e.g., factor market and commodity market or input market and output market and
(b) number of firms and degree of competition, e.g., competitive market (large number of firms
with homogenous products), monopolistic market (many firms with differentiated products),
oligopolistic market.
THE DEMAND SIDE OF THE MARKET

Meaning of Demand
Conceptually, demand can be defined as the desire to buy a good for which the demander has ability and
willingness to pay. In simple words, demand is a desire for a good, backed by ability and willingness to pay.
A desire without ability to pay is merely a wish. A desire with ability to pay but without willingness to
pay is only a potential demand.
A desire accompanied by ability and willingness to pay makes a real or effective demand.
Individual and Market Demand. For the purpose of demand analysis, a distinction is often
made between the individual demand and the market demand—individual demand for analysing
consumer behaviour and market demand for analysing market behaviour.
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The Market Forces: Demand and Supply 37
Individual Demand. Can be defined as the quantity of a commodity that a person is willing to buy
at a given price over a specified period of time, say per day, per week, per month, etc.
Market Demand. Refers to the total quantity that all the users of a commodity are willing to buy
at a given price over a specific period of time. In fact, market demand is the sum of individual
demands for a product. Individual and market demand curves are discussed ahead in detail. Let
us now discuss the law of demand. Since we are concerned in this chapter with market demand,
The law of demand will be discussed in the context of market demand.
The Law of Demand

The law of demand states the relationship between the quantity demanded and the price of a commodity.
In general, quantity demanded of a commodity depends on many other factors also, viz., consumer’s
income, price of the related goods (substitutes and complements), consumer’s taste and preferences,
advertisement, etc. However, price of a good is the most important and the only determinant of its
demand in the short run because other factors remain constant. Therefore, the law of demand is linked
to the price of the product.
The law of demand can be stated as ‘all other things remaining constant, the quantity demanded
of a commodity increases when its price decreases and decreases when its price increases’. This law
implies that demand and price are inversely related. Marshall states the law of demand as ‘the amount
demanded increases with a fall in price and diminishes with a rise in price’. This law holds under ceteris
paribus assumption, i.e., all other things remain unchanged. The law of demand can be illustrated through
a demand schedule and a demand curve.
The Demand Schedule

A demand schedule is a tabular presentation of quantity demanded of a commodity at different prices per
unit of time. A hypothetical market demand schedule is given in Table 3.1. This table presents price of
shirts (Ps) and the corresponding number of shirts demanded (Qs) per month.
Table 3.1 illustrates the law of demand. As data given in the table shows, the demand for shirts
(Qs) increases as its price (Ps) decreases. For instance, at price Rs 800 per shirt, only 10,000 shirts are
demanded per month. When price decreases to Rs 400, the demand for shirts increases to 30,000 and
when price falls further to Rs 100, demand rises to 80,000. Similarly, one can read the table in reverse
order and arrive at the conclusion that as price of shirt increases, its demand decreases. This relationship
between the price and the quantity demanded gives the law of demand.
Table 3.1 Demand Schedule for Shirts

Ps (price in Rs) Qs (shirts in ‘000)
800 8
600 15
400 30
300 40
200 55
100 80
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38 Chapter 3
P
900
800 D
700
Price of shirts (Rs)
J
600
500
400 K
L
300
M
200
D’
100
O Q
10 20 30 40 50 60 70 80 90
No. of shirts (in ‘000)
Figure 3.1 The Demand Curve
The Demand Curve

A demand curve is a graphical presentation of the demand schedule. For example, when the data given
in the demand schedule (Table 3.1) are presented graphically as shown in Figure 3.1, the resulting curve
DD’ is the demand curve. The curve DD’ in Figure 3.1 depicts the law of demand. It slopes downward to
the right. That is, it has a negative slope. The negative slope of the demand curve DD’ shows the inverse
relationship between the price of shirt and its quantity demanded. The inverse relationship means that
demand increases with the decrease in price and decreases with the rise in price. As can be seen in
Figure 3.1, downward movement on the demand curve DD’ from point D towards D’ shows fall in price
and rise in demand. Similarly, an upward movement from point D’ towards D reads rise in price and fall
in demand.
The law of demand is based on an empirical fact. For example, when prices of cell phones and personal
computers (PCs), especially of the latter, were astronomically high, only few rich persons and big firms
could afford them. Now with the revolution in computer and cell phone technology and the consequent
fall in their prices, demand for these goods has shot up in India though other factors too contributed to
rise in demand for these goods.
The Factors Behind the Law of Demand

According to the law of demand, when a price of a product increases, its demand decreases and vice
versa, all other things remain the same. A question arises here: what are the factors behind the law of
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demand or why does demand decrease when price rises or other way round? The factors behind the law
of demand are the following.
1. Income Effect. When the price of a commodity falls, real income of its consumers increases
in terms of this commodity. In other words, their purchasing power increases since they are
required to pay less for the same quantity. According to another economic law, increase in real
income (or purchasing power) increases demand for the goods and services in general and for
the goods with reduced price in particular. The increase in demand on account of increase in
real income is called income effect.
It should, however, be noted that the income effect is negative in case of inferior goods. In case,
price of an inferior good accounting for a considerable proportion of the total consumer
expenditure falls substantially, consumers’ real income increases. Consequently, they substitute
superior goods for inferior ones. Therefore, income effect on the demand for the inferior good
becomes negative.
2. Substitution Effect. When price of a commodity falls, it becomes cheaper compared to its
substitutes, prices of substitutes remaining constant. In other words, when price of a commod-
ity falls, price of its substitutes remaining the same, its substitutes become relatively costlier.
Consequently, rational consumers tend to substitute cheaper goods for costlier ones within
the range of normal goods—goods whose demand increases with the increase in consumer’s
income—other things remaining the same. Therefore, demand for the relatively cheaper goods
increases. The increase in demand on account of this factor is known as substitution effect.
3. Diminishing Marginal Utility. Marginal utility is the utility derived from the marginal unit
consumed of a commodity. Diminishing marginal utility is also responsible for the increase in
demand for a commodity when its price falls. When a person buys a commodity, he exchanges
his money income with the commodity in order to maximize his satisfaction. He continues
to buy goods and services so long as marginal utility of his money (MUm) is less than the
marginal utility of the commodity (MUc). Given the price (Pc) of a commodity, the consumer
adjusts his purchases so that MUc = MUm. This proposition holds under both constant MUm and
diminishing MUm.
If MUm is assumed to be constant, then MUm = Pc. Under this condition, utility-maximizing consumer
makes his purchases in such quantities that
MU m = Pc = MU c
When price falls, (MUm = Pc) < MUc. The only way to regain his equilibrium is to reduce MUc. So the
consumer purchases more of the commodity. When the stock of a commodity increases, MUc decreases.
As a result, demand for a commodity increases when its price decreases.
This conclusion holds also under diminishing MUm. When price of a commodity falls and consumer
buys only as many units as before the fall in price, he saves some money on this commodity. As a result,
his stock of money increases and his MUm decreases, whereas MUc remains unchanged because his
stock of commodity remains unchanged. Since MUm is less than MUc the utility-maximizing consumer
exchanges money with commodity to equate MUm with MUc, with a view to maximizing his satisfaction.
Consequently, demand for a commodity increases when its price falls.
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40 Chapter 3
Exceptions to the Law of Demand

The law of demand is one of the fundamental laws of economics. The law of demand, however, does not
apply to the following cases.
1. Expectations Regarding Future Prices. When consumers expect a continuous increase in the
price of a durable commodity, they buy more of it, despite the increase in its price, to avoid
the pinch of still higher price in future. Similarly, when consumers anticipate a considerable
decrease in the price in future, they postpone their purchases and wait for the price to fall
further, rather than buy the commodity when its price initially falls. Such decisions of the
consumers are contrary to the law of demand.
2. Prestigious Goods. The law does not apply to the commodities which are used as a ‘status symbol’,
which enhance social prestige or display wealth and richness, e.g., gold,2 precious stones, rare
paintings and antiques. Rich people buy such goods mainly because their prices are high.
3. Giffen Goods. A classic exception to the law of demand is the case of Giffen goods named after
a British economist, Sir Robert Giffen (1837–1910). A Giffen good does not mean any specific
commodity. It may be any inferior but essential commodity much cheaper than its substitutes,
consumed mostly by the poor households and claiming a large part of their income. If the
price of such goods increases (price of its substitute remaining constant), its demand increases
instead of decreasing. For instance, let us suppose that the monthly minimum consumption of
food grains by a poor household is 30 kg including 20 kg of bajra (an inferior good) and 10
kg of wheat (a superior good). Suppose also that bajra sells at Rs 5/kg and wheat at Rs 10/kg.
At these prices, the household spends Rs 200 per month on food grains. That is the maximum it
can afford. Now, if price of bajra increases to Rs 6 per kg, the household will be forced to reduce
its consumption of wheat by 5 kg3 and increase that of bajra by the same quantity in order to
meet its minimum monthly consumption requirement within Rs 200 per month. Obviously,
household’s demand for bajra increases from 20 to 25 kg per month despite increase in its price
and that of wheat falls to 5 kg.
The Market Demand

As already mentioned in Section ‘Meaning of Demand’, market demand for a commodity is the sum of
all individual demands for the commodity at a given price, per unit of time. In this section, we explain
the concept of market demand in detail and illustrate the derivation of the market demand curve.
Suppose, there are only three consumers (A, B and C) of Pepsi and their weekly individual demand for
Pepsi at its different prices is given in Table 3.2. The last column of the table shows the market demand,
i.e., the sum of individual weekly demands for Pepsi cans.
Table 3.2 Weekly Individual and Market Demand for Pepsi Cans
Price (Rs) No. of Pepsi Cans Demanded By Market Demand
=A+B+C
A B C
24 0 0 0 0
20 0 0 4 4
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Price (Rs) No. of Pepsi Cans Demanded By Market Demand

=A+B+C
A B C
16 0 4 8 12
12 3 8 12 23
8 5 12 16 33
4 8 16 20 44
0 11 20 24 55
Graphical Derivation The market demand curve can be drawn straightaway by plotting the data in
the last column of Table 3.2. Alternatively, market demand curve can be derived graphically by horizontal
summation of the individual demand curves at each price of the Pepsi cans. Graphical derivation of the
market demand curve is illustrated in Figure 3.2. The individual demand curves of buyers A, B and C
are shown by the demand curves DA, DB and DC, respectively. Horizontal summation of these demand
curves produces weekly market demand curve for Pepsi cans as shown by the curve DM. Thus, graphically,
a market demand curve is horizontal summation of individual demand curves at different prices.
It is important to note here that there is a significant difference between the individual demand
curves and the market demand curves. The individual demand curves may not slope downward in case
of many seasonal and occasional consumer goods, e.g., a book by an author, an umbrella, a cinema
ticket for a show, or a passenger ticket. But market demand for all such goods slopes downward follow-
ing the decrease in their prices because the fall in price causes increase in the number of consumers.
In other words, even if individual demands are in the form of vertical lines, market demand curve slopes
downward to the right.
24
Price of Pepsi (per can)
20
16
12
4
DA DB DC DM
O 5 10 15 20 25 30 35 40 45 50 55 60
Pepsi cans demanded per week
Figure 3.2 Derivation of Market Demand Curve
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42 Chapter 3
Determinants of Market Demand

Price of a product is the most important determinant of its market demand in the short run. In the long
run, however, market demand for a product is determined by a number of other factors. We will discuss
here some other important quantifiable and non-quantifiable determinants of demand for a product in
the long run.
1. Price of Substitutes and Complementary Goods. The demand for a commodity depends also
on the prices of its substitutes and complementary goods. Two commodities are deemed to be
substitutes for one another if (i) both the goods satisfy the same human need and (ii) change
in price of one affects the demand for the other in the same direction. For instance, tea and
coffee, hamburger and hot-dog, wheat and rice, alcohol and drugs are some common examples
of common substitutes. By definition, the relation between demand for a product and price of
its substitute is of positive nature. When price of a product (say, tea) falls (or increases), then
the demand for its substitute (coffee) falls (or increases). The relationship of this nature is given
in Figure 3.3(a).
A commodity is deemed to be a complement of another when it complements the use of the
other. For example, petrol is a complement to motor vehicles; butter and jam are complements
to bread; milk and sugar are complement to tea and coffee and so on. As regard the relationship
between the price of a good and the demand for its complement, an increase in the price of one
causes a decrease in the demand for another. It implies that the nature of relationship between
the complementary goods is similar to that between the demand for a normal good and its
price. That is, there is an inverse relationship between the demand for a good and the price of its
complement. For instance, an increase (or a decrease) in the price of petrol causes a decrease
(or an increase) in the demand for car, other things remaining the same. The nature of relation-
ship between the demand for a product and the price of its complement is given in Figure 3.3(b).
2. Consumers’ Income and Engel Curves. Consumer income is the basic determinant of the
quantity demanded of a product. It is a common knowledge that the people with higher
disposable income spend a larger amount on consumer goods and services than those with
(a) Substitute goods (b) Complementary goods
Demand curve
Demand curve for car
Price of for tea
coffee
(Rs) Price of
coffee
(Rs)
O O
Demand for tea Demand for car
Figure 3.3 Demand for the Substitute and Complementary Goods
M03_DWIV9400_02_SE_C03.indd 42 06/07/11 10:54 PM

Engel curve
C3
C2
C1
Consumer demand
I
O I1 I2 I3
Income
Figure 3.4 Income–Consumption Curve—The Engel Curve
lower income. The relationship between income and consumer demand for goods and services
was first studied by a German statistician, Ernst Engel; and was illustrated by an income–
consumption curve, called Engel Curve4 as shown in Figure 3.4. In Figure 3.4, the horizontal axis
measures consumer’s income and vertical axis measures the consumer demand. As the figure
shows, as income increases, the demand for goods and services in general goes on increasing.
This shows a positive relationship between income and consumer demand. However, it is impor-
tant to not that the rate of increase in consumer demand with increase in his/her income goes on
decreasing. This fact is shown by the decreasing slope, i.e., ΔC/ΔI, of the Engel curve.
However, it is important to note here that the nature and the slope of the Engel curve depend
on the nature of the commodity—it varies from commodity to commodity.
For the purpose of income–demand analysis, consumer goods and services may be grouped
under four broad categories, viz. (a) essential goods; (b) normal goods; (c) inferior goods; and
(d) prestige and luxury goods. The relationship between income and different kinds of goods is
presented through the Engel curves.
(a) Essential Consumer Goods (ECG). The goods and services which fall in this category are
basically necessities and are consumed by all persons of a society, e.g., food grains, clothes,
vegetable oils, sugar, matches, cooking fuel, and housing. The quantity demanded of such
goods increases with increase in consumer’s income only up to a certain limit, other fac-
tors remaining the same. The relation between goods and services of this category and
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44 Chapter 3
LG
Y
ECG
NG
Consumer’s income
Y2
IG
Y1
O Q1 Q2 X
Quantity demanded
Figure 3.5 Income–Demand Curves
consumer’s income is shown by curve ECG in Figure 3.5. As the curve shows, consumer’s
demand for essential goods increases until his income rises to OY2 and beyond this level of
income, it increases only marginally or insignificantly.
(b) Normal Consumer Goods. In economic sense, normal goods are those which are demanded
in increasing quantities as consumers’ income rises. Clothing is the most important
example of this category of goods. Household furniture, electricity, telephones, household
gadgets, etc., are other examples of this category of goods. The nature of relation between
income and demand for normal goods is shown by the curve NG in Figure 3.5. As the
curve shows, demand for such goods increases with increase in income of the consumer,
but at different rates at different levels of income. Demand for normal goods initially
increases rapidly with the increase in income and later, at a lower rate.
(c) Inferior Consumer Goods. Inferior and superior consumer goods are generally known to
both consumers and sellers. For instance, every consumer knows that bajra is inferior to
wheat and rice; bidi (an indigenous cigarette) is inferior to cigarette, coarse textiles are
inferior to refined ones, kerosene stove is inferior to gas stove; travelling by bus is inferior
to travelling by taxi, and so on. In economic terminology, however, a commodity is deemed
to be inferior if its demand decreases with the increase in consumers’ income. The relation
between income and demand for an inferior good is shown by curve IG in Figure 3.5,
assuming that other determinants of demand remain the same. Demand for such goods
may initially increase with the increase in income (say up to Y1) but it decreases when
income increases beyond this level.
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(d) Prestige and Luxury Goods. Prestige and luxury goods are those which are consumed mostly
by the rich section of the society, e.g., precious stones, diamond, studded jewellery, costly
cosmetics, luxury cars, air conditioners, costly decoration items (e.g., antiques). Demand for
such goods arises only beyond a certain level of consumer’s income. The income–demand
relationship of this category of goods is shown by the curve LG in Figure 3.5.
3. Consumer’s Taste and Preference. Consumer’s taste and preferences play an important role in
determining the demand for a product. Taste and preferences depend, generally, on the social
customs, religious values attached to a commodity, habits of the people, the general life-style of
the society and also the age and sex of the consumers. Change in these factors changes consum-
ers’ taste and preferences. When there is a change in consumers’ liking, tastes and preferences
for certain goods and services following the change in fashion, people switch their consump-
tion pattern from cheaper and old-fashioned goods over to costlier ‘mod’ goods, so long as
price differentials commensurate with their preference. For example, preference for ‘junk food’
in the younger generation has increased as compared to normal home-made nutritious food.
Consumers are prepared to pay higher prices for ‘mod’ goods even if their virtual utility is the
same as that of old-fashioned goods. This fact reveals that tastes and preferences also influence
demand for goods and services.
4. Utility-Maximizing Behaviour. Most consumers have limited income to satisfy their unlimited
wants. They spend their income on various goods they consume in such a manner that the
total satisfaction derived out of their limited income is maximized. A consumer maximizes
his total satisfaction or his total utility when marginal utility, per unit of expenditure, derived
from each commodity is the same. For example, let us suppose that a consumer has to spend
his limited income on bread (b), shirts (s), and cinema shows (c). Given their respective prices
as Pb, Ps, Pc, he would spend his income on these items according to the law of equi-marginal
utility5 so that marginal utility (MU) per unit of expenditure from each of these goods is the
same, i.e.,
MU b MU s MU c
= =
Pb Ps Pc
where MUb, MUs and MUc denote the MU of bread, shirts and cinema shows, respectively.
This is a necessary condition of consumer’s equilibrium. Since MU schedule for each of these
goods would be different, the consumer would buy different quantities of these goods with a
view to equalizing their MU per unit of expenditure. The equilibrium condition itself deter-
mines the quantity of each good (given their MU schedule) which a utility-maximizing con-
sumer would like to buy. Although, in practice, a consumer may not be able to achieve the
theoretical precision of his equilibrium, his pattern of expenditure and the quantity of each
commodity that he would buy would approximate to the equilibrium condition stated above.
Thus, utility-maximizing behaviour also determines the demand for a product.
5. Consumers’ Expectations. Consumers’ expectations regarding the future course of economic
events particularly expectations regarding changes in prices, income, and supply position of
goods, etc., play an important role in determining the demand for goods and services in the
short run. If consumers expect a rise in the price of a commodity, they would buy more of it
at its current price, with a view to avoiding the pinch of price rise in future. On the contrary,
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46 Chapter 3
if consumers expect prices of certain goods to fall, they postpone their purchases of such
goods with a view to taking advantage of lower prices in future, mainly in case of non-essential
goods. This behaviour of consumers reduces (or increases) the current demand for the goods
whose prices are expected to decrease (or increase) in future. Similarly, an expected increase
in income, say, on account of the announcement of revision of pay scales, dearness allowance,
bonus, etc., induces increase in current purchase, and vice versa.
6. Demonstration Effect. When new commodities or new models of existing ones appear in the
market, rich people buy them first. Some people buy new goods or new model of goods because
they have genuine need for them while others buy because they want to exhibit their afflu-
ence. But once new commodities come in vogue, many households buy them, not because they
have a genuine need for them but because others or neighbours have bought these goods. The
purchase by the latter category of buyers is made out of such feelings as jealousy, competition,
equality in the peer group, social inferiority and the desire to raise social status. Purchases
made on account of these factors are the result of ‘Demonstration Effect’ or the ‘Bandwagon
Effect’. These effects have a positive effect on the demand. On the contrary, when a commodity
becomes the thing of common use, some people, mostly rich, decrease or give up the consump-
tions of such goods. This is known as ‘Snob Effect’. It has a negative effect on the demand for
the related goods.
7. Consumer-Credit Facility. Availability of credit to the consumers from the sellers, banks,
relations and friends or from any other source encourages the consumers to buy more than
what they would buy in the absence of credit facility. That is why the consumers who can
borrow more consume more than those who can borrow less or cannot borrow at all. Credit
facility affects mostly the demand for consumer durables, particularly those which require bulk
payment at the time of purchase. For example, the rapid increase in demand for cars and resi-
dential flats in 2008 was due mainly to large availability of loans from both public and private
sector banks.
8. Population of the Country. The market demand for a product depends also on the size
of population. Given the price, per capita income, taste and preferences, etc., the larger the
population, the larger the demand for a product of common use. With increase in population,
employment percentage remaining the same, demand for the product increases. The relation
between market demand for a product (normal) and the size of population is similar to the
income–demand relationship.
9. Distribution of National Income. The distribution pattern of national income also affects the
market demand for different kinds of goods. If national income is evenly distributed, market
demand for normal goods will be the largest. If national income is unevenly distributed, i.e.,
if majority of population belongs to the lower income groups, market demand for essential
goods will be the largest whereas the same for other kinds of goods will be relatively low.
The relationship between market demand for a normal good and national income distribution
is illustrated in Figure 3.6. In the figure, vertical axis measures the Gini efficient6 (a measure of
national income distribution—G) and the horizontal axis measures the quantity demanded of
a normal good. As Figure 3.6 shows, at high value of G = 0.4, quantity demand of a normal good
is small which is equal to Q1. As G decreases from 0.4 to 0.1 (i.e., income distribution becomes
more and more even) quantity of a normal goods demanded increases from Q1 to Q2.
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Value of Gini-coefficient (G) 0.4
0.3
0.2
0.1
O Q1 Q2
Quantity demanded
Figure 3.6 Gini-Coefficient and Demand
Demand Function
In mathematical language, a function is a symbolic statement of relationship between two or more
interrelated variables – generally one dependent and one or more independent variables. Demand func-
tion states the relationship between demand for a product (the dependent variable) and its determinants
(the independent variables). Let us consider the most common form of a demand function, i.e., the
short-run demand function, which consists of quantity demanded of a product (D) – the dependent
variable – and price of the product (P) – the independent variables. Assume that the quantity demanded
of a commodity X (Dx) depends only on its price (Px), other factors remaining constant. The demand
function will then read as ‘demand for a commodity (Dx) depends on its price (Px)’. The same statement
may be written in its functional form as
Dx = f (Px) (3.1)
where Dx is demand for commodity X (the dependent variable) and Px is price of X (the independent
variable).
The function (3.1), however, states only that there is a relationship between quantity demanded of
commodity X and its price. More specifically, it states that the quantity demanded of X depends on its
price. It does not give the quantitative relationship between Dx and Px. When quantitative relationship
between Dx and Px is known, the demand function may be expressed in the form of an equation as
Dx = a − bPx (3.2)
where a and b are constants—a is intercept (the Dx at zero price) and b quantifies the relationship
between Dx and Px.
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48 Chapter 3
The form of equation depends on the empirical demand–price relationship. The two most common
forms of demand–price relationship are linear and non-linear. Accordingly, the demand function may
take a linear or a non-linear form. There is another kind of demand function, called dynamic demand
function, which takes into account all the determinants of demand. The nature and form of these demand
functions are explained and illustrated below.
Linear Demand Function A demand function takes a linear form when the ratio of change in
quantity demand due to change in price, i.e., ∆D/∆P, remains constant for all changes in price. The sim-
plest form of a linear demand function is given by Eq. (3.2). In Eq. (3.2), the alphabet a denotes total
demand at zero price and b = ∆D/∆P, also a constant, denotes slope of the demand curve.
Given the demand function (3.2), if values of a and b are known, total demand (Dx) for any given
price (Px) can easily be obtained. For example, let us assume that a = 100 and b = 5. Now the demand
function (3.2) can be written as
Dx = 100 − 5Px (3.3)
Given Eq. (3.3), the value of Dx can be easily obtained for any value of Px. For example, if Px = 4,
Dx = 100 − 5( 4 )
= 80
and if Px = 10,
Dx = 100 − 5(10)
= 50
Thus, a demand schedule can be prepared assigning different values to Px. When this demand sched-
ule is plotted, it produces a linear demand curve as shown in Figure 3.7.
20
15 D
x!
10
Price (PX)
0
"
10 5P
x
5
4
O
20 25 40 50 60 80 100
Quantity (DX)
Figure 3.7 Linear Demand Function
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From the demand function, one can easily derive a corresponding price function. For example, given
the demand function (3.2), the price function may be written as
a − Dx
Px = (3.4)
b
or
a 1
Px = − D
b b x
Denoting a/b by a’ and 1/b by b’, Eq. (3.4) may be written as

Px = a’ − b’Dx
Given the demand function (3.3), price function can be derived as follows:
if
Dx = 100 − 5Px,
then
Px = 20 − 0.20Dx
When plotted, the price function produces the same demand curve as shown in Figure 3.7.
Non-Linear Demand Function A demand function is said to be non-linear or curvilinear

when the slope of a demand curve (∆P/∆Q) changes all along the demand curve. A non-linear demand
function yields a demand curve instead of a demand line. The non-linear demand curve is shown in
Figure 3.8. A non-linear demand function, generally, takes the form of a power function as
Dx = aPx-b (3.5)
or of a rectangular hyperbola of the form
a
Dx = b (3.6)
Px + c
where a, b, c > 0.
Note that the exponent (−b) of the price in a non-linear demand function (3.5) gives the measure of
the coefficient of price elasticity of demand. In case of rectangular hyperbola type of demand function,
the elasticity of demand remains constant throughout. Therefore, demand function given in Eqs. (3.5)
and (3.6) is also called Constant Elasticity Demand Function.
Dynamic Demand Function The demand function with price as a single independent variable,
as described above, may be termed as short-term demand function. A short-run demand function is
based on the assumption that all factors other than price remain constant. In the long run, however,
most demand determinants do not remain constant, they keep changing. Therefore, market demand for
a product depends on the composite impact of all the determinants operating simultaneously. Therefore,
in a long-run or dynamic demand function, all the relevant determinants of demand for a product are
included in the demand function. For instance, in the long run, individual demand (Dx) for a commodity
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50 Chapter 3
Price (PX)
DX
Quantity (DX)
Figure 3.8 Non-linear Demand Function

X depends on a number of factors, viz., the price (Px) of the product X, consumer’s income (Y), consumer’s
wealth (W), price of the substitute (Py), price of complementary goods (Pc), consumer’s taste (T), adver-
tisement expenditure (A) and expectations about the future price (FP) of X. In that case, demand func-
tion can be expressed as
Dx = f (Px, Y, W, Py, Pc, T, A, FP) (3.7)
If relationship between Dx and the independent variables Px, Y, W, Py, Pc, and A is of linear form, the
estimable form of the demand function is expressed as
Dx = a − bPx + cY + wW + dPy − gPc + jA (3.8)
where a is a constant term and b, c, w, d, g and j are the coefficient of relation between Dx and the
respective independent variables.
In a market demand function for a product, other independent variables, viz., size of population (N)
and a measure of income distribution, i.e., Gini-coefficient (G), may also be included.
Shift in Demand Curve

A short-run demand curve is drawn on the basis of a demand schedule or a short-run demand function.
So long as price–demand relationship is fixed, the demand curve remains fixed at its position, as shown
in Figure 3.7. However, given the price–demand relationship, if there is a change in other determinants of
demand, e.g., in consumer’s income and in the price of substitute or complementary goods, the demand
curve may shift upward or downward depending on the direction of the change in other determinants. Let
us suppose that the demand curve, D2, in Figure 3.9 is the original demand curve for commodity X. As
shown in the figure, at price OP2, demand equals OQ2 units of X, other factors remaining constant. But if any
of the other factors (e.g., consumers’ income or price of the substitutes) changes, it will change consumer’s
M03_DWIV9400_02_SE_C03.indd 50 06/07/11 10:55 PM

E1 E2 E3
P2
Price of X (Px)
P1
D3
D2
D1
O Q1 Q2 Q3
Quantity demanded of X (QX)
Figure 3.9 Shift in Demand Curve
ability and willingness to buy commodity X. For example, if consumer’s disposable income decreases due
to, say, increase in income tax, he may be able to buy only OQ1 units of X instead of OQ2 at price OP2. As a
result, demand curve D2 shifts downward D1. This is true for the whole range of price of X, that is, consumers
would be able to buy less at all other prices. This will cause a downward shift in demand curve from D2 to D1.
Similarly, increase in disposable income of the consumer, say, due to reduction in taxes, may cause an upward
shift from D2 to D3. For example, suppose consumer is initially at equilibrium at point E2 on demand curve D2.
Let consumer’s income increase, all other factors remaining constant, so that he can buy more of commod-
ity X. As a result, the consumer shifts to point E3 on demand curve D3 and can buy OQ3 units of commodity
X. This condition applies to all the levels of prices. So the demand curve shifts from the position of D2 to D3.
Such changes in the location of demand curves are known as shifts in demand curve.
Reasons for Shift in Demand Curve Shifts in a demand curve may take place owing to the
change in one or more of the determinants of demand. Consider, for example, the decrease in demand
for commodity X by Q1Q2 in Figure 3.8. This fall in demand may have been caused by any or many of
the following reasons:
1. Fall in the consumer’s income so that consumer can buy only OQ1 of X at price OP2—it is called
income effect;
2. Fall in the price of substitute of commodity X so that the consumers find it gainful to substitute
Q1Q2 of X for its substitute—it is substitution effect;
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52 Chapter 3
3. Advertisement made by the producer of the substitute changes consumer’s taste or preference
against commodity X so much that they replace Q1Q2 of it with its substitute—again a advertise-
ment effect;
4. Increase in the price of complements of X so that consumers can afford only OQ1 of X. This is
price effect of the complementary good; and
5. Other reasons such as commodity X is going out of fashion, its quality has deteriorated, con-
sumers’ technology has so changed that only OQ1 of X can be used, and change in season if
commodity X has only seasonal use.
THE SUPPLY SIDE OF THE MARKET

In a market economy, while buyers of a product constitute the demand side of the market, sellers of that
product make the supply side of the market. In this section, we discuss the supply side of the market.
Market Supply
Supply Means the Quantity of a Commodity Which Its Producers or Sellers Offer for Sell at a Given
Price, Per Unit of Time Market supply, like market demand, is the sum of supplies of a commodity made
by all individual firms or suppliers.
The Law of Supply

In general sense of the term, the supply of a commodity depends on its price. In other words, supply of
a product is the function of its price. The law of supply is expressed generally in terms of price–quantity
relationship. The law of supply can be stated as follows: The supply of a product increases with the increase
in its price and decreases with decrease in its price, other things remaining constant. It implies that the
supply of a commodity and its price are positively related. This relationship holds under the assumption
that “other things remain the same”. “Other things” include technology, price of related goods (substi-
tute and complements), consumers’ taste and preferences, and weather and climatic conditions in case of
agricultural products.
The Supply Schedule and Supply Curve

The law of supply can be depicted by a supply schedule and a supply curve. A supply schedule is a table
showing different prices of a commodity and the corresponding quantity that suppliers are willing to
offer for sale. Table 3.3 presents a hypothetical supply schedule of shirts, i.e., number of shirts supplied
per month at different prices.
The supply curve is a graphical presentation of the supply schedule. The supply curve SS’ given in
Figure 3.10 has been drawn by plotting the price–supply data given in Table 3.3. The points S, P, Q, R, T
and S’ show the price–quantity combinations on the supply curve SS’. The supply curve, SS’, depicts the
law of supply. The upward slope of the supply curve indicates the rise in the supply of shirts with the rise
in its price and vice versa. That is, the supply of shirts increases with the rise in its price and vice versa. For
example, at price Rs 200, only 35,000 shirts are supplied per month. When price rises to Rs 400, supply
increases to 60,000 shirts.
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Table 3.3 Supply Schedule of Shirts

Price (in Rs) Supply (shirts in ‘000)
100 10
200 35
300 50
400 60
600 75
800 80
900
S'
800
700
600 T
500
400 R
300 Q
200 P
100 S
10 20 30 40 50 60 70 80 90
No. of shirts ('000)
Figure 3.10 Supply Curve of Shirts
As shown in Figure 3.10, a supply curve has a positive slope. The positive slope of the supply curve is
caused by seller’s desire to make larger profit and, more importantly, by the rise in cost of production.
In fact, when price of a commodity increases, its suppliers tend to supply more and more. To supply
more and more, they need to produce more and more. When they increase production, cost of produc-
tion increases due to the law of diminishing returns. In fact, supply curve is derived from the marginal
cost curve. (The derivation of supply curve on the basis of the marginal cost curve is discussed in detail
and illustrated ahead in Chapter 15.)
Shift in the Supply Curve

We have shown above that a change in the price of a commodity causes a change in its quantity supplied
along a given supply curve. Although price of a commodity is the most important determinant of its
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54 Chapter 3
S'
S
S''
Price
Quantity
Figure 3.11 Shift in the Supply Curve
supply, it is not the only determinant. Many other factors influence the supply of a commodity. Given the
supply curve of a commodity, when there is a change in its other determinants, the supply curve shifts
rightward or leftward depending on the effect of such changes. Let us now explain how other determi-
nants of supply cause shift in the supply curve.
1. Change in Input Prices. Input prices include the price of labour, raw materials, overheads, etc.
When input prices decrease, the use of inputs increases. As a result, product supply increases
and the supply curve SS shifts to the right to SS”, as shown in Figure 3.11. Similarly, when input
prices increase, product supply curve shifts leftward from SS to SS’.
2. Technological Progress. Technological progress reduces cost of production or increases labour
productively or do both. Technological progress that reduces cost of production or increases
efficiency causes increase in product supply. For instance, introduction of high-yielding vari-
ety of paddy and new techniques of cultivation increased per-acre yield of rice in India in the
1970s. Such changes make the supply curve shift to the right.
3. Product Diversification and Cost Reduction. In production of many commodities, it is pos-
sible to produce some other goods which require a similar technology. For example, a refrigera-
tor company can also produce ACs; Tatas famous for truck production can also produce Nano
and other types of cars; Maruti Udyog can produce trucks and so on. Product diversification
may cause reduction in the production cost of the main product. This may lead to the rise in the
supply of the main product due to capacity utilization for profit maximization.
4. Nature and Size of the Industry. The supply of a commodity depends also on whether an
industry is monopolized or competitive. Under monopoly, supply of a product is shorter than
it is in a competitive market. When a monopolized industry is made competitive, the total
supply increases. Besides, if size of an industry increases due to new firms joining the industry,
the total supply increases and supply curve shifts rightward.
5. Government Policy. When government imposes restrictions on production, e.g., import quota
on inputs, rationing of or quota imposed on input supply, etc., production tends to fall. Such
restrictions make supply curve to shift leftward.
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6. Non-Economic Factors. The factors like labour strikes and lock-outs, war, droughts, floods,
communal riots, epidemics, etc. also affect adversely the supply of commodities making supply
curve shift leftward.
Supply Function
A supply function is a mathematical statement which states the relationship between the quantity sup-
plied of a commodity and its determinants. The short-run market supply function is based on the law of
supply. The law of supply states only the nature of relationship between the price and the quantity sup-
plied, i.e., supply increases with the increase in price. A supply function that quantifies this relationship
is written as
Qx = dPx (3.9a)
where Qx denotes the quantity supplied of commodity X, Px denotes its price and d gives the measure of
relationship between Qx and Px.
Once the relationship between Qx and Px is measured in numerical terms, i.e., the numerical value of
‘d’ is known, then the supply function can be expressed numerically. For example, suppose d = 10, then
the supply function can be expressed as
Qx = 10Px (3.9b)
Given the supply function (3.9b), a supply schedule can be obtained by substituting numerical values
for Px. For example, if Px = 2, Qx = 20 and if Px = 5, Qx = 50. By plotting the supply schedule, a supply curve
can be obtained. (For procedure, refer to the section on demand function).
THE MARKET EQUILIBRIUM: THE EQUILIBRIUM OF DEMAND

AND SUPPLY
Determination of Price in a Free Market
In sections ‘The Demand Side of the Market’ and ‘The Supply Side of the Market’, we have explained
the laws governing the market forces demand and supply — and how demand and supply behave in
response to the change in price and other determinants. In this section, we explain how demand and
supply strike a balance, how market attains equilibrium, and how equilibrium price is determined in a
free market. A free market is one in which market forces of demand and supply are free to take their own
course and there is no outside control on price, demand and supply.
The Concept of Market Equilibrium

In physical sense, the term equilibrium means the ‘state of rest’. In general sense, it means balance in
opposite forces. In the context of market analysis, equilibrium refers to a state of market in which quantity
demanded of a commodity equals the quantity supplied of the commodity. The equality of demand and
supply produces an equilibrium price. The equilibrium price is the price at which quantity demanded of a
commodity equals its quantity supplied. That is, at equilibrium price, demand and supply are in balance.
Equilibrium price is also called market-clearing price. Market is cleared in the sense that there is no
unsold stock and no unsupplied demand.
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56 Chapter 3
Table 3.4 Monthly Demand and Supply Schedules for Shirts

Price per Shirt Demand Supply Market Position Effect on Price
(Rs) (‘000 shirts) (‘000 shirts)
100 80 10 Demand exceeds supply Rise
200 55 28 Demand exceeds supply Rise
300 40 40 Equilibrium Stable
400 28 50 Supply exceeds demand Fall
Determination of Market Price

The equilibrium price of a commodity in a free market is determined by the market forces of demand
and supply. In order to analyse how equilibrium price is determined, we need to integrate the demand
and supply curves. For this purpose, let us use the example of shirts. Let us suppose that the market
demand and supply schedules for shirts are given as shown in Table 3.4.
As the table shows, there is only one price of shirts (Rs 300) at which the market is in equilibrium, i.e.,
the quantity demanded equals the quantity supplied at 40,000 shirts per month. At all other prices, the
shirt market is in disequilibrium. That is, there is imbalance between supply and demand. When market
is in the state of disequilibrium, either demand exceeds supply or supply exceeds demand. As the table
shows, at all prices below Rs 300 per shirt, demand exceeds supply showing shortage of shirts in the
market. Likewise, at all prices above Rs 300, supply exceeds demand showing excess supply.
In a Free Market, Disequilibrium Itself Creates the Condition for Equilibrium When
there is excess supply, it means unsold stock. The unsold stock causes a loss to the firms. This forces firms
to cut down their supply and price. Thus, excess supply itself forces downward adjustments in the price
and the quantity supplied. The process of downward adjustments continues till supply equals demand.
Similarly, when there is excess demand, it forces upward adjustments in the price and quantity demanded.
When there is excess demand, firms take the advantage of the market situation and increase supply. When
they increase production, cost of production goes up. But consumers, given their demand curve, are will-
ing to pay a higher price. This process continues until demand equals supply. In our example, the process
of downward and upward adjustments in price and quantity continues till the price reaches Rs 300 and
quantities supplied and demanded per month balance at 40,000 shirts. This process is automatic. Let us
now look into the process of price and quantity adjustments called market mechanism.
Market Mechanism: How Market Brings About Balance

Market mechanism is a process of interaction between the market forces of demand and supply to
determine equilibrium price. To understand how it works, let us explain the process through our own
example. Suppose price of the shirts be initially set at Rs 100. As shown in Table 3.4, at this price, the
quantity demanded of shirts is 80,000 and the quantity supplied is 10,000 shirts. Thus, at price Rs 100 per
shirt, demand exceeds the quantity supplied by 70,000 shirts. The shortage will force buyers to bid higher
price to buy the desired number of shirts. This gives sellers an opportunity to raise the price. Increase in
price enhances the profit margin. This induces firms to produce and sell more in order to maximize their
M03_DWIV9400_02_SE_C03.indd 56 06/07/11 10:55 PM

profits. This trend continues till price rises to Rs 300. As Table 3.4 shows, at price Rs 300, the buyers are
willing to buy 40,000 shirts. This is exactly the number of shirts that sellers would like to sell at this price.
At this price, there is neither shortage nor excess supply of shirts in the market. Therefore, Rs 300 is the
equilibrium price. The market is, therefore, in equilibrium.
Similarly, at all prices above Rs 300, supply exceeds demand showing excess supply of shirts in the
market. The excess supply forces the competing sellers to cut down the price. Some firms find low price
unprofitable and go out of market and some cut down their production. Therefore, supply of shirts goes
down. On the other hand, fall in price invites more customers. This process continues until price of shirts
falls to Rs 300. At this price, demand and supply are in balance and market is in equilibrium. Therefore,
the price at Rs 300 per shirt is equilibrium price.
Graphical Illustration of Price Determination

The determination of equilibrium price is illustrated graphically in Figure 3.12. The demand curve DD’
and the supply curve SS’ have been drawn by plotting the demand and supply schedules, respectively,
(given in Table 3.4) on the price and quantity axes.
As Figure 3.12 shows, demand and supply curves intersect at point E determining the equilibrium price
at Rs 300. At this price, the quantity demanded (40,000 shirts) per month equals the quantity supplied.
Thus, the equilibrium price is Rs 300 and the equilibrium quantity is 40,000 shirts. The equilibrium
D S'
700
A B
600
Surplus
500
400
300 E
200
J Shortage
K
100
D'
S
O 15
10 20 30 40 50 60 70 80 Q
Shirts (in '000) per month
Figure 3.12 Equilibrium of Demand and Supply: Price Determination
M03_DWIV9400_02_SE_C03.indd 57 06/07/11 10:55 PM

58 Chapter 3
condition is not fulfilled at any other point on the demand and supply curves. Therefore, if price is set
at any price other than Rs 300, there would be either excess supply or excess demand for shirts in the
market.
Let us now see how market works to bring about balance in demand for and supply of shirts. Let the
price be initially set at Rs 600. At this price, suppliers bring in a supply of 60,000 shirts, whereas buy-
ers are willing to buy only 15,000 shirts. The supply, obviously, far exceeds the demand. As Figure 3.12
shows, the excess supply equals, AB = 60,000 − 15,000 = 45,000 shirts. The suppliers would, therefore,
lower down the price gradually in order to get rid of the unsold stock and cut down the supply simulta-
neously. Besides, when price falls, demand for shirts increases too. In this process, the supply–demand
gap is reduced. This process continues until price reaches Rs 300 at point E, the point of equilibrium
where demand and supply equal at 40,000 shirts. At this price, the market is in equilibrium and there is
no inherent force at work which can disturb the market equilibrium.
Likewise, if price is initially set at Rs 100, the buyers would be willing to buy 80,000 shirts, whereas
suppliers would be willing to supply only 10,000 shirts. Thus, there would be a shortage of 70,000 shirts
as shown by the distance JK in Figure 3.12. The shortage will force the buyers to bid a higher price. This
will lead to increase in price which will encourage the suppliers to increase their supply. This process
of adjustment will continue as long as demand exceeds supply. When price rises to Rs 300, the market
reaches its equilibrium.
Price Determination by Demand and Supply Functions

In the preceding section, we have illustrated graphically how equilibrium of demand and supply is
determined at the point of intersection of the demand and supply curves. If demand and supply func-
tions are known, the equilibrium quantity and equilibrium price can also be determined by using the
demand and supply functions.
Let demand function for a commodity X be given as
Dx = 150 − 5Px
and supply function as
Sx = 10Px
We know that at market equilibrium, the quantity supplied equals the quantity demanded, i.e., Dx = Sx.
So the equilibrium price can be determined by equating the supply and demand functions. By
equating the demand supply functions, we get
S x = Dx
10 Px = 150 − 5Px
Px = 10
Thus, given the supply and demand functions, equilibrium price Px = 10 and the quantity supplied
and demanded are also in equilibrium.
The algebraic determination of equilibrium price and quantity is illustrated graphically in Figure 3.13.
The demand curve Dx’ has been drawn by using the demand function Dx = 150 − 5Px and the supply
curve Sx’ by using the supply function Sx = 10Px. As the figure shows, demand and supply curves intersect
at point P. A perpendicular drawn from point P to the quantity axis determines the equilibrium quantity
M03_DWIV9400_02_SE_C03.indd 58 06/07/11 10:55 PM

Px
20
Sx
Qd
=1
15
50
Px
5P
10
!
x
Qs
Price (Rs)
10 P
Dx
Qx
O 20 40 60 80 100 120 140 160 180 200
Quantity (units)
Figure 3.13 Determination of Equilibrium Price and Quantity
at 100 units and a line drawn from point P to the price axis determines the equilibrium price at Rs 10.
At this price, the quantity demanded equals the quantity supplied and hence the product market is in
equilibrium.
SHIFT IN DEMAND AND SUPPLY CURVES AND MARKET

EQUILIBRIUM
Shift in Demand Curve
Whenever there is a shift in the demand and/or supply curve, there is also a shift in the equilibrium
point. The effect of shift in the demand curve on the equilibrium is shown in Figure 3.14(a). Suppose
that the initial demand curve is given by the curve DD1 and supply curve by SS. The demand and supply
curves intersect at point P. The equilibrium price is determined at PQ and equilibrium quantity at OQ.
Let the demand curve now shifts from its position DD1 to DD2, supply curve remaining the same. The
demand curve DD2 intersects the supply curve SS’ at point M. Thus, shift in the demand curve causes
M03_DWIV9400_02_SE_C03.indd 59 06/07/11 10:55 PM

60 Chapter 3
S1
D D
S S2
D
P
M
M
Price
Price
S
D2
S
S S
D1
O Q N O Q N
Quantity Quantity
(a) (b)
Figure 3.14 (a) Shift in Demand Curve and Equilibrium and (b) Shift in Supply Curve
and Equilibrium
a shift in the equilibrium from point P to point M. At the new equilibrium, the quantity demanded and
supplied increases from OQ to ON and the price increases from PQ to MN. Note that, the supply curve
remaining the same, a rightward shift in the demand curve results in a higher equilibrium price and a
higher equilibrium quantity. A downward shift in the demand curve from DD2 to DD1 produces a reverse
result—fall in both the equilibrium price and the quantity demanded and supplied.
Shift in Supply Curve

Figure 3.14(b) shows the effect of shift in the supply curve on the equilibrium, demand curve remaining
the same. Suppose that the demand curve is given as DD and initial supply curve as SS1. The curves DD
and SS1 intersect at point P, determining equilibrium price at PQ and equilibrium demand and supply
at OQ. Let the supply curve now shifts from its position SS1 to SS2, demand curve remaining unchanged.
The new supply curve SS2 intersects the demand curve at point M. Thus, a new equilibrium takes place
at point M where equilibrium price is MN and equilibrium quantity is ON. Note that a rightward shift
in the supply curve, demand curve remaining the same, causes equilibrium price to fall and output to
increase.
Parallel Shift in Demand and Supply Curves

We have seen above that a rightward shift in the demand curve causes a rise in market price
(Figure 3.14(b)), and a rightward shift in the supply curve (Figure 3.14(b)) causes a fall in the market
price. Let us now look at the effect of simultaneous and parallel shifts in demand and supply curves on
the equilibrium price and output. The effect of a simultaneous and parallel rightward shift in demand
and supply curves on the equilibrium price and output depends on how big or small is the relative shift in
demand and supply curves. The simultaneous and parallel shifts in demand and supply curves in different
measures and its effect on equilibrium price and output are illustrated in panels (a) and (b) of Figure 3.15.
Figure 3.15(a) shows (i) a parallel and equal shift in both demand and supply curves and (ii) a
larger shift in supply curve than the demand curve and their effect of the market price and the output.
M03_DWIV9400_02_SE_C03.indd 60 06/07/11 10:55 PM

D (a) D (b)
S1
D S1
S2 D
S2
S3
E1 E2
P1
Price
Price
P2 E2
P0 E3 P1 E1
S
S
S S
S D2
D2
D1
D1
O O
Q1 Q2 Q3 Q1 Q2
Quantity Quantity
Figure 3.15 Parallel Shift in Demand and Supply Curves and Its Effect on the Equilibrium
Price and Output
To explain it further, let us suppose that the initial demand and supply curves are given as DD1 and
SS1, respectively. These demand supply curves intersect at point E1 determining the equilibrium price
at P1 and the equilibrium output at Q1. Now let us suppose that there is a parallel and equal shift in
both demand and supply curves—demand curve from DD1 to DD2 and supply from SS1 to SS2. The
demand curve DD2 and the supply SS2 intersect at point E2 determining a new and a greater equilibrium
output (Q2), while price remains constant at the previous level (P1). This means that when there is a
parallel and equal shift in the demand and supply curves, price remains the same but output increases.
Let us now see what happens when the shift in the supply curve is greater than that in the demand
curve. Let us suppose that demand curve shifts from DD1 to DD2 and supply from SS1 to SS3. Note that
the shift in the supply curve is obviously greater than that in the demand curve. As a result, market
equilibrium shifts from point E1 to E3 determining equilibrium price at E0 and equilibrium output at Q3.
Note that a greater shift in the supply curve than the demand curve results in a lower price and a much
greater equilibrium output.
Figure 3.15(b) shows the effect of a larger shift in the demand curve than that in the supply curve.
Suppose initial demand curve is given as DD1 and the supply curve as SS1. As the figure shows, the
original demand and supply curves intersect at point E1 determining the equilibrium price at P1 and
the equilibrium output at Q1. Now let the demand curve shifts from DD1 to DD2 and the supply curve
shifts from SS1 to SS2. Note that the shift in the demand curve is much larger than the shift in the supply
curve. The new demand and supply curves intersect at point E2 determining the equilibrium price at P2
and the equilibrium output at Q2. Note that if the upward shift in the demand curve is greater than that
in the supply curve, both equilibrium price and output increase. These are theoretical propositions often
so observed in real life.
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62 Chapter 3
STABILITY OF MARKET EQUILIBRIUM

In Section ‘The Market Equilibrium: The Equilibrium of Demand and Supply’, we have discussed how
market forces—demand and supply—interact to determine the market equilibrium price and output.
And, in Section ‘Shift in Demand and Supply Curves and Market Equilibrium’, we have shown that when
there is a shift in the demand curve or in the supply curve or in both, the market reaches a new equilib-
rium point where it remains stable. These explanations of market equilibrium might create an impres-
sion that market equilibrium once determined remains stable and when external factors disturb the
market equilibrium, market forces do interact again to restore the market equilibrium. A question arises
here: Does market equilibrium necessarily return to its original position and remains stable? The answer is
that market equilibrium may return to its original position and be stable in a static economy or station-
ary economy but not in a dynamic economy. Before we proceed further let us understand the meaning of
static economy and the dynamic economy.
A static economy is a motionless economy in the sense the nothing changes in the economy and the
same output is produced and sold at the same price, per unit of time. A static economy is, in fact, a model
economy, not a realistic economy. If some changes do take place in a static economy, the consequent
changes in demand, supply and price are supposed to be instant with no time lag.
A dynamic economy, in contrast, is one in which economic conditions keep changing and a change in
the market conditions creates conditions for other changes also. In fact, change is a continuous process
in a dynamic economy though there is a time lag in the process of market adjustments.
Turning to the question of stability of the equilibrium, in a dynamic economy, market equilibrium may
remain or may not remain stable. It all depends on the demand and supply conditions and on the time
lag, i.e., the time taken by the market to adjust to the changing conditions. A question arises here: How
does market equilibrium behave in a dynamic economy? The economists have offered an answer to this
question through an analytical system called Cobweb theorem. In this section, we explain the stability
and instability of the market equilibrium under dynamic conditions through the Cobweb theorem.
Market Equilibrium Under Dynamic Conditions

As already noted, an important feature of the dynamic economy is the time lag in the adjustment process
of the market forces—there is no instant adjustment. For the sake of simplicity in our analysis here, we
assume that supply is a lagged function of price, while demand is a normal function of price. With these
assumptions, we explain the stability and instability of the market equilibrium in a dynamic economy.
The simplest way to illustrate the stability and instability of equilibrium position under dynamic condi-
tions is provided by ‘Cobweb Theorem’, The name, ‘Cobweb’ Theorem, has been derived from the appear-
ance of the diagram it produces. The Cobweb Theorem can be stated in the form of three theorems.
1. Theorem I. If slope of demand curve (∆Q/∆P) is less than that of supply curve (∆S/∆P), the
equilibrium is stable: the system is convergent.
2. Theorem II. If ∆Q/∆P > ∆S/∆P, equilibrium is unstable. The adjustment process is divergent or
oscillatory.
3. Theorem III. If ∆D/∆P = ∆S/∆P, equilibrium is non-damped oscillating: the system keeps
circulating around the original equilibrium with a constant change in the price and in the
quantity demanded and supplied.
Theorem I: Stable Equilibrium Under Dynamic Conditions As mentioned above, an

equilibrium position is said to be stable if displacement of equilibrium itself sets forces into action which
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restore the initial equilibrium position. Figure 3.16 illustrates the stable equilibrium, the Theorem I.
A necessary condition for stable equilibrium is that the slope of the demand curve (∆D/∆P) is greater
than the slope of the supply curve (∆S/∆P). The demand and supply curves in Figure 3.16 satisfy this
condition. As the figure shows, demand and supply curves, DD¢ and SS¢, respectively, intersect each
other at point P determining equilibrium price at OP3 and equilibrium output at OQ4. If price rises for
some reason in, say, period t0 to OP5, equilibrium will be disturbed. For, at the new price demand falls
to OQ1 which is much less than the supply OQ4 at the old price. In period t1, however, supply rises to
OQ6 which far exceeds the current demand. The supply exceeds demand by O1Q6. Consequently, price
falls to OP1 causing a rise in demand to OQ6. But in response to fall in price, supply decreases in period
t2 to OQ2. The demand now exceeds supply by Q2Q6. Therefore, price rises to OP4, causing an increase in
supply by Q2Q5 in period t2. It is now the turn of price to adjust itself to the existing demand and supply
conditions. This whole process is repeated period after period. Note that each time the process of adjust-
ment is repeated, the magnitude of change in supply, price and demand goes on decreasing. For example,
in period t1 supply increases by Q1Q6, and in period t2 it decreases by Q2Q6 and in period t3 it increases
by Q2Q5. Note that Q1Q6 > Q2Q5 > Q3Q4. So is the case with price and demand. As a result of decreas-
ing magnitude in changes, the system in Figure 3.16 converges to the original equilibrium point P.
Thus, the equilibrium once displaced sets the forces which restore the original equilibrium position.
The equilibrium position is therefore stable.
S'
D
P5
P4
Price
P3 P
P2
P1
D'
S
O Q1 Q2 Q3 Q4 Q5 Q6
Quantity
Figure 3.16 Stable Equilibrium
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64 Chapter 3
Theorem II: Unstable Equilibrium Under Dynamic Conditions Let us now discuss the
unstable equilibrium, i.e., Theorem II. If supply curve has a greater slope than of the demand curve, i.e.,
if ∆S/∆P > ∆D/∆P, then the process of adjustment makes the price and quantity diverge away and away
from the equilibrium position. In this case, the amplitude of change in price and output around the
equilibrium point goes on increasing and this creates an explosive situation. The original equilibrium
position is therefore never regained. The case of unstable equilibrium is illustrated in Figure 3.17. Note
that the slope of the supply curve, SS’, is greater than that of the demand curves, DD1 and DD2, i.e.,
∆S/∆P > ∆D/∆P. As the figure shows, the original equilibrium position is at point P. Now let the demand
curve, DD1 shift upward to DD2. Owing to upward shift in demand curve, price in period, say, t0 rises
from OP2 to OP3. Since there is a supply lag of one period, supply increases in period t1 from OQ2 to QO3.
Now, supply exceeds demand by Q2O3 and hence price falls to OP1. In the following period, t2, supply
decreases by Q1Q3 (= NM) due to fall in price to OP1. Now demand exceeds supply and, therefore, price
rises to OP4. Note that in each period of adjustment, the amplitude of fluctuations in price and quantity
goes on increasing causing movement of price–quantity combination further and further away from the
original equilibrium points. Therefore, equilibrium becomes unstable.
This process, however, cannot continue infinitely. The explosive conditions on the one hand and
scarcity of resources, on the other, force the producers to restrict the supply so that the slope of supply
D
D S’
R T
P4
K L
P3
P2
P
Price
M
P1
N
P0
S D2
D1
O
Q1 Q2 Q3 Q4
Quantity
Figure 3.17 Unstable Equilibrium: Dynamic Analysis
M03_DWIV9400_02_SE_C03.indd 64 06/07/11 10:55 PM

curve is reduced. When slope of the supply curve becomes less than that of the demand curve, price and
output converge to a new equilibrium position (as shown in Figure 3.16).
Theorem III: Undamped Oscillating Equilibrium We have illustrated above the stable and
unstable equilibrium under dynamic conditions.7 Here, we illustrate another kind of unstable equilib-
rium, called undamped oscillating equilibrium. The undamped oscillating equilibrium is one which when
displaced keeps shifting in a circular way around the original equilibrium point with a constant change
in demand, supply and price. This happens when ∆D/∆P = ∆S/∆P, i.e., the slope of demand curve equals
the slope of supply curve. The undamped oscillatory equilibrium is illustrated in Figure 3.18. The origi-
nal equilibrium point is shown at point E where equilibrium price is OP2 and output is OQ2.
Now, if the equilibrium point E is displaced by a change in price, equilibrium will keep circling round
the original point E and will never return to its original position. For example, if price rises from OP2
to OP3, demand decreases from OQ2 to OQ1 and supply increases from OQ2 to OQ3. This causes an
excess supply of Q1Q3 = AB. This excess supply causes a fall in price by P1P3 = BC. A fall in price by BC
causes demand to rise and supply to fall which results in an excess demand of Q1Q3. This excess demand
pushes price up by P1P3. This process of change in quantity and price continues indefinitely. Note that the
change in price each time is the same P1P3 = AD = BC and change in quantity each time is also the same
Q1Q3 = DC = AB. Therefore, the path of equilibrium movement is fixed. This is so because both demand
and supply curves have an equal slope, i.e., ∆D/∆P = ∆S/∆P.
S S'
A B
P3
E
Price
P2
P1
D C
S
D'
O Q1 Q2 Q3 Q
Quantity
Figure 3.18 Undamped Oscillating Equilibrium
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66 Chapter 3
CONCLUSION
In the preceding section, we have discussed whether market equilibrium remains stable or unstable if
it is disturbed by some external factors. It may be concluded from the foregoing discussion that market
equilibrium remains stable under static economic conditions. Under dynamic conditions, however, mar-
ket equilibrium may remain stable or unstable depending on the elasticity of demand and supply. In fact,
whether market equilibrium remains stable or unstable under dynamic economic conditions depends
on the relative elasticity, rather slope, of the demand and supply curves. Going by the Cobweb Theorem,
the stability and instability of market equilibrium can be summarized as follows:
1. If slope (∆Q/∆P) of the demand curve is less than the slope of the supply curve, market equi-
librium is stable. If market equilibrium is disturbed by sudden increase or decrease in the price
due to external factors, the market equilibrium returns to the original equilibrium through
a process of demand and supply adjustments.
2. If slope of the demand curve is greater than the slope of the supply curve, market equilibrium is
unstable. If market equilibrium is disturbed due to some external factors, the equilibrium keeps
moving away and away from the original equilibrium.
3. If slopes of the demand and supply curves are equal, market equilibrium is unstable. But, under
this condition, equilibrium keeps oscillating around the original equilibrium and does not
return to the original equilibrium.

1. ‘Demand’ is a word of common usage. What is the meaning of demand in economics? How is
demand different from desire, want and need?
2. Define market demand. What are the determinants of market demand in the short run and in
the long run? How do increase in consumers’ income and price of the substitute goods affect
the demand for a commodity?
3. What are the factors that are held constant while deriving an individual demand curve? What
will happen when such factors are not held constant?
4. Define the law of demand. Why do demand curves for most goods slope downward to the right?
5. Explain demand schedule, demand curve and demand function. Suppose a demand function is
given as Q = 50 − 10P. Derive a demand curve from the demand function.
6. From the demand function Q = 600/P, show that the total expenditure on the commodity remains
unchanged as price falls. Estimate elasticity of demand along the demand curve at P = Rs 4 and
P = Rs 2.
7. Explain the law of supply through a supply schedule and a supply curve. Why does a supply
curve slope upward to the right? What factors cause a rightward shift in the supply curve?
8. Explain why market equilibrium is determined at the intersection of the demand and supply
curves. How is market equilibrium affected when consumers’ income changes, all other factors
remaining the same?
9. Find out equilibrium quantity from demand function Qd = 25 − 10P and supply function
Qs = 25P. What is the change in price if demand function changes to Qd = 30 − 10P; supply
function remaining the same?
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10. The sales data of a book publishing company produces a demand function as Q = 5000 − 50P.
From this demand function, find out:
(a) demand schedule and demand curve,
(b) number of books sold at price Rs 25,
(c) price for selling 2,500 copies,
(d) price for zero sales,
(e) sales at zero prices.
11. What is meant by equilibrium price and quantity? What factors cause an upward-right and
upward-left shifts of the equilibrium point from its original position?
12. From a demand function Qd = 2000 − 30P and a supply function Qs = 20P, find out:
(a) equilibrium price,
(b) equilibrium quantity,
(c) gap between demand and supply at P = Rs 20 and P = Rs 50.
13. From a price function given as P = (Qd − 20)/3 and a supply function as P = Qs/2, find out:
(a) whether there is excess demand or excess supply at prices Rs 2 and Rs 5,
(b) the quantity of excess demand or excess supply at these prices.
14. Which of the following statements are True or False?
(a) The demand for a commodity is inversely related to the price of its substitutes.
(b) When income increases, the demand for essential goods increases more than propor-
tionately.
(c) Decrease in input prices causes a leftward shift in the supply curve.
(d) There cannot be a market without a place.
(e) The desire for a commodity backed by ability and willingness to pay is demand.
(f) The law of demand states the relationship between the quantity demanded and price
of a commodity, consumers income, price of the related goods and advertisement.
(g) An individual demand curve marks the upper limits of his/her intentions to buy
a commodity at different prices.
(h) A market demand curve represents the maximum quantity that an individual would
be willing to buy at different prices.
(i) The income–effect on demand for an inferior good is negative.
(j) Demand for car and price of petrol are inversely related.
(k) Most demand functions are of the form D = a + b P.
(l) A straight line supply function is of the form P = Q/b.
[(Ans. True: (e), (g), (h), (i), (1) False: (a), (b), (c), (d), (f), (j), (k)]
15. Which of the following conditions makes an approximate definition of ‘market’?
(a) Market is a meeting place for buyers and sellers.
(b) The buyers and sellers meet to transact business.
(c) The buyers and sellers must transact business by or without meeting in a place.
16. Suppose characteristics of three persons—A, B and C are given as follows:
(a) A wants to buy a book on microeconomics but has no money to pay for it.
(b) B has sufficient money to buy the book but prefers to borrow books from the library.
(c) C has money and is willing to spend his money on a book on microeconomics.
Who creates demand for books on microeconomics?
M03_DWIV9400_02_SE_C03.indd 67 06/07/11 10:55 PM

68 Chapter 3
17. An individual demand curve slopes downward to the right because of:
(a) income effect of fall in prices,
(b) substitution effect of decrease in price,
(c) diminishing marginal utility,
(d) conditions (a), (b) and (c) hold, or
(e) none of the above.
18. A Giffen good is one whose demand increases, other thing remaining the same, when:
(a) its price increases,
(b) consumer’s income increases, or
(c) price of its superior substitutes decreases.
Give the correct answer.
19. An upward shift in the demand curve for a product is caused by which of the following?
(a) decrease in price of the product,
(b) increase in consumer’s income,
(c) fall in the price of substitutes,
(d) none of the above.
20. Suppose a demand function is given as D = 20 − 2P and a supply function is given as S = − 30 + 2P.
Will there be a realistic equilibrium output?
[Ans. 17 (c), 18 (d), 19 (d), 20 (a), 21 (b), 22 (no)]
21. What is meant by the term ‘equilibrium’ in economics? What are the uses of equilibrium concept
in economic analysis?
22. Distinguish between stable and unstable equilibrium in the context of a perfectly competitive
industry. Indicate the circumstances under which the market adjustment process fails to ensure
a stable equilibrium between demand and supply. Illustrate your answer graphically.
23. (a) Explain and show graphically the difference between stable and unstable equilibrium.
(b) Specify the conditions of stable and unstable equilibrium in a competitive market. Illustrate
the conditions.
24. (a) Will equilibrium be stable or unstable if:
(i) demand curve has a negative slope and supply curve a positive slope,
(ii) ∆D/∆P > ∆S/∆P?
(b) Will equilibrium be stable or unstable if:
(i) demand and supply curves have both a negative slope,
(ii) ∆D/∆P < ∆S/∆P?
25. Distinguish between static and dynamic equilibrium. Discuss in this regard the Cobweb
Theorem. What makes a Cobweb stable or unstable?
26. Which of the following statements are correct?
(a) An equilibrium is stable if its displacement creates condition for its restoration,
(b) An equilibrium is stable if ∆D/∆P < ∆S/∆P,
(c) A supply curve cannot have negative slope,
(d) A demand curve cannot have positive slope,
(e) Under static conditions, the equilibrium is always unstable,
M03_DWIV9400_02_SE_C03.indd 68 06/07/11 10:55 PM

(f)Under dynamic conditions, the equilibrium is always stable,

(g)If demand function is given as Qd = 100 − 10P and supply function as Qs = 100 + 10P,
there cannot be equilibrium in the market.
[Ans. (a), (b)]
27. Suppose ∆D/∆P < ∆S/∆P. Does it produce damped or oscillating equilibrium? If it is oscillating,
does the oscillation continue indefinitely? If not, why?
ENDNOTES
1. Samuelson attributes this statement to ‘anonymous’ in his Economics, 13th Edn., p. 55.
2. Goods of this category are also accumulated to store value.
3. The increase in demand for bajra by 5 kg can be worked out as follows. Suppose the household
maintains its food consumption at its minimum level of 30 kg. For this, it will be required to
substitute x kg of bajra for the same quantity of wheat (x kg). Its food consumption basket may
be expressed as (20 + x) kg of bajra + (10 − x) kg of wheat = 30 kg. Since household can afford
only Rs 200 per month, its budget equation can be written as 6(20 + x) + 10(10 − x) = Rs 200.
Solving this equation for x, we get x = 5 kg.
4. Engel Curve has been named after a German Statistician, Christian Lorenze Ernst Engel
(1821–1986), who was one of the first who study systematically the relation between the quan-
tity demanded of a good and the consumer’s income. According to Engel’s law, proportion of
expenditure on essential goods decreases as income increases.
5. This law is discussed in detail in Chapter 6.
6. Gini-coefficient is a standard measure of national income distribution through Phillips curve.
Gini-coefficient (G) having numerical value equal to zero indicates equal distribution of
national income. G > O indicates inequality. The higher the value of G, the greater the inequal-
ity in the distribution of national income.
7. In this case, there is no equilibrium. The term ‘equilibrium’ refers to the working system.
FURTHER READINGS
Pindyck, R.S. and Rubinfeld, D.L. (2001), Microeconomics (London: Prentice-Hall), 5th Edn., Chapter 2.
*Schneider, E. (1962), Pricing and Equilibrium: An Introduction to Static and Dynamic Analysis (London:
George Allen and Unwin), Chapters 3 and 4.
*Samuelson, P.A. (1953), Foundation of Economic Analysis (Cambridge: Harvard University Press),
Chapters 4–8.
Samuelson, P.A. and Nordhaus, W. (1995), Economics (New York: McGraw-Hill, Inc), 15th Edn., p. 23.
(*readings are advanced, not meant for graduate students)
M03_DWIV9400_02_SE_C03.indd 69 06/07/11 10:55 PM

Chapter 4
Elasticity of Demand and

Supply
CHAPTER OBJECTIVES
The laws of demand and supply, discussed in Chapter 3, state only the direction of change in the quan-
tity demanded and supply with the change in price. But what is more important for analysing the effect
of change in price on demand and supply is the elasticity of demand and supply. By going through this
chapter, you learn:
The meaning of elasticity of demand and supply;
The method of measuring the elasticity of demand and supply;
The factors that determine the elasticity of demand;
How price elasticity of demand affects the total sales revenue;
Different kinds of demand elasticity; and
Application of elasticity of demand and supply for making appropriate business decisions and
government policies.
In Chapter 3, we have discussed the laws of demand and supply and some other important aspects of
demand theory. The laws of demand and supply state only the nature of relationship between the change in
price and the quantity demanded and the quantity supplied, respectively. The laws of demand and supply
do not reveal the extent or the measure of relationship between the price change and the quantity demanded
and supplied. In other words, the laws of demand and supply do not give the degree of response of demand
and supply to a given change in price. For example, the law of demand tells only that when price of a com-
modity increases, demand for it decreases. But the law of demand does not tell demand decreases by what
percentage if price increases, say, by 10 per cent. So is the case with the law of supply. The laws of demand
and supply give only the direction of change in demand and supply when there is change in price. But,
just the nature of relationship between the price and the quantity demanded and supplied alone is not suf-
ficient for the application of the laws of demand and supply for making pricing decisions by the business
firms and also for the government to formulate its pricing policies especially regarding:
1. price determination of public utilities;
2. fixing prices of essential goods;
M04_DWIV9400_02_SE_C04.indd 70 06/07/11 11:04 PM

Elasticity of Demand and Supply 71
3. determination of rates of commodity taxes; and

4. determination of export and import duties.
For applying the laws of demand and supply, it is very important to measure the extent of relationship
between the price of a product and its demand and supply. The extent of relationship between the price
and the demand (or supply) is measured by measuring the degree of responsiveness of demand (or supply)
for a product to the change in its price. This is called the elasticity of demand and supply. In this chapter, we
discuss the concept and the method of measuring the elasticity of demand and supply and the applica-
tion of demand elasticity.
THE ELASTICITY OF DEMAND

Before we proceed to discuss the elasticity of demand, let us have clear view of the kinds of demand
elasticities. We have so far referred to only one determinant of demand, i.e., the price of the product, and
only one kind of demand elasticity, i.e., the price elasticity of demand. But, as discussed in Chapter 3, the
demand for a product especially in the long run is determined by many other factors, viz.
1. consumers’ income;
2. price of substitutes and complements;
3. advertisement of the product;
4. future price expectations; and
5. consumers’ taste and fashion.
Of these demand determinants, the effect of change in ‘consumers’ taste and fashion’ is difficult to
quantify. In practice, therefore, the overall demand for a product is generally deemed to be determined
by some major demand determinants, viz., price of the product, consumers’ income, price of the substitutes
and compliments, ad-spending by the firms and consumers’ expectations about the future prices. Therefore,
the overall demand and change in demand for a product depends on the nature and extent of change
in these demand determinants. And, the overall elasticity of demand for a commodity depends on the
combined effects of changes in these demand determinants. Therefore, the elasticity of demand is mea-
sured separately with respect to all its major determinants. Following this practice, we discuss in this
chapter, the following kinds of demand elasticities.
1. Price elasticity of demand; It is the degree of responsiveness of demand to change in the price level
It is the degree of reponsivness of demand to change in the price level
2. Income elasticity of demand; and
3. Cross-elasticity of demand, i.e., demand elasticity with reference to price of substitutes and
complementary goods.
All these kinds of demand elasticities are discussed in this chapter. However, of these kinds of elastici-
ties of demand, price elasticity of demand is of the greatest significance from both theoretical and prac-
tical points of view. Therefore, the price elasticity of demand will be discussed here in a greater detail.
PRICE ELASTICITY OF DEMAND

The price elasticity of demand is defined as the degree of responsiveness or sensitiveness of demand for a
commodity to the change in its price. The price elasticity of demand, i.e., the responsiveness of demand
M04_DWIV9400_02_SE_C04.indd 71 06/07/11 11:04 PM

72 Chapter 4
for a commodity to change in its price, is measured as the percentage change in the quantity demanded
divided by the percentage change in the price. That is,
Percentage change in the quantity demandeed
ep =
Percentage change in the price
Here, ep denotes the price elasticity of demand. The numerical value of ep is called the coefficient of
demand elasticity.
A general formula for measuring the price elasticity of demand is derived as follows:
Q2 − Q1 Q2 − Q1
× 100
Q1 Q1
ep = =
P2 − P1 P2 − P1
× 100
P1 P1
Here, Q1 = original demand, Q2 = demand after price change, P1 = original price and P2 = changed price.
By denoting Q2 − Q1 by ∆Q and P2 − P1 by ∆P, a general formula for measuring price elasticity
coefficient can be expressed as follows:
∆Q ∆P
ep = ÷
Q1 P1
∆Q P1 (4.1)
ep = ×
∆P Q1
To measure price elasticity of demand numerically by using the formula given in Eq. (4.1), let us
Q 1) suppose that price of a commodity X decreases from Rs 10 per unit to Rs 8 per unit and, as a result,
the quantity demanded of X increases from 50 to 60 units per time unit. Thus, ∆P = Rs 10 − Rs 8 =
Rs 2 and ∆Q = 50 − 60 = −10. By substituting these values in elasticity formula, as given in Eq. (4.1),
we get:
−10 10
ep = − × = 1.0
2 50
Thus, elasticity coefficient (ep) equals 1.
Note that a minus sign (−) is inserted in the formula (Eq. (4.1)) with a view to making elasticity coeffi-
cient a non-negative value. The coefficient of price elasticity calculated without minus sign in the formula
will always be negative, because either ∆P or ∆Q will carry a negative sign depending on whether price
increases or decreases. But a negative coefficient of elasticity is rather misleading because elasticity can-
not be negative—less than zero. The ‘minus’ sign is, therefore, inserted in the price elasticity formula as
a matter of ‘linguistic convenience’ to make the coefficient of elasticity a non-negative value. Sometimes,
it is also advised to ignore the negative sign of ∆P or ∆Q. The price elasticity measure is, however, always
reported with a negative sign just to indicate inverse relationship between the price change and the
quantity demanded.
M04_DWIV9400_02_SE_C04.indd 72 06/07/11 11:04 PM

The Arc and Point Elasticity

When price elasticity of demand is measured between any two finite points on a demand curve, it is
called arc elasticity and elasticity measured at a point on the demand curve is called point elasticity.
As noted above, the elasticity of demand measures the percentage change in the quantity demanded
due to a certain percentage change in price. The percentage change in price may be considerably high
(e.g., 10 per cent, 20 per cent or even higher) or it may be very small—so small that it is not significantly
different from zero. When change in price is significantly high, it shows a movement from one point on
the demand curve to another point, making an arc. Therefore, the price elasticity measured for a consid-
erably high change in price is called arc elasticity of demand. And, when price elasticity is measured for
very small changes in price—not significantly different from zero—it is called point elasticity.
Measuring Arc Elasticity

The arc elasticity of demand, i.e., the elasticity coefficient between any two finite points on a demand
curve, is measured by using the formula given in Eq. (4.1). For example, the measure of the price elastic-
ity of demand between points J and K on the demand curve PM in Figure 4.1 is the measure of arc elas-
ticity. The movement from point J to K on the demand curve PM shows a fall in price of commodity X
from Rs 25 to Rs 15 and the consequent increase in demand from 30 to 50 units. Here, ∆P = 25 − 15 = 10
and ∆Q = 30 − 50 = −20. The arc elasticity between points J and K (moving from J to K ) can be measured
as given below:
∆Q P0
ep = − ×
∆P Q0
where P0 and Q0 are the original price and the original quantity demanded.
45
40 P
35
Price of X (PX) (Rs)
30
J
25
20
K
15
10
5
M
O
10 20 30 40 50 60 70 80 90
Quantity of X (QX)
Figure 4.1 C an e in ice and c a ticit Coefficient
M04_DWIV9400_02_SE_C04.indd 73 06/07/11 11:04 PM

74 Chapter 4
−20 25 (4.2)
ep = − × = 1.66
10 30
Interpretation of Price Elasticity Elasticity coefficient is interpreted as percentage change

in demand due to 1 per cent change in price. For example, in Eq. (4.2), elasticity coefficient is 1.66.
The elasticity coefficient (1.66) means that a 1 per cent decrease in price of commodity X would result in a
1.66 per cent increase in demand for it. Going by the change in the price and the quantity demanded, it
means that a 40 per cent decrease in price causes a 66.66 per cent increase in demand.
Problem in Using Arc Elasticity The use of arc elasticity concept involves a risk of misinterpreta-
tion because the measure of arc elasticity between any two finite points on a demand curve produces two
different elasticity coefficients for the same fall and rise in price in other words, the arc elasticity coefficient
varies between the same two finite points on a demand curve when the direction of change in price is reversed.
For example, arc elasticity of the demand curve PM between points J and K (Figure 4.1), i.e., for a fall in price
from Rs 25 to Rs 15 is estimated to be 1.66 (see Eq. (4.2)). This measure of arc elasticity can be mistaken to
be the price elasticity of demand curve PM between points J and K, irrespective of the direction of change
in price, whereas this elasticity coefficient is relevant only for the fall in the price not for the rise in price.
In case of rise in the price from Rs 15 to Rs 25, i.e., for the movement from point K to J, we have:
P = 15, ∆ P = 15 − 25 = −10
and
Q = 50, ∆Q = 50 − 30 = 20
Substituting these values into the elasticity formula (Eq. (4.1)), we get
20 15 (4.3)
ep = − × = 0.60
−10 50
Note that price elasticity coefficient (0.60) for the increase in price by Rs 10 is vastly different from
price elasticity (1.66) for the same decrease (Rs 10) in price. Clearly, arc elasticity between any two finite
points on a demand curve depends also on the direction of change in price. So the use of arc elasticity
without reference to the direction of change in price would be misleading.
Suggested Modifications Economists have suggested some modifications in the elasticity for-
mula to remove this anomaly in the concept of arc elasticity.
First, it is suggested that the problem arising due to the change in the direction of price change may be
avoided by using the lower values of P and Q in the elasticity formula. The formula is then
∆Q P1 (4.4)
ep = ×
∆P Q1
where subscript 1 denotes lower values of P and Q.
M04_DWIV9400_02_SE_C04.indd 74 06/07/11 11:04 PM

Going by this formula for measuring elasticity between points J and K in Figure 4.1, we use P1 = 15
(the lower one of the two prices) and Q1 = 30 (the lower one of the two quantities). By substituting these
values in Eq. (4.4), for decrease in price, we get:
20 15
ep = − × = 1.0
−10 30
This method, however, violates the rule of computing percentage change. The choice of the lower
values of P and Q is illogical. What is more objectional, the elasticity so estimated is not related to the
relevant price and quantity. The lower quantity (Q1) refers to a higher price and the lower price (P1) is
linked to a higher quantity. This method is, therefore, devoid of any logic.
Second, the another method suggested1 to resolve this problem is to use averages of the upper and
lower values of P and Q in the fraction P/Q. This method is called mid-point method. The suggested
formula can be written as
∆Q ( Pu + Pl ) / 2
ep = − ×
∆P (Ql + Qu )/ 2
or
Ql − Qu ( Pu + Pl ) / 2 (4.5)
ep = − ×
Pu − Pl (Ql + Qu )/ 2
where subscripts ‘u’ and ‘l’ refer to upper and lower values, respectively.
By substituting the values from Figure 4.1, we get:
30 − 50 ( 25 + 15) / 2
ep = − ×
25 − 15 (30 + 50) / 2
−20 20
=− × = 1.0
10 40
This method measures the elasticity at mid-way between points J and K—not the arc elasticity between
points J and K. The elasticity coefficient (1.0) is not applicable to the whole range of price−quantity com-
bination between points J and K (see Figure 4.1). Although, as Mankiw claims (op. cit., p. 62), it resolves
the problem that arises due to the reversal of the direction of the price change, it does not resolve the
problem of variability of elasticity between any two points on the demand curve. It gives only the mean
of the elasticities between the two points.
An alternative method to avoid this problem is to use point elasticity.
Measuring Point Elasticity

Point Elasticity is the measure of price elasticity at a finite point on a demand curve. However, as ‘point’ is
defined in geometry, it occupies no space and has no dimensions. It implies that there is no change in the
price and hence no change in the quantity demanded. Therefore, the concept of ‘point elasticity’ may not
appear to be reasonable. However, from practical point of view, point elasticity concept is applied to an
insignificant change in the price and the consequent change in the quantity demanded. Point elasticity is,
in fact, the measure of the proportionate change in the quantity demanded in response to a very small
M04_DWIV9400_02_SE_C04.indd 75 06/07/11 11:04 PM

76 Chapter 4
proportionate change in the price. The concept of point elasticity is useful where change in the price and
the consequent change in the quantity demanded are infinitesimally small.2 Besides, it offers an alterna-
tive to the arc elasticity. Point elasticity may be symbolically expressed as
∂Q P
ep = ⋅ (4.6)
∂P Q
The method of measuring price elasticity on linear and non-linear demand curves is explained below.
Point Elasticity of a Linear Demand Curve To illustrate the measurement of point elastic-
ity on a linear demand curve, let us suppose that a linear demand curve is given by MN in Figure 4.2
and that we need to measure elasticity at point P. Let us now substitute the values from Figure 4.2 in
Eq. (4.6). It is obvious from the figure that P = PQ and Q = OQ. What we need to find now are the
values for ∂Q and ∂P. These can be obtained by assuming a very small change in the price. But it will
be difficult to depict these changes graphically as ∂P → 0 and hence ∂Q → 0. There is, however, an easy
way to find the value for ∂Q /∂P. In fact, the ratio ∂Q /∂P gives the reciprocal of the slope of the demand
curve, MN. The reciprocal of the slope of a straight line, MN, at point P is geometrically given by QN/PQ.
Therefore,
∂Q QN
=
∂P PQ
Since at point P, price (P) = PQ and Q = OQ, by substituting these values (ignoring the minus sign)
in Eq. (4.6), we get:
QN PQ QN
ep = × =
PQ OQ OQ
M
Price
R P
X
O Q N
Quantity
Figure 4.2 Point Elasticity on a Linear Demand Curve
M04_DWIV9400_02_SE_C04.indd 76 06/07/11 11:04 PM

It can be proved geometrically that
QN PN
ep = = (4.7)
OQ PM
The proof of the fact that QN/OQ = PN/PM is given below.

Proof: Given the demand line, MN, the price OR = PQ and the quantity demanded OQ = RP in
Figure 4.2, there are three triangles ΔMON, ΔMRP and ΔPQN. Note that ∆MON, ∆MRP and ∆PQN of
these triangles are right (90°) angles. Therefore, the other corresponding angles of the three triangles are
equal. Given these properties of the triangles, ΔMON, ΔMRP and ΔPQN are similar triangles.
According to geometrical properties of similar triangles, the ratio of any two sides of a triangle is
equal to the ratio of the corresponding sides of the other triangles. Therefore, in ΔPQN and ΔMRP,
QN RP
=
PN PM
Note that RP = OQ. By substituting OQ for RP, we get
QN OQ
=
PN PM
By proportionality rule,
QN PN
= (4.8)
OQ PM
It is, thus, proved that the point elasticity QN/OQ = PN/PM.

Note that PN marks the lower segment and PM marks the upper segments of the demand curve, MN.
It may thus be said that price elasticity at any point on a straight line demand curve is given by
Lower segment
ep =
Upper segment
Given this formula, if the selected point falls at the mid point of the demand curve, elasticity equals 1.
If the point falls below the mid point, elasticity is less than 1 and if it falls above the mid point, elasticity
is greater than 1.
Measuring Point Elasticity on a Non-linear Demand Curve Point elasticity of a non-

linear demand curve at a point is measured by drawing a tangent to the demand curve at the chosen
point and measuring the elasticity of the tangent at this point. This gives the elasticity of the demand
curve at the chosen point. Suppose a non-linear demand curve is given as DD¢ in Figure 4.3 and we want
to measure the elasticity of demand curve DD¢ at point P. Let us now draw a line tangent to the demand
curve DD¢ at point P as shown by the tangent MN. Since the demand curve DD¢ and the line MN pass
through the same point (P), the elasticity of the demand curve DD¢ at point P is equal to the elasticity of
M04_DWIV9400_02_SE_C04.indd 77 06/07/11 11:04 PM

78 Chapter 4
D
M
Price
P
R
D'
O Q N
Quantity
Figure 4.3 Point Elasticity on a Non-linear Demand Curve
the tangent, MN, at point P. By measuring the elasticity at point P on the tangent MN, we get the elasticity
at point P on the demand curve DD¢. The elasticity of the tangent MN at point P can be measured by
using the point elasticity formula as shown below:
∂Q P
ep = ⋅
∂P Q
By substitution,
QN PQ QN
ep = × =
PQ OQ OQ
As proved above, QN/OQ = PN/PM = e (for Proof, see the preceding section). The same procedure
can be used to measure the point elasticity at any other point on the demand curve DD¢.
Price Elasticity Varies Along the Demand Curve

The price elasticity of demand varies all along a demand curve. Consider a linear demand curve MN in
Figure 4.4. At one and only point, ep = 1. At all other points (except terminal points), ep < 1 or ep > 1. At
terminal point N, ep = 0 and at terminal point M, elasticity is undefined. This point is explained below.
M04_DWIV9400_02_SE_C04.indd 78 06/07/11 11:04 PM

Undefined
ep>1
Price
ep=1
P
ep<1
ep=0
X
O Quantity N
Figure 4.4 Point Elasticity Along the Demand Curve
We know that if a point on a demand curve is marked, it divides the demand curve into two parts.
For example, if we choose a point mid-way, point P, on demand curve MN in Figure 4.4, it divides the
demand curve into two parts: PM (the upper segment) and PN (the lower segment). Given the above
measure of point elasticity (ep = PN/PM), the elasticity at a point on a linear demand curve may be inter-
preted as the ratio of the lower segment (PN) to the upper segment (PM) of the demand curve. That is,
Lower segment PN
ep = =
Upper segment PM
Since in Figure 4.4, PN = PM, ep = 1. It follows that:

1. at mid point on a linear demand curve, ep = 1.
2. at any point on the upper (half) segment, ep > 1;
3. at any point on the lower (half) segment, ep < 1;
4. at point N, ep = 0; and
5. at point M, elasticity is an undefined reason that is given below.
Important The point that elasticity at the terminal point on the price axis is undefined needs a
clarification. It is a general practice of the text-book authors to show ep = ∞ at terminal point on the
vertical axis, i.e., at point M in Figure 4.4. This is mathematically incorrect. The reason is measuring
M04_DWIV9400_02_SE_C04.indd 79 06/07/11 11:04 PM

80 Chapter 4
elasticity at point M involves division by zero, and division by zero is undefined. For example, at point M,
lower segment equals MN and upper segment equals zero. Therefore, elasticity at point M is undefined.
To quote Baumol:
Here [at point M] elasticity is not even defined because an attempt to evaluate the fraction p/x at that
point forces us to commit the sin of dividing by zero. The readers who have forgotten why division by
zero in immoral may recall that division is the reverse operation of multiplication. Hence, in seeking
the quotient c = a/b we look for a number, c, which when multiplied by b gives us the number a, i.e., for
which cb = a. But if a is not zero, say a = 5, and b is zero, there is no such number because there is no c
such that c c × o = 50 .3
1. Constant Elasticity Demand Curves. The elasticity of most demand curves is not the same
throughout. It varies from zero (0) to close to infinity, i.e., 0 < ep < ∞. In case of some demand
curves, however, elasticity remains the same throughout their length, as shown in Figure 4.5.
Such demand curves are placed in the following categories:
(i) A perfectly inelastic demand curve—it has ep = 0 throughout.
(ii) A unitary elastic demand curve—it has ep = 1 throughout.
(iii) A perfectly elastic demand curve—it has ep = ∞ throughout.
The three kinds of demand curves are shown in Figure 4.5(a), (b) and (c), respectively.
The Slope of Demand Curve and Price Elasticity

The concepts of slope and elasticity of demand are often confused to be the same. The elasticity of a
demand curve is often judged by its slope—the flatter the demand curve, the greater the elasticity, and
the steeper the demand curve, the lower the elasticity. But such conclusions are incorrect because two
demand curves with different slopes may have the same elasticity at a given price. In fact, what the
appearance of a demand curve reveals is its slope, not the elasticity. The slope of the demand curve gives
the relationship between marginal change in the price (ΔP) and the resulting change in the quantity
demanded (ΔQ). The slope of demand curve is expressed as ΔP/ΔQ, whereas price elasticity is expressed
as (ΔQ/ΔP)(P/Q).
(a) (b) (c)
Perfectly inelastic Unitary elastic Perfectly elastic
ep = 0 ep = 1 ep = ∞
Price
Price
Price
O Quantity O Quantity O Quantity
Figure 4.5 Constant Elasticity Demand Curve
M04_DWIV9400_02_SE_C04.indd 80 06/07/11 11:04 PM

Let us now prove the points that demand curves having:

1. different slopes may have the same elasticity at a given price and
2. the same slope may have different elasticities at a given price.
Elasticity With Different Slopes of Demand Curves Let us first illustrate that two demand
curves with different slopes have the same elasticity at a given price. In Figure 4.6, demand curves AB
and AD have different slopes, as shown below:
OA
Slope of demand curve AB = ;
OB
and
OA
Slope of demand curve AD = .
OD
Note that the numerator OA is common to both the ratios, but the denominator OB < OD. Therefore,
the slope of the demand curve AB is greater than the slope of the demand curve AD, i.e.,
OA OA
> .
OB OD
Obviously, the slopes of the two demand curves are different. Let us now show that, at a given price,
both the demand curves have the same elasticity. As shown in Figure 4.6, at price OP, the relevant points
Q
Price
P R
X
O M N B D
Quantity
Figure 4.6 Demand Curves with Different Slopes and Same Elasticity
M04_DWIV9400_02_SE_C04.indd 81 06/07/11 11:04 PM

82 Chapter 4
for measuring the point elasticity are Q and R on the demand curves AB and AD, respectively. As we have
already shown, price elasticity at a point on a linear demand curve is obtained as
Lower segment
ep =
Upper segment
Given this formula for measuring the point elasticity, the price elasticity of the demand curve AB
at point Q, ep = QB/QA, and at point R on the demand curve AD, ep = RD/RA. It may be geometrically
proved that the two elasticities are equal, i.e.,
QB RD
=
QA RA
Let us first consider ΔAOB. As shown in Figure 4.6, an ordinate drawn from Q to M at the horizontal
axis forms three triangles—ΔAOB, ΔAPQ and ΔQMB. Note that ÐAOB, ÐAPQ and ÐQBM are right
angles. Therefore, all the three triangles are right-angle triangles. One of the properties of right-angle tri-
angles is that the ratios of their two corresponding sides are always equal. Considering only the relevant
triangles, ΔAPQ and ΔQMB, we have
QB AQ
=
QM AP
Since QM = OP, by substituting QP for QM in ratio QB/QM, we get

QB AQ
=
OP AP
By the proportionality rule, the ratios of numerators of equal ratios are equal to the ratios of their
denominators. By this rule, the ratios of their numerators and denominators are equal. Thus,
QB OP
= = Elasticity of demand curve AB at point Q .
AQ AP
It can be similarly proved that

RD OP
= = Elasticity of demand curve AD at point R .
RA AP
It is thus proved that
QB RD OP
= =
QA RA AP
It is thus proved that the demand curves AB and AD with different slopes have the same price elasticity
at price OP.
Price Elasticity of Parallel Demand Curves at a Price The fact that slope and price elas-
ticity are two different concepts can also be proved by showing that demand curves with the same slope
M04_DWIV9400_02_SE_C04.indd 82 06/07/11 11:04 PM

J
Price
R Q
P
X
O X N K M
Quantity
Figure 4.7 Different Elasticities of Parallel Demand Curves
have a different elasticity at a given price. Let us now show that the two demand curves having the same
slope have a different elasticity at a given price. Consider the demand curves JK and LM in Figure 4.7.
The demand curves JK and LM are parallel and, therefore, have the same slope. Point R on the demand
curve JK and point Q on the demand curve LM show the quantities demanded at a given price, OP.
The elasticity at point R on demand curve JK is RK/RJ and the elasticity at point Q on demand curve
LM is QM/QL. It can be easily proved that
RK QM
≠
RJ QL
Following the logic of the preceding section, we can prove that
RK PO
=
RJ PJ
and
QM PO
=
QL PL
It can be seen from Figure 4.7 that PJ < PL. Therefore,

PO PO
>
PJ PL
M04_DWIV9400_02_SE_C04.indd 83 06/07/11 11:05 PM

84 Chapter 4
It is thus proved that

RK QM
>
RJ QL
Recall that point elasticity at point R on demand line JK is RK/RJ and point elasticity at point Q on
demand line LM is QM/QL. And, RK/RJ > QM/QL.
It may be concluded from the above conclusions that the demand curves having the same slope may
have a different elasticity, and the demand curves having different slopes may have the same elasticity,
both at a given price.
DETERMINANTS OF PRICE ELASTICITY OF DEMAND

The price elasticity of demand varies from commodity to commodity depending on the nature of the
commodity. While the demand for some commodities is highly elastic, for some it is highly inelastic.
Besides, given the nature of a commodity, there are several other factors which determine the price elas-
ticity of demand for a commodity. This section describes the main determinants of the price elasticities
of demand:
1. Availability of Substitutes. One of the most important determinants of price elasticity of
demand for a commodity is the availability of its substitutes. The closer the substitute, the
greater the price elasticity of demand for a commodity. For instance, coffee and tea may be
considered as close substitutes for one another. If price of one of these goods (say, coffee)
increases, then the demand for coffee decreases more heavily. The reason is that the other
commodity (tea) becomes relatively cheaper. Therefore, consumers buy more of the relatively
cheaper good (tea) and less of the costlier one. The elasticity of demand for both these goods
will be higher. Besides, the wider the range of the substitutes, the greater the elasticity. For
instance, soaps, toothpastes, cigarettes, etc. are available in different brand names, each brand
being a close substitute for the other, all other things remaining the same. Therefore, the price
elasticity of demand for each brand will be much greater than the generic commodity. On the
other hand, sugar and salt do not have their close substitute and hence their price elasticity
is lower.
2. Nature of Commodity. Price elasticity of demand depends also on the nature of a commod-
ity. Commodities can be grouped broadly as luxuries, comforts and necessities, on the basis
of the degree of intensity of the need they satisfy. Demand for luxury goods (e.g., air condi-
tioners, costly TV sets, cars, and decoration items) is more elastic than the demand for other
kinds of goods because consumption of luxury goods can be postponed when their price rises.
On the other hand, consumption of necessities (e.g., sugar, clothes, vegetables, and electricity,
medicines) cannot be postponed and hence their demand is inelastic. Demand for comforts is
generally more elastic than that for necessities and less elastic than the demand for luxuries.
Commodities may also be classified as durable goods and non-durable goods. Demand for
durable goods is more elastic than that for non-durable goods—mainly necessities because
when the price of the former increases, people either get the old one repaired instead of replac-
ing it or buy a ‘second-hand’.
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3. Proportion of Income Spent. Another factor that influences the elasticity of demand is the
proportion of consumer’s income spent on a particular commodity. If proportion of income
spent on a commodity is very small, its demand will be inelastic, and vice versa. Classic examples
of such commodities are salt, matches, books, toothpastes, which claim a very small proportion
of consumers’ income. Demand for these goods is generally inelastic because increase in the
price of such goods does not substantially affect consumer’s budget.
4. Time Factor. Price elasticity of demand for high-price goods depends also on the time consum-
ers can take to adjust their consumption expenditure to buy a new commodity—the shorter the
time taken, the greater the elasticity. Consumers are able to adjust their expenditure pattern to
price changes over a short period of time. For instance, if price of TV sets is decreased, demand
will immediately increase if people possess excess purchasing power and require a short time to
take decision. But, if not, then people may not be able to adjust their expenditure pattern over a
short period of time to buy a TV set at the (new) lower price. If consumption adjustment takes
a long period, it creates uncertainty and makes elasticity lower.
5. Range of Alternative Uses of a Commodity. The wider the range of alternative uses of a product,
the higher the elasticity of its demand for decrease in price and the lower elasticity for rise in price.
Decrease in the price of a multi-use commodity encourages the extension of their use. Therefore,
the demand for such a commodity generally increases more than the proportionate decrease in
its price. For instance, milk can be taken as it is, it may be converted into curd, cheese, ghee and
butter milk. The demand for milk will, therefore, be highly elastic. Similarly, electricity can be
used for lighting, cooking, heating and for industrial purposes. Therefore, demand for electricity
is highly elastic, especially for decrease in price. Reverse is the case for rise in their price.
6. The Proportion of Market Supplied. Technically, the elasticity of market demand depends also on
the proportion of the market supplied at the ruling price. If less than half of the market is supplied,
elasticity of demand will be higher and if more than half of the market is supplied elasticity will be
lower. That is, towards the upper end, demand curve is more elastic than towards the lower end.
7. Direction of Change in Price. The direction of change in price, i.e., where price rises or falls,
also determines the elasticity coefficient. Between any two points on the demand curve, price
elasticity coefficient is higher for the fall in price and it is lower for the same rise in price. (for
proof, see section ‘Measuring Arc Elasticity’; Problem in Using Arc Elasticity).
MEASURING PRICE ELASTICITY FROM A DEMAND

FUNCTION
We have explained above the concept and measurement of price elasticity of demand by using graphical
and geometric methods. The use of these methods is, no doubt, a very convenient and self-explanatory
method of illuminating the concept and measurement of price elasticity of demand. But the application
of graphical method for measuring the price elasticity from actual data involves a cumbersome process.
Alternatively, the relationship between price and quantity demanded is measured statistically from the
demand function of the products. Given the demand function, the price elasticity of demand can be
measured very conveniently and in a short-cut way. In this section, we describe the method of measuring
price elasticity from a given linear and non-linear demand function.
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86 Chapter 4
Measuring Price Elasticity from a Linear Demand Function

Suppose a linear demand function is given as
Q = a − b⋅ P
Given the demand function, the formula for measuring price elasticity of demand (ep) through a
demand function can be expressed as follows:
P
ep = − b
Q
(where b = ΔQ/ΔP).
The derivation of the formula can be explained as follows.
Given the demand function, the total demand at a given price, say P1, can be estimated as
Q1 = a − b ⋅ P1
When price changes from P1 to P2, the total demand can be worked out as
Q2 = a − b ⋅ P2
Given the formula for measuring the price elasticity, we need two ratios − ΔP/ΔQ and P/Q. Given the
demand at two different prices, P1 and P2, the ratio ΔP/ΔQ can be obtained as follows:
∆Q Q2 − Q1 ( a − b ⋅ P2 ) − ( a − b ⋅ P1 )
= = = −b
∆P P2 − P1 P2 − P1
By substituting −b for ΔQ/ΔP in the elasticity formula, we get

P
ep = − b (4.9)
Q
Alternatively, ΔQ/ΔP can be obtained (especially in case of point elasticity) by differentiating the
demand function Q = a − bP.
∆Q ∆( a − b ⋅ P)
= =−b
∆P ∆P
Here, −b denotes the decrease in quantity demanded when price increases by Rs 1. Given a demand
function, price elasticity can be expressed as ep = −b(P/Q). Given this formula, the price elasticity can be
measured by substituting the numerical values for a, b, P and Q from an estimated demand function.
Numerical Example For a numerical example, suppose a factual demand function is given as
Q = 100 − 5 P
In this demand function, −5 denotes ΔQ/ΔP. This can be proved as follows. By differentiating the
demand function, we get
∆Q ∆(100 − 5 P)
=
∆P ∆P
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Since 100 is a constant value, it will not change. Therefore,
∆Q −5∆P
= = −5
∆P ∆P
Once numerical value of ΔQ/ΔP = −5 is obtained, point elasticity can be measured for any given price.
For example, price elasticity for P = 10 can be obtained as follows. At P = 10,
Q = [100 − 5(10)] = 50
By substituting these values into the elasticity formula (Eq. (4.9)), we get
e p = (−5)(10 /50) = −1
Similarly, at P = 8, Q = 100 − 5(8) = 60, and
e p = (−5)(8 /60) = −0.67
In order to measure the arc elasticity, given the demand function, let us suppose that price falls from
Rs 10 to Rs 8. At P = 10,
Q = 100 − 5(10) = 50
and at P = 8,
Q = 100 − 5(8) = 60
Thus, ΔQ = 60 − 50 = 10 and ΔP = 8 − 10 = −2.

Given these values, the arc elasticity can be measured as given below:
∆Q P1 10 10
ep = × = × = − 1.
∆P Q1 −2 50
Price Elasticity from a Non-linear Demand Function

Suppose a non-linear demand function of multiplicative form is given as
Q = aP− b (4.10)
By differentiating demand function (Eq. (4.10)), we get
δQ (4.11)
= −baP− b−1
δP
By substitution, price elasticity formula given in Eq. (4.9) can be written as
e p = (−b aP− b−1 ) P/Q

(4.12)
(−b aP− b−1 ) P −b aP− b
= =
Q Q
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88 Chapter 4
Since Q = aP−b, by substitution, Eq. (4.12) can be written as
−baP− b
ep = = −b (4.13)
aP− b
This shows that price elasticity coefficient in case of a power demand function equals the power of
price (P) and remains constant: it does not change with change in price.
For a numerical example, suppose a non-linear demand function is given as
Q = 5 P−2
By differentiating the demand function, we get
∂Q
= (−2)5 P−2−1
∂P
By multiplying it by Q/P, we get price elasticity as
P
e p = (−2)5 P−2−1
Q
or
(−2)5P−2−1 (P)
ep =
Q
Since Q = 5P−2, by substitution, we get
(−2)5 P−2−1 ( P) (−2)5 P−2

ep = = = −2
5 P−2 5 P−2
Thus, price elasticity in case of a non-linear demand function equals the power of the variable price, P.
In our example, price elasticity equals −2.
PRICE ELASTICITY AND SALES REVENUE

In the preceding sections, we have discussed the concepts and various methods of measuring price elas-
ticity and also some technical aspects related to price elasticity. But, from the view point of application of
price elasticity to economic analysis of price change and price decision making, what matters a great deal
is how price elasticity affects the total sales revenue, marginal revenue and average revenue of business
firms. In this section, we look into the relationship between (i) price elasticity of demand and marginal
revenue; (ii) marginal revenue and average revenue; and (iii) price elasticity and total revenue. These
relationships are of great importance in business analysis.
M04_DWIV9400_02_SE_C04.indd 88 06/07/11 11:05 PM

Price Elasticity and Marginal Revenue

Marginal revenue is the addition to the total revenue (TR) as a result of sale of one additional unit. It is
also defined as the first derivative of TR function, i.e.,
∂TR
MR =
∂Q
The relationship between price elasticity and marginal revenue (MR) can be derived as follows.
Let us suppose that a given output, Q, is being sold at a price P, so that the total revenue (TR) equals
P times Q, i.e.,
TR = P ⋅ Q
The marginal revenue (MR) can be obtained by differentiating TR = P . Q with respect to Q. Thus,
∂ ( P ⋅ Q)
MR =
∂Q
∂P ∂P
=P +Q
∂Q ∂Q
∂P
= P+Q
∂Q
⎛ Q ∂P⎞
MR = P ⎜1 + ⋅ ⎟
⎝ P ∂Q ⎠ (4.14)
Q ∂P
Note that ⋅ in Eq. (4.14) is the reciprocal of the price elasticity coefficient. It means that
P ∂Q
Q ∂P 1
⋅ =−
P ∂Q e
Q ∂P
By substituting − 1 for ⋅ in Eq. (4.14), we get
e P ∂Q
⎛ 1⎞
MR = P ⎜1 − ⎟ (4.15)
⎝ e⎠
Eq. (4.15) gives the relationship between price elasticity (e) and MR. Given the relationship between
e and MR as shown in Eq. (4.15), the following conclusions can be drawn.
1. If e = 1, MR = 0—it means total revenue remains constant for both rise and fall in price;
2. If e > 1, MR > 0—it means that increasing price decreases total revenue and vice versa, and
3. If e < 1, MR < 0—it means that increasing price increases total revenue, and vice versa.
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90 Chapter 4
Relation Between MR and AR

In Eq. (4.15), P is the same as AR. Therefore, by substituting AR for P, Eq. (4.15) can be written as
⎛ 1⎞
MR = AR ⎜1 − ⎟ (4.16)
⎝ e⎠
and
MR
AR =
(1 − (1/ e))
or
⎛ e ⎞
AR = MR ⎜ ⎟ (4.17)
⎝ e − 1⎠
Eq. (4.17) gives the relationship between AR and price elasticity.

Graphical Proof. Eq. (4.17) gives the relationship between AR and MR and between AR and price
elasticity. The relationship between MR and AR can also be derived geometrically. Suppose AR curve is
given by the curve AR in Figure 4.8 and MR curve is given by the curve AM.
H
P
B
AR and MR
MR AR
O Q M R
Quantity
Figure 4.8 Relationships between AR and MR
M04_DWIV9400_02_SE_C04.indd 90 06/07/11 11:05 PM

Let us suppose that price is given at PQ (= OB). As has been proved earlier, price elasticity at point P
on the AR curve (which is the same as demand curve) can be expressed as
QR PR OB
e= = =
OQ AP AB
Consider the last term, i.e., e = OB/AB. Since OB = PQ, by substituting PQ for OB, we get
PQ (4.18)
e=
AB
In Figure 4.8, AB = PT.4 By substituting PT for AB in Eq. (4.18), we get

PQ (4.19)
e=
PT
Since PT = PQ − TQ, Eq. (4.18) may be written as
PQ
e= (4.20)
PQ − TQ
It can be seen in Figure 4.8 that PQ = AR and TQ = MR. Therefore, Eq. (4.19) can be expressed as
AR
e=
AR − MR
and
AR (4.21)
MR = AR −
e
or
⎛ 1⎞
MR = AR ⎜1 − ⎟ (4.22)
⎝ e⎠
Then,
MR
AR =
⎛ 1⎞
⎜1 − e ⎟
⎝ ⎠
or
⎛ e ⎞
AR = MR ⎜ ⎟ (4.23)
⎝ e − 1⎠
Note that Eq. (4.22) is the same as Eq. (4.16) and Eq. (4.23) is the same as Eq. (4.17). Thus, we arrive
at the same relationship between MR and AR as given in Eq. (4.16) and Eq. (4.17).
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92 Chapter 4
Price Elasticity and Total Revenue

Since total revenue (TR) and marginal revenue (MR) are interrelated and also MR and ep are interrelated,
the relationship between TR and price elasticity of demand (ep) can be traced through the relationship
between MR and price elasticity (ep). Given the relationship between MR and ep in Eq. (4.22), the relation-
ship between TR and ep can be summed up as follows:
1. if ep = 1, MR = 0—it means, TR does not change with change in price;
2. if ep < 1, MR < 0—it means, TR decreases with decrease in price and increases with increase
in price; and
3. if ep > 1, MR > 0—it means, TR decreases with increase in price and increases with decrease
in price.
This nature of relationships between TR and ep can be illustrated graphically. We know that TR = P . Q.
The TR curve can be derived by assuming a demand function. Let us suppose a demand function to be
given as
Q = 100 − 5 P
Given the demand function, price function can be obtained as given below:
P = 20 − 0.2Q
Now that the value of P is known, TR can be obtained as follows:
TR = P ⋅ Q = ( 20 − 0.2Q )Q
= 20Q − 0.2Q 2
From the TR function, MR function can be derived as
∂TR
MR = = 20 − 0.4Q
∂Q
The TR function is presented graphically in panel (a) and the demand (AR) and MR functions are
presented in panel (b) of Figure 4.9. Now the relationship between TR and ep can be traced by compar-
ing the data contained in panels (a) and (b) in Figure 4.9. As the figure shows, at point P on the demand
curve, i.e., at price = Rs 10, ep = 1 where output, Q = 50. Below point P, ep < 1 and above point P, ep > 1.
It can be seen in panel (a) of Figure 4.9 that TR increases with decrease in price over the range of demand
curve having ep > 1; TR reaches its maximum level where ep = 1; and it decreases with decrease in price
over the range ep < 1.
The relationship between price elasticity and TR is summed up in Table 4.1. As the table shows, when
demand is perfectly inelastic (i.e., ep = 0 is as the case of price elasticity at the terminal point at the x-axis)
a rise in price increases the total revenue and vice versa.
In case of an inelastic demand (i.e., ep < 1), the quantity demanded increases by less than the propor-
tionate decrease in price and hence the total revenue falls when price falls. The total revenue increases
when price increases because the quantity demanded decreases by less than the proportionate increase
in price.
M04_DWIV9400_02_SE_C04.indd 92 06/07/11 11:05 PM

600 (a)
M
500
Total revenue (Rs)
400
300
TR = Q ∙ P
200
180
100
O
10 20 30 40 50 60 70 80 90 100 110
Quantity (QX)
20
(b)
18 ep > 1
15
ep = 1
Price and MR (Rs)
10
P
M
ep < 1
R
=
Q
20
5 =
10
!
0
0.
-5
4Q
P DX = AR
O
10 20 30 40 50 60 70 80 90 100 110
Quantity (QX)
MR
MR = 20 - 0.4Q
Figure 4.9 Price Elasticity and Total Revenue
If demand for a product is unit elastic (ep = 1) the quantity demanded increases (or decreases) in the
proportion to decrease (or increase) in the price. Therefore, total revenue remains unaffected.
If demand for a commodity has ep > 1, change in the quantity demanded is greater than the
proportionate change in the price. Therefore, the total revenue increases when price falls and vice versa.
Conversely, if e < 1, increase in price results in increase in TR and decrease in price causes decrease in TR.
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94 Chapter 4
Table 4.1 Elasticity, Price Change and Change in TR

Elasticity Coefficient Nature of Demand Change in Price Change in TR
ep = 0 Perfectly inelastic Increase Increase
Decrease Decrease
ep < 1 Inelastic Increase Increase
Decrease Decrease
ep = 1 Unitary elastic Increase No change
Decrease No change
ep > 1 Elastic and highly elastic Decrease Decrease
Increase Increase
PRICE ELASTICITY AND CONSUMPTION EXPENDITURE

Another important relationship which is often referred in economic analysis is one between price elas-
ticity and total consumption expenditure on the product. From the law of demand, we know that the
quantity demanded of a commodity increases when its price falls. But, what happens to the total expen-
diture (TE) on that commodity—does it fall or increase?
It is important to note here that TE = TR. Therefore, the relationship between TE and price elasticity is
similar to that between TR and price elasticity. However, for the sake of clarity, the relationship between
price elasticity and total consumption expenditure may be explained as follows.
The total consumption expenditure (TEx) on commodity X, at a given price Px, all other prices remain-
ing the same, is given by
TEx = Qx × Px (4.24)
By differentiating Eq. (4.24) with respect to Px, we get marginal expenditure (MEx) as
∂(Q × P) ∂Q
MEx = = Qx + Px x
∂Px ∂Px
⎡ P ∂Q ⎤
= Qx ⎢1 + x ⋅ x ⎥
⎣ Qx ∂Px ⎦ (4.25)
In Eq. (4.25),
Px ∂Qx
⋅ = −e p
Qx ∂Px
Px ∂Qx
By substituting −e p for ⋅ in Eq. (4.25), MEx can be expressed as
Qx ∂Px
MEx = Qx (1 − e p ) (4.26)
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Table 4.2 Elasticity and Consumption Expenditure

Elasticity (ep) Price Change Marginal Expenditure Total Expenditure
ep > 1 Rise ME < 0 Decrease
Fall ME > 0 Increase
ep = 1 Rise ME = 0 Constant
Fall ME = 0 Constant
ep < 1 Rise ME > 0 Increase
Fall ME < 0 Decrease
It may be inferred from Eq. (4.26) that whether the total expenditure increases, decreases or remains
constant as a result of change in price depends on whether
>
Qx (1 − e p ) = Qx
<
Whether Qx(1 − ep) is greater than, equal to or less than Qx depends on whether ep is equal to or greater
than or less than 1. The relationship between, total consumer expenditure and price elasticity of demand
has been summarized in Table 4.2.
The price elasticity and consumption relationship as shown in Table 4.2 can be explained as follows:
1. When ep > 1, i.e., demand is elastic, an increase in the price causes more than proportionate decrease
in the quantity demanded. Hence, total expenditure decreases. And, if the price decreases, the
quantity demanded increases more than proportionately. As a result, total expenditure increases.
2. When ep = 1, a rise (or fall) in the price causes a proportionate decrease (or increase) in the
quantity demanded leaving total expenditure unchanged.
3. When ep < 1, i.e., when demand is inelastic, a rise in the price causes increase in the total expen-
diture because demand decreases less than proportionately, and a fall in price reduces it as the
quantity demanded increases less than proportionately.
OTHER ELASTICITIES OF DEMAND

We have discussed above the various aspects of price elasticity of demand. The price of a product is
undoubtedly the most important determinant of its demand, especially in the short run. But price is not
the only determinant of demand, especially in the long run. Going by the dynamic demand function,
there are some other important demand determinants, viz., (i) price of the related good—substitutes
and complements, (ii) income of the consumers, (iii) advertisement of the product, and (iv) future price
expectation. The elasticity of demand with respect to these demand determinants plays a significant role
in determining the future demand prospects and in business planning. In this section, however, we will
discuss elasticities of demand with respect to the first two determinants of the demand mentioned above.
Cross-Elasticity of Demand
Cross-Elasticity is the measure of responsiveness of demand for a commodity to the changes in the
price of its substitutes and complementary goods. For instance, cross-elasticity of demand for tea (T ) is
M04_DWIV9400_02_SE_C04.indd 95 06/07/11 11:05 PM

96 Chapter 4
the percentage change in its quantity demanded due to a change in the price of its substitute, coffee (C).
Formula for measuring cross-elasticity of demand for tea (et,c) with respect to price of coffee (Pc) is given
below:
Percentage change in demand for tea (Qt )

et ,c =
Percentage change in price of coffee (Pc )
Going by the price elasticity formula, the cross-elasticity with respect to demand for tea and price of
coffee is given as follows:
Pc ∆Qt
et ,c = ⋅ (4.27)
Qt ∆Pc
Similarly, the cross-elasticity of demand for coffee (Qc) with respect to price of tea (Pt) can be
expressed as
Pt ∆Qc
ec ,t = .
Qc ∆Pt
For a numerical example, suppose that price of coffee (Pc) increases from Rs 10 to Rs 15 per 10 g, and
as a result, demand for tea increases from 20 to 30 tons per week, price of tea remaining constant. By
substituting these values in Eq. (4.27), we get cross-elasticity of demand for tea with respect to the price
of coffee, as
10 20 − 30
et ,c = .
20 10 − 15
10 . −10
=
20 −5
= 1.0
Note that cross-elasticity with respect to substitutes is always positive.
The same formula is used to measure the cross-elasticity of demand for a good in response to change
in the price of its complementary goods. Electricity to electrical gadgets, petrol to automobile, butter to
bread, sugar and milk to tea and coffee, are the examples of complementary goods.
It is important to note here that when two goods are substitutes for each other, their demand has
a positive cross-elasticity because increase in the price of one increases the demand for the other. But,
the demand for complementary goods has negative cross-elasticity, for increase in the price of a good
decreases the demand for its complementary goods.
Another important aspect of cross-elasticity is that if cross-elasticities between any two goods are
positive, the two goods can be treated as substitutes for each other. Also, the higher the cross-elasticity,
the closer the substitute. Similarly, if cross-elasticity of demand for any two related goods is negative,
the two may be considered as complementary for each other: the higher the negative cross-elasticity, the
higher the degree of complementarity.
Income Elasticity of Demand

Apart from price of a product and its substitutes, another important determinant of demand for a
product is consumer’s income. As noted earlier, the relationship between demand for normal goods
M04_DWIV9400_02_SE_C04.indd 96 06/07/11 11:05 PM

and consumer’s income is of positive nature. In simple words, the demand for normal goods and ser-
vices increases with increase in consumer’s income and vice versa. The responsiveness of demand to the
change in consumer’s income is known as income elasticity of demand.
Income elasticity (em) of demand for a product, say X, with respect to change in money income (M)
can be defined as:
∆Qx / Qx M . ∆Qx
em = = (4.28)
∆M / M Qx ∆M
where Qx = quantity of X demanded; M = disposable money income; ∆Qx = change in quantity demanded
of X; and ΔM = change in income.
Unlike price elasticity of demand (which is negative except in case of Giffen goods), income elastic-
ity of demand has a positive sign because there is a positive relationship between the income and the
quantity demanded of a product. There is an exception to this rule. Income elasticity of demand for an
inferior good is negative, because of negative income effect. The demand for inferior goods decreases
with increase in consumer’s income and vice versa. When income increases, consumers switch over to
the consumption of superior commodities. That is, they substitute superior goods for inferior ones. For
instance, when income rises, people prefer to buy more of rice and wheat and less of inferior food grains
like bajra, ragi, etc. and use more of taxi and less of bus service and so on.
Nature of Commodity and Income Elasticity For all normal goods, income elasticity is
positive though the degree of elasticity varies in accordance with the nature of commodities. As noted
above, consumer goods are generally grouped under three broad categories, viz., necessities (essential
consumer goods), comforts and luxuries. The general pattern of income elasticities for goods of different
categories for increase in income and their impact on sales are given in Table 4.3.
Income elasticity of demand for different categories of goods may, however, vary from household to
household and from time to time, depending on choice, taste and preference of the consumers; levels of their
consumption and income; and their susceptibility to ‘demonstration effect’. The other factor which may cause
deviation from the general pattern of income elasticities is the frequency of increase in income. If income
increases regularly and frequently, income elasticities will conform to the general pattern, otherwise not.
Uses of Income Elasticity Some important uses of income elasticity are following:
First, the concept of income elasticity can be used to estimate the future demand for a product pro-
vided the rate of increase in income and income elasticity of demand for the product are known. The
knowledge of income elasticity can be used for forecasting demand, when a change in personal income
is expected, other things remaining the same.
Secondly, the concept of income elasticity can also be used to define the ‘normal’ and ‘inferior’ goods.
The goods whose income elasticity is positive for all levels of income are termed as ‘normal goods’. On
the other hand, the goods for which income elasticities are negative, beyond a certain level of income,
are termed as ‘inferior goods’.
Table 4.3 Nature of Commodities, Income Elasticity and Expenditure

Commodities Coefficient of Income Elasticity Impact on Expenditure
1. Necessities Less than unity (ey < 1) Less than proportionate change in expenditure
2. Comforts Almost equal to unity (ey ≅ 1) Almost proportionate change in expenditure
3. Luxuries Greater than unity (ey > 1) More than proportionate increase in expenditure
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98 Chapter 4
APPLICATION OF DEMAND ELASTICITY

Although Samuelson5 condemned the concept of elasticity as an ‘essentially arbitrary’ and a more or less
‘useless concept’, it has many important uses in both economic analysis and formulation of economic
policies. Some important uses of elasticity concept are as follows:
First, the concept of elasticity of demand plays a crucial role in business decisions regarding manoeu-
vring of prices with a view to making larger profits. For instance, when cost of production is increasing,
the firm would like to raise the price. Firms may decide to change the price even without change in cost
of production. But, whether raising price following the rise in cost or otherwise will prove beneficial or
not depends on (a) the price elasticity of demand for the products and (b) its cross-elasticity because
when the price of a product increases, its substitutes become automatically cheaper even if their prices
remain unchanged. Raising price will be beneficial only if (i) demand for a product has an elasticity less
than 1 and (ii) demand for its substitute has cross-elasticity less than 1. Although most businessmen,
intuitively, are aware of the elasticity of demand of the goods they make,6 use of precise estimates of
elasticity of demand adds precision to the business decisions.
Secondly, the elasticity concept can be used in formulating government policies, particularly in
respect of (a) commodity taxation policy aiming at raising revenue or controlling demand; (b) granting
subsidies to the industries; (c) determining prices for public utilities; (d) fixing prices of essential goods;
and (e) in determining export and import duties and the rate of devaluation of domestic currency. To
consider an example, suppose government wants to impose sales tax on a particular commodity with
the sole objective of raising revenue. Whether adequate revenue can be raised or not depends on the
price elasticity of that commodity. If demand is highly elastic, the revenue yield will be much less than
expected. The tax will instead cause price distortion and affect production adversely. But, if objective is
to control demand, then the price elasticity must be greater than 1.
Thirdly, the concept of elasticity is useful in economic analysis, at least for specifying the relationship
between the dependent and independent variables. Besides, the elasticity concept is used in specify-
ing and estimating demand functions. The most common form of demand function used in empirical
research is the ‘constant elasticity demand function’ of the form given below.
QX = A PXB ϒ C P D E FT
in which PX , Y , PY and EET represent, respectively, price of commodity X, consumer’s income, price of
other goods and a trend factor of ‘taste’, and superscripts B, C, D are the respective elasticity coefficients,
and A is a constant.
PRICE ELASTICITY OF SUPPLY

Definition and Measurement
Price elasticity of supply is the measure of responsiveness of the quantity supplied of a good to the
change in its market price. The coefficient of price elasticity of supply (ep) is the measure of percentage
change in the quantity supplied of a good due to a given percentage change in its price. The formula of
supply elasticity is given as
% change in quantity supplied (Q )
ep =
% change in price (P )
M04_DWIV9400_02_SE_C04.indd 98 06/07/11 11:05 PM

The formula is algebraically expressed as

∆Q / Q ∆Q P
= = .
∆P / P ∆P Q
Note that the formula for measuring the price elasticity of supply is the same as for the price elas-
ticity of demand, (without a minus sign). Given the formula, price elasticity of supply can be easily
measured.
Example Suppose that the supply curve for a commodity is given as SS¢ in Figure 4.10 and we want
to measure the price elasticity of the supply between points J and B for rise in price. As the figure shows,
point J indicates price (P) = Rs 5 and supply (S) = 60 units. The movement from point J to B indicates
increase in price from Rs 5 to Rs 7.5 and increase in supply from 60 units to 100 units. In that case,
∆Q = 100 − 60 = 40
∆P = 7.5 − 5 = 2.5
P = 5, and
Q = 60
20 S'
T
15
K
Price (Rs)
10
B
7.5
J
5
O
20 40 60 80 100 120 140 160 180
Quantity supplied X (QX)
Figure 4.10 Price Elasticity of Supply
M04_DWIV9400_02_SE_C04.indd 99 06/07/11 11:05 PM

100 Chapter 4
Substituting these values into the elasticity formula, we get
∆Q . P
ep =
∆P Q
40 . 5
= = 1.33
2.5 60
Consider another example. Suppose we want to measure the price elasticity of supply between points
B and K. Here,
120 − 100 7.5 20 7.5
ep = × = × = 0.6
10 − 7.5 100 2.5 100
The price elasticity of a supply curve like one given in Figure 4.10 may vary between zero and infin-
ity depending on the levels of the supply. For example, as we have seen above, e > 1 for upward move-
ment from point J to B and e < 1 from points B to K. By measuring elasticity for different points, one
can find that price elasticity below point B is greater than unity and it is less than unity beyond point K.
Thus, a supply curve is said to be (i) elastic when e > 1; (ii) inelastic when e < 1; and (iii) unitary elastic
when e = 1. A perfectly inelastic supply has e = 0 throughout its length and is a straight vertical line.
A perfectly elastic supply curve has e = ∞ all along its length and is a straight horizontal line.
Determinants of the Price Elasticity of Supply

The price elasticity of the supply depends on the following factors.
1. Time Period. Time period is the most important factor in determining the elasticity of the supply
curve. In a very short period, the supply of most goods is fixed and inelastic. In the long run, the
supply tends to become elastic. In the long run, the supply of most of the products has maximum
elasticity because the long run provides opportunities and possibilities of increasing production
inputs, new investments, improvement in technology, and for a greater availability of inputs.
It is important to note here that short and long periods are not fixed in terms of days, months
or years. It varies depending on the nature of the product. For example, for the supply of perish-
able commodities like milk and fish in a city, a week’s time may be a short period. For agricul-
tural products, one year can be a short period. But in regard to the local supply of petroleum
products in India, a period of two years or even more may be regarded as a short period.
2. Law of Diminishing Returns. The other factor that determines the elasticity of supply is the
law of diminishing returns. We will discuss this law later in detail when we take-up the laws of
production. Here, suffices it to say that if the law of diminishing returns comes in force at an
early level of production, cost increases rapidly. As a result, supply tends to become less and
less elastic.

1. What is meant by elasticity of demand? What is the purpose and use of the concept of demand
elasticity?
2. What is meant by price elasticity of demand? How is price elasticity of demand measured?
M04_DWIV9400_02_SE_C04.indd 100 06/07/11 11:05 PM

3. (a) Explain the following concepts separately:

(i) price elasticity of demand;
(ii) income elasticity of demand;
(iii) price elasticity of supply; and
(iv) cross-elasticity of demand.
(b) What are the uses of these concepts of elasticity in demand analysis?
4. (a) Explain the concepts of arc and point elasticities of the demand for a commodity.
(b) What is the problem in using the arc elasticity? How can this problem be resolved?
(c) How is the point elasticity on a curvilinear demand curve measured?
5. Prove the following:
(a) Two parallel straight line demand curves have unequal price elasticities at a given price.
(b) Two intersecting straight line demand curves have different elasticities at the point of
intersection.
6. Explain the concept of price elasticity of demand and its relationship with average revenue and
marginal revenue.
7. (a) ‘Elasticity of demand is not just the inverse of the slope’. Comment.
(b) Bring out the relationship between price elasticity of demand, average revenue and mar-
ginal revenue. Why should a revenue maximizing firm not sell below the price where
elasticity is less than 1?
8. (a) What are the determinants of price elasticity of demand?
(b) Prove that two intersecting straight line demand curves have different price elasticities at
the point of intersection.
(c) Prove that in case of two straight line demand curves, with the same point of origin on the
price axis, elasticity at a given price is the same inspite of their different slopes.
9. (a) Compare the elasticity of two parallel demand curves at a given price.
(b) Compare the elasticity of two straight line demand curves intersecting each other at the
point of their intersection.
(c) Explain how average revenue, marginal revenue and elasticity of demand are related with
each other.
10. Suppose a consumer consumes two goods X and Y both being substitutes for one another.
(a) When price of good X rises from Rs 8 to Rs 10, the demand for good Y increases from
50 units to 60 units. Find the cross-elasticity of demand for good Y?
(b) When price of good Y rises from Rs 10 to Rs 12, the demand for X increases from
40 units to 50 units. What is the cross-elasticity of demand for good X?
(c) Will the producer of X or producer of Y prefer to raise its price?
11. What are the different methods of measuring price elasticity of demand? Explain the method of
measuring point elasticity of demand.
12. Suppose a demand schedule is given as follows:
Price (Rs) 100 80 60 40 20 0
Quantity demanded 100 200 300 400 500 600
(a) Find the elasticity for the fall in price from Rs 80 to Rs 60.
(b) Calculate the elasticity for the increase in price from Rs 60 to Rs 80.
(c) Why is elasticity coefficient in (a) different from that in (b)?
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102 Chapter 4
13. Prove:
(a) MR = P[1 − 1/e]
(b) if e = l, MR = 0
(a) When percentage change in price is greater than the percentage change in quantity
demanded, e > 1.
(b) The coefficient of the price elasticity of a demand curve between any two points
remains the same irrespective of whether price falls or rises.
(c) The slope of a demand curve gives the measure of its elasticity.
(d) The slope of demand curve multiplied by P/Q gives the measures the elasticity of
demand.
(e) Two parallel straight line demand curves have the same elasticity at a given price.
(f) Two intersecting straight line demand curves have the same elasticity at the point of
their intersection.
(g) Two straight line demand curves originating at the same point on the price axis have
the same elasticity at a given price.
(h) When income increases, the expenditure on essential goods increases more than
proportionately.
(i) The demand for a commodity increases when price of its substitute increases.
(j) The greater the cross-elasticity, the closer the substitute.
(k) Price elasticity of supply of a commodity is always negative.
(l) Income elasticity of the demand for luxury goods is always positive.
(m) If price elasticity is less than one and price rises, the total expenditure decreases.
(n) If ep = 1, the total revenue increases with the increase in the price.
15. Which of the following gives the measure of price elasticity of demand?
(a) ratio of change in demand to change in price;
(b) ratio of change in price to change in demand;
(c) ratio of percentage change in demand to percentage change in price; and
(d) none of the above.
16. Which of the following gives the measure of price elasticity of demand?
(a) (∆Q/∆ P)(P/Q)
(b) (∆ P/∆Q)(P/Q)
(c) (∆Q/∆ P)(Q/P)
17. Suppose price of a commodity falls and its demand increases so much that elasticity is estimated
to be 1.25. Suppose price increases back to its old level. Will price elasticity be
(a) the same
(b) less than 1.25
(c) higher than 1.25?
18. At a given price, two parallel demand curves have
(a) the same point elasticity,
(b) a different point elasticity?
19. Two intersecting demand curves have at the point of their intersection
(a) the same elasticity
(b) a different elasticity?
M04_DWIV9400_02_SE_C04.indd 102 06/07/11 11:05 PM

20. A less than zero income elasticity indicates that with an increase in income, consumption of
a product
(a) turns negative
(b) increases
(c) decreases
(d) remains constant
21. Suppose a demand function is given as:
Qd = 12 − p
(a) Find demand and marginal revenue schedules;
(b) Plot AR and MR schedules;
(c) Find marginal revenue when P = 10, 6 and 2;
(d) Estimate elasticity coefficient of the demand curve, when total revenue is at maximum.
22. A publishing company plans to publish a book. From the sales data of other publishers of simi-
lar books, it works out the demand function for the book as Q = 5000 − 5P. Find out:
(a) demand schedule and demand curve;
(b) number of books sold at P = Rs 25;
(c) price for selling 2500 copies;
(d) price for zero sales;
(e) point elasticity of demand at price Rs 20; and
(f) arc elasticity for a fall in price from Rs 25 to Rs 20.
23. Suppose demand function for a product is given as Q = 500 − 5P. Find out:
(a) quantity demanded at price Rs 15;
(b) price to sell 200 units;
(c) price for zero demand; and
(d) quantity demanded at zero price.
24. Which of the following statements is true?
(a) if price elasticity = 1, MR = 0
(b) if price elasticity > 1, MR > 0
(c) the price elasticity < 1, MR < 0
[Ans. All Three]
25. Suppose individual demand schedules for A, B and C are given as follows:
Price (Rs) A’s demand B’s demand C’s demand

5 80 40 20
10 40 20 10
15 20 10 5
20 10 5 0
25 0 0 0
Find:
(a) market demand schedule;
(b) market demand curve;
M04_DWIV9400_02_SE_C04.indd 103 06/07/11 11:05 PM

104 Chapter 4
(c) elasticity when price falls form Rs 15 to Rs 10; and

(d) elasticity when price rises from Rs 10 to Rs 15.
[Ans. 15 (c), 16 (a), 17 (b), 18 (b), 19 (b), 20 (c)]
ENDNOTES
1. Lancaster, K. (1974), Introduction to Modern Microeconomics (Chicago: Rand McNally College
Publishing), 2nd Edn. and Mankiw, N.G. (1998), Principles of Economics (Thomson: South-
Western, UK), pp. 92−93.
2. For example, Indian Oil Corporation raised petrol price from Rs 52.63/L to Rs 52.86/L, i.e., by
32 paise in the first week of November 2010. The petrol price had gone up by 0.6 per cent. This
is, of course, an insignificance change in petrol price.
3. Baumol, W.J. (1965), Economic Theory and Operation Analysis (New Delhi: Prentice-Hall of
India Private Limited), 4th edition, p. 187.
4. Proof At price PQ, total revenue = PQ × OQ, which equals the area OBPQ. Considering from
MR angle, the total revenue at price PQ is given by the area OATQ. Therefore, OBPQ = OATQ.
It can be observed from Figure 4.8 that area OBHTQ is common to the areas OBPQ and
OATQ. Therefore, area of ΔABH = area of ΔTPH. Note that ∠ABH and ∠TPH are right angles.
Therefore, ΔABH = ΔTPH. The properties of right-angle triangles of equal size tell that their
corresponding sides are equal. Therefore, BH = HP, AH = HT, and AB = PT.
5. Samuelson, P.A. (1953), Foundation of Economic Analysis (Cambridge: Harvard University
Press), pp. 125−126.
6. Mansfield, E. (ed) (1966), Managerial Economics and Operation Research (New York, NY:
W.W. Norton & Co., Inc.), p. 11.
FURTHER READINGS
Bishop, R.L. (1952), ‘Elasticities, Cross-elasticities and Market Relationships’, American Economic Review.
Browning, E.K., Browning, J.M. (1986), Microeconomic Theory and Applications (New Delhi: Kalyani
Publishers), 2nd Edn., Chapter 3.
Gould, J.P. and Lazear, E.P. (1993), Microeconomic Theory (Illinois: Richard D Irwin, Inc.), 6th Edn.,
Chapter 7.
Koutsoyiannis, A. (1979), Modern Microeconomics (London: Macmillan), 2nd Edn., Chapter 2.
Lerner, A.P. (1933) ‘The Diagrammatical Representation of Elasticity of Demand’, Review of Economics
and Statistics, October.
Lipsey, R.G. (1989), An Introduction to Positive Economics (Oxford: ELBS), 7th Edn., Chapter 6 and
Appendix to Chapter 6.
Marshall, A. (1959), Principles of Economics (London: Macmillan), 8th Edn., Book III, Chapter IV.
Robinson, J. (1959), Economics of Imperfect Competition (London: Macmillan), Chapter 2.
M04_DWIV9400_02_SE_C04.indd 104 06/07/11 11:05 PM

Chapter 5
Application of Market
Laws and Elasticities
CHAPTER OBJECTIVES
By going through this chapter, you learn how laws of demand and supply and the concept of elasticity
are applied to measure the positive and negative effects of certain government policies. The main aspects
discussed here include:
How imposition of a commodity tax (excise duty) affects price, production and consumption of
a commodity;
Who bears the burden of a commodity tax—buyers, sellers, or both? If both bear the tax burden,
what determines the distribution of tax burden between the buyers and sellers;
How a subsidy granted by the government affects production and consumption of a commodity
and who benefits from the subsidy—buyers or sellers;
When the price of a commodity is controlled by the government, how it affects the production and
consumption of the commodity; and
How import tariffs affect imports and how export subsidies affect exports, and how and to what
extent consumption and production of imported and exported goods are affected.
In two previous chapters, we have discussed the laws of demand and supply and also the concept and
measurement elasticity of demand and supply. The laws or demand and supply have been formulated
under restrictive assumptions. The restrictive assumptions of the laws of demand and supply restrict the
application of these laws to certain specific conditions. In spite of this limitation, the laws of demand and
supply can be fruitfully applied to analyse the effects of change in market conditions. More importantly,
the laws of demand and supply can be used to measure and to analyse the effects of certain policy actions
taken by the government. For example, these laws, along with the elasticity of demand and supply, can
be applied to analyse the effect of government’s taxation and subsidy, price control policy, and the effects
of import and export duties. The market laws and elasticities are the two most widely used economic
theories and concepts to analyse the effects of government interventions with the market system. In this
chapter, we will see how demand-and-supply tools can be applied in combination with their elasticities
M05_DWIV9400_02_SE_C05.indd 105 05/07/11 1:24 AM

106 Chapter 5
to find answers to certain important questions pertaining to the effects of government interventions with
the market system.
EXCISE TAX: ITS EFFECTS AND INCIDENCE

We begin our analysis with one of the most common types of government intervention, i.e., imposition
of commodity tax. A commodity tax, also called indirect tax, may be in the form of an excise duty or
sales tax.1 The excise (or sales) tax is imposed either at a lump-sum amount per unit of product or at an
ad valorem rate, i.e., at a percentage rate of the value of the product. Imposition of an indirect tax on
a product has a wide range of impact on its production, price, tax revenue and distribution of the tax
burden, i.e., tax incidence on the consumers and the producers. It all depends on the elasticity of demand
for and supply of the product. In this section, we discuss these aspects of the indirect taxation, just to
show the application of the elasticity of demand and supply to assess the various effects of commodity
taxation. We begin by examining the effects of excise tax imposed at both specific and ad valorem rates.
The effect of excise duty on the market equilibrium, price and production of the product and the distri-
bution of tax burden between the producers and consumers.
Lump-Sum and Ad Valorem Excise Tax

Let us suppose that market demand and supply curves (prior to the imposition of tax) are given by
curves DD¢ and SS1, respectively, as shown in Figure 5.1. The demand curve DD¢ and supply curve SS1
intersect at point E determining equilibrium output at OQ1 and price at OP1.
Let the government now impose an excise tax on the commodity. The excise tax rate may be in the
form of a lump-sum (per unit) tax or in the form of an ad valorem rate. A lump-sum tax rate is a fixed tax
rate per unit of commodity whereas an ad valorem tax is a proportional tax rate imposed as a percentage
of the commodity price. Figure 5.1 illustrates the effect of both lump-sum and ad valorem tax.
S3
S2
D
S1
Tax
P2 A
Price
P1 E
C
P0 B
S
S
S D'
O
Q1 Q2
Quantity
Figure 5.1 Lump-sum and Ad Valorem Excise Tax, Price and Incidence
M05_DWIV9400_02_SE_C05.indd 106 05/07/11 1:24 AM

Application of Market Laws and Elasticities 107
The Lump-Sum Tax Let us see first the effect of a lump-sum tax on demand and supply conditions.
When a lump-sum tax is imposed on a commodity, tax is added to its sale price. As a result, supply curve
shifts leftward remaining parallel to the original one, as shown by the supply curve SS2, in Figure 5.1. The
vertical distance between the two supply curves shows the excise tax per unit. For example, AB measures
the lump-sum excise tax. Note that the new supply curve (SS2) intersects the demand curve at point A,
determining a new equilibrium price OP2 and output OQ1. As Figure 5.1 reveals, imposition of excise tax
causes a decrease in output from OQ2 to OQ1 and an increase in equilibrium price from OP1 to OP2. Note
that the post-tax equilibrium has created a difference between the price buyers pay and the price sellers
retain. At equilibrium point A, the price buyers pay equal to OP2 (= AQ1) and price sellers retain equals
OP0 (= BQ1). The difference between the two prices is the unit excise tax, i.e., excise tax = OP2 − OP0 =
P0P2 or tax = AQ1 − BQ1 = AB.
Ad Valorem or Proportional Excise Tax In case excise tax is imposed at an ad valorem rate
(i.e., at some percentage of the supply price), the supply curve shifts leftward, as shown by the dashed
supply curve, SS3, in Figure 5.1. Note that a proportional tax changes the slope of the supply curve:
the vertical gap between the initial and the new supply curve goes on increasing because per unit tax
increases in proportion to price rise. The new supply curve may pass through any point on the demand
curve depending on the tax rate. In our case, post-tax supply curve (SS3) passes through point A. It shows
that the amount of specific tax and proportional tax is the same at equilibrium output.
The Effects of Excise Tax on Production and Price

Let us now look at the effect of excise tax and production and price of a taxed commodity. It can be seen
in Figure 5.1 that imposition of a tax affects both equilibrium output and price. The excise tax causes
equilibrium output to decrease from its pre-tax level (OQ2) to a lower post-tax level (OQ1) and the price
that buyers pay increases from its pre-tax level OP1 to a higher level OP2. This result holds under the
condition that all other things remain the same. It is clear from the foregoing analysis that the laws of
demand and supply can be applied to find answer to the question: how does commodity taxation affect
price and production? The answer to this question is useful in formulating the tax policy. For, if tax
causes a heavy decline in output and a high rise in price, it may not be desirable to impose tax on essen-
tial and normal goods as it affects social welfare adversely.
Who Bears the Tax Burden?

Excise and sales taxes are intended to be borne entirely by the final consumers and it is also generally
believed that the entire tax burden is borne by the consumers. This is not true. The reason is that market
system distributes the tax burden between both the buyers and sellers. So, given the tax−policy, a ques-
tion arises: who bears the tax burden and in what proportion? Economists apply the laws of demand and
supply and elasticities to find answer to this question. An answer to this question can be obtained graphi-
cally and also numerically. Let us first illustrate the distribution of the tax burden graphically.
Graphical Illustration of Tax Distribution As Figure 5.1 shows, the equilibrium price before
tax was OP1. This is the price which consumers paid and sellers received and retained. After the imposi-
tion of tax, the price that buyers pay rises to OP2 and the price that sellers retain falls to OP0. The differ-
ence between the two prices is the tax, i.e., OP2 − OP0 = P0P2 = tax. For buyers, price rises by P1P2. It means
that buyers pay P1P2 part of the tax (P1P2). On the other hand, for sellers’ price falls by P0P1. It means that
M05_DWIV9400_02_SE_C05.indd 107 05/07/11 1:24 AM

108 Chapter 5
sellers lose P0P1 part of their price. It means that they bear P0P1 part of the tax. Thus, buyers bear P1P2 part
and sellers bear P0P1 part of the tax. Note that P1P2 + P0P1 = P0P2 = tax.
How Is Tax Burden Distributed? The share of buyers and sellers in tax incidence depends on
the price-elasticities of demand and supply. It can be seen in Figure 5.1 that both demand curve (DD¢) and
supply curve (SS1) have almost the same elasticity.2 Therefore, as the figure shows, tax burden is distrib-
uted between the buyers and sellers almost equally. Note that P1 P2 ≅ P0 P1 . This means that if elasticities
of demand and supply for a given change in price are equal, then the buyers and sellers share the tax
burden equally. However, where elasticities of demand and supply are unequal, the distribution of tax is
also unequal. As a general rule, the lower the elasticity, the higher the tax burden and vice versa. This point
is illustrated in Figure 5.2.
How Elasticities Determine Tax Burden In panel (a) of Figure 5.2, demand curve has a
steeper slope and hence it has a lower elasticity than the supply curve, at a given price. Since demand
curve (DD¢) has a lower elasticity than the supply curve (SS1), tax burden on the buyers is larger than
that on the sellers. Buyers bear a tax burden equal to AB = P2P3 and sellers bear the rest of the tax burden
BC = P1P2. It is obvious from the figure that AB > BC or P2P3 > P1P2. It means that buyers bear a higher
tax burden.
Panel (b) of Figure 5.2 presents a reverse case, supply curve having a lower elasticity than the demand
curve. As the figure shows, supply curves SS1 and SS2 are less elastic than the demand curve (DD¢).
Therefore, tax burden on the sellers is larger than that on the buyers. As the figure shows, the tax burden
that falls on the sellers equals to BC and the tax burden that falls on the buyers equals AB. Since BC > AB,
sellers bear a higher tax burden.
(b)
(a)
D D S2
S2
S1
A
S1 P3
A
P3
P2 E
B
Price
Price
P2 B
E
P1 P1 C
C
S S
D'
S S
D'
O O
Q1 Q2 Q1 Q2
Quantity Quantity
Figure 5.2 Elasticities of Demand and Supply and Tax Burden
M05_DWIV9400_02_SE_C05.indd 108 05/07/11 1:24 AM

The Formula for Measuring Tax Incidence Economists have devised the following formula3
for measuring the tax incidence on the buyers and sellers. The formula for measuring the tax incidence
on the buyer (∆Tb ) is given as follows:
es
∆Tb = ∆T
es − ed
(where ∆Tb = buyer’s share in tax; es = elasticity of supply; ed = elasticity of demand; and ∆T = change in
amount of tax).
For example, suppose elasticity of demand for computers is −0.6; elasticity of computer supply
BE . EQ2 BE . EQ2
ed = and es =
AB OQ2 BC OQ2
Since denominator AB is apparently less than denominator BC, all other values being the same, ed >
es is 0.4; and government imposes a tax of Rs 100 per computer. Assuming this is a new tax, ΔT = T. The
tax burden on the computer buyers can be measured as follows:
0.4
∆P = Rs 100 = Rs 40
0.4 − (−0.6)
This shows that the computer buyers bear only Rs 40 of a tax of Rs 100 and the rest (i.e., Rs 60) falls
on the sellers. Computer buyers bear a lower tax burden because demand elasticity is higher (−0.6) than
the supply elasticity (0.4). If elasticity coefficients are reversed, then the distribution of tax burden will
also be reversed. For example, if es = 0.6 and ed = −0.2, the tax incidence on computer buyers will be much
higher (Rs 75) as shown below:
0.6
∆p = Rs 100 = Rs 75
0.6 − (−0.2 )
This proves the point that the lower the elasticity, the higher the tax burden.
What About Sales Tax? A sales tax is imposed on the buyers at the point of sale of a commodity.
The analysis of the production and price effects and distribution of sales tax is similar to that of excise
duty. There is, however, a difference. In case of sales tax, it is the price that buyers pay is affected. There-
fore, in case of sales tax, it is the demand curve which shifts downward,4 supply curve remaining the
same. Rest of the analysis is the same.
PRODUCTION SUBSIDY AND ITS EFFECTS

A subsidy is financial help granted to the producers or to the consumers of subsidized commodities.
Accordingly, a subsidy may be in the form of (a) production subsidy, and/or (b) user subsidy. Under the
production subsidy scheme, the government charges producers a lower price than the market price of the
government supplied inputs, e.g., electricity, transportation and materials, etc. For example, central and
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110 Chapter 5
state governments in India provide fertilizer and electricity subsidy to the farmers, food grains subsidy to
the poor consumers, and education subsidy to the students. The question that we are concerned here are:
1. How does a subsidy affect the equilibrium price and output of the subsidized commodity? and
2. Who benefits from the subsidy?
Let us first look at the effects of production subsidy and its distribution of its benefit between the
producers and consumers.
The Effect of Production Subsidy

A production subsidy may be in the form of a financial grant or in the form of input subsidy.5 From an
analysis point of view, production subsidy can be treated as a negative tax. Therefore, its effect on produc-
tion and price is just reverse to that of excise duty. The effects of subsidy on production and price is illus-
trated in Figure 5.3. The market demand curve is shown by the curve DD¢ and pre-subsidy supply curve by
SS1. The pre-subsidy equilibrium is shown at point A. The equilibrium output is OQ1 and price is OP1 = AQ1.
Let us now suppose that a subsidy of AG (per unit of output) is granted to the producers. The grant
of subsidy reduces the producer’s cost to the same extent for each level of output. As a result, the supply
curve shifts from SS1 to SS2, determining a new equilibrium at point C. As Figure 5.3 shows, grant of
subsidy causes an increase in production from OQ1 to OQ2 and reduces price for the consumers from
S1
D
S2
B
P2
A
P1 J
Price
P0 C
G
S
D´
S
O
Q1 Q2
Quantity
Figure 5.3 Effect of Production Subsidy
M05_DWIV9400_02_SE_C05.indd 110 05/07/11 1:24 AM

OP1 to QP0. At equilibrium, subsidy equals BC = AG. Thus, the application of demand-and-supply model
brings out the effect of production subsidy on equilibrium production and on the price level.
Who Benefits from Production Subsidy?

The term production subsidy makes one feel that the entire benefit goes to producers. But not quite so.
In fact, a part of the benefit gets passed on to the consumers. As Figure 5.3 shows, grant of subsidy creates
a difference between the price consumers pay and the price producers receive. At new equilibrium, the
price that consumers pay equals OP0 = CQ2 and the price that producers receive equals BQ2 − OP2. The
difference between the two prices equals subsidy, i.e., BQ2 − CQ2, = BC = subsidy. Note that at the new
equilibrium, consumers are now required to pay a lower price, CQ2 or OP1. Therefore, consumers benefit
by OP1 − OP0 = P0P1 = JC. Thus, a part of subsidy (JC = P0P1) goes to the consumers. The part of subsidy
that is retained by the producers equals BC − JC = BJ. Clearly, subsidy benefits both the producers
and the buyers. It may be noted at the end that the proportion of benefits that goes to the producers and
to the buyers depends on the elasticities of demand and supply: the lower the elasticity, the higher the
gains from subsidy and vice versa.
IMPORT TARIFFS AND EXPORT SUBSIDIES

This section illustrates the application of the demand-supply model to examine the effects of government
intervention with foreign trade—imports and exports. The most common forms of intervention with
foreign trade are import tariffs and export subsidies. The effects of import tariffs and export subsidies are
analysed below. Let us look first, at the effects of import tariffs.
Import Tariffs
Import tariff, also called import duty, is imposed on the imports with two main objectives: (i) control-
ling imports to protect the domestic industry and (ii) making revenue. The two objectives are often
combined. In India, almost all imports bear import duty.
To begin the analysis, let us consider the case of a country which produces and consumes a commod-
ity, e.g., motor car, and does not allow import of cars. Its domestic demand and supply conditions of car
market are shown by the demand and supply curves, DDC and SSC, respectively, in Figure 5.4.
In the absence of car import, car market equilibrium is determined at point B and the country
produces and consumes AB number of cars at price OA.
Let the country now open trade in cars and allow import of unlimited number of cars. Suppose price
of foreign cars is given at OF in Figure 5.4. With trade opened, car price in the country falls from OA
to OF. At car price OF, total demand for car increases from AB to FK. However, given the domestic car
supply curve, SSC domestic car companies supply only FG number of cars and rest of the demand is met
with imports. Total import of cars equals FK − FG = GK.
Let the government impose a specific tariff of CF on imported cars. As a result, car price increases in
the domestic market from OF to OC = OF + CF. Due to increase in car price, domestic demand for car
decreases from FK to CE of which CD is supplied domestically and DE is imported.
Look at the effects of import tariff. Two obvious effects of import tariff are: (i) domestic production
of car increases from FG to CD, and hence increases domestic employment, and (ii) government makes
a revenue from import duty equal to number of imported cars multiplied by the import tariff (CF).
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112 Chapter 5
SC
D
A B
Car price
C D E
Tariff
F
G H J K
DC
S
S
O
Q1 Q2
No. of cars
Figure 5.4 Effects of Import Tariff
The tariff revenue equals DE × CF. Since import tariff CF = DH, total revenue from import duty equals
DH × DE = DEJH as shown by the shaded rectangle.
Export Subsidy
Export subsidy is similar to production subsidy. The objective of export subsidy is to increase exports
with a view to increasing employment and export earning. The effect of export subsidy is illustrated in
Figure 5.5. The curve DDC is the domestic demand curve and SSC is the domestic supply curve for motor
cars. In the absence of export of cars, the market equilibrium is given at point B which shows total pro-
duction at OQ2 at market clearing price OA = BQ2.
Let us assume that car price in foreign market is OC. Therefore, cars will be exported at a price higher
than the domestic price (OA). As a result, car price increases in the domestic market also from OA to
OC. At this price, total production of cars increases from AB to CF. Of the total production (CF), CE is
consumed domestically and EF is exported.
Clearly, when exports take place, it results in a higher production and higher employment and also
in foreign exchange earnings. This makes sufficient ground for the government to subsidize car export.
Let us suppose that the government provides export subsidy to the extent of CK per unit of car. With
the provision of export subsidy, supply price increases to OK = HQ3—subsidy part of the cost borne by
the government. As a result, supply of cars increases from CF to KH. However, domestic demand for
domestic cars decreases from CE to KJ. This happens because car producers charge domestic buyers a
M05_DWIV9400_02_SE_C05.indd 112 05/07/11 1:24 AM

D SC
J H
K
C G
Car price
D E F
A B
S DC
O
Q1 Q2 Q3
No. of cars
Figure 5.5 Effect of Export Tariff
price equal to the export price. They would otherwise like to export the entire car production. Due to
increase car price in the domestic market, domestic demand for car decreases to KJ. Given the total car
production at KH, total car export equals KH − KJ = JH.
Looking at the effects of export subsidy, like import tariff, there are two obvious gains from the export
subsidy: (i) domestic production of cars increases from CF to KH increasing the level of employment,
and (ii) exports increase from EF to JH, which enhances export earnings of the country. Note also that
with export subsidy, domestic demand for domestic cars declines from CE to KJ. This creates exportable
surplus. However, the provision of export subsidy has a great disadvantage, i.e., it involves financial bur-
den to the extent of export subsidy. The burden of export subsidy equals total export multiplied by export
subsidy per car. As Figure 5.5 shows, total exports equal JH and export subsidy equals KC = JD per unit
of exports. Since KC = JD, total export subsidy equals JD × JH = JHGD. However, total export earning
which equals JH × JQ1 = JQ1Q3H (in terms of domestic currency) is much larger than the financial cost of
export subsidy. Although export earning increases, domestic consumption of cars decreases. The advan-
tage of export subsidy depends on the countries need for foreign exchange.
REVIEW QUESTIONS
1. Explain and illustrate graphically how imposition of excise tax on a commodity affects its price
and production. The entire excise tax is intended to be borne by the buyers. But do the buyers
bear the entire excise tax in reality? If not, why? Illustrate your answer.
M05_DWIV9400_02_SE_C05.indd 113 05/07/11 1:24 AM

114 Chapter 5
2. Suppose price-elasticity of demand for a commodity is 0.5 and price-elasticity of its supply is
1.0 and a tax of Rs 50 per unit is imposed on the commodity. Find the amount of tax that buyers
and sellers will have to bear per unit of commodity.
3. Suppose that the government grants a subsidy to the producers of a commodity. Does the entire
benefit of production subsidy go to the producers? If not, what determines the share of produc-
ers and consumers in the subsidy? Illustrate your answer by using demand and supply curves.
4. What is the objective of import tariff? Explain and illustrate graphically how import of a com-
modity imposed with import tariff is affected? What are its other effects?
5. What is the objective behind the grant of export subsidy? Illustrate graphically how export of
commodity provided with export subsidy is affected? What are financial implications of export
subsidy?
ENDNOTES
1. While excise tax is imposed on goods at the stage of their production, sales tax is imposed at the
stage of their final sale to the consumers.
2. Recall that ep = (∆Q/∆P) (P/Q). At point E, P/Q is the same for both DD¢ and SS1. So the elas-
ticities of the demand and supply curves can be obtained by comparing their respective slopes.
The shift of equilibrium from point E to point A shows that ∆Q in case of both the demand and
supply is the same (CE) and ∆P is almost the same because AC ≅ CB. Therefore, elasticities of
demand and supply curves are almost equal.
3. For the derivation of the formula, see Perloff, J.M. (2001), Microeconomics (New York: Addison
Wesley), 2nd Edn., Appendix 3A.
4. The downward shift in the demand curve after the sales tax imposition can be illustrated as
follows. Suppose a demand function is given as D1 = 50 − 5P. If a sales tax of Rs 2 per unit is
imposed, the demand function would read as D2 = 50 − 5(P + 2). When two demand functions
are plotted graphically, the demand function D2 will be placed below the demand function, D1.
5. In both the cases, cost of production decreases and hence the supply curve shifts right.
FURTHER READINGS
Browning, E.K. and Browning, J.M. (1986), Microeconomic Theory and Applications (New Delhi: Kalyani
Publishers), 2nd Edn., Chapter 4.
Maddala, G.S. and Miller, E. (1989), Microeconomics: Theory and Applications (New York: McGraw-Hill),
Chapters 3 and 4.
Perloff, J.M. (2001), Microeconomics (New York: Addison Wesley), Chapter 3.
M05_DWIV9400_02_SE_C05.indd 114 05/07/11 1:24 AM

Part III
Theory of Consumer Demand
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Chapter 6
Theory of Consumer Demand:

Cardinal Utility Approach
CHAPTER OBJECTIVES
This chapter deals with consumer behaviour. Consumer behaviour refers to how a consumer decides
‘what to consume’ and ‘how much to consume’ so that his/her total utility is maximized, given his/her
income and options. There are two measures of utility—cardinal and ordinal. This chapter presents the
analysis of consumer behaviour based on the cardinal measure of utility. By going through this chapter,
you learn:
What is the meaning of cardinal utility and how it is measured;
How cardinal utility changes with change in consumption of a commodity;
How a consumer finds the level of consumption of a commodity which maximizes his/her total
utility in case of a single commodity case; and
How a consumer consuming many goods find the quantity consumed of each good which maxi-
mizes his/her total utility, given his income and prices of different goods.
INTRODUCTION
In Part II of this book, we had discussed the law of market demand. Recall that market demand is the sum
of individual demand. In this part, we move on to discuss the theory of individual demand. The theory of
individual demand seeks to answer the question: how do individuals and individual households decide
what quantity of a commodity to consume? In fact, almost all households have a limited income and
hence a limited family budget. They spend their budget money on different goods and services they
consume—food, clothes, rent, education, medicine, transport, electricity, entertainment and so on. The
questions that arise here are (i) how do the households decide the quantity of a commodity to consume
at a given price? and (ii) how do they allocate their total consumer expenditure on different goods and
services they consume? These questions take us to the Theory of Consumer Demand. This is the subject
matter of this Part of the book.
The theory of consumer demand formulated by the economists of different schools of thought is
based on the axiom that a consumer is a utility maximizing entity, i.e., maximization of utility is the basic
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118 Chapter 6
objective of the consumer’s choice-making behaviour. But different schools of thought differ on the mea-
surability of utility. While the classical1 and neoclassical2 economists assume that ‘utility is measurable
cardinally’, i.e., measurable in terms of cardinal numbers (1, 2, 3 and so on), the modern economists
believe that ‘utility is not measurable cardinally, it is measurable only ordinally’, i.e., in terms of prefer-
ability of one good over another. This has lead to two main approaches to the analysis of consumer
demand, viz.,
1. Cardinal utility approach and
2. Ordinal utility approach.
In this chapter, we discuss the theory of consumer demand based on cardinal utility approach. The
theory of consumer demand based on ordinal utility approach will be discussed in the next chapter.
The discussion on the further developments in the theory of consumer demand, especially Friedman’s
‘Revealed Preference Theory’ follows in the subsequent chapter.
CARDINAL UTILITY APPROACH TO DEMAND ANALYSIS

As noted earlier, cardinal utility approach to the analysis of consumer demand is based on the assump-
tion that utility is measurable cardinally. Based on this assumption, the neoclassical economists, espe-
cially Alfred Marshall, analysed consumer’s decision-making behaviour in deciding (i) what quantity of
a product to consume and (ii) how to allocate the total consumption expenditure on different goods and
services so that the total utility (TU) is maximized. Before we proceed to discuss the consumer’s behav-
iour based on cardinal utility approach, let us acquaint ourselves with some concepts and laws related to
utility analysis, viz.,
1. The concept of cardinal utility and its measurement.
2. The meaning of TU and marginal utility (MU).
3. The law of diminishing MU.
Let us begin by explaining the concept and measurement of cardinal utility.
The Concept of Cardinal Utility and Its Measurement

The concept of ‘utility’ was introduced to social thoughts by Bentham in 1789 and to economic thoughts
by Jevons in 1871. In general sense, utility is the ‘want satisfying power’ of a commodity. In economic
sense, utility is a psychological phenomenon: it is a feeling of satisfaction, pleasure, happiness or well being
which a consumer derives from the consumption or possession of a commodity. As regards the measure-
ment of utility, some early psychological experiments on individuals’ response to different kinds of
stimuli led the neoclassical economists to believe that ‘utility’ is measurable in cardinal terms, i.e., it can
be expressed in terms of cardinal numbers like 1, 2, 3, …
The neoclassical economists devised the following system to measure the utility of a commodity.
A neoclassical economist, Walras, coined a term ‘util’, meaning ‘units of utility’ and used money as the
measure of utility with the following assumptions:
1. Utility of a commodity equals the money a consumer is willing to pay for it.
2. Utility of money remains constant.
3. Utility of one unit of money = one util, e.g., for an Indian, Re 1 = 1 util.
M06_DWIV9400_02_SE_C06.indd 118 06/07/11 11:21 PM

Theory of Consumer Demand: Cardinal Utility Approach 119
Going by this method of measuring utility, the utility of a commodity for a consumer equals the
money (the price) which he or she is willing to pay for the commodity. For example, if a thirsty person is
willing to pay Rs 50 for one can of Pepsi, his/her utility of one can of Pepsi is 50 utils.
Although there are problems in the quantitative measurement of a utility, the consumption theory
based on cardinal utility concept provides a deep insight into the consumer’s psychology and behaviour
and it remains an indispensable part of economic theory. In fact, it serves as a starting point in the study
of further advances in the theory of consumer demand.
As noted earlier, the theory of consumer demand analyses how consumers decide ‘how much to buy
of a commodity’. The consumer’s decision on ‘how much to buy’ is governed by the law of diminishing
MU. Before we discuss the law of diminishing MU, let us understand the meaning of TU and MU.
The Total and Marginal Utility

Total Utility According to the cardinal utility approach, it is possible to measure and express TU and
MU in quantitative terms. TU from a single commodity, may be defined as the sum of the utility derived
from each unit consumed of the commodity. For example, if a consumer consumes four units of a com-
modity and derives U1, U2, U3 and U4 utils from the successive units consumed, then
TU = U1 + U2 + U3 = U4
If the consumer consumes n units of a commodity, then his TU derived from n units of the commod-
ity may be expressed as
TU = U1 + U2 + U3 + … + Un
In case number of commodities consumed is greater than one, say, x, y, z, …, n, then
TU = TUx + TUy + TUz + … + TUn
where subscripts x, y, z and n denotes commodities.
Marginal Utility The MU can be defined as the utility derived from the marginal or the last unit
consumed. MU is also defined as the addition to the TU derived from the consumption or acquisition of
one additional unit. More precisely, MU is the change in the TU resulting from the consumption of one
additional unit. That is,
∆TU
MU =
∆C
where ΔTU = change in TU, and ΔC = change in consumption by one unit.
MU may also be expressed as
MU = TU n − TU n −1
where TUn = TU derived from the consumption of n units and TUn–1 = TU derived from the consump-
tion of n–1 units.
THE LAW OF DIMINISHING MARGINAL UTILITY

The law of diminishing MU is the fundamental law on which the cardinal utility analysis of the consumer
behaviour is based. This law states that as the quantity consumed of a commodity increases per unit of
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120 Chapter 6
time, the utility derived by the consumer from the successive units goes on decreasing, provided the
consumption of all other goods remains constant. This law stems from the basic facts that (i) the utility
derived from a commodity depends on the intensity or urgency of the need for that commodity and
(ii) as more and more quantities of a commodity is consumed, the need gets satisfied and therefore the
intensity of need decreases. For these reasons, the utility derived from the marginal unit goes on dimin-
ishing. For example, suppose you are very hungry and you are offered sandwiches to eat. The utility that
you derive from the first piece of sandwich would be the maximum because intensity of your hunger
is the highest. When you eat the second piece, you derive a lower satisfaction because intensity of your
hunger is reduced. As you go on eating more sandwiches, the intensity of your hunger goes on decreas-
ing and therefore the satisfaction which you derive from the successive units goes on decreasing. If you
continue to eat sandwiches, a point is reached when your hunger is fully satisfied and therefore the last
piece of sandwich gives you zero utility. Eating sandwiches any more will give you a negative utility in the
form of discomfort or stomachache. This relationship between quantity consumed and utility derived
from each successive unit consumed is called the law of diminishing MU.
Numerical Example
Table 6.1 presents a numerical illustration of the law of diminishing MU. As the table shows, TU increases
with increase in consumption of sandwiches, but at a decreasing rate. It means that MU decreases with
increase in consumption. This is shown in the last column of the table.
It may be seen in the table that the TU reaches its maximum level at 100 at four sandwiches con-
sumed. The consumption of the fifth sandwich gives no utility, i.e., its MU = 0. Consumption of the sixth
sandwich yields a negative utility of 10 and the TU declines to 90.
Graphical Illustration
The law of diminishing MU is graphically illustrated in Figure 6.1. The TU and MU curves have been
obtained by plotting the data given in Table 6.1. The TU curve is rising till the fourth sandwich is con-
sumed. Note that the TU curve is rising but at a diminishing rate. It shows decrease in the MU, i.e., the
utility added to the total. The diminishing MU has been shown by the MU curve. Beyond five sand-
wiches consumed, the MU turns negative. It means that additional consumption of sandwiches yields
disutility in the form of discomfort.
Assumptions
The law of diminishing MU holds only under certain given conditions. These conditions are often
referred to as the assumptions of the law.
Table 6.1 Total and Marginal Utility

Sandwiches Total Utility Marginal Utility = TUn - TUn–1
1 40 40 − 0 = 40
2 70 70 − 40 = 30
3 90 90 − 70 = 20
4 100 100 − 90 = 10
5 100 100 − 100 = 00
6 90 90 − 100 = −10
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110
100
90
80
70
Total and marginal utility
60 TU
50
40
30
20
10
0
1 2 3 4 5 6 7
–10
–20
Sandwiches consumed MU
per unit of time
Figure 6.1 Total and Marginal Utility
First, the unit of the consumer goods must be standard, e.g., a cup of tea, a bottle of cold drink,
a pair of shoes or a shirt and so on. If the units are excessively small or large, the law may not apply. For
example, a sip of tea or a bite of sandwich may increase your desire for more tea or sandwich. It means
that MU increases.
Secondly, consumer’s taste and preference remains unchanged during the period of consumption.
If taste and preference change during the period of consumption, the law may not apply.
Thirdly, there must be continuity in consumption and where break in continuity is necessary, it must
be appropriately short.
Fourthly, the mental condition of the consumer remains normal during the period of consumption.
For, if a person is eating and also drinking alcohol the utility pattern will not be certain.
Given these conditions, the law of diminishing MU holds universally. In some cases, e.g., accumula-
tion of money, collection of hobby items like stamps, old coins, rare paintings and books, and melodious
songs, MU may initially increase rather than decrease, but it does decrease eventually. That is, the law of
MU generally operates universally.
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122 Chapter 6
CONSUMERS’S EQUILIBRIUM: CARDINAL UTILITY

APPROACH
A consumer attains his equilibrium when he maximizes his TU given his income, consumption expendi-
ture and prices of commodities he consumes. Analysing consumer’s equilibrium requires answering the
question ‘how does a consumer allocate his money income to the various goods and services he consumes
to arrive at his equilibrium?’ In this section, we explain how a consumer attains his equilibrium by apply-
ing the cardinal utility approach, first in single commodity case and then the multiple commodity case.
The cardinal utility approach or what is called also as the Marshallian approach to consumer’s
equilibrium is based on the following assumptions.
Assumptions
1. Rationality. It is assumed that the consumer is a rational being in the sense that he satisfies his
wants in order of their merit and the necessity. It means that he buys first a commodity which
yields the highest utility and he buys last a commodity which gives the least utility.
2. Limited Money Income. The consumer has a limited money income to spend on the goods and
services he chooses to consume.
3. Maximization of Satisfaction. Every rational consumer intends to maximize his satisfaction
from his given money income. That is, he chooses the commodities and spends his income on
each of the commodity in such a way that his TU is maximized.
4. Utility is Cardinally Measurable. The cardinalists assume that utility is cardinally measurable,
i.e., it can be measured in absolute terms and in cardinal numbers.
5. Diminishing MU. The cardinalist assumed that the utility gained from successive units of a
commodity consumed decreases as a consumer consumes more and more units of it.
6. Constant Utility of Money. The MU of money remains constant whatever the level of con-
sumer’s income and each unit of money has utility equal to one.
7. Utility is Additive. Cardinalists maintain that utility is not only cardinally measurable but also it
is additive. The additivity of the utility can be expressed through a utility function. Suppose that
the basket of goods and services consumed by a consumer contains n items, and their quantities
may be expressed as x1, x2, x3, …, xn. The utility function of the consumer may be expressed as
U = f(x1, x2, x3, …, xn)
8. Given the utility function, the TU obtained from n items may be expressed as
Un = U1(x1) + U2(x2) + U3(x3) + … +Un(xn)
Consumer Equilibrium: A Single Commodity Case

Having noted the assumptions of cardinal utility approach, we turn to analyse consumer’s equilibrium.
As a general rule, a utility maximizing consumer consuming several commodities reaches his equi-
librium when he maximizes his TU. However, for the sake of simplicity, we illustrate first consumer’s
equilibrium with a simple one-commodity case.
Suppose that a consumer with certain money income consumes only one commodity, X. Since both
his money income and commodity X have utility for him, he can either spend his money income on
M06_DWIV9400_02_SE_C06.indd 122 06/07/11 11:21 PM

commodity X or retain it with himself. If he has total money and no commodity X, the MU of money
will be lower than that of commodity X because MUm = 1. So long as MU of commodity X (i.e., MUx)
is greater than MU of money income (MUm), TU can be increased by exchanging money for the com-
modity. Therefore, a utility maximizing consumer exchanges his money income for the commodity
as long as MUx > MUm. As assumed earlier, MU of commodity of X is subject to diminishing returns
(assumption 5), whereas MU of money income (MUm) remains constant (assumption 6). Therefore, the
consumer will exchange his money income for commodity X as long as MUx > MUm. The utility maxi-
mizing consumer reaches his equilibrium at the level of consumption at which MUx = MUm.
In reality, however, the price of most goods is more than Re 1. In that case, the consumer’s equilibrium
can be expressed as
MUx = Px (MUm) : (where MUm = 1) (6.1)
It implies that the consumer reaches equilibrium where,

MU x
=1 (6.2)
Px (MU m )
Consumer’s equilibrium in a single commodity case is graphically illustrated in Figure 6.2. The hori-
zontal line Px(MUm) shows the constant utility of money weighted by Px (the price of commodity X) and
MUm curve represents the diminishing MU of commodity X. The Px(MUm) line and MUx curve inter-
sect at point E, where MUx = Px(MUx). Therefore, consumer is in equilibrium at point E. At any point
above E, MUx > Px(MUm). Therefore, if a consumer exchanges his money income for commodity X, he
increases his satisfaction per unity of commodity. At any point below E, MUx < Px(MUm), the consumer
M
Marginal utility
E
P Px (MUm)
MUx
O Q
Quantity of commodity X
Figure 6.2 Consumer’s Equilibrium: One Commodity Case
M06_DWIV9400_02_SE_C06.indd 123 06/07/11 11:21 PM

124 Chapter 6
can therefore increase his satisfaction by reducing his consumption of commodity X. That is, at any
point other than E, the consumer gets satisfaction less than maximum. Therefore, point E is the point of
consumer’s equilibrium.
The theoretical fact that the consumer is in equilibrium at point E can be proved by the data shown in
Figure 6.2. As the figure reveals, the TU that the consumer derives by consuming OQ units of X equals
the area OMEQ. The total money that consumer pays for OQ units equals OP × OQ = OPEQ. This is the
total utility of money lost for consuming OQ units. When we subtract the total utility paid (OPEQ) from
the total utility gained (OMEQ), we get the net utility gained. That is, OMEQ − OPEQ = MPE = net util-
ity gain. The net utility gained (MPE) is maximum. It can be checked that any consumption less than or
more than OQ units will reduce the area MPE. So the consumer maximizes his utility at point E where
MUx = MUm.
Consumer Equilibrium: The Multiple Commodity

We have explained earlier consumer’s equilibrium in a single commodity case. In reality, however, a con-
sumer consumes a large number of goods. Let us now see how a consumer consuming a large number of
goods and services reaches his equilibrium.
We know that the MU schedules of various commodities may not be the same. Some commodities
yield higher utility and some lower. The MU of some goods decreases more rapidly than that of others.
A rational and utility maximizing consumer consumes commodities in the order of their utilities. He
picks up the commodity which yields the highest utility and next he picks up the commodity which
yields the second highest utility and so on. He switches his expenditure from one commodity to another
in accordance with their MU. He continues to switch his expenditure from one commodity to the other
until he reaches a stage where MU of each commodity per unit of money expenditure is the same. This is
called the law of equi-MU.
The Law of Equi-MU Let us now present the law of equi-MU in a simple two-commodity case.
Let us suppose that a consumer consumes only two commodities X and Y, their prices given as Px and
Py, respectively. Following the equilibrium rule of single commodity case, the consumer distributes his
expenditure between commodities X and Y so that
MUx = Px(MUm)
and
MUy = Py(MUm)
or alternatively, consumer is in equilibrium where
MU x (6.3)
=1
Px (MU m )
and
MU y
=1 (6.4)
Py (MU m )
M06_DWIV9400_02_SE_C06.indd 124 06/07/11 11:21 PM

Equations (6.3) and (6.4) may be combined to express consumer’s equilibrium condition as follows.
MU x MU y
=1=
Px (MU m ) Py (MU m )
or
MU x Px (MU m )
= (6.5)
MU y Py (MU m )
Since, by assumption 5, MU of each unit of money (or each rupee) remains constant, Eq. (6.5) may
be rewritten as
MU x Px
=
MU y Py (6.6)
or
MU x MU y
=
Px Py (6.7)
Equation (6.7) gives the utility maximization rule that the consumer reaches his equilibrium when
the MU derived from each rupee spent on the two commodities X and Y is the same.
The two-commodity case provides the basis for generalizing the consumer’s equilibrium by the cardi-
nal utility approach in a multi-commodity case. In fact, a consumer consumes a large number of goods
and services with his given income and at different prices. Supposing a consumer consumes A to Z goods
and services, his equilibrium condition may be expressed as follows:
MU A MU B MU C MU Z
= = = ... = (6.8)
PA PB PC PZ
Obviously, a utility maximizing consumer consuming several goods and services intends to equal-
ize the MU of each unit of his money expenditure on various goods and services. This conclusion is in
conformity with the general rule mentioned at the beginning of this section.
DERIVATION OF DEMAND CURVE

The basic purpose of the analysis of consumer behaviour is to derive a consumer demand curve. We
now turn, in this section, to derive the demand curve following the cardinal utility approach. For the
derivation of the demand curve, we consider a single-commodity (X) case. According to cardinal utility
approach, as stated above, a consumer reaches his equilibrium where MUx = Px. This logic of consumer’s
equilibrium provides a convenient basis for the derivation of individual demand curve for a commodity.
Marshall3 was the first economist to explicitly derive the demand curve from consumer’s equilibrium
condition for a single commodity, say X, as MUx = Px. This equilibrium condition is used to derive con-
sumer’s demand curve for commodity X as shown in Figure 6.3(a).
M06_DWIV9400_02_SE_C06.indd 125 06/07/11 11:21 PM

126 Chapter 6
(a)
E1
Marginal utility and price

P3 P3
E2
P2 P2
E3
P1 P1
MUx
O Q1 Q2 Q3 Commodity X
(b)
P3 J
P2 K
Price
P1 L
Dx
O Q1 Q2 Q3 Quantity
Figure 6.3 Derivation of Demand Curve
Suppose that the consumer is in equilibrium at point E1, where given the price of X at P3, MUx = P3.
Here, the equilibrium quantity is OQ1. Now, if the price of the commodity falls to P2 the equilibrium
condition will be disturbed making MUx > P3. Since MUm is constant, the only way to attain the equilib-
rium again is to reduce MUx. This can be done only by buying more of commodity X. Thus, by consuming
Q1Q2 additional units of X he reduces his MUx to E2Q2 and, thereby, restores equilibrium condition, i.e.,
MUx = P2. Similarly, if the price falls further, he buys and consumes more to maximize his satisfaction.
Figure 6.3(a) shows that when the price is P3, the equilibrium quantity is OQ1. When the price
decreases to P2, the equilibrium point shifts downwards to point E2 where the equilibrium quantity is
OQ2. Similarly, when the price decreases further to P1 and price line shifts downwards, the equilibrium
point shifts to E3 where the equilibrium quantity is OQ3. It may be inferred from these facts that as the
price decreases, the quantity demanded increases. This price and equilibrium quantity relationship is
shown in Figure 6.3(b). The price–quantity combination corresponding to equilibrium point E3 is shown
at point J. Similarly, the price quantity combinations corresponding to equilibrium points, E2 and E1 have
been shown by points K and L, respectively. By joining the points J, K and L, we get the demand curve
for commodity X. The demand curve, Dx, is the usual downward sloping Marshallian demand curve.
M06_DWIV9400_02_SE_C06.indd 126 06/07/11 11:21 PM

DRAWBACKS OF CARDINAL UTILITY APPROACH

Although cardinal utility approach provides a sound basis for analysing consumer behaviour, the econo-
mists have pointed out the drawbacks of this approach. The following are the basic drawbacks of the
cardinal utility theory, as pointed out by the economists.
First, the very first assumption of cardinal utility approach that utility is cardinally (or objectively)
measurable is untenable. Utility is a subjective concept which cannot be measured objectively or quan-
tifiably.
Secondly, cardinal utility approach assumes that MU of money remains constant and serves as a mea-
sure of utility. This assumption is unrealistic because the MU of money, like that of all other goods, is
subject to change. And, therefore, it cannot serve as a measure of utility derived from goods and services.
Thirdly, the psychological law of diminishing MU has been established from introspection. This law
is accepted as an axiom without empirical verification.
Fourthly, cardinal utility approach and derivation of demand curve on the basis of this approach are
based on the ceteris paribus assumption which is unrealistic. It is for this reason that this theory ignores
the substitution and income effects which might operate simultaneously.
Finally, cardinal approach considers that the effect of price changes on demand curve is exclusively
price effect. This assumption is also unrealistic because price effect may include income and substitution
effects also.

1. What is meant by utility? Distinguish between the cardinal and ordinal measures of utility.
What are the problems in cardinal measurement of utility?
2. Distinguish between the total utility and the marginal utility. Show that total utility is maxi-
mum when marginal utility equals zero.
3. Explain the law of diminishing utility. Illustrate your answer with appropriate diagrams. Discuss
also the assumptions and limitations of this law.
4. What is meant by the consumer’s equilibrium? What is the condition of the consumer’s equilib-
rium under cardinal utility approach?
5. (a) Suppose the price of a commodity is given at Rs 8 and the marginal utility schedule for four
units consumed is given, respectively, as 12, 10, 8 and 6 utils. What is equilibrium quantity?
(b) Explain the limitations of the equilibrium under cardinal utility approach.
6. Explain the relationship between the law of diminishing marginal utility and the law of demand.
Using this relationship derive a demand curve.
7. Suppose the marginal utility schedule for six units consumed of a commodity is given as follows.
Units consumed 1 2 3 4 5 6
Marginal utils 100 80 60 40 20 0
Find the equilibrium quantity at price Rs 110, Rs 80, Rs 50 and Rs 0.0 assuming (a) the com-
modity is divisible and (b) the commodity is indivisible.
M06_DWIV9400_02_SE_C06.indd 127 06/07/11 11:21 PM

128 Chapter 6
8. From the data given in the following table, derive the TU and MU curves, and find equilibrium
quantity at price Rs 15.
Units 1 2 3 4 5 6 7 8
TU 30 55 75 90 100 100 90 75
9. Which of the following statements is not correct?

(a) Utility is an inherent quality of commodity.
(b) Utility is an absolute concept.
(c) A consumer is in equilibrium when per rupee MU from all the goods he/she consumes
is the same.
(d) The total utility is maximum when MU = 0.
(e) The total utility falls when MU < 0.
(f) At equilibrium, price = MU.
(g) At equilibrium, MU derived from all goods consumed by a consumer is the same even
if price is different.
(h) Any point on the MU-curve can be a point of equilibrium.
(i) Marginal utility of money does not remain constant.
[Ans.: (b) and (g)]
10. Cardinal utility approach assumes which of the following?
(a) MU of money is variable,
(b) MU of money remains constant, or
(c) MU of money is greater than commodity utility?
[Ans.:10 (b)]
11. A consumer consuming three goods, A, B and C, is in equilibrium when MU(A) = MU(B) = MU(C)
under which of the following conditions.
(a) prices of A, B and C remain constant.
(b) prices of three goods are equal.
(c) prices decrease with decrease in MU?
[Ans.: 11 (b)]
ENDNOTES
1. Bentham, J. (1789), An Introduction to the Principles of Morals. For a brief interpretation of
Bentham’s view, see Samuelson, P.A., Economics, 13th Edn., Chapter 19, and Hirshleifer, J.
(1987), Price Theory and Applications, 3rd Edn., pp. 61–64.
2. Including Gossen of Germany (1854), William Stanley Jevons of England (1871), Leon Walrus of
France (1874), Karl Menger of Austria, and Alfred Marshall of England (1890). It was Marshall
who made significant refinements in ‘neoclassical utility theory’ which is called ‘Marshallian
Utility Analysis’.
3. Marshall, A., Principles of Economics, Mathematical Appendix II.
M06_DWIV9400_02_SE_C06.indd 128 06/07/11 11:21 PM

FURTHER READINGS
Alchian, A.A. (1968), ‘The Meaning of Utility Measurement’, The American Economic Review, March
1953, reprinted in W. Breit and H.M. Hochman (eds), Readings in Microeconomics (New York:
Holt, Rinehart and Winston, Inc.), pp. 69–88; and in H. Townsend (ed.), Readings in Price Theory
(Harmondsworth, Middlesex: Penguin, 1971).
Baumol, W.J. (1958), ‘The Cardinal Utility Which is Ordinal’, Economic Journal, 665–72.
——— (1980), Economic Theory and Operations Analysis (New Delhi: Prentice Hall of India), 4th Edn.,
Chapter 9.
Boulding, K.E. (1966), Economic Analysis: Microeconomics (New York: Harper and Row), Vol. 1, 4th Edn.,
Chapters 11 and 12.
Ferguson, C.E. (1958), ‘An Essay on Cardinal Utility’, Southern Economic Journal, 11–23.
——— (1972), Microeconomic Theory (Homewood, IL: Richard D. Irwin, Inc.), 3rd Edn., Chapters 1, 2,
3 and 4.
Green, H. (1971), Consumer Theory (Harmondsworth, Middlesex: Penguin Books).
Hicks, J.R. (1946), Value and Capital, 2nd Edn. (Oxford University Press), Parts I and II.
——— (1956), A Revision of Demand Theory (Oxford: Clarendon Press).
Knight, F.H. (1944), ‘Realism and Relevance in the Theory of Demand’, Journal of Political Economy,
December.
Little, I.M.D. (1949), ‘A Reformulation of the Theory of Consumer’s Behaviour’, Oxford Economic Papers,
January.
Marshall, A. (1920), Principles of Economics (London: Macmillan and Co.), 8th Edn., Book II, Chapter 4
and Book V, Chapters 1 and 2.
Mishan, E.J. (1961), ‘Theories of Consumer’s Behaviour—A Cynical View’, Economica, reprinted in
W. Breit and H.M. Hochman (eds), Readings in Microeconomics (New York: Halt, Rinehart and
Winston, Inc., 1968).
Robertson, D.H. (1957), Lectures in Economic Principles (London: Staples Press), Vol. l, Chapters 1,
2 and 3.
Samuelson, P.A. (1964), ‘A Note on Pure theory of Consumer’s Behaviour’, Economica, February.
M06_DWIV9400_02_SE_C06.indd 129 06/07/11 11:21 PM

Chapter 7
Theory of Consumer Demand:

Ordinal Utility Approach
CHAPTER OBJECTIVES
The objective of this chapter is to present a detailed analysis of consumer behaviour based on the ordinal
utility approach, which is a reasonably technical and extensive subject. By reading this chapter, rather
intensively, you would acquire knowledge regarding the following:
The meaning and properties of an indifference curve, a new tool for analysing consumer behaviour;
The meaning and derivation of a consumer’s budget line, a line derived on the basis of a consumer’s
income and the prices of goods, which determine the consumers’ consumption options;
How consumers find their equilibrium, that is, how a consumer finds the optimum combination
of any two goods that maximizes their total utility, given the consumer’s income and the prices of
the two commodities;
How a consumer’s equilibrium changes with changes in the consumer income in the case of both
normal and inferior goods, all other factors remaining the same;
How a consumer’s equilibrium changes when prices change (consumer’s income remaining the
same) in the case of normal and inferior goods;
How the income and substitution effects of changes in the prices of normal and inferior goods are
measured by using the indifference curve technique;
What is the Giffen paradox and what is its analytical importance.
In the preceding chapter, we have discussed the theory of consumer demand following the cardinal
utility approach, which is based on the assumption that utility is cardinally measurable. In this chapter,
we will discuss the theory of consumer demand based on the ordinal utility approach. The theory of
consumer behaviour based on the ordinal utility concept was developed by two British economists,
namely, J.R. Hicks and R.G.D. Allen, in 1934. This approach is also known as the Hicks–Allen approach.
The ordinal utility approach to consumer analysis is based on the postulate that utility is not measurable
M07_DWIV9400_02_SE_C07.indd 130 07/07/11 12:40 AM

Theory of Consumer Demand: Ordinal Utility Approach 131
cardinally and that cardinal measurement of utility is not necessary for analysing consumer behaviour.
To analyse consumers’ decision-making behaviour, Hicks and Allen used the concept of ordinal utility
and a new tool of analysis called the indifference curve, although the ordinal utility concept and indiffer-
ence curve, as tools of economic analysis, were introduced to economics much earlier.1 In this chapter,
we present a detailed discussion of the application of the ordinal utility approach to the analysis of
consumer behaviour. We will first discuss the analytical tools of the ordinal utility approach—the indif-
ference curve and the budget line—in detail because this provides the analytical framework. Let us begin
our discussion with a brief description of the concept of ordinal utility.
ORDINAL UTILITY CONCEPT AND ITS ASSUMPTIONS

The term ordinal utility indicates the consumer’s preference or choice for one commodity or basket of
goods over another of the same. Preference is expressed in terms of ‘more’ or ‘less’ preferable. It is not
expressed in terms of a quantity or in a numerical value. The concept of ordinal utility is based on the
following axioms:
1. It may not be possible for a consumer to express the utility of a product in quantitative terms.
However, it is always possible for the consumers to tell which of any two goods they prefer.
For example, an individual may not be able to specify how much utility they derive by eating a
chocolate. However, they can always tell what they prefer given a choice between chocolate and
ice cream; between a pair of shoes and a fancy hat; and so on.
2. Consumers can list all the commodities they consume in the order of their preference for the
goods. This gives the essence of ordinal utility.
In the opinion of the ordinalists, these assumptions are sufficient to analyse consumer behaviour. In
their opinion, as mentioned earlier, absolute measurement of utility is neither feasible nor necessary for
analysing consumer behaviour. This marks the most significant departure of the ordinalists from the
cardinal utility approach to consumer analysis.
Assumptions of the Ordinal Utility Theory

The ordinal utility theory of consumer behaviour is based on the following assumptions:
1. Rationality. A consumer is assumed a rational being. It means that consumers aim at maximiz-
ing their total satisfaction; given their incomes and the prices of goods and services, all their
choices and decisions are consistent with this objective. In addition, they have full knowledge
of their own circumstances and the conditions required for a rational decision.
2. Ordinal Utility. Unlike the cardinal utility approach, the ordinal utility approach assumes that
utility is only ordinally measurable by a consumer’s subjective evaluation—an evaluation based
on feeling and opinion. That is, consumers are able to express only the order of their preferences.
3. Transitivity and Consistency of Choice. Consumer’s choices are assumed transitive. Transitivity
of choice means that if a consumer prefers A to B and B to C, they must prefer A to C. Or, if they
treat A = B and B = C, they must treat A = C. Consistency of choice means that if a consumer
prefers A to B during one period, they must not prefer B to A in another period or must not
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132 Chapter 7
treat them as equal, every other factor remaining the same. The transitivity and consistency in
consumer choices may be symbolically expressed as follows:
Transitivity: If A > B and B > C, then A > C; and
Consistency: If A > B in one period, then B >/ A or B ≠ A in another.

4. Non-Satiety. Non-satiety means that consumers have not reached the point of saturation in
the case of a commodity and they are not oversupplied with the goods in question. Therefore,
a consumer always prefers a larger quantity of all the goods.
5. Diminishing Marginal Rate of Substitution. The marginal rate of substitution (MRS) is the
rate at which a consumer is willing to substitute one commodity (X) for another (Y) so that the
total satisfaction obtained from the product remains the same. In this case, the MRS is given by
∆Y/∆X or ∆X/∆Y. The assumption is that, in case the goods X and Y are imperfect substitutes,
then MRS = ∆Y/∆X continues to decrease when a consumer continues to substitute X for Y.
Similarly, when the consumer substitutes Y for X, the MRS = ∆X/∆Y goes on diminishing.
(The MRS is discussed further in the next section.)
INDIFFERENCE CURVE
An indifference curve is defined as the locus of points each representing a different combination of two
goods yielding the same utility or level of satisfaction. Therefore, a consumer is indifferent between any
two combinations of goods when it comes to making a choice between them. Such a situation arises
because a consumer consumes a large number of goods and services and often finds that one commod-
ity serves as an adequate substitute for another. This gives the consumers an opportunity to substitute
one commodity for another. In that case, they are able to form various combinations of two substitute
goods that give them the same level of satisfaction. When a consumer is faced with such combinations
of goods, they would be indifferent between the combinations. When such combinations are plotted
graphically, it results in a curve. This curve is known as the indifference curve. Indifference curves are
also called iso-utility or equal utility curves.
For example, let us suppose that a consumer forms five combinations a, b, c, d and e of two com-
modities, X and Y, as presented in Table 7.1. All these combinations yield the consumer the same level of
satisfaction (U). The consumer is, therefore, indifferent to the choice between them. The five combina-
tions of the two commodities X and Y may be called an indifference schedule.
Table 7.1 Indifference Schedule of Commodities X and Y

Combination Commodity X + Commodity Y Utility
a = 25 + 5 = U
b = 15 + 7 = U
c = 10 + 12 = U
d = 6 + 20 = U
e = 4 + 30 = U
M07_DWIV9400_02_SE_C07.indd 132 07/07/11 12:40 AM

30
25 a
20
Commodity Y
b
15
c
10
d
5 e
O 5 7 10 12 15 20 25 30
Commodity X
Figure 7.1 Indifference Curve
Table 7.1 shows five combinations of two goods, X and Y, which give the same utility. The last column
of the table shows an unquantified utility (U) derived from each combination of X and Y. Utility (U) is
unquantified because, under the ordinal utility approach, utility is not measurable quantitatively.
When the combinations a, b, c, d and e given in Table 7.1 are plotted and joined by a smooth curve (as
shown in Figure 7.1), the resulting curve IC is known as the indifference curve. On this curve, one can
locate many other points showing many other combinations of X and Y, which yield the same level of
satisfaction. Therefore, the consumer is indifferent to the choice between the points on the indifference
curve. Therefore, the curve is called the ‘indifference curve’.
Indifference Map
Figure 7.1 presents a single indifference curve IC drawn based on the indifference schedule given in
Table 7.1. The consumer may similarly frame many other combinations of X and Y with less amounts
of both the goods such that each combination yields the same level of satisfaction but which is less than
the level of satisfaction indicated by the indifference curve IC in Figure 7.1. Similarly, a consumer can
concoct many other combinations with more of one or both the goods—each combination yielding
the same satisfaction, but with values greater than the satisfaction indicated by the lower indifference
curves. Thus, another indifference curve can be drawn above the IC curve. This exercise may be repeated
as many times as one wants, each time generating a new indifference curve. A set of indifference curves
constitute the indifference map, as shown in Figure 7.2.
In fact, the area between the X- and the Y-axes is known as the indifference plane or the commodity space.
This plane contains finite points and each point on the plane indicates a different combination of the goods
X and Y. Intuitively, it is always possible to locate two or more points indicating different combinations of
the goods X and Y yielding the same satisfaction. It is thus possible to draw a number of indifference curves
M07_DWIV9400_02_SE_C07.indd 133 07/07/11 12:40 AM

134 Chapter 7
Commodity Y
IC4
IC3
IC2
IC1
O
Commodity X
Figure 7.2 The Indifference Map
that neither intersect nor are tangent to one another, as shown in Figure 7.2. The set of indifference curves,
IC1, IC2, IC3 and IC4, drawn in this manner constitute the indifference map. In fact, an indifference map may
contain any number of indifference curves ranked in the order of consumer’s preferences.
The Concept of Marginal Rate of Substitution (MRS)

As mentioned earlier, the MRS is the rate at which one commodity can be substituted for another, the
level of satisfaction remaining the same. The MRS is given by the slope of the IC curve.
To explain the concept of MRS, let us suppose that a consumer consumes only two goods X and Y and
that the utility function of the product for the consumer is given as
U = f (X, Y ) (7.1)
where X and Y are imperfect substitutes.
Let us now suppose that the consumer substitutes X for Y such that the total utility remains the same.
When the consumer sacrifices some units of Y, the stock of Y decreases by ∆Y and the consumer loses
a part of the total utility of the goods. This loss of utility2 may be expressed as
−∆Y ⋅ MUy
On the other hand, as a result of substitution, the stock of X increases by ∆X. The corresponding gain
of utility from ∆X equals
+∆X ⋅ MUx
The total utility remains the same only when
−∆Y ⋅ MUy = +∆ X ⋅ MUx (7.2)
M07_DWIV9400_02_SE_C07.indd 134 07/07/11 12:41 AM

Rearranging the terms in Eq. 7.2, we get,

∆Y MUx
− =
∆X MUy
Here, ∆Y/∆X is simply the slope of the indifference curve, which gives the MRSy.x when X is substi-
tuted for Y. Similarly, ∆X/∆Y gives MRSx.y when Y is substituted for X. Symbolically,
∆X MU y ⎫
MRS x , y = − = ⎪
∆Y MU x ⎪
⎪ (7.3)
and ⎬ − Slope of the indifference curve
∆Y MU x ⎪
MRS y , x =− = ⎪
∆X MU y ⎪⎭
Postulates of Diminishing MRS

Diminishing MRS is one of the basic assumptions during the indifference curve analysis of consumer
behaviour in the case of substitute goods. The axiomatic assumption of the ordinal utility theory is anal-
ogous to the assumption of ‘diminishing marginal utility’ in the cardinal utility theory. The assumption
of diminishing MRS states an observed behavioural rule that when a consumer substitutes one commod-
ity (say X) for another (say Y), the MRS decreases as the stock of X increases and that of Y decreases. The
diminishing MRSx,y computed from Table 7.1 is presented in Table 7.2.
As Table 7.2 shows, when the consumers move from point a to point b on the indifference curve
(Figure 7.1), they give up 10 units of the commodity Y and take in 2 units of commodity X. It gives the
following expression:
−∆Y −10
MRS y , x = =− =5
∆X 2
As the consumers move down from point b to point c, they lose five units of Y and gain five units
of X, giving the equation
−∆Y −5
MRS y , x = = − =1
∆X 5
The MRSy,x continues to decrease as the consumer moves further down along the indifference curve,
from points c through d and e. The diminishing MRS causes the indifference curves to be convex to the
origin.
Table 7.2 Diminishing MRS Between Commodities X and Y

Movements on IC Change in Y (-DY ) Change in X (D X) MRSy,x = DY/D X
From point a to point b −10 2 −5.0
From point b to point c −5 5 −1.0
From point c to point d −4 8 −0.5
From point d to point e −2 10 −0.2
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136 Chapter 7
A
Commodity Y
∆Y1
B
∆X1
∆Y2
C
∆X2
∆Y3
D
∆X3 IC
O Commodity X
Figure 7.3 Diminishing Marginal Rate of Substitution
The diminishing MRS can also be illustrated graphically as shown in Figure 7.3. The MRSy,x is given
by the slope of the indifference curve.
As shown in Figure 7.3, as the consumers move from the point A to B, from B to C, and from C to D,
they give up a constant quantity of Y (i.e., ∆Y1 = ∆Y2 =∆Y3). For a constant ∆Y, they require an increasing
quantity of X (i.e., ∆ X1 < ∆ X2 < ∆ X3) to maintain the total utility of the goods at the same level. Because
MRS equals the slope of the indifference curve (i.e., ∆Y/∆X), arranging the slopes between the point A
through point D in the same order, we get
∆Y1 ∆Y2 ∆Y3
> >
∆ X1 ∆ X 2 ∆ X 3
It can be seen that ∆Y1 = ∆Y2 = ∆Y3, whereas ∆X1 < ∆X2 < ∆X3. Therefore, the value of MRSy,x = ∆Y/∆X
continues to decrease as the consumer moves from point A towards point D.
The diminishing MRS is illustrated graphically in Figure 7.4. Lines tangential to the indifference
curve at the points A, B and C measure the slope of the curve at these points. It can be seen from the
figure that as the consumer moves from point A towards D, the tangential lines become flatter indicating
a decrease in the slope of the indifference curve. This indicates a diminishing MRS all along the indif-
ference curve.
Why the MRS Declines

The decline in the MRS in the case of two imperfect substitute goods is caused by two factors, namely
1. the law of diminishing marginal utility (MU), and
2. the decline in the ability of the consumer to sacrifice a commodity whose quantity goes on
declining.
M07_DWIV9400_02_SE_C07.indd 136 07/07/11 12:41 AM

A
Commodity Y
C
IC
O Commodity X
Figure 7.4 Marginal Rate of Substitution at Different Points on the IC Curve
Let us now see how these factors cause decline in the MRS.
1. The Declining MU. The movement along an indifference curve—downwards or upwards—indicates
a decline in the quantity of one good and increase in the quantity of the other. In the consumer’s
subjective perception, the MU of the commodity with decreasing quantity increases and that of the
commodity with increasing quantity decreases. For example, if the consumer goes on substituting
commodity X for commodity Y, the quantity of Y goes on decreasing and the quantity of X goes on
increasing. As a result, the MU of Y goes on increasing and the MU of X goes on decreasing. There-
fore, when consumers sacrifice an additional unit of Y, they require increasing units of X to recover
the loss of utility and to maintain the level of their satisfaction. As a result, the MRS decreases.
2. Decline in Consumer’s Ability to Sacrifice a Commodity. Another factor causing the MRS to
diminish is the quantity of a commodity available to the consumer. When the combination of
two goods at a point of the indifference curve is such that it includes a large quantity of one com-
modity, (say, Y ) and a small quantity of the other commodity (X), then the consumer’s capacity
to sacrifice Y is greater than that to sacrifice X. Therefore, they can sacrifice a larger quantity of Y
in favour of a smaller quantity of X. For example, in the combination a (Table 7.1), the total stock
of Y is 25 units and that of X is 5 units. Therefore, the consumer is willing to sacrifice five units of
Y for one unit of X (Table 7.2). This is an observed behavioural rule that the consumer’s willing-
ness and capacity to sacrifice a commodity is greater when its stock is greater and lower when its
stock is smaller. This is another reason why the MRS decreases all along the indifference curve.
PROPERTIES OF INDIFFERENCE CURVES

The indifference curve is a tool of analysis. As a tool of analysis, it has the following four basic properties:
1. Indifference curves have a negative slope.
2. Indifference curves combining imperfect substitutes are convex with reference to the origin.
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138 Chapter 7
3. Indifference curves do not intersect.

4. An upper indifference curve implies a higher level of satisfaction than the lower ones.
Indifference Curves Have a Negative Slope

‘So long as each commodity has a positive marginal utility, the indifference curve must slope down-
wards to the right’.3 The negative slope of an indifference curve implies that in a basket of two substitute
goods, if the quantity of one commodity decreases, the quantity of the other commodity must increase
if the consumer has to maintain the same level of satisfaction. For, if the quantity of the other com-
modity does not increase simultaneously, the basket of commodities decreases with the decrease in
the quantity of one commodity. Moreover, a smaller bundle of goods is bound to yield a lower level of
satisfaction.
Indifference Curves Are Convex with Reference to the Origin

Indifference curves for normal goods have not only a negative slope, but are also convex with reference
to the origin. The convexity of the indifference curves implies that:
The two goods are imperfect substitutes for one another.
The MRS between the two goods decreases as a consumer moves along an indifference curve.
Convexity in the indifference curve is caused by the diminishing MRS.
Indifference Curves Neither Intersect Nor Are Tangential

to One Another
If two indifference curves intersect or are tangential to each other, it would imply two types of inconsis-
tencies in indifference curve logistics: (1) upper and lower indifference curves indicate the same level of
satisfaction; and (2) two different combinations—one being larger than the other—yield the same level
of satisfaction. Such conditions are improbable if a consumer’s subjective valuation of utility of a com-
modity is greater than zero. Obviously, if two indifference curves intersect, it would mean a violation of
the consistency or transitivity assumption for consumers’ preferences.
Let us now prove the point graphically. Suppose two indifference curves, IC1 and IC2, intersect at
point A, as shown in Figure 7.5. Consider two other points—point B on the indifference curve IC1 and
point C on the indifference curve IC2, both falling on a vertical line.
Points A, B and C represent three different combinations of commodities X and Y. Let us call these
combinations, respectively, as A, B and C. Note that combination A is common to both the indifference
curves, points A and B fall on the same IC curve IC1 and points A and C fall on the same IC curve IC2. It
implies that because points A and B fall on the same indifference curve IC1, in terms of utility, the com-
binations of goods X and Y at these points yield the same utility. That is, in terms of utility:
A=B
Similarly, points A and C fall on the same indifference curve, IC2. It means that in terms of utility:
A=C
Because A = B and A = C, it means that:
B=C
M07_DWIV9400_02_SE_C07.indd 138 07/07/11 12:41 AM

Commodity Y
B
IC1
IC2
O M N
Commodity X
Figure 7.5 Intersecting Indifference Curves
However, if B equals C, it would mean that, in terms of utility:

ON of X + BN of Y = ON of X + CN of Y.
Because ON of X is common to both the terms, it means that BN of Y is equal to CN of Y. However,
as Figure 7.4 shows, BN > CN. Therefore, combinations B and C cannot be equal in terms of utility in the
subjective introspection of the consumer. The intersection, therefore, violates the transitivity rule, which
is a logical necessity in indifference curve analysis.
Higher Indifference Curves Represent a Higher level of

Satisfaction than the Lower Ones
An indifference curve placed above and to the right of another represents a higher level of
satisfaction than the lower one. The reason is that an upper indifference curve contains all along its
length a larger quantity of one or both the goods than the lower one. Moreover, a larger quantity of a
commodity is supposed to yield a greater satisfaction than a smaller quantity of the same, provided
MU > 0.
For example, consider the indifference curves ICl and IC2 in Figure 7.6. The vertical movement from
point a on the lower indifference curve, IC1, to point b on the upper indifference curve, IC2, means an
increase in the quantity of Y by ab, the quantity of X remaining the same (OX). Similarly, a horizontal
movement from point a to point d means a greater quantity of commodity X, the quantity of Y remain-
ing the same. A diagonal movement from point a to point c means larger quantities of both X and Y.
Unless the utility of additional quantities of X and Y are equal to zero, these additional quantities will
yield additional utility. Therefore, the level of satisfaction indicated by the upper indifference curve IC2
would always be greater than that indicated by the lower indifference curve IC1.
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140 Chapter 7
b
Quantity of Y
Y d
a
IC2
IC1
O X
Quantity of Y
Figure 7.6 Comparison Between Lower and Upper Indifference Curves
OTHER TYPES OF INDIFFERENCE CURVES

In the preceding sections, we have discussed the nature, shape and characteristics of the indifference
curves pertaining to normal, but imperfect, substitute goods. In reality, however, the consumers’ con-
sumption basket contains many other types of consumer goods. From an analysis point of view, the other
types of consumer goods are classified under the following two categories.
Perfect substitutes
Complementary goods
In this section, we discuss the nature and the shape of the indifference curves pertaining to perfect
substitutes and complementary goods.
Perfect Substitutes
Generally, two goods are considered perfect substitutes for one another when the utility derived from
either of the goods is the same. For example, wheat and rice, tea and coffee, electricity and cooking gas
for the kitchen, petrol and diesel, whisky and rum, and so on are perfect substitutes for some, if not for
all, consumers. In the case of two goods (X and Y) being perfect substitutes for one another, the MRS
between them (i.e., ∆X/∆Y and ∆Y/∆X) remains constant and the indifference curve assumes the shape
of a straight line, as shown by the line MN in Figure 7.7(a).
Complementary goods
A number of pairs of complementary goods may be cited: tables and chairs, shirts and trousers, tea
and sugar, bread and butter, tyres and tubes, car and petrol, and so on. The indifference curve for
complementary goods is L-shaped, as shown in Figure 7.7(b). The indifference curve has a sharp
M07_DWIV9400_02_SE_C07.indd 140 07/07/11 12:41 AM

(a) (b)
Perfect Complements
Quantity of Y
Quantity of Y
substitutes
O N O
Quantity of X Quantity of X
(a) (b)
Figure 7.7 Indifference Curves: (a) Perfect Substitutes; (b) Complementary Goods
convexity only at one point, giving it a rectangular shape. The rectangular shape of the indifference
curve implies that an increase in the quantity of X without an increase in the quantity of Y (or an increase
in the quantity of Y without any addition to the quantity of X) leaves the consumer at the same level of
satisfaction. It means that an additional quantity of one commodity without a corresponding increase in
the quantity of the other does not yield additional satisfaction.
GOODS, BADS AND NEUTERS

In the preceding sections, how a consumer fabricates combinations of any two goods. The goods are
defined as the goods and services that yield pleasure or satisfaction. Goods yield positive utility, for
example, food, clothes, house, furniture, car, pen, paper, and so on. Goods add to the welfare of the
consumer. In other words, things that do some good to the consumers are called goods. It must, how-
ever, be noted that some goods may not necessarily do any good to the consumer in the real sense. For
example, cigarettes and drugs do not do any good to the smokers and drug users, respectively. Such
goods are called bads. However, these are goods to the corresponding consumers in the economic sense
of the term. In addition, some goods do neither good nor bad. Such goods are called neuters. In real life,
however, the consumers’ choices are not limited to only goods. People are often faced with a situation in
which they have to make choices between goods and bads and between goods and neuters.
In this section, we discuss how consumers organize combinations of goods and bads; and goods and
neuters.
What Are the Bads and the Neuters?

Bads Bads are the things that yield disutility to the people, for example, environmental pollution,
water pollution, noise pollution, adulterated commodities, unhygienic sanitation, industrial toxins,
atomic radiation, passive smoking and social insecurity. Such things are called bads. Because bads give
negative utility to the people, less of bads is always preferable to having more of them.
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142 Chapter 7
Some ‘bads’ are produced directly for a profit motive and are consumed willingly, for example,
cigarettes, drugs, ghutka and so on. However, most bads are by-products of goods. For example, environ-
mental pollution is the by-product of industrial production; air pollution is the by-product of thermo-
electricity; air and noise pollution are the by-products of transportation facilities in the city; the growth
of slums and slum-born diseases are the by-products of industrial growth; risk and return in the choice
of asset portfolio; and so on. It is important to note here that most bads are associated with some goods.
Furthermore, goods turn into bads when they begin to yield disutility beyond a certain level
of consumption. That is, goods become bads when they begin to yield negative marginal utility.
This happens in the case of almost all normal consumer goods. For example, food is good but eating
food beyond a limit is bad because it is dangerous for health.
Neuters Things that yield neither utility nor disutility to their consumers are called neuters. Your old
furniture and paintings (which you do not feel like throwing away), old newspapers, neighbour’s old car
lying on the roadside, neighbour’s pets, and somebody playing unobjectionable music in your neigh-
bourhood are some examples of neuters. Objects whose disutility cancels out their utility also fall in this
category. The neuters may turn bads beyond a certain level.
While there are definitely certain goods, bads and neuters, some goods may turn neuters and then
bads, beyond a certain level of consumption and with a change in consumers’ tastes and preferences. Let
us now look at the possible shapes of the indifference curves related to goods, bads and neuters.
Indifference Maps for Goods, Bads and Neuters

Because goods are often accompanied by bads and neuters, consumers have to make up their consump-
tion basket comprising (1) good and good, (2) good and bad, (3) good and neuter, and (4) bad and bad.
The indifference curves and indifference maps pertaining to good and good—the normal goods—have
already been discussed in the section ‘Properties of Indifference Curves’. In this section, we depict the
indifference map for the combinations of goods, bads and neuters.
1. Indifference Map for a Good and a Bad. In fact, more of a good is always preferable to less of it
and less of bad is always preferable to more of it. Therefore, if people have the option, they will
opt for all goods and no bads. However, consuming some bad is often unavoidable. Therefore,
people combine the unavoidable minimum of bad and any amount of good they can afford.
In this case, an indifference curve will be a straight line—vertical or horizontal.
In reality, however, bads are often inseparable from goods. For example, heavy industrial pollu-
tion inevitably goes along with higher industrial production; a larger demand for automobiles
means greater air pollution and traffic congestion in the city, and a greater demand for wooden
furniture or timber leads to greater level of deforestation. Therefore, if society wants to have
more of such goods, it will have to accept more of bads too. The indifference curve will, there-
fore, have a positive slope, as shown in Figure 7.8.
In Figure 7.8, the vertical axis measures the number of automobiles (a good) and the horizontal
axis measures air pollution (a bad). If a society chooses to have greater number of automobiles,
it will have to accept greater air pollution and vice versa. This is shown by the indifference curves
IC1, IC2 and IC3 in Figure 7.8. All the points on the same indifference curve denote equal sat-
isfaction. However, any point on the upper indifference curve IC2 is preferable to any point on
the lower indifference curves. For example, point L on IC2 is preferable to points J and K on IC1
because it signifies a combination of good and bad yielding a greater utility. Similarly, point M on
IC3 is preferable to point L on IC2.
M07_DWIV9400_02_SE_C07.indd 142 07/07/11 12:41 AM

IC3 IC2 IC1
Automobiles (a good)
M
L K
Preference
direction
O
Air pollution (a bad)
Figure 7.8 Indifference Map for a Good and a Bad
2. Indifference Curve for a Good and a Good-Turning-Bad. Certain goods remain goods for any
level of consumption, such as money, gold, jewellery, house, car, and so on. In general, however,
most consumer goods retain the property of being a good only up to a certain point, that is, the
point of satiety. Beyond the point of satiety, such goods become bads if consumed or are forced to
be consumed beyond that level. The common examples of such goods are eatables and drinks, for
example, ice cream, fruits, sweets, tea, coffee, and so on. Apparently, these are all goods. However,
eating or drinking these things beyond the point of satiety results in discomfort or displeasure.
It means, they become bads as they begin to yield disutility. So is the case with clothes and other
consumer durables. Such goods create a storage problem, occupy space and involve cost of main-
tenance. This is their disutility. Therefore, beyond the point of satiety, lesser amounts of such
goods are preferable to more of them. However, if one has to consume more of a bad, then a
much larger quantity of good will be required to offset the disutility of the bad. In such cases, the
indifference curve takes the shape of a bowl, as shown in Figure 7.9.
Figure 7.9 shows the indifference curve of money—an eternal good—and car, which turns a
bad beyond the point of satiety. Suppose point J on the indifference curve IC1 marks the desir-
able number of cars. Up to this point, cars remain a good. The consumer is willing to substitute
money with car. Beyond point J, however, car becomes a bad as it involves the cost of mainte-
nance, parking space, driver, and so on, yielding little or no utility. Therefore, the direction of
the consumer’s preference becomes changed. Consumers would be equally happy with more of
money (the good) and more of car (now, the bad), as indicated by point L; and less of money
and less of car, as indicated by point M. However, given the opportunity, the consumer would
prefer to move from points K and L towards point M.
3. Indifference Curves for a Good and a Neuter. A neuter is a commodity that gives neither util-
ity nor disutility. The consumer is, therefore, indifferent to the level of its consumption. In
Figure 7.10, the commodity X is a neuter and commodity Y is a normal good. Whatever the con-
sumption level of Y, the consumers do not care whether they have more or less of the commod-
ity X, the neuter. In this case, the indifference curve takes the form of a straight horizontal line.
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144 Chapter 7
Zone I Zone II
preference preference
direction direction
IC3
IC2
IC1
Money
M L
K
J
N
Car
Figure 7.9 Indifference Map for a Good and a Good Turning Bad
Preference
direction
Quantity of Y (normal good)
IC3
IC2
IC1
Quantity of X (neuter)
Figure 7.10 Indifference Map for a Good and a Neuter
However, if the neuter is measured along the vertical axis, it will be a vertical line. As shown in
Figure 7.10, the consumer will prefer to move from the lower to the upper indifference curve—
from IC1 to IC2 and from IC2 to IC3.
This takes us to the end of our discussion (given the undergraduate courses) on the indifference curve
as a tool of analysis. In the next section, we will discuss consumers’ budget options for making a choice
from among different possible combinations of two goods that they consume.
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BUDGETARY CONSTRAINT AND THE BUDGET LINE

The indifference curve, as a tool of analysis, is not sufficient to determine the utility-maximizing basket of
the consumer. Given an indifference map, a utility-maximizing consumer would like to reach the highest
possible indifference curve on the indifference map. However, the consumer is assumed to have a limited
income. It follows that unless the consumer’s income and the prices of the goods are known, the con-
sumer’s utility-maximizing consumption basket cannot be determined. The reason is that a consumer’s
limited income and the prices of goods create a constraint on the consumer’s choice. The consumer’s
limited income and the prices of goods act as constraints on the utility-maximizing behaviour of the
consumer. This is known as budgetary constraint. The budgetary constraint, assuming a two-commodity
model and given income in terms of money, may be expressed as:
Px ⋅ Qx + Py ⋅ Qy = M (7.4)
where Px and Py are the prices of X and Y, respectively; Qx and Qy are their respective quantities; and
M is the consumer’s income in terms of money.
Equation 7.4 is called the budget equation. The budget equation indicates that a consumer, given a
specific income and the market prices of X and Y, can buy only a limited quantity of the two goods
(i.e., Qx and Qy). From Eq. 7.4, Qx and Qy can be worked out as follows:
M Py (7.5)
Qx = − Q
Px Px y
M Px (7.6)
Qy = − Q
Py Py x
Equations 7.5 and 7.6 show how Qx and Q y can be estimated, given the numerical values of M, Px, Py
and Qx (or Qy). Given these equations, the values of Qx and Qy can be calculated as shown here:
If Qy = 0, then Qx = M / Px ; and if Qx = 0, then Qy = M /Py
Similarly, Qx (or Q y) may be alternatively assigned any positive numerical value and the corre-
sponding values of Qy (or Qx) may be obtained. In this way, a schedule showing different combinations
of Qx and Qy can be prepared. When the values of Qx and Qy are plotted on the X- and Y-axes, respec-
tively, it gives a line, which is called the budget line or price line, as shown in Figure 7.11. Note that the
budget line has a negative slope. It means that if more of X is purchased, then less of Y can be purchased.
An easier method of drawing the budget line is to find a point M/Py on the Y-axis (assuming Qx = 0)
and a point M/Px on the X-axis (assuming Qy = 0). These points are indicated by the points M/Px and
M/Py on the X- and Y-axes, respectively, in Figure 7.11. The budget line can be obtained by joining these
points by a line, as given by the budget line in Figure 7.11. The slope of the budget line remains constant
because Px and Py are the exchange rate Qx ⋅ Px/ΔQy ⋅ Px is constant.
Note that the budget line divides the commodity space into two parts, which may be termed the
feasibility and non-feasibility areas. The area lying below the budget line is the feasibility area (Figure 7.11).
Any combination of goods X and Y, which is represented by a point in this area (e.g., point A) or on
the boundary line (i.e., the budget line) is a feasible combination, given M, Px and Py. The area above
the budget line is the non-feasibility area because any point falling in this area, for example, point B,
is unattainable (given M, Px and Py).
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146 Chapter 7
M/Py
Q
y = M B
P Non-feasibility
Quantity of Y
x
P area
x
P
y Q
x
A
Feasibility Budget line
area
x
O M/Px
Quantity of X
Figure 7.11 Budget Line and Budget Space
What Causes Shifts in the Budget Line

The two factors that cause shifts in the budget line are as follows:
1. Changes in consumer’s income
2. Change in the prices of goods
The budget line changes its position following a change in the consumer’s income or the prices of
commodities. If a consumer’s income increases—the prices of X and Y remaining the same—the budget
line shifts upwards, remaining parallel to the original budget line. As shown in Figure 7.12, given the
consumer’s income M, Px and Py, the budget line is given by the line AB. When M increases (prices
remaining constant), the budget line shifts to CD. Income M remaining the same, a change in prices
changes the position of the budget line. For example, if M and Py remain constant and Px decreases to half
the original value (i.e., new price = Px/2), the budget line will shift to AF. Similarly, M and Px remaining
constant, if Py is doubled, the budget line shifts downwards to the position of EB.
Slope of the Budget Line

Another aspect of the budget line, which is of great importance in determining consumers’ equilibrium,
is its slope. The slope of the budget line AB in Figure 7.13 is given by:
∆Qy OA
=
∆Qx OB
M07_DWIV9400_02_SE_C07.indd 146 07/07/11 12:41 AM

C
Quantity of Y
x
O B D F
Quantity of X
Figure 7.12 Shift in the Budget Line
A M/Py = OA
Quantity to Y
!Qy
!Qx
M/Px = OB
x
O B
Quantity to X
Figure 7.13 Slope of the Budget Line
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148 Chapter 7
Because OA = M/Py and OB = M/Px (Figure 7.13), the slope of the budget line can be expressed as:
OA M /Py P (7.7)
= = x
OB M/Px Py
Thus, the slope of the budget line equals the price ratio of the two goods.
CONSUMER EQUILIBRIUM: THE ORDINAL

UTILITY APPROACH
Having introduced the necessary tools of analysis—the indifference curve and the budget line—used in
the ordinal utility approach, we proceed now to discuss consumer behaviour under this approach. We
begin with the analysis of consumer equilibrium.
As noted earlier, consumers attain equilibrium when they maximize the total utility of their com-
modities, given their income and the prices of goods and services they consume. According to the ordi-
nal utility approach, two conditions must be satisfied for the consumer to be in equilibrium. These are
1. necessary or first-order conditions
2. supplementary or second-order condition.
The necessary condition for maximum utility requires that the MRS must be equal to the price ratio.
Considering our two-commodity model, the necessary condition may be expressed as:
Px
MRS. y =
Py
The second-order or supplementary condition requires that the necessary condition must be fulfilled
at the highest possible indifference curve.
Consumers attain their equilibrium at a point where both these conditions are satisfied. Consumer
equilibrium is illustrated in Figure 7.14. The indifference curves IC1, IC2 and IC3 represent a hypothetical
indifference map of a consumer and the corresponding budget line is given by the line AB. The budget
line AB is tangential to IC2 at point E. This point fulfils both the necessary and the supplementary condi-
tions. At point E, the slopes of the indifference curve IC2 and the budget line AB are equal. This fulfils
the first-order condition.
∆Y
= MRS y . x
∆X
We know from Eq. 7.3 that the slope of an indifference curve is given by:
∆Y
= MRS y , x
∆X
and that the slope of the budget line is given by Eq. 7.7 as:
OA Px
=
OB Py
M07_DWIV9400_02_SE_C07.indd 148 07/07/11 12:41 AM

J
Quantity of Y
E
Qy
P M
IC3
IC2
X
K
IC1
O Qx B
Quantity of X
Figure 7.14 Equilibrium of the Consumer
In Figure 7.14, point E marks the consumer’s equilibrium because at point E, MRSy.x = Py/Px. This
satisfies the necessary condition. Therefore, the consumer is in equilibrium at point E. The tangency of IC2
with reference to the budget line, AB, indicates that IC2 is the highest possible indifference curve that the
consumer can reach, given their budgetary constraint. Point E satisfies, therefore, also the second-order
condition. At the equilibrium point E, the consumer consumes OQx of X and OQy of Y, which yield the
maximum satisfaction for the consumer, given the constraints.
Note that the necessary condition is satisfied with reference to two other points also—points J and K
(i.e., the points of intersection between the budget line AB and the indifference curve IC1). These points
do not satisfy the supplementary or second-order condition because the indifference curve IC1 is not
the highest possible curve on which the necessary condition is fulfilled. Given the budget line AB, the
indifference curve IC2 is the highest possible indifference curve that the consumer can reach. Therefore,
as long as utility-maximizing consumers have the opportunity to reach curve IC2, they would not like to
settle for a lower indifference curve.
From the information contained in Figure 7.14, it can be proved that the level of satisfaction at point E
is greater than that on any point on IC1. Suppose that the consumer is at point J. If the consumer moves to
point M, they will be equally well-off because points J and M are on the same indifference curve. If they
move from point J to M, they will have to sacrifice JP of Y and take PM of X. However, in the market,
they can exchange JP of Y for PE of X. That is, they can get extra ME (= PE – PM) of X. Because ME
gives the consumer extra utility, they reach point E. Point E yields a utility higher than that at point M
or J. Therefore, point E is preferable to points M and J. The consumer will, therefore, have a tendency to
move to point E from any point on IC1 to reach the highest possible indifference curve, all other factors
(taste, preference, and prices of goods) remaining the same.
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150 Chapter 7
Corner Solution: The Extreme Choice

Sometimes, some consumers make extreme choices between a set of two substitute goods. For example,
some consumers prefer to spend their total money on clothing and no money on making trips to hill
stations, even though they have the option of making a choice between various combinations of these
goods. Some consumers behave just to the contrary. Similarly, some people prefer to buy books rather
than spend money on movies; some people prefer work to leisure, and so on. In such cases, the necessary
equilibrium conditions, that is, MRS = Px/Py, does not apply. In this section, we use indifference curve
analysis to show the choice-making behaviour of such consumers.
Figure 7.15 illustrates the case of such extreme preference of a consumer. Let us suppose that a
consumer has to make a choice between clothing and tours and is faced with the budget line CT. The
indifference map is given by the indifference curves IC1, IC2 and IC3. Given the budget line and the
indifference map, the consumer is shown to be in equilibrium at point C, the corner point. This type of
solution is known as the corner solution. As Figure 7.15 shows, the consumer’s indifference curve IC1
intersects the budget line. Because IC1 is a lower curve, the consumer cannot maximize the utility of
commodities on the indifference curve IC1. However, the indifference curve IC2 meets the budget line at
the corner point C. This is the point of the consumer’s equilibrium, the point of maximum satisfaction.
Note that in the case of a corner solution or corner equilibrium, MRS ≠ price ratio: the slope of the indif-
ference curve IC2 at point C is less than the slope of the budget line CT. The corner solution shows that
consumers spend their entire money on clothing and nothing on tours to hill stations. This implies that
if consumers had more income, they would spend it on clothing, not on travels. This presents the case
of the corner solution.
IC3
Clothing
IC2
IC1
O T
Tours
Figure 7.15 The Corner Solution
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Composite Goods Case

The indifference curve analysis is based on a two-commodity model. A question that arises here is
whether the two-commodity model applies to the real world where people consume a large number
of goods and services. The two-commodity model is used because the multiple-goods case cannot be
graphically presented on a two-dimensional paper. This should not mean that indifference curve analysis
cannot be applied to the multiple-goods case. It can still be applied meaningfully to the multiple-goods
case by grouping various goods and services—food, clothing, housing, education, medicine and so on—
into two broad categories: (1) food and (2) all other goods4 making a ‘composite good’ with their given
prices. This approach is known as the composite good convention.
Figure 7.16 illustrates consumer equilibrium under the composite-good convention. As the figure
shows, total expenditure on composite good is measured on the vertical axis and food on the horizontal
axis. Suppose that the consumer gets a weekly money income of OM. The consumer has the option to
spend the total income either on food or on composite good or on a combination thereof. If consumers
spend their total income on food, they are at point N; and if they spend their total income on composite
good, they are at point M. Their budget line is given by the line MN. Unlike the budget line in the
Figure 7.15, here, the slope of the budget line shows how much food the consumers can buy by shifting
one rupee from composite good to food. The consumers’ indifference map is given by IC1, IC2 and IC3 and
their budget line MN is tangential to the indifference curve IC2 at point E. It means that the consumers
spend MA part of their income on food and buy AE = OQ quantity of food. They spend an amount OA
on composite good. This pattern of expenditure takes them to point E. Point E satisfies the consumer
equilibrium conditions. Therefore, at point E, they maximize the total utility of their commodities.
M
Expenditure on composite good
E
A
IC3
IC2
IC1
O Q N
Expenditure on food
Figure 7.16 Consumer Equilibrium: Composite Goods Case
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152 Chapter 7
CHANGES IN INCOME AND CONSUMER BEHAVIOUR

We have so far discussed consumer behaviour under the assumption that the consumer’s income and the
prices of goods and services remain constant. In reality, however, a consumer’s income and commod-
ity prices do not remain constant, changing over time. These changes cause changes in the consumer’s
consumption basket. In this section, we examine the effects of changes in consumers’ income on their
consumption behaviour, assuming that the prices of all goods and services and the consumers’ tastes and
preferences remain constant. In the following section, we will analyse the effects of changes in prices.
Income Effects on Consumer Behaviour Towards Normal Goods

Normal goods are, in general, goods whose consumption increases with increase in consumer’s income.
When consumers’ income increases, prices remaining constant, their budget line shifts upwards, remain-
ing parallel to the original budget line. In addition, when their income decreases, the budget line shifts
downwards. It implies that when consumers’ income increases, they consume more of normal goods;
and vice versa.
Figure 7.17 illustrates the parallel and upward shift in the budget line and its effect on the consumed
quantity of two normal goods, X and Y. Suppose, a consumer’s income is given by M1 and the prices of
X and Y are Px and Py, respectively. With the money income M1 and prices Px and Py, the consumer’s
budget line is given by the line AB and the consumer is initially in equilibrium at point E1 on IC1. Let the
J
C
Income–consumption
C curve (ICC)
Quantiy of Y
E4
A E3
E2
IC4
E1
IC3
IC2
I
IC1
O B D K N
Quantity of X
Figure 7.17 Income Effect and Income–Consumption Curve
M07_DWIV9400_02_SE_C07.indd 152 07/07/11 12:41 AM

consumer’s income now increase to M2. As a result, the budget line shifts from position AB to CD and
the consumer reaches a new equilibrium point E2 on IC2. Similarly, if the income increases successively
from M2 to M3 and then to M4, the budget line shifts from CD to JK and then to TN; and the consumer
will move from equilibrium E2 to E3 and then to E4. Thus, with each successive upward shift in the budget
line, the equilibrium position of the consumer shifts upwards.
The successive equilibrium combinations of the goods X and Y at four different levels of income are
indicated by the points E1 E2, E3 and E4 in Figure 7.17. These points of equilibrium joined by a curve
give the path of increase in consumption resulting from the increase in income. This curve is called the
income–consumption curve (ICC) and is shown by the curve IC. An ICC may be defined as the locus of
points representing various combinations of two commodities purchased by the consumers at different levels
of their income, all other factors remaining the same.
Inferior Goods
An inferior good is one whose consumption decreases with an increase in consumer’s income. In other
words, when the income effect on the consumption of a commodity is negative, the commodity is said
to be inferior. It must be borne in mind that no commodity is in itself superior or inferior—there may
be some exceptions. In fact, the level of income and the consumers’ perceptions, tastes and preferences
make a commodity superior or inferior. The general consumer behaviour, however, shows that some
commodities are inferior to some others and people consume less of such goods when their income
increases. For example, when income increases, the consumption of inferior food grains, such as bajra,
millet, maize and so on, decreases beyond a level of income. Similarly, with an increase in income, the
demand for two-wheelers decreases and that for four-wheelers increases. Figures 7.18(a) and (b) present
the case of the negative income effect on the consumption of inferior goods. Figure 7.18(a) presents the
ICC for X as an inferior good. Its consumption decreases from OX2 to OX1 when the consumer’s income
increases and the budget line shifts from AB to JK. The income effect on consumption of X is, therefore,
negative. In Figure 7.18(b), the income effect on Y is negative because Y is an inferior commodity.
J
(a) (b)
Commodity Y (inferior)
C
J
Commodity Y
A
ICC
C
IC3
A Y2
Y1
IC2 ICC
IC1 IC2
IC1
IC3
O X1 X2 B D K O B D K
Commodity X (inferior)
Commodity X
Figure 7.18 Income–Consumption Curves of Inferior Goods
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154 Chapter 7
Income and Consumption: The Engel Curve 5

Engel curve is the graphical presentation of the relationship between quantity of a commodity purchased
at equilibrium and the consumer’s income. It should be borne in mind that the ICC and the Engel curve
are not the same. The ICC shows the relationship between a consumer’s income and the combination
of two goods consumed by the consumer, whereas the Engel curve shows the relationship between the
income and expenditure, in terms of money, on a particular good. However, the ICC does provide the
necessary information required to draw the Engel curve. The derivation of the Engel curve from the ICC
is illustrated in Figures 7.19(a) and (b). The ICC in Figure 7.19(a) shows that consumption of commod-
ity X increases from OX1 to OX2 to OX3 and then to OX4 as the income increases from M1 to M2 to M3 and
M4
(a)
M3 (ICC)
Quantity of Y
E4
M2
E3 IC4
M1
E2
IC3
E1
IC2
IC1
O X1 X2 X3 X4
Quantity of X
Engel curve
(b)
M4
Total income
M3
M2
M1
O X1 X2 X3 X4 Quantity of X
Figure 7.19 Derivation of the Engel Curve
M07_DWIV9400_02_SE_C07.indd 154 07/07/11 12:41 AM

Engel curve
Income
O Quantity of X
Figure 7.20 Engel Curve for an Inferior Good
then to M4; simultaneously, the consumer moves from equilibrium El to E2 to E3 to E4. In Figure 7.19(a),
the income levels have been shown on the vertical axis. The quantities of X demanded plotted in relation
to the corresponding levels of income represents the Engel curve, as shown in Figure 7.19(b).
Although the income–consumption curve (ICC) and the Engel curve are not identical, the curvature
of the ICC depends on the Engel curve. In other words, the shape of the Engel curve depends on the
shape of the ICC. For example, if commodity X is an inferior one and the information contained in
Figure 7.18(a) is plotted, the Engel curve will assume the shape shown in Figure 7.20.
Engel and Demand Curves

The Engel curve shows the relationship between income and consumption of a commodity. The income–
consumption relationship in the case of normal goods is shown in Figure 7.19(b). The income–
consumption relationship is not sufficient to analyse consumer demand. However, the Engel curve can
be used to show the effect of changes in income on the demand curve for a commodity. The effect of
changes in income on the demand curve is illustrated in Figure 7.21(a) of the figure presents an Engel
curve for a normal good, X, and Figure 7.21(b) presents the price–demand relationship. As Figure 7.21(a)
shows, at income OM1, the consumer is at point A and consumes OX1 of commodity X, given its price.
Let us suppose that the consumer’s demand curve for commodity X is given by the demand curve
D1 shown in Figure 7.21(b). Assuming the price of commodity X to be Px and linking this price to the
quantity consumed, OX1, in Figure 7.21(a), we locate point A′ in Figure 7.21(b). Point A′ signifies that, in
a price–commodity plane, one of the consumer’s demand curves will pass through this point, as shown
by demand curve D1.
Now, let the consumer’s income increase from OM1 to OM2 and the consumption of X increase from
OX1 to OX2, as shown by point B in Figure 7.21(a). When we link this change in demand for commodity
X with the given price Px, we reach point B′ in Figure 7.21(b) of the figure. Point B′ falls on a higher
demand curve D2. This implies that an increase in income, given the price of a commodity, shifts the
demand curve rightwards.
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156 Chapter 7
Y (a)
Engel curve
Money income
B
M2
A
M1
x
O X1 X2 Commodity X
(b)
Px
Price of commodity X
A´ B´
Px
D2
D1
x
O X1 X2 Commodity X
Figure 7.21 Engel Curve and Demand Curves
Engel Curve and Income Elasticity of Demand

Income elasticity of demand (ey ), as shown in Chapter 4, is measured as follows.
∆Q Y
ey = ⋅
∆Y Q
where Y is the income in terms of money.
M07_DWIV9400_02_SE_C07.indd 156 07/07/11 12:41 AM

Now that we have derived the Engel curve, we have a clear view of the income–demand relationship.
In fact, the Engel curve is the same as the income–demand curve because it gives the quantity of a com-
modity demanded at different levels of consumer income. The Engel curve gives the variables used in
measuring the income elasticity. For example, the movement from point A to point B in Figure 7.21(a)
of Figure 7.21 gives ∆Y = M1M2 and ∆Qx = X1X2, with M = M1 and Q = X1. By substituting these values in
the income-elasticity formula, we get
X 1 X 2 M1
ey = ⋅
M1 M 2 X 1
Considering a numerical example, suppose the weekly income (M) of an individual increases from
Rs 5,000 to Rs 6,000 and the corresponding weekly demand for petrol (Q) increases from 20 litres to
25 litres. In that case,
M = 5,000
Q = 20
DM = 6,000 – 5,000 = 1,000
DQ = 25 – 20 = 5
By substituting these values in the income-elasticity (ey) formula given earlier, we get
5 5, 000
ey = ⋅ = 1.25
1, 000 20
It means that a 1 per cent increase in income causes a 1.25 per cent increase in the demand for petrol.
CHANGES IN PRICES AND CONSUMER BEHAVIOUR

In the previous section, we have discussed the effects of changes in consumer’s income on the quantity
of a commodity consumed, assuming the prices of goods as constant. In this section, we discuss the
effects of changes in the prices of a commodity on the quantity of its consumption, all other prices and
consumer’s income remaining constant. The consumer’s response to the change in price depends, ceteris
paribus, also on whether a commodity is a normal good or an inferior good. We discuss here first the
consumer response to a change in the price of normal goods. The case of inferior goods will be discussed
later in a subsequent section.
Changes in Price and Consumer Behaviour: Case of Normal Goods

When the price of a commodity changes, all other factors remaining constant, both the position and
the slope of the budget line change. This changes the consumer’s budgetary options. Given the new
budgetary options and relative prices, a rational consumer adjusts the consumption basket to maximize
the utility of the commodities. The change in the consumption basket caused by the changes in prices
is called the price effect. The price effect may be defined as the change in the consumption basket due to a
change in prices.
Let us now discuss in detail the effect of price change on consumer behaviour. The consumer’s
response to changes in the price of X and the resulting change in the combination of two goods are
illustrated in Figure 7.22.
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158 Chapter 7
L
Quantity of Y
Price–consumption
curve (PCC)
E1 E4
E2 E3
IC4
IC2 IC3
IC1
M N P Q
O
Quantity of X
Figure 7.22 Price–Consumption Curve
Suppose that the consumer is initially in equilibrium at point E1. Now, let the price of X decrease,
ceteris paribus, so that the consumer’s budget line shifts from its initial position LM to the position LN.
This shift takes place due to the increase in the consumer’s purchasing power with reference to X. Armed
with this increased purchasing power, the consumer can buy more of X (or more of both the goods). As
a result, the consumer reaches a higher indifference curve IC2 and finds a new equilibrium at point E2.
As shown in Figure 7.22, with successive falls in the price of X, the consumer’s equilibrium shifts from
E2 to E3 to E4. The shift in equilibrium shows the changes in the equilibrium quantities of X and Y. By
joining the points of equilibrium E1, E2, E3 and E4, we get a curve called the price–consumption curve
(PCC). The PCC is a locus of all those points of equilibrium on the indifference curves that result from
the change in the price of commodity X, all other factors remaining the same. It shows the changes in
the consumption basket due to changes in the price of commodity X. In other words, the PCC shows the
consumer’s response to changes in the price of X.
Derivation of Consumer Demand Curve

The basic purpose behind the analysis of consumer responses to changes in price is to derive the
consumer demand curve, especially from the market analysis viewpoint. In Chapter 6, we have discussed
the derivation of consumer demand under the cardinal utility approach using the MU curve. In this
section, we show the derivation of consumer demand under the ordinal utility approach using the
indifference curve technique.
To draw the individual demand curve for a commodity, say X, we need data regarding the different
prices of the commodity X and the quantity of X demanded at different prices. This information is
provided by the PCC. The derivation of the demand curve for commodity X is illustrated in Figure 7.23.
M07_DWIV9400_02_SE_C07.indd 158 07/07/11 12:41 AM

M (a)
Commodity Y
E1
PCC
E2 E3
IC1 IC3
IC2
O X1 N1 X2 N2 X3 N3
Quantity of X consumed per unit of time
(b)
E1
Px3 Px3 = M/ON1
Price (Px)
E2
Px2 Px2 = M/ON2
E3
Px1 Px1 = M/ON3
Dx
O X1 X2 X3
Quantity of X demanded per unit of time
Figure 7.23 Derivation of Individual Demand Curve
Figure 7.23(a) shows the derivation of the PCC. Given the consumer’s income, the prices of goods
X and Y and the corresponding indifference map, the consumer is shown to be initially in equilib-
rium at point E1, where they consume OX1 of X. When the price of X decreases, the consumer moves
to equilibrium point E2, where they consume OX2; and when the price of X falls further, the consumer
moves to equilibrium point E3, where they consume OX3. What we need now is to find the correspond-
ing price for each of these quantities of X consumed at different prices. The price of commodity X can be
worked out by assuming that the consumer has a money income M, which they spend on goods X and Y.
The budget line MN1 shows that if the consumer spends the total income M on X, they can buy ON1
of X. It means that the price of X = M/ON1. Let us denote this price by Px3, this being the highest price.
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160 Chapter 7
Table 7.3 Demand Schedule for Commodity X

Price (Px) Equilibrium Point Quantity of X Demanded
Px3 = M/ON1 E1 OX1
Px2 = M/ON2 E2 OX2
Px1 = M/ON3 E3 OX3
It means that the consumer consumes ON1 of X at price Px3. Similarly, we can work out the prices with
reference to the other budget lines and construct a demand schedule for the commodity X, as given in
Table 7.3. A demand curve for commodity X can be drawn by plotting the demand schedule, as shown
in Figure 7.23(b).
Graphical Derivation of Demand Curve

The demand curve can be drawn directly by plotting the data shown in Figure 7.23(a). This is shown
in Figure 7.19(b). Let the vertical axis of Figure 7.23(b) measure the price of commodity X—Px3, Px2
and Px1 representing the three prices we have considered in Figure 7.23(a). If we draw horizontal lines
from points Px3, Px2 and Px1, we get three price levels in Figure 7.23(b), shown by the dashed lines,
Px3 = OM/ON1, Px2 = OM/ON2, and Px1 = OM/ON3. We know that the quantity consumed at Px3 is OX1
[Figure 7.23(a)]. If we extend the ordinate E1X1, to the X-axis of Figure 7.23(b), it intersects the line
Px3 at point E1. By repeating this process for the prices Px2 and Px1, we get points E2 and E3. By joining
the points E1, E2 and E3, we get the demand curve, Dx, as shown in Figure 7.23(b). This demand curve
pertains to normal goods.
(i) It may be added here that the precise shape and slope of the demand curve depends on the direc-
tion in which the income and substitution effects6 of the price fall work. In fact, the substitution
effect is positive7 in the case of normal goods, but the income effect is uncertain. Therefore, given
the positive substitution effect, the shape of the demand curve depends on the direction and mag-
nitude of the positive income effect. The four possible combinations of substitution and income
effects of a fall in the price of a commodity and the corresponding nature of the demand curve
may be summarized as follows:
1. When the substitution and income effects are positive, the quantity of X demanded increases
as Px decreases. Therefore, the demand curve slopes downwards to the right. This is a case
of ‘normal’ goods.
2. If the income effect is negative but less than the substitution effect (as happens in the case of
inferior goods), the demand curve slopes downwards to the right more steeply than usual.
3. If the income effect is zero, the demand curve follows the substitution effect, that is, as
the price decreases, the demand increases. The demand curve has a negative slope but is
relatively flatter.
4. If the income effect is negative and is more powerful than the substitution effect (as happens
in the case of Giffen goods), the demand curve bends backwards, similar to the Engel
curve. However, it is most unlikely that any demand curve will slope downwards to the left
throughout its whole length.8 It will be so only over that particular range of price changes
over which the negative income effect is stronger than the substitution effect. This aspect
of the demand curve will be discussed in detail when we take up the case of inferior goods.
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INCOME AND SUBSTITUTION EFFECTS OF PRICE

CHANGE: NORMAL GOODS CASE
As noted earlier, a change in the price of a commodity, say X, other factors remaining the same, causes a
change in the demand for X. This change in demand is called the price effect. The total price effect con-
sists of two direct effects of the price change on a consumer’s choice, namely, the income effect and the
substitution effect.
Income effect arises due to a change in a consumer’s real income or purchasing power caused by the
change in price. A rise in price reduces and a fall in price increases a consumer’s real income. Further,
a change in the real income causes a change in the consumer’s consumption basket. This is called the
income effect of price change.
On the other hand, substitution effect arises due to a change in the relative price. When the price of
one commodity decreases, it becomes relatively cheaper than the other. The consumers have an inherent
tendency to substitute cheaper goods for relatively costlier ones. This is called substitution effect.
Thus, the total price effect is composed of the income and substitution effects. These effects are not
reflected in quantitative terms in consumers’ choices. Economists have, however, used the indifference
curve technique to decompose the price effect into income and substitution effects.
In this section, we will explain how the total price effect is split into its two components—income
and substitution effects. There are two methods of decomposing the total price effect into income and
substitution effects:
1. Hicksian Method
2. Slutskian Method
We now describe how these two methods accomplish the task of measuring the income and substitu-
tion effects of the total price effect in the case of normal goods.
Hicksian Approach
Income and Substitutions Effects of Decrease in Price The Hicksian method of mea-
suring income and substitution effects is illustrated in Figure 7.24, assuming a fall in the price of com-
modity X, all other factors remaining the same. Let the consumer be in equilibrium initially at point P
on the indifference curve IC1 and the budget line MN. Here, the consumer consumes PX1 of Y and OX1 of
X. Now, let the price of X fall, the price of commodity Y remaining the same, so that the new budget line
is MN″. The new budget line MN″ is tangential to IC2 at point Q. Thus, when the price of X falls, other
factors remaining the same, the consumer reaches a new equilibrium at point Q. At this point, the con-
sumer buys an additional quantity X1X3 of X. Thus, the total price effect on the consumption of X is X1X3.
Now, the problem is how to split the price effect X1X3 into the income and substitution effects of a fall
in Px. We know that the price effect PE equals the income effect IE plus the substitution effect SE, that is,
PE = IE + SE
Given this equation, if we can measure any one of these effects, IE or SE, we can easily find the other.
Hicks suggested a convenient and direct way to first measure the income effect.9 The income effect sub-
tracted from the price effect gives the substitution effect.
The Hicksian method of measuring the income effect involves reducing the consumer’s income (by way
of taxation) so that the consumer returns to the original indifference curve IC1 in accordance with the new
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162 Chapter 7
M´
Quantity of Y
P Q
R
T
IC2
SE IE IC1
X
O X1 X2 X3 N N´ N˝
Quantity of X
Figure 7.24 Income and Substitution Effects: Hicksian Approach
price ratio. Hicks calls it the ‘income compensation approach’—it is the same as the income adjustment
approach. This is done by drawing an imaginary budget line M′N′ parallel to MN″ and tangential to the
indifference curve IC1. It means that when a consumer’s income is taxed away to the extent of the real
income effect, the budget line MN″ shifts downwards to M′N′. The budget line M′N′ is tangential to the
indifference curve IC1 at point R. Point R represents the equilibrium of the consumer at the new price ratio
of the goods X and Y, after elimination of the real income effect. It means that, after income adjustment, the
consumer will move from point Q to R. The consumer’s movement from point Q to R means a decrease by
X2X3 in the quantity of good X demanded. This change in quantity of X demanded results from a decrease
in the consumer’s real income due to taxation. Therefore, X2X3 is the income effect.
Once the income effect is measured, it is easy to find the substitution effect. It can be obtained by
subtracting the income effect IE from the price effect PE. Thus, subtracting the income effect X2X3 from
the price effect X1X3, we get the substitution effect as follows:
Substitution effect = PE – IE = SE
= X1 X 3 – X 2 X 3 = X1 X 2
Thus, the substitution effect of a decrease in the price of good X equals X1X2. It implies that when
the price of good X decreases, other factors remaining constant, the consumer substitutes X1X2 of good
X for PT of good Y. Note that X1X2 = TR and TR/PT = ∆X/∆Y = MRS. It means that the substitution effect
matches the MRS between points P and R on the indifference curve IC1.
Income and Substitution Effects of Price Rise Figure 7.25 illustrates the decomposition
of the price effect into the income and substitution effects of a price rise. Suppose that the consumer’s
initial budget control line is given by the line AB and the consumer is in equilibrium at point E2 on
M07_DWIV9400_02_SE_C07.indd 162 07/07/11 12:41 AM

A
Commodity Y
E3
E1 E2
IC2
IC1
IE SE
O
X1 X2 X3 D C B
Commodity X
Figure 7.25 Income and Substitution Effects of Price Rise
the indifference curve IC2 where they consume OX3 of commodity X. When the price of X increases,
the budget line shifts from AB to AD and the consumer moves to a new equilibrium point E1 on a
lower indifference curve IC1. Note that the consumer’s movement from the equilibrium point E2 to E1
shows a decrease in the consumption of X from OX3 to OX1. This decrease in consumption of X, that is,
OX3 − OX1 = X1X3, is the price effect.
What we need to do now is to decompose the price effect X1X3 into substitution and income. Follow-
ing the Hicksian method—the ‘income compensation approach’—let us suppose that the government
grants ‘dearness allowance’ (DA) to the consumers just sufficient to compensate them for the loss of their
real income due to the rise in price of X. It means that the consumer is compensated so that they move
on to the original indifference curve, IC2. With the grant of compensatory DA, the consumer’s budget
line AD shifts parallel to HC. The new budget line HC is tangential to the original indifference curve
IC2 at point E3. Point E3 is, therefore, the consumer’s equilibrium point after income compensation. The
consumer’s movement from point E1 to point E3 shows a rise by X1X2 in the consumption of X. This rise
in consumption of commodity X is the result of a rise in the real income after the grant of compensatory
DA. Therefore, X1X2 is the income effect.
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164 Chapter 7
Now that the income effect is known, we can find the substitution effect as follows. We know that
PE − IE = SE. Because PE = X1X3 and IE = X1X2, substitution effect = X1X3 − X1X2 = X2X3. In Figure 7.25,
the consumer moves, after the grant of DA, from equilibrium point E2 to E3. This movement indicates
a decrease in the consumption of commodity X by X2X3. This means that the consumer reduces the
consumption of commodity X when its price rises. Thus, X2X3 is the substitution effect.
SIutskian Approach
Eugene Slutsky,10 a Russian economist, had earlier used a slightly different method of decomposing the
income and substitution effects of price change. Recall that, according to the Hicksian method, the con-
sumer’s real income is so adjusted (say, by way of taxation) after the fall in price of commodity X that the
income-adjusted budget line is tangential to the original budget line (Figure 7.24). In other words, the
consumer’s real income is so adjusted that they return to the original indifference curve, irrespective of
whether the consumption basket changes. In contrast, Slutsky suggested that consumer’s income should
be so adjusted that the consumer returns not only to their original indifference curve but also to the
original point of equilibrium; that is, they are able to buy the original combination of the two goods after
the change in the price ratio. In other words, the consumer’s income-adjusted budget line must pass
through the initial equilibrium point on the original indifference curve.
Slutsky’s method of splitting the income and substitution effects is illustrated in Figure 7.26. Suppose
that the consumer, given an income and the prices of commodities X and Y, is initially in equilibrium
at point P on the indifference curve IC1, where they consume OX1 of commodity X. When the price of
X falls, other factors remaining the same, the consumer moves to a new equilibrium point Q) on the
indifference curve IC3. The movement from point P to point Q increases the consumer’s purchase of
X by X1X3. This is the price effect caused by the fall in price of X. The problem now is to measure the
M´
Quantity of Y
P Q
R
IC3
IC2
IC1
SE IE
O X1 X2 X3 N N´ N˝
Quantity of X
Figure 7.26 Income and Substitution Effects: Slutskian Approach
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substitution and income effects. As mentioned earlier, measuring the income effect is more convenient.
This can be done by taxing away the increase in the consumer’s real income resulting from the fall in
price of X. The consumer would then consume a different combination of the two goods. As already
mentioned, the Slutskian approach differs from the Hicksian approach in this aspect.
According to the Slutskian approach, the consumer’s real income is so reduced that they are able to
purchase the original combination of the two goods (i.e., OX1 of X and PX1 of Y) at the new price ratio.
This is accomplished by drawing an imaginary budget line M′N′ through point P. Note that M′N′ is
parallel to MN″, the new budget line. Because the whole commodity space is full of indifference curves,
one of them will be tangential to the imaginary budget line M′N′. This is shown by the indifference curve
IC2, which is tangential to M′N′ at point R. Point R is the consumer’s equilibrium after income adjust-
ment, which indicates a decrease by X2X3 in the consumption of X. The quantity X2X3 is, therefore, the
income effect. We may now find the SE by subtracting the income effect IE from the total price effect PE
as follows:
Substitution Effect = PE – IE = SE
= X1 X 3 – X 2 X 3 = X1 X 2
In Figure 7.26, the movement from P to R and the consequent increase in the quantity purchased of X
(i.e., X1X2) is the substitution effect. Similarly, the consumer’s movement from R to Q and the consequent
increase in the quantity purchased of X is the income effect.
Comparison of the Hicksian and Slutskian Methods

A comparative view of the Hicksian and Slutskian methods of splitting the price effect into substitution
and income effects, and their results, are presented in Figure 7.27. Let the consumer be initially in equi-
librium at point P on the indifference curve IC1. When the price of X falls, the consumer moves to
point Q. The movement from P to Q is the total price effect, which equals X1X4 of the commodity X.
Until this point, there is no difference between the Slutskian and Hicksian methods. However, beyond
this point, they differ. According to the Slutskian method, the movement from point P to point T is
the substitution effect and the movement from T to Q is the income effect. According to the Hicksian
method, the movement from P to R is the substitution effect and the movement from R to Q is the
income effect. The substitution and income effects of the Slutsksian and Hicksian methods are summed
up in quantitative terms in Table 7.4.
As Figure 7.27 shows, there is a great difference between the Hicksian and Slutskian measures of the
income and substitution effects. The Hicksian measure of the income effect (X2X4) is greater than the
Slutskian measure (X3X4). Therefore, the Hicksian measure of the substitution effect (X1X2) is smaller
than the Slutskian measure (X1X3).
There are also other differences between the two methods. The Hicksian method is considered a
‘highly persuasive solution’ to the problem of splitting the price effect into the substitution and income
effects, whereas the Slutskian approach is intuitively ‘perhaps less satisfying’.
Table 7.4 Comparison of Hicksian and Slutskian Substitution and Income Effects
Method Price Effect Substitution Effect Income Effect
Hicksian X1X4 X1X2 X2X4
Slutskian X1X4 X1X3 X3X4
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166 Chapter 7
M1
Quantity of Y
M2
M3
P
Q
T IC3
R
IC2
IC1
O X1 X2 X3 X4 N1 N2 N3 N4
Quantity of X
Figure 7.27 Hicksian Approach Vs. Slutskian Approach
However, both the methods have their own merits. The merit of the Slutskian method, what Hicks
calls the ‘cost-difference’ method, lies in its property that both substitution and income effects can be
directly computed from the observed facts. In the case of the Hicksian method, these effects cannot be
obtained without the knowledge of the consumer’s indifference map. Hicks has himself recognized this
merit of Slutsky’s method. The merit of the Hicksian method, called the ‘compensating variation method’,
is that it is a more convenient method of measuring the substitution effect. In Hick’s own words, ‘The
merit of the cost-difference method is confined to [its] property … that its income effect is peculiarly
easy to handle. The compensating variation method [i.e., Hicks’ own method] does not share in this par-
ticular advantage; but it makes up for its clumsiness in relation to income effect by its convenience with
relation to the substitution effect’.11
Measurability of Income and Substitution Effects

We have described earlier the Hicksian and Slutskian methods of decomposing the income and substitu-
tion effects of the price effect. Let us now look at the need for separating the income effect from the sub-
stitution effect. As Hicks12 has pointed out, ‘substitution effect is absolutely certain; it must always work
in favour of an increase in demand for a commodity when the price of that commodity falls’. Thus, the
behaviour of the substitution effect is predictable: it follows directly from the principle of diminishing
MRS. On the contrary, the ‘income effect is not so reliable’13 and its behaviour is unpredictable in general.
In fact, whether the income effect is positive or negative depends on whether a commodity is treated
by the consumer as a ‘superior’ or an ‘inferior’ good. Because the subjective valuation of a commodity
may vary from person to person, the response of the consumer in general to the change in real income
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becomes uncertain and unpredictable. It is quite likely that while in some cases, the substitution effect
works in a positive direction, the income effect works in a negative direction. In such cases, a systematic
analysis of price–demand relationships becomes an extremely difficult task. It becomes, therefore, neces-
sary to eliminate the unpredictable income effect so that ‘the systematic and predictable behaviour of the
substitution effect can be revealed’.14 That is why attempts to measure and split away the income effect
from the price effect are considered the right approach.
INCOME AND SUBSTITUTION EFFECTS: INFERIOR GOODS

In the foregoing section, we have discussed the concept and measurement of the income and substitu-
tion effects of a change in price on the consumption of ‘normal’ goods. Let us now see how these effects
of a rise in income and change in price work on the consumption of an inferior good.
Before we proceed, it should be added that inferiority or superiority is not an absolute or intrinsic prop-
erty of a commodity. These properties are often determined by a consumer’s taste and preference. One can,
nevertheless, mention a number of commodities that are generally treated by consumers as being inferior to
their substitutes. For example, bajra and millet are considered inferior to wheat and rice; cotton fabrics are
regarded inferior to silk and synthetic cloth; kerosene oil is perceived to be an inferior fuel to cooking gas;
bidi is viewed as inferior to cigarettes; bus and railway services are deemed inferior to air services; and so on.
However, by definition, an inferior good is one whose consumption decreases with an increase in
consumer’s income beyond a certain level. In other words, an inferior good is one for which the income
effect is negative. The reason for the income effect for an inferior good being negative is the natural
tendency of a consumer to reduce the consumption of ‘inferior goods’ and increase the consumption of
superior or normal goods when the income increases. The income of the consumer may increase either
due to increase in the money income, prices remaining the same; or due to increase in the real income
due to fall in prices, money income remaining constant; or due to both. Let us first look at the effect of
rise in money income on the consumption of an inferior good.
Effect of Rise in Money Income

The income effect of rise in income on the consumption of an inferior good (say, X) is illustrated in
Figure 7.28. In the figure, the vertical axis measures the money income and the horizontal axis measures
an inferior good, X. Let us suppose that the consumer is initially in equilibrium at point E1, where they
consume OX3 units of X. As the income increases from OM1 to OM2, the price of X remaining constant, the
budget line shifts to M2N2 and the consumer reaches an upper indifference curve IC2. The new equilibrium
point is E2, where they consume only OX2 units of X. Note that OX2 < OX3. That is, the consumption of
X decreases due to increase in the income. The consumption of X decreases further to OX1 as the income
increases to OM3. The curve joining the equilibrium points E1, E2 and E3 is the ICC for the inferior commodity
X. It has a negative slope beyond a point, showing the negative income effect beyond equilibrium point E1.

Case of Inferior Goods
Let us now examine the income and substitution effects of fall in the price of an inferior good. Suppose
a consumer consumes two goods X and Y, good X being an inferior good. The income and substitution
effects of a fall in the price of X are illustrated in Figure 7.29. Suppose that the consumer is in equilibrium
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168 Chapter 7
M3
M2
E3 Income–consumption curve
Money income
M1
IC3
E2
IC2
E1
IC1
O X1 X2 X3 N1 N2 N3
Quantity of X (inferior good)
Figure 7.28 Income Effect: Inferior Goods Case
M1
Quantity of Y (normal good)
R
M2
P
IC2
IC1
O X1 X2 X3 N1 N2 N3
Figure 7.29 Income and Substitution Effects: Inferior Goods Case
at point P, where the budget line M1N1 is tangential to the indifference curve IC1. At point P, the equilib-
rium combination of X and Y consists of OX1 of X and PX1 of Y. Now, let the price of X fall, other factors
remaining the same, so that the budget line shifts to M1N3 and the consumer moves from equilibrium
point P to R. The movement from P to R is the price effect. To eliminate the income effect of the price
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change, let us draw, following the Hicksian method, a compensatory budget line M2N2 tangential to the
original indifference curve IC1 at point Q. Point Q is, therefore, the consumer’s equilibrium point after
elimination of the income effect. The result is that, after income adjustment, the consumer moves from
the original equilibrium point P to point Q. The consumer’s movement from P to Q means an increase by
X1X3 in the quantity consumed of X. This is the substitution effect, which results from a fall in the price
of X. Note that the substitution effect of a fall in the price of an inferior good (X) is very powerful. It is
so powerful that the substitution effect X1X3 exceeds the total price effect X1X2. This makes the income
effect of a change in the price of an inferior good negative.
The movement from Q to R shows the negative income effect, that is, a decrease in the quantity of X
demanded. The negative income effect IE may be computed as follows:
PE − SE = IE
X1 X 2 − X1 X 3 = − X 2 X 3
It is obvious that the income effect of a fall in the price of an inferior good X is negative, whereas in
the case of normal goods, it is positive. Thus, in the case of an inferior good, the income and substitution
effects work in opposite directions. That is, while the income effect of a fall in the price of an inferior
good causes a decrease in the consumption of the good, the substitution effect increases its quantity
demanded.
It is important to note here that, in the case of an inferior good, the positive substitution effect X1X3—
measured by income adjustment—is greater than the negative income effect X2X3. It means that the
positive substitution effect outweighs the negative income effect. It means also that the stronger substi-
tution effect causes a net increase in the demand for an inferior good, even though there is a negative
income effect. This shows that the law of demand applies to most inferior goods, that is, their quantity
demanded increases as their prices fall.
Giffen Paradox
It has been illustrated in the preceding section that the law of demand applies to an inferior good as it
applies to a normal good. However, there are certain cases of inferior goods to which the law of demand
does not apply. Such goods are known as Giffen goods.15 In the case of Giffen goods, the substitution
effect is positive and the income effective is negative, and the negative income effect is greater than the
positive substitution effect. Therefore, when the price of an inferior good of the Giffen type decreases,
its demand decreases; and vice versa. This phenomenon shows a paradoxical situation, that is, when
the price of an inferior good increases, its quantity demanded increases. The reason is that, to meet the
minimum consumption need, the consumer has to cut their expenditure on superior goods and spend
the saved amount on the inferior good, which is cheaper even after the rise in its price. As a result, the
demand for the inferior good increases due to increase in its price. For details, see Appendix to this
chapter. This paradox is known as the Giffen paradox.16 The Giffen paradox is a very strong exception to
the law of demand.
The Giffen paradox is illustrated in Figure 7.30. Let us suppose that the consumer is initially in
equilibrium at point P. Now, let the price of inferior good X decrease so that the consumer moves to
equilibrium point R on IC2. Because of this movement, the quantity of X demanded decreases by X1X2.
This is the price effect.
Let us now separate the income and substitution effects of the price effect in the case of Giffen goods.
Following the Hicksian method, let us eliminate the income effect by drawing an imaginary budget line
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170 Chapter 7
M2
Quantity of Y (superior good)
R
M1
IC2
P
IC1
X
O X1X2 X3 N1 N2 N3
Figure 7.30 Giffen Paradox
M2N2 parallel to the budget line M2N3 and tangential to the original indifference curve IC1. The imagi-
nary budget line is tangential to IC1 at point Q. Point Q marks the consumer’s equilibrium after income
adjustment. The consumer’s movement from P to Q and the consequent increase by X2X3 in the quantity
of X demanded is the substitution effect. We may now find the income effect as follows:
Income effect = PE − SE
X1 X 2 − X 2 X 3 = − X1 X 3
It may be observed from Figure 7.30 that the income effect (−X1X3) is greater than the substitution
effect (X2X3). In other words, the income effect outweighs the substitution effect. The net result is that the
quantity of X demanded falls as its price decreases. That is, contrary to the law of demand, the demand
for a Giffen good decreases when its price decreases and increases when its price increases.
The case of a Giffen good exists when consumers spend a major portion of their income on an inferior
good. This type of situation exists in the case of most poor families in underdeveloped countries, which
spend a major portion of their wage income on inferior food grains. When the prices of such items are
low, poor families can afford some quantity of superior food grains. However, when the prices of inferior
goods go up, they are forced to curtail their expenditure on superior food grains and spend more on the
inferior ones to meet their basic consumption needs.
An important point that needs to be noted here is that all Giffen goods are inferior goods, but not
all inferior goods are Giffen goods. The important distinction between the two types of inferior goods
can be stated as follows. Recall that, in both the cases, the substitution effect is positive and the income
effect is negative. However, in the case of non-Giffen inferior goods, positive substitution outweighs the
negative income effect. Therefore, the demand curve for non-Giffen inferior goods has a negative slope.
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However, in the case of Giffen goods, the negative income effect outweighs the positive substitution
effect. Therefore, the demand curve for Giffen goods has a positive slope.
COMPARISON OF CARDINAL AND ORDINAL UTILITY

APPROACHES
In Chapter 6, we had discussed consumer behaviour based on the cardinal utility approach. In this
chapter, we have discussed consumer behaviour based on the ordinal utility approach. Both approaches
have their own merits and demerits, similarities and differences. In this section, we compare the cardinal
and ordinal utility approaches to consumer analysis and look into their relative merits.
Similarity Between the Two Approaches

1. Similarity in Assumptions. Most of the assumptions made under the two approaches are
the same. For example, both cardinal and ordinal approaches assume consumer’s rational-
ity, transitivity of choices, limited income, perfect knowledge and utility maximization. The
diminishing MU assumption of the cardinal utility approach is also implicit in the diminishing
MRS assumption of the ordinal utility approach.
2. Equilibrium Conditions Are Identical. Both cardinal and ordinal utility approaches use
identical equilibrium conditions. The necessary equilibrium condition of the cardinal utility
approach is given as:
MU x Px
=
MU y Py
and the first-order equilibrium condition under the ordinal utility approach is given as:
Px
MRS x . y =
Py
Because MRSx.y = MUx/MUy, the first-order equilibrium condition under the two approaches
is the same.
The second-order equilibrium condition of the cardinal utility approach is that the total expen-
diture must not exceed a consumer’s total income. The ordinal utility approach makes a similar
assumption in the form of budgetary constraint. That is, if a consumer having money income M,
consumes only two goods, X and Y, given their prices Px and Py , then:
Qx Px + Qy Py = M
Thus, although the cardinal and ordinal approaches are based on different assumptions regard-
ing the measurability of utility, both arrive at the same conclusion.
Superiority of the Indifference Curve Approach

In spite of their similarity in assumptions and equilibrium conditions, the Hicksian indifference curve
analysis is, in many aspects, superior to the Marshallian cardinal utility approach. The indifference
curve analysis has made major advances in the theory of consumer behaviour, at least in the following
aspects.
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172 Chapter 7
First, the assumptions of the indifference curve approach are less stringent or restrictive than those
of the cardinal utility approach. While the cardinal utility approach assumes the cardinal measurability
of utility, the ordinal utility approach assumes realistically only ordinal measures of utility. Moreover,
unlike the cardinal utility approach, the ordinal utility approach does not assume the constancy of utility
of money. The Marshallian assumption of the constancy of MU of money is incompatible with demand
functions involving more than one good.
Second, the indifference curve approach provides a better method for the identification of goods as
substitutes and complementary goods. This is considered one of the most important contributions of the
ordinal utility approach. The cardinal utility approach uses the sign + or − of cross elasticity for identify-
ing goods as substitutes and complementary goods. In the case of two goods, for example X and Y, if
the cross elasticity has a positive sign, it means that X and Y are substitutes for one another; and if cross
elasticity has a negative sign, it means they are complementary goods. This method of classifying goods
into substitutes and complementary goods is incorrect and misleading because cross elasticity uses the
total effect of a price change (∆Px) on the quantity demanded (∆Qy) without adjusting it for the income
effect caused by the change in the price of a commodity (i.e., ∆Px).
On the contrary, the indifference curve analysis suggests measuring of cross elasticity after elimina-
tion of the real income effect resulting from a change in the price Px. According to Hicks, goods X and Y
are substitutes for each other if the cross elasticity measured after eliminating the income effect is posi-
tive. In other words, X and Y are substitutes for each other only if a change in the price of X leads to a
change in the demand for Y, after the income effect of a change in the price of X is eliminated.
However, although the indifference curve technique for identifying goods as substitutes and comple-
mentary goods is no doubt theoretically superior to the cross-elasticity method (unadjusted for the real
income effect), this method is impracticable17 because the existence of an indifference curve in real-
ity has been questioned. Therefore, estimating the income and substitution effects of a price change
is extremely difficult, if not impossible. On the other hand, the cross-elasticity method is practicable
because it requires only the knowledge of an empirically estimated market demand function.
Third, the indifference curve analysis provides a more realistic measure of a ‘consumer’s surplus’18—
defined as the difference between the price that a consumer is willing to pay and the price which they
actually pay—compared to the one measured by the Marshallian method. The Marshallian concept of ‘con-
sumer’s surplus’ is based on the assumptions that utility is cardinally measurable in terms of money and that
utility of money remains constant. Neither of the two assumptions is realistic. The indifference curve analy-
sis measures a consumer’s surplus in terms of ordinal utility. However, the Hicksian measure of a consumer’s
surplus is also impracticable because of the problem involved in the derivation of an indifference curve.
DRAWBACKS OF INDIFFERENCE CURVE APPROACH

Although the indifference curve approach to the analysis of consumer behaviour is, in many aspects,
theoretically sounder than the cardinal utility approach, it has its own limitations.
1. The main weakness of the indifference curve approach lies in its axiomatic assumption that
there exists a convex indifference curve. The indifference theory does not establish the exis-
tence or the shape of the indifference curve.19 It simply assumes the existence of indifference
curves having the property of convexity with reference to the origin.
2. Indifference curve analysis assumes that the consumers have complete knowledge of their pref-
erences and choices and are capable of arranging them in order. However, it is questionable
whether consumers are able to order their preferences as precisely as required by the theory.
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Moreover, even if this assumption is granted, it remains valid only for a very short period,
because consumers’ preferences are continuously influenced by a number of factors, for exam-
ple, changes in prices, income, tastes, and so on; and uncertainty. Hicks has admitted this weak-
ness of the earlier theory. He says, ‘…one of the most awkward of the assumptions into which
the older theory appeared to be impelled by its geometrical analogy was the notion that the
consumer is capable of ordering all conceivable alternatives that might be possibly presented
to him; all the portions which might be represented by points on his indifference map. This
assumption is so unrealistic that it was bound to be a stumbling block’.20
3. As Hicks has himself admitted,21 the indifference curve technique can effectively analyse con-
sumer’s behaviour when a consumer has to make a choice between the various combinations of
only two goods. Where more than two commodities are involved, a high-power mathematics
may have to be used because the geometrical device of an indifference curve altogether fails.
The use of high-power mathematics obscures the economic content of the analysis.
4. The ordinal utility theory is not capable of formalizing consumers’ behaviour when their prefer-
ences involve risk or uncertainty in expectations.22
5. The indifference curve approach rules out the existence of the influences of advertisements, per-
sistence of a consumer’s habit and interdependence of consumer preferences. The ordinal util-
ity approach considers that such influences introduce irrationality to a consumer’s behaviour
and rules them out.23 Moreover, this theory ignores speculative demand and consumers’ random
behaviour, that is, the irrational purchases based on their impulse, immediate urge, whims, and
so on, which play an important role in the firm’s pricing and output decisions.
Owing to these limitations of the indifference curve analysis, this theory has been subject to dispar-
aging remarks such as ‘the new theory is the old wine in a new bottle’ (Robertson); ‘indifference curve
analysis of demand is not a step forward; it is in fact a step backward’ (Knight); ‘from a practical stand-
point, we are not much better off when drawing purely imaginary indifference curves than we are when
speaking of purely imaginary utility function’ (Schumpeter).
APPENDIX
Explanatory Note on Giffen Paradox
To understand the nature of Giffen goods, consider the case of a poor household with the following
features.
1. Minimum monthly food consumption requirement of the household is 30 kg;
2. The household consumes 10 kg of wheat (a superior good) and 20 kg of millet (an inferior
good), i.e., Qw = 10 kg; and Qm = 20 kg;
3. The household can afford only Rs 600 per month on family food consumption;
4. Wheat price (Pw) is Rs 30 per kg and millet price (Pm) is Rs 15 per kg.
Given these conditions, the budget equation of the household can be expressed as
Pw (Qw) + Pm (Qm) = M
30 (10) + 15 (20) = 60
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174 Chapter 7
Now, suppose that the millet price rises from Rs 15 to Rs 18. Now, what are the options available to the
household? The household may cut down millet consumption or wheat consumption. If the household
cuts down its millet consumption, say, by 2 kg, it saves Rs 30. By spending this amount on wheat, it can
buy only 1 kg of wheat. Therefore, the total food consumption goes down to 29 kg. It means that the
family will have to forego one meal per month. The other option open to the household is to cut down
wheat consumption by some quantity, say by x kg, save some money and spend it on millet. The numeri-
cal value of x can be worked out as follows. The budgetary option of the household can be expressed as
30(10 − x ) + 18( 20 + x ) = 600
300 − 30 x + 360 + 18x = 600
−12x = −60
x=5
It means that the household will have to cut down wheat consumption and increase millet consump-
tion by 5 kg. This will meet both its consumption requirement of 30 kg per month and the budgetary
limit, as shown here:
Rs 30(5) + Rs 18(25) = 600
This example explains the case of a Giffen good, in addition to explaining the Giffen good paradox,
that is, the quantity of the Giffen good demanded increases when its price increases, other factors
remaining the same.

1. Explain the concept of ordinal utility. How is the ordinal utility concept different from the
cardinal utility concept?
2. What is an indifference curve? What are the properties of an indifference curve for two normal
goods? What will be the shape of an indifference curve when one of the two goods is a free
natural good?
3. Why is an indifference curve for two normal goods convex with reference to the origin? Why
cannot it be a concave curve or a straight line?
4. What is the marginal rate of substitution (MRS)? Why does the MRS diminish along the indif-
ference curve? Suppose at point A on the indifference curve for goods X and Y, Abhishek has
10 units of X and 20 units of Y. When he moves down to point B on the indifference curve, his
combination of two goods changes to 12 units of X and 19 units of Y. What is the MRS between
points A and B.
5. One of the properties of an indifference curve is that two indifference curves do not intersect.
Suppose two indifference curves for two normal goods do intersect, what does it mean?
6. What is the budget equation? Suppose the income of a consumer consuming only two goods X
and Y has a money income M and the prices of goods X and Y are given by Px and Py, respec-
tively. Construct the budget equation of the consumer.
7. Sonia has a limited income which she spends on goods X and Y, the market price of X is Rs 15
per unit and of Y is Rs 20 per unit. When she draws her budget line, it terminates at the X-axis
at 50 units. Find Sonia’s income and the slope of her budget line.
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8. What is meant by consumer’s equilibrium? Show that a consumer’s equilibrium condition

under the ordinal utility approach is the same as that under the cardinal utility approach.
9. What are the conditions for a consumer’s equilibrium in the ordinal utility approach? Why does a
consumer choose a combination of two goods where the MRS equals the commodity price ratio?
10. Suppose a domestic servant spends their total income on only two goods, food and clothing.
What will be the effect of increase in their income on their consumption of food and clothing?
Illustrate the derivation of their income–consumption curve.
11. What is the Engel curve? Illustrate graphically the derivation of an Engel curve. When does it
tend to bend backwards?
12. Derive the Engel curve by using the indifference curve method and show the stage at which a
commodity remains a necessity though it is an inferior good.
13. What is a price–consumption curve (PCC)? Can you prepare a demand schedule on the basis
of data provided by the PCC? Illustrate the derivation of a demand curve for a normal good
and a Giffen good.
14. Define income and substitution effects of a price change. Using the Hicksian method, illustrate
graphically the decomposition of the substitution and income effects of changes in the price of
a commodity.
15. Illustrate the difference between the Hicksian and Slutskian methods of separating the income
and substitution effects of price change of a normal good. Which method gives, in your opin-
ion, a better measure of the two effects and why?
16. Suppose Rajat likes chocolates more than ice creams. How do his indifference curves appear?
In what way are they different from the usual indifference curves? Show graphically Rajat’s
equilibrium combination of chocolates and ice creams.
17. Suppose a consumer consumes two goods X and Y. Draw indifference curves assuming (a) X
and Y are normal goods, and (b) X is an inferior good and Y is a superior good. Are the indif-
ference curves different in the two cases? If yes, how are they different?
18. What is a Giffen good? Assuming a two-commodity case, show that in the case of a Giffen good,
the substitution effect is more powerful than the price effect.
19. ‘All Giffen goods are inferior goods but all inferior goods are not Giffen goods.’ Explain this
statement showing graphically the difference between the substitution and the income effects
of a price change on the demand for two types of goods.
20. What is meant by ‘composite goods convention’? In what way are the slopes of the budget
line and indifference curves in the composite goods case different from those in the case of
two normal goods? How does a consumer achieve their equilibrium point in the composite
goods case?
21. Write the correct answer.
(a) Indifference curve was invented by
(i) Edgeworth,
(ii) Hicks,
(iii) Marshall, or
(iv) Slutsky.
(b) Each point on an indifference curve shows
(i) different combinations of goods and different levels of utility,
M07_DWIV9400_02_SE_C07.indd 175 07/07/11 12:41 AM

176 Chapter 7
(ii) the same combinations and the same utility,

(iii) different combinations and the same utility, or
(iv) none of these options.
(c) Along the indifference curve, the MRS between two goods
(i) decreases,
(ii) increases, or
(iii) remains constant.
(d) The MRS between two normal goods is
(i) always positive, or
(ii) always negative.
(e) The MRS is
(i) equal to,
(ii) greater than, or
(iii) less than the slope of the indifference curve.
(f) The indifference curves for two normal goods are always
(i) convex with reference to the origin,
(ii) concave with reference to the origin, or
(iii) neither convex nor concave.
(g) Two indifference curves
(i) do not intersect nor are they tangential;
(ii) can intersect but cannot be tangential;
(iii) cannot intersect but can be tangential.
(h) A consumer consuming two commodities, X and Y, is in equilibrium where
(i) MUx /MUy = Py /Px,
(ii) MUx /MUy = Px /Py,
(iii) MUy /MUx = Px Py, or
(iv) none of these.
(i) In the case of an inferior good, the income–consumption curve (ICC) can be
(i) backward bending,
(ii) upward sloping,
(iii) downward bending, or
(iv) none of these.
(j) The slopes of the indifference curve and the budget line are
(i) equal on all points,
(ii) not equal at any point, or
(iii) equal only at the point of tangency.
(k) An inferior good is one whose consumption
(i) increases,
(ii) decreases, or
(iii) remains constant, when the income of the consumer increases.
(l) The income effect on the consumption of an inferior good is
(i) positive,
(ii) negative, or
(iii) neutral.
M07_DWIV9400_02_SE_C07.indd 176 07/07/11 12:41 AM

[Ans. Correct statements: (a) (i); (b) (iii); (c) (i); (d) (ii); (e) (i); (f) (i);
(g) (i); (h) (ii); (i) (l) or (3); (j) (iii); (k) (ii); (l) (ii).]
22. When an indifference curve indicates an increase in the quantities of both the goods, then it is
a case of
(a) a good and a good,
(b) a good and a bad,
(c) a bad and a bad, or
(d) a good and a neuter.
23. The MRS decreases along an indifference curve because
(a) the MU decreases when the stock of a good increases,
(b) two goods are not perfect substitutes, or
(c) a consumer’s capacity and willingness to sacrifice a good decrease with the decrease,
in the stockof a good.
24. An indifference curve is convex with reference to the origin because
(a) it has a negative slope,
(b) two goods are perfect substitutes,
(c) the MRS decreases all along the curve, or
(d) the MU of money diminishes.
25. An Engel curve shows the relationship between
(a) commodity and money,
(b) income and consumption expenditure,
(c) income and capital expenditure, or
(d) price and demand for Giffen goods.
26. In the case of inferior goods
(a) demand increases with increase in income,
(b) demand decreases with decrease in income, or
(c) demand remains unaffected by the change in income.
27. In the case of Giffen goods, the income and substitution effects
(a) work in the same direction,
(b) work in opposite directions,
(c) move in uncertain directions, or
(d) cannot be said.
ENDNOTES
1. The ‘indifference curve’, as a tool of analysis, was first developed and used in 1881 by
Francis Y. Edgeworth in his book, Mathematical Physics (London, C.R. Paul & Co., 1881) to
show the possibility of commodity exchange between any two individuals. About a decade
later, Irvine Fisher used the indifference curve to explain a consumer’s equilibrium in his book,
Mathematical Investigations in Theory of Value and Prices (1892). Incidentally, both Edgeworth
and Fisher believed in the cardinal measurability of utility. It was the famous Italian econ-
omist, Vilfred Pareto, who introduced the ordinal utility concept to the indifference curve,
M07_DWIV9400_02_SE_C07.indd 177 07/07/11 2:04 PM

178 Chapter 7
in 1906, in his book, Menual d’ Economic Politique (Paris, V. Giard and E. Bre’re, 1906, later
translated into English in 1909). In the subsequent decades, many important contributions
were made to cardinal utility analysis by Eugene E. Slutsky in his study “On the Theory of
the Budget of the Consumer” (reprinted in Readings in Price theory, ed. by K.E. Boulding and
G.I. Stigler, 1953), W.E. Johnson in his article “Pure Theory of Utility Curve” (Economic
Journal, December 1913), and A.L. Bowley in his book, Mathematical Groundwork (1924). Yet,
the indifference curve technique could not gain much ground in the analysis of consumer
behaviour until the early 1930s. In 1934, Hicks and Allen developed the indifference curve as
a powerful tool for analysing consumer behaviour in their joint publication “A Reconstruc-
tion of the Theory of Value” (Economica, February–May 1934). Later on, Hicks provided a
complete exposition of the indifference curve technique in his book Value and Capital (Oxford
University Press, 1946) and refined it further in his book A Revision of Demand Theory (London,
Macmillan, 1956). Since then, the indifference curve is being used as a tool for the economic
analysis of consumer behaviour.
2. Here, ‘utility’ is the consumers’ subjective assessment of the loss of utility of their goods.
3. Value and Capital, 1946, p. 13.
4. This type of grouping is not unrealistic, because the largest part (about 60 per cent) of consumer
expenditure in low-income families goes to food.
5. The ‘Engel Curve’ is named after the 19th-century German statistician, Christian Lorenz Ernst
Engel (1821–1896). He conducted a pioneering study of the relationship between a consumer’s
income and the quantity of a commodity purchased.
6. Income and substitution effects of price change are discussed subsequently.
7. In the sense that the consumer substitutes a low-priced good for a relatively high-priced good;
however, technically, it is negative.
8. Stonier, A.W. and Hague, D.C. (1972), A Textbook of Economic Theory (London: Longman), p. 71.
9. This method is direct in the sense that the income effect can be obtained directly by eliminating
the real-income effect of a fall in the price of commodity X.
10. Slutsky, E. (1952), ‘On the Theory of the Budget of the Consumer’, reprinted in Kenneth E.
Boulding and George Stigler, (eds), Readings in Price Theory (Homeswood, Illinois: Irwin).
11. Hicks, J.R. (1969), A Revision of Demand Theory (London: Oxford), p. 69.
12. Value and Capital, p. 32.
13. Ibid, p. 32.
14. Baumol, W.J. (1985), Economic Theory and Operations Analysis, (New Delhi: Prentice Hall of
India, 4th Edn.), p. 212.
15. Named after Robert Giffen, a British economist of the 19th century.
16. Marshall attributed this paradox to Robert Giffen in his Principles of Economics (1949), p. 132.
It is, however, said that there is no mention of this paradox in Giffen’s own writings. Moreover,
economists doubt whether the Giffen paradox was actually observed. However, if one examines
the case of very poor rural families of India, the existence of the Giffen paradox cannot be denied.
However, whatever might be the case, because this paradox is useful in explaining an exception
to the law of demand, it is retained in the economic literature.
17. The cross elasticity between two goods X and Y is given by (∆Qy/∆Px) (Px/Qy).
M07_DWIV9400_02_SE_C07.indd 178 07/07/11 12:41 AM

18. The concept of consumer’s surplus is discussed in Chapter 10.

19. Ibid.
20. Neumann, J.V. and Morgsnstern, O. (1947), The Theory of Games and Economic Behaviour
(Princeton University Press); and Armstrong, W.E. (1948), ‘Uncertainty and the Utility
Function’, Economic Journal, March.
21. Leibenstein, H. (1950, 1968), ‘Bandwagon, Snob and Veblon Effects’, The Theory of Consumers’
Demand’, Quarterly Journal of Economics, Reprinted in William Breit and Harold M. Hochman
(eds), Readings in Microeconomics (New York: Holt Rinehart and Winston, Inc.), pp. 123–139.
22. Koutsoyiannis, A. (1979), Modern Microeconomics (New York: Macmillan), p. 27.
23. Hicks, J.R. (1969), A Revision of Demand Theory (London: Macmillan), p. 20.
FURTHER READINGS
Alchian, A.A. (1968), ‘The Meaning of Utility Measurement’, in William Breit and Harold M. Hochman
(eds), The American Economic Review, March 1953, reprinted in Readings in Microeconomics, (New
York: Halt, Rinehart and Winston, Inc), pp. 69–80; and in H. Townsend (ed.), Readings in Price
Theory (Penguin).
Baumol, W.J. (1958), ‘The Cardinal Utility Which is Ordinal’, Economic Journal, 1958, pp. 665–72.
———, W.J. (1980), Economic Theory and Operations Analysis (New Delhi: Prentice Hall of India),
4th Edn., Chapter 9.
Boulding, K.E. (1967), Economic Analysis: Microeconomics (New York: Harper and Row), Chapters 11
and 12.
Browning, E.K. and Browning, J.M. (1986), Microeconomic Theory and Applications (New Delhi: Kalyani
Publications), reprint 1998, Chapters 2 and 3.
Ferguson, C.E. (1958), ‘An Essay on Cardinal Utility’, Southern Economic Journal, 1958, pp. 11–13.
Gould, J.P. and Lazear, E.P. (1993), Microeconomic Theory (Illinois: Richard D. Irwin), 6th Edn.,
Chapters 2,3 and 4.
Green, H. (1971), Consumer Theory (Middlesex: Penguin Book).
Hicks, J.R. (1946), Value on Capital (Oxford University Press), 2nd Edn., Parts I and II.
——— (1956), A Review of Demand Theory (Oxford: Clarendon Press).
Knight, F.H. (1944), ‘Realism and Relevance in the Theory of Demand’, Journal of Political Economy,
pp. 289–318.
Leibenstein, H. (1950), ‘Bandwagon, Snob and Veblen Effects in the Theory of Consumer’s Theory’,
Quarterly Journal of Economics, pp. 183–205.
Little, I.M.D. (1949), ‘A Reformulation of the Theory of Consumer’s Behaviour’, Oxford Economic Papers.
Marshall, A. (1920), Principles of Economics (London: Macmillan), 8th Edn., 1958, Book III, Chapter 4;
and Book V, Chapters 1 and 2.
Mishan, E.J. (1961), ‘Theories of Consumer’s Behaviour: A Cynical View’, in D.R. Chamerschen (ed.),
Economica, reprinted in Readings in Microeconomics (Wiley, 1969).
Nueman, J.V. and Margenstern, O. (1947), Theory of Games and Economic Behaviour (New Jersey:
Princeton University Press), 2nd Edn., Chapter 1.
M07_DWIV9400_02_SE_C07.indd 179 07/07/11 12:41 AM

Chapter 8
Application of Indifference
Curve Analysis
CHAPTER OBJECTIVES
This chapter shows the application of indifference curve—a tool of analysis—to measure the effects of
some government taxation and subsidization policies and also presents a more logical derivation of the
labour supply curve. By going through this chapter, you learn:
How income tax and commodity tax (e.g., excise tax) affect the economic welfare of the society;
How income subsidy and price subsidy affect the economic welfare of the society;
Why rationing of consumption of scarce goods and services becomes a necessity and how it affects
welfare of the people; and
How labour supply changes with change in the wage rate, i.e., how labour makes a choice between
work and leisure when wage rate changes, and why labour supply curve bends backward when
wages continue to rise.
INTRODUCTION
In the previous chapter, we discussed in detail the various aspects of consumer behaviour under the
ordinal utility approach by using the indifference curve technique. The indifference curve analysis of
consumer behaviour presented, as in the previous chapter, appears to be an abstract theoretical analysis.
However, this is not the case. Indifference curve analysis can be used gainfully to analyse certain impor-
tant real world problems. The main areas to which indifference curve can be applied gainfully include the
evaluation of government policies, e.g., taxation, subsidy and rationing policies; determining the gain
from exchange of commodities between the individuals, sectors and countries, derivation of labour sup-
ply curve, indexing cost of living, etc. Besides, indifference curve analysis has a wide application in the
theory of international trade and welfare economics. We demonstrate, in this chapter, the applications of
indifference curve technique to some real world problems.
M08_DWIV9400_02_SE_C08.indd 180 05/07/11 4:43 AM

Application of Indifference Curve Analysis 181
MEASURING WELFARE EFFECTS OF INCOME AND

EXCISE TAXES
Choice Between Taxes
An important area in which indifference curve technique has been gainfully used is of making choice
between direct and indirect taxes. For example, policymakers are often faced with a question: what tax to
impose—income tax or excise duty? It is generally argued that income tax is preferable to an indirect tax
(e.g., excise or sales tax) as a source of government revenue. The main argument runs as follows. Income
tax is considered to be more efficient and desirable because income tax of a given amount places a lower
tax burden on the taxpayer than the excise tax of equal amount. In the other words, the negative welfare
effect of direct taxes is lower than that of indirect taxes. The relative burden of income tax and excise tax
is shown in Figure 8.1 with the aid of indifference curve analysis.
Let us suppose that a consumer has an annual money income of OM, as shown in Figure 8.1, and that
he spends his total income on commodity X.1 given the price of commodity X, his budget line is given by
the line, MT. In the absence of any kind of tax, the consumer would be in equilibrium at point E3 on indif-
ference curve IC3. Now suppose that the government imposes excise duty on commodity X. As a result,
price of commodity X rises so that his budget line MT shifts to MR. As a result, consumer’s equilibrium
shifts to E1 on a lower indifference curve IC1. At equilibrium E1, the consumer buys OQ units of X and pays
MP = JE1 for it. In the absence of the excise tax, OQ (=NK) units of X could have been purchased only for
JK (=MN) of consumer’s income. It means that the excess payment that equals JE1 − JK = KE1 is excise tax.
M J
Money income
N K
E3
P
E1
E2
IC3
IC2
IC1
X
O Q R S T
Quantity of X
Figure 8.1 Income Tax Vs. Excise Tax
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182 Chapter 8
Now, let us suppose that excise tax is replaced with income tax and the same amount of revenue
(i.e., KE1) is collected through the income tax. The effect of income tax (which equals KE1 = MN) can be
traced by drawing an imaginary budget line passing through the equilibrium point E1 and parallel to the
original budget line MT. This is shown by the budget line NS in Figure 8.1. Since budget line NS is paral-
lel to the pre-income-tax budget line MT, income tax MN equals excise tax KE1. The budget line passing
through point E1 indicates that the consumer pays income tax equivalent to excise duty but he moves
on to an upper indifference curve IC2. The consumer’s equilibrium point now is E2. Thus, income tax of
an equal amount places the consumer on a higher indifference curve than does the excise tax. This is so
because an excise tax, which changes the price structure, imposes both income and substitution effects
on the consumer’s choice whereas income tax imposes only income effect. Consequently, an excise tax
reduces consumer’s satisfaction or welfare due to both income and substitution effects whereas income
tax reduces it only to the extent of income effect.
However, this proof of superiority of income tax over the excise tax is subject to certain qualifications.
First, in the above example, we have considered excise tax on a single commodity, X. If total excise tax
is uniformly spread over all the goods so as to keep the structure of relative prices unchanged, its effect
on the consumer would be similar to that of income tax.
Secondly, while income tax affects all those who have a taxable income, excise tax affects only those
who consume the taxed commodity. For example, an excise tax on wine does not impose any burden
on the teetotalers, whereas an income tax does. It all depends, however, on the nature and spread of
taxation.
Thirdly, the above analysis which is in the tradition of partial equilibrium analysis would not be valid
if applied to the community as a whole.2 But, the question here is not whether the conclusion drawn
from Figure 8.1 is or is not valid in general equilibrium analysis. Rather, the question is whether the
indifference curve technique can be profitably applied to the problems of the above nature. Obviously,
it can be.
MEASURING EFFECTS OF EXCISE AND INCOME SUBSIDIES

Indifference curve analysis has also been used to analyse and compare the effects of excise and income
subsidies as policy measures. Let us suppose that the government is planning to raise the levels of liv-
ing of the poor families and has to make a choice between (i) income subsidy in the form of lump-sum
money grant and (ii) excise subsidy or subsidy in the form of food subsidy, rent subsidy and loan subsidy.
The relevant questions that arise in this regard are: (i) Which of these measures costs less to the govern-
ment? and (ii) Which of these measures would be preferable to the people who are intended to benefit
from these policy measures? These questions can be answered with the aid of indifference curve analysis.
Let us analyse a simple case of choice between excise subsidy on a commodity (say, X) and a lump-sum
income subsidy, granted to a single consumer.
Measuring the Financial Cost of Excise Subsidy

In Figure 8.2, the vertical axis measures income and the horizontal axis measures quantity of commod-
ity X. Consumer’s budget line is shown by MN1 which represents consumer’s budgetary options in the
absence of excise or income subsidy. The consumer is shown to be initially in equilibrium at point E1 on
indifference curve IC1 where he consumes OX1 units of X for which he pays MP of his income and retains
OP for other goods.
M08_DWIV9400_02_SE_C08.indd 182 05/07/11 4:43 AM

Income
T
Cost of
income
subsidy
M
E2
S
E3
D
Cost of E1 J IC2
P
excise
subsidy
B K IC1
O X1 X2 X3 N1 N2 N3
Quantity of X
Figure 8.2 Excise Subsidy Vs. Income Subsidy
Let us now suppose that the government subsidizes commodity X by 50 per cent of its price so
that price consumers pay is reduced to a half. As a result, budget line shifts from MN1 to MN3 and the
consumer moves on to equilibrium point E3. Here, he consumes OX3 units of X for which he pays DM
of his income (at subsidized price). In the absence of excise subsidy, the consumer would have paid MB
of his income for OX3. Thus, MB − MD = DB is the cost of subsidy which the government would pay to
the producers of commodity X.
Measuring the Financial Cost of Lump-Sum Income Subsidy

Let us now consider what will happen if the government replaces excise subsidy by income subsidy or a
supplementary income grant. The effect of income subsidy is also shown in Figure 8.2.
Suppose that the government supplements consumer’s income by an amount that makes the con-
sumer to move from IC1 to his indifference curve IC2 which he had reached after subsidization of com-
modity X. That is, income subsidy is just sufficient to maintain the level of consumer’s utility with the
price subsidy. The effect of income subsidy can be obtained by drawing a budget line parallel to the
original budget line MN1 and tangent to IC2, as shown by the budget line TN2 (Figure 8.2). With new
budget line drawn, the consumer reaches equilibrium point E2 on IC2. At his new equilibrium point E2,
the consumer buys OX2 of X for which he pays TS of his income including income subsidy. Of TS paid
by the consumer, TM is the income subsidy granted by the government. Note that the cost of income
subsidy to the government equals TM.
Let us now compare the cost of two kinds of subsidies. We have noted that the cost of excise subsidy
equals DB and the cost of income subsidy equals TM. It can be seen in Figure 8.2 that
1. Excise subsidy DB = E3K and
2. Because the budget lines MN1 and TN2, are parallel, income subsidy TM = JK.
M08_DWIV9400_02_SE_C08.indd 183 05/07/11 4:43 AM

184 Chapter 8
As Figure 8.2 shows, E3K > JK. It shows that the cost of excise subsidy (E3K) is greater than the income
subsidy (JK) though both the policy measures achieve the same goal of increasing consumer’s satisfac-
tion to the level indicated by the indifference curve IC2.
The inferences that can be drawn from the foregoing analysis may be summed up as follows:
1. If the level of consumer’s satisfaction under both subsidy schemes is maintained at the same
level, cost of income subsidy will be lower than that of the excise subsidy. Therefore, income
subsidy is more efficient from the government’s point of view.
2. If cost of excise subsidy equals the cost of income subsidy, the latter makes the consumer reach
a higher indifference curve than one attainable under price subsidy. This means that income
subsidy is more efficient from consumer’s point of view too.
Making Choice of Policy

It has been shown above that income subsidy is more efficient and, therefore, it is always preferable
to excise subsidy. It should be however borne in mind that this analysis is based on an assumed set of
indifference curves. Since subjective evaluation of utility function varies from individual to individual,
indifference map may vary from individual to individual. Therefore, the above conclusion may not be
applicable universally.
Besides, choice between any two policy measures is not a matter of efficiency alone. It depends also
on a number of other considerations. An important consideration is the objective of the policy measures.
If policy objective is to encourage consumption of a commodity—say, food on health grounds—excise
subsidy is preferable because income subsidy may reduce food consumption. This effect can be seen in
Figure 8.2—income subsidy reduces consumption of X from OX3 to OX2 or it increases food consump-
tion only marginally from OX1 to OX2. Indirect effect of a policy measure is another consideration. For
example, if income subsidy encourages consumption of non-essential goods like alcohol, fancy clothes,
etc., excise subsidy would be preferable.
Policy effectiveness is yet another consideration. Subsidization of primary education, i.e., free primary
education, has not encouraged majority of poor parents to send their children to school, especially in the
rural areas. They prefer to put their children to some job as child labour. In contrast, income subsidy may
encourage parents to educate their wards because parents may spare their child labour for schooling. For,
there is a link between income and demand for education.
MEASURING WELFARE EFFECT OF COMMODITY

EXCHANGE BETWEEN INDIVIDUALS
Indifference curve analysis has also been used to explain why, under certain conditions, exchange of
commodities between individuals, regions and countries can be gainful and how the exchange promotes
the welfare of at least one individual without affecting the welfare of the other. This point is proved by
using the Edgeworth box diagram.3 It is the popular analytical tool used to explain how to judge the
efficiency in the allocation of goods between the consumers and how it can be improved. We have illus-
trated below, by using Edgeworth diagram, how exchange of commodities between two individuals can
be gainful to at least one of them.
M08_DWIV9400_02_SE_C08.indd 184 05/07/11 4:43 AM

Quantity of X
XB OB
M
A2
B1
P B
YA
YB
B2 J
K
Commodity Y
B3 A5
Commodity Y
B4 M
A4
B5
R A3
A2
A
A1
QA XA M
Commodity X
Figure 8.3 d e ot o -Dia am c an e fficienc
Suppose that there are two individuals, A and B, and two commodities, X and Y, and that indifference
maps of A and B for commodities X and Y are known and given. The placement of indifference maps of
A and B in the Edgeworth box diagram is shown in Figure 8.3. In the box diagram, A’s indifference map
containing his indifference curves A1, A2, …, A5 have been shown as usual, the point of origin being OA.
The indifference map of B is shown in an inverted position and superimposed on A’s indifference map.
B’s indifference map, containing his indifference curves B1, B2, …, B5 have their origin at point OB, in
the northeast of the box diagram. Corner points M indicate maximum quantity of X and Y available to
consumers A and B. Let us now examine the effects of exchange of goods between the two individuals.
The efficient distribution of goods X and Y between the two individuals A and B is given only at the
points where MRS between X and Y is the same for both of them, i.e., where
A B
MRS x , y = MRS x , y
Such points are given by the points of tangency between A’s and B’s indifference curves. If these
points are joined together, the resulting curve, OA and OB, is known as Edgeworth’s contract curve. The
Edgeworth contract curve may be defined as the locus of points of tangency between the indifference
curves of two individuals. It is shown by the curve OAOB in Figure 8.3. The contract curve represents
the optimum distribution of available quantities of goods X and Y between the two consumers, A and B.
Any other distribution pattern given by any point away from the contract curve would be sub-optimal.
It is sub-optimal, in the sense that, by redistributing the goods between A and B, at least one of the con-
sumers can be made better off. For example, suppose that both the consumers are at point P. Point P
represents the distribution of X and Y between A and B as follows:
A has OAXA of X and OAYA of Y
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186 Chapter 8
and
B has OB XB of X and OBYB of Y
Note that
OA XA + OB XB = total quantity of X
and
OAYA + OBYB = total quantity of Y
If shows that the total quantity of X and Y is distributed between A and B.
Given the distribution of the two commodities, A is at his indifference curve A2 and B at his indif-
ference curve B2. Since point P is not on the contract curve, the distribution of commodities X and Y
between consumers, A and B, is suboptimal. It can be shown that a redistribution of the two goods
along the indifference curve A2, moving from point P towards point R, place B on higher IC curve B4,
A remaining on his IC curve, A2. This will increase B’s level of satisfaction without affecting A’s satis-
faction. Similarly, a redistribution of two goods along B2, moving from point P towards point T, will
increase A’s level of satisfaction without affecting B’s satisfaction. For example, if commodities X and Y
are so distributed between A and B that they reach point K, the individual B will move on to a higher
indifference curve, B3, individual A remaining on his indifference curve A2. A further redistribution
of commodities between the two consumers taking them to point R will increase B’s utility further as
indicated by his indifference curve B3 without affecting A’s level of utility. Similarly, if goods X and Y
are so distributed that A and B reach point J, consumer B remains on the same indifference curve (B2)
but A moves on to an upper indifference curve A3. A further exchange of commodities taking them to
point T increases A’s utility further without making B worse off.
By the same logic, it can be shown that redistribution of goods X and Y along the line PN (moving
from point P towards N) increases the level of satisfaction of both A and B. Point N denotes the optimum
distribution of the two goods between the two consumers, because no other distribution can make both
the consumers better off or even at least one without affecting the other. It may thus be inferred that
the central point on the contract curve. OAOB gives the optimum distribution of goods X and Y between
consumers A and B.
DERIVATION OF LABOUR SUPPLY CURVE

The labour supply curve shows the relationship between supply of labour and wage rate. Labour sup-
ply curve is a backward bending curve. The backward bend in the labour supply curve is the result of
labour’s choice between income and leisure. The indifference curve can be applied to show labour’s
choice between income and leisure and to derive the supply curve of labour.
Income–Leisure Choice
Let us assume that utility function of an individual worker is given as
U = f (M, L)
(where M = money income from work and L = leisure).
Assume also that an individual divides his daily time between work and leisure so as to maximize his
utility functions. Given the number of hours at his disposal, if he increases his hours of work, his income
increases but his hours of leisure decrease and vice versa. For the labour, income and leisure are treated
M08_DWIV9400_02_SE_C08.indd 186 05/07/11 4:43 AM

M
Income
E
P
IC (I:L)
O N H X
Leisure
Figure 8.4 Equilibrium of Individual Worker
as substitutes for one another. A utility maximizing labour has to find a leisure–income combination that
maximizes his total utility. Let us now see how a labour makes his choice between leisure and income to
maximize his utility function by applying the indifference curve technique.
The income–leisure choice of the worker is shown in Figure 8.4 in which X-axis measures the hours
available to a labour and Y-axis measures his money income. Let us assume that the total hours available
—
to the labour are OH and that hourly wage rate is fixed at W. If he works for OH hours and enjoys no
—
leisure, his total income will be OM = OH . W. If the individual enjoys his whole time (OH) as leisure, he
will be at point H with zero income. By joining the points M and H by a line, we get his income–leisure
—
curve, MH. This curve shows, income–leisure combinations at a given wage rate, W. Another important
—
point to be noted is that the slope of the income–leisure curve, OM/OH = W.
Let us now assume that the indifference curve of an individual labour for income and leisure (I:L)
is given by the curve IC in Figure 8.4. This curve is known as income–leisure trade-off curve. Its slope
indicates the MRSL,M between income and leisure, i.e., ΔM/ΔL. The labour’s equilibrium is determined
at point E where income–leisure line is tangent to his income–leisure trade-off curve. It means that the
individual worker is in equilibrium where
∆M
W= = MRS L , M
∆L
Point E in Figure 8.4 shows labour’s optimum combination of income and leisure, with OP of income
and ON hours of leisure. For his income OP(=EN), he works for NH hours.4 With the combination of
income (OP), leisure hours (ON), and working hours (NH), he maximizes his utility function as at point E,
MUM = MUL given the wage rate. However, with the change in wage rate and consequent increase in wage
income, the equilibrium combination of leisure and income goes on changing. In fact, when wage rate
continues to increase, the labour cuts his leisure and works for larger number of hours for higher income.
But, beyond a certain level of income, this trend is reversed. This kind of labour behaviour is shown by
a wage–labour offer curve. The derivation of wage-offer curve and labour supply curve is shown below.
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188 Chapter 8
Wage–Labour Offer Curve and Labour Supply Curve

Figure 8.4 shows the labour’s equilibrium under static conditions. Under dynamic conditions, wage rate
tends to change. With the change in wage rate, labour’s preference for work and leisure changes. For
example, if wage rate increases, labour’s preference for working large number of hours for a higher income
increases and his preference for leisure decreases—up to a point, of course. This kind of behaviour of the
labour forms the basis of the labour supply. Labour supply curve is derived from the wage–labour offer
curve. The wage-offer curve may be derived by introducing change in wage rate into the above analysis.
The process of deriving wage-offer curve is shown in Figure 8.5.
Let us suppose that a labour is initially in equilibrium at point E1 where his income–leisure line M1H
is tangent to his income–leisure trade-off curve IC1. At this equilibrium point, the individual optimizes his
income–leisure combination. He enjoys a leisure of ON1 hours, and he works for N1H hours. By working
for N1H hours, he makes an income of E1N1. Let the wage rate increase so that his income–leisure line
shifts upward from M1H to M2H and he moves to equilibrium point E2. Note that his leisure hours
decrease and work hours increase. As a result, his income increases to E2N3. This trend continues until
he reaches equilibrium point E3. But, beyond this point his preference for leisure increases with increase
in his income. If we join the equilibrium point E1, E2, E3 and E4 by a curve, we get wage–labour offer curve
which forms the basis of labour supply curve.
M4
M3
IC4
Money income
IC3 Wage-offer curve
M2
IC2 E4
E3
IC1 E2
M1
E1
O
N3 N2 N1 H
Leisure
Work
Figure 8.5 Derivation of Wage-Offer-Curve
M08_DWIV9400_02_SE_C08.indd 188 05/07/11 4:43 AM

Figure 8.5 provides data required for drawing labour supply curve. To draw labour supply curve, we
need wage rate and labour supplied (hours of work) at different wage rates. Wage rate is given by the
slope of the income–leisure line (M1H, M2H, …, M4H). For example, slope of income–leisure line M1H
equals OM1/OH = wage rate. Let us denote this wage rate by W1. At wage rate W1, labour is in equilibrium
at E1 and his labour supply is HN1. Similarly, we can obtain wage rate and the corresponding labour sup-
ply for other equilibrium points, as given in the following table.
By plotting the wage rate and labour supply given in the table, we get a labour supply curve as shown
in Figure 8.6. As the figure shows, the labour supply curve has a backward bend beyond a certain wage
rate. This shows that labour supply curve is a backward bending. This shows another important applica-
tion of indifference curve.
Table 8.1 Wage Rates and Labour Supply

Equilibrium Point Wage Rate Labour Supply
E1 OM1/OH = W1 HN1
E2 OM2/OH = W2 HN3
E3 OM3/OH = W3 HN3
E4 OM4/OH = W4 HN2
SL Labour supply
curve
W4
W3
Wage rate
W2
W1
O N1 N2 N3
Hours of work (labour supply)
Figure 8.6 Derivation of Labour Supply Curve
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190 Chapter 8
EVALUATING RATIONING OF CONSUMER GOOD

Rationing is a measure to ensure a fair and equitable distribution of scarce essential consumer goods.
The use of rationing by the governments is a common practice during the war periods. In less developed
countries, governments use rationing to ensure fair distribution of essential consumer goods in short
supply. In India, for example, rationing of food grains (wheat and rice), sugar, kerosene and cement had
been a common practice until 1970s. Indifference curve analysis can be used to show the conditions
under which rationing of goods can be effective.
The purpose of rationing of scarce consumer goods and services is two-fold.
1. Preventing excessive consumption of some goods and services by the rich households. This is
called preventive rationing.
2. Ensuring availability of scarce essential consumer goods to low-income households. This is
called consumption control rationing or fair distribution rationing.
Here, we show the conditions under which rationing is effective or ineffective by using the indiffer-
ence curves.
Rationing of One Commodity

Preventive Excessive Consumption Figure 8.7 shows the case of preventive rationing. In
this figure, budget line JK represents the budgetary constraints of poor households. Given the income
and prices of commodities X and Y, the area under and the points on the budget line JK represent the
‘market opportunity set’, i.e., the consumption feasibility area, for the poor households. Under the given
conditions, poor households would be in equilibrium at point P. Similarly, budget line MN represents the
budgetary constraints for the rich households. Given their incomes and prices of commodities X and Y,
rich households would be in equilibrium at point Q. It is clear from the figure that a rich household
captures a larger share of the scarce good.
M
Commodity Y
P
IC2
T
IC1
O X1 X2 R K N
Commodity X
Figure 8.7 Preventive Rationing
M08_DWIV9400_02_SE_C08.indd 190 05/07/11 4:43 AM

Now, let the government impose rationing on the consumption of commodity X at quantity OR. An
ordinate drawn from point R shows the limits to which consumption of X can be increased. It can be seen
in Figure 8.7 that the permissible limit of X’s consumption (OR) far exceeds the equilibrium quantity of
X which poor and rich households would like to consume in the absence of rationing. Therefore, ration-
ing at OR is ineffective. In case of poor households, low income itself serves as constraint on consump-
tion. It is ineffective also in case of rich households. Therefore, no government, fully aware of supply and
demand situation, will adopt this kind of rationing.
However, fixing the upper limit of consumption by rationing at OR is not without policy implication.
Note that rationing at OR is potentially effective in the sense that it would prevent rich households from
increasing their consumption of X beyond point R. This kind of rationing may be used where intention
is to allow poor households to meet fully their basic need of an essential commodity and to prevent the
rich households to consume X beyond a certain limit. This kind of rationing can be more appropriately
called as preventive rationing or precautionary rationing.
Effective Rationing The purpose of effective rationing is to control consumption to a desirable limit
to make a scarce product available to a larger section of population. Figure 8.8 presents the case of fully
effective rationing. The budget line MN and the area under the budget line represent the ‘market opportu-
nity set’ available to the consumers. In the absence of rationing, the consumers would be in equilibrium
at point U on indifference curve IC2. After the imposition of rationing at OR, consumers move to a con-
strained equilibrium at point C on a lower indifference curve, IC1. Their consumption of X falls from OQ
to OR. Rationing is, therefore, completely effective. It is doubly effective if rationing aims at reducing con-
sumption of X and increasing that of Y. This kind of rationing has a serious welfare implication. However,
it cannot be judged from Figure 8.8 whether loss of consumers’ welfare is matched with gains of rationing.
Rationing of More Commodities

Precautionary Rationing The government imposes rationing generally on more than one
commodity. In case two goods, e.g., X and Y, are subjected to rationing, its effectiveness depends again
C
Commodity Y
IC2
IC1
O R Q N
Commodity X
Figure 8.8 Effective Rationing
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192 Chapter 8
Commodity Y M
MY
J
U
YO
K
IC
O XO RX N
Commodity X
Figure 8.9 Preventive Rationing of Goods X and Y
on the limits of permissible consumption. If permissible consumption limits of both the goods are in
excess of what consumers consume in the absence of rationing, then rationing would be ineffective in the
sense that it does not displace consumers’ equilibrium. This situation is shown in Figure 8.9. Given the
budget line MN, the consumers would be in equilibrium at point U. If the government imposes ration-
ing at OMy for Y and at ORx for X, it would be ineffective. For, consumers are in equilibrium at point U
which is well within their ‘market opportunity set’ and rationing limits. They will consume only OX0 of X
and OY0 of Y, both being less than their respective rationing limits. This kind of rationing may, however,
be used as a precaution against expected increase in consumption of X and Y or expected accumulative
demand for these goods in anticipation of deterioration in supply position.
Effective Rationing Figure 8.10 presents the case of effective rationing in case of both the goods,
X and Y. In the absence of rationing, consumers would be in equilibrium at point U consuming ON0
of X and OM0 of Y. With rationing imposed at ORx for X and ORy for Y, the consumers will be forced
to move to point C on a lower indifference curve. At point C, their consumption is limited to ration
quantity—ORx for X and ORy for Y. This kind of rationing is, therefore, effective rationing.
It must, however, be borne in mind that this analysis of rationing is purely theoretical. In practice,
there are a number of practical problems in implementing rationing. It is a general experience that
rationed commodities go out of market and are sold in black market at exorbitantly high prices.
Therefore, effectiveness of rationing depends on (i) the degree of government control on the market
conditions, (ii) how effective is the implementation of rationing and (iii) government’s capability and
powers to prevent black marketing and price-hike following the imposition of rationing. In the absence
of these imperatives, rationing will not be effective nor will it serve its basic purpose.
M08_DWIV9400_02_SE_C08.indd 192 05/07/11 4:43 AM

Commodity Y M
U
M0
C
RY
IC2
IC1
O RX NO N
Commodity X
Figure 8.10 Effective Rationing of Goods X and Y

1. Suppose that the government is required to raise certain amount of revenue through taxation
to meet the government expenses. At the same time, the government makes its taxation policy
in such a way that the welfare cost of taxation is minimum. Suppose also that the government
has to make a choice between income tax and excise tax. Given the government objective of
taxation, which of the two taxes will you recommend to the government and why? Illustrate
your arguments graphically.
2. It is generally said that income tax of a certain amount imposes a lower welfare cost on the
taxpayers than excise duty or sales tax of the same amount. Do you agree with the statement?
Prove your point of view graphically.
3. Using indifference curve analysis, show that excise tax or sales tax imposes a higher welfare cost
than a lump-sum income tax of the same amount.
4. Suppose that the government wants to subsidize the consumption of some essential commodities
with a view to raising the standard of living of poor citizens. The government has two alterna-
tive measures of subsidy to choose from: (i) excise subsidy, i.e., reducing the excise tax on some
selected goods and (ii) providing lump-sum income subsidy in the form of grants. Which of
these measures involves a lower cost to the government for a given increase in consumption of
the poor people? Illustrate your answer graphically.
5. Using indifference curve analysis, show that income subsidy provided to the poor people
involves lower financial cost to the government than excise subsidy for a given increase in the
consumption of the poor families.
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194 Chapter 8
6. Indifference curve analysis can be gainfully used to show how exchange of commodities
between two consumers can improve exchange efficiency. Prove this point of view by using
Edgeworth’s box diagram.
7. Suppose a labour has his utility function given as U = f(M, L), where M is labour income and L
is leisure. What is the condition for the labour to optimize his income and leisure? Illustrate the
equilibrium position of the labour.
8. Using indifference curve analysis, illustrate the derivation of labour supply curve. Why is the
labour supply curve backward bending?
9. What is the purpose of rationing of certain commodities? Illustrate when rationing is ineffec-
tive or is only preventive and when it is effective and restrictive.
ENDNOTES
1. Commodity X may be taken as a bundle of goods.
2. For details see Friedman, M. Price Theory: A Provisional Taxt (A Monograph), pp. 59–61.
3. The Edgeworth box diagram is also referred to as Edgeworth–Bowley diagram because Edgeworth
and Bowley are believed to have used the box diagram first. It is, however, contended that it
was Vilfred Pareto who used this device first in his Manuale d’ Economic Politica (1906). (For
details, see Jarascio, V.J. (1972), ‘A Correction: On the Geneology of the So-called Edgeworth–
Bowley Diagram’, Western Economic Journal, June.) In economic literature, however, the device
is popularly known as Edgeworth diagram.
4. Working hours equal the number of available hours less leisure hours, e.g., working hours
(NH) = Available hours (OH)–Leisure hours (ON).
FURTHER READINGS
Browning, E.K. and Browning, J.M., Microeconomic Theory and Applications (New Delhi: Kalyani
Publishers), Chapters 4 and 15.
Maddala, G.S. and Miller, E. (1989), Macroeconomics: Theory and Applications (New York: McGraw-Hill),
Chapters 4 and 5.
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Chapter 9
Revealed Preference Theory
CHAPTER OBJECTIVES
Recall that the Marshallian approach to the analysis of consumer behaviour is based on cardinal utility
and Hicksian approach is based on ordinal utility. Measurability of utility continues to remain a debat-
able issue. However, Samuelson has developed a theory known as ‘Revealed Preference Theory’ based
on the consumer’s preferences about goods revealed in the market. This theory does not involve the
problem of measuring utility. The Revealed Preference Theory is the subject matter of this chapter. This
chapter tells you:
The meaning and practice of revealed preference;
How consumers reveal their preference for goods and services they consume;
How the demand curve can be derived by using consumer’s revealed preference;
How the indifference curve can be derived from consumer’s revealed preference; and
How income and substitution effects can be measured.
INTRODUCTION
The issue of measurability and behaviour of utility derived from consumer goods and money income
marks the major points of departure of the modern economists from the neoclassical economists.
Neoclassical economists, specially Marshall, assumed cardinal measurability of utility. The ordinalists,
specially Hicks and Allen, discarded the cardinal concept of utility and used the ordinal concept of utility
to explain the consumer’s behaviour. For some time, it looked as if the issue of measurability of utility
was resolved. For many economists, however, it remained an issue of contention. As a result, the search
for a more satisfactory treatment of utility concept in consumption theory continued. Before we proceed
to discuss Revealed Preference Theory, let us have a brief look at the post-Hicks–Allen developments in
the theory of consumer behaviour.
One of the most significant contributions to the theory of consumer behaviour was made by
Paul A. Samuelson1 in his ‘Revealed Preference Theory’. Samuelson showed, in his ‘Revealed Preference
Theory’, that the consumer’s demand curve may be derived straightway from the consumer’s budgetary
M09_DWIV9400_02_SE_C09.indd 195 07/07/11 12:47 AM

196 Chapter 9
constraint and his preferences revealed in the market, without involving the problem of cardinal or ordinal
measurement of utility. Later on, Von Neumann and Margenstern attempted to provide a measure of
cardinal utility in the form of the cardinal utility index, with a view to explaining the decision making
under the condition of uncertainty. Friedman and Savage attempted to show that as the income of an indi-
vidual increases, marginal utility of his income first decreases, then increases, and finally decreases. This
behaviour of marginal utility of money income explains why people buy insurance and, at the same time,
indulge in gambling. Leibenstein attempted to incorporate the ‘external effects’ on the personal utility,
such as ‘bandwagon effect’2 ‘snob effect’3 and ‘Veblen effect’4 into the ‘current theory of demand’. Because of
some of these developments, perhaps, Hicks felt it necessary to revise his ‘theory of demand’ which he had
developed in his book Value and Capital. In mid-1960s, Kelvin Lancaster added another dimension to the
theory of demand by exploring what he calls technology of consumption, a technique similar to indifference
curve. Given the target readership of this book, however, we present in this chapter a brief description of
only one of these developments, i.e., Samuelson’s ‘Revealed Preference Theory’ of consumer behaviour.
REVEALED PREFERENCE: ASSUMPTIONS AND AXIOMS

In succession of Hicks–Allen ordinal utility approach, Samuelson5 proposed in 1947, another theory,
called the ‘Revealed Preference Theory’ of consumer behaviour. The main merit of the revealed prefer-
ence theory is that ‘law of demand’ can be derived directly from the revealed preference axioms without
using the indifference curve and most of its restrictive assumptions. What is needed is simply to record
the consumer’s observed behaviour in the market, i.e., the basket of goods a consumer buys at different
prices. Besides, the revealed preference theory is also capable of establishing the existence of indifference
curves and their convexity. For its merits, revealed preference theory is treated as ‘the third root of the
logical theory of demand’. The revealed preference theory is discussed here briefly.
Assumptions
Revealed preference theory is based on the following assumptions:
1. Rationality The consumer is a rational being: he prefers a larger basket of goods to the smaller ones.
2. Transitivity Consumer’s preferences are transitive. That is, given the alternative baskets of goods,
A, B and C, if he considers A > B and B > C, then he considers A > C.
3. Consistency Consumer’s taste remains constant and consistent. Consistency implies that, if a
consumer, given his circumstances, prefers A to B, he will not prefer B to A under the
same conditions.
4. Price inducements Given the consumer’s choice for a basket of goods, the consumer can be induced to buy
a different basket of goods by providing him sufficient price incentives.
Revealed Preference Axiom

The ‘revealed preference axiom’ can be stated as follows. Given the budgetary constraint and alter-
native baskets of goods having the same price, if a consumer chooses a particular basket, he reveals
his preference. For example, suppose that a consumer has a given income which he spends on two
commodities, X and Y. Suppose also that there are two alternative baskets A and B of the two goods, X
M09_DWIV9400_02_SE_C09.indd 196 07/07/11 12:47 AM

Revealed Preference Theory 197
and Y, and that both the baskets are equally expensive. Given these conditions, if the consumer chooses
basket A rather than basket B, he reveals his preference for basket A. This is the basic axiom of the
revealed preference theory.
To explain the axiom further, in general, a consumer chooses a particular basket either because
he likes it more or because it is less expensive than the other. When a consumer prefers a
basket of goods because it is cheaper than the other baskets, then his preference is not revealed
for the obvious reason that a cheaper basket is always preferable to the costlier one, satisfaction
level being the same. For example, if the consumer prefers basket A to B because basket A is
cheaper, then the preference for basket A cannot be said to have been revealed. But, if both
the baskets are equally expensive, and the consumer prefers basket A, then there is only one
plausible explanation for the preferability of basket A, i.e., the consumer likes basket A more
than he likes basket B. In this case, the consumer reveals his preference for basket A.
The revealed preference axiom is shown in Figure 9.1. The consumer’s budgetary constraint is shown
by the budget line MN. This budget line is the same as the Hicks–Allen budget line (see Chapter 7,
Section 3). The budget line, MN, shows the various combinations of goods, X and Y, given his income
and prices of the goods. If a consumer chooses a particular basket of goods X and Y, e.g., the basket
represented by point A on the budget line, it implies that he prefers point A to any other point on the
budget line, say, point B. Since point B is on the same budget line, basket B is as expensive as basket A. If
consumer chooses point A, it means that the consumer reveals his preference for A compared to B. Any
point below the budget line, e.g., point C, represents a smaller and cheaper basket of X and Y. But it is
not certain whether point C is revealed inferior to point A because its cost is unknown. Any point above
the budget line, e.g., point D, represents a larger and more expensive basket of goods than indicated by
point A. Therefore, point D is preferable to point A.
Y
M
D
Quantity of Y
A
P
C B
X
O X N
Quantity of X
Figure 9.1 Revealed Preference Axiom
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198 Chapter 9
DECOMPOSITION OF SUBSTITUTION AND INCOME EFFECTS

AND DERIVATION OF DEMAND CURVE
An important merit of the indifference curve analysis is that it can be used to segregate income and
substitution effects of the price effect with the purpose of deriving the consumer’s demand curve which
is the ultimate objective of the analysis of consumer behaviour. The beauty of revealed preference axiom
is that it can be used to measure the income and substitute effects of the price effect and also to derive the
demand curve. In this section, we show the measurement of income and substitution effects of a price
change and derive the law of demand by using revealed preference theory.
Let us suppose that the initial budget line is given by M1N1 in Figure 9.2 and the consumer chooses
a bundle of goods X and Y indicated by point A (i.e., AX1 of Y and OX1 of X). Since all the bundles
represented by the various points on the budget line M1N1 are equally expensive, the consumer reveals
his preference by choosing bundle A. Let us now suppose that price of X falls, price of Y remaining the
same, so that his budget line shifts to MlN3 and the consumer shifts to point C. This shift results from the
two effects of price change is the income and substitution effects. Let us now decompose the income and
substitution effects of the price effect by using Slutskian method. This has been done by drawing a budget
line M2N2 through point A. Since this budget line passes through point A, it implies that the bundle of X
and Y at point A is still available to the consumer. Now let us look at a consumer’s response to change in
the price of commodity. The consumer will not choose any point between A and M2 as they are inferior
to point A—inferior because all the points between A and M2 fall below the points between A and M1.
He will therefore buy either bundle A or at any other point (say B) on the AN2 segment of the budget line,
preferably between points A and H. If he continues to buy the basket at point A, substitution effect will be
zero. And, if he chooses point B, substitution effect is X1X2 and income effect is X2X3 = X1X3 − X1X2. Note
that the substitution effect on the consumption of commodity X is positive. It means that the demand
for X increases as a result of decrease in its price. This behaviour of the consumer conforms to the law
M1
M2 D
Commodity Y
A
C
B
X
O X1 X2 X3 N1 N2 N3
Commodity
Figure 9.2 Substitution and Income Effects: Revealed Preference Approach
M09_DWIV9400_02_SE_C09.indd 198 07/07/11 12:47 AM

of demand. Thus, the Marshallian demand curve with a negative slope can easily be drawn following the
revealed preference of the consumer.
DERIVATION OF INDIFFERENCE CURVE

Samuelson’s revealed preference theory can also be used to construct the indifference curve of a con-
sumer. As noted earlier, ordinal utility approach assumes only the existence of indifference curves and
their convexity: it does not provide proofs for its existence. In contrast, revealed preference theory provides
the proofs for the existence of indifference curve and its convexity. Samuelson derives such proofs from
observed market behaviour of the consumer, i.e., his choices of basket of goods at various prices. The
derivation of indifference curve through the revealed preference theory is shown in Figure 9.3.
Let us assume that the basket of goods at point A on the budget line MN is initially preferred by the
consumer, given his income and prices. Any other point on the budget line, MN, is therefore revealed
inferior to point A. Also, the whole area under the budget line, MN, i.e., the area shown by the triangle
MON, is the inferior zone as it contains smaller, though cheaper, combinations.
Let us now look at the consumer’s preferences in the area above the budget line. The area above the
line MN is divided into three zones: JAK, JAM and KAN (see Figure 9.3). The area JAK is the preferred
zone. Any point on the line JA shows a larger quantity of Y, quantity of X remaining the same. Similarly,
any point on the line AK shows a larger quantity of X, quantity of Y remaining the same. And, area to
the right of AJ and above AK represents a basket with more of both the goods. Therefore, any point on
the lines AJ and AK and between them is preferable to A. The whole area has therefore been named as
preferred zone.
The area JAM and KAN are ignorance zones, because, in these areas, any combination of the two goods
contains more of one good and less of another compared to combination A. That is, in areas JAM and
KAN, a part of one good needs to be substituted for another. The consumer’s reaction to such changes is
difficult to know. Therefore, consumer’s preferences are unknown and cannot be determined precisely.
Therefore, these areas are called ignorance zones.
Y J
M Ignorance
zone
Preferred
zone
Commodity Y
A
K
Inferior
zone
Ignorance
zone
O N
Commodity X
Figure 9.3 Division of Commodity Space
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200 Chapter 9
It may, thus, be inferred that the consumer’s indifference curve will pass through point A and through
some points in the ignorance zones, JAM and KAN, to retain its convexity. The course of indifference
curve in the ignorance zones, may be traced by ranking consumer’s choices in these areas. This can be
accomplished by the procedure shown in Figure 9.4.
Suppose that the initial budget line is given by MN. Now let the price of good X, (PX) fall and price
of Y, (PY), increase so that the budget line MN shifts to a position shown by PT (assumption 4), after
adjusted for income effect. The consumer will choose either a basket at point B or at any point on the BT
segment of the new budget line. The behavioural assumption of consistency (assumption 4) prevents the
consumer to choose any point on the BP segment of the new budget line, because it lies in the inferior
zone and any point on this segment is inferior to B. Since the consumer chooses point B, as revealed
preference axiom suggests, any other point on or below PT is inferior to B. Therefore, any combination in
the area NBT is revealed inferior to B. Thus, the triangle NBT which is a part of the ignorance zone, KAN,
is clipped off because the consumer’s ranking of this area is now known.
This procedure can be repeated for as many points as one wishes and the area of ignorance zone can
be reduced bit by bit. For example, we may select a point C on the BT segment of PT and draw a prob-
able price line QR. Following the same procedure, we may show that points in the area marked by the
triangle TCR are revealed inferior to A and chop off the area from the ignorance zone. Moving up along
the budget line MN, we may choose point D and hack away triangle UDM.
The same procedure may be adopted to whittle away the ‘upper ignorance zone’ marked by triangle
JAM and to find points in relation to A. The procedure is shown in Figure 9.4. The consumer is assumed
to be initially at point A on the budget line MN. Let us now suppose that PX increases and PY decreases
and the new budget line, MN, passes through the point D and that the consumer chooses point D on the
budget line MN. At new prices, bundle A is equally expensive as bundle D. We know from the revealed
preference theory that point D is preferable to point A and any point in the area ADU is revealed pre-
ferred to D. This procedure may be repeated by drawing other price line through the points above point
A and the ‘upper ignorance zone’ can be reduced bit by bit.
J
U
G
E
Commodity X
D
P
A
Q K
B
H
C
F
X
O V N T R
Commodity X
Figure 9.4 Derivation of Indifference Curve Through Revealed Preference Theorem 1
M09_DWIV9400_02_SE_C09.indd 200 07/07/11 12:47 AM

M J
F
Commodity Y
C
K
A
F’
C’
X
O N
Commodity X
Figure 9.5 Location of Indifference Curve
If we join all the points—D, A, B and C in Figure 9.4—which have been located on the various budget
lines, we get a curve which Samuelson called offer curve as shown by the curve FF ′ in Figure 9.5. The
position of the offer curve is the probable position of indifference curve.
This probability of the existence of an indifference curve can be established by the following infer-
ences which can be drawn from the foregoing discussion.
First, the indifference curve cannot be a straight line like MN because choice of point A shows that
all other points on MN are revealed inferior to A, and therefore, the consumer cannot be indifference
between point A and any other point on the budget line.
Secondly, all the points below the budget line MN are revealed inferior to A. Therefore, an indiffer-
ence curve cannot intersect the budget line nor be it concave through point A as shown by curve CC ′.
Finally, since all the points on or above the offer curve are revealed superior to A, an indifference curve
cannot pass through the preferred zone, JAK. Therefore, the only probable position of indifference curve
is somewhere in the ignorance zone as shown by the curve FF ′.
APPRAISAL OF REVEALED PREFERENCE THEORY

Samuelson’s revealed preference theory is a major contribution to the theory of demand in at least the
following respects.
One of its merits is that, unlike Marshallian demand theory and Hicks–Allen indifference curve
analysis, it can be used to derive demand curve without using utility concept. Besides, in its approach to
consumer analysis, it uses behaviourist method which is empirically observable in the market whereas
Marshallian psychological method and Hicksian introspective method are not empirically verifiable.
Two, the revealed preference theory abandons most of the restrictive assumptions of the indifference
curve analysis, e.g., the assumption of utility maximization and continuity, etc. It can be used to con-
struct indifference curve under weaker assumptions.
Three, the revealed preference theory provides also the basis for constructing index number of cost of
living. In spite of these merits, the revealed preference theory has yet to gain applicability and popular-
ity. Surprisingly, even Samuelson has not included this theory in his own highly acknowledge text book
Economics (15th edn).
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202 Chapter 9

1. One of the main problems in consumer analysis has been the measurement of utility. How does
revealed preference theory analyse consumer’s behaviour without involving the problem of
measurement of utility?
2. What is the main proposition of ‘revealed preference theory? What are its basic assumptions
and axiom? In what way is revealed preference theory an improvement over indifference curve
analysis?
3. Consumer demand curve can be drawn straight away from his observed market behaviour.
Do you agree with the statement? If yes, illustrate the derivation of demand curve from the
revealed preference axiom.
4. One of the advantages of indifference curve analysis is that it provides a technique to measure
income and substitution effects of price change. Show graphically that this task can be accom-
plished by using revealed preference axioms.
5. It is claimed that even an indifference curve can be drawn by using the revealed preference
axioms. Do you agree with the claim? If yes, illustrate the derivation of indifference curve from
the revealed preference axioms.
6. Illustrate graphically the derivation of the demand curve by using the revealed preference axioms.
7. The income and substitution effects of the price can be measured straightway by using the
budget line. Do you agree with the statement? Prove your point graphically.
ENDNOTES
1. Samuelson, P.A. (1947), Foundation of Economic Analysis (Cambridge, MA: Harvard University
Press).
2. When a consumer demands more of a commodity because others of his class and his superiors
consume more of that commodity, it is called ‘bandwagon effect’.
3. ‘Snob effect’ means decrease in the consumption of a commodity by rich people when it
becomes a commodity of common consumption.
4. ‘Veblen effect’ means decrease in consumption of a commodity because it has become cheaper.
It implies a positive relationship between price and quantity consumed.
5. Samuelson, P.A. (1947), Foundation of Economic Analysis (Cambridge, MA: Harvard University
Press), Chapters 5, 6; and ‘Consumption Theory in Terms of Revealed Preference.’ Economica,
November 1948, pp. 243–253. Samuelson had however conceived the idea much earlier in
his paper ‘A Note on the Pure Theory of Consumer’s Behaviour,’ Economica, February and
August 1938.
FURTHER READINGS
Koutsoyiannis, A. (1979), Modern Microeconomics (London: Macmillan), 2nd Edn., Chapter 2(III).
Pindyck, R.S. and Rubinfeld, D.L. (2001), Microeconomics (Delhi: Pearson Education), 5th Edn., Chapter 3.
Samuelson, P.A. (1947), Foundations of Economic Analysis (Cambridge, MA: Harvard University Press).
——— (1948), ‘Consumer Theory in Terms of Revealed Preference’, Economica, pp. 243–53.
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Chapter 10
Consumer Surplus
CHAPTER OBJECTIVES
Consumer surplus is an important concept used especially in measuring the positive and negative effects
of the government policy actions. By going through this chapter, you learn:
The meaning of consumer surplus;
The Marshallian method of measuring consumer surplus;
The Hicksian method of measuring consumer surplus;
The application of consumer surplus concept to evaluate some policy effects;
How to measure the deadweight loss of taxation, price control, imposition of trade barriers; and
How to measure the gains of subsidy to the producers and consumers.
INTRODUCTION
In the preceding analyses of consumer behaviour, it was assumed that consumers are aware of prices of
goods and services they consume. In real life, however, the consumers may not necessarily be aware of
all the prices. They find often that the price which they are willing to pay is different from what they are
actually required to pay. If the price a consumer is willing to pay is higher than the price which he actu-
ally pays, then the consumer is said to have a surplus. This surplus is called consumer surplus.
The concept of consumer’s surplus is believed to have been originated by a French engineer, Arsene
Julis Dupuit in 1844, in his effort to measure social benefit of such collective goods as roads, canals and
bridges.1 In his opinion, the value of the benefit of such collective goods was greater than the price actu-
ally charged because most people would be willing to pay a higher price than they actually paid. The
concept was later refined by Marshall who also provided a measure of consumer’s surplus. His premise
of measuring consumer’s surplus was, however, rejected by the ordinalists who attempted to provide a
different method of measuring consumer’s surplus through their indifference curve technique.
In this chapter, we discuss the various methods of measuring consumer’s surplus and their merits
and demerits. We also point out the application of the concept of consumer surplus, especially on the
formulation of the taxation policy by the government and pricing policy of the business firm. Let us first
look at the Marshallian concept and measure of consumer surplus and its drawbacks.
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204 Chapter 10
MARSHALLIAN CONCEPT OF CONSUMER SURPLUS

AND ITS MEASUREMENT
Although the concept of consumer surplus was originated by Dupuit as early as 1844, it remained an
immeasurable concept until Marshall suggested, as late as 1920, a method of measuring consumer’s
surplus in money terms. Marshall defined consumer’s surplus as ‘the excess of the price which [a con-
sumer] would be willing to pay rather than go without the thing, over that which he actually does pay.’
According to the Marshallian theory of demand, what a consumer is willing to pay for one unit of a
commodity measures the money value of his expected utility and what he actually pays measures the
monetary cost of the expected utility. According to Marshall, the difference between the two values is
‘consumer surplus’. For example, if you are prepared to pay Rs 500 for a ticket to watch a cricket match
and you pay only Rs 200, the actual price of the ticket, you have a consumer surplus of Rs 300.
The concept of consumer’s surplus can be expressed also in terms of utility (or satisfaction). Recall
that Marshall assumed marginal utility (MU) of money to remain constant. Under this condition, what a
consumer is willing to pay for a commodity indicates the utility that he expects from the commodity and
what he actually pays measures the loss of utility (of money). The difference between the utility gained
and the utility lost in acquiring the commodity is the consumer’s ‘surplus satisfaction’ which Marshall
called ‘consumer’s surplus’.
The Marshallian concept of consumer’s surplus and its measurement are graphically illustrated in
Figure 10.1. Suppose the consumer’s demand curve for a commodity X is given by the demand line
MN. The consumer’s willingness to pay is shown by his straight line demand curve MN. The curve MN
also indicates the utility derived from each successive unit of a commodity.2 Suppose that the market
price, i.e., the price which a consumer actually pays, is given by OP. At price OP, the consumer buys
OQ units. The total utility derived by the consumer from OQ units is shown by the area OMBQ, for
which the consumer pays OPBQ = OQ × OP. Thus, in the Marshallian sense, total consumer surplus
equals = OMBQ − OPBQ = MPB. That is, the shaded area MPB represents the consumer’s surplus in the
Marshallian sense when the consumer buys OQ units of a commodity X.
M
Price
B
P
O Q N
Commodity X
Figure 10.1 Consumer’s Surplus
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Consumer Surplus 205
Assumptions
The above analysis of the consumer’s surplus is based on the following assumptions:
First, it is assumed that the market price is given so that neither the sellers nor the buyers can affect
the price. The consumer’s surplus will not exist if there is a monopolist and he adopts first degree
price discrimination3 in his pricing policy.
Secondly, the utility is cardinally measurable and MU of consumer’s money income remains con-
stant throughout.
Thirdly, the utility of each commodity is absolute and is independent of other goods and services
consumed by the consumer.
Fourthly, there is no close substitute for the commodity in question. For, if close substitutes are
available, there may not be any difference between ‘what the consumer would be willing to pay’
and ‘what he actually pays’ for the commodity in question.
Critical Appraisal
The Marshallian concept and measurement of consumer’s surplus have been criticized on many grounds.
But the criticism is equally questionable. The criticism of Marshallian concept of consumer surplus and
its validity are discussed here.
First, economists have pointed out difficulties in measuring the consumer’s surplus as defined
by Marshall and represented by ‘a triangle’, as shown by triangle MPB in Figure 10.1. However,
Mark Blaug rejects this criticism. In the words of Mark Blaug, ‘It is sometimes objected that
demand curves are usually asymptotic to the price axis. If the individual’s offer for the first unit is
not defined so that the demand curve does not touch the Y-axis, the integral under the demand
curve is infinite. But this objection is easily overcome by measuring consumer’s surplus from some
selected value of qx > 0’,4 i.e., quantity demanded is greater than zero.
Secondly, a ‘more fatal objection’ to Marshall’s method of measuring consumer’s surplus as ‘the
triangle’ under the demand curve is that real income does not remain constant along the demand
curve even for ‘unimportant’ commodities. As the price falls along the demand curve (as shown
in Figure 10.1), real income makes the estimate of consumer’s surplus as ambiguous one.5 This
criticism too does not hold because increase in demand due to decrease in price is caused also by
its income effects.
Thirdly, it is generally alleged that the assumptions on which the Marshallian concept of con-
sumer’s surplus is based are unrealistic. It is argued that MU of money does not remain constant;
cardinal measurement of utility is not possible; utilities of various goods consumed by a consumer
are not independent of each other; most goods have their substitutes—close or remote, and so
on. Therefore, it is alleged that the Marshallian concept of consumer’s surplus is imaginary and
hypothetical. However, this criticism too does not hold in literal sense. Although utility may not
be measurable cardinally or ordinally, consumers do have a mental perception of the usefulness
of a commodity and, accordingly, they have a willingness to pay an amount for a commodity they
need. It is not hypothetical.
Fourthly, in the ultimate analysis of the consumer’s purchases of various goods and services,
consumer’s surplus is reduced to zero. For, a consumer’s willingness to pay (i.e., ‘potential price’)
cannot exceed his income, i.e., what he actually pays out. It means that, when all purchases have
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206 Chapter 10
been made, the consumers willingness to pay (which equals his income) equals what he actually
pays (i.e., his income).’6 This criticism is more hypothetical than the concept of consumer surplus
as claimed by some economists.
Fifthly, the concept of consumer’s surplus cannot be convincingly applied to ‘essential’ and pres-
tigious goods. For example, a hungry affluent person may be willing to pay thousands of rupees
for a piece of bread whereas he may be required to pay only ten rupees. As such, his consumer’s
surplus will be equal to Rs 99,990 which seems ridiculous. In case of prestigious goods, e.g., rare
paintings, diamonds, jewellery, etc., what a buyer is willing to pay, generally, equals what he actu-
ally pays. It means there is no consumer’s surplus. Thus, Marshallian concept of consumer surplus
becomes illusory. However, these cases may be exceptions and exceptions prove the rule.
Although criticisms of Marshallian concept of consumer surplus are not strong enough to reject the
concept, Samuelson considers this concept as of only ‘historical and doctrinal interest’ and suggests
that ‘the economists had best dispense with it’.7 Hicks has, however, tried to rehabilitate the consumer’s
surplus as, in his opinion, this concept is of great importance in the economics of welfare and also from
pricing policy point of view.
HICKSIAN METHOD OF MEASURING CONSUMER SURPLUS

According to Hicks, Marshallian consumer surplus8 can be measured also by using indifference curve
analysis under Marshallian assumption of constant MU of money and also under variable MU of money.
In this section, we show the measurement of consumer surplus by using indifference curve.
Measuring Consumer Surplus under Constant MU of Money

Let us first illustrate the measurement of consumer’s surplus under Marshall’s assumption of constant
MU of money income.
In Figure 10.2, Y-axis measures consumer’s money income, and X-axis measures the quantity of
commodity X. Assuming consumer’s money income to be given at OM and the price of commodity
at Px, consumer’s budget line is given by the line MN. Given his indifference map, the consumer is
shown to be in equilibrium at point E on indifference curve IC2. At point E, he buys OQ units of X for
which he pays MP2 of his income. The amount MP2 is what the consumer actually pays for OQ(=P2E)
units of X.
Let us now find what the consumer would be willing to pay for OQ units of X, rather than go without
it. As Figure 10.2 shows, given his indifference curve IC2, the consumer would like to substitute TP2 of
his income for P2E quantity of X. It means that he would be willing to pay TP2 amount of money for OQ
units of X, as indicated by the slope of indifference curve IC2. But consumer’s income is limited to OM.
So the question arises: How can the consumer be willing to pay extra amount of TM or how can he be
willing to pay TP2 for P2E = OQ?
Hicks has devised a method to find an equivalent of TP2 within the consumer’s budgetary constraints.
This he has done by drawing a lower indifference curve having two qualifications that:
1. the lower indifference curve must pass through point M and
2. the lower indifference curve must be vertically parallel to the upper indifference curve.
The second condition is necessary to comply with the Marshallian assumption that the MU of money
remains constant. The indifference curve having these qualifications is shown by the curve IC1. Since the
M10_DWIV9400_02_SE_C10.indd 206 07/07/11 12:53 AM

Money income M
P2 E
P1 E´
IC2
IC1
O Q N
Quantity demanded of X
Figure 10.2 Marshallian Consumer’s Surplus Through Indifference Curve Analysis
two indifference curves, IC1 and IC2, are vertically parallel, they have the same slope for a given quan-
tity. For example, point E on IC2 and E′ on IC1 refer to the same quantity OQ and has the same slope. It
implies that point E ′ satisfies the equilibrium condition. Note also that IC1 is the simple reproduction of
IC2 at a lower level of utility. The further analysis can be carried out as follows.
Since point M and E′ are on the same indifference curve, IC1, it means that the consumer would be
equally well off at these points. That is, his total satisfaction from OM money income and zero units of X
will be the same as from OP1 of money income and OQ units of X. It means that he would be willing to
pay OM − OP1 = MP1 of his income for OQ units of X. Thus, what the consumer is willing to pay for OQ
is MP1 and what he actually pays (given the Px) is MP2. Therefore,
Consumer surplus = MP1 − MP2 = P1P2 = E′E
Since IC1 and IC2 are vertically parallel, E′E = TM. It means the E ′E gives the measure of the Marshallian
consumer surplus under the assumption that MU of money is constant.
Measuring Consumer Surplus under Variable MU of Money

Let us now illustrate Hicks’ measurement of a consumer’s surplus assuming the MU of money to be
variable—it decreases with increase in money. Suppose that the consumer is initially in equilibrium
at point E in Figure 10.3. At point E, the consumer buys OQ units of X for which he pays DM of his
income. Following the analysis in the section on Measuring Consumer Surplus under Constant MU of
Money, it can be said that the amount which the consumer would be willing to pay for OQ rather than
go without it (MU of money remaining constant) is shown by point E″ on the adjusted indifference
curve, IC0. Note that indifference curve IC0 is vertically parallel to the indifference curve IC2. Therefore,
as shown in Figure 10.3, the slopes of IC2 at point E and of IC0 at point E″ are equal. Under these con-
ditions, the consumer’s surplus under the assumption that MU remains constant can be measured as
MP − MD = DP = EE″.
Let us now find the maximum amount which the consumer would be willing to pay for OQ (rather
than go without it) under diminishing MU of money. It is important to note here that if an adjusted
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208 Chapter 10
T
M
Money income
T
D
E´
B
IC2
P E˝ IC1
IC0
O Q N
Quantity of X
Figure 10.3 Consumer’s Surplus Under Diminishing MU of Money
indifference curve (say IC1) is drawn under the condition of diminishing MU of money, intuitively, it
will not be vertically parallel to the original indifference curve IC2: it will be rather flatter than IC2 for
any given quantity of X. It implies that MRS of IC1 will be lower9 than that of IC0, at any level of X, and
IC1 will pass through points above IC0. Let the indifference curve IC1 pass through point E′. Point E′
indicates that TE′ is the maximum amount which the consumer would be willing to pay for OQ rather
than go without it. The consumer’s surplus under diminishing MU of money may be obtained as follows:
TE ′ − TE = EE′
or
MB − MD = DB = EE′
Note that under constant MU of money, the consumer’s surplus is EE″ which is larger than EE′ by EE″.
Thus, the consumer’s surplus under diminishing MU of money is smaller than Marshallian consumer’s
surplus.
EXTENTIONS OF HICKSIAN APPROACH TO CONSUMER

SURPLUS
Hicks’ Four Concepts of Consumer Surplus
Hicks has pointed out, in his book Value and Capital, that Marshallian consumer’s surplus was the same
as his income-compensating variation. It was, however, shown by Henderson11 that Hicks’ income-
compensating variation is not the same as the Marshallian consumer’s surplus. In the Marshallian
measure of consumer’s surplus, the quantity purchased remains the same, whereas in the Hicksian
measure, the quantity purchased varies in accordance with the consumer’s choice. In other words, there
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Money income
M´
B
E
T
I2
I1
O
Q N´ N
Quantity demanded of X
Figure 10.4 Marshallian Consumer Surplus Vs. Income-compensating Variation
is commodity constraint in the Marshallian measure of consumer’s surplus, whereas there is no such
constraint in the Hicksian income-compensating variation. This difference is shown in Figure 10.4.
Marshallian measure of consumer’s surplus is shown by BT, while the Hicksian measure of consumer
surplus under income-compensating variation is BD = MM′ which is greater than BT, for given quantity
OQ. Besides, if the consumer shifts to point E, there will be commodity variation also.
Realizing this fallacy in his measure of consumer’s surplus, Hicks has reformulated the measure of
consumer’s surplus by assuming a price change and finding the compensating payment that would leave
the consumer as well off as before the change in price, if he were not allowed to move to his original posi-
tion. It implies that the consumer would be so compensated that he would like to stay on the indifference
curve to which he moves after the change in price and should be as well off as before the change in price.
This can be accomplished by compensating the consumer in terms of price and quantity, price remaining
constant. Accordingly, Hicks has reformulated four different concepts of consumer’s surplus as listed below:
1. consumer surplus as the quantity-compensating variation;
2. consumer surplus as the price-compensating variation;
3. consumer surplus as the quantity-equivalent variation and
4. consumer surplus as the price-equivalent variation.
Let us now illustrate these consumer’s surpluses.
1. Consumer Surplus as the Quantity-Compensating Variation. Figure 10.5 shows the consumer’s
surplus with quantity-compensating variation. Suppose that the consumer is in equilibrium at P
on indifference curve IC1. At P, he consumes OQ units of commodity X. Let its price, Px, fall so
that the new budget line is MN′. With this change, the consumer moves to a new equilibrium A
on IC2 where he buys OD of X.
Now the problem is how to measure the consumer surplus. The problem arises because there
is a variation in quantity consumed due to change in Px. However, the problem can be solved
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210 Chapter 10
M´
Money income
P A
B IC2
R
T IC1
O Q C D N M˝ N´
Quantity of X
Figure 10.5 Consumer’s Surplus: The Quantity-compensating Variation
by finding out the amount of money the consumer would be willing to forego to return back to
his original indifference curve, IC1, maintaining his consumption at OD. Thus, the question is
how much money should be withdrawn from the consumer so that he is as well off as he was
at his original indifference curve IC1, with the quantity OD of X purchased at the new price. As
shown in the figure, if an amount AR is taken away from the consumer, he will be put back on
his original indifference curve IC1 with OD quantity of X. Thus, AR is one of the measures of
consumer’s surplus under the quantity-compensating variation. It is so because the consumer
would be willing to pay AR to buy extra quantity QD of X at the new price.
2. Consumer Surplus as the Price-Compensating Variation. Price-compensating variation means
the maximum amount a consumer would be willing to pay to regain his higher level of satisfac-
tion. For illustration of price-compensating variation, consider the original equilibrium position
of the consumer at P and IC1 in Figure 10.5. Let the price of X fall so that the consumer moves to
point A on IC2. If the whole real income gain (MM′) resulting from the fall in the price is taken
away from the consumer, he will move to the equilibrium point B. Now the question is: How
much should the consumer be paid to bring him back to the equilibrium point A at the new
price? Obviously, if MM′ is paid back to the consumer, he would move to A. Note that MM′ = AT.
It implies that the consumer would be willing to pay AT if he is allowed to move to point A. Thus,
point AT is price-compensating variation.
3. Consumer Surplus as the Quantity-Equivalent Variation. The quantity-equivalent variation is
the maximum sum which a consumer would be willing to accept as compensation, for being
prevented from reaching an upper indifference curve as a result of fall in price. The quantity-
equivalent variation is shown in Figure 10.6. The consumer is, let us suppose, in equilibrium
at point P on IC1 At this point, he buys OQ of commodity X. When price of X falls so that new
budget line is MN′, the consumer moves to a new equilibrium point P′ on IC2 and his purchase
M10_DWIV9400_02_SE_C10.indd 210 07/07/11 12:53 AM

R
M B
Money income
P
P´
IC2
IC1
O Q Q´ N K N´
Quantity of X
Figure 10.6 Consumer’s Surplus: The Quantity and Price-equivalent Variation
of X increases from OQ to QQ′. Now the question is: If the consumer is to be prevented from
moving to point P′, how much money will have to be paid to him as compensation so that
he attains the level of satisfaction indicated by IC2 remaining at point P. This amount can be
obtained by extending the ordinate PQ to the IC2. As Figure 10.6 shows, the consumer will have
to be paid PR to make him reach IC2. With PR given to him, the consumer will be as well off at
point R as at point P′. Thus, PR is the quantity-equivalent variation.
4. Consumer Surplus as the Price-Equivalent Variation. The price-equivalent variation is, accord-
ing to Hicks, the maximum sum the consumer will accept as compensation for being deprived
of the advantage of a fall in the price of a commodity. This sum equals the gain in terms of
real income due to fall in price. The price-equivalent variation can, therefore, be obtained
by measuring the real-income effect. The real-income effect of a fall in price of X, say, from
P1 = OM/ON to P2 = OM/ON ′ can be measured by drawing a budget line JK tangent to IC2. (see
Figure 10.6). As the figure shows, the real income gain resulting from the fall in the price of X
from P1 to P2 equals MJ = PB. It means that if MJ amount is paid to the consumer, he would be
economically as well off as he would be due to fall in the price of X. Thus, MJ(=PB) is the price-
equivalent variation.
It is important to note here that none of the Hicksian measures correspond precisely to
Marshall’s measure of consumer’s surplus.
APPLICATION OF CONSUMER SURPLUS

As noted earlier, measuring consumer surplus, as defined by Marshal, has been beset with problems.
Nevertheless, the economists have applied the concept of consumer surplus to resolve several practical
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212 Chapter 10
problems, at least theoretically. In this section, we discuss the application of consumer surplus concept in
explaining certain practical economic problems related to policy issues. Although the area to which the
concept of consumer surplus can be applied is very vast, we confine our discussion here to the following
economic issues:
1. measuring the deadweight loss of taxation;
2. measuring gains of subsidy;
3. deadweight loss of price control and
4. deadweight loss of trade barriers.
In this section, we discuss the application of consumer surplus to measure the deadweight loss caused
by taxation, price control and trade barrier (tariffs), and the gains from the grant of subsidy.
The Deadweight Loss of Commodity Taxation

The concept of consumer surplus is applied to measure the deadweight loss caused by commodity taxa-
tion, also called indirect taxation. What is deadweight loss? When a tax is levied on a commodity, it
changes the demand and supply conditions. Change in demand and supply conditions make consum-
ers lose a part of their consumer surplus and sellers/producers lose a part of their producer surplus.
A part of lost consumer and producer surplus goes to the government as tax payment. But a part of lost
consumer and producer surplus goes to none in the society. This loss of consumer and producer surplus
is called, in economics terminology, as deadweight loss. The deadweight loss is also referred to as loss of
social welfare.
A commodity tax may be imposed on buyers (e.g., sales tax), or on the producers or sellers (e.g.,
excise duty). A commodity tax on buyers shifts the demand curve downward,12 and a tax imposed on
sellers shifts the supply curve upward,13 In either case, there is deadweight loss. In this section, we show
how deadweight loss caused by commodity taxations is measured. The measurement of deadweight loss
caused by sales tax (a tax on buyers) is explained and illustrated here by using the concept of consumer
surplus.
Deadweight Loss from Sales Tax: Tax on Consumers

The deadweight loss of sales tax—a tax on buyers—is shown in Figure 10.7. Suppose the pre-tax demand
and supply curves for a commodity are given as DD1 and SS1, respectively. Demand and supply curves
intersect at point E determining the pre-tax equilibrium price at OP and equilibrium quantity demanded
and supplied at OQ2. At this equilibrium price and output, the consumer’s had a consumer surplus of
DPE and sellers had a producer surplus of SPE.
Now suppose that the sales tax is imposed at a fixed rate on the commodity so that the demand curve,
DD1, shifts downward to DD2. The demand curve DD2 intersects with the supply curve at point T deter-
mining the post-tax market equilibrium of demand and supply at OQ1 and price at BQ1. Note that with
the imposition of sales tax, the both demand and supply decrease from OQ2 to OQ1 but price rises from
EQ2 to BQ1. Thus, the difference between the price paid by the consumers minus the price retained by the
sellers is the per unit sales tax, i.e., per unit sales tax = BQ1 − CQ1 = BT.
With these changes in equilibrium quantity and price, both consumers and producers lose a part
of their surplus. Consumer surplus decreases from DPE to DAB. The loss of consumer surplus equals
DPE − DAB = APEB. A major part of this loss of consumer surplus is paid as sales tax. As shown in
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D
B
A
E
C
P
Price
H T
D1
S
D2
O
Q1 Q2 Quantity of commodity X
Figure 10.7 Deadweight Loss of Tax on Buyers
Figure 10.7, after the imposition of sales tax, the price rises from EQ2 to BQ1. Thus, BQ1 − EQ2 = BC is
the per unit sales tax paid by the consumers. The total sales tax paid by the consumers equals BC × PC =
ABCP (where PC = OQ1 is the quantity demanded at post-tax price. The area ABCP is a part of the
lost consumer surplus, which goes to the government as tax revenue. But the loss of consumer surplus
marked by triangle BCE benefits none. Therefore, the shaded area BCE measures the deadweight loss due
to imposition of tax.
We have explained so far the deadweight loss resulting from the loss of consumer surplus. The dead-
weight loss is caused also by the loss of producer surplus. As shown in Figure 10.7, before the imposi-
tion of the sales tax, producer surplus equalled the area ESP. After the imposition of sales tax, producer
surplus decreases to THS. It means that, after the imposition of sales tax, sellers lose their surplus by
ESP − THS = EPHT. A part of this lost producer surplus is tax burden on the sellers. The surplus cost by
the sellers due to tax equals CT × HT = CPHT. The remaining part of the lost producer surplus, i.e., the
shaded area ECT, goes to none. This gives the measure of deadweight loss due to decrease in sales.
The total deadweight loss equals the sum of the deadweight loss of consumer surplus and deadweight
loss of producer surplus. The total deadweight loss = BCE + ECT = BTE.
What Determines the Tax Burden on the Buyers and Sellers? As Figure 10.7 shows, the tax burden of
sales tax on buyers equals the area ABCP and tax burden on the sellers equals the area PCTH. Both the
areas appear to be almost equal. It may therefore be inferred that buyers and sellers bear the tax burden
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214 Chapter 10
in almost equal proportions. But, that is not the case in reality. In fact, the tax burden borne by the buyers
and sellers depends on the price elasticity of demand and supply. As a matter of rule, the lower the price
elasticity, the higher the tax burden. This fact is shown in Figure 10.8.
Panel (a) of Figure 10.8 shows the case of a highly price-inelastic demand and a highly price-elastic
supply. The pre-tax equilibrium output is given at OQ2 and equilibrium price at OP. With the imposition
of a specific sales tax, price rises from OP to OA and demand and supply fall from OQ2 to QQ1. The per
unit sales tax equals BT. Of BT tax, buyers bear BC part and sellers bear only CT part of the sales tax.
Note that BC is much greater than CT. It means that, if the demand for a product has low price inelastic-
ity, the proportion of tax burden on the buyers much greater than that on the sellers.
Panel (b) shows of Figure 10.8 the reverse case. Here, the demand for the product is highly price
elastic and supply is highly price inelastic. As the panel (b) shows, the tax burden on sellers is CT and tax
burden on buyers is BT. Note that CT is much greater than BT. This means that if supply is less elastic
than demand, the major proportion of tax burden falls on the sellers.
The rule can be described briefly as follows:
1. If the elasticity of demand and elasticity of supply are equal, i.e., if Ed = Es, then buyers and
sellers bear tax burden in equal proportions.
2. If the elasticity of demand is lower than that of supply, i.e., if Ed < Es, buyers bear a higher
proportion of tax burden.
3. If the elasticity of supply is lower than that of demand, i.e., if Es < Ed, sellers bear a higher
proportion of tax burden.
4. In case the elasticities of demand and supply are unequal, the buyers and sellers, bear tax burden
in proportion to the elasticities of demand supply.
What Determines the Deadweight Loss? Price elasticity of demand and supply determines not only
the share of buyers and sellers in tax burden, but also it determines the overall deadweight loss of tax-
ation. When either demand or supply has low price elasticity or both demand and supply have low
(a) (b)
D
S1
D
D
B
A S1
B
A
C D
P P E
C
Price
H T
T
S H
D1
D1 D2
D2
O Q1 Q2 O S Q1 Q2
Quantity Quantity
Figure 10.8 Elasticities of Demand and Supply and Tax Burdon
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price elasticity, the overall deadweight loss from taxation will be higher. This point can be examined by
comparing the deadweight loss of taxation in Figures 10.7 and 10.8.
Measuring Gains of Subsidy

A subsidy is a monetary support by the government to producers of some essential goods and services
with the purpose of increasing their production and supply. A subsidy is virtually a negative tax. With
the grant of subsidy, price that sellers receive is higher than the price that consumers pay. The difference
between the two prices gives the measure of the subsidy. The grant of subsidy benefits both the consum-
ers and producers. This benefit is reflected in increase in both consumer surplus and producer surplus.
The benefit of subsidy to buyers and sellers and its effect on price and production are shown in
Figure 10.9. Suppose the demand and supply curves for a product are given by DD′ and SS′, respectively,
and pre-subsidy equilibrium price is determined at OP and equilibrium demand for and supply of the
products are determined at OQ1.
Now let a subsidy be granted by the government to the producers of the product. As a result, the
price that the sellers receive rises from OP to DM and the price that buyers pay falls from OP to OL. The
difference between the two prices is the measure of subsidy, i.e., subsidy equals OM − OL = LM = BC.
As Figure 10.9 shows, after the grant of subsidy, consumer surplus increases from DEP to DBL. That is,
consumer surplus increases by DBL − DEP = PEBL. Similarly, with the grant of subsidy, producer surplus
increases from PES to MCS. Thus, the producer surplus increases by MCS − PES = MCEP. Not only that,
subsidy increases both production and consumption, which adds to social welfare.
S´
M C
P E Subsidy
B
Price
S
D´
O Q1 Q2
Quantity
Figure 10.9 Gains from Subsidy
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216 Chapter 10
Deadweight Loss of Price Control

A free-market works on the principles of demand and supply, and equilibrium price and output are
determined where demand equals supply. However, under certain kind of market conditions, govern-
ment intervention with market system and price control becomes a social necessity. Some very common
examples are cited here. First, in case of some essential goods and services like food items, house rent, etc,
market determined price is unaffordable by a fairly large section of the society. This has been a common
affair in India, especially when there short supply of food grains due to bad weather and house rent control
till mid-1990s. Secondly, during the period of short supply of some goods (including both essential and
non-essential goods like gas and petrol, onions, in 2011, etc.), black marketers and hoarders create a larger
scarcity of such goods and charge a price unaffordable even by the rich sections of the society. Thirdly,
during the war period, supply of certain goods is transmitted to the war sector causing shortage of supply
for the residents of the country. Consequently, free-market price for common man shoot up to unafford-
able level for the majority of the people. In such cases, controlling price within a reasonable limit becomes
a social necessity. The price fixed by the government by law is generally lower than the free-market price.
The question that arises here is: Is price control beneficial for the society or does it cause deadweight
loss to the society? Economists’ answer to this question is that price control does not necessarily benefit
the society; instead it causes a high deadweight loss to the society, though it depends on the elasticity of
demand and supply. The point of view that price control results in a deadweight loss is discussed in this
section by using the concept of consumer and producer surplus.
The deadweight loss of price control is shown in Figure 10.10. Suppose in a free market, demand and
supply curves for a good are given by DD′ and SS′ curves in Figure 10.10. The demand and supply curves
intersecting at point E determine the market equilibrium price at OP2 and equilibrium output at OQ2.
P2 E
B
Price
P1 D
C
D´
S
O Q1 Q2 Q3 Quantity
Figure 10.10 Dead Weight Loss of Price Control
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Given the equilibrium levels of price and output, consumer surplus equal the area of triangle DEP2 and
producer surplus equals the area of triangle P2SE.
Now let the government fix a maximum price of the product by law at OP1. At the legal price, demand
for the product rises from OQ2 to OQ3 and its supply decreases from OQ2 to OQ1. As a result demand
exceeds supply by OQ3 − OQ1 = Q1Q3. Thus, Q1Q3 measures the shortage of supply over demand. After
the imposition of price control, total supply and total demand are fixed at OQ1.
Let us now look at the change in consumer and producer surplus and measure the deadweight loss.
At consumption level OQ1, consumer surplus is given by DACP1. By comparing pre-price-control and
post-price-control consumer surplus, we find that consumers lose surplus by ABE and they gain surplus
by rectangle P2BCP1. As is obvious from the figure, the consumer surplus gained after price control
(P2BCP1) is greater that consumer surplus lost (ABE). So the consumers have a net gain in terms of
consumer surplus.
What About Producer Surplus? After the imposition of price control, producer surplus decreases
from P2ES to P1CS. Thus, the producer surplus decreases by P2ES − P1CS = P2ECP1. Note that P2BCP1
part of producer surplus lost is exactly the same as consumer surplus gained after the price control, i.e.,
consumers gain by what producers lose. In overall assessment, therefore, consumer surplus gained is
cancelled out by producer surplus lost. Thus, in the final analysis, consumers lose their surplus by ABE
and producers lose their surplus by BEC. The sum of the loss of consumer and producer surplus is the
total deadweight loss price control. As Figure 10.10 shows, the deadweight loss of price control equals
ABE + EBC = ACE.
What Determines the Deadweight Loss of Price Control? As in case of sales tax, the overall dead-
weight loss of price control depends on the elasticity of demand and supply. In case demand has low
price elasticity, the loss of consumer surplus is lower and in case supply is price inelastic, loss of producer
surplus is lower. And in case both demand and supply have low price elasticity, the overall deadweight
loss from price control is lower.
Deadweight Loss of Trade Barriers

Trade barriers refer to the measures adopted by the government to control import of the country with
the purpose of promoting the growth of domestic industry. Two most important trade barriers are (i)
tariffs, i.e., import duty, imposed on imports, and (ii) import quota imposed on imports.
While the effectiveness of tariff depends on the price elasticity of demand for and supply of imported
goods, quota limits the imports directly. In this section, we show how trade barriers—be it tariff or
import quota—cause deadweight loss to the society by using the concept of consumer surplus. In case of
both tariff and import quota, the method of measuring the deadweight loss is the same. We explain the
measure of deadweight loss caused by tariffs.
The deadweight loss of tariffs, i.e., import duty, imposed on imports is illustrated in Figure 10.11.
To begin with, let us consider a case of a closed economy—an economy which has no trade with other
countries. The demand and supply curves for a product in the closed economy are given by DD’ and SS’
curves, respectively, as shown in Figure 10.11. The equilibrium price for the product is determined at
OP and equilibrium demand and supply at OQ2. That is, in the absence of foreign trade, the producers
will produce and supply OQ2 and consumers will consume OQ2 quantity of the product. In that case,
consumers enjoy a consumer surplus of DEP and producers enjoy a producer surplus of PES.
Now let the country adopt a free-trade policy with no barrier on imports and exports. Suppose for-
eign price of the product is OM which is lower than the domestic price OP by PM. Note that at price
OM domestic supply decreases to OQ0 and demand increases to OQ4. This creates a demand-supply gap
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218 Chapter 10
of Q0Q4. This demand-supply gap is met with imports. It means that the country imports Q0Q4 quantity
of the foreign product. Note that with Q0Q4 import of the product, consumer surplus increases from DEP
to DCM and producer surplus falls from PES to MHS. Note also that additional consumer surplus equals
PECM and loss of producer surplus equals TGHM. As can be seen in the figure that the area PECM > the
area TGHM. It means that the consumer surplus gain (PECM) is much greater than the loss of producer
surplus (TGHM) and that the country has a net gain from the imports.
However, large imports create such problems for the country as loss of employment, trade deficits
(if imports > exports), foreign exchange problem, and fall in the GDP growth rate. Suppose that for
these reasons, the country imposes tariffs on imports to the extent of TM. The imposition of tariff causes
several changes in the product market:
1. import price rises from OM to OT;
2. total domestic demand decreases from OQ4 to OQ3;
3. domestic supply increases from OQ0 to OQ1 and
4. import decreases from Q0Q4 to Q1Q3.
Because of these changes in the market conditions, consumers lose their surplus by TBCM and
producers gain a surplus of TGHM. Note that, as Figure 10.11 shows, producer surplus gained (TGHM)
is a part of the consumer surplus lost (TBCM). It means that a part of consumer surplus lost goes to
producers as producer surplus. The remaining part of consumer surplus lost is the deadweight loss to the
society. Thus,
Net deadweight loss = TBCM − TGHM = GBCH
D S´
P E
G B
T
Price
H C
M
S D2
O
Q0 Q1 Q2 Q3 Q4 Quantity
Figure 10.11 Deadweight Loss of Frade Barriers
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It must be noted at the end that the quantum of gain or loss of consumer surplus and producer surplus
depends on the elasticity of demand and supply. The lower the elasticity of demand, the lower the loss of
consumer surplus due to tariff and vice versa, and the lower the elasticity of supply, the greater the gain
of producer surplus and vice versa.
REVIEW QUESTIONS
1. What is consumer’s surplus? Explain and examine critically the Marshallian measures of
consumer’s surplus.
2. Explain the concept of consumer surplus. What is the Marshallian method of measuring
consumer surplus?
3. Using indifference curve technique measure consumer’s surplus if (i) the marginal utility of
money is constant, (ii) marginal utility of money is variable.
4. What is the Hicksian method of measuring consumer surplus? Will there be any difference
in consumer surplus if marginal utility of money is assumed to remain constant and to be
variable?
5. Discuss the uses of the concept of the consumer’s surplus in economic analysis and policy for-
mulation.
6. Explain briefly the Hicksian measure of consumer’s surplus under (i) the quantity variation,
(ii) the price-compensating variation, (iii) the quantity-equivalent variation and (iv) the price-
equivalent variation.
7. In what way does Hicksian measure of consumer surplus offer a superior way of looking at
consumer surplus than one provided by Marshall?
ENDNOTES
1. Quoted in Mark Blaug, Economic Theory in Retrospect (London: Heinemann), 2nd edn, 1968,
p. 337.
2. Recall that consumer’s demand curve is derived on the basis of his MU-curve for a commodity.
3. The first degree price discrimination means that the monopolist charges each consumer a price
he is willing to pay. This aspect is discussed ahead in detail in the chapter on monopoly pricing.
4. Mark Blaug, Economic Theory and Operations Analysis, op. cit., p. 361.
5. For detail, see Mark Blaug, Ibid., pp. 361–362, and Richard A. Bilas, Microeconomic Theory
(Tokyo: McGraw-Hill Kogakusha, 1971), pp. 98–102.
6. Ulisee Gobbi quoted in A.K. Dasgupta, 1942, The Concept of Surplus in Theoretical Economics
(Calcutta: Gupta and Co.), p. 20.
7. Samuelson, P.A., Foundations of Economic Analysis, op. cit., p. 82.
8. This topic may be treated as one of the cases of applications of indifference curve analysis in
Chapter 8.
9. It can be proved easily. Note that MRS between points M and E′ on IC1 equals MB/BE ′ and
the MRS between points M and E′ on IC0 equals MP/PE′. Since MB < MP and BE ′ = PE ′,
MB/BE ′ < MP/PE ″
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220 Chapter 10
10. Undergraduate students may skip this section.

11. Henderson, A.M. (1941), ‘Consumer’s Surplus and Compensating Variation’, Review of Economic
Studies, VIII(2): 117.
12. The downward shift can be proved as follows. Suppose pre-taxation demand function for a
commodity is given as D = 100 − 5P. After the imposition of sales tax, say, Rs 5 per unit, the
post-taxation demand function reads as D = 100 − 5(P + 5). By graphing the pre-tax and post
demand functions, one can easily see the downward shift in the demand curve.
13. The upward shift can be proved as follows. Suppose pre-taxation supply function for a com-
modity is given as S = 5P. After the imposition of excise duty, say, Rs 5 per unit, the post-
taxation supply function reads as S = 100 − 5(P + 5). A graphical presentation of the pre-tax and
post-tax supply functions, shows the upward shift in the supply curve.
FURTHER READINGS
Besanko, D.A. and Braeutigam, R.R. (2002), Microeconomics: An Integrated Approach (New York: John
Wiley & Sons, Inc.), Chapter 5.
Boulding, K.E. (1945), ‘The Concept of Economic Surplus,’ American Economic Review.
Dasguptza, A.K. (1942), Concept of Surplus in Theoretical Economics (Calcutta: Dasgupta & Co.).
Henderson, A.M. (1942), ‘Consumer’s Surplus and the Compensating Variation in Income’, Review of
Economic Studies.
Hicks, J.R. (1941), ‘Rehabilitation of Consumer’s Surplus,’ Review of Economic Studies, February.
——— (1943a), ‘Four Consumer’s Surpluses’, Review of Economic Studies.
——— (1943b), ‘The Four Consumer Surpluses,’ Review of Economic Studies, (this is an Advanced
Reading).
——— (1946), Value and Capital (Oxford: Oxford University Press), 2nd Edn., Chapter 2.
——— (1956), Revision of Demand Theory (Oxford: Oxford University Press), Chapters 7 and 8.
Lerner, A.P. (1963), ‘Consumer’s Surplus and Micro-Macro,’ Journal of Political Economy, February.
Little, I.M.D. (1957), A Critique of Welfare Economics (New York, NY: Oxford University Press), 2nd
Edn., Chapter 10.
Marshall, A., Principles of Economics (Macmillan, 1920), Chapter 6.
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Part IV
Theory of Production and

Analysis of Cost
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Chapter 11
Theory of Production: Laws

of Returns to a Variable Input
CHAPTER OBJECTIVES
In this chapter, we move from the theory of consumption to the theory of production. The objective of
this chapter is to explain the basic concepts used for production analysis and to lay the foundation for
understanding the nature of the input–output relationships. This chapter helps you learn the following
aspects of production analysis:
The meaning of ‘production’ in economic sense of the term;
The meaning and purpose of production function—a tool of production analysis—and how it
forms the basis of production analysis;
The difference between the short-run and long-run production function;
How short-run production function can be used to show how output changes with increase in
labour, all other inputs remaining constant; and
How marginal and average productivity of labour change with increase in labour.
All these aspects help you learn the short-run laws of production.
INTRODUCTION
In Part III of this book, we were concerned with the demand side of the market. In this part, we move to
the supply side of the market. Supply is created through production. Production is an activity of trans-
forming inputs into output. The rate at which a given quantity of inputs can be transformed into output
is governed by the laws of production. The laws of production are also called the laws of returns or the
theory of production. Theory of production states the quantitative relationship between inputs and output.
In simple words, theory of production tells how output is most likely to change in response to change in
the quantity of inputs, given the technology. In this and the subsequent chapter, we discuss the theory of
production.
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224 Chapter 11
Another aspect that has been discussed in this part is the theory of cost. As noted above, production
is a process of transforming inputs into output. Inputs include everything that goes into the process
of production, e.g., land, labour, capital, time, space, materials, water, power, fuel and managerial skill
and so on. However, economists classify factors of production as labour, land, capital and entrepreneur-
ship. None of these inputs is available free of cost. All the inputs have a price. It means that production
of a commodity involves cost of production. Cost of production is the main determinant of the supply
of a commodity. The rate at which cost of production changes with the change in output depends on
the cost–output relationship. This relationship is based on the laws of returns to inputs. The relation-
ship between production and cost of production is studied under the theory of cost. Theory of cost will be
discussed in Chapter 12.
Before we proceed to discuss the theories of production and cost, however, it will be useful to have
a closer look at the basic terms and concepts used in the exposition of the theory of production.
SOME BASIC CONCEPTS

Meaning of Production
In economics, the term ‘production’ means an activity by which resources (men, material, time and so
on) are transformed into a different and more useful commodity or value-added service. In general,
production means transforming inputs (labour, machines, raw materials, time and so on) into an output.
This concept of production is, however, limited to only ‘manufacturing’.
In economic sense, the production process may take a variety of forms other than manufacturing.
Transporting a commodity in its original form from one place to another where it can be consumed or
used in the process of production is production. For example, a sand dealer collects and transfers sand
from the river bank to the construction site; a coal company does virtually nothing more than transport-
ing coal from coal mines to the market place. Similarly, a fisherman only catches and transports fish
from sea, lake and river to the fish market. Their activities, too, are ‘production’. Transporting men and
materials from one place to another is a productive activity. For example, roadways, railways and airways
produce service. Storing a commodity for future sale or consumption is also ‘production’. Wholesaling,
retailing, packaging, assembling are all productive activities. These activities are just as good examples of
production as manufacturing. Cultivation is the earliest form of productive activity.
Besides, production process does not necessarily involve physical conversion of inputs into tangible
goods. Some kinds of production involve an intangible input to produce an intangible output. For
example, in the production of legal, medical, social and consultancy services both input and output are
intangible; lawyers, doctors, social workers, consultants, hairdressers, musicians, orchestra players are all
engaged in producing intangible goods.
Input and Output

An input is any thing—a good or a service—that is used in the process of production. In the words of
Baumol, ‘An input is simply anything which the firm buys for use in its production or other processes.’1
Production process requires a wide variety of inputs, depending on the nature of product. But econo-
mists have classified inputs as:
1. land including area, underground and overground resources;
2. labour including physical and mental effort and skill;
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Theory of Production: Laws of Returns to a Variable Input 225
3. capital, machinery, equipments, tools used in production and also factory and office buildings;
4. raw materials used for producing another good or material;
5. entrepreneurship including management skill and risk-bearing intention and ability;
6. technology—technique of production using different combination of labour and capital and
7. time—all kind of goods and services require some time for their production.
All these variables are treated as ‘flow’ variables, as they are measured per unit of time or output.
Fixed and Variables Inputs Inputs are classified as (i) fixed inputs or fixed factors and (ii) variable
inputs or variable factors. Fixed and variable inputs are defined in economic sense and in technical sense.
In economic sense, a fixed input is one whose supply is inelastic in the short run and is used in a fixed
quantity in the short run. Therefore, all of its users together cannot buy more of it in the short run. In
technical sense, a fixed factor or input is one that remains fixed (or constant) for a certain level of output.
In economic sense, a variable input is defined as one whose supply in the short run in elastic, e.g.,
labour and raw material and so on. All the users of such factors can employ a larger quantity in the short
run. Technically, a variable input is one that changes with the change in output.
It is important to note here that in the long run, all inputs are variable because, in the long run, supply
of all the inputs becomes elastic and more of all the inputs can be used to produce a larger output.
An output is any good or service that comes out of production process. An output may be tangible
or intangible. For example, bread and butter, clothes, cars and computers are the tangible products and
services produced by doctors, lawyers, consultants, teachers and social workers are intangible.
Short Run and Long Run

The reference to time period involved in production process is another important concept used in
production analysis. The two reference periods are short run and long run. Short run refers to a period
of time in which the supply and the use of certain inputs (e.g., plant, building, machinery and so on) is
fixed. In the short run, therefore, production of a commodity can be increased to a limited quantity by
increasing the use of only variable inputs (labour).
It is important to note here that ‘short run’ and ‘long run’ are economists’ jargon. They do not refer
to any fixed time period. While in some industries short run may be a matter of few weeks or few
months, in some others (e.g., electricity and power industry, automobiles and so on), it may mean
three or more years.
The long run refers to a period of time in which the supply of all the inputs is elastic, but not enough to
permit a change in technology. That is, in the long run, all the inputs are variable. Therefore, in the long
run, a firm can employ more of both variable and fixed inputs to increase its production.
Economists use another term, i.e., (very long run) which refers to a period in which the technology
of production is also supposed to change. In the very long-run period, the production function also
changes. The technological advances result in a larger output from a given quantity of inputs.
PRODUCTION FUNCTION
We know that the output of a commodity depends on the inputs used. In other words, the quantity
produced of a commodity depends on the quantity of inputs used to produce the commodity. It means
that there is a relationship between input and output. When input–output relationship is expressed in the
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226 Chapter 11
form of an equation, it is called production function. By definition, production function is a mathematical

statement which describes the technological relationship between inputs and output in physical terms.
In its general form, it states that production of a commodity depends on certain specific inputs. In its
specific form, it presents the quantitative relationships between inputs and output.
Besides, the production function represents the technology of a firm, of an industry or of the econ-
omy as a whole. A production function may take the form of a schedule or table, a graphed line or curve,
an algebraic equation or a mathematical model. But each of these forms of a production function can be
converted into its other forms.
Before we illustrate the various forms of a production function, let us see how a complex production
function is simplified and the number of inputs in the production function (used as independent vari-
ables) is reduced to a manageable number, especially in theoretical analysis or models.
An empirical production function is generally very complex. It includes a wide range of inputs, viz.,
(i) land, (ii) labour, (iii) capital, (iv) raw material, (v) time and (vi) technology. All these variables enter
the actual production function. The long-run production function is generally expressed as
Q = f (LB, L, K, M, T, t)
where LB = land and building; L = labour; K = capital; M = materials, T = technology and t = time.
Economists have, however, reduced the number of variables used in a production function to only
two, viz., capital (K) and labour (L), for the sake of convenience and simplicity in the analysis of input–
output relation. Production function is generally expressed as
Q = f (L, K)
The reasons for ignoring other inputs are following. Land and building (LB), as inputs, are constant
for the economy as a whole, and hence it does not enter into the aggregate production function. In the
case of individual firms, land and building are lumped with ‘capital’.2 In case of ‘raw materials’, it has
been observed that ‘this input bears a constant relation to output at all levels of production’. For example,
cloth bears a constant relation to the number of ready-made garments. Similarly, for a given size of a
house, the quantity of bricks, cement, steel and so on remains constant, irrespective of number of houses
constructed. In car manufacturing of a particular brand or size, the quantity of steel, number of the
engine, and number of tyres and tubes are fixed per car. This constancy of input–output relations leaves
the methods of production unaffected. So is the case, generally, with time. That is why; in most produc-
tion functions, only two inputs—labour and capital—are included.
We will illustrate tabular and graphic forms of production function when we move on to explain the
laws of production. Here, let us illustrate the algebraic form of production function assuming that tech-
nology of production remains unchanged over a period of time. It is this form of production function
which is most commonly used in production analysis.
To illustrate mathematical form of production function, let us suppose that a coal-mining firm
employs only two inputs—capital (K) and labour (L)—in its coal production activity. Thus, the general
form of its production function may be expressed as
Q = f (K, L) (11.1)
where Q = the quantity of coal produced per time unit, K = capital and L = labour.
The production function (11.1) implies that quantity of coal produced depends on the quantity of
capital, K, and labour, L, employed to produce coal. Increasing coal production will require increasing
K and L. Whether the firm can increase both K and L or only L depends on the time period it takes into
for increasing production, i.e., whether a short run or a long run.
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Short-run and Long-run Production Function

By definition, short run refers to the period during which supply of capital is inelastic and long run is the
period during which supply of both labour and capital is elastic. In the short run, therefore, the firm can
increase coal production by increasing labour only since the supply of capital in the short run is fixed.3
In the long run, however, the firm can employ more of both capital and labour because supply of capital
also becomes elastic over time. Accordingly, there can be two kinds of production functions.
1. Short-run production function and
2. Long-run production function.
The short-run production function or what may also be termed as ‘single-variable production function’,
can be expressed as
Q = f ( K , L) (11.2)
where K denotes constant K.
In the long-run production function both K and L are included and the function takes the form
Q = f (K, L) (11.3)
In Eq. (11.3), both capital (K) and labour (L) are treated as variable factors.
Assumptions
A production function is based on the following assumptions.
1. Perfect divisibility of both inputs and output;
2. There are only two factors of production—labour (L) and capital (K);
3. Limited substitution of one factor for the other, i.e., labour and capital are imperfect substitutes;
4. Technology is given and
5. Inelastic supply of fixed factors in the short run.
These are the general assumptions on the basis of which a production function is constructed. However,
if there is a change in these assumptions, the production function will have to be modified accordingly.
Having introduced the concept of production function, we now proceed to discuss the theory of
production by using the production function. The traditional theory of production has been formulated
under two conditions: (i) short-run conditions and (ii) long-run conditions. Under short-run condi-
tions, only labour is assumed to be a variable factor, all other factors assumed to remain constant. Under
long-run conditions, both labour and capital are treated as the variable factors. Accordingly, there are
1. short-run laws of production and
2. long-run laws of production.
The laws of production under short-run conditions are called ‘the laws of variable proportions’, the
‘laws of returns to a variable input’ and the ‘law of diminishing marginal returns’. Under the long-run
conditions, the input–output relations are studied assuming all the input to be variable. The long-run
input–output relations are studied under the ‘laws of returns to scale’. In the following section, we explain
the ‘laws of return to a variable input’. The ‘laws of returns to scale’ or what is also called ‘long-run laws
of production’, will be discussed in the next chapter.
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228 Chapter 11
PRODUCTION WITH ONE VARIABLE INPUT:

THE SHORT-RUN LAWS OF PRODUCTION
The Laws of Returns to Variable Input (Labour)
The laws of returns to variable input states that when more and more units of a variable input are used,
given the quantity of fixed inputs, the total output may initially increase at an increasing rate and then at
a constant rate but it will eventually increase at diminishing rates. The ultimate law is that the marginal
increase in total output eventually decreases when additional units of a variable factor are applied to a
given quantity of fixed factors. In the words of Hirshleifer, ‘If one factor (or group of factors) is increased
while another factor (or group of factors) is held fixed, output or total product q will first tend to rise.
But, eventually at least, a point will be reached where the rate of increase, the Marginal Product [MP1 =
ΔQ/ΔL] associated with increments of the variable factor, begins to fall; this is the point of diminishing
marginal returns.’4 Baumol states the law of diminishing returns in similar terms: ‘As more and more
of some input, i, is employed, all other input quantities being held constant, eventually a point will be
reached where additional quantities of input i will yield diminishing marginal contributions to total
output.’5 Accordingly, there are three laws of returns to variable inputs (i) the law of increasing returns,
(ii) the law of constant returns and (iii) the law of diminishing returns. Before we discuss these laws, let
us take note of assumptions under which these laws are formulated.
Assumptions
The law of returns to variable input is based on the following assumptions:
1. The state of technology is given;
2. Labour is homogenous and
3. Capital remains constant.
To illustrate the law of diminishing returns with the help of our coal mining, example, let us assume
that (i) the coal-mining firm has a set of mining machinery as its capital (K), fixed in the short run, and
(ii) it can employ more of mine workers to increase its coal production. Thus, the short-run production
function for the firm will take the following form.
Qc = f (L, K )
where Qc = quantity of coal produced, L = labour; and K = capital (held constant).
Let us assume that the labour–output relationship in coal production is given by a cubic production
function of the following form.
Qc = −L3 + βL2 + αL
When estimated with actual data, it takes the following form.
Qc = −L3 + 15L2 + 10L (11.4)
Given the production function (11.4), the quantity of coal (Qc) that can be produced with different
number of workers can be easily worked out by assigning a numerical value to the variable factor (L). For
example, if L = 5, Qc can be worked out as follows:
Qc = − 53 + 15 × 52 + 10 × 5
= − 125 + 375 + 50
= 300
M11_DWIV9400_02_SE_C11.indd 228 07/07/11 1:03 AM

A tabular array of output levels associated with different number of workers from 1 to 12, in our
hypothetical coal production, example is given in Table 11.1 (Columns 1 and 2).
To understand the laws of returns to the variable input labour (L), what we need now is to work out
marginal productivity of labour (MPL) to find the trend in the contribution of the marginal labour and
average productivity of labour (APL) to find the average contribution of labour. The MPL and APL can
be worked out from the data given in Table 11.1. The process of working out MPL and APL is explains
below.
Marginal Productivity of Labour

Marginal productivity of labour (MPL) can be obtained by differentiating the production function (11.4)
with respect to labour (L) as follows:
∂QC
MPL = = −3L2 + 30L + 10 (11.5)
∂L
By substituting numerical value for labour (L) in Eq. (11.5), MPL can be obtained at different levels
of labour employment. However, this method can be used only where labour is perfectly divisible and
∂L → 0. Since, in our example, each unit of L = 1, calculus method cannot be used. Alternatively, where
labour can be increased at least by one unit, MPL can be obtained as
MPL = TPL − TPL–1
The MPL worked out by this method is presented in column 3 of Table 11.1.
Table 11.1 Total, Marginal and Average Products

Number of Total Product Marginal Product* Average Product** Stage of
Workers (L) (TPL) (tonnes) (MPL) (APL) Returns
(1) (2) (3) (4) (5)
1 24 24 24 I Increasing
returns
2 72 48 36
3 138 66 46
4 216 78 54
5 300 84 60
6 384 84 64
7 462 78 66 II Diminishing
returns
8 528 66 66
9 576 48 64
10 600 24 60
11 594 −6 54 III Negative
returns
12 552 −42 46
*MPL = TPn − TPn–1. Note that MPL obtained by differential method will be different.
**APL = TPLIQ
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230 Chapter 11
Average Productivity of Labour

Average productivity of labour (APL) can be obtained by dividing production function by L.
QC – L3 + 15L2 + 10 L
APL = =
L L
(11.6)
= – L2 + 15L + 10
Now APL can be obtained by substituting numerical values for L in Eq. (11.6). APL obtained by this
method is given in column 4 of Table 11.1.
The Three Stages in the Law of Diminishing Returns

Table 11.1 and Figure 11.1 present the three general stages in the application of the law of diminishing
returns. In Stage I, TPL increases at increasing rate. This is indicated by the rising MPL until the employ-
ment of the fifth worker. Given the production function (11.4), the fifth and sixth workers represent an
intermediate stage of constant returns to the variable factor, labour. In Stage II, TPL continues to increase
but at diminishing rates, i.e., MPL begins to decline. This stage in production shows the law of dimin-
ishing returns to the variable factor. Total output reaches its maximum level at the employment of the
tenth worker. Beyond this level of labour employment, TPL begins to decline. This marks the beginning
of Stage III in production.
The laws of variable proportions can be illustrated graphically also. The information contained in
Table 11.1 is presented graphically in panels (a) and (b) of Figure 11.1. Panel (a) of Figure 11.1 presents
the total product curve (TPL) and panel (b) presents the marginal product (MPL) and average prod-
uct (APL) curves. The TPL schedule demonstrates the law of diminishing returns. As the curve TPL
shows, the total output increases at an increasing rate until the employment of the sixth worker, as
indicated by the increasing slope of the TPL curve (see also column 3 of the table). Beyond sixth worker,
700
(a) (b)
Marginal and average product
600
Total output (tonnes)
90
500 75
Increasing TPL
returns
400 60
Decreasing Negative 45
300
returns returns
30
200
15 APL
100
0
0
1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12
Labour Labour MPL
Figure 11.1 Total, Average and Marginal Products
M11_DWIV9400_02_SE_C11.indd 230 07/07/11 1:03 AM

TPL increases (until the tenth worker) but the rate of increase in TPL (i.e., marginal addition to TPL)
begins to fall and turns negative from eleventh worker onwards. The TPL curve shows the operation of
the law of diminishing returns.
To conclude, the law of diminishing returns can be stated as follows. Given the fixed factor (capi-
tal), when more and more workers are employed, the return from the additional worker, i.e., MPL, may
initially increase but will eventually decrease.
Factors Behind the Laws of Returns

The questions that arise here are (i) what factors cause increasing returns to labour? and (ii) what factors
cause decreasing returns to labour? The factors behind the increasing returns to the variable input—
labour—can be described as follows.
One of the important factors causing increasing returns to a variable factor is the indivisibility of
fixed factor (capital). Each capital unit requires an optimum number of labour. If labour is less than the
optimum number, it results in under utilization of capital and therefore lower productivity of labour.
Let us suppose that optimum capital–labour combinations are 1:6. If capital is indivisible and less than
six workers are employed, then capital would remain under utilized. When more and more workers are
added, utilization of capital increases and also the productivity of additional worker. Another reason for
the increase in labour productivity is that employment of additional workers gives the advantages of
division of labour, until optimum capital–labour combination is reached.
What causes diminishing returns to labour? Once the optimum capital–labour ratio is reached, employ-
ment of additional workers amounts to substitution of capital with labour. But, technically, one factor can
substitute another only to a limited extent. In other words, there is a limit to which one input can be
substituted for another for the same marginal output. Hence, to replace the same amount of capital, more
and more workers will have to be employed because per worker marginal productivity decreases.
Applicability of the Law of Diminishing Returns

The law of diminishing returns is an empirical law, often observed in various production activities. This
law, however, may not apply universally to all kinds of productive activities since the law is not as true
as the law of gravitation. In some productive activities, it may operate at early stage of production; in
some, its operation may be delayed and in some others, it may not appear at all. This law has been found
to operate in agricultural production more regularly than in industrial production. The reason is, in
agriculture, natural factors play a predominant role whereas man-made factors play the major role in
industrial production. Despite the limitations of the law, if increasing units of an input are applied to the
fixed factors, the marginal returns to the variable input decrease eventually.
GRAPHICAL DERIVATION OF MARGINAL AND AVERAGE

PRODUCT CURVES
In the previous section, marginal and average product curves are derived numerically in Figure 11.1
by assuming a continuous production function of cubic form (Eq. (11.4)). In this section, we illustrate
geometric derivation of marginal and average product curves, assuming again a continuous production
function.
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232 Chapter 11
Derivation of Marginal Product Curve (MP L)

For graphical derivation of the marginal product curve, we continue to assume a continuous production
function with labour as a variable input (capital held constant). The total product curve under these
assumptions is shown by the curve TPL in Figure 11.2. By definition, marginal product is the addi-
tion to the total production (TPL) due to a marginal increase in the variable input, labour (L). Given
a continuous production function, marginal product of labour (MPL) can be defined as
∂TPL
MPL =
∂L
Graphically, MPL is given by the slope of the TPL curve (see Figure 11.2). Given the definition of MPL,
the MPL curve may be derived from the TPL curve, as shown in Figure 11.2.
The MPL curve can be derived by measuring the slope of TPL at its various points and by plotting the
measures. For example, if we choose point P on TPL curve to measure the MPL. For the purpose, we draw
a tangent ab through this point. Note that the slopes of the TPL and of the tangent ab at point P are the
same. An ordinate PM drawn from point P measures the output resulting from OM labour. The contri-
bution of the marginal labour, say NM amount of labour, can be obtained by drawing a line parallel to
the tangent ab from point N through PM. Note that the parallel line meets PM at point P′. Thus, P′M is
the marginal product of NM labour. This process may be repeated for several other points chosen on the
TPL curve and MP of labour obtained. By joining the resultant points (say, P′, Q′ and T), we draw the
MPL curve as shown in Figure 11.2.
Q
TPL
Output (Q)
P Q´
P´
a
N M T
Labour (L)
MPL
Figure 11.2 Derivation of MPL Curve
M11_DWIV9400_02_SE_C11.indd 232 07/07/11 1:03 AM

W
TPL
Output (Q)
M P
T
P´ S
APL
O Q N M E Labour (L)
Figure 11.3 Derivation of APL Curves
Derivation of Average Product Curve (AP L)

In our example, average product of labour (APL) can be defined as
Q
APL =
L
The APL curve can also be derived from the TPL, curve. The TPL curve derived in Figure 11.3 is similar
to one derived in Figure 11.2. Suppose that we want to measure APL at point P on the TPL in Figure 11.3.
At point P, output is PN = OM and the total labour employed is ON = MP. If we draw a line from point P
to the point of origin O, we get a line OP. The line OP represents the TPL with constant returns to labour.
The slope of line OP gives, therefore, the constant returns to marginal labour. When MPL is constant, then
MPL = APL. It means that APL can be obtained by measuring the slope of the line OP. Therefore, once the
constant return lines are obtained, then there is a simple method to measure the average product. For
example, after line OP is drawn, we locate a point measuring one unit of labour and draw a line parallel to
OP through the ordinate PN. Let us suppose that QN measures one unit of labour. Now if we draw a line
parallel to OP from Q through the line PN, the point of intersection gives APL. Note that line QP′ is parallel
to line OP and intersects PN at P′. Thus, NP′ is the measure of APL at total output PN. The same procedure
can be repeated for all other points chosen on the TPL (say, W and R) and APL measured for the respective
points as shown by point P′, T and S. By joining these joints, we get the APL curve, given the TPL curve.
THE THREE STAGES OF PRODUCTION

Economists identify three stages of production6 on the basis of the marginal and average returns to the
variable input, i.e., labour (L) in our case. The features of the three stages of production may be described
as follows.
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234 Chapter 11
Stage I: The marginal product of the variable input (labour) is higher than its average product,
i.e., MPL > APL
Stage II: The marginal product of the variable input (labour) falls below its average product, i.e., in
Stage II, MPL < APL, but both remaining greater than zero.
Stage III: The marginal product of the variable input (labour) turns negative, while average product
remains greater than zero.
The three stages of production are illustrated in Figure 11.4. The total product (TPL) curve in panel (a)
of the figure is similar to one shown in Figure 11.1. The marginal product (MPL) and average product
(APL) curves shown in panel (b) are derived as explained in Figures 11.2 and 11.3. Figure 11.4 shows the
behaviour of MPL and APL at different stages of production.
As Figure 11.4 (b) shows, the Stage I of production continues until the employment of OL2 units of
labour. In this stage, marginal product of the variable input, labour, increases until the use of OL1 units
of labour and then begins to decline whereas average product of labour continues to increase until OL2
(a)
Stage Stage Stage
I II M III
B
Total product
TPL
Point of
A
inflection
O L1 L2 L3
Units of labour
Average and marginal product
(b)
A´
B´
APL
O L3
L1 L2
Units of labour MPL
Figure 11.4 The Three Stages of Production
M11_DWIV9400_02_SE_C11.indd 234 07/07/11 1:03 AM

units of labour. In Stage I, marginal product is throughout higher than the average product of labour.
Marginal and average products get equalized at OL2 units of labour employed, as shown by point B ′.
Point B ′ marks the end of Stage I and beginning of the Stage II.
Stage II of production ranges between OL2 and OL3 units of labour. In this stage, both marginal and
average product of labour decline. However, marginal product declines at a faster rate. What is impor-
tant to note here is that, at OL3 units of labour, total product is maximum, as shown by point M in
panel (a), and marginal product reaches zero level at point L3.
Stage III begins with the decline in total product (TPL). As the figure shows, the use of labour in excess
of OL3 causes decline in total product because of over crowding of labour.
THE THREE STAGES OF PRODUCTION AND PRODUCTION

DECISIONS
The three stages of production can be used for production decisions and also determining the gainful
employment of the variable input, labour. Let us suppose here that cost minimization is the objective7 of
the business firms. It is obvious from Figure 11.4(b) that a cost-minimizing firm will not employ labour
in Stage III for it will result in negative MPL leading to decline in total output (TPL). So the production
decision lies in Stages I and II. Let us now examine the condition in Stages I and II. In Stage I, however,
total production increases at an increasing rate until OL1 units of labour as shown by increasing MPL
curve. Between OL1 and OL2 units of labour, the total production increases but at a diminishing rate as
shown by the declining MPL curve in panel (b). However, in this range, APL continues to increase. There-
fore, it is advisable for a cost-minimizing competitive firm to produce until the end of Stage I. The reason
is that, given the wage rate, increasing APL means decreasing average cost. And, as long as average cost is
decreasing, it is unwise for a cost-minimizing firm to stop production.
What About Stage II?

Stage II is the economically meaningful range of production and employment because it is in this stage
that business decisions have to be taken: how much labour to employ and what quantity to produce.
This stage begins with the highest APL and it begins to decline with the increase in labour employment
because MPL declines at an increasing rate. Given the wage rate, declining APL means increasing labour
cost of production. The profit maximizing output and employment lies in this stage of production.
As panel (b) of Figure 11.4 shows, APL rises to its maximum at OL2 employment of labour. It means that,
at OL2 employment of labour average cost is minimized. This is the production decision arrived at by
the analysis.
This discussion takes us to the end of our discussion on the input–output relationship under the
condition of one variable input. In the next chapter, we discuss input–output relations with two variable
inputs.

1. Distinguish between (a) variable input and fixed input and (b) short run and long run. How do
these concepts matter in the formulation of the laws of production?
2. What is a production function? How does a production function serve a useful purpose in
production analysis?
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236 Chapter 11
3. Define average and marginal products of the variable input. When marginal product begins to
decline, what happens to the average product?
4. What is the nature of relationship between marginal and average products? What is the basis
of this relationship?
5. State the law of diminishing marginal returns. What are the conditions for this law to apply?
Does this law apply to all kinds of industries?
6. Discuss the law of variable proportions using an appropriate production function. Why is this
law so called? Explain with example.
7. What are the three stages of returns in the law of diminishing returns? Why does production
increase at increasing rate in the initial stage of the law of diminishing marginal returns?
8. Illustrate graphically the derivation of TP, MP and AP curves. Show also the three stages of
production. What economic purpose do the stages of production serve?
9. Suppose a production function is given as follows.
Q = 10L + 5L – L3
Find the following.
(a) TP, MP and AP schedules;
(b) TP where MP = AP;
(c) Labour (L) required to maximize output.
10. Show the derivation of TP, MP and AP curves using the production function given in question 9
and illustrate the three stages of production.
11. The law of diminishing returns is an empirical law. But this law does not apply to all kinds of
industries in the same manner. Comment.
12. Suppose a production schedule is given as follows. Complete the table and find the following.
Labour Total Production Marginal Product Average Product

1 5
2 11
3 18
4 26
5 35
6 45
7 55
8 64
9 70
10 75
11 72
12 60
M11_DWIV9400_02_SE_C11.indd 236 07/07/11 1:03 AM

(a) Employment maximizing production,

(b) Output with the highest APL, and
(c) Employment at which MPL = APL.
13. When total output is maximum, which of the following holds?
(a) APL = MPL,
(b) APL > MPL,
(c) APL < MPL, or
(d) none
(APL = average productivity, and MPL = marginal productivity of labour)
14. Under which of the following condition, MPL = 0?
(a) MPL = APL
(b) MPL > APL
(c) MPL < APL
15. Marginal productivity of labour decreases due to which of the following factors?
(a) indivisibility of capital,
(b) labour is imperfect substitute of capital, or
(c) there is a change in production technology.
16. Suppose a firm is operating under the laws of variable proportions. Explain graphically the fea-
tures of the three stages of production. Also find the cost-minimizing employment and output.
ENDNOTES
1. Baumol, W.J., Economic Theory and Operations Analysis (New Delhi: Prentice Hall, 1985),
p. 267.
2. Koutsoyiannis, A., Modern Microeconomics (London: Macmillan, 1979), p. 70.
3. Supply of capital may, of course, be elastic in the short run for an individual firm under perfect
competition but not for all the firms put together. Therefore, for the sake of convenience in
explaining the laws of production, we will continue to assume that, in the short run, supply of
capital remains inelastic.
4. Hirshleifer, J., Price Theory and Applications, 3rd Edn. (New Delhi: Prentice Hall, 1987), p. 316.
5. Baumol, W.J., Economic Theory and Operations Analysis, 4th Edn. (New Delhi: Prentice Hall,
1985), p. 270.
6. The stages of production described here do not correspond with the ‘stages of returns’ given
in Table 11.1. There the ‘stages in returns’ show the trends in marginal returns before and after
the law of diminishing returns comes into force. The ‘stages of production’ discussed here serve
a different purpose. It is more relevant for decision making, i.e., how much labour to employ
and how much to produce.
7. In the traditional theory of business firms, profit maximization is assumed to be the basic
objective of the firm. But, since wage rate and the price of the product are not known, profit-
maximization rule, i.e., MC = MR, cannot be applied here. However, cost-minimization objec-
tive serves the same purpose under the assumption that wage rate and product price are given.
M11_DWIV9400_02_SE_C11.indd 237 07/07/11 1:03 AM

238 Chapter 11
FURTHER READINGS
Browning, E.K., Browning, J.M. (1986), Microeconomics: Theory and Applications (New Delhi: Kalyani
Publisher), 2nd Edn., Chapter 6, pp. 171–180.
Ferguson, C.E., (1969), The Neo-Classical Theory of Production and Distribution (London: Cambridge
University Press), Chapter 1–6.
Gould, J.P., Lazear, E.P. (1993), Microeconomic Theory (Homewood, IL: Richard D. Irwin), 6th Edn.,
Chapter 6.
Maddala, G.S. and Miller, E. (1989), Microeconomics: Theory and Applications (New York, NY:
McGraw-Hill), Chapter 6, pp. 160–168.
Perloff, J.M. (2001), Microeconomics (New York, NY: Addison Wesley Longman), Chapter 6, pp. 146–153.
Salvalore, D. (2003), Microeconomics: Theory and Practice (New York, NY: Oxford University Press),
Chapter 7.
M11_DWIV9400_02_SE_C11.indd 238 07/07/11 1:03 AM

Chapter 12
Theory of Production: Laws

of Returns to Two Variable
Inputs
CHAPTER OBJECTIVES
In this chapter, we move on from the laws of production related to one variable input (labour) to the
laws of production related to two variable inputs (labour and capital), known also as long run laws of
production and the law of return to scale. The objective of this chapter is to introduce the application of a
new tool of production analysis, called isoquant and to explain the laws of returns to scale by using the
isoquants. This chapter helps you learn:
The meaning and the properties of the isoquants;
The different kinds of shapes of the isoquants, with different production techniques;
The meaning and purpose of measurement of marginal rate of substitution and how the elasticity
of substitution between the inputs is measured;
The laws of returns to scale, i.e., how output increases with a simultaneous and proportionate
increase in inputs—labour and capital; and
Presentation of the laws of returns to scale through the production function.
INTRODUCTION
In the preceding chapter, we have discussed the theory of production with one variable input (labour). The
theory of production with a variable input brings out the relationship between the variable input (labour)
and output, capital remaining constant. Production with variable labour and fixed capital is a short-run
phenomenon. In this chapter, we will discuss the theory of production with two variable inputs (labour
and capital). This is a long-run phenomenon. In the long run, both the inputs (labour and capital) are
supposed to be available in a larger supply. Therefore, firms can use a larger quantity of both the inputs
to increase the level of output. A firm’s long-run production function is then expressed as Q = f(L, K).
M12_DWIV9400_02_SE_C12.indd 239 07/07/11 1:37 AM

240 Chapter 12
With simultaneous increase in both the inputs (labour and capital), a firm’s scale of production increases.
The input–output relationship under increasing scale of production is also known as laws of returns to
scale. In this chapter, we discuss the laws of returns to scale.
Recall from Chapter 11 that there are three methods of presenting the laws of production, viz.,
(i) tabular, (ii) graphical and (iii) functional. The graphic method, used to illustrate the laws of return
to variable input, cannot be used conveniently to illustrate input–output relationships with two variable
inputs. Economists have, therefore, devised a more convenient technique to explain and illustrate the laws
of return to scale. The technique is called isoquant curves. The laws of returns to scale can be explained by
using production isoquants and production function with two variable inputs. We will explain the input–
output relationship with two variable inputs by using both the methods. We will first explain the laws of
return to scale with the help of isoquant curves and then through production function. Isoquant curves
are the most convenient tool of analyzing the laws of production. Let us, therefore, first of all explain the
meaning and the properties of the isoquant curve.
THE ISOQUANT CURVE

The term ‘isoquant’ has been derived from a Greek word ‘iso’ meaning equal and a Latin word ‘quantus’
meaning quantity. The ‘isoquant curve’ is, therefore, also known as equal product curve and production
indifference curve. By definition, an isoquant is locus of points representing different combinations of two
inputs (labour and capital) yielding the same output.
An isoquant curve is analogous to consumer indifference curve with two differences:
1. while an indifference curve represents different combinations of two consumer goods yielding
the same level of satisfaction, an isoquant curve represents different combination of two pro-
ducer goods (labour and capital) producing the same quantity of a commodity; and
2. while an indifference curve represents immeasurable ‘utility’, i.e., the level of satisfaction, an
isoquant represents a measurable quantity of output of a product.
The possibility that a given quantity of a commodity can be produced by different combinations of two
inputs (labour and capital) is based on the assumption that a large variety of techniques of production is
available. For example, a certain acre of wheat crop can be harvested per unit of time by 20 labour with
20 sickles (i.e., little of capital) or two labour and a harvesting machine (i.e., a large capital). Consider
another example. A certain length of road can be constructed per unit of time by using 50 labours and 20
spades and levelling instrument or by using only five labour and a road roller, and so on. These technical
possibilities are shown by an isoquant curve.
DERIVATION OF ISOQUANT CURVE

Assumptions
Isoquant curves are drawn on the basis of the following assumptions:
1. There are only two inputs, labour (L) and capital (K), to produce a commodity, say X;
2. The two inputs (L and K) can be substituted for one another at a diminishing rate, up to a cer-
tain limit and
3. Production function is continuous, implying that labour and capital are perfectly divisible and
can be substituted in any small quantity.
M12_DWIV9400_02_SE_C12.indd 240 07/07/11 1:37 AM

Theory of Production: Laws of Returns to Two Variable Inputs 241
K4 A
Capital (K)
–DK1
K3 B
DL 1
–DK2 C
K2
DL 2
–DK3 D Qx=200
K1
DL 3
Qx=100
O L1 L2 L3 L4 L
Labour(L)
Figure 12.1 Isoquant Curves
Table 12.1 Capital–Labour Combinations and Output

Points Input Combinations K + L Output
A OK4 + OL1 =100
B OK3 + OL2 =100
C OK2 + OL3 =100
D OK1 + OL4 =100
Given these assumptions, it is always possible to produce a given quantity of commodity X with various
combinations of capital and labour. The factor combinations are so formed that the substitution of one
factor for the other leaves the output unaffected. This technological fact is presented through an isoquant
curve (Qx = 100) in Figure 12.1. The curve IQ1 all along its length represents a fixed quantity, 100 units of
product X. This quantity of output can be produced with a number of labour–capital combinations. For
example, points A, B, C and D on the isoquant Qx represent four different combinations of inputs, K and
L, as given in Table 12.1, all yielding the same output—100 units. Note that movement from A to D indi-
cates decreasing quantity of K and increasing number of L. This implies substitution of labour for capital
such that all the input combinations yield the same quantity of commodity X, i.e., Qx = 100, whatever the
combination of labour and capital.
PROPERTIES OF ISOQUANT CURVES

Isoquants have the same properties as indifference curves. They are explained here in terms of input and
output, under the condition that two inputs are not perfect substitutes.
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242 Chapter 12
Isoquants Have a Negative Slope

An isoquant has a negative slope in the economic region1 or in the relevant range. The economic region
is the region on the isoquant plane in which substitution between inputs is technically efficient. It is also
known as the product maximizing region. The negative slope of the isoquant implies substitution of one
input for another so that output remains the same. It means that if one of the inputs is reduced, the other
input has to be increased that the total output remains unaffected. For example, movement from A to
B on Qx (Figure 12.1) means that if K4K3 units of capital are removed from the production process, L1L2
units of labour have to be brought into maintain the same level of output. The substitution of one input
for another gives isoquant a negative slope.
Isoquants Are Convex to the Origin

Convexity of isoquant means that it has a bend towards the point of origin. Isoquants are convex to
origin because the rate at which one input is substituted for the other goes on diminishing along their
length. The rate at which inputs are substituted one for another at different levels is called the marginal
rate of technical substitutions2 (MRTS). The MRTS is defined as:
−∆K
MRTS = = slope of isoquant
∆L
In plain words, MRTS is the rate at which labour can substitute capital at margin, and vice versa,
without affecting the total output. This rate is indicated by the slope of the isoquant. The MRTS decreases
for two reasons:
1. no factor is a perfect substitute for another and
2. inputs are subject to diminishing marginal return.
It is for these reasons that, more and more units of an input are needed to replace each successive unit
of the other input. This means diminishing marginal rate of substitution. That MRTS goes on diminish-
ing along the isoquant can be proved by deriving the MRTS from IQx = 100 in Figure 12.1. Suppose that
in Figure 12.1, X4X3 = X3X2 = X2X1, it means that ΔK1 = ΔK2 = ΔK3.
But as the figure shows, the subsequent units of L substituting K go on increasing, i.e.,
L1 L2 < L2 L3 < L3 L4 or ∆L1 < ∆L2 < ∆L3
Let us workout the MRTS = ΔK/ΔL.

∆K1 ∆K 2 ∆K 3
> >
∆L1 ∆L2 ∆L3
This shows that MRTS goes on decreasing.
Isoquants Do Not Intersect or Are Tangent to Each Other

The intersection or tangency between any two isoquants implies two inconsistent production possibili-
ties that:
1. the same combination of inputs can produce two different quantities of the same commodity and
2. a given quantity of a commodity can be produced with a smaller as well as a larger input
combination.
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Capital (K)
Q2 = 200
Q1 = 100
L
O L1 L2
Labour (L)
Figure 12.2 Intersecting Isoquants
These conditions contradict the laws of production unless marginal productivity of inputs is zero or
less than zero. In Figure 12.2, two isoquants intersect at point M. At point M, input combination is given
as ML1 of capital and OL1 of labour. Since point M falls on both the isoquants (Q1 = 100 and Q2 = 200),
it means that the same combination of inputs can produce 100 and 200 units of the commodity. This is
practically impossible, unless productivity of some input is equal to zero.
To prove inconsistency, consider two other points—point J on isoquant marked Q1 = 100 and
point K on isoquant marked Q2 = 200. One can easily infer that a quantity that can be produced with the
combination of K and L at point M can be produced also with factor combination at points J and K. On
the isoquant Q1 = 100, factor combinations at point M and J are equal in terms of their output. On the
isoquant Q2 = 200, factor combinations at M and K are equal in terms of their output. Since point M is
common to both the isoquants, it follows that input combinations at J and K are equal in terms of output.
This implies that, in terms of output, OL2 + JL2 = OL2 + KL2
Since OL2 is common to both the sides, it means that, in terms of output, JL2 of K = KL2 of K.
But this cannot be possible because, as can be seen in Figure 12.2, JL2 < KL2.
But the intersection of the isoquants means that output from JL2 and KL2 units of capital are equal.
This cannot happen as long as MP of capital is greater than zero. That is why isoquant will not intersect
or be tangent to one another. If they do, it violates the law of production.
Upper Isoquants Represent a Higher Level of Output

Between any two isoquants, the upper one represents a higher level of output than the lower one. The
reason is that any point on an upper isoquant implies a larger input combination, which, in general,
produces a larger output. Therefore, upper isoquants indicate a higher level of output.
For instance, isoquant Q2 in Figure 12.3 will always represent a higher level of output than iso-
quant Q1. For, any point at isoquant Q2 consists of more of either capital or labour or both. For example,
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244 Chapter 12
c
Quantity of K
Y d
a
Q2 = 200
Q1 = 100
O X
Quantityof L
Figure 12.3 Comparison of Out at Two Isoquants
consider point a on isoquant Q1 and compare it with any point at isoquant Q2. Point b on isoquant Q2
indicates more of capital (ab), point d more of labour (ad) and point c more of both. Therefore, isoquant
Q2 represents a higher level of output (200 units).
MARGINAL RATE OF TECHNICAL SUBSTITUTION (MRTS)

A reference has already made to the marginal rate of technical substitution (MRTS) in the previous sec-
tion. Before we proceed to discuss the laws of returns to scale, let us explain MRTS in some detail and
look at the reason behind the decline in MRTS along an isoquant. As mentioned earlier, the marginal
rate of technical substitution (MRTS) is the rate at which one input can be substituted for another, output
remaining constant. The rate at which one input can be substituted for another at the margin, holding the
output constant, is given by the slope of the isoquant. The slope of the isoquant (moving downward) on
an isoquant is given as follows:
−∆K
MRTS = = slope of isoquant
∆L
The condition that the total output should remain constant implies that
( K ⋅ MPK ) = ( L ⋅ MPL ) (12.1)
where MPK = marginal product of capital and MPL = marginal product of labour.
By rearranging the terms in Eq. (12.1), we get
−∆K MPL
=
∆L MPK
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Table 12.2 Alternative Methods of Producing 100 Units of a Commodity

Input Combination Output Changes in K and L MRTS = -∆K/∆L
K + L ∆K ∆L
10 2 100 −1 1 −1.0
9 3 100 −1 5 −0.2
8 8 100 −1 10 −0.1
7 18 100
Since
−∆K
= MRTS
∆L
MPL
= MRTS (12.2)
MPK
Thus, MRTS of L for K is determined as the ratio of the marginal product of labour (MPL) to the
marginal product of capital (MPK).
To illustrate MRTS numerically, let us suppose that a given production function may be presented
in a tabular form as given in Table 12.2. The table presents five alternative combinations of K and L that
can be used to produce a given quantity, say, 100 units of a commodity. The downward movement in
the table shows substitution of labour for capital. As a result, the amount of capital decreases while the
number of workers increases, output remaining constant.
As the table shows, the units of labour which can substitute one unit of capital (or the quantity of
capital that can substitute one unit of labour) goes on increasing. As a result, the MRTS = −ΔK/ΔL
goes on decreasing. The reason is that both the factors are subject to the laws of diminishing marginal
return. As the number of labour increases, its marginal productivity decreases. On the other hand, with
the decrease in the quantity of capital, its marginal productivity increases. Therefore, to substitute each
subsequent unit of capital, more and more units of labour are required to maintain the production at the
same level. That is why the MRTS decreases.
ISOQUANT MAP AND ECONOMIC REGION OF PRODUCTION

Isoquant Map
An isoquant map is a set of isoquants presented on a two-dimensional plane as shown by isoquants
Q1, Q2, Q3 and Q4 in Figure 12.4. Each isoquant shows various combinations of labour and capital that
can be used to produce a given level of output. As shown in Figure 12.3, an upper isoquant is formed
by a greater quantity of one or both the inputs than the input combination indicated by the lower iso-
quants. For example, isoquant Q2 indicates a greater input combination than that shown by isoquant Q1,
and so on.
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246 Chapter 12
Upper ridge line

M
c Lower ridge line

Capital (K)
b h Q4
g Q3
a
f Q2
e
Q1
O
Labour (L)
Figure 12.4 Isoquant Map and Economic Region
Since upper isoquants indicate a larger input combination than the lower ones, each successive upper
isoquant indicates a higher level of output than the lower ones. For example, in Figure 12.4, if isoquant Q1
represents an output equal to 100 units, isoquant Q2 represents an output greater than 100 units, i.e., 200
units. As one of the properties of isoquants, no two isoquants can intersect or be tangent to one another.
Economic Region of Production

It is noteworthy that the whole isoquant map or production plane is neither technically efficient nor
every point on an isoquant technically efficient. The reason is that, on a convex isoquant, the MRTS
decreases along the isoquant and zero is the limit to which the MRTS can decrease. The point at which
MRTS equals zero marks the limit to which one input can substitute another. It also determines the
minimum quantity of an input which must be used to produce a given output. Beyond this point, an
additional employment of one input will necessitate employing additional units of the other input. Such
a point on an isoquant may be obtained by drawing a tangent to the isoquant and parallel to the vertical
and horizontal axes, as shown by dashed lines in Figure 12.4. By joining the resulting points a, b, c and d,
we get a line called the upper ridge line, OM. Similarly, by joining the points e, f, g and h, we get the lower
ridge line, ON. The ridge lines are locus of points on the isoquants where the marginal products of the
inputs are equal to zero. The upper ridge line implies that marginal productivity of capital is zero along
the line, OM. The lower ridge line implies that marginal productivity of labour is zero along the line, ON.
The area between the two ridge lines, OM and ON, is called ‘economic region’ or ‘technically efficient
region’ of production. Any production technique, i.e., capital–labour combination, within the economic
region is technically efficient to produce a given output. And, any production technique outside this
region is technically inefficient, since it requires more of both the inputs to produce the same quantity.
For example, suppose that the quantity represented by isoquant Q2 is to be produced, we have two points,
b and f, on the isoquant Q2, which fall on the ridge lines. Consider first point b, i.e., the point of intersection
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between the isoquant Q2 and the upper ridge line. Point b indicates minimum of labour and maximum of
capital required to produce Q2. A smaller amount of capital, given the labour input at point b, would be
insufficient to produce Q2. Beyond point b, producing Q2 would require more of capital and labour, which is
technically inefficient. It would mean producing the same quantity with a larger input combination. It may be
inferred from the above that: (i) at point b, marginal productivity of capital is zero and (ii) further substitution
of capital for labour is technically inefficient. Similarly, point f indicates minimum of capital and maximum of
labour required to produce Q2. Any smaller input of labour would be insufficient to produce Q2. Any further
substitution of labour for capital is technically inefficient, since MP of labour at point f is zero. Any addition
to the quantity of capital would not yield any additional output. Capital is therefore redundant. Even if both
labour and capital is used, the level of output will not increase. These limits determine the economic religion.
OTHER FORMS OF ISOQUANTS

We have discussed earlier, the derivation of the isoquant and properties of the curvilinear convex are
isoquant. It is this form of the isoquant which is most widely used in production theory. However, in
reality, one can discover some other forms of isoquants. The shape of an isoquant, in fact, depends on
the assumption regarding the degree of substitutability between the factors in the production function.
The convexity of isoquant constructed of two imperfect substitutes in Figure 12.3 assumes continuous
substitutability of capital and labour with MRTS at a diminishing rate. Some economists have, however,
discovered some other degrees of substitutability between K and L and have demonstrated the existence
of three other kinds of isoquants, viz, linear, L-shaped and kinked isoquants. These kinds of isoquants
and the reason behind their shapes are discussed below.
Perfect Substitutes and Linear Isoquants

In case two inputs—L and K—are perfect substitutes for one another, the isoquant takes the form of a
straight line. A linear isoquant has been presented by the line AB in Figure 12.5. A linear isoquant is
A
Capital (K)
O Labour (L) B
Figure 12.5 Linear Isoquant
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248 Chapter 12
based on the condition that there is perfect substitutability between the two factors, K and L. In simple
words, the two inputs are perfect substitutes. The isoquant AB indicates that a given quantity of a prod-
uct may be produced by using only capital or only labour or by using both. This is possible only when
the two factors, K and L, are perfect substitutes for one another. A linear isoquant implies that the MRTS
between K and L remains constant all along its lengths.
A linear isoquant is the product of a linear demand function. A linear production function is
expressed as:
Q = aK + bL (12.3)
The production function given in Eq. (12.3) that the total output, Q, is simply the weighted sum of K
and L. The slope of the isoquant, i.e., MRTS means of this production function is given by (−)b/a when
capital is substituted for labour and by (−)a/b when labour is substituted for capital. In case of a linear
isoquant, MRTS remains constant. This can be proved as follows.
Given the production function (12.3),
∂Q
MPK = =a
∂K
and
∂Q
MPL = =b
∂L
Recall that MRTS = MPL/MPK for substitution of capital for labour.
Since MPL = b and MPK = a, by substitution,
b
MRTS = − = slope of isoquant
a
In case, capital is substituted for labour, the MRTS = −a/b. In both cases, the MRTS remains constant.
The production function exhibiting perfect substitutability of factors is, however, considered to be a
rare phenomenon in the real world production process.
The Fixed Factor Technology and L-shaped lsoquant

In modern times, one often comes across a technology in which the proportion of capital (K) and labour
(L) is fixed. For example, consider such cases: one taxi and one labour (driver); one bus and two labour–
driver and conductor; one computer and one operator and so on. When production technology is such
that there is a fixed proportion between K and L, the isoquant takes ‘L’ shape, as shown by Q1 and Q2
in Figure 12.6. Such an isoquant implies zero substitutability between K and L. Instead, it assumes per-
fect complementarity and non-substitutability between the factors. That is, K and L are treated as perfect
complements to one another. Perfect complementarity implies that a given quantity of a commodity can
be produced by one and only one combination of K and L and that the proportion of the inputs is fixed.
In other words, K and L are required in a fixed proportion to produce a given quantity of a commodity. It
implies also that if quantity of an input is increased, quantity of other inputs held constant, there will be
no change in the output. Thus, output can be increased only by increasing both the inputs proportionately.
As shown in Figure 12.6, to produce Q1 units of a commodity, a minimum of OK1 units of K and OL1
units of L is required. It means that if OK1 units of K are being used, OL1 units of labour must be used to
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B
Capital (K)
K2 Q2
K1 Q1
O L1 L2
Labour (L)
Figure 12.6 The L-shaped Isoquant
produce Q1 units of the commodity. Similarly, if OL1 units of labour are employed, OK1 units of capital
must be used to produce Q1. In either case, if units of K or L are increased, output will not increase. For
example, if OL2 units of labour are used with OK1 units of capital, then the additional L1L2 units of labour
would remain idle or be redundant. Similarly, if OK2 units of capital are used with OL1 units of labour,
then the additional K1K2 units of K would be redundant.
One possible mathematical form of a fixed-proportion production function, called a Leontief func-
tion, is given as:
Q = f ( K , L)
= min( aK , bL) (12.4)
In Eq. (12.4), ‘min’ means that production of Q equals the lower of the two terms, aK and bL. That
is, if aK > bL, Q = bL and if bL > aK, then Q = aK. If aK = bL, it would mean that both K and L are fully
employed. Then, the fixed capital–labour ratio will be K/L = b/a.3
In contrast to a linear production function, fixed proportion production function has a wide range
of applications in the real world. One can easily find the techniques of production in which the propor-
tion of labour and capital is fixed. For example, recall the case of transport service. To run a taxi service
or to operate a truck transport service needs a minimum of one worker, a driver. In these cases, the
machine–labour proportion is fixed. Any extra labour would be redundant. Similarly, one can find cases
in manufacturing the industries where capital–labour proportions are fixed and an additional unit of
capital would require a minimum number of workers, and vice versa.
The Kinked or Linear Programming Isoquants

The fixed proportion production function (given in Figure 12.6) assumes that the production technology
is such that capital and labour can be combined in only a fixed proportion. To double the production
would require doubling both the inputs, K and L. The line OB (Figure 12.6) represents the only production
process available. In real life, however, the businessmen and the production engineers find in existence
many, but not infinite, techniques of producing a given quantity of a commodity, each technique having
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250 Chapter 12
a different fixed proportion of inputs. In fact, there is a wide range of machines available to produce a
commodity. Each machine requires a fixed number of workers to work with. This number is different
for each machine. For example, 40 persons can be transported from one place to another by hiring:
(i) 10 taxis and 10 drivers; (ii) two mini buses and two drivers, and (iii) one bus and one driver. Each
of these methods is a different process of production and has a different fixed proportion of capital and
labour. One can, similarly, find many such processes of production in manufacturing industries, each
process having a different fixed factor proportion.
Let us suppose that for producing 100 units of a commodity, X, there are four different techniques
of production available. Each technique has a different fixed factor proportion, as given in Table 12.3.
The four hypothetical production techniques, given in Table 12.3, are graphically presented in
Figure 12.3. The ray OA represents a production process having a fixed K:L ratio of 10:2. It also implies
Table 12.3 Alternative Techniques of Producing 100 Units of X

S. No. Technique Capital Units Labour Units Capital:Labour Ratio
1 OA 10 2 10:2
2 OB 6 3 6:3
3 OC 4 6 4:6
4 OD 3 10 3:10
Note: OA, OB, OC and so on, are rays in Figure 12.7 each indicating different techniques of production—
each techniques having the same K/L ratio.
12
10 A 100
8
Capital (K)
6 B 100
4 C 100
100
D
2
O
2 4 6 8 10 12
Labour (L)
Figure 12.7 Fixed Proportion Processed of Production
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that 50 units of the commodity can be produced with five units of capital and one unit of labour. The three
other production processes having fixed K:L ratio are shown by the rays OB, OC and OD, respectively. By
joining their terminal points A, B, C and D, we get a kinked isoquant, ABCD.
Each of the points on the kinked isoquant represents a different combination of capital and labour
capable of producing 100 units of commodity X. If there are other techniques of production, many other
rays would be passing through different points between A and B, B and C and C and D, increasing the
number of kinks of the isoquant ABCD.
The kinked isoquant assumes a limited substitutability of K and L, i.e., only between the points of kink.
Since this form of isoquant is used basically in linear programming, it is also called linear programming
isoquant or activity analysis isoquant.
ELASTICITY OF TECHNICAL SUBSTITUTION

We have discussed earlier, the meaning and measure of marginal rate of technical substitution (MRTS)
and have noted that MRTS decreases along the convex isoquant. The MRTS refers only to the slope of
the isoquant. It does not reveal how ‘difficult’ or ‘easy’ is the substitution one input for another. In simple
words, MRTS does not reveal the degree of substitutability of one factor for another. Economists have
devised a method of measuring the degree of substitutability of factors, called the elasticity of technical sub-
stitution. The elasticity of substitution (σ) is formally defined as the percentage change in the capital–labour
ratio (K/L) divided by the percentage change in the marginal rate of technical substitution (MRTS), i.e.,
Percentage change in K / L
σ=
Percentage change in MRTS
or
∂( K / L) / ( K /L)
σ=
∂( MRTS ) / ( MRTS )
Since all along an isoquant, K/L and MRTS move in the same direction, value of σ is always positive.
Besides, the elasticity of substitution (σ) is ‘a pure number independent of the units of the measurements
of K and L, since both the numerator and the denominator are measured in the same unit.’4
The concepts of elasticity of substitution are graphically presented in Figure 12.8. The movement
from point A to B on the isoquant Q gives the ratio of change in the MRTS. The rays OA and OB rep-
resent two techniques of production with different factor intensities given by K/L. While process OA is
capital intensive, process OB is labour intensive. The shift of line OA to OB gives the change in factor
intensity. The ratio between the two changes measures the substitution elasticity.
The value of elasticity of technical substitution depends on the curvature of the isoquants. It varies
between 0 and ∞, depending on the nature of the production function. Production function determines
the curvature of the various kinds of isoquants. For example, in case of a fixed proportion, production
function yielding an L-shaped isoquant (see Figure 12.6), σ = 0. If production function is such that the
resulting isoquant is linear (Figure 12.5), σ = ∞. And, in case of a homogenous production function of
degree 1 of the Cobb–Douglas type, σ = 1.
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252 Chapter 12
A MRT SA
Capital (K)
B MRT SB
(K/L)A
Q
(K/L)B
O
Labour (L)
Figure 12.8 Graphic Derivation of Elasticity of Substitution
THE LAWS OF RETURNS TO SCALE

In this chapter so far, we have discussed the nature, kinds and the properties of isoquants—a tool of
analyzing the input–output relationship. In this section, we discuss the input–output relationships under
the condition that both the inputs (labour and capital) are variable and their quantity is changed pro-
portionately and simultaneously. When both the inputs (labour and capital) are changed proportionately,
the scale of production, i.e., the size of the firm, changes. The laws of production, i.e. the input–output
relationships under the condition of changing scale of production, are called the laws of returns to scale.
As mentioned earlier, the laws of returns to scale are a long-term phenomenon. In the long run, supply of
both labour and capital is supposed to be elastic. The firms can therefore employ more of both labour
and capital to increase their production. The question that we will answer here is: how does total output
change when both the inputs are increased proportionately and simultaneously? The answer to this ques-
tion lies in what law of returns to scale.
Three Laws of Return to Scale

When both labour and capital are increased proportionately and simultaneously, there are technically
three possible ways in which total output may increase:
1. Output may increase more than proportionately to increase in input,
2. Output may increase proportionately to increase in input and
3. Output may increase less than proportionately to increase in input.
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For example, if both the inputs (labour and capital) are doubled, the resulting output may be more
than double, equal to double or less than double. This kind of input–output relationship gives three kinds
of laws of returns to scale:
1. the law of increasing returns to scale,
2. the law of constant returns to scale, and
3. the law of decreasing returns to scale.
These three law of returns to scale are explained below first graphically with the help of isoquants and
then through the production function.
The Law of Increasing Returns to Scale

When both the inputs—labour and capital—are increased proportionately and simultaneously and
output increases more than proportionately, it gives the law of increasing returns to scale. The law of
increasing returns to scale implies that output increases more than proportionately to the increase in
inputs and the rate of increase in output goes on increasing with each subsequent increase in inputs. For
example, suppose inputs are increased by 50 per cent and output increases by more than 50 per cent, say
by 75 per cent, and when inputs are again increased again by 50 per cent and output increases by 100 per
cent and so on. This kind of input–output relationship shows that the law of increasing returns to scale is
in operation. This kind of returns to change in scale is illustrated in Figure 12.9. The three isoquants—Q1,
4K A Product lines
3K c
B
Capital (K)
2K b Q3 = 50
a Q2 = 25
1K
Q1 = 10
O 1L 2L 3L 4L
Labour (L)
Figure 12.9 Increasing Returns to Scale
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254 Chapter 12
Q2 and Q3—represent three different levels of production—10, 25 and 50 units, respectively. Product
lines OA and OB show the relationship between input and output. For instance, movement from point a
to b denotes doubling the inputs, labour and capital. As Figure 12.9 shows, input combination increases
from 1K + 1L to 2K + 2L. The movement from a to b also indicates increase in output from 10 to 25 units.
This means that when inputs are doubled, output is more than doubled.
Similarly, movement from point b to c shows increase in inputs from 2K + 2L to 3K + 3L, i.e., a 50 per
cent increase in inputs, and a rise in output from 25 to 50 units, i.e. a 100 per cent rise in output. This
also gives a more than proportionate increase in the output in response to rise in inputs. This reveals the
law of increasing returns to scale.
Factors Causing Increasing Returns to Scale: The Economies of Scale The law
of increasing returns to scale comes into operation because of economies of scale. There are at least three
kinds of economies of scale that make plausible reasons for increasing returns to scale.
1. Technical and Managerial Indivisibilities. Certain inputs, particularly machinery and mana-
gerial skills, used in the process of production are available in a given size. Such inputs are
indivisible. That is, capital and managers cannot be divided into parts to suit the small scale of
production. For example, half a turbine cannot be used; a part of a locomotive engine cannot
be used; one third or a part of a composite harvester or earthmover cannot be used. Similarly,
half of a manager cannot be employed, if part-time employment is not acceptable to him, and
so on. Because of their indivisibility, such factors have to be employed in a minimum quantity
even if scale of production is much less than their production capacity. Therefore, when scale of
production is increased by increasing all inputs, the productivity of indivisible factors increases
exponentially. This results in increasing returns to scale.
2. Higher Degree of Specialization. Another factor causing increasing returns to scale is higher
degree of specialization of both labour and managerial manpower, which becomes possible with
increase in the scale of production. The use of specialized labour and management increases
productivity per unit of inputs. Their cumulative effects contribute to the increasing returns to
scale. Managerial specialization contributes a great deal to increasing production.
3. Dimensional Relations. Increasing returns to scale is also a matter of dimensional relations.
For example, when the size of a room (15’ × 10’ = 150 sq. ft.) is doubled to 30’ × 20’, the area of
the room is more than doubled, i.e., 30’ × 20’ = 600 sq. ft. When diameter of a pipe is doubled,
the flow of water is more than doubled. Following this dimensional relationship, when the
labour and capital are doubled, the output is more than doubled over some level of output.
The Law of Constant Returns to Scale

When change in output is proportional to the change in inputs, it shows constant returns to scale. In other
words, if quantities of both the inputs, K and L, are doubled and output is also doubled, then the returns
to scale are constant. The constant returns to scale is illustrated in Figure 12.10. The lines OA and OB are
product lines indicating two hypothetical techniques of production. The isoquants, Q1 = 10, Q2 = 20 and
Q3 = 30 indicate three different levels of output. In the figure, the movement from point a to b indicates
doubling both the inputs—capital increases from 1K to 2K and labour increases from 1L to 2L. When
inputs are doubled, output is also doubled, i.e., output increases from 10 to 20. The movement from point
b to c indicates 50 per cent increase in the inputs, as K increases from 2K to 3K and L from 2L to 3L.
M12_DWIV9400_02_SE_C12.indd 254 07/07/11 1:37 AM

4K A
Product lines
3K c
B
Capital (K)
2K b Q3 = 50
1K a Q2 = 20
Q1 = 10
O 1L 2L 3L 4L
Labour (L)
Figure 12.10 Constant Returns to Scale
As a result, output increases from 20 to 30, i.e., by 50 per cent. This relationship between the change in
inputs and the proportionate change in output may be summed up of as follows.
1K + 1L = Q = 10
2 K + 2 L = 2Q = 20
3K + 2 L = 3Q = 30
This kind of input–output relationship exhibits the constant returns to scale.
Why Constant Returns to Scale? The constant returns to scale are attributed to the limits of
the economies of scale. With the expansion in the scale of production, economies arise from such fac-
tors as indivisibility of certain inputs, greater possibility of specialization of capital and labour, use of
labour-saving techniques of production and so on. But, there is a limit to the economies of scale.5 When
economies of scale disappear and diseconomies are yet to begin, the returns to scale become constant.
The diseconomies arise mainly because of decreasing efficiency of management and scarcity of certain
inputs.
The constant returns to scale are said to occur also in productive activities in which factors of pro-
duction are perfectly divisible. When the factors of production are perfectly divisible, the production
function is homogenous of degree 1 like Cobb–Douglas production function (discussed below).
The Law of Decreasing Returns to Scale

When output increases less than proportionately to increase in inputs, K and L, and the rate of rise in
output goes on decreasing it is called decreasing returns to scale. Decreasing returns to scale are illustrated
in Figure 12.11. As the figure shows, when inputs, K and L, are doubled, i.e., inputs are increased from
1K + 1L to 2K + 2L, the output increases from 10 to 18 units, i.e., 80 per cent increase, which is less than
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256 Chapter 12
K
B
4K
3K
Capital (K)
b
2K
Q3 = 40
a
1K Q2 = 18
Q1 = 10
O 1L 2L 3L 4L L
Labour (L)
Figure 12.11 Decreasing Returns to Scale
the proportionate increase in inputs. The movement from point b to c indicates a 50 per cent increase in
the inputs. But, the output increases only by 33.3 per cent. This shows decreasing returns to scale.
Causes of Diminishing Returns to Scale Decreasing returns to scale are caused by the
diseconomies of scale.6 The most important factor causing diminishing returns to scale is ‘the diminishing
return to management’, i.e., due to managerial diseconomies. As the size of the firm expands, managerial
efficiency decreases causing decrease in the rate of increase in output.
Another factor responsible for diminishing returns to scale is the limitedness or exhaustibility of the
natural resources. For example, doubling the size of coal-mining plant may not double the coal output
because of limitedness of coal deposits or difficult accessibility to coal deposits. Similarly, doubling the
fishing fleet may not double the fish output because the availability of fish may decrease when fishing is
carried out on an increasing scale.
PRODUCTION FUNCTION AND RETURNS TO SCALE

The laws of returns to scale may be explained more precisely through a production function. Let us
assume a production function involving only two variable inputs, K and L, and one commodity. The
production function may thus be expressed as
Q = f ( K , L) (12.5)
Let us also assume a Cobb–Douglas type of production function homogenous of degree 1. A produc-
tion function is said to be homogenous of degree 1 when all the inputs are increased in the same propor-
tion and this proportion can be factored out. And, if all the inputs are increased in a certain proportion
(say k) and the output increases in the same proportion (k), then the production function is said to be
M12_DWIV9400_02_SE_C12.indd 256 07/07/11 1:37 AM

homogenous of degree 1. This is also known as ‘linear homogenous production function.’ A homogeneous
production of degree 1 may be expressed as:
kQ = f ( kK , kL)
kQ = k ( K , L) (12.6)
A linear homogenous production function implies constant returns to scale. As production function
(12.6) shows, when K and L are increased by a factor k, output also increases by factor k. The production
function (12.6) can, however, be used with some modification to illustrate other laws of returns to scale.
As we know, it is quite likely that if all the inputs are increased by a certain proportion, say, by k, output
may not increase in the same proportion. The production function may then be written as
hQ = f ( kK , kL) (12.7)
where h denotes the h-times increase in Q as a result of k-times increase in the inputs, K and L.
In production function (12.7), the factor h may be greater than, equal to or less than k. Accordingly,
it shows the three laws of returns to scale.
1. If h = k, the production function reveals constant returns to scale.
2. If h > k, the production function reveals increasing returns to scale.
3. If h < k, production function reveals decreasing returns to scale.
Cobb–Douglas Production Function 7 and Returns to Scale

We have used above a simple Cobb–Douglas type of linear homogenous production function to illustrate
the laws of returns to scale. We will now use Cobb–Douglas production function to illustrate the laws of
returns to scale. The Cobb–Douglas production function is given as
Q = AK α Lβ (12.8)
where parameters A is a constant and α and β are positive exponents and β = 1 − α.

It is important to note here that exponent α gives the elasticity of output with respect to capital (i.e.,
change in output for one per cent change in capital) and also the relative share of capital in the output.
Similarly, exponent β gives the elasticity of output with respect to labour (i.e., change in output for one per
cent change in labour) and also its relative share in output.
Let us now illustrate the application of Cobb–Douglas production function for deriving the laws
of returns to scale. Given the production function in Eq. (12.8), if inputs, K and L, are multiplied by a
factor k, then Eq. (12.8) can be written as
hQ = A( kK )α ( kL)β
By factoring out k, as common factor, we get
hQ = Ak α k β ( K α Lβ )
= Ak α+β ( K α Lβ )
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258 Chapter 12
or
hQ = k α+β ( AK α Lβ ) (12.9)
Equation (12.9) gives the rules for the laws of returns to scale. Note that in Eq. (12.9), factor h = kα+β.
From this relationship, one can derive the rules for the laws of returns to scale as follows.
1. If α + β > 1, h > k, the production function gives increasing returns to scale.
2. If α + β = 1, h = k, the production function gives constant returns to scale.
3. If α + β < 1, h < k, the production function gives decreasing returns to scale.
For example, suppose a Cobb–Douglas production function is given as
Q = AK 0.40 L0.75
In this production function, the exponent α = 0.40 and exponent β = 0.75. The sum of exponents
(α + β) = 0.40 + 0.75 = 1.15. Since (α + β) > 1, this production function shows increasing returns to scale.
Likewise, in a production function Q = AK0.25 L0.50, the sum of exponents (α + β) = 0.25 + 0.50 = 0.75.
Since (α + β) < 1, this production function shows decreasing returns to scale.
Similarly, if production function takes the form as Q = AK0.50 L0.50, the sum of exponents (α + β) = 1.
Therefore, this production function gives constant return to scale.
It is important to note here that Douglas8 found in his empirical study of the US manufacturing
industries that, in most cases, (α + β) = 1. However, the Cobb–Douglas finding that (α + β) = 1 may not
hold in all kinds of productive activities and in all countries. It is quite likely that in some industries,
α + β > 1 and in some α + β < 1. If α + β > 1, Cobb–Douglas production function is homogenous of
degree greater than one and it exhibits increasing returns to scale. And, in case α + β < 1, the Cobb–
Douglas production function is homogenous of degree less than one and it exhibits decreasing returns
to scale.
LAWS OF VARIABLE PROPORTIONS AND RETURNS

TO SCALE COMPARED
In this section, we compare the laws of variable proportions and the laws of returns to scale and illustrate
these laws with the help of isoquants.
The basic difference between the laws of returns to a variable factor and the laws of returns to scale
lies in the assumptions on which these laws are based.
1. In case of the laws of returns to a variable factor, only one input is variable—all other inputs
remaining constant—whereas in case of the laws of returns to scale, all the inputs are variable.
2. The laws of returns to a variable factor is a short run phenomenon because supply of capital in
the short run is inelastic. On the contrary, the laws of returns to scale are a long run phenom-
enon because supply of all the inputs in the long run is elastic and more and more of all the
inputs can be employed. In the analysis of the input–output relationship, therefore, in case of
the law of returns to a variable factor a single-variable production function is used whereas in
case of the laws of returns to scale a two-variable production function is used.
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C
3
B
300
2
Capital (K)
F A
J
1 F´
K 200
175
150
100
O
1 2 3 4 5
Labour (L)
Figure 12.12 Laws of Diminishing Returns and Returns to Scale Compared
Graphic Comparison
The laws of returns to scale and the laws of variable proportions are compared in Figure 12.12. The
figure presents a comparative analysis of the law of constant returns to scale and diminishing returns to
a variable factor (labour). The line OS shows proportionate increase in both labour and capital. This line
read in combination with isoquants reveals constant returns to scale. Similarly, line FF′ shows capital
held constant at one unit (or OF) and variation in the quantity of labour used. The line FF′ read with
isoquants, reveals diminishing returns to the variable factor (labour). Remember that when quantity of
labour increases, capital held constant, capital-labour ratios (i.e., factor proportions) vary all along the
line FF′.
The constant returns to scale and diminishing returns to variable input (labour) are illustrated in the
following Table 12.4.
The left half of the table shows constant returns to scale. The movement from point A to B shows an
addition of 1K + 1L to the quantity of inputs, capital and labour. As a result output increases by 100 units.
Table 12.4
Constant Returns to Scale Diminishing Returns to Variable Factors
Movements ∆K + ∆L ∆Q Movements ∆L ∆Q
A→B 1K + 1L 100 A→J 1 50
B→C 1K + 1L 150 J→K 1 25
A→C 2K + 2L 200 K→L 1 15
Note: The point L is not given in the table. If an isoquant is drawn between isoquant 175 and isoquant 200, the
point L will fall in between on the line AF.
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260 Chapter 12
And movement from point B to C indicates the same (1K + 1L) addition to the inputs and the same
(100 units) rise in output. This means constant returns to scale. The constant returns to scale can also be
shown in another way. At point A, total input combinations is 1K + 1L. This input combination yields
an output of 100 units. When we move from point A to B, input combination increase from 1K + 1L
to 2K + 2L. It means doubling the inputs. When inputs are doubled, output is also doubled—from 100
to 200 units. A movement from point B to C means a 50 per cent increase in inputs and a 50 per cent
increase in output. This also shows constant returns to scale.
The right half of the table shows diminishing returns to the variable factor, labour. The movement
each from point A to J, from J to K and from K to L, shows subsequent use of one additional unit of
labour, capital remaining constant. Each subsequent addition of one unit of labour contributes diminish-
ing units of output. This shows diminishing returns to variable proportion. The first labour produces 100
units, the second one produces 150–100 = 50 units, and the third produces only 175 − 150 = 25 units.
This input–output relationship shows diminishing returns to the variable factor (labour).
Are the Laws of Returns Compatible?

It can be concluded from the above description that constant returns to scale and diminishing returns to
variable proportions are compatible with each other. It can be similarly shown that the law of diminish-
ing returns is compatible with the laws of increasing and decreasing returns to scale. The reason is, while
the law of diminishing returns is a short-run phenomenon, the laws of returns to scale are long-run phe-
nomenon. In the short run increasing production is feasible only by way of increasing the variable factors
because other factor (capital) is available in a fixed supply. In the long run, however, the supply of all the
inputs becomes elastic. Therefore, more and more of all the inputs can be used to increase the production.
In fact, the two kinds of laws operate on different time scales. There is, therefore, no conflict between the
two kinds of laws of production. Both kinds of laws can be presented on the same scales of a diagram.
Can the Two Kinds of Laws Operate Simultaneously?

If time distinction is eliminated or if it is possible, by assumption, to increase output either by increasing
only one input or by employing more of both the inputs, then compatibility of the law of diminishing
returns and the law of returns to scale depends on the nature of production function. If production func-
tion is such that labour and capital are treated as perfect substitutes in the production process, then these
laws will be compatible. But, if they are not perfect substitutes for one another, then these laws will not be
compatible. In other words, if some of the inputs are subject to diminishing returns, then the two kinds
of laws would not be compatible. They would be compatible, only if productivity of one of the inputs is
so high, that it compensates or more than compensates the decreasing productivity of the other input(s).
APPENDIX
Properties of Cobb–Douglas Production Function
The Cobb–Douglas production function has the following very useful properties.
First, Cobb–Douglas production function reveals that average and marginal products of labour and
capital depends on their ratio in the production function. For a proof, look at the computation of the mar-
ginal products of capital and labour. Given the production function as
M12_DWIV9400_02_SE_C12.indd 260 07/07/11 1:37 AM

Q = AK α Lβ ,
∂Q
MPK = = α AK α −1 Lβ
∂K
Since β = 1– α,
K α −1
MPK = α AK α −1 L1−α = α A
Lα −1
Therefore,
α −1
⎛K⎞
MPK = α A ⎜ ⎟ (A.1)
⎝ L⎠
Eq. (A.1) shows that MPK depends on the capital–labour ratio or the factor proportion, not on the
absolute quantity of capital.
It can be similarly shown that marginal product of labour (MPL) depends on the labour–capital ratio.
Given the production function Q = ΔKα Lβ,
∂Q
MPL = = AK L −1
∂L
Since α = 1 − β, by substituting 1 − β for α,
K 1−β
MPL = β AK 1−β Lβ −1 = β A
L1−β
Therefore,
1−β
⎛K⎞
MPL = β A ⎜ ⎟
⎝ L⎠
Thus, MPL also depends on the capital–labour ratio or on the factor proportion, not on the absolute
quantity of labour.
Secondly, the multiplicative form of the production function, Q = AKαLβ, can be converted into its log
linear form as given below.
log Q = log A + α log K + β log L
In its logarithmic form, Cobb–Douglas production function becomes simple to handle and can be
easily estimated using linear regression analysis.
Thirdly, this function is a homogenous function and the degree of its homogenity is determined by
the sum of the exponents, α and β. As already mentioned, if α + β = 1, the function is homogenous of
degree 1 which implies constant returns to scale.
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262 Chapter 12
Fourthly, exponents α and β represent the elasticity coefficients of output for inputs, K and L,
respectively. The output elasticity coefficients (∈) in respect of capital may be defined as a proportional
change in output as a result of a given change in capital (K), labour (L) remaining constant. Thus,
∂Q ∂K ∂Q . K
εK = = (A.2)
Q K ∂K Q
By differentiating the production function Q = A Kα Lβ, with respect to K, we get
∂Q
= α AK α −1 Lβ
∂K
By substituting the values for Q and ∂Q /∂K in Eq. (A.2), we get
⎛ K ⎞
ε K = α AK α −1 Lβ ⎜ ⎟=α
⎝ AK α Lβ ⎠
Thus, output-elasticity coefficient for K is ‘α’. The same procedure may be adopted to show that β is
elasticity coefficient of output for L.
Fifthly, exponents α and β represents the relative distributive share of inputs K and L. The share of K
in Q is given by
∂Q
K
∂K
and the share of L by
∂Q
L
∂L
The relative share of K can be obtained as
∂Q . ⎛ 1 ⎞ α AK α −1 Lβ K
K⎜ ⎟= =α
∂K ⎝Q ⎠ AK α Lβ
Similarly, it can be shown that β represents the relative share of L in the total output.
Finally, Cobb–Douglas production function in its general form, Q = AKαLβ indicates that at zero cost,
there will be zero production.

1. How will you distinguish production with one variable input from production with two vari-
able inputs? Does the difference between the two techniques of production make any difference
in the laws of production?
2. What is the difference between short run and long run from (i) a single producer’s point of view
and (ii) all producers’ point of view, planning to expand the scale of their production?
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3. What is an isoquant? What are the properties of isoquants? Illustrate your answer with appro-
priate diagrams.
4. What is meant by marginal rate of technical substitution (MRTS)? Assuming a convex isoquant,
show that MRTS = MPL/MPK. Under what condition does MRTS decrease along an isoquant?
What is the rate of change in MRTS when two inputs are perfect substitutes?
5. What is meant by economic region on the production plane? Illustrate graphically the determi-
nation of economic region assuming that two inputs are imperfect substitutes.
6. Under what conditions are the isoquants convex to origin? Suppose two isoquants intersect,
how does this violate the laws of production?
7. Suppose there are some commodities which can be produced with only labour, with only capi-
tal or with a combination of both labour and capital, draw an isoquant for this kind of produc-
tive activity. How does MRTS behave?
8. Explain the following and illustrate graphically.
(a) Economic region;
(b) Constant elasticity of substitution;
(c) L-Shaped isoquants;
(d) Perfect substitutability and
(e) Perfect complementary.
9. In case of a convex isoquant, how does MRTS behave?
(a) It decreases at decreasing rate;
(b) It decreases at increasing rate;
(c) It neither increases nor decreases; or
(d) It increases along the isoquant.
10. When MRTS = 1, which of the following conditions holds?
(a) MPL/MPK =2;
(b) MPL/MPK >1;
(c) MPL/MPK = 1; or
(d) MPL/MPK < 1?
11. The elasticity of technical substitution is measured by which of the following formulae?
(a) (ΔK/ΔL)/(K/L);
(b) Δ(K/L)/MRTS;
(c) [Δ(K/L)/(K/L)]/[ΔMRTS/MRTS]; or
(d) [(ΔK/ΔL)/(K/L)/ΔMRTS.
12. Suppose a chartered bus company needs one driver, one conductor and one mechanic (i.e., in all
three labour) and a 50-seat bus to ferry 50 passengers between Delhi and Mathura per unit of
time. What kind of isoquants will the transport company have? Suppose the number of workers
increases by 33 per cent, what will be the increase in the number of passengers transported?
13. Define and explain the concept of elasticity of technical substitution. Show graphically that
the elasticity of technical substitution is different on any two points on an isoquant. Why does
elasticity of technical substitution change along the isoquant?
14. How are the laws of returns to scale different from the laws of variable proportions? What are
the factors that cause increasing and decreasing returns to scale?
15. What is a linear homogenous production function? What kind of returns to scale is indicated by
a linear homogenous production function? Prove your answer by using a production function.
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264 Chapter 12
16. Suppose a production function is given as Q = f (K, L). When inputs K and L are increased by
factor k, production function reads as follows.
hQ = f ( kK , kL)
What kind of returns to scale does the production function reveals if (a) h = k, (b) h > k, and (c)
h < k?
17. Suppose two production functions are given as follows.
(a) Q = 0.5 K L, and
(b) Q = 2K + 5L
Do these production functions exhibit increasing, constant or diminishing returns to scale?
18. Suppose a production function is given as Q = f (K, L). When inputs K and L are doubled and
production function reads as follows.
hQ = f ( 2 K , 2 L)
What condition must be fulfilled for the production function to show constant returns to scale?
19. Using Cobb–Douglas production function, show the conditions for:
(a) increasing returns to scale,
(b) constant returns to scale, and
(c) diminishing returns to scale.
20. Suppose given the Cobb–Douglas production function,
Q = AKαLβ,
inputs K and L are increased by a factor k. Show the conditions under which Cobb–Douglas pro-
duction function shows (a) increasing, (b) constant and (c) diminishing returns to scale.
21. Suppose production function for Maruti Udyog Ltd, has been estimated as QM = 100 K0.25 L0.75
and for Tata Automobiles it is Q1 = 50 K0.25 L0.80 where Q = number of cars produced per day,
K = units of capital, L = units of labour. Suppose also that both the companies are using capital
and labour in the same proportion, find the following.
(a) Which of the companies is operating under law of returns to scale?
(b) Which of the companies has a greater marginal productivity of labour?
22. Using Cobb–Douglas production function in its general form, show that
(a) MPK = αA(K/L)α–1, and
(b) MPL = βA(K/L)1–β
ENDNOTES
1. The concept of ‘economic region’ is discussed below in detail.
2. The concept of marginal rate of technical substitution is discussed in detail in the forthcoming
section.
3. See also Walter Nicholson, op. cit., 144 fn.
4. Koutsoyiannis, A., Modern Microeconomics, 2nd Edn, p. 74
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5. The ‘economies and diseconomies of scale’ are discussed in detail in Chapter 14.
6. Diseconomies of scale are discussed in detail in Chapter 14.
7. The production function widely known as Cobb–Douglas production function was first devel-
oped by Paul H. Douglas in his book The Theory of Wages (New York, NY: Macmillan, 1924).
It was improved further by Charles W. Cobb and Paul H. Douglas in their paper ‘A Theory of
Production’, Am. Eco. Rev., March 1928 (Suppl.) and was used by Paul H. Douglas, 20 years
later, in his paper ‘Are There Laws of Production’, Am. Eco. Rev., March 1948. For properties of
Cobb–Douglas production function, see Appendix to this chapter.
8. In his paper ‘Are There Laws of Production?’ (op. cit.), Douglas used Cobb–Douglas production
function for US manufacturing in 1948, based on both time-series and cross-section data and
estimated labour-elasticity (β) of output at 0.73 and capital-elasticity of output at 0.25. This
makes β + α ≅ 1.
FURTHER READINGS
Baumol, W.J. (1985), Economic Theory and Operations Analysis (New Delhi: Prentice Hall of India), 4th
Edn., Chapter 11.
Besanko, D.A. and Braeutigam, R.R. (2002), Microeconomics: An Integrated Approach (New York, NY:
John Wiley & Sons, Inc.), Chapter 6.
Cassels, J. (1946), ‘On the Law of Variable Proportions’, in Readings in Theory of Income Distribution,
American Economic Association.
Douglas, P.H. (1948), ‘Are There Laws of Production?’, American Economic Review, 38 (March): 1–41.
Gould, J.P. and Lazear, E.P. (1993), Microeconomics: Theory and Applications (Homewood, IL: Richard
D. Irwin), 6th Edn., Chapters 6 and 7.
Hicks, J.R. (1946), Value and Capital (Oxford: Oxford University Press), 2nd Edn.
Perloff, J.M. (2001), Microeconomics (New York, NY: Addison Wesley), 2nd Edn., Chapter 6.
Robinson, J. (1955), ‘The Production Function’, Economic Journal, 39–51.
Salvatore, D. (2003), Microeconomics: Theory and Applications (New York, NY: Oxford University Press),
4th Edn., Chapter 7.
Tangri, O.P. (1966), ‘Omissions in the Treatment of the Laws of Variable Proportions’, American Economic
Review, 56 (June): 484–492, reprinted in Readings in Microeconomics, W.L. Breit, H.M. Hochman
(ed), American Economic Association.
M12_DWIV9400_02_SE_C12.indd 265 07/07/11 1:38 AM

Chapter 13
Optimum Combination of
Inputs
CHAPTER OBJECTIVES
The explanation and the illustration of the laws of production in the previous chapter is based on the
assumptions that a firm has unlimited resources and it is free to choose any technique of production.
In reality, however, that is not the case. The firms have limited resources and total cost varies from
technology to technology. So, the firm cannot afford any technique of production. A cost-minimizing
firm has to find a technique that matches with its investible resources. The basic objective of this
chapter is to explain the process by which a firm can find the most suitable technique of production
with optimum combination of inputs, given their resources and input prices. By going through this
chapter, you learn:
The meaning of optimum combination of inputs;
How resource limitations determine a firm’s options for choice of technology—the most affordable
input combination;
What is the meaning of isocost and how it is derived;
What are the conditions for the least cost combination of inputs for a cost-minimizing firm;
How change in a firm’s resources and input prices changes its options for the choice of techno-
logy; and
How a firm finds the optimum combination of inputs.
INTRODUCTION
A profit maximizing firm has to minimize its cost for a given output or to maximize the output from a
given total cost. An isoquant shows the technological possibilities—it shows that a given output can be
produced with different input combinations. But all inputs combinations do not conform to the cost-
minimization objective. Our discussion on the theory of production so far does not provide any rule or
criterion for cost minimization. In this chapter, we show how a firm finds the least cost combination of
inputs for a given output and how it can maximize the output given the costs. In other words, we also
show how a firm makes the choice of technology that maximizes its output from a given cost.
M13_DWIV9400_02_SE_C13.indd 266 06/07/11 12:32 AM

Optimum Combination of Inputs 267
K3 A
Capital (K)
K2 B
C Q2 = 200
K1
Q1 = 100
O L1 L2 L3
Labour (L)
Figure 13.1 Input Combinations
To clarify the issue here, let us consider the information contained in Figure 13.1. As the figure shows,
100 units of a commodity X can be produced with all the combinations of K and L that can be formed
on the isoquant Q1. For example, points A, B and C represent three different combinations of K and L:
(i) OK3 + OL1, (ii) OK2 + OL2 and (iii) OK1 + OL3. All these input combinations can produce 100 units
of X. Similarly, all other combinations of capital and labour that can be formed on the isoquant Q1 can
be used to produce 100 units of commodity X. Therefore, any of these combinations may be chosen for
producing 100 units of X. But, given the input prices—price of capital (PK) and price of labour (PL)—the
total cost of production varies from point to point, and only one of the combinations gives the minimum
cost, not necessarily at any of points A, B and C. The problem now, is how to find the input combina-
tion that gives the minimum cost of production. The least cost combination of inputs can be determined
by combining the firm’s production and cost functions. We know that the firm’s production function is
represented by its isoquants. What we need here is to derive the firm’s cost function and find possible
input combinations with a given cost.
DERIVATION OF ISOCOST
In order to construct a cost function, let us assume that a firm has a limited money to spend as its total
cost, C, on both K and L and that price of capital (PK) and price of labour (PL) are given. Given these
conditions, the firm’s cost function may be expressed as
C = K × PK + L × PL (13.1)
From Eq. (13.1), the quantity of capital, K, and of labour, L, that can be hired out of the total cost, C,
can be obtained as follows:
C PL
K= − L
PK PK (13.2)
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268 Chapter 13
K3
K2
Capital (K)
K1
∆K
∆L
O L1 L2 L3
Labour (L)
Figure 13.2 Isocosts
and
C PK
L= − K
PL PL (13.3)
Equations (13.2) and (13.3) yield a line which represents the alternative combination of K and L that can
be hired from the given total cost, C. This curve is known as isocost. The isocost is also known as the budget
line, or the budget constraint line. If numerical value of C, PK and PL are known, one can work out a series
of K and L that can be hired. By graphing the series, the isocost line can be drawn as shown in Figure 13.2.
There is another and a simpler way of deriving the isocost line. Consider, e.g., the isocost K1L1
given in Figure 13.2. This isocost is drawn on the assumption that a firm has the option of spending
its total cost (C) either on K or on L, or on both. If total resources are spent on K, and no amount on L,
then the firm can buy OK1 units of K and no units of L, as shown in the following equation similar to
Eq. (13.2),
C PL
OK1 = − L
PK PK
where L = 0.
Similarly, if the firm spends total C on L, it can buy OL1 units of L with K = 0, as shown below.
C PK
OL1 = − K
PL PL
where K = 0.
M13_DWIV9400_02_SE_C13.indd 268 06/07/11 12:32 AM

The total quantity of capital OK1 (where L = 0) is marked at point K1 in Figure 13.2 and the total
quantity of labour, OL1 (where K = 0), is marked at point L1. By joining point K1 and L1 by a line, we get
the isocost line. The line K1L1 is the isocost line. It shows the whole range of combinations of K and L that
can be hired, given the total cost and factor prices.
Given the factor prices, if the total cost increases, the larger quantities of both K and L can be hired,
making the isocosts shift upwards to the right, as shown by K2L2 and K3L3. Similarly, given the total cost,
if the factor prices decrease proportionately, the isocost line will shift upward.
It is important to note here that the slope of the isocosts (i.e., −ΔK/ΔL) gives the marginal rate of
exchange (MRE) between K and L, more importantly, the factor price ratio (PL/PK). Since factor prices are
constant, MRE between the inputs is constant and equal to the average rate of exchange all along the line.
THE LEAST COST CRITERIA OF OPTIMUM INPUT

COMBINATION
There are two criteria, called first order and second order criteria, that must be fulfilled for the least
cost combination of inputs. The first order criterion or the necessary condition for the least cost input
combination can be expressed in both physical and value terms. Given the two inputs—K (capital) and
L (labour)—the first order criterion in physical terms can be stated as MRE between K and L must be
equal to the ratio of their marginal productivity, i.e.,
∆K MPL
=
∆L MPK (13.4)
where ΔK/ΔL is the exchange ratio between K (capital) and L (labour) at market price and MPL/MPK is
the ratio of marginal productivity of L and K.
Equation (13.4) means that an input combination at which the factor exchange ratio (given factor
prices) equals the marginal productivity ratio of inputs are equal gives the least cost input combination.
This is the first order criterion.
The first order criterion for the least cost or optimal input combination may be expressed also in terms
of factor prices—PL and PK.
MPL PL MPL MPK
= or =
MPK PK PL PK (13.5)
where PL and PK are prices of labour and capital, respectively.
Note that in Eq. (13.4) ΔK/ΔL = the slope of the isocost, and MPK/MPL = the slope of the isoquant. It
means that the least cost combination of inputs is given by the point where the slope of the isoquant is
equal to the slope of the isocost. The least cost combination of K and L is shown in Figure 13.3. Suppose,
given the firm’s total resources, its isocost line is given by K2L2. The isoquant Q2 = 200 is tangent to isocost
K2L2 at point P. At this point, the combination of K and L is given as OM of K plus ON of L.
This combination of K and L is optimal because it satisfies the first order condition of the least cost
criterion. That is, at point P,
MPK ∆L MPL ∆K
=− or =−
MPL ∆K MPK ∆L
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270 Chapter 13
K2
K1
M P
B Q2 = 200
Q1 = 100
D
O N L1 L2
Labour (L)
Figure 13.3 The Least Cost Input Combination
Thus, the first order or the necessary condition for the least cost combination of inputs is satisfied at
point P, the point of tangency between the isoquant Q2 and the isocost K2L2.
The second order condition is that the first order condition must be fulfilled at the highest possible
isoquant. Otherwise, the cost will not be minimum. Note that in Figure 13.3, the first order condition
of the least cost combination of inputs is also satisfied at points A and D—the points of intersection
between the isoquant Q1 = 100 and the isocost K2L2. Therefore, at points A and D also, MPK/MPL = −ΔL/
ΔK and hence the first order condition is satisfied. But points A and D satisfy the first order condition at
a lower output of 100 units. Note that while point P is associated with output Q2 = 200, points A and D,
being on a lower isoquant, are associated with a lower output of 100 units. It means that, given the total
cost, a firm can produce 100 units as well as 200 units. Note also that 100 units can be produced at
point B. Point B falls on a lower isocost, K1L1 indicating a lower cost of production. Therefore, a cost-
minimizing firm will not opt for input combinations at point A or D. Thus, point P satisfies both the
first order and the second order condition. Point P is, therefore, the point of optimum combination of
inputs.
Criterion in Value Terms

Physical criterion can be converted into value terms by multiplying the factor exchange ratios with factor
prices and MRTS with product price (P), as shown below.
By multiplying the factor ratio, we get MRE in value terms as
∆K . PK
=1
∆L . PL
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It means that ΔK . PK = ΔL . PL. It implies that ΔK/ΔL = PL/PK. Similarly, MRTS can be converted in
value terms as follows. We know that
MPL
MRTS =
MPK
By multiplying MPL/MPK by the product price (P), we get the marginal revenue productivity (MRP) ratio.
Thus,
( MPL ) P MRPL
=
( MPK ) P MRPK (13.6)
where MRP = marginal revenue productivity of the factor and P = product price.
Since, in a competitive market, MRPL = PL and MRPK = PK the least cost criterion given in Eq. (13.6)
can be put in terms of input and output ratio as:
PL MRPL
=
PK MRPK
or
MRPL MRPK
=
PL PK (13.7)
It may be inferred from Eq. (13.7) that the least cost or optimal input combination requires that the
MRP ratios of inputs must be equal to their price ratios.
CHOICE OF OPTIMAL EXPANSION PATH

In the long run, all inputs are variable. If there is no resource constraint on the expansion of the output,
the firms can employ more of both capital and labour and expand their scale of production. But a profit
maximizing firm would employ capital and labour in a proportion that is economically most efficient.
This is called optimum factor proportion which is essentially the same as the least cost input combina-
tion. Given the production function and input prices, the optimal factor proportion is determined by the
point of tangency between the isocost and isoquant. In other words, the optimality of factor proportion
requires that the factor price ratio (PK/PL) must be equal to MRTS. The expansion of input and output
through the points of optimal factor proportions gives the optimal expansion path.
The optimal path of expansion is shown in Figure 13.4 under homogeneous and non-homogeneous
production functions. If the production function is homogeneous of degree 1, the expansion path is a
straight line (OB) from the origin, as shown in Figure 13.4(a).
The line OB is obtained by joining the tangential points J, K and L, each of which represents the
optimal factor combination for a given level of output. Points J, K and L represent equilibrium points at
different levels of output. Note that all along the expansion path line MRTS is constant.
If production function is non-homogeneous or of a general form, the expansion path is represented
by a curve as shown by the curve OD in Figure 13.4(b). The expansion path represents the equilibrium
path of output expansion.
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272 Chapter 13
(a) Homogeneous (b) Non-homogeneous

production function production function
Optimal path Optimal path

of expansion of expansion
B
D
Capital (K)
Capital (K)
L
R
K
L
J
K
J
O O
Labour (L) Labour (L)
Figure 13.4 Optimal Expansion Paths
EFFECTS OF CHANGE IN INPUT PRICES

We have shown in the preceding section, the path of expansion assuming increase in total investment
and input prices to remain constant. In this section, we show the effects of change in input prices, assum-
ing total expenditure on inputs to remain constant.
Change in Input Prices and Isocosts

When input prices change, then the slope and position of the isocosts changes. The change in the input
prices may be of varied nature. Some kinds of change in input prices and their effect on isocosts are
shown in Figure 13.5. To begin with, let us suppose that the firm’s resources and input prices are given
and the firm’s isocost is given by the line KL. Let us now assume change in input prices and see its effect
on the isocost.
1. If the price of capital increases (price of labour remaining constant) so that the firm can buy
only OJ of capital, then the isocost rotates anticlockwise to the position of JL and its slope
changes from OK/OL to OJ/OL. Note that OK/OL > OJ/OL.
2. If the price of labour decreases and the price of capital remains constant, the isocost KL rotates
anticlockwise to KN and its slope changes from OK/OL to OK/ON.
3. If the price of capital increases and that of labour decreases, then the isocost shifts to a position
shown by the line JN, its slope being different from that of KL.
4. If the prices of both capital and labour decreases, but capital price decreases at a higher rate,
then the isocost is TM which has a slope different from KL.
5. If price of both capital and labour decreases in the same proportion, then isocost makes a par-
allel upward shift to the position shown by the line TN—it has the same slope as the original
isocost KL.
M13_DWIV9400_02_SE_C13.indd 272 06/07/11 12:32 AM

K
Capital (K)
O L M N
Labour (L)
Figure 13.5 Change in Input Prices and Isocost
Change in Input Prices and Expansion Path

The change in input prices changes the firm’s path of expansion in two ways: (i) change in the rela-
tive price of inputs causes substitution effect which changes the direction of expansion path and
(ii) change in input prices affects the resource position of the firm which shifts the firm’s isocost line
up or down.
If input prices change proportionately and in the same direction, it has the same effect on the resources
of the firms. Its effect on the expansion path is similar to the one shown in Figure 12.5. Here, we illus-
trate the effect of change in relative prices of inputs on the expansion path. Note that if the input prices
change disproportionately in the same direction as shown by shift in the budget line from KL to TM in
Figure 13.5, then the direction of the expansion path changes.
Change in Relative Price of Inputs

If the input prices change in different proportions and different directions, they change the relative prices
of inputs—some factors become cheaper and some costlier. A cost-minimizing firm substitutes the
cheaper inputs for the costlier ones, except where substitution effect of change in input prices is negative.
The effect of fall in labour price (price of capital remaining constant) on the isocosts and expansion
path is shown in Figure 13.6(a). Given the input prices and firm’s resources, isocost is given by KL.
Now, let the price of labour fall (all other things remaining the same) so that the isocost KL shifts to the
position of KM and the least cost equilibrium point shifts from A to B. This shift implies that the firm
substitutes DB of labour for AD of capital. If labour price falls further, isocost shifts to KN and the least
cost point shifts from B to C. The movement from point A to C shows the path of expansion due to fall
in labour price. The movement along the expansion path shows that the firm expands its production by
using more and more of labour and less and less of capital. In other words, the firm substitutes labour
for capital due to fall in labour price. This change in input combination is called factor price effect. It is
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274 Chapter 13
(a) (b)
T
K
Expansion
path Expansion
K path
Capital (K)
Capital (K)
A R
B J
C
D Q
O L M N O L
Labour (L) Labour (L)
Figure 13.6 Changes in Input Prices and Expansion Path
important to note here that substitution effect may not always be in the form of substitution of labour for
capital. It is quite likely that the quantity of capital may remain constant or may even increase with fall
in labour price. This is resource effect.
Exactly the same logic holds when the price of capital falls, all other things remaining the same. The
effect of fall in capital price on the isocost and expansion path is shown in Figure 13.6(b). As the price
of capital falls, isocosts line moves from JL to LK and then to TL. Subsequently, the least cost point shifts
from P to Q and then to R. The curve passing through these points marks the path of expansion. The end
result is that the firm increases its stock of capital and reduces employment of labour because capital has
become relatively cheaper. But, there is technical limit to substitution of capital for labour. Beyond this
point, employment of labour increases with increase in capital.
SUBSTITUTION AND RESOURCE EFFECTS OF CHANGE IN

INPUT PRICES
In the preceding section, we have discussed the price effect of change in the relative price of inputs. There
are, however, two effects of change in relative prices of inputs, viz., resource effect or budget effect and
substitution effect. In this section, we illustrate the substitution and resource effects of a fall in the price
of one input on a firm’s choice of input combination.
In order to explain the effect of change in factor prices on the input combination, we assume
1. PK and PL are given or, in other words, r and w are constant;
2. the total resources are indicated by isocosts KL (see Figure 13.7) and
3. the firm’s initial input combination is OK2 of K and OL1 of L, at point E on isoquant Q1.
Given the initial conditions, let PL decrease, while PK remains constant, so that the relevant isocost is
KW. The isocost KW is tangent to isoquant Q2 at point N. At this point, the firm’s new least cost com-
bination of inputs is OK1 + OL3. Thus, as a result of decrease in PL, the firm reduces its K by K1K2 and
increases L by L1L3. This change in input combination is the result of factor price effect. The factor price
M13_DWIV9400_02_SE_C13.indd 274 06/07/11 12:32 AM

K´
K
M
K3
Capital (K)
K2 E
N
K1 P T
Q2
Q1
O L1 L2 L L3 L´ W
Labour (L)
Figure 13.7 Substitution Effect and Input Combination
effect is indicated by movement from point E to N. Note that when PL decreases, the firm reduces its K
by K1K2 = EP and adds L1L3 = PN to its labour input. Note also that PN of L is much more than EP of K
and is required to substitute output remaining the same. It means that the total PN(=L1L3) is greater than
the substitution effect. The difference is budget effect.
To find the budget effect, let us find out how much additional labour will the firm employ, if its
resources increase so that the firm reaches the isoquant Q2, inputs prices remaining the same. This can
be done by drawing an isocost parallel to KL and a tangent to Q2, as shown by isocost K′L′. The isocost
K′L′ is tangent to isoquant Q2 at point M. It means that if PK and PL remain constant and firm’s resources
increase, it will settle at point M where its input combination will be OK3 of K and OL2 of L. The change in
labour employment, L1L2, is called budget effect or resource effect. If we deduct the budget effect on labour
employment from the price effect, we get the substitution effect, as given below.
Substitution effect = Price effect − Budget effect
Because price effect = L1L3, and budget effect = L1L2
Substitution effect = L1L3 − L1L2 = L2L3.
Thus, we find that as a result of change in price of one input, input combination of the firm changes:
the firm employs more of the cheaper input and less of the costlier one. Besides, the level of output
also changes. If the price of an input decreases, the level of output increases, and vice versa. It is also
noteworthy that the total effect of change in input price has two components: (i) substitution effect and
(ii) budget effect.
This concludes our brief discussion on the traditional production theory, production function,
laws of variable proportions, law of returns to scale and the choice of least cost input combination.
These aspects have been explained in physical term, i.e., in terms of physical quantities of input and
output. In the next chapter, we shall discuss the theory of cost.
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276 Chapter 13

1. What are the isocost lines? What is the difference between isocosts and isoquants?
2. What is a firm’s expansion path? Under what conditions would it be a straight line?
3. What is meant by optimum input combination? State the conditions under which a firm can
minimize the cost for a given level of production.
4. What are the conditions for least cost combination of inputs? Show the maximization of output
with the help of isocosts and isoquants at a given total cost.
5. Use isoproduct and isocost curves to explain how a producer minimizes his cost of production
for a given level of output.
6. Show the effect of change in input prices on the isocost curve. How is the least cost combination
of inputs affected if (a) price of only one input changes and (b) prices of both the inputs change
proportionately?
7. Using isocosts and isoquants show the direction of change in the expansion path of a firm
assuming change in price of only one input at a time.
8. What is substitution effect of change in the price of an input? How can it be measured? Illustrate
your answer with the help of isoproduct and isoquant curves.
9. Which of the following conditions specifies the least cost input combination?
(a) PL/PK = MRTS
(b) PL/PK =MPL/MPK
(c) MPL/PL=MPK/PK
(d) MPK/MPL = ΔL/ΔK
(e) All the above
10. Given the total cost as C, price of labour (L) as PL, price of capital (K) as PK, an isocost curve can
be drawn from which of the following functions?
(a) K = C/PK + (C/PL)L
(b) C = C/PL + C/PK
(c) C = K ⋅ PK + L ⋅ PL
(d) L = C/PK − (C/PL)K
11. Expansion path is a straight line when the production function is
(a) homogeneous,
(b) non-homogeneous
(c) of any form
[Ans. 9(e), 10(c), 11(a)]
FURTHER READINGS
Baumol, W.J. (1985), Economic Theory and Operations Analysis (New Delhi: Prentice Hall of India), 4th
Edn., Chapter 11.
Cassels, J. (1946), ‘On the Law of Variable Proportions’, in Readings in Theory of Income Distribution,
American Economic Association.
Douglas, P.H. (1948), ‘Are There Laws of Production?’, American Economic Review, (March): 1–41.
M13_DWIV9400_02_SE_C13.indd 276 06/07/11 12:32 AM

Gould, J.P., Lazear, E.P. (1993), Microeconomics: Theory and Applications (Homewood, IL: Richard
D. Irwin), 6th Edn., Chapters 6, 7.
Hicks, J.R. (1946), Value and Capital (Oxford: Oxford University Press), 2nd Edn.
Tangri, O.P. (1966), ‘Omissions in the Treatment of the Laws of Variable Proportions’, American
Economic Review, (June): 484–92. Reprinted in Readings in Microeconomics, Breit, W.L. and
Hochman, H.M. (ed), American Economic Association.
M13_DWIV9400_02_SE_C13.indd 277 06/07/11 12:32 AM

Chapter 14
Theory of Cost
CHAPTER OBJECTIVES
We move on to this chapter from the theory of production to discuss the theory of cost. Theory of cost
deals with cost–output relationship, i.e., how cost of production changes with changes in production.
As in case of theory of production, the theory of cost has also been formulated under short-run and
long-run conditions. By going through this chapter, you learn the following aspects of the cost theory:
The meaning and measures of various cost concepts that are used in cost analysis;
The traditional theory of cost, i.e., cost–output relationship in the traditional theory of cost;
The method of deriving the various kinds of cost curves including total cost (TC), marginal cost
(MC) and average cost (AC) curves;
The cost behaviour, i.e., how TC, MC and AC change with change in output under short-run pro-
duction conditions—the short-run theory of cost;
The nature and pattern of long-run cost–output relationship, i.e., the behaviour of cost with change
in output under long-run production conditions, i.e., the long-run theory of cost;
The meaning of economies and diseconomies of scale and how they affect the cost behaviour; and
The modern approach to analyse cost–output relationship.
INTRODUCTION
In two preceding chapters, we were concerned with the laws of production, i.e., the relationship between
input and output. It may be recalled that the laws of production are expressed in terms of physical
quantities, e.g., labour as number of workers or labour man days, capital as units of plant or machinery,
and output in terms of some other measures of output, e.g., tons of wheat, meters of cloth and so on or
in terms of units 1, 2, 3. However, as most business decisions regarding price and production are taken
on the basis of money value of inputs and money value of output rather than on the basis of their physi-
cal quantities. The money value of inputs is called cost of production and the money value of output is
referred to as sales revenue—the value of output sold. In fact, the entire theory of price and output deter-
mination, that follows in Part IV of this book, is based on cost and revenue behaviour in response to the
change in output.
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Theory of Cost 279
In this chapter, we move from the theory of production to the theory of cost. We have discussed here
the relationship between the output and cost of production. We begin our discussion on the theory of
cost with some basic cost concepts used in cost analysis and cost theory.
COST CONCEPTS
A variety of cost concepts are used in economic analysis and firm’s decision making. From our purpose here,
cost concepts can be classified as: (i) accounting cost concepts, (ii) analytical cost concepts and (iii) policy
related cost concepts. Some important cost concepts of these categories are discussed here briefly.
Accounting Cost Concepts

Actual and Opportunity Costs Actual costs are the expenditures which are actually incurred by
the firm in payment for labour, material, plant, building, machinery, equipments, travelling and trans-
port, fuel and so on. The total money expenses recorded in the books of accounts are, for all practical
purposes, the actual costs. Actual cost concept comes under the accounting cost concept.
Opportunity cost is the loss of income due to opportunity foregone. Opportunity cost is also called
alternative or economic cost. It arises because of scarcity and alternative uses of resources. We know that
the resources that are available, at any point of time, to a firm or any business organization, are limited
and resources have alternative uses. Therefore, profit-maximizing firms have to choose the best from
the alternatives available to them. When they opt for the best of the opportunities, they lose the returns
expected from the second best alternative use of their resources. The foregone benefit is called oppor-
tunity cost of the gains from the chosen use of the resources. More precisely, the opportunity cost is the
expected returns from the second best use of the resources foregone to avail the gains of their best use.
For example, suppose a man has Rs 50,000 to invest. He has only two alternatives: he can invest this
amount either in a printing machine or in a photocopier. He expects to earn an annual net income of
Rs 20,000 from the printing machine and Rs 15,000 from the photocopier. If the man is an income maxi-
mizer, he would invest his money in the printing machine. If he does so, he foregoes an annual income
of Rs 15,000 expected from the photocopier. Thus, the opportunity cost of income from the printing
machine is Rs 15,000. Real-life situation is full of such examples: if a student opts for a graduate degree in
economics, he or she cannot be simultaneously a science graduate; if an MBBS opts for private practice,
he/she foregoes the salary expected from employment in a public or private hospital and so on.
Associated with the concept of opportunity cost is the concept of economic rent or economic profit.
Economic rent is the difference between the actual earning and the opportunity cost. In our example,
economic rent of printing machine is the excess of its earning over the income from the photocopier.
That is, economic rent of printing machine = Rs 20,000 − Rs 15,000 = Rs 5000. The business implication
of this concept is that investing in printing machine is preferable as long as its economic rent is greater
than zero. Also, if firms know the economic rent of the various alternative uses of their resources, the
choice of the best investment avenue will not be a problem.
Business and Full Costs Business costs include all the expenses which are incurred in carrying
out the business. The concept of business cost is similar to the actual or real cost. Business costs ‘include
all the payments and contractual obligations made by the firm together with the book cost of deprecia-
tion on plant and equipment.’1 Both these cost concepts are used in calculating actual profits and losses
in the business, in filing returns for income tax, and for other legal purposes.
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280 Chapter 14
The concept of full costs includes opportunity cost and normal profit. Opportunity cost, as defined
above, includes the expected earning from the second best use of the resources, e.g., the loss of market
rate of interest on the total capital investment, and also the value of entrepreneur’s own services which
are not charged in the current business. Normal profit is a necessary minimum earning, in addition to
alternative cost, which a firm must get to remain in its present occupation. Practically, normal profit is the
rate of profit earned by most of the firms in the industry.
Explicit and Implicit Costs Explicit costs are those which are actually incurred by the business
firms and are entered in the books of accounts. The payments on account of wages, salaries, utility
expenses, interest, rent, purchase of materials, licence fee, insurance premium and depreciation charges
are the examples of explicit costs. These costs involve cash payments and are clearly reflected by the
usual accounting practices. In contrast to these costs, there are certain other costs which do not take the
form of cash outlays, nor do they appear in the accounting system. Such costs are known as implicit or
imputed costs. Implicit costs are similar to opportunity cost. For example, suppose an entrepreneur does
not utilize his services in his own business and works as a manager in some other firm on a salary basis.
If he starts his own business, he foregoes his salary as manager. The loss of salary is an implicit cost of
his own business. It is implicit because the income foregone by the entrepreneur is not charged as the
explicit cost of his own business. The implicit cost includes implicit wages, implicit rent, implicit interest
and so on. Although implicit costs are not taken into account while calculating the loss or gain of the
business, these costs do figure in business decisions.
Analytical Cost Concepts

Total, Average, and Marginal Costs Total cost (TC) represents the cost of the total resources
used in the production of goods and services. If refers to the total outlays of money expenditure, both
explicit and implicit, on the resources used to produce a given output. The total cost for a given output
is obtained from the cost function.
Average cost (AC) is of statistical nature, rather than being an actual cost. It is obtained simply by
dividing the total cost (TC) by the total output (Q), i.e., TC/Q = average cost.
Marginal cost (MC) is the addition to the total cost on account of producing one additional unit of
product. Or, marginal cost is the cost of marginal unit produced.
Total, average and marginal cost concepts, used in the economic analysis of the firm’s productive
activities, are discussed in detail in the following section.
Fixed and Variable Costs Fixed costs are the costs which are fixed in amount for a certain level of
output. Fixed costs do not vary with the variation in the output between zero and a certain level or out-
put. The costs that do not vary over a certain level of output are known as fixed cost. Fixed cost includes
cost of (i) managerial and administrative staff; (ii) depreciation of machinery, building and other fixed
assets and (iii) maintenance of land. The concept of fixed cost is associated with short run.
Variable costs are those which vary with the variation in the total output. Variable costs are functions
of the output. Variable costs include direct labour cost, cost of raw materials, and running cost of fixed
capital, such as fuel, ordinary repairs, routine maintenance expenditure and the costs of all other inputs
that vary with output.
Short-run and Long-run Costs Two other important cost concepts associated with variable
and fixed cost concepts that often figure in economic analysis of cost behaviour are short-run and
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Theory of Cost 281
long-run costs. Short-run costs include fixed cost and the variable cost, i.e., the costs which vary with
the variation in output, the size of the firm remaining the same. Long-run costs are the costs incurred
in the long run. In the long run, there is no fixed cost. All the costs are variable cost. It implies that even
the costs incurred on fixed assets, like plant, building, machinery and so on become the variable costs.
In other words, in the long run, even the fixed costs become variable costs. Firms can hire more of
all the inputs if they decide to increase the size of the firm or scale of production. Broadly speaking, ‘the
short-run cost are those associated with variable costs in the utilization of fixed plant or other facilities,
whereas long-run cost-behaviour encompasses changes in the size and kind of plant’.2
Policy Related Cost Concepts: Private and Social Costs

We have so far discussed the cost concepts that are related to the functioning of a firm as a production
unit, and those that are used in the cost–benefit analysis of the business decisions. There are, however,
certain other costs, which arise due to functioning of the firm but do not normally figure in the business
decisions, nor are such costs explicitly paid by the firms. Instead, such costs are borne by the society.
Thus, the total cost generated by the firm’s decision may be divided into two categories: (i) those paid out
or provided for by the firms and (ii) those not paid by firms including use of resources freely available
and the disutility created in the process of production. The costs of the category are known as: (i) private
costs, and costs of category and (ii) external or social costs. Let us look at the distinctive features of the
private and social costs.
Private Cost Private costs are those which are actually incurred or provided for by an individual or
a firm on the purchase of goods and services from the market. For a firm all the actual costs, both explicit
and implicit, are private cost. Private costs are internalized in the sense that ‘the firm must compensate
the resource owner in order to acquire the right to use the resource.’ It is only the internalized cost which
is included in the firm’s total cost of production.
Social Cost Social cost, on the other hand, implies the cost which a society bears on account of
production of a commodity. Social cost includes both private cost and the external cost. External cost
includes (i) the cost of ‘resources for which the firm is not compelled to pay a price’, e.g., atmosphere,
rivers, lakes and also for the use of public utility service like roads, drainage system and so on and
(ii) the cost in the form of ‘disutility’ created through air, water, and noise pollutions and so on. For
instance, Mathura Oil Refinery discharges its wastes into the Yamuna River causing water-pollution
causing danger to the beauty of Taj Mahal; mills and factories located in a city cause air-pollution by
emitting smoke; cars, buses, trucks and so on, causes both air and noise pollution. Such pollutions cause
tremendous health hazards which impinge a cost on the society as a whole. Such costs do not figure in
the cost structure of the firms and hence are termed external costs from the firm’s point of view, and social
cost from society’s point of view. The cost of category (iii) is generally assumed to be equal to the total
private and public expenditure incurred to safeguard the individual and public interest against the vari-
ous kinds of health hazards created by the production system. But private and public expenditure serve
only as an indicator, not as a measure, of public disutility.
THEORY OF COST: AN OVERVIEW

Cost of production depends on the level of production. As a matter of fact, when production increases,
cost of production increases too. How production cost is related to production is the matter of theory
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282 Chapter 14
of production. The theory of cost deals with the cost–output relationship. The theory of cost reveals how
cost of production changes with change in production. Production depends on the quantity of inputs
used—inputs including—labour and capital. The input–output relationship is the subject of theory of
production. In fact, the theory of production forms the basis of the theory of cost. In other words, the
rate of change in production with change in inputs determines the rate of change in production cost.
In general, the change in the total, marginal and average costs depends on what law of production is in
operation. It means that the theory of cost is linked to the theory of production. So, the theory of cost
can be explained in the framework of the theory of production. Recall that the theory of production has
been constructed under two types of production conditions, viz.,
1. short-run conditions;
2. long-run conditions.
Like theory of production that deals with input–output relationship, the economists have developed
the theory of cost that deals with cost–output relationship under short-run and long-run conditions.
The short-run and long-run conditions for cost analysis are, in fact, the same under which short-run
and long-run theories of production have been developed (see Chapter 12). It may be recalled here
that, given the production function as Q = f (K, L), under short-run conditions, capital (K) is assumed
to remain constant and labour (L) is assumed to be the only variable factor. Under long-run conditions,
both capital (K) and labour (L) are treated to be variable factors. The theory of cost has also been devel-
oped under the same conditions—short-run and long-run conditions. Accordingly, the conventional
theory of cost is classified as:
1. theory of short-run cost
2. theory of long-run cost
The short-run theory of cost has been discussed in the following section. The long-run theory of cost
has been discussed in a forthcoming section. It may be added here that the some modern economists
have adopted a different approach to analyse the long-run cost–output relationship. Their approach to
the analysis of long-run cost–output relationship is known as modern approach to cost–output relation-
ship. The modern approach to analyse the long-run cost–output relationship has been discussed in a sub-
sequent section.
THEORY OF SHORT-RUN COST

Before we discuss the theory of short-run cost, let us have a look at the cost parameters used in short-run
cost analysis.
Let us begin our discussion with short-run cost–output relationship.
Short-run Cost Measures

From cost theory point of view, short run refers to a period during which some costs remain fixed and
some costs are variable. Thus, the total short-run cost (TC) consists of fixed cost and variable cost. Thus,
the short-run TC is composed of two major elements: total fixed cost (TFC); and total variable cost
(TVC). Thus,
TC = TFC + TVC,
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Theory of Cost 283
As mentioned earlier, TFC (i.e., the cost of plant, building, equipment and so on) remains fixed in
the short run, for a certain level of output, whereas TVC varies with the variation in the output. A brief
analysis of these cost components and their interrelationship is given below.
For a given output, Q, the average total cost (ATC or AC), average fixed cost (AFC) and average
variable cost (AVC) can be obtained as follows.
Since
TC = TFC + TVC
TC TFC TVC
Averages cost = = +
Q Q Q
Thus,
AC = AFC + AVC
Marginal cost (MC) is defined as MC = TCn − TCn−1

where subscript n denotes the total number of units produced at a point of time.
Alternatively, in case an estimated cost functions is given, the marginal cost (MC) is defined as the
first derivative of the TC function.
∂TC
MC =
∂Q
Since ∂TC = ∂TFC + ∂TVC, and in the short run, ∂TFC = 0

∴∂TC = ∂TVC
In other words, in the shot run,
MC = ∂TVC
The Short-run Cost–Output Relationship

Let us now discuss the short-run cost–output relationship, i.e., how cost changes with changes in output.
The theory of short-run cost behaviour can be stated as the cost of production increases with the increase
in production and vice versa: In fact, it is the rate of increase in output that determines the rate of increase
in the cost of production. Here, the question arises: What determines the rate of change in the output?
The answer to this question lies in the short-run theory of production, i.e., the laws of returns to variable
input, or the law of diminishing returns. Recall the laws of returns to variable input (labour).3 The laws of
returns to variable input can be stated as ‘capital remaining constant, when more and more labour is used
to produce a commodity, the output increases initially at increasing rate and ultimately at diminishing
rate’. It is this law of production that determines the cost behaviour with increase in output. As a matter
of fact, given the cost of labour (the wage rate), as long as output increases at increasing rate, the cost of
production increases at decreasing rate and when output increases at decreasing rate, cost of production
increases at increasing rate. It is this kind of cost–output relationship that forms the basis of the short-run
theory of cost.
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284 Chapter 14
(a) (c)
Diminishing
Marginal and average productivity

returns
Increasing TP
returns
Output
APL
O L1 L2 L3 O L1 L2 L3
Labour Labour MPL
(b) (d)
TC MC
TVC
Cost increasing AC
at increasing
Cost rate
increasing
Marginal and average cost
at decreasing
rate
Total cost
TFC
O Q1 Q2 Q3 O Q1 Q2 Q3
Output Output
Figure 14.1 The Law of Diminishing Returns and Cost Behaviour
The short-run cost–output relationship is shown in panels (a) and (b) of Figure 14.1. As panel (a)
shows when labour increases from 0 to L1, output increases at increasing rate. The increasing rate of
output is indicated by the increasing slope (ΔQ/ΔL) of the TP curve—the slope of the TP curve gives the
marginal productivity of labour (MP). The increasing MPL gives the law of increasing returns to the vari-
able input (labour) until OL1 labour. Note that when labour is increased beyond OL1, output increases
but at decreasing rate, i.e., ΔQ/ΔL goes on decreasing. The decreasing rate of output is indicated by the
decreasing slope (ΔQ/ΔL) of the TP curve. As panel (a) shows, with increase in labour from L1 to OL2,
output increases at diminishing rate and output is maximized at OL3 labour.
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Theory of Cost 285
How is Cost Affected by the Trend in TP? The change in cost with change in TP can be
assessed by linking employment of labour L1, L2 and L3 in panel (a) to change in output Q1, Q2 and Q3,
respectively. In fact, output Q can be estimated by multiplying L with its average output, i.e., Q = L ⋅ APL.
For example, in panel (b), Q1 = OL1 × (OQ/OL1). Panel (b) of Figure 14.1 shows the trends in increase in
the total cost (TQ) corresponding to the change in output (TP). As panel (b) shows, over the OL1 range of
labour, TC increases at decreasing rate. The increase in TC at decreasing rate is indicated by the decreas-
ing slope (ΔTC/ΔL) of the TC curve. The increasing TC at decreasing rate in panel (b) corresponds to
the output (TP) increasing at increasing rate in panel (a). Similarly, the increasing TC at increasing rate
corresponds to the range of TP increasing at diminishing rate in panel (b). This trend of relationship
between cost and output proves the point that laws of returns to variable input forms the basis of the
theory of cost.
Given the above description of the cost–output relationship, the short-run theory of cost can be
summarized as follows.
1. total cost (TC) increases with increase in total production (TP);
2. as long as TP increases at increasing rate, TC increases at decreasing rate;
3. when TP increases at constant rate, TC also increases at constant rate and
4. when TP increases at decreasing rate, TC increasing at increasing rate.
The Average and Marginal Cost Behaviour We have explained above the relationship
between TP and TC. What is more important from firms’ price and output determination point of view
is the behaviour of average cost (AC), and marginal cost (MC) with increase in output. The nature of rela-
tionship between marginal output (ΔTP) and marginal cost (ΔMC), and between average output (TP/L)
and average cost (TC/Q) are graphically illustrated in panels (c) and (d) of Figure 14.1.
In panel (c), the curve marked MPL shows the marginal productivity of labour, i.e., the rate of change
in production (TP) with change in labour employment, i.e., ΔTP/ΔL. The MPL has been measured by the
slope of the TP curve. The curve marked APL shows the average productivity of labour at different levels
of labour employment. The APL is measured as TP/L. For example, at labour OL1, total output is, OQ.
Thus, APL = OQ/OL1.
Panel (d) shows the trends in MC and AC with increase in labour and consequent increase in output.
MC has been measured by the slope of the TC curve, i.e., MC = ΔTC/ΔQ and AC has been measured
as TC/Q.
We can now link the trends in APL and MPL curves at different levels of labour in panel (c) and
the trends in AC and MC curves at different corresponding levels of output in panel (d) and trace the
relationship between output and cost curves. Note that MPL goes on increasing until OL1 labour in
panel (c), and MC goes on decreasing till the: corresponding output Q1 in panel (d). MPL reaches its
maximum at OL1 and MC reaches its minimum at the same level of output (OQ1). As MPL begins to
decline, MC begins to rise.
One can similarly link the trend in AC with the trend in APL. In can be observed from panels (c)
and (d) that as APL goes on increasing, AC goes on decreasing; where APL reaches its maximum, AC
decreases to its minimum; and when APL begins to decline, AC begins to rise. Another important point
that needs to be noted is that at L2 labour APL = MPL and at the corresponding level of output (OQ2),
AC = MC.
The nature of cost–output relationships illustrated above can be presented better by using a cost
function. This task has been accomplished in the following section.
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286 Chapter 14
SHORT-RUN COST FUNCTION AND COST CURVES

In the proceeding section, we have explained and illustrated the cost–output relationship graphically
through the cost curves. The cost–output relationships and the nature of cost curves are, in fact, deter-
mined by the nature of the cost function. The cost function of a firm is derived on the basis of the actual
cost and production data of the firm. Given the cost and production data, cost function may take a vari-
ety of forms: it may be a linear, quadratic or cubic cost function. The simplest total cost function which
produces U-shaped average and marginal cost curves is of cubic polynomial form as given below.
TC = A + bQ − cQ2 + dQ3 (14.1)
where A = total fixed cost (TFC) and b, c and d are parametric constants.
The AFC, AVC, AC and MC can be derived from Eq. (14.1) as follows.
A
AFC = (14.2)
Q
TVC CT − A bQ − cQ 2 + dQ 3
AVC = = =
Q Q Q
= b − cQ + dQ 2
(14.3)
TC A + bQ − cQ 2 + dQ 3
AC = =
Q Q
A
= + b − cQ + dQ 2 (14.4)
Q
∂TC
MC = = b − 2cQ + 3dQ 2 (14.5)
∂Q
Numerical Example
Let us suppose that the cost function is empirically estimated as follows.
TC = 10 + 6Q − 0.9Q2 + 0.05Q3 (14.6)

The various kinds of cost measures calculated on the basis of Eq. (14.6) are presented in Table 14.1.
The TFC, TVC and TC have been graphically presented in Figure 14.2. As the figure shows, TFC remains
fixed for the whole range of output, and hence, it takes the form of a horizontal line—TFC. The TVC
curve shows that the total variable cost first increases at a decreasing rate and then at an increasing
rate with the increase in the output. The pattern of change in the TVC stems directly from the law of
increasing and diminishing returns to the variable inputs. As output increases, larger quantities of vari-
able inputs are required to produce the same quantity of output due to diminishing returns. This causes
a subsequent increase in the variable cost for producing the same output.
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Theory of Cost 287
Table 14.1 Cost–Output Relations

Q FC TVC TC AFC ÅVC AC MC*
(1) (2) (3) (4) (5) (6) (7) (8)
0 10 0.0 10.00 – 0.0 10.0 0.00
1 10 5.15 15.15 10.00 5.15 15.15 5.15
2 10 8.80 18.80 5.00 4.40 9.40 3.65
3 10 11.25 21.25 3.33 3.75 7.08 2.45
4 10 12.80 22.80 2.50 3.20 5.70 1.55
5 10 13.75 23.75 2.00 2.75 4.75 0.95
6 10 14.40 24.40 1.67 2.40 4.07 0.65
7 10 15.05 25.05 1.43 2.15 3.58 0.65
8 10 16.00 26.00 1.25 2.00 3.25 0.95
9 10 17.55 27.55 1.11 1.95 3.06 1.55
10 10 20.00 30.00 1.00 2.00 3.00 2.45
11 10 23.65 33.65 0.90 2.15 3.05 3.65
12 10 28.80 38.80 0.83 2.40 3.23 5.15
13 10 35.75 45.75 0.77 2.75 3.52 6.95
14 10 44.80 54.80 0.71 3.20 3.91 9.05
15 10 56.25 66.25 0.67 3.75 4.42 11.45
16 10 70.40 80.40 0.62 4.40 5.02 14.15
*MC = TCn − TCn−1
Derivation of Behavioural Cost Equations

Given the TC function in Eq. (14.6), we can derive AFC, AVC and AC functions. Let us first
consider AFC.
Average Fixed Cost (AFC) As already mentioned, the costs that remain fixed for a certain level
of output make the total fixed cost in the short run. The fixed cost is represented by the constant term ‘A’
in Eq. (14.6) and A = 10. Substituting 10 for TFC in Eq. (14.2), we get
10
AFC = (14.7)
Q
Equation (14.7) expresses the behaviour of AFC in relation to change in Q. The behaviour of AFC
for Q from 1 to 16 is given in Table 14.1 (column 5) and presented graphically by the AFC curve in
Figure 14.2. The AFC curve is a rectangular hyperbola.
Average Variable Cost (AVC) Given the TC function in Eq. (14.6), AVC function can be derived
numerically following the TVC function given in Eq. (14.2), as follows.
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288 Chapter 14
90
TC TVC
80
70
60
TC, TVC and TFC
50
40
30
20
TFC
10
0 2 4 6 8 10 12 14 16 18 20
Output
Figure 14.2 Derivation of TFC, TVC and TC Curves
6Q − 0.9Q 2 + 0.05Q 3
AVC =
Q
= 6 − 0.9Q + 0.05Q 2 (14.8)
Having derived the AVC function in Eq. (14.8), we may easily obtain the behaviour of AVC in response
to change in Q. The behaviour of AVC for Q = 1 − 16 is given in Table 14.1 (column 6), and graphically
presented in Figure 14.3 by the AVC curve.
Critical Value of AVC From Eq. (14.8), we may compute the critical value of Q in respect of AVC.
The critical value of Q (in respect of AVC) is one that minimizes AVC. The AVC will be minimum, when
its (decreasing) rate of change equals zero. The critical value of Q can be obtained by differentiating
Eq. (14.8) and setting it equal to zero as shown below. Thus, critical value of Q an be obtained as
∂AVC
Critical value of Q = = −0.9 + 0.10Q
∂Q
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Theory of Cost 289
16
14 MC
AC
AFC, AVC AC and MC
12
10
8 AVC
AFC
Q
O 2 4 6 8 10 12 14 16
Output
Figure 14.3 Short-run Cost Curves
By setting −0.9 + 0.10Q equal to 0, we get

0.10Q = 0.9
Q=9
In our example, the critical value of Q = 9. This can be verified from Table 14.1. The AVC is minimum
(1.95) at output equal to 9.
Average Cost (AC) Using Eq. (14.6) we get

TC 10 + 6Q − 0.9Q 2 + 0.05Q 3
AC = =
Q Q
10
= + 6 − 0.9Q + 0.05Q 2 (14.9)
Q
Equation (14.9) gives the behaviour of AC in response to change in Q. The values of AC for Q = 1 − 16
are given in Table 14.1 and graphically presented in Figure 14.3 by the AC curve. Note that AC curve in
U-shaped.
Minimization of AC One of the objectives of business firms is to minimize AC of their product.

The level of output that minimizes AC can be obtained by differentiating Eq. (14.9) and setting it equal
to zero. Thus, the optimum value of Q can be obtained as follows.
∂AC 10
= − 0.9 + 0.1Q = 0
∂Q Q 2
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290 Chapter 14
When simplified, this equation takes the form of a quadratic equation as follows.
−10 − 0.9Q2 + 0.1Q3 = 0 (14.10)
Let us multiply Eq. (14.10) by 10 to eliminate decimal digits. Equation (14.10) is then written as
Q3 − 9Q2 − 100 = 0 (14.11)
By solving Eq. (14.11), we get Q = 10.
4
Thus, the critical value of output in respect of AC is 10. That is, AC reaches its minimum at Q = 10.
This can be verified from Table 14.1.
Marginal Cost (MC) The concept of marginal cost (MC) is of great importance in economic
analysis. Since MC is the first derivative of the TC function, the MC function can be obtained by differ-
entiating the TC function in Eq. (14.6) as follows.
MC = =
(
∂TC ∂ 10 + 6Q − 0.9Q + 0.05Q
2 3
)
∂Q ∂Q
= 6 − 1.8Q + 0.15Q 2
(14.12)
Equation (14.12) represents the behaviour of MC. The values of MC for Q = 1 − 16 computed as
MC = TCn − TCn−1 (assuming indivisible output) are given in Table 14.1 (column 8) and graphically
presented by the MC curve in Figure 14.3. The critical value of Q with respect to MC is 6 or 7. This can
be seen from Table 14.1.
LONG-RUN COST–OUTPUT RELATIONSHIP

In the previous section, we have discussed short-run cost–output relations by using a short-run cost
function under the condition that capital remains constant. In this section, we will discuss cost–output
relationships in the long run—a period in which all the inputs are variable.
The fundamental difference between the short run and long run, is that, in the short run, some costs,
especially the cost of capital, are fixed whereas in the long run, all costs become variable. It implies that
in the long run, firms can hire more of both labour and capital, more of raw materials and other inputs,
while technology remains constant.
In order to understand the long-run cost–output relationships and to derive the long-run cost curves,
it is helpful to look at long run and short run in continuity, and to treat long run as the sum of the short
runs. As a corollary of this, long-run cost curves would be composed of a series of short-run cost curves.
We may now derive the long-run cost curves and study the relationship between the costs and output.
Derivation of Total Long-run Cost (LTC) Curve

In order to derive LTC curve, suppose that production function of a firm is such that it yields a short-
run total cost curve, i.e., STC curve, as shown by STC1 in Figure 14.9(a). Note that STC1 is similar to the
TC-curve shown in Figure 14.7. Let the firm add another plant to its size in short-run-2. Adding another
plant means that the firm adds more of machinery and equipment to its stock of capital and employs
more of labour accordingly. As a result, the firm’s TC increases and increase in cost increases the output.
When cost of the second plant is added to the first one, TC-curve shifts upward from STC1 to STC2 as
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Theory of Cost 291
shown in panel (a) of Figure 14.4. The process is repeated when the firm adds the third plan to its size in
short-run-3 and a new STC is drawn as shown by STC3.
Once STCs are drawn as STC1, STC2 and STC3, the LTC can be obtained by drawing a curve tangent
to the bottom of the STCs as shown by the curve LTC in panel (a) of Figure 14.4. The tangential curve
is drawn through the bottom of the STCs under the assumption that the firm intends to minimize the
cost. The gaps between the LTC and STCs (under the points of intersection between STCl and STC2 and
between STC2 and STC3 will disappear if more and more STCs are inserted between them. The LTC takes
a shape as shown by the thick line in panel (a) of Figure 14.4.
(a) LTC
STC3
STC2
STC1
Total cost
O Q1 Q2 Q3
Output
(b) LAC
SAC3
SAC2
Average cost
C1 SAC1 C3
C2
O Q1 Q2 Q3
Output
Figure 14.4 Long-run Total and Average Cost Curves
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292 Chapter 14
Derivation of Long-run Average Cost (LAC) curve

The derivation of the LAC is shown in panel (b) of Figure 14.4. There are three SACs corresponding to
three STCs is panel (a). SACl corresponding to STC1 is given in panel (b) of the figure. The firm has its
minimum SAC1 equal to C1Q1 at output OQ1. The SAC2 curve is related to STC2. Note that SAC of the
second plant is lower than that of the first plant, as shown by the curve SAC2 in panel (b) due to econo-
mies of scale (discussed under the section on Modern Approach to the Theory of Cost of this chapter).
Economies of scale arise from several factors with the increase in the scale of production. An important
reason is that with the addition of the second plant, availability of capital per worker increases and
productivity of labour increases, including workers employed in the first plant. Consequently, unit cost
of output decreases, given the input prices. However, when the third plant is added, this kind of advan-
tage is reduced or disappears. Therefore, SAC begins to rise and the minimum of SAC3 rises to C3Q3 after
the inclusion of the third plant.
The long-run average cost curve (LAC) can now be drawn by drawing a curve tangent to SAC1, SAC2
and SAC3 as shown in Figure 14.4(b). The LAC curve is also called as ‘envelope curve’. It is also called as
‘planning curve,’ as it serves as a guide to the entrepreneurs in their planning to expand the production
in future. A more general process of deriving ‘envelope curve’ is shown in Figure 14.5.
The relationship between LTC and output and between LAC and output can now be easily inferred.
As is obvious from the LTC in Figure 14.9(a), the long-run cost–output relationship is similar to the
short-run cost–output relation. With the subsequent increase in the output, the LTC first increases at
a decreasing rate, and then, at an increasing rate. As a result, LAC initially decreases until the optimum
utilization of the second plant. The addition of the third plant makes the LAC move upward because
SAC3 lies above the level of SAC2. This trend in LAC implies that when the scale of production increases,
per unit cost first decreases, but it increases ultimately as shown in Figure 14.9(b). The decrease in per
unit cost is the result of the internal and external economies and the eventual increase in cost is caused
Envelope
curve
LAC
SAC and LAC
O Output
Figure 14.5 Derivation of Envelope Curve: The LAC
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Theory of Cost 293
by the internal and external diseconomies (discussed under the section on Modern Approach to the
Theory of Cost of this chapter).
Derivation of Long-run Marginal Cost (LMC) Curve

The long-run marginal cost curve (LMC) is derived from the short-run marginal cost curve (SMCS).
The process of derivation of LMC curve is exactly the same as the process of deriving the LAC curve. The
derivation of LMC is shown in Figure 14.6 in which SACs and LAC are the same as in Figure 14.4(b).
In addition, SMC curves are drawn corresponding to each SAC. To derive the LMC, consider the points of
tangency between SAC curves and the LAC, i.e., points A, B and C for the long-run production planning.
The tangential points determine the optimum output levels in the short-run with long-run production
planning. For example, if we draw perpendiculars from point A, B and C to the X-axis, the correspond-
ing optimum output levels are determined at OQ1, OQ2 and OQ3. The perpendicular AQ1 intersects SMC1
at point M. It means that LMC is MQ1 at output OQ1. Going by the same process, SMC can be obtained
for different plants. For example, when output increases to OQ2, marginal cost is BQ2 determined by the
intersection of LMC and SMC2. Similarly, the perpendicular CQ3 determines the optimum level of SAC
for output CQ3. When perpendicular CQ3 is extended upward intersects SMC3 at point N. Thus, NQ3
measures the LMC at output OQ3. If a curve is drawn through points M, B and N, as shown by the LMC,
the curve represents the behaviour of marginal cost in the long run. This curve is known as the long-run
marginal cost curve (LMC).
Optimum Size of the Firm in the Long Run

Long-run cost curves, LAC and LMC, can be used to determine the optimum size of the firm. The
optimum scale of production is one which gives the most efficient utilization of resources—determined
LMC
SMC3 LAC
SMC1 SMC2
SAC 1 SAC 3
SAC 2
N
SAC, LAC and LMC
M B
O Q1 Q2 Q3
Output
Figure 14.6 Derivation of LMC Curve
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294 Chapter 14
by minimum LAC. Given the state of technology over time, there is technically a unique size of the firm
and the level of output associated with the least cost concept. This unique size of the firm is determined
by the point of intersection between LAC and LMC curves. In Figure 14.6, the optimum size of the firm
consists of two plants which produce OQ2 units of a product at minimum long-run average cost (LAC)
of BQ2. The downtrend in the LAC indicates that until output reaches the level of OQ2, the firm is of
non-optimal size. Similarly, expansion of the firm beyond production capacity OQ2 causes rise in LMC
as well as in LAC. It follows that, given the technology, a firm aiming to minimize its average cost over
time must choose a scale of production that minimize its LAC. The LAC is minimized at a point where
SAC = SMC = LAC = LMC. This condition is fulfilled at point B in Figure 14.6. Besides, this condition
assures the most efficient utilization of resources.
ECONOMIES AND DISECONOMIES OF SCALE: FACTORS

BEHIND COST BEHAVIOUR
In the preceding section, we have explained the behaviour of the LAC and LMC. As shown in Figure 14.6,
LAC and LMC decrease till a certain level of output and then begin to increase. In this section, we answer
the question as to what determines the shape of LAC and LMC in the framework of the traditional theory
of cost. In brief, the decrease in LAC and LMC is attributed to the economies of scale and increase in LAC
and LMC is attributed to the diseconomies of scale. The economies of scale refer to cost saving resulting
from the increase in the scale of production while diseconomies of scale refer to cost escalation due to
increase in the scale of production. In this section, we will discuss briefly the various kinds of economies
and diseconomies of scale.5
The Economies of Scale: Factors Causing Decrease in LAC

The economies of scale are the cost reducing factors that arise due to the increase in the scale of
production. Cost reducing factors arises both inside the firm and outside the firm. Accordingly, the
economies of scale are classified under:
1. Internal Economies and
2. External Economies
The internal or external economics of scale are discussed here in turn.
Internal Economies Internal economies are the economies that arise within the firm due to the
expansion of its scale of production. In other words, internal economies are available exclusively to an
expanding firm. Increasing scale of production may be in the form of expansion of the existing plant or
adding more plants to the existing ones. In case production scale is expanded, there may be one product
or production may be diversified. Internal economies are also called ‘real economies’. The economies
are ‘real’ in the sense that they arise out of increasing in productivity per unit of cost or decrease in cost
of production caused by increase in the scale of production. Internal economies are classified under the
following categories.
1. Economies in production,
2. Economies in marketing—buying inputs and selling outputs,
3. Managerial economies, and
4. Economies in transportation and storage cost.
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Theory of Cost 295
Economies in Production Economies of scale in production arise mainly from the increasing
returns to scale resulting from the expansion of the production scale. The expansion of the produc-
tion scale may be in the form of a proportionate or unproportionate increase in the inputs. Production
economies are of two kinds, viz., technical economies and labour economies. Let us now look at technical
and labour economies in some detail.
1. Technical Economies. Technical economies include the economies that arise due to the advantage
of (i) opportunity for using specialized kind of machinery, (ii) indivisibility of specialized
machinery forcing its optimum utilization, (iii) once-for-all cost of large-scale set-up, (iv) scope
of building reserve capacity and (v) advantage of large-scale inventories. An expanding firm is
in a position to enjoy these technical advantages by increasing its scale of production. Modern
technology provides a specialized-capital equipment combining the entire process of produc-
ing a commodity. For example, given the modern technology, a large-scale cotton textile mill
can use one composite and indivisible plant combining such units as: (i) spinning, (ii) weaving,
(iii) printing and pressing and (iv) packaging. Likewise, a modern milk dairy plant combines:
(i) milk processing, (ii) skimming and toning, (iii) chilling and (iv) bottling units. It gives
increasing returns to scale as it saves both time and cost. Production by this kind of technology
gives a higher productivity of capital per unit of time. A higher productivity of capital reduces
unit cost of production compared to production in small scale. A small size firm cannot afford
this kind of technology, nor can it have the technical economies of scale. A large-scale expand-
ing firm can afford technically advanced plant and enjoy technical economies.
2. Labour Economies. Labour economies arise from the increase in labour productivity. Produc-
tivity of labour increases due to: (i) advantages of division of labour and (ii) specialization of
labour and improved skill. Advantages of division of labour and specialization are described
here briefly. When firm’s scale of production expands, more and more workers of specialized
skills and qualifications are employed. With the employment of larger number of workers, it
becomes increasingly possible to divide the labour according to their qualification, skill and to
place them in the process of production where they are best suited. This is known as division of
labour. Division of labour leads to specialization. It increases efficiency and labour productivity
which, in turn, reduces cost of production. Besides, specialized workers develop more efficient
tools and techniques and gain speed of work. These advantages of division of labour improve
productivity of labour per unit of cost and time.
Economies in Marketing—Buying Inputs and Selling Outputs Economies in market-

ing arise from the large-scale purchase of raw materials and other material inputs and large-scale selling
of firm’s own products. As regards to economies in purchase of inputs, the large-size firms normally
make bulk purchases of their inputs. The large sale purchase entitles the firm for certain discounts which
are not available on the small purchases. As such, the growing firms gain economies on the cost of their
material inputs.
The economies in marketing firm’s own product arise due to: (i) economies in advertisement cost,
(ii) economies in large-scale distribution through wholesalers, and so on and (iii) low managerial cost
due to large-scale marketing. With the expansion of the firm, the total production increases. But the
expenditure on advertising the product does not increase proportionately. Similarly, selling through
the wholesale dealers reduces the cost on distribution of the firm’s production. The large-scale firms
also gain on large-scale distribution through better utilization of ‘sales force, distribution of sample and
so on.’ This kind of economy, however, does not directly affect the production conditions.
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296 Chapter 14
Managerial Economies Managerial economies arise from (i) specialization in different areas of
management and (ii) mechanization of managerial functions. For a large-size firm, it becomes possible
to divide its management into specialized departments under specialized personnel, such as, produc-
tion manager, sales manager, personal manager, human resource managers and so on. This increases
efficiency of management at all the levels because of decentralisation of decision making. Large-size firms
have the opportunity to use advanced techniques of communication, telephones and telex machines,
computers, and their own means of transport. These factors lead to quick decision making, help in
saving the valuable time of the management, and thereby improve the managerial efficiency. For these
reasons, although managerial cost increases but less than proportionately to the increase in production
scale, up to a certain level.
Economies in Transportation and Storage Cost Economies in transportation and storage

costs arise from full utilization of transport and storage facilities of the firm. Transportation costs are
incurred on both production and sales sides. Similarly, storage costs are incurred on both raw materials
and finished products. The large-size firms may acquire their own means of transportation and they can
thereby reduce the unit cost of transportation compared to the market rate, at least to the extent of profit
margin of the transport companies. Besides, own transport facility prevents the delays in transporting
goods. Some large-scale firms have their own railway tracks from the nearest railway point to the factory,
and thereby they reduce the cost of transporting goods in and out. For example, Bombay Port Trust has
its own railway tracks and oil companies have their own fleet of tankers. Similarly, large-scale firms can
build their own godowns in the various centres of product distribution and can save on storage cost.
External Economies External economies are also called ‘pecuniary economies’. External or
pecuniary economies accrue to the expanding firms from the advantages due to conditions chang-
ing outside the firm. Pecuniary economies accrue to the large-size firms in the form of discounts and
concessions on: (i) large scale purchase of raw material, (ii) large scale acquisition of external finance,
particularly from the commercial bank, (iii) massive advertisement campaigns and (iv) large scale hiring
of means of transport and warehouses and so on. These benefits are available to all the firms of an
industry—they are not specific to any one particular firm.
Besides, expansion of an industry invites and encourages the growth of ancillary industries which
supply inputs and complementary parts. In the initial stages, such industries also enjoy the increasing
returns to scale. In a competitive market, therefore, input prices go down. This benefit accrues to the
expanding firms in addition to discounts and concessions. For example, growth of automobile industry
helps the development of tyre industry and other motor parts industries. If Maruti Udyog Limited starts
producing tyres for its cars and ancillaries, cost of Maruti cars may go up. Consider another example,
growth of fishing industry encourages growth of firms that manufacture and supply fishing nets and
boats. Competition between such firms and laws of increasing returns in the initial stages, reduce cost of
inputs for the expanding firms. This is an important aspect of external economies.
Diseconomies of Scale: Why LAC Increases

Diseconomies of scale are disadvantages that arise due to the expansion of production scale and lead
to rise in the cost of production. Like economies, diseconomies may be internal and external. Internal
diseconomies are those which are exclusive and internal to a firm as they arise within the firm. External
diseconomies arise outside the firms, mainly in the input markets. Let us describe the nature of internal
and external diseconomies in some detail.
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Theory of Cost 297
Internal Diseconomies Like every thing else, economies of scale have a limit too. This limit is
reached when the advantages of division of labour and potentials of managerial staff are fully exploited;
excess capacity of plant, warehouses, transport and communication system and so on is fully used; and
economy in advertisement cost tapers off. Although some economies may still exist, diseconomies begin
to overweigh the economies and costs begin to rise.
Managerial Inefficiency Diseconomies begin to appear first at the management level. Managerial
inefficiencies arise, among other things, from expansion of scale itself. With fast expansion of the
production scale, personal contacts and communication between (i) owners and managers and
(ii) managers and labour, get rapidly reduced. Close control and supervision gets replaced by remote
control and management. With the increase in managerial personnel, decision making becomes complex
and delay in decision making becomes inevitable. Implementation of decisions is also delayed due to
coordination problems.
Besides, with the expansion of the scale of production, management is professionalized beyond a
point. As a result, owner’s objective function of profit maximization is gradually replaced by managers’
utility function, like job security and high salary, a standard or reasonable profit target, and satisfying
functions. All these lead to laxity in management and, hence, managerial inefficiency leads to rise in cost
of production.
Labour Inefficiency Another source of internal diseconomy is overcrowding of labour leading

to loss of control on labour productivity and their accountability. On the other hand, increase in the
number of workers encourages labour union activities, which mean simply the loss of output per unit of
time and, hence, rise in cost of production.
External Diseconomies External diseconomies are the disadvantages that originate outside the
firm especially in the input markets. External diseconomies arise also due to natural constraints, specially
in agriculture and extractive industries. With the expansion of the firm, particularly when all the firms of
the industry are expanding, the discounts and concessions that are available on bulk purchases of inputs
and concessions on large borrowings come to an end. More than that, increasing demand for inputs puts
pressure on the input markets and input prices begin to rise causing a rise in cost of production. Such
diseconomies are called pecuniary diseconomies.
On the production side, the law of diminishing returns to scale comes into force due to excessive use
of fixed factors, more so in agriculture and extractive industries. For example, excessive use of cultivable
land turns it into a barren land; pumping out water on a large scale for irrigation causes water table to
go down resulting in rise in cost of irrigation; extraction of minerals on a large scale soon exhausts the
mineral deposits on upper levels and mining further deep causes rise in cost of production; extensive
fishing reduces the availability of fishes and the fish catch decreases even when fishing boats and nets are
increased. These kinds of diseconomies make the LAC move upward.
MODERN APPROACH TO THE THEORY OF COST

Some economists, especially George Stigler6 have questioned theoretically as well as empirically the
U-shaped cost curves of ‘the traditional theory of cost’ and have attempted to establish that the shape
of the cost curves, at least in the long run, is L-shaped. However, this point of view does not appear to
have received a general recognition by the economists7 or as much attention as the traditional theory
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298 Chapter 14
of cost, at least in the context of pricing theory. One possible reason is that the traditional theory of
cost has a greater application to the theory of price determination and has a greater predicting power
than the ‘modern theory’. However, this section provides a brief description of the ‘modern approach’
to the theory cost. Incidentally, like traditional theory of cost, modern theory too analyses cost–output
relationships in the short-run and long-run framework.
Modern Approach to Short-run Cost Behaviour

Like traditional theory of cost, modern theory recognizes that in the short run,
TC = TFC + TVC
and
AC = AFC + AVC
In traditional as well as in modern theory of cost, TFC includes the following elements of costs:
1. the salaries of administrative staff and related expenses;
2. the salaries of direct production labour paid on fixed-term basis;
3. standard depreciation allowance and
4. maintenance cost of land and building.
This point onwards, the modern theory deviates from the traditional theory. Traditional theory
assumes optimum capacity of a plant to be technically given (where SAC in minimum) and a cost-min-
imizing firm has no choice but to utilize the plant to its optimum capacity. On the other hand, modern
theory of cost emphasizes that firms, in their production planning, choose a plant with flexible capacity,
i.e., a plant with built-in reserve capacity. According to the modern theory, firms want to have some
reserve capacity, as a matter of planning for the following reasons:
1. to meet the ‘seasonal’ and eventual increase in demand;
2. to avoid loss of production due to break-down and repair works;
3. to have provision for meeting anticipated growth in demand;
4. to take the advantage of technology providing built-in reserve capacity;
5. to build excess capacity in land and building for expansion, if required and
6. to make full utilization of excess ‘organizational and administrative’ capacity.
Under these conditions, a firm does not necessarily choose a plant that gives the lowest cost of pro-
duction. Instead, it chooses a plant (a set of machinery) that gives ‘maximum flexibility’ in production
with minor adjustment in technique. For example, let us suppose that the firm has the option of setting
up a plant which has an absolute limit to produce a commodity at the minimum cost. This absolute limit
is shown by the quantity OQ1 in Figure 14.7. Note that if the firm chooses this plant, it can produce a
maximum quantity of OQ2 at the minimum AFC of DQ2 as shown in the figure by the boundary line BQ2.
Since there is no excess capacity, the firm cannot produce any quantity beyond OQ2 even if demand
increases and hence the firm will not be able to take the advantage of rising demand for its product.
Therefore, the firm chooses a flexible plant capable of producing more than OQ2 with minor adjustment
or alternation in the production technique. For example, let us suppose that the firm chooses a flexible
plant with absolute limit of output OQ1 as shown by the boundary line AQ1. Now let the firm anticipate
a rise in demand for its product and add a small unit machinery, to its flexible plant at the output level
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Theory of Cost 299
AFC A B
Average fixed cost
C B
D
Q
O Q1 Q2
Output
Figure 14.7 The Built-in Reserve Capacity and AFC Curve
OQ1. As Figure 14.7 shows, with the addition of small unit machinery firm’s AFC increases from CQ1
to AQ1 on the boundary line AQ1. But what is important from the firm’s point of view is that the firm
can increase its production beyond OQ2 to meet the anticipated increase in demand. Though its AFC
increases initially, it declines as production increases, as shown by the curve AB and goes below the limit
set by the inflexible plant. In the flexible capacity system of production plant, the firm is a gainer.
What Happens to the Average Variable Cost (AVC)?

The average variable cost, as in traditional theory, includes average cost of (i) direct labour, (ii) raw mate-
rials and (iii) running cost of machinery. There is, however, a difference between the short-run average
variable cost (SAVC) curves of the traditional and modern cost theories. While in traditional theory, the
SAVC curve is U-shaped, in modern theory, it is saucer- or bowl-shaped. Panel (a) of Figure 14.8 shows
SAVC curve of the traditional theory, and panel (b) shows SAVC curve of the modern theory.
As panel (b) of Figure 14.8 shows, according to the modern theory of cost, the SAVC remains constant
over a large quantity of output, say, between OQ1 and OQ2. The constancy of SAVC in the modern theory
is attributed to the built-in reserve capacity of the flexible plant. The utilization of the built-in reserve
capacity keeps the SAVC constant. This is an ‘innovative’ aspect of the modern theory of cost. In the
traditional theory, by assumption, there is no such built-in reserve capacity and therefore SAVC begins
to rise once the technically efficient level of output is reached.
The SAVC and SMC Curves

A more important aspect of the modern theory of cost is the nature of relationship between the SAVC
and the SMC curves. The derivation of SAVC and the short-run marginal cost (SMC) curves is shown in
Figure 14.9. The SAVC curve is the same as shown in panel (b) of Figure 14.8. The SMC curve follows the
pattern of the traditional theory. The SMC decreases with increase in output up to a certain level.
This behaviour of SMC curve is shown in Figure 14.10 until the output OQ1. However, in the range of
output, between OQ1 and OQ2, the SAVC remains constant. It is therefore equal to SMC. We know from
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300 Chapter 14
(a) Traditional cost theory (b) Modern cost theory
SAVC
SAVC
SAVC
Reserve capacity
Q Q
O Output O Q1 Q2
Output
Figure 14.8 The Traditional and Modern SAVC Curves
SMC
SAVC
Cost
SAVE = MC
Q
O Q1 Q2
Output
Figure 14.9 Modern SAVC and SMC Curves
the traditional theory cost that when SMC begins to rise, it rises faster than SAVC. This behaviour of
SMC is shown at output OQ2 and beyond. Beyond output OQ2, the SMC begins to rise and it rises faster
than the SAVC as is the case in the traditional theory. The nature of relationship between SMC and SAVC
in the modern theory of cost is shown by these curves beyond output OQ2.
The Short-run Average Cost (SAC) Curves

As in traditional theory, in modern theory of cost too, SAC = AFC + SAVC. Incidentally, in modern
theory of cost, AFC includes normal profit. Derivation of the SAC curve in the modern theory is shown
in Figure 14.10. The SAVC curve (and also the SMC curve) is similar to one given in Figure 14.9. For the
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Theory of Cost 301
SMC SAC
SAVC
Cost
SAVC = MC
AFC
O Q1 Q2 Q
Output
Figure 14.10 Derivation of the Modern SAC Curve
derivation of the SAC curve, the AFC curve is added to Figure 14.10. The SAC curve is obtained by the
vertical summation of the SAVC and AFC curves.
As Figure 14.10 shows, AFC falls continuously whereas SAVC decreases until output OQl and remains
constant between output OQ1 and OQ2. Therefore, a vertical summation of AFC and SAVC curves gives
the SAC curve which declines continuously until output OQ2. Thus, in modern theory of cost, SAC
decreases until the built-in reserve capacity is fully exhausted. The reserve capacity is exhausted at output
OQ2. Beyond output OQ2, therefore, SAC begins to increase and goes on increasing following the increase
in SAVC while decreasing AFC loses its significance.
Modern Approach to Long-run Cost Behaviour:

The L-shaped Scale Curve
In respect of long-run cost behaviour, the modern theory of cost distinguishes between production costs
and managerial costs. Both these costs are variable in the long run. The behaviour of these costs deter-
mines the shape of the long-run average cost curve LAC. According to the modern theory, the long-run
LAC is broadly L-shaped. Let us now look at the behaviour of the production and managerial costs in the
long run and how they determine the shape of the LAC curve.
Production Cost Behaviour Production cost decreases steeply in the beginning with the increase
in the scale of production but the rate of decrease slows down as the scale increases beyond a certain level
of production. The decrease in the production costs is caused by the technical economies which taper off
when the scale of production reaches its technical optimum scale. Nevertheless, some economies of scale
are always available to the expanding firms due to (i) ‘decentralization and improvement in skills’ and
(ii) decreasing cost of repairs per unit of output. Besides, in case of multi-product firms producing some
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302 Chapter 14
of their raw materials and equipments have economies in material cost compared to purchase made
from outside. These factors cause production cost to decrease though at decreasing rates.
Managerial Cost Behaviour The modern theory of cost assumes that, in modern management
technology, there is a fixed managerial or administrative set up with a certain scale of production. When
the scale of production increases, management set up has to be accordingly expanded. It implies that there
is a link between the scale of production and the cost of management. According to the modern theory,
the managerial cost first decreases but begins to increase as the scale of production is expanded beyond
a certain level.
What Makes LAC L-shaped? The net effect of decreasing production cost and increasing mana-
gerial cost determines the shape of the long-run average cost (LAC). Recall that production cost contin-
ues to decrease though slowly beyond a certain scale of production and managerial cost too decreases
initially but rises later. In the initial stage of production, therefore, the LAC decreases very steeply.
Beyond a certain scale of production, however, while production cost continues to decline, management
cost begins to rise. According to the modern theory of cost, the rise in managerial cost is more than
offset by the decrease in the production costs. In simple words, decrease in production cost is more than
increase in managerial cost. Therefore, the LAC continues to fall but very slowly. In case the decrease in
production cost is just sufficient to offset the rise in the managerial cost, the LAC becomes constant. This
makes LAC an L-shaped curve.
Derivation of the LAC Curve

The derivation of the LAC curves is shown in Figures 14.11 and 14.12. Figure 14.11 shows the
decreasing LAC curve—the LAC decreases continuously. Let us suppose that, given the technology, the
SAC 1
A SAC 2
SAC 3
B
Cost
SAC 4
C
LAC
Q
O Output
Figure 14.11 Derivation of LAC Curve in Modern Theory
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Theory of Cost 303
C C
(a) (b)
LAC
Cost
Cost
LAC = LMC
LMC
Minimum
LAC optimal
LMC scale
Q
O Output O Q
Output
Figure 14.12 Derivation of the L-shaped LAC Curve
optimum scale of production consists of four plants and SAC curves from SAC1 to SAC4 in Figure 14.11
represent the addition of four plants to the scale in each period of time. Clower and Due8 have found
that firms use ‘normally’ only 2/3 to 3/4 of the plant size. This is called ‘load factor’. The load factor
is the ‘ratio of average actual rate of use to the capacity or best rate of use, and this load factor will gen-
erally be smaller than one’.9 The points A, B, C and D on the SAC curves mark the ‘load factor’ in case
of each plant, respectively—it may be any value between 2/3 and 3/4 of the plant size. By drawing
a curve through the ‘load-factor’ points, we get the LAC curve. If there are a larger number of plants,
we will get much larger number of ‘load factor’ points and draw a smooth LAC curve as shown in
Figure 14.11.
To compare the LAC of the modern and traditional theories of cost, two points need to be noted:
(i) the LAC curve of the modern theory does not show the tendency to turn up even at a very large scale
of production whereas the traditional LAC curve does turn up and (ii) unlike traditional LAC forming
an envelope curve, modern LAC intersects at the factor load points.
If case scale of production involves a minimum optimal scale of plant, as shown by output level OQ
in panel (b) of Figure 14.12, all economies of scale are achieved at output OQ and the LAC becomes
constant even if scale of production is expanded. In this case, the LMC lies below the LAC until the mini-
mum optimal scale of plant is reached, as shown in panel (a) of Figure 14.12. When the firm operates in
the range of no-scale-economies, i.e., beyond output OQ in panel (b) of Figure 14.12, the LAC becomes
constant and the LAC curve takes the shape of a horizontal line. Both the parts (declining and constant)
of the LAC curve put together make it roughly L-shaped.
From practical point of view, the modern LAC curve is regarded to be more realistic. But from
analytical and prediction point of view, the traditional cost curves still hold the ground firmly. In fact,
the so-called ‘modern theory of cost’ is a modification of the traditional theory on the basis of empirical
data in some manufacturing industries of some countries.
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304 Chapter 14

1. Distinguish between the following cost concepts:
(a) Opportunity cost and actual cost;
(b) Explicit cost and implicit costs;
(c) Private and social cost; and
(d) Short-run and long-run cost.
2. Suppose Mr Dolittle carries out his own business and makes an annual average income
of Rs 12,00,000. For some market reasons, he expects his business income to go down to
Rs 10,00,000 per annum with no hope to increase in future. Therefore, he decides to take up a
manager’s job in a multinational company which offered him a salary of Rs 90,000 per month.
Find Mr Dolittle’s opportunity cost of his job as a manager.
3. Explain the meaning of and distinguish between the AFC, AVC, AC and MC. Illustrate graphi-
cally the behaviour of relationship between these cost concepts. Why does AFC take the form
of a hyperbola?
4. Illustrate graphically the derivation of SAVC curve from the TVC curve assuming a cubic cost
function. At what point of the TVC curve is the SAVC minimum?
5. Illustrate graphically the derivation of SAC curve from the TC curve assuming a cubic cost
function. At what point of the TC curve is the SVC minimum?
6. Define marginal cost. Show that MC = ΔTVC. (Hint: ΔTFC = 0)
7. Illustrate graphically the derivation of SMC from the STC assuming a cubic cost function as
TC = a + bQ − CQ2 + dQ3. At what level of output is the SMC minimum?
8. Suppose cost–output relationship is given by a cubic cost function. Illustrate graphically
the relationship between AFC, SAVC, SAC and SMC. Why does SMC intersect SAC at its
minimum?
9. Explain and illustrate the relationship between SAC and SMC assuming a cubic cost function.
10. Suppose a cost function is given as TC = A + bQ − cQ2 + dQ3. Derive the SAC, SAVC and SMC
functions. Find the output (Q) at which SAC = SMC.
11. Suppose a firm’s cost function is given as TC = 10 + 6Q − 0.9Q2 + 0.05Q3. Derive firm’s SMC and
SAC functions. What output should the firm produce that minimizes the SAC?
12. What is meant by the ‘envelope curve’? Show graphically the derivation of the envelope curve—
long-run average variable cost curve (LAC). How can you find the minimum LAC?
13. Show graphically the derivation of LMC curve. Why does LMC intersect LAC at its minimum?
14. Suppose that a firm produces an output of 20 units and at this level output firm’s SAC = LAC and
SMC = Rs 50. What is LMC at the output of 20 units?
15. Explain with examples the economies and diseconomies of scale. How do economies and
diseconomies of scale determine the shape of the LAC?
16. Distinguish between the internal and external economies of scale. What are the internal and
external economies of scale?
17. Following the expansion of an industry in a city, many commercial banks set up their branches
in the city. Due to competition among the banks, the rate of interest goes down. As a result,
firm’s cost of borrowing goes down. Is it an internal or external economy to a firm?
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Theory of Cost 305
18. Suppose Pearson Education, a book publishing company, sets up two retail bookshops close
to the Delhi University and the Indraprastha University. It appoints one manager for both
the shops and two assistants for each shop. Encouraged by the increase in the book sale,
the company sets up three more book shops in three other parts of the city under the same
manager. The company hires two assistants for each of these shops. Company’s all other costs
increase proportionately. Does the company have any economy of scale? If yes, what kind of
economy?
19. What is the foundation of the modern theory of cost? How do you think modern theory explains
the firm’s behaviour more appropriately than the traditional theory of cost?
20. What is the basic difference between the traditional and modern theories of cost? Why do firms
under modern theory of cost choose for a machinery set with built-in reserve capacity?
21. What is point of deviation of the modern theory of cost from the traditional theory? The
modern theory of cost states that short-run average variable cost curve (SAVC) not U-shaped.
Why is it so? Show graphically the difference between the modern SAVC and traditional SAVC
curves.
22. The short-run average variable cost (SAVC) is saucer-shaped, not cup-shaped. Illustrate and
explain. Show the derivation and relationship between SAVC and SMC under the assumptions
of the modern theory of cost.
23. Under the assumptions of the modern theory of cost, the short-run average cost curve (SAC)
declines continuously. Explain and illustration of derivation of the SAC curve. Why is it not like
the envelope curve?
24. Derive the long-run average cost curve (LAQ) according to the modern theory of cost. Explain
why LAC curve under the modern theory is L-shaped.
25. The validity of the traditional theory of cost has been questioned on both theoretical and
empirical grounds. Does the modern theory of cost provide a better alternative approach to
explain and predict firm’s behaviour in regard to price and output determination?
26. What is mean by ‘load factor’? How does load factor determine the shape of the LAC curve?
27. Why is LAC curve L-shaped? Illustrate and explain the derivation of the LAC curve.
ENDNOTES
1. Watson, D.S. (1963), Price Theory and Its Uses (Boston, MA: Houghton Mifflin Company),
p. 126.
2. Dean, J. (1960), ‘Managerial Economics’, op. cit., p. 262.
3. As narrated in Chapter 13, given the short-run production function given as Q = f (L, K), K is
assumed to remain constant, while L is the variable input. It implies that, in short run, capital
(K) remaining constant, output can be increased by increasing employment of labour.
4. One method of solving quadratic equation is to factorize it and find the solution. Thus,
Q 3 − 9Q 2 − 100 = 0
(Q − 10)(Q 2 + Q + 10) = 0
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306 Chapter 14
For this to hold, one of the terms must be equal to zero. Suppose
(Q2 + Q + 10) = 0
Then, Q − 10 = 0 and Q = 10.
5. For a detailed discussion, see Koutsoyiannis, A. (1979), Modern Microeconomics (London:
Macmillan), 2nd Edn., pp. 128–138.
6. Stigler, G. (1939), ‘Production and Distribution in the Short Run’, J. Polit. Econ., reprinted in
Readings in the Theory of Income Distribution, American Economic Association, Baltimore,
MD, 1946.
7. Most authors of economics texts including, e.g., Samuelson (now Samuelson and Nordhaus),
Stonier and Hague, Baumol, Lipsey, Ferguson (now Gould and Lazear), Hirshleifer, Nicholson,
Henderson and Quandt, Hall Varian, Lipsey and Crystals, Stiglitz and Driffill, Mankiw,
Pindyck and Rubinfeld, Browning and Browning, Perloff, Maddala and Miller, do not find the
so called ‘modern cost theory’ worth mention in their text. The two notable exceptions are
books by K. Lancaster and A. Koutsoyiannis. In fact, there is nothing like ‘modern theory of
cost’ recognized by the economists in general. However, some textbook authors, and under-
graduate course committees of some universities, e.g., Delhi University (B.Com., Hons.) do
recognize the ‘modern theory of cost’. Therefore, we give here a brief description of the so called
‘the modern theory of cost’ for the sake of completeness.
8. Clower, R.W. and Due, J.F. (1972), Microeconomics (Georgetown, Canada: Irwin-Dorsey),
p. 232 (quoted in Koutsoyiannis, op. cit., p. 121).
9. Bain, J.S. (1956), Barriers to New Competition (Cambridge, MA: Harvard University Press),
p. 63.
FURTHER READINGS
Baumol, W.J. (1985), Economic Theory and Operations Analysis (New Delhi: Prentice-Hall of India), 4th
Edn., Chapter 11.
Chamberlin, E.H. (1948), ‘Proportionality, Divisibility and Economies of Scale’, Q. J. E., pp. 229–263.
Douglas, P.H. (1948), ‘Are There Laws of Production’, American Economic Review, 38 (March): 1–41.
Gould, J.P. and Lazear, E.P. (1993), Microeconomic Theory (Homewood, IL: Richard D. Irwin), 6th Edn.,
Chapters 6 and 7.
Hicks, J.R. (1946), Value and Capital (Oxford: Oxford University Press), 2nd Edn., pp. 78–98.
Hirshleifer, J. (1987), Price Theory and Applications (New Delhi: Prentice Hall of India), 3rd Edn.,
Chapter 7.
Koutsoyiannis, A. (1979), Modern Microeconomics (London: Macmillan Press Ltd), 2nd Edn.,
Chapters 3 and 4.
Leftwich, R.H. (1973), The Price System and Resource Allocation (New York: Hold, Richart and Winston),
5th Edn., Chapters 8 and 9.
Leibhafsky, H.H. (1968), The Nature of Price Theory (Homewood, IL: The Dorsey Press and Richard
D. Irwin), Revised Edn., Chapter 7.
Lipsey, R.G. (1978), An Introduction to Positive Economics (London: English Language Book Society),
Chapter 17.
M14_DWIV9400_02_SE_C14.indd 306 06/07/11 1:12 AM

Theory of Cost 307
Mishan, E.J. and Borts, G.H. (1962), ‘Exploring the Uneconomic Regions of the Production Function’,
Rev. Econ. Stud., pp. 300–312.
Nicholson, W. (1975), Intermediate Microeconomics and Its Applications (Hinsdale, IL: Drydon Press),
Chapters 6 and 7.
Robertson, D.H. (1924), ‘Those Empty Boxes’, Economic Journal, (March): 16–30. Reprinted in Readings
in Price Theory, G.J. Stigler and K.E. Boulding (ed), (Homewood, IL: Richer D. Irwin).
Samuelson, P.A. (1947), Foundation of Economic Analysis (Cambridge, MA: Harvard University Press),
pp. 57–89.
Shepherd, R.W. (1953), Cost and Production Functions (Princeton: Princeton University Press).
Stonier, A.W. and Hague, D.C. (1972), A Textbook of Economic Theory (New York, NY: John Wiley and
Sons), 4th Edn., Chapters 5 and 10.
Tangri, O.P. (1966), ‘Omissions in the Treatment of the Laws of Variable Proportions’, American
Economic Review, (June): 484–492. Reprinted in Readings in Microeconomics, Briet, W.L. and
H.M. Hochman (ed).
Viner, J. (1931), ‘Cost Curves and Supply Curves’, in Am. Eco. Assn., Readings in Price Theory (Homewood,
IL: Richard D. Irwin, 1952), pp. 198–232.
M14_DWIV9400_02_SE_C14.indd 307 06/07/11 1:12 AM

M14_DWIV9400_02_SE_C14.indd 308 06/07/11 1:12 AM

Part V
Theory of Firm:
Determination of Price
and Output
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Chapter 15
The Objectives of Business

Firms and Their Market
Powers
CHAPTER OBJECTIVES
In this and the subsequent four chapters, we shall discuss the theories that deal with price and output
determination by the firms. There are two most important factors that play the major role in a firm’s
decision on price and output determination: (i) firm’s own objectives, i.e., what the firm wants to achieve
and (ii) its market power to decide on the price and output that meet its objectives. The objectives of this
chapter are to explain the following aspects:
What are the various objectives of business firms under different kinds of market conditions;
Why profit maximization is assumed, at least theoretically, to be the basic objective of business
firms;
What are and what can be the alternative objectives of business firms, i.e., the objectives other than
profit maximization; and
What are the different kinds of markets—the play ground of firms—and how the nature of the
market determines firm’s power to make a decision on price and output for its profit maximization.
THE OBJECTIVES OF BUSINESS FIRMS

The economists of different ages have perceived different objectives of business firms. The economics
literature reveals that business objectives are various and vary from firm to firm. The various objectives
of business firm that appear in economics literature are as follows:
1. Maximization of profit
2. Maximization of sales revenue
3. Maximization of firm’s growth rate
4. Maximization of managerial utility function
M15_DWIV9400_02_SE_C15.indd 311 07/07/11 1:49 AM

312 Chapter 15
5. Maximization of firm’s net worth

6. Satisfactory or standard profit
7. Long-run survival and market share.
Of these objectives, profit maximization forms the basis of the traditional theory of firm. This objec-
tive has, however, been a matter of controversy. Profit maximization is, therefore, discussed in detail.
Other objectives are briefly described under Alternative Objectives of Business Firms.
Profit Maximization as Business Objective

The traditional economic theory assumes profit maximization as the sole objective of business firms.
This assumption has a long history in economic literature and, as mentioned above, conventional theory
of price determination is based on this very assumption. The profit-maximization assumption is regarded
as the most realistic and analytically most ‘productive’ assumption. The strength of this assumption lies
in the fact that it has never been unambiguously disproved.
Another argument in support of the profit-maximization objective is that the theory of firm based
on this objective has a great predictive power. It helps in predicting the behaviour of business firms in the
real world. The profit-maximization objective helps also to predict the price and output determination
under changing market conditions. It is generally accepted that no other business objective explains and
predicts behaviour of the business firms better than profit-maximization objective.
When Is the Profit Maximum? Total profit (П) is defined as the excess of total revenue (TR) over
the total cost (TC), i.e.,
Π = TR − TC.
Profit, defined as above, is maximum when TR − TC is maximum. A profit-maximizing firm seeks
to maximize TR − TC. To achieve this goal, the firm chooses a price and an output which maximizes
TR − TC. Let us now discuss the technical conditions of profit maximization.
Profit-Maximization Conditions
There are two conditions that must be satisfied for the profit to be maximum. These conditions are
known as:
1. necessary or first-order conditions and
2. supplementary or second-order condition.
The technical meaning of these conditions and their application are explained below:
The Necessary or First-Order Condition The first-order condition for profit maximization
requires that marginal cost (MC) must be equal to marginal revenue (MR), i.e., profit is maximum at the
level of output (Q) at which
MC = MR (15.1)
This is a necessary condition in the sense that it must satisfy for profit to be maximum: profit is not
maximized if this condition is not fulfilled.
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The Objectives of Business Firms and Their Market Powers 313
Marginal cost has already been defined in Chapter 14. To recall, marginal cost (MC) equals the first
derivative of the total cost (TC) function. That is,
∂TC
MC = (15.2)
∂Q
Similarly, given the TR function, marginal revenue (MR) can be obtained as the first derivative of the
TR function, i.e.,
∂TR
MR = (15.3)
∂Q
Having defined MC and MR, as given in Eqs. (15.2) and (15.3), respectively, the first-order condition
of profit maximization may now be stated as follows:
Profit is maximum where
∂TC ∂TR
=
∂Q ∂Q
or
∂TC ∂TR
− =0 (15.4)
∂Q ∂Q
This point can be proved by using TC and TR functions. Suppose TC and TR function are given as
follows:
TC = 100 + 60Q − 12Q 2 + Q 3 (15.5)
and
TR = 60Q (15.6)
(where Q = quantity produced and sold).
Given the total cost (TC) function as in Eq. (15.5), we get
∂TC
MC = = 60 − 24Q + 3Q 2 (15.7)
∂Q
And, by differentiating the TR function as given in Eq. (15.6), we get
∂TR
MR = = 60 (15.8)
∂Q
Going by the necessary condition, we need to find profit-maximizing output. The profit-maximization
output (Q) is obtained by equating MC and MR functions as given in Eqs. (15.7) and (15.8), respectively,
and finding the value for Q.
MC = MR
60 − 24Q + 3Q 2 = 60
Q =8
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314 Chapter 15
In accordance with the first-order condition, given the TC function (Eq. (15.5)) and TR function
(Eq. (15.6)), profit is maximum at output Q = 8. Given the first-order condition, profit is maximized at
Q = 8 and at no other output.
The Second-Order Condition The second-order condition normal of profit maximization

requires that the first-order condition must be fulfilled under the condition of rising marginal cost.
In technical terms, the second-order condition of profit maximization requires that the second deriv-
ative of TR function is less than that of TC function. Or, in other words, the first derivative of MR
function is less than that of MC function. The second-order condition may be expressed as
∂2TR ∂2TC
< 2
∂2 Q ∂Q
or
∂MR ∂MC
< (15.9)
∂Q ∂Q
In the example above, MR = 60 and MC = 60 − 24Q + 3Q2. So the second-order condition (Eq. (15.9))
can be written as
∂MR ∂MC
− <0 (15.10)
∂Q ∂Q
By substituting MR and MC function, in Eq. (15.10), we express the second-order condition as
∂(60) ∂(60 − 24Q + 3Q 2 )

− <0
∂Q ∂Q
or
0 − (−24 + 6Q ) < 0 (15.11)
This point can be proved as follows. In our example, profit-maximization output is 8. By substituting
8 for Q in Eq. (15.11), we get
24 − 48 < 0.
Thus, the second-order condition is also fulfilled at Q = 8.
Numerical Illustration
We have illustrated above the application of necessary and supplementary conditions of profit maxi-
mization by using the TC and TR functions. Now, we illustrate the application of profit-maximization
conditions numerically by using the same TC and TR functions.
For the purpose, let us recall the TC and TR functions in Eqs. (15.5) and (15.6), given respectively as
TC = 100 + 60Q − 12Q 2 + Q 3
and
TR = 60Q
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Table 15.1 Cost and Revenue Functions

Q TC = 100 + 60Q - TR = 60Q P = TR - TC MC* = ìTC/ìQ = MR = ìTR/ìO
12Q2 + Q3 60 - 24Q + 3Q2
(1) (2) (3) (4) (5) (6)
0 100 0 −100 100 60
1 149 60 −89 39 60
2 180 120 −60 24 60
3 199 180 −19 15 60
4 212 240 28 12 60
5 225 300 75 15 60
6 244 360 116 24 60
7 275 420 145 39 60
8 324 480 156 60 60
9 397 540 143 87 60
10 500 600 100 120 60
11 639 660 21 159 60
12 820 720 −100 204 60
*Except for zero output.
The cost and revenue data generated for output from 0 to 12 are presented in Table 15.1. Columns
(2) and (3) show the TC and TR, respectively, for output from 0 to 12. Column (4) shows the total profit,
TR − TC = П. As the table shows, the total profit (П) is maximized at Rs 156 and the profit-maximizing
output is 8 units. Note that, at output of 8 units, MC = MR = Rs 60. This satisfies the necessary condition
of profit maximization.
A look at the MC figures in column (5) reveals that the profit-maximizing output (Q = 8) satisfies
also the supplementary conditions. That is, the necessary condition (MC = MR) of profit maximization is
satisfied under rising MC. As column (5) shows, MC begins to rise at output 5 units and continues to rise
as output increases. The rising MC equals MR at output 8 units.
This description provides a numerical proof of the profit-maximization conditions presented algebra-
ically in Eqs. (15.1)–(15.11).
Graphical Instruction
The firm’s cost and revenue functions are presented graphically in Figure 15.1. Since price is assumed
to be constant (at Rs 60), TR curve, as shown in Figure 15.1(a), is a straight line with a slope equal to
∂TR/∂Q = 60. It shows that TR increases at a constant rate of Rs 60 with each unit produced and sold.
The cost function, which is of cubic form, gives a TC curve that shows increase in total cost at varying
rates, it increases first at increasing rates and then at decreasing rates, as shown in Figure 15.1(a).
As panel (a) of Figure 15.1 shows, up to three units of output, TC curve lies above the TR curve. It
means TC > TR till three units of output. The firm is, therefore, incurring loss to the extent of TC − TR.
At Q = 4, its TR exceeds TC and the firm begins to earn profits from output four units onwards. Beyond
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316 Chapter 15
900 (a) TC
Total cost and total revenue (Rs) 800 TC = 100 + 60Q – 12Q2+ Q2
TR
700 TR = 60Q
600
P
500
K
400
300
M
200 T
J Profit curve
100
Q
O 1 2 3 4 5 6 7 11 12
8 9 10
Quantity (Q) Π
200 (b)
160
MC = 60 – 24Q + 3Q2
MC
MC and MR
120
80
A B
60 MR
40
O 1 2 3 4 5 6 7 8 9 10 11 12
Quantity (Q)
Figure 15.1 Dete mination of a im m ofit and t t
11 units, however, TC overtakes TR. It means that the firm’s profitable range of output lies between 4 and
11 units. But the total profit (П) varies from output to output. Note that the distance between TR and
TC first increases and then decreases. It implies that profit first increases with the increase in output, but
beyond a certain level of output, it begins to decrease. In simple words, profitable range of output lies
between 4 and 11 units of output and the maximum profit lies in between.
Given the TC and TR functions, graphical method requires drawing a tangent to TC in the range
output at which TR > TC and parallel to TR, as shown by the line JK in panel (a) of Figure 15.1. The line
JK is tangent to TC at point M. As Figure 15.1(a) shows, the gap between TR and TC is maximum at
point M. A perpendicular drawn from point M to TR gives the maximum difference, PM, between TR
and TC. Thus, PM is the maximum possible profit. The profit-maximizing output can, now, be obtained
by extending the line PM to the output axis. Going by this process as shown in Figure 15.1(a), eight units
of output maximize the profit. This is, incidentally, also the optimum level of output for the firm.
M15_DWIV9400_02_SE_C15.indd 316 07/07/11 1:49 AM

The maximum of profit at output eight units can also be shown by plotting the profit data, as shown
by the curve marked П. The profit curve shows the rise and fall in the total profit with the increase
in output. It can be seen that profit reaches its maximum level (TQ) when output reaches eight units.
Note also the PM and TQ fall on the same line and PM = TQ, at Q = 8.
Controversy on Profit-Maximization Objective

Although profit-maximization assumption continues to form the basis of the price theory, there has been
a good deal of controversy on this assumption. The profit-maximization objective has been criticized on
the following grounds:
First, Hall and Hitch1 have made the most damaging criticism of profit-maximization objective. In
their empirical study ‘Price Theory and Business Behaviour’, they produced a startling result that firms
do not attempt to maximize their profit.
Secondly, profit-maximization approach is too simple to explain the real world business phenom-
enon. According to Baumol, even business executives are not fully aware of objectives which they really
pursue in their business decisions. In his own words, ‘It is most frequently assumed in economic analysis
that the firm is trying to maximize its total profit. However, there is no reason to believe that all business-
men pursue the same objective.’ He adds,
In fact, it is common experience when interviewing executives to find that they will agree to every
plausible goal about which they are asked. They say they want to maximize sales and also to maximize
profits; that they wish, in the bargain, to minimize costs; and so on. Often most of these objectives
conflict with one another and it is normally impossible to serve such a multiplicity of goals at a time.2
Thirdly, there exist alternative and equally plausible hypotheses that can better explain the reality in the
business world. It is likely that a small, owner-managed firm seeks to maximize its profit. In large business
organizations, however, management is separated from ownership and managers use their discretion in
setting the goal(s) for the firm they manage. A variety of alternative hypotheses have therefore been put
forward, particularly in respect of objectives of the business firms, such as sales maximization, a target
rate of return on investment, a target market share, ‘preventing price competition’ and so on.
Fourthly, a very important controversy surrounds the idea of marginalism. It is argued that real world
firms do not have the necessary knowledge and a priori data to equalize their MR and MC. Hence, they
cannot maximize their profits in terms of profit-maximization conditions. Even if they do possess the
necessary information, they may not maximize their profits. Most economists agree that real world firms
do not have necessary information to maximize their profits in as exact a manner as proclaimed under
profit-maximization hypothesis. Most firms actually have only a vague idea about the demand curve
for their product and also about their MR and MC curve. It is, also, argued that empirical evidence on
whether firms maximize profits is not unambiguous.
Defence of Profit-Maximization Objective The arguments against profit-maximization

hypothesis should not mean that pricing theory has no relevance to the actual pricing policy of the busi-
ness firms. A section of economists, popularly known as ‘marginalists’, have successfully defended the
‘marginal principle’ of pricing and output decisions. The empirical and theoretical support put forward
by them in defence of the marginal rule of pricing may be summed up as follows.
In two empirical studies of 110 ‘excellently managed companies’, Early3 has concluded that firms do
apply the marginal rules in their pricing and output decisions. Fritz Machlup4 has argued in abstract
theoretical terms that empirical studies by Hall and Hitch, and Lester do not provide conclusive evi-
dence against the marginal rule and these studies have their own weaknesses. He argues that there has
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318 Chapter 15
been a misunderstanding regarding the purpose of the traditional theory of value. According to him, the
traditional theory seeks to explain market mechanism, resource allocation through price mechanism and
has a predictive value, rather than deal with specific pricing practices of the firms. He has further argued
that the relevance of marginal rules in actual pricing system of firms could not be established because of
lack of communication between the businessmen and the researchers as they use different terminology.
Businessmen are not quite familiar with economic terminology like MR, MC and elasticities. Besides, busi-
nessmen, even if they do understand economic concepts, would not admit that they are making abnormal
profits on the basis of marginal rules of pricing. They would instead talk of a ‘fair profit’. Also, Machlup is
of the opinion that the practice of setting price equal to average variable cost plus a profit margin is not
incompatible with the marginal rule,5 and that the assumptions of traditional theory are plausible.
It is however difficult to give judgement on the controversy between the economists supporting
marginalism in profit maximization and the empirical researchers. The controversy remains unresolved.
The proponents of profit-maximization hypothesis have, however, put forward the following arguments
in defence of the profit-maximization objective.
First, it is argued that only those firms will survive in a competitive market which is able to make
reasonable profits. That is, for their survival, the firms will have to make profits and maintain their total
earnings above their total costs. Since they are in business, they would always try to maximize their prof-
its. All other objectives are secondary to this primary objective. In their effort to maximize their profits,
firms would eventually tend to behave in accordance with the marginal rules of profit maximization,
at least approximately.
Secondly, the strength of profit-maximization hypothesis lies in the fact that economists have found
this hypothesis extremely accurate in predicting certain aspects of a firm’s behaviour. Milton Friedman
argues that one cannot judge the validity of profit-maximization hypothesis either by a priori logic or by
asking business executives. The ultimate test is predictive ability of the hypothesis. And, predictive ability
of profit-maximization hypothesis is greater than any alternative hypothesis.6
Thirdly, profit maximization is a time-honoured hypothesis and the evidence against this hypothesis
is not unambiguous. ‘Most economists today … believe that the assumption of profit maximization pro-
vides a close enough approximation for the analysis of many problems, and it has become the standard
assumption regarding the behaviour of the firm.’7
For the sake of completeness, however, we have briefly discussed below some major alternative
hypotheses which have been suggested by different economists to analyse firm’s behaviour.
Alternative Objectives of Business Firms

Although, profit-maximization assumption continues to remain the most popular hypothesis in
economic analysis, as Baumol has argued ‘there is no reason to believe that all businessmen pursue
that same objective’.8 The observed facts reveal that business firms, in fact, pursue multiple objectives,
often conflicting with each other. Some major alternative objectives of firms, suggested by different
economists, may be grouped as follows:
1. Maximization of the managerial utility function
2. Satisfying goals of the firms
3. Long-run survival and market-share goals
4. Entry prevention and risk avoidance.
These business objectives are briefly discussed herein.
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Maximization of Managerial Utility Function Managerial theories of firms postulate that

owners and managers are separate entities in large corporations. The dichotomy between the ownership
and the management allows managers to use their discretion in setting the goals for the organization
they manage. The managers of such corporations, instead of maximization profits, set such goals that
can keep the owners satisfied, on the one hand, and secure and promote their own interest in the firm,
on the other. The managers have, in fact, their own utility function to maximize and, at the same time,
keeping owners of the firm satisfied. Although there is no unanimity on the variable that are included in
the utility functions of the managers, the most common ones are manager’s salary, job security, managers’
perks, a reasonable profit, market share, prestige of the firm and trouble-free management.
The main theories under maximization of managerial utility functions are:
1. Baumol’s sales revenue maximization hypothesis;
2. Marris’s theory of growth rate maximization; and
3. Williamson’s theory of managerial discretion.
Managerial objectives of this category are briefly discussed herein.
Baumol’s Theory of Sales Revenue Maximization Baumol9 has postulated maximization

of sales revenue as an alternative objective to profit maximization. The reason behind this objective is
dichotomy of ownership and management. This dichotomy gives managers an opportunity to set their
own goals, other than profit maximization which most owner businessmen pursue. Given the opportu-
nity, managers choose to maximize their own utility function. According to Baumol, the most plausible
factor in manager’s utility function is maximization of sales revenue.
The factors which explain the pursuance of this goal by the managers are as follows:
First, salary and other earnings of managers are more closely related to sales revenue than the profits.
Secondly, banks and financial corporations look at sales revenue while financing the corporation.
The reason is while sales data are available periodically whereas the final profit data are available only
annually.
Thirdly, trend in sales revenue is the readily available indicator of performance of the firm. It also
helps in handling the personnel problems.
Fourthly, increasing sales revenue enhances the prestige of managers while profits go to the owners.
Fifthly, managers find profit maximization a difficult objective to fulfil consistently over time and at
the same level. Profits may fluctuate with changing conditions.
Finally, growing sales strengthen competitive spirit of the firm in the market.
So far as empirical validity of sales maximization hypothesis is concerned, empirical evidences are
inconclusive.10 Most empirical works are based on inadequate data since requisite data are mostly not
available. Besides, it is also argued that, in the long run, sales- and profit-maximization hypotheses con-
verge into one. For, in the long run, the sales maximization objective tends to yield only normal level of
profit and normal profit turns out to be the maximum profit under competitive conditions. Thus, sales
maximization is not incompatible with profit maximization.
Marris’s Hypothesis of Growth Rate Maximization Marris has suggested11 another alter-
native objective to profit maximization, i.e., maximization of balanced growth rate of the firm. It means
‘maximization of demand of firm’s product and growth of capital supply’. According to Marris, by
maximizing these variables, managers maximize both their own utility function and that of the owners.
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320 Chapter 15
The managers can do so because most of the managerial variables (salaries, status, job security, power
and so on) appearing in their utility function and those appearing in the utility function of the owners
(e.g. profits, capital, market share and so on) are positively and strongly correlated with a single variable,
i.e., size of the firm. Maximization of these variables depends on the maximization of the growth rates of
the firm. The managers, therefore, seek to maximize the steady growth rate.
Although Marris’s theory is more rigorous and sophisticated than Baumol’s sales maximization, it has
its own weaknesses. It fails to deal satisfactorily with oligopolistic interdependence. A serious shortcom-
ing of his model is that it ignores the price determination which is the main concern of profit-maximi-
zation hypothesis.
Williamson’s Maximization of Managerial Utility Function Like Baumol and Marris,

Williamson12 argues that managers have discretion to pursue objectives other than profit maximiza-
tion. That is, managers seek to maximize their own utility function subject to a minimum level of
profit. A minimum profit is necessary to satisfy the shareholders or else security of the manager’s job
is endangered.
The utility function, which managers see to maximize, include a quantifiable variable, e.g., salary,
sales and so on, and such non-quantifiable variables as prestige, power, status, job security, professional
excellence and so on. The non-quantifiable variables are expressed quantitatively so as to make them
operational, in terms of expense preference which is defined as ‘satisfaction derived out of certain types
of expenditures’ (such as slack payments), and ready availability of funds for discretionary investment.
Like other alternative hypotheses, Williamson’s theory too suffers from certain weaknesses. His model
fails to deal with the problem of oligopolistic interdependence. This hypothesis is said to hold only where
rivalry is not strong. Where rivalry is strong, profit maximization is claimed to be a more appropriate
hypothesis. Thus, Williamson’s managerial utility function too does not offer a hypothesis more satisfac-
tory than profit maximization.
It may be explained, at the end, that the hypotheses suggested by Baumol, Marris and Williamson are
similar in nature. They differ in respect of the variables to be maximized.
Satisfying Goals of the Firms Some economists13 argue that the real business world is full of
uncertainty; accurate and adequate data are not readily available; where data are available, managers
have little time and ability to process them; and managers work under a number of constraints. Under
such conditions, it is not possible for the firms to act in terms of postulated profit-maximization
hypothesis. Nor do the firms seek to maximize sales, growth or anything else. Instead they seek to
achieve a satisfactory profit or satisfactory growth, and so on. This behaviour of firms, he terms, as ‘satis-
fying behaviour’. The underlying assumption of satisfying behaviour of firms is that a firm is a coalition
of different groups connected with various activities of the firm, e.g., shareholders, managers, workers,
input suppliers, customers, bankers, tax authorities and so on. All of these groups have expectations—
often conflicting—from the firm, and the firm seeks to satisfy all of them in one way or another by
sacrificing their own profit to some extent.
The behavioural theory has, however, been criticized on the following grounds: First, though behav-
ioural theory deals realistically with the firm’s activity, it cannot explain the firm’s behaviour under
dynamic conditions in the long run. Secondly, it cannot be used to predict exactly the future course of
firm’s activities. Thirdly, this theory does not deal with equilibrium of the industry. Fourthly, like other
alternative hypotheses, this theory too, fails to deal with interdependence and interaction of the firms
under oligopolistic conditions.
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Long-run Survival and Market-share Goals Another alternative objective to profit-

maximization hypothesis, suggested by Rothschild14 is that the primary goal of the firm is to survive
in the long run. Some others have suggested that attainment and retention of a constant market share,
is the objective of the firms. The managers, therefore, seek to secure their market share and long-run
survival, the firms may seek to maximize their profit in the long run, though it is not certain.
Entry Prevention and Risk Avoidance Another objective of the firms suggested by some
authors is to prevent entry of new firms into the industry. The motive behind entry prevention may be
(a) profit maximization in the long run, (b) securing a constant market share and (c) avoidance of risk
caused by the unpredictable behaviour of the new entrants. They argue that the evidence on whether firms
maximize profits in the long run is not conclusive. Some economists argue also that where management
is divorced from the ownership, the possibility of profit maximization is reduced. Some also argue that
only profit-making firms can survive in the long run. They can achieve all other subsidiary goals easily
if they maximize their profits.
No doubt, preventing entry may be the major objective in the pricing policy of the firm, particularly
in case of limit pricing but then the motive behind entry prevention is to secure a constant share in the
market. Securing constant market share is thus compatible with profit maximization.
Conclusion
Although profit maximization continues to remain the most popular hypothesis in economic analysis,
there is no reason to believe that this is the only objective that firms pursue. Modern corporations, in fact,
pursue multiple objectives. The economists have suggested a number of alternative objectives that firms
pursue. The main factor behind the multiplicity of the objective, particularly in case of large corpora-
tions, is the dichotomy of management and the ownership. Besides, objectives of business firms keep
changing under the changing market conditions. For example, the objective of Air India in 2009–2010
was not to make profit—let alone the profit maximization. Its main objective was to cut cost with the
purpose of reducing its losses over the past four years.
However, profit-maximization hypothesis is a time-honoured one. It is easier to handle. The empiri-
cal evidence against this hypothesis is not unambiguous or conclusive. The alternative hypotheses are
not strong enough to replace the profit-maximization hypothesis. What is more important, profit-
maximization hypothesis has a greater explanatory and predictive power than the alternative hypotheses.
Therefore, profit-maximization hypothesis still forms the basis of price theory.
THE MARKET STRUCTURE AND POWER OF FIRMS

Apart from firm’s objective, another factor that plays an important role in firm’s choice of price and
output is the nature of market structure. The term market structure refers to the organizational features
of an industry that influence the firm’s behaviour in its choice of price and output. The difference in the
market structure is an economically significant feature of the market. It determines the powers and the
behaviour of firms in respect of their production and pricing decisions. Market structure is classified on
the basis of the nature of competition in the industry, more specifically, on the basis of degree of compe-
tition among the firms. In general, the organizational features include the number of firms, distinctive-
ness of their products, elasticity of demand and the degree of firm’s control over the price of the product.
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322 Chapter 15
In this section, we present a brief description of the market structure, i.e., the playing field of the
firms. This will give us an idea of the coverage and subject matter of this part of the book. The nature
and the characteristics of different kinds of market will be discussed in detail in the subsequent chapters
along with price and output determination in each kind of market. Here, we present only an overview
of the market structure.
The market structure is generally classified on the basis of the nature of competition as follows:
1. Perfect competition
2. Imperfect competition
3. Monopoly.
The basic features of these kinds of markets are summarized in Table 15.2 and below are the brief
description of each market.
Table 15.2 Kinds of Market Structure

Types of Market Number of Nature of Product Firm’s Control
Firms over Price
1. Perfect competition Very large Homogeneous (wheat, sugar, None
vegetables and so on)
2. Imperfect competition
(a) Monopolistic Many Real or perceived difference in Some
competition product (most retail trade)
(b) Oligopoly Few 1. Product without differentiation Some
(e.g. bread, steel, and chemical,
sugar and so on)
2. Differentiated products (e.g. tea,
toothpastes, soaps, detergents,
automobiles and so on)
3. Monopoly Single Products without close substitutes, Full but generally
like gas, electricity and telephones regulated
Perfect Competition
Perfect competition is a market situation in which a large number of producers offer a homogenous
product to a very large number of buyers of the product. The number of sellers is so large that each seller
offers a very small fraction of the total supply, and therefore, has no power to control the market price.
Likewise, the number of buyers is so large that each buyer buys an insignificant part of the total supply
and has no power to control the market price. Both buyers and sellers are price takers, not price makers.
The price of a commodity is determined in this kind of markets by the market demand and market sup-
ply. Each seller faces a horizontal demand curve (with e = ∞), which implies that a seller can sell any
quantity at the market determined price. Each firm is in competition with so large number of firms that
there is virtually no competition. This kind of market is, however, more of a hypothetical nature rather
than being a common or realistic one. Some examples of a perfectly competitive market include share
markets, vegetable markets, wheat and rice mandis where goods are sold by auction.
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Imperfect Competition
Perfect competition, in strict sense of the term, is a rare phenomenon. In reality, markets for most
goods and services have imperfect competition. Imperfect competition is said to exist when a num-
ber of firms sell homogeneous or differentiated products with some control over the price of their
product. Barring a few goods such as shares and vegetable (daily) markets, you name any commodity,
its market is imperfect. In spite of a large number of dealers (arhatias) in wheat market, the Food
Corporation of India is the biggest buyer and seller of wheat in India, with a great degree of control
over wheat prices.
Sources of Imperfect Competition Imperfect competition arises mainly from the barriers to
entry. Barriers to entry of new firms are generally created by the following factors:
First, large-size firms which enjoy economies of scale can cut down their prices to the extent that can
eliminate new firms or prevent their entry to the industry, if they so decide.
Secondly, in some countries, like India, industrial licencing policy of the government creates barrier
for the new firms to enter an industry.
Thirdly, patenting of rights to produce a well-established product or a new brand of a commodity
prevents new firms from producing that commodity.
Fourthly, sometimes entry of new firms to an industry is prevented by law, with a view to enabling the
existing ones to have economies of scale so that prices are low.
Imperfect competition creates two different forms of markets, with different number of producers,
with different degrees of competition, classified as (a) monopolistic competition and (b) oligopoly.
1. Monopolistic Competition. Monopolistic competition is a kind of market where a large num-
ber of firms supply differentiated products. The number of sellers is so large that each firm can
act independently of others, without its activities being watched and countervailed by others.
Besides, it is not only extremely difficult to keep track of competitors’ strategy, but also it is not
of any avail. In this respect, it is similar to perfect competition. It differs from perfect competi-
tion in that the products under monopolistic competition are somewhat differentiated whereas
they are homogeneous under perfect competition. In perfect competition, there is free entry
and free exit of firms.
2. Oligopoly. Oligopoly is an organizational structure of an industry in which a small number
of firms supply the entire market, each seller having a considerable market share and control
over the price. Most industries in our country are oligopolistic. A small number of compa-
nies supply the entire range of products such as sugar, tea, soaps, medicines, cosmetics, refrig-
erators, TV sets and VCRs, cars, trucks, jeeps, salt, vegetable oils (vanaspati), and so on. The
producers of all these goods have some control over the price of their products. Their prod-
ucts are somewhat differentiated, at least made to look different in the consumers’ perception.
Products of different firms in the industry are treated as close substitutes for one another, for
example, Britannia and Modern breads. Therefore, demand curve for their product has high
cross-elasticity, but less than infinity, unlike under perfect competition.
Monopoly
Monopoly is the kind of market in which there is a single seller with control over of a product price
and output. Monopoly is the antithesis of perfect competition. Absolute monopolies are rare these days.
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324 Chapter 15
They are found mostly in the form of government monopolies in public utility goods, e.g., electricity,
telephone, water, gas, petrol and petroleum products, rail and postal services and so on.
A PRELUDE TO THE THEORY OF FIRM

The theory of firm came into existence during the 1930s with Joan Robinson’s The Economics of Imperfect
Competition and Edwin H. Chamberlin’s The Theory of Monopolistic Competition, both written indepen-
dently in 1933. Earlier, the theory related to price determination was known as the Theory of Value attrib-
uted mainly to Alfred Marshall formulated in his Principles of Economics. The theory of value founded
by Marshall on the assumptions of perfect competition and in static equilibrium system was taken to
provide answer to all questions regarding price, output and income. The existence of perfect competition
was, however, challenged by Sraffa. He showed that perfect competition was not logically consistent with
partial equilibrium analysis. This led to the abandonment of the assumption of the perfect competition
and Robinson and Chamberlin developed independently their own theories of imperfect competition and
theory of monopolistic competition, respectively. Joan Robinson and Chamberlin have demonstrated that
price and output are determined by firm’s individual decisions under the conditions of imperfect competi-
tion. They had, however, retained the earlier assumption of profit maximization. Later this assumption
was challenged, as we explained in profit-maximization conditions, and many new theories of firms were
suggested. None of the theories has, however, received a universal acceptance.
In the forthcoming chapters, we will discuss in detail the various theories of firm dealing with price
and output determination.

1. Write a note on the objectives of business firms and their acceptability in the theory of firms.
2. Profit is maximum when the difference between the total revenue and the total cost is the
largest. How is this equivalent to saying that the profit is maximized when marginal revenue
equals marginal cost?
3. Show graphically that profit is maximum where marginal cost equals marginal revenue. Is there
any exception to this rule?
4. Suppose revenue and cost function of a firm are given, respectively, as follows:
C = 100 + 60Q − 12Q2 + Q3
R = 60
Find (i) MC and MR (ii) profit-maximization output.
5. Given the cost function as C = 128 + 169Q − 14Q2 + Q3 and P = 60, find MC, MR at output that
maximizes profit.
(Ans. MC = 60, MR = 60, Q = 9)
6. Find maximum-profit output and maximum profit from cost function, C = 50 − 6Q2, and price
function P = 100 − 4Q. Also derive MC and MR.
(Ans. Q = 5, Maximum profit = 200)
7. What are the arguments against profit maximization as the objective of business firm? Is there
conclusive evidence against profit-maximization hypothesis?
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8. What are the alternative objectives to profit maximization by the firms? On what grounds are
based the alternative hypothesis?
9. Compare and contrast Baumol’s sales revenue maximization hypothesis and Williamson’s
hypothesis of maximization of managerial utility function.
10. What is meant by market structure? What are the main kinds of market structure? How does
organizational set-up of an industry influence the firm’s behaviour in its choice of price and
output?
ENDNOTES
1. Hall, R.L. and Hitch, C.J. (1952), ‘Price Theory and Business Behaviour’, Oxford Econ. Pap.,
1939, reprinted in Studies in Price Mechanism, T. Wilson and P.W.S. Andrews (ed), (Oxford:
Oxford University Press).
2. Baumol, W.J. ‘Economic Theory and Operations Analysis’, (New Delhi: Prentice-Hall), pp. 377
and 3780.
3. Early, J.S. (1956), ‘Recent Developments in Cost Accounting and the Marginal Policies of
Excellently Managed Companies’, American Economic Review.
4. Machlup, F. (1946), ‘Marginal Analysis and Empirical Research’, Am. Eco. Rev., and ‘Theories of
the Firm: Marginalist, “Managerialist, Behavioural”’, American Economic Review, 1967.
5. This point has been discussed in detail in Chapter 19.
6. Friedman, M. ‘The Methodology of Positive Economics’, op. cit.
7. Browning, E.K. and Browning, J.M. Microeconomic Theory and Application, (op. cit.), p. 231.
8. Baumol, W.J. ‘Economic Theory and Operations Analysis’, (op. cit.), p. 378.
9. ——— W.J. (1959), Business Behaviour, Value and Growth (New York: Macmillan), and rev. edn
(Harcourt Brace and World Inc., 1967).
10. For more details, see Koutsoyiannis, op. cit., pp. 346–351.
11. Marris, R.L. (1963), ‘A Model of the Managerial Enterprise’, Q.J.E. See also his Theory of
Managerial Capitalism (New York: Macmillan, 1963).
12. Williamson, O.E. (1963), ‘Managerial Discretion and Business Behaviour’, American Economic
Review.
13. Cyert, R.M. and March, J.G. (1963), A Behavioural Theory of Firm (Englewood Cliffs,
NJ: Prentice Hall). Earlier this theme was developed by H.A. Simon in his ‘A Behavioural Model
of Rational Choice’, Q.J.E., 1995, pp. 99–118.
14. Rothschild, K.W. (1947), ‘Price Theory and Oligopoly’, Economic Journal, 57: 297–320.
FURTHER READINGS
Baumol, W.J. (1980), Economic Theory and Operations Analysis (New Delhi: Prentice Hall of India),
4th Edn., pp. 377–380.
Browning, E.K., Browning, J.M. (1986), Microeconomic Theory and Application (New Delhi: Kalyani
Publications), p. 231.
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326 Chapter 15
Early, J.S. (1956), ‘Recent Developments in Cost Accounting and the Marginal Policies of Excellently
Managed Companies’, American Economic Review.
Friedman, M. (1953), The Methodology of Positive Economics, in his Essays in Positive Economics (Chicago:
University of Chicago Press).
Hall, R.L., Hitch, C.J. (1952), ‘Price Theory and Business Behaviour’, Oxford Economic Paper, 1939,
reprinted in Studies in Price Mechanism, T. Wilson and P.W.S. Andrews (eds), (Oxford University
Press).
Machlup, F. (1946), ‘Marginal Analysis and Empirical Research’, American Economic Review, 1946,
and ‘Theories of the Firm: Marginalise “Managerialist, Behavioural”’, American Economic Review
(1967).
Rothschild, K.W. (1947), ‘Price Theory and Oligopoly’, Economic Journal, 57: 297–320.
M15_DWIV9400_02_SE_C15.indd 326 07/07/11 1:49 AM

Chapter 16
Price and Output

Determination under Perfect
Competition
CHAPTER OBJECTIVES
The objective of this chapter is to explain the theory of price and output determination by a firm under
perfect competition. This chapter helps you learn:
What is the meaning of and what are the characteristics of a perfectly competitive market;
How firms under perfect competition achieve their equilibrium—the point where they maximize
their profit;
How short-run supply curve of a firm and of an industry is derived;
How equilibrium of the firms and of the industry as a whole are determined in the long run; and
How long-run supply curve of the industry is derived under constant, increasing and decreasing
cost conditions.
In Chapter 15, we have discussed the objectives of business firms (with emphasis on profit-maximization
objective) and have also described briefly the market structure, kinds of markets, their features and
powers of firms. Now, we proceed to discuss the theory of price and output determination in differ-
ent kinds of markets—perfect competition, monopoly, monopolistic competition and oligopoly. In this
chapter, we will discuss price and output determination under perfect competition and equilibrium of
the firm and industry. Section 16.1 describes the characteristics of perfect competition. Section 16.2
discusses the relative position of a firm in a perfectly competitive industry. Section 16.3 analyses how a
firm reaches its equilibrium. We have shown in Section 16.4 the derivation of short-run supply curves
of both the firm and the industry. Section 16.5 provides an analysis of the short-run equilibrium of the
industry. Section 16.6 analyses firm’s and industry’s equilibrium in the long run. Section 16.7 explains
the derivation of the long-run industry supply curve under different cost conditions.
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328 Chapter 16
CHARACTERISTICS OF PERFECT COMPETITION

A perfectly competitive market is one in which there is large number of buyers and sellers of a homogeneous
product and neither a seller nor a buyer has any control on the price of the product. As mentioned earlier,
perfect competition as perceived by the economists is a rare phenomenon. Nevertheless, analysis of price
and output determination under perfect competition ‘lays the foundation’ of pricing theory. This kind
of a notional market is therefore created by assumption for theoretical purpose. A perfectly competitive
market is assumed to have the following characteristics:
1. Large Number of Sellers and Buyers. Under perfect competition, the number of sellers (the
firms) is assumed to be so large that the share of each seller in the total supply of a product is
very small. Therefore, no single seller can influence the market price by changing his supply
or can charge a higher price. Therefore, firms are price-takers, not price-makers. Similarly, the
number of buyers is so large that the share of each buyer in the total demand is very small and
that no single buyer or a group of buyers can influence the market price by changing their indi-
vidual or group demand for a product.
2. Homogeneous Product. The commodities supplied by all the firms of an industry are assumed
to be homogeneous or almost identical. Homogeneity of the product implies that buyers do not
distinguish between products supplied by the various firms of the industry. Product of each
firm is regarded as a perfect substitute for the products of other firms. Therefore, no firm can
gain any competitive advantage over the other firms. This assumption eliminates the power of
all the firms, the supplier, to charge a price higher than the market price.
3. Perfect Mobility of Factors of Production. Another important characteristic of perfect com-
petition is that the factors of production are freely mobile between the firms. Labour can
freely move from one firm to another or from one occupation to another. There is no barrier
to labour mobility—legal, linguistic, climate, skill, distance or otherwise. There is no trade
union. Similarly, capital can also move freely from one firm to another. No firm has any kind of
monopoly over any industrial input. This assumption implies that factors of production—land,
labour, capital and entrepreneurship—can enter or exit a firm or the industry at will.
4. Free Entry and Free Exit. In a perfectly competitive market, there is no legal or market barrier
on the entry of new firms to the industry. Nor is there any restriction on the exit of the firms
from the industry. A firm may enter the industry or exit it at its will. Therefore, when firms
in the industry make supernormal profit for some reason, new firms enters the industry and
supernormal profits are eliminated. Similarly, when profits decrease or more profitable oppor-
tunities are available elsewhere, firms exit the industry.
5. Perfect Knowledge About the Market Conditions. Both buyers and sellers have perfect knowl-
edge about the market conditions. This means that all the buyers and sellers have full information
regarding the prevailing and future prices and availability of the commodity. As Marshall put it, ‘…
though everyone acts for himself, his knowledge of what others are doing is supposed to be gener-
ally sufficient to prevent him from taking a lower or paying a higher price than others are doing.’1
Information regarding market conditions is available free of cost. There is no uncertainty in the
market.
6. No Government Interference. Government does not interfere in anyway with the function-
ing of the market. There are no discriminatory taxes or subsidies; no licencing system, no
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Price and Output Determination under Perfect Competition 329
allocation of inputs by the government, or any other kind of direct or indirect control. That is,
the government follows the free enterprise policy. Where there is intervention by the govern-
ment, it is intended to correct the market imperfections if there are any.
7. Absence of Collusion and Independent Decision Making by Firms. Perfect competition
assumes that there is no collusion between the firms, i.e., the firms are not in league with one
another in the form of guild or cartel. Nor are the buyers in any kind of collusion between
themselves, i.e., there are no consumers’ associations. This condition implies that buyers and
sellers take their decisions independently and they act independently.
Perfect versus Pure Competition

Sometimes, a distinction is made between perfect competition and pure competition. The difference
between the two kinds of competition is a matter of degree. While ‘perfect competition’ has all the
features mentioned earlier, under ‘pure competition’, there are no perfect mobility of factors and no
perfect knowledge about market conditions. That is, perfect competition less ‘perfect mobility’ and ‘perfect
knowledge’ is pure competition. ‘Pure competition’ is ‘pure’ in the sense that it has absolutely no element
of monopoly.
The perfect competition, with its all characteristics mentioned earlier is considered as a rare phenom-
enon in the real business world. The actual markets that approximate to the conditions of a perfectly com-
petitive market include markets for stocks and bonds and agricultural market (mandis). Despite its limited
scope, perfect competition model has been widely used in economic theories due to its analytical value.
ROLE OF A FIRM IN A PERFECTLY COMPETITIVE MARKET

In a perfectly competitive market, the role of a firm is limited to producing a commodity or service and
selling it at the market determined price. In fact, an individual firm is one among a very large number of
firms producing an almost identical commodity. The share of a firm in the total supply of the commod-
ity is, therefore, very small. A firm’s status in a perfectly competitive market can be described as follows.
1. A Firm Has No Control Over Price. As mentioned earlier, the market share of an individual
firm is so small, rather insignificant, that a firm cannot determine the price of its own product,
nor it can influence the prevailing market price by changing its supply. In other words, an indi-
vidual firm has no control over the market price.
2. A Firm is a Price-Taker. Under perfect competition, an individual firm does not determine
the price of its own product. Price for its product is determined by the market demand and
market supply for the industry as a whole. The determination of market price has already been
explained in Chapter 3. It is reproduced in Figure 16.1(a). The demand curve, DD′, represents
the market demand for the commodity of an industry as a whole. Likewise, the supply curve,
SS ′, represents the total supply created by all the firms of the industry. As Figure 16.1(a) shows,
market price for the industry as a whole is determined at OP and equilibrium output for the
industry is determined at output OQ. Equilibrium price OP is given for all the firms of the
industry. No firm has power to change this price. At this price, a firm can sell any quantity. It
implies that the demand curve for an individual firm is a straight horizontal line, as shown by
the line, pd, in Figure 16.1(b), with infinite elasticity.
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330 Chapter 16
D (a) (b)
S´
Price
Price
P p d
D´
O Q O
Market demand and supply Demand for individual firms
Figure 16.1 Determination of Market Price and Demand for Individual Firms
3. No Control over Cost. Because of its small purchase of inputs (labour and capital), under
perfect competition a firm has no control over input prices. Nor can it influence the technol-
ogy. Therefore, cost function for an individual firm is given. This point is, however, not specific
to firms in a perfectly competitive market. This condition applies to all kinds of market except
in case of bilateral monopoly.
What Are the Firm’s Options

The firm’s option and role in a perfectly competitive market are very limited. The firm has no option
with respect to price and cost. It has to accept the market price and produce with a given cost function.
The only option the firm has is to produce a quantity that maximizes its profits given the price and cost.
Under profit-maximizing assumption, a firm has to produce a quantity which maximizes its profit and
attains its equilibrium. This point is explained further in the following section.
SHORT-RUN EQUILIBRIUM OF THE FIRM

As explained earlier, in the traditional theory of firm, the equilibrium of a firm is determined in the
following conditions: (i) profit maximization is assumed to the basic objective of a business firm and
(ii) profit is maximized at the level of output at which MR = MC, under rising MC. Given these condi-
tions, profit-maximizing firm attains its equilibrium at the level of output at which its MC = MR. This
condition applies in both short run and long run, even though MR and MC conditions are somewhat
different in the long run. In this section, we discuss firm’s short-run equilibrium. Long-run equilibrium
of the firm will be discussed in the forthcoming section.
Assumptions
The short-run equilibrium of a firm is analysed under the following assumptions:
1. capital cost is fixed but labour cost is variable;
2. prices of inputs are given;
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(a) Industry S
(b) Firm
SMC SAC
Price
Price
E
P P
P=MR
P´ E´
O Q Output O Q´ Output
Figure 16.2 Short-run Equilibrium of the Firm
3. price of the commodity is fixed; and

4. the firm is faced with short-run U-shaped cost curves.
The firm’s equilibrium in the short run is illustrated in Figure 16.2. The determination of market
price is shown in panel Figure 16.2(a). As shown in Figure 16.2(a), the market price of a commodity is
determined at OP by the market forces—demand and supply—in a perfectly competitive market. The
price OP is fixed for all the firms of the industry. Therefore, a firm faces a straight line or horizontal
demand curve, as shown by the line P = MR. The straight horizontal demand line implies that price
equals marginal revenue, i.e., AR = MR. The short-run average and marginal cost curves of the firm are
shown by SAC and SMC, respectively.
Firm’s short-run equilibrium is illustrated in panel Figure 16.2(b). As can be seen in panel
Figure 16.2(b), SMC curve intersects the P = MR line at point E, from below. At point E, SMC = MR.
Point E determines, therefore, the point of firm’s equilibrium. A perpendicular drawn from point E to the
output axis determines the equilibrium output at OQ. It can be seen in the figure that output OQ meets
both the first and the second order conditions of profit maximization. At output OQ, therefore, profit is
maximum. The output OQ is, thus, the equilibrium output. At this output, the firm is in equilibrium and
is making maximum profit. Firm’s maximum pure profit is shown by the area PEE′P′ which equals PP′ ×
OQ (=PE) where PP′ is the per unit super normal profit at output OQ.
Does a Firm Always Make Profit in the Short-run?

Figure 16.2 shows that a firm makes supernormal profit in the short run. A question arise here: Does a
firm make necessarily a supernormal profit in the short run? In the short-run equilibrium, a firm may
not always make profits. In the short run, it may make just a normal profit or even make a loss. Whether
a firm makes abnormal profits, normal profits or makes losses depends on its cost and revenue condi-
tions. If its short-run average cost (SAC) is below the price (P = MR) at equilibrium (Figure 16.2), the
firm makes abnormal or pure profits. If its SAC is tangent to P = MR line, as shown in Figure 16.3(a), the
firm makes only a normal profit as it covers only its SAC which includes normal profit. But, if its SAC
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332 Chapter 16
falls above the price (P = MR) line the firm makes losses as shown in Figure 16.3(b), it makes loss. The
per unit loss = SAC − AR. As Figure 16.3(b) shows, at equilibrium output OQ, per unit loss = E′Q − EQ =
E′E. The total loss is shown by the area PEE′P′ (= PP′ × OQ′), while per unit loss PP′ = EE′.
Shut-down or Close-down Point

In case a firm is making loss in the short run, it must minimize its losses. In order to minimize its losses,
it must cover its short-run average variable cost (SAVC). The behaviour of short-run average variable cost
is shown by the curve SAVC in Figure 16.4. A firm unable to recover its minimum SAVC will have to
(a) (b) SAC

SMC SAC SMC
Costs and price
Costs and price

E´
P
E P = MR
P P´ P = MR
E
O Q O Q
Output Output
Figure 16.3 Short-run Equilibrium of Firm with Normal and Losses
SMC
SAC SAVC
Cost and price
E
P P = MR
AFC
O Q
Output
Figure 16.4 Shut-down Point
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close down. Its SAVC is minimum at point E where it equals its MC. Note that SMC intersects SAVC at its
minimum level as shown in Figure 16.4. At point E, therefore, firm’s loss is minimum.
Another condition that must be fulfilled for loss minimization is that P = MR = SMC. That is, for loss
to be minimum, P = MR = SMC = SAVC. This condition is fulfilled at point E in Figure 16.4. Point E
denotes the shut-down point or break-down point because at any price below OP, it pays the firm to close
down as it fails to recover even its variable cost.
DERIVATION OF SUPPLY CURVE: A DIGRESSION

We have drawn the supply curve so for—whenever required—on the basis of the law of supply, i.e., the
supply of a product increases when its price increases, all factors other than cost remaining the same.
‘Why does this law come into operation’ has not been explained so for. This is the right opportunity to
answer this question. That is why we digress from the main topic and explain the factor behind the law
of supply.
Derivation of Firm’s Supply Curve

The supply curve of an individual firm is derived on the basis of its equilibrium output. The equilib-
rium output, determined by the intersection of MR and MC curves, is the optimum supply by a profit
maximizing (or cost minimizing) firm. Under increasing MC, a firm will increase supply only when
price increases. This forms the basis of a firm’s supply curve. The derivation of supply curve of a firm is
illustrated in Figure 16.5(a) and (b). As Figure 16.5(a) shows the firm’s SMC passes through point M on
its SAVC. The point M marks the minimum of firm’s SAVC which equals MQ1. The firm must recover its
SAVC = MQ1 to remain in business in the short run. Point M is the shut-down point in the sense that if
price falls below OP1, it is advisable for the firm to close down. However, if price increases to OP2, MR
increases to OP2, firm’s equilibrium point (MR = MC) shifts to R and output increases to OQ2. Let the
price increase further to OP3. Then the equilibrium output rises to OQ3. When price rises to OP4, the
equilibrium output rises to OQ4. By plotting this information, we get a supply curve (SS′) as shown in
SMC S´
(a) (b)
P P
P4 P4
Price, MR and MC
SAC
T T
Price
P3 P3
SAVC R
R
P2 P2
M M
P1 P1
O Q1 Q2 Q3 Q4 O Q1 Q2 Q3 Q4
Output Output
Figure 16.5 Derivation of Firms Supply Curve
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334 Chapter 16
(a) (b)
S1 S2 S´
P3 D E
P3 T
Price
Price
P2 C
P2 N
P1 P1
M
A B S
O Output O Output
Figure 16.6 Derivation of Industry Supply Curve
Figure 16.5(b). In fact, it is the SMC curve beyond the point M where SMC = SAVC, which represents
the supply curve.
Derivation of Industry Supply Curve

The industry supply curve, or what is also called market supply curve, is the horizontal summation of the
supply curves of the individual firms. If cost curves of the individual firms of an industry are identi-
cal, their individual supply curves are also identical. In that case, industry supply curve can obtain by
multiplying the individual supply at different prices by the number of firms. In the short run, however,
the individual firm’s supply curves may not be identical. If so, the market supply curve can be obtained
by summing horizontally the individual supply curves. Let us consider only two firms having their indi-
vidual supply curves as S1 and S2 in Figure 16.6(a). At price OP1, the market supply equals P1A + P1B
which equal P1M in Figure 16.6 (b). (Note that output scale in part (b) is different from that in part (a).)
Similarly, at price OP2, the industry supply equals 2(P2C) = P2N in Figure 16.6(b). In the same way,
point T is located, i.e., at point T, total supply equals P3D + P3E. By joining the points M, N and T, we get
the market or industry supply curve, SS′.
SHORT-RUN EQUILIBRIUM OF INDUSTRY AND FIRM

We have discussed above the equilibrium of the firm in the short run. To complete the discussion on
short-run price and output determination, we discuss now the short-run equilibrium of the industry.
An industry is in equilibrium in the short run when market is cleared at a given price, i.e., when the total
supply of the industry equals the total demand for its product. The price at which the market is cleared is the
equilibrium price. When an industry reaches its equilibrium, there is no tendency to expand or to contract the
output. The equilibrium of industry is shown at point E in Figure 16.7. The industry demand curve DD′ and
supply curve SS′ intersect at point E, determining equilibrium price OP. At price OP, D = S. The industry is
supplying as much as consumers demand. In the short-run equilibrium of the industry, some individual firms
may make pure profits, some normal profits and some may make even losses, depending on their cost and
revenue conditions. As we have explained below, this situation will, however, not continue in the long run.
M16_DWIV9400_02_SE_C16.indd 334 07/07/11 1:54 AM

D S´
E
Price
S D´
O Q
Output
Figure 16.7 Equilibrium of the Industry
Link Between Short-run Equilibrium of the Industry and the Firm

The short-run equilibrium of the firm and industry have been analysed separately in the previous
sections. There exists, however, a link between a firm’s and industry’s equilibrium. In a perfectly competi-
tive market, change in the equilibrium of an individual firm does not affect the industry’s equilibrium,
for the simple reason that the total output of a single firm constitutes a small fraction of the industry’s
output. But, a change in the industry’s equilibrium does alter the equilibrium of an individual firm.
In this section, we show how individual firms move from one equilibrium position to another, when
there is a change in industry’s equilibrium. For the sake of simplicity, we assume that all the firms of an
industry have identical cost conditions and cost curves.
The link between industry’s and firm’s equilibrium is illustrated in Figure 16.8. Suppose industry’s
initial demand and supply curves are given as DD and SS, respectively (Figure 16.8(a)). As shown in
Figure 16.8(a), industry’s demand and supply curves intersect each other at point P, determining the
market price at PQ = OP1 and industry’s equilibrium output is OQ. Thus, the price PQ is given to all the
firms of the industry. Given the price PQ and firm’s cost curves, an individual firm finds its equilibrium
at point E in Figure 16.8(b), where its MC = MR. Firm’s equilibrium output is OM (see Figure 16.8(b)).
At price EM = PQ, the firm is making an abnormal profit in the short run to the extent of EN per unit of
output. The firm’s total pure profit is shown by the shaded area, P1ENT.
Let industry demand curve DD now shift downward for some reason to DD′, supply curve remaining
unchanged. As a result, market price falls to P′Q′ and industry’s equilibrium output falls to QQ′. With
the fall in price, firm’s equilibrium shifts from point E to E′ where its MC = MR. At this point, the firm is
making a loss because its AR which equals E′M′ is lower than its AC (see the difference between AC curve
at point E′). Thus, change in industry’s equilibrium changes firm’s equilibrium. Firms making loss is, how-
ever, a short-run situation. Losses will disappear in the long run through a process of market adjustment.
The process of market adjustment begins with loss-making firms exiting the industry. When loss-making
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336 Chapter 16
Cost and price

(a) Industry (b) Firm
D S´ S MC AC
D
AVC
P AR = MR
P1 P1 E
Price
T
P´ N
P2 P2 E´
S AR = MR
S
D
D´
O Q´ Q O M´ M
Output Output
Figure 16.8 Industry’s Vs. Firm’s Equilibrium in the Short Run
firms quit the industry, supply declined and the supply curve shifts left side as shown by the dotted supply
curve SS′. Price goes up and loss disappears and firm reaches another equilibrium point.
LONG-RUN EQUILIBRIUM OF THE FIRM AND INDUSTRY

To begin the discussion on the long-run equilibrium of the firm and industry, let us have comparative
look at the short- and long-run market conditions. The short run is, by definition, a period in which
(i) firm’s cost and revenue curves are given, (ii) firms cannot change their size—their capital is fixed,
(iii) existing firms do not have the opportunity to leave the industry and (iv) new firms do not have the
opportunity to enter the industry. In contrast, long run is a period in which these constraints disappear.
Long run permits improvement in production technology and a larger employment of both, labour and
capital, i.e., firms can change their size. Some of the existing firms may leave and new firms may enter the
industry. In the long run, supply curve not only shifts downward but also becomes more elastic. In this
section, we will analyse the equilibrium of the firm and industry in the long run.
Equilibrium of the Firm in the Long-run

To explain how a firm reaches its long-run equilibrium, let us begin with a short-run equilibrium of
the firms. Suppose (i) short-run price is given at OP1 (Figure 16.9(a)) and (ii) that firm’s short-run cost
curves are given by SAC1 and SMC1, as shown Figure 16.9(b). Given the price OP1, firms are in equilib-
rium at point E1. It can be seen in Figure 16.9(b) that the firms are making an abnormal profit of E1M =
E1Q1 − MQ1 per unit of output. Abnormal profit brings about two major changes in the industry. First,
existing firms get incentive to increase the scale of their production. Their average and marginal costs go
down caused by the economies of scale. This phenomenon is shown by SAC2 and SMC2. When we draw
the LAC and LMC curves, these curves show decreasing costs in the long run. Secondly, attracted by the
abnormal profit, new firms enter the industry increasing the total supply.
For these reasons, the industry supply curve, SS1 shifts downward to SS2 (Figure 16.9(a)). This shift, in
the supply curve brings down the market price from OP1 to OP2 which is the long-run equilibrium market
price. Thus, the equilibrium price is once again determined for the industry though at a lower level.
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Price and cost

(a) (b)
S1
S2 LMC
D LAC
SMC1 SMC2
E1 SAC 1 SAC 2
Price
E1
P1 P1 AR=MR
E2
E2
P2 M
P2 AR=MR
P3
AR=MR
S
S D
O N N´ O Q1 Q2
Output
Output
Figure 16.9 Long-run Equilibrium of the Firm and Industry
Given the new market price, OP2, firms attain their equilibrium in the long run at point E2 where
AR = MR = LMC = LAC = SMC = SAC as shown in Figure 16.9(b). As the figure shows, the firms of
industry reach their equilibrium in the long run where both short- and long-run equilibrium conditions
are satisfied simultaneously. In a perfectly competitive market, the cost and revenue conditions are given
for the firms. Therefore, when price goes down to OP2, what firms are required to do is to adjust their
output to the given revenue and cost conditions in order to maximize their profit. Through this process
of adjustment for output, the firms reach the equilibrium in the long run at point E2. Point E2 is the point
of equilibrium for all the firms in the long run.
In case market price falls below OP2, say, to OP3, all the firms make losses. This brings in a reverse
process of adjustment. While some firms quit the industry, some firms cut down the size of the firm. As a
result, total supply decreases, demand remaining the same. Consequently, price tends to rise. This process
of output adjustment continues until industry reaches back to its equilibrium at point E2, where LAC is
tangent to P = AR = MR for each firm in the industry. At point E2, the point of equilibrium, P = MR =
LMC = LAC = SMC = SAC. Since P = LAC, the firms make only normal profits in the long run. If firms
deviate from point E2, due to some short-run disturbances, the market forces will restore the equilibrium.
Equilibrium of Industry
An industry is in equilibrium at a price and output at which its market demand equals its market supply.
The equilibrium of the industry is illustrated in Figure 16.9(a). When an industry is in equilibrium, all its
firms are supposed to be in equilibrium (as shown in Figure 16.9(b)) and earn only normal profits. This
is so because under the conditions of perfect competition, all the firms are assumed to achieve the same
level of efficiency in the long run. Since industry yields only normal profits, there is no incentive for new
firms to enter the industry. These conditions are fulfilled at price OP2 in Figure 16.9(a) and (b). At price
OP2, all the firms are in equilibrium, as for each firm, LMC = LMR = SMC = SAC = P = LAC.
Since P = LAC, all the firms are earning only normal profit. At industry’s equilibrium output OM,
market demand equals market supply (Figure 16.9(a)). At price OP2, therefore, market is cleared. The
output OM may remain stable in the long run. For, there is no incentive for new firms to enter the indus-
try and no reason for the existing ones to leave the industry. The industry is, therefore, in equilibrium.
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338 Chapter 16
LONG-RUN SUPPLY CURVE OF A COMPETITIVE INDUSTRY

We have earlier derived the short-run supply curve of the industry by summing up horizontally the
supply curves of the individual firms (see Figure 16.6). The long-run supply curve of a competitive
industry, however, has nothing to do with the LMC curves. The shape of the long-run supply curve of
an industry, under perfect competition, depends on whether factor prices remain constant, decrease or
increase in the long run as a result of expansion of the output of the industry. Depending on whether
industry’s cost is constant, increasing or decreasing, industries are classified as constant cost industry,
increasing cost industry and decreasing cost industry. Let us, now, derive the long-run supply curve of
industries conforming to their firms having constant, increasing and decreasing cost.
Constant Cost Industry

An industry with constant cost in the long run is referred to as constant cost industry. In other words,
when the expansion of output in an industry does not entail an increase in factor prices, the industry is said
to be a constant cost industry. The shape of the supply curve of such an industry is illustrated by the line
LRS in Fig. 16.10(a) and (b). To explain the horizontal shape of the supply curve, let us suppose that the
industry is in equilibrium at P where demand curve DD1 and supply curve SS1 intersect each other. The
industry is in equilibrium at price OP1 and output OQ1. At price OP1, all firms are in equilibrium as their
LMC = P = MR = SMC = SAC.
Now, let the demand curve DD1 shift to DD2 due to, say, increase in consumers’ income or increase in
population or due to both, supply curve remaining the same. As a result market price increases to OP2.
In the short run, this increase in price can induce an increase in supply by the individual firms only by
MN. Figure 16.10(b) as determined by the point of intersection between firms’ SMC and new price line
through P2. The firms enjoy abnormal profit to the extent of AR2 − LAC.
In the long run, however, the abnormal profits attract new firms to the industry. The entry of new
firms leads to increase in demand for inputs. However, the industry being a constant-cost industry,
factor prices do not increase. Cost of production for all the firms remains constant at the previous level.
But, due to the entry of new firms, market supply increases and market supply curve shifts from SS1 to
(a) Industry (b) A typical firm

Price and cost
D S1
S2 LMC
D LAC
SMC
SAC
Price
P´ E´
P2 P2 AR2 = MR2
P P˝ E
P1 LRS P1 AR1 = MR1
S D2
D1
S
O Q1 Q2 O M N
Output Output
Figure 16.10 Long-run Supply Curve of the Constant Cost Industry
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SS2 (Figure 16.10(a)). Consequently, in the long run, market price falls to its previous level, OP1, and
firms return to their previous equilibrium point E. But the industry output increases from OQ1 to OQ2
and industry moves from equilibrium point P to P″. By joining the two points of industry equilibrium P
and P″, we get long-run supply curve (LRS) of the constant cost industry. Obviously, LRS of a constant
cost industry is a horizontal straight line, as given by the line LRS.
Increasing Cost Industry

An increasing cost industry is one which faces increasing input prices. The increase in input prices may
be caused by increase in demand for inputs by the firms for increasing their production. The long-run
supply curve of an increasing cost industry has a positive slope as illustrated in Figure 16.11(a).
The derivation of long-run market supply curve under increasing cost condition is demonstrated in
Figure 16.11. Let the original demand and supply curves of the industry be given, respectively, as DD1
and SS1 and industry be in equilibrium of point A. Let us also suppose that demand curve DD1 shifts to
DD2, supply curve remaining the same. As a result, short-run market price increases from OP1 to OP3
given the supply curve S1. With this increase in price, the demand curve for the firms shifts upward to
AR3 = MR3 as shown in Figure 16.11(b). The firms, therefore, enjoy a supernormal or economic profit to
the extent of P1P3.
This supernormal profit attracts new firms to the industry and demand for inputs increases. If supply
of inputs is less than infinitely elastic, the entry of new firms causes an increase in demand for inputs
and, therefore, an increase in the input prices. Consequently, cost curves, both short and long run, shift
upward from LAC1 to LAC2. In this process of adjustments, however, industry supply increases and
market supply curve SS1 shifts downward to SS2. With this shift in the supply curve, the industry reaches
another equilibrium position at point C where new demand and supply curves intersect each other.
A new market price QP2 is determined. At price OP2, (Figure 16.11(b)), the long- and short-run cost
curves are tangent to the price line OP2 = AR2 = MR2. The individual firms shift to a new long-run
equilibrium point E2, their individual output remaining the same. Whether equilibrium output of the
firms remains constant, increases or decreases, depends on whether cost curves shifts upward vertically,
upward to the right or upward to the left.

Cost
D S1 S2 SAC 2 LAC2
D B LRS
P3 P3 AR3 = MR3
Price
C E2 LAC1
P2 P2 AR2 = MR2
SAC 1
E1
P1 P1 AR1 = MR1
A
D2
S S D1
O Q1 Q2 O Output
Output
Figure 16.11 Long-run Supply Curve of an Increasing Cost Industry
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340 Chapter 16
Note that at price OP2, both industry and individual firms are in equilibrium. In the absence of any
further disturbance, the equilibrium of both firms and industry will remain stable. Thus, at the new
equilibrium price OP2, the industry output increases from OQ1 to OQ2 and the equilibrium point shifts
from point. A to point C. By joining the long-run equilibrium points A and C, we get the long-run supply
curve for the industry, as shown by the curve LRS. Obviously, the LRS has a positive slope in an increas-
ing cost industry.
Decreasing Cost Industry

If expansion of output of an industry is associated with decrease in the input prices, the industry is
referred to as a decreasing cost industry. A decreasing cost industry has a long-run supply curve with a
negative slope.
The derivation of long-run industry supply curve (LRS) under decreasing cost condition is illustrated
in Figure 16.12(a) and (b). Let the industry be initially in equilibrium at point A in Figure 16.12(a) and
firms at point E2 in Figure 16.12(b). Now suppose that demand curve shifts from DD1 to DD2 and, conse-
quently, price rises from OP2 to OP3. The short-run equilibrium of firms at price OP3 in Figure 16.12(b)
moves upward on the SMC2 where the firms make abnormal profits. The abnormal profits attract new
firms to the industry causing increase in demand for inputs. If industries are enjoying increasing returns
to scale due to economies of scale, the increase in demand for inputs would encourage increased sup-
ply of inputs. Increase in the supply of inputs causes input prices to fall. The industry, therefore, enjoys
the external economies to scale. As a result, their long- and short-run cost curves shift downward, from
LAC2 to LAC1 (Figure 16.12(b)).
From the industry’s point of view, industry supply increases due to the entry of new firms, even if
the existing firms maintain their old level of output. Therefore, as shown in Figure 16.12(a), the indus-
try supply curve shifts from SS1 to SS2 which intersects with the new demand curve DD2 at point C.
Thus, the equilibrium of the industry shifts from A to C. Industry output increases from OQ1 to OQ2.
In the absence of any external disturbance, the industry equilibrium point C, would tend to stabilize.
By joining the two equilibrium points, A and C, we get the long-run supply curve (LRS) of the decreasing
cost industry. The LRS has a negative slope.

Cost
S1
D S2
D B SMC2 SAC LAC
2
P3 P3 2
Price
E2 LAC 1
P2 P2
A SMC1SAC 1
C E1
P1 P1
LRS
S D2
S D1
O Q1 Q2 O
Output
Output
Figure 16.12 Long-run Supply Curve of a Decreasing Cost Industry
M16_DWIV9400_02_SE_C16.indd 340 07/07/11 1:54 AM

Whether Decreasing Cost

Some authors argue that the ‘phenomenon of decreasing cost … is not consistent with all the require-
ments of perfect competition.’2 However, the possibility of a decreasing cost industry cannot be ruled out
in a very long period. One reason for this is the likelihood of the existence of large external economies
of scale, particularly in case of young industries in the undeveloped areas.3 An increase in the number
of industries and the consequent growth of transportation, marketing facilities and financial institutions
may reduce the industry’s cost of production. Nevertheless, it depends on how substantial are the exter-
nal economies of scale. R.G. Lipsey has cited the car industry of England as an example of decreasing
cost industry. In his own word,
As the output of cars increased, the industry’s demand for tyres grew greatly. This … would have
increased the demand for rubber and tended to raise its price, but it also provided the opportunity for
tyre manufacturers to build large modern plants and reap the benefits of increasing returns in tyre pro-
duction. At first, these economies were large enough to offset any factor price increases and tyre price
charged to car manufacturers fall. Thus car costs fell because of lower prices of an important input.4
CONCLUSION
To conclude, whether costs of an industry remain constant or decrease due to increase in the price of
some of its inputs, depends also on what proportion of the total input supply is consumed by the indus-
try. For example, output of pencil industry can be increased without substantially affecting the lumber
prices as pencil industry uses a small proportion of lumber Output.
But a large increase in the output of furniture industry will not leave lumber prices unaffected.
Similarly, output of a pin industry can be substantially increased without affecting the steel price. But a
substantial increase in car output cannot leave steel prices unaffected.
Another factor which may cause a rise in input prices is whether or not input industries enjoy
economies of scale.
Moreover, the most common cases are of the constant and increasing cost industries. Decreasing cost
industries are most unlikely to exist for a long time. The constant and decreasing cost industries tend
over time to become increasing cost industries because external economies have a limit.

1. What are the characteristics of perfect competition? Distinguish between perfect and pure
competition.
2. What is the relative position of a firm in a perfectly competitive industry? How does a profit-
maximizing firm determine the price of its product under perfect competition.
3. Analyse the equilibrium of a firm under the conditions of perfect competition in the short run?
Discuss in this regard the importance of AR, AC, MR and MC under perfect competition.
4. Explain the short-run equilibrium of a competitive firm. When would a competitive firm close.
Do down its business in the short run?
5. You agree that perfect competition leads to optimum size of the firm? Give reasons for your
answer.
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342 Chapter 16
6. Under perfect competition, average revenue equals average cost in the long-run equilibrium.
Yet why do firms produce under such a condition?
7. Show how under the condition of perfect competition in the long run, the price of a commodity
equal to its average and marginal cost.
8. Distinguish between short- and long-run equilibrium of a firm under perfect competition.
What differences, if any, are there in conditions of equilibrium in the two cases?
9. Bring out the essential difference in the nature of equilibrium of a firm under perfect competi-
tion in the short run and in the long run.
10. How is short-run supply curve of a firm derived under perfect competition? Why can’t it be
downward sloping?
11. Write a short note on the relationship between firm’s short-run cost curves and supply curve.
Under what conditions is the industry supply curve is a downward sloping one?
12. Show graphically how long-run supply curves of an industry are drawn under perfect competi-
tion? Also illustrate graphically the derivation of the long-rum supply curve of a firm under
perfect competition.
13. The long-run supply curve of a competitive industry may be upward sloping, downward slop-
ing or a horizontal line. Explain the conditions under which the long-run supply can take these
forms.
14. If all the firms in a perfectly competitive industry have U-shaped cost curves, can then supply
curve of the industry be downward sloping?
15. Suppose a competitive firm is in long-run equilibrium. What will happen to price in the long
run if there is a rise in demand for the product of the industry?
(a) Perfect competition less perfect knowledge and perfect factor mobility is pure com-
petition,
(b) Under perfect competition, a firm fixes its price where its AR = MR,
(c) A firm is a price-taker under perfect competition,
(d) In a perfectly competitive industry, a firm is in equilibrium in the short run only when
its AC = AR = MR = MC,
(e) Firm’s short-run supply curve has a negative slope,
(f) A firm reaches its shut-down point when price goes below its AC,
(g) Industry supply curve is a horizontal summation of its firms’ supply curves,
(h) An industry is in equilibrium in the short run when market is cleared,
(i) Change in the industry equilibrium changes firm’s equilibrium,
(j) Industry supply curve has a positive slope under decreasing cost conditions,
(k) In the long run, a firm is in equilibrium when its AR = MR = LAC = LMC.
[Ans. (a), (c), (g), (h), (i) and (k)]
17. Which of the following features are absent in pure competition?
(a) Large number of buyers and sellers,
(b) Free entry and free exit,
(c) Perfect knowledge,
(d) Perfect mobility,
(e) Absence of collusion.
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18. For a firm under perfect competition the ‘shut-down’ point falls under which of the following
conditions?
(a) any where below SAC,
(b) where SMC = SAVC = P,
(c) where SMC = SAC, or
(d) where SAC = SAVC.
19. Which of the following is relevant for a perfectly competitive industry?
(a) Industry equilibrium is affected by the change in firm’s equilibrium,
(b) Change in industry’s equilibrium affects firm’s equilibrium,
(c) Change in industry’s equilibrium does not affect firm’s equilibrium,
(d) Change in firm’s equilibrium does not affect industry’s equilibrium,
20. Under perfect competition, firms are in equilibrium in the long run, where
(a) P = SMC = SAC,
(b) SMC = SAC = AR = MR,
(c) LAC = LMC = AR = MR, or
(d) AR = MR but LMC > LAC?
Write the correct statement.
[Ans. 19: (c) and (d); 20: (b), 21: (b), 22: (c)]
ENDNOTES
1. Marshall, Alfred (1920), Principles of Economics, (London: Mamillan) p. 341.
2. See, for example, Ferguson, C.E., Microeconomic Theory, 2nd Edn., op. cit., p. 276.
3. Leftwitch, R.H., The Price System and Resource Allocation, 5th Edn., op. cit., p. 220.
4. Lipsey, R.G., An Introduction to Positive Economics, 5th Edn., op. cit., p. 257.
FURTHER READINGS
Browning, E.K. and Browing, J.M. (1998), Microeconomic Theory and Applications (New Delhi Hall):
Kalyani Publishers), 2nd Edn., Chapters 8 and 9.
Clark, J.M. (1940), ‘Towards a Concept of Workable Competition’, American Economic Review, 30 (2):
241–256.
Gould, J.P. and Lazear, E.P. (1993), Microeconomic Theory (Homewood, IL: Richard D. Irwin), 6th Edn.,
Chapter 9.
Koutsoyiannis, A. (1978), Modern Microeconomics (London: Macmillan), 2nd Edn., Chapter 5.
Maddala, G.S. and Miller, E. (1989), Microeconomics: Theory and Applications (New York, NY:
McGraw-Hill Book Co.), Chapter 10.
Marshall, A. (1920), Principles of Economics, Book VI (London: Macmillan).
Pindyck, R.S. and Rubinfeld, D.L. (2001), Microeconomics (New York, NY: Prentice Hall), 5th Edn.,
Chapters 8 and 9.
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University Question Papers
B.Com. (Hons) I Year

Paper III – 2008
MICROECONOMIC THEORY AND APPLICATIONS – I
Time: 3 hours Maximum marks: 75
Note—The maximum marks printed on the question paper are applicable for the candidates registered with
the School of Open Learning for B.A. (Hons.)/B.Com. (Hons.). These marks will, however, be scaled
down proportionately in respect of the students of regular colleges, at the time of posting of awards
for compilation of result.
All questions are compulsary and carry equal marks.
Q. 1. (a) Differentiate between income elasticity of demand and cross elasticity of demand. 6
(b) Show:
(i) When QDY = 600/PY the total expenditures on commodity Y remain unchanged
as PY falls.
(ii) From (i) derive the value of elasticity of demand along the demand curve.
(iii) Verify (ii) by finding elasticity mathematically at PY = Rs 4 and at PY = Rs 2. 9
Or
(a) Prove that the supply curve given by QSX = 20,000 PX has unitary elasticity and supply curve
given by QSY = 40,000 + 20,000 PY is inelastic (PX and PY are given in rupees). 8
(b) Derive Engel curve from income consumption curve and show that the commodity is necessity,
luxury and inferior good at different points on the Engel curve. 7
Q. 2. (a) Starting from the position of consumer equilibrium show the substitution effect and income
effect of a price reduction for a giffen good and normal good. 8
(b) Explain the effects of food subsidy vs. lump sum subsidy on the welfare of the recipients. Why
will Govt. prefer food subsidy to lump sum subsidy? 7
Or
(a) What is the relationship between a price consumption curve and price elasticity of demand? 5
(b) Explain the convex shape of indifference curves. What will be its likely shape when one of
the goods is an economic ‘bad’? 5
(c) Write a short note on Hicksian consumer surplus. 5
Z01_DWIV9400_02_SE_QUES.indd 345 08/07/11 3:56 PM

346 University Question Papers
Q. 3. (a) Explain the law of variable proportion. Why would a producer prefer second stage of pro-
duction? Give reasons in support of your answer. 9
(b) “If production function exhibits constant returns to scale, it is consistent with diminishing
returns to factor.” Do you agree with the statement? Give reasons. 6
Or
(a) What are ‘ridge lines’? What is the relevance of these lines in theory of production? 6
(b) How a rational producer minimises his cost of production for a given level of output? 9
Q. 4. (a) Explain the concept of economies of scope. How are they measured?
(b) Derive long-run average cost curve (LAC) from short-run plant curves. Also explain why
LAC curve is flatter than short-run cost curves? 9
Or
(a) Distinguish between:
(i) Economic profit and Accounting profit;
(ii) Sunk Cost and Fixed cost. 6
(b) What do you understand by linearly homogeneous production function? Give example
of such type of production function. 5
(c) What is an ‘Expansion Path’? Show long-run and short-run expansion path. 4
Q. 5. (a) Explain the concepts of stable and unstable equilibrium as given by Walras. 7
(b) “Perfectly competitive firm can never earn more than normal profit in the long-run.” Explain. 8
Or
(a) Show with the help of suitable diagrams, that the impact of subsidy depends on elasticities of
demand and supply. 7
(b) What is meant by dead weight loss? Why does a price ceiling usually result in a deadweight
loss? 8

Paper III – 2009
Note—The maximum marks printed on the question paper are applicable for the candidates registered
with the School of Open Learning for B.Com. (Hons.). These marks will, however, be scaled down
proportionately in respect of the students of regular colleges, at the time of posting of awards for
compilation of result.
Attempt all questions. Marks are indicated against them.
Q. 1. (a) Table below gives quantities bought of commodities x, y and z before and after a change in
their prices:
Commodities Before After
Price (Rs) Quantity/Month Price (Rs) Quantity/Month

y 3.0 30 2.0 40
x 1.0 15 1.0 10
z 1.5 10 2.0 9
x 1.0 15 1.0 12
(i) Define cross-elasticity of demand.

(ii) Find cross elasticity of demand from the table given between x and y (exy) and between x
and z (exz) and find the nature of their relationship. 5
Or
(a) Prove that price elasticity of demand varies between zero and infinity on a straight line demand
curve. 5
(b) If QSX = 5PX − 5, find elasticity of supply. If PX = 0, find QSX. 5
Or
(b) Explain the relationship between average revenue and price elasticity of demand and marginal
revenue. 5
(c) If Engel curve for good X is a vertical line (good X being measured on X-axis), can X be a
Giffen good? Give reasons. 5
Or
(c) A consumer spends all his income on two goods X and Y. Other things remaining constant, if
a 50% increase in the price of good X does not change the amount consumed of Y, what is price
elasticity of good X? 5

Q. 2. (a) Using indifference curve theory, explain the splitting up of price effect into income and substi-
tution effect for a fall in price of inferior good. 5
(b) When we use a composite good convention, what do we mean by a composite good and how do
we measure it? What is the slope of budget line in this case? Show the equilibrium of the con-
sumer in a diagram if his income is Rs 300, price of X is Rs 15 and he buys 8 units of X. 5
(c) Derive demand curve from price consumption curve for a normal good.
Or
(a) Explain the effect of a good subsidy on the well being of recipients and compare it with an
equal sized lump sum subsidy. Explain why might the Government prefer the food subsidy to
the lump sum subsidy. 5
(b) Draw indifference curves between two economic bads like work and pollution. What charac-
teristics do these curves have? 5
(c) Draw indifference map between two goods that are perfect substitutes. What can you say about
consumer equilibrium? 5
Q. 3. (a) If the production function reveals constant returns to scale, what can you say about the returns
to a variable factor? Explain diagrammatically. 5
(b) A product can be produced by using inputs L and K and firm’s present output position indi-
cates MPK = 3, PK = Re 1, MPL = 6 and PL = Rs 4. Is the firm employing cost minimizing com-
binations of input K and L? If not, what should the firm do? 5
(c) What are three stages of production? In which stage of production producers produce and
why? 5
Or
(a) If two factors of production have the same price, what will be the slope of Isoquant at the least
cost output? 5
(b) Show that in linear homogeneous Cobb-Douglas production function X = AKαL1 – α, average
product of labour and marginal product of labour depends only upon the ratio of factors and
it shows constant returns to scale. 5
(c) How does a producer choose an optimal input combination to maximise output subject to a
given cost? 5
Q. 4. (a) Explain the concept of economies of scope and how do we measure it. 5
Or
(a) How can you derive the Long run Average Cost (LAC) from the Short run Average Cost (SAC)
under traditional cost theory? 5
(b) Explain the concept of “Learning Curve”? What is its shape? What is the impact of learning on
downward sloping “LAC” curve? 5
Or
(b) If TC = (50 + Q) (90 + Q) where TC = total cost, Q = units of a good produced, find TFC, AFC,
TVC, AVC, AC, MC. 5

(c) Can the short run average cost be less than the long run average cost? Why or why not? 5
Or
(c) Distinguish between “Accounting Cost” and “Economic Cost”. Which is more relevant for
taking economic decisions. 5
Q. 5. (a) Explain the shape of the long-run supply curve of a constant cost industry. 5
Or
(a) “Long-run equilibrium for a firm under perfect competition takes place when price is equal to
the minimum long-run average cost.” Explain. 5
(b) How does a price ceiling by the government affect the producer surplus and consumer
surplus? 5
Or
(b) Explain the concept of stable and unstable equilibrium as given by Walras. 5
(c) Derive short-run supply curve of a firm under perfect competition. 5
Or
(c) What are ridge lines and what do they indicate? 5

Paper III – 2010
Note—The maximum marks printed on the Question Paper are applicable for the candidates registered
with the School of Open Learning for B.Com. (Hons.). These marks will, however, be scaled down
proportionately in respect of the students of regular colleges, at the time of posting of awards for
compilation of result.
Attempt All questions.
Marks are indicated against each question.
Q. 1. (a) Calculate cross elasticity of demand between coffee (X) and tea (Y) from the following data
and comment on the relationship between the two goods: 5
Before After
Price Quantity Price Quantity

( `/Units) (Units/month) (`/Units) (Units/month)
Coffee (X) 20 40 20 50
Tea (Y) 40 50 60 30
Or
(a) From the two demand schedules given below, determine if these are elastic or inelastic using
only the total expenditure criterion: 5
Price Quantity of X Quantity of Y

1 320 1200
2 200 500
3 150 325
4 120 225
5 110 160
6 105 100
(b) Prove that any straight line supply curve passing through the origin has value of elasticity of
supply equal to one. 5
Or
(b) Prove that weighted sum of cross-price elasticity of demand and own-price elasticity of
demand equals one. 5
(c) Using Samuelson’s revealed preference analysis prove that price and quantity demanded for a
normal commodity are inversely related. 5
Or
(c) Explain Hicksian consumer surplus with the help of indifference curve technique. 5

Q. 2. (a) Sanjiv’s budget line relating to good X and good Y has intercepts of 40 units of good X and
20 units of good Y. If the price of the good X is ` 8; what is Sanjiv’s income? Calculate the
price of good Y and slope of the budget line. 5
Or
(a) If the consumer faces a zero price for commodity X, what would the budget line relating
to other goods and good X look like. Show the equilibrium of the consumer by drawing indif-
ference curves. Show that at point of equilibrium, the marginal rate of substitution MRS is
equal to the price ratio. 5
(b) Explain the relationship between Income Consumption Curve and Engel Curve in case of
inferior good. 5
Or
(b) What is the relationship between a price consumption curve and price elasticity of
demand? 5
(c) Explain with the help of indifference curves, the effects of lumpsum subsidy vs. excise subsidy
on consumers and the government. 5
Or
(c) Draw indifference map in the following situations: 5
(i) Economic “good” on the vertical axis and an economic “bad” on the horizontal axis.
(ii) Economic “bad” on both the axes.
Q. 3. (a) What are the three stages of production? In which stage of production will a rational producer
produce and why? 5
Or
(a) A product can be produced by using inputs L and K and firm’s present output position indi-
cates MPk = 3, Pk = ` 1, MPL = 6 and PL = ` 4. Is the firm employing cost minimizing combina-
tions of input K and L? If not, what should the firm do? 5
(b) Explain the concept of economies of scope. How are they measured? 5
Or
(b) If there are constant returns to scale, there may be diminishing returns to factor. Prove with
the help of isoquants. 5
(c) Show that in a linear homogeneous Cobb-Douglas production function X = ALαKβ
(i) If all inputs are increased in the same proportion then output also increases by the same
proportion.
(ii) The average and marginal product function depend only upon the input ratio . 5
Or
(c) What are ridge lines? What is the relevance of these lines in theory of production? 5
Q. 4. (a) Explain the concept of “Learning Curve”? What is its shape? What is the impact of learning
on downward sloping “LAC” curve? 7½
Or
(a) How does a price ceiling by the government affect the producer surplus and consumer
surplus? 7½

(b) Explain that long-run marginal cost curve is derived from short-run marginal cost curves but
does not envelope them. 7½
Or
(b) Explain the shapes of short-run cost curves—AFC, AVC, MC and SAC. Why the short-run
average cost curve is U-shaped? 7½
Q. 5. (a) Derive diagrammatically the long-run supply curve of a perfectly competitive industry in case
of decreasing costs and increasing costs. 7½
Or
(a) Explain the difference between the short-run and the long-run equilibrium of a firm under
perfect competition. If the firms are in short-run equilibrium, will the competitive industry,
as a whole, be in equilibrium in the long-run also? Comment. 7½
(b) What is a ‘subsidy’? Explain how the benefit of a subsidy is split between buyers and sellers in
a competitive market. 7½
Or
(b) What is the difference between:
(i) Accounting Profit and Economic Profit.
(ii) Walrasian Stability and Marshallian Stability. 7½

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Microeconomics – I

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Duration: 3 Hours Max. Marks: 100

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2. The Economy: Its Basic Problems

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How Market Mechanism Solves the Basic Economic Problems?—21

Part II Market Mechanism: How Markets Work

3. The Market Forces: Demand and Supply 35

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4. Elasticity of Demand and Supply 70

5. Application of Market Laws and Elasticities 105

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Review Questions 113

Part III Theory of Consumer Demand

6. Theory of Consumer Demand: Cardinal

7. Theory of Consumer Demand: Ordinal

A01_DWIV9400_02_SE_PREL.indd 10 08/07/11 4:08 PM

Goods, Bads and Neuters—141

8. Application of Indifference Curve Analysis 180

A01_DWIV9400_02_SE_PREL.indd 11 08/07/11 4:08 PM

Measuring the Financial Cost of Excise Subsidy 182

9. Revealed Preference Theory 195

10. Consumer Surplus 203

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Review Questions 219

Part IV Theory of Production and Analysis of Cost

12. Theory of Production: Laws of Returns to

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Isoquants Do Not Intersect or Are Tangent to Each Other 242

13. Optimum Combination of Inputs 266

14. Theory of Cost 278

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Accounting Cost Concepts 279

Part V Theory of Firm: Determination of Price and

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Perfect Competition 322

16. Price and Output Determination under

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Economics Is a Social Science

Why Economizing Behaviour?

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Two Major Branches of Economics

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IS MICROECONOMICS A POSITIVE OR A NORMATIVE

Microeconomics As a Positive Science

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Microeconomics As a Normative Science

METHODOLOGY OF POSITIVE ECONOMICS: MODEL BUILDING

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An important element of scientific method of inquiry is model building. An analytical model is an