MICRO ECONOMICS

B.A. I - Year (1st Semester)

Authors
Dr. Akkenapally Meenaiah, M.A., M.Phil., Ph.D.
Retired HOD Economics : N.G College Nalgonda (Autonomous),
President : Nalgonda Economics Forum,
Executive member : Telangana Economics Association
Economy Columnist : Velugu, Sakshi, Namaste Telangana &
Nava Telangana Daily News Papers.

T. Bhasker Reddy, M.A., SET.

Asst. Prof. of Economics, GDC (W), Nalgonda.
Associate President : Nalgonda Economics Forum

M. Shathavahana, M.A.
Lecturer in Economics, Sri Raghavendra Degree College, Nalgonda,
Vice President: Nalgonda Economics Forum.

Sk. Sulthana, M.A., SET.

Lecturer in Economics TSWRDC (W) Nalgonda,
Secretary: Nalgonda Economics Forum.

P. Naresh Kumar, M.A., SET.

Faculty of Economics B.C & S.C, T.S Study Circles,
Treasurer: Nalgonda Economics Forum.

D. Pravalika, M.A., SET

Lecturer in Economics TTWRDC (W) Suryapet,
Executive Member: Nalgonda Economics Forum.

M.Shobha, M.A., SET.

Lecturer in Economics TSWRDC (W) Suryapet,
Executive Member: Nalgonda Economics Forum.

M. Kavitha, M.A., SET.

Faculty of Economics, Nalgonda Economics Forum,
Executive Member: Nalgonda Economics Forum.

(i)
Micro Economics
(First Year - 1st Semester)

by
NALGONDA ECONOMICS FORUM

First Edition : September, 2019

Copies : 1000

Cover Page by
Giri Babu Kathula

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Foreword

The Nalgonda Economics Forum came into existence on the 12th of January
2007and was subsequently registered on 10th May, 2013 with the registered number 297/
2013. It is the proudest boast of the Forum that as many as 450 students got selected to
PG courses in different universities. And students trained at this Forum stood in the first
rank in the PG entrance examinations both at the Osmania and the Kakatiya universities
consecutively in 2016, 2017 and 2018 academic years. Most other students of this study
forum got through SET, NET and other such examinations, besides as many five Ph. Ds
holders to its credit. And recently, five candidates have become lecturers of different
Residential Colleges, four have become PGTs, and about 25 candidates are working as
faculty members at different colleges.
It is also to be particularly mentioned that the Forum, keeping in view the year
after year changing examination patterns, is updating itself with a view to catering to the
needs of the examination goers. Hence we created a website of our own to help students
face the Computer Based Tests, providing study material, and bringing to the doorsteps
the latest relevant information that boosts up the students morale and the self-confidence.
As to the aims and objectives of the Forum, it is to be added that it has been
offering free coaching to candidates taking different competitive examinations like Group
Tests, and SI, Police Constable and Banking examinations. To be mentioned next are the
debates and seminars being conducted from time to time to enable students develop
economic awareness, establishment of a fully equipped library, conducing very frequently
quiz and essay-writing competitions, and holding model tests for various competitive
examinations and presenting cash awards to developing competitive spirit among our
wards.
As has already been made apprehensible as regards the purpose behind bringing
into existence this Nalgonda Economics Forum, the very spirit of the essential motto of
the organizers has all through been seeing to it that all sorts of academic, competitive
and other such needs of the students of the subject of Economics are meticulously
pinpointed out and duly made available to them the materials as per their requirements.
As a component of this goal, the organizers of the Forum have mooted out a project of
bringing out Economics Textbooks for the UG students of the universities in the state of
Telangana. Also again as part of this programme, in tune with the Choice Based Credit
System that has come into vogue with the present academic year 2019-20, the Forum is
now publishing a textbook MICRO ECONOMICS both in Telugu and English languages
for the First Semester BA Economics students. In the process, the Forum will be bringing
out textbooks for the subsequent semesters in due course to meet again the requirements
of both Telugu and English media.

Dr. Akkenepally Meenaiah

President
Nalgonda Economics Forum

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( iv )
 B.A. (ECONOMICS) SYLLABUS
Semester - I
MICRO ECONOMICS - I
Discipline Specific Course - Paper - I
MICRO ECONOMICS

Module-I : CONSUMER BEHAVIOUR

Ordinal utility Analysis: Properties of Indifference curves, concept of budget line, equilibrium of
consumer, price consumption curve, income consumption curve, derivation of demand curve with
the help of ordinal utility analysis. Concepts of price, income and substitution effects; separation of
price effect: compensating variation and cost difference methods.

Module-II : PRODUCTION ANALYSIS

Concepts of Short run and long run production function; properties of iso-product curves, concept
of factor price line, analysis of least cost input combination, concepts of expansion path and
economic region of production, concept of returns scale and types of returns to scale. Linear and
homogeneous production function, properties of Cobb-Douglas production function.

Module-III : COST AND REVENUE ANALYSIS

Cost concepts: Accounting, real, opportunity, explicit cost. Total cost, total fixed cost, total variable
cost, average cost, average fixed cost, average variable cost, marginal cost and the relationship
between average and marginal cost, derivation of long run average cost curve. Economies of
scale: internal and external. Revenue concepts: total, average and marginal, relationship between
Average revenue & marginal revenue and price elasticity of demand.

Module--IV : MARKET STRUCTURE: IMPERFECT COMPETITION

Monopoly: Equilibrium of a monopolist with price discrimination, degrees of price discrimination,

welfare loss under monopoly. Monopolistic competition: characteristics, concepts of product
differentiation and selling cost, analysis of resource wastage under monopolistic competition.
Oligopoly: characteristics of oligopoly, reasons for price rigidity in non-collusive oligopoly. Duopoly:
Augustin Cournot’s modern version of duopoly.

Module-V : ANALYSIS OF BUSINESS FIRM, PROFIT AND PRICING STRATEGIES

Characteristics of a business firm, objectives of business firm: profit maximization, sales revenue
maximization, market share maximization, growth maximization. Profit concepts: Accounting and
economic; break-even point and profit –volume analysis Pricing strategies: Cost plus pricing,
marginal cost pricing, rate of return pricing, price skimming, penetration pricing, loss-leader pricing,
mark-up pricing and administered prices.

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 MODEL QUESTION PAPER
COMMON CORE SYLLABUS (with effect from 2019-20)
(For All Universities In Telangana State)
B.A. ECONOMICS : FIRST YEAR - PAPER - I ( Micro Economics )
Time: 3 Hours Max. Marks : 80
PART - A ( 5x4 = 20 MARKS )
Answer any 5 of the following questions
1. Define ordinal utility and explain any two assumptions of ordinal utility analysis
2. Explain briefly about four factors of production
3. Cob-Douglas production function
4. Explain about the concept of opportunity cost
5. Explain any four internal economies of scale
6. Degrees of Price Discrimination
7. Explain any four features of duopoly market
8. Discuss briefly about break-even point

PART - B ( 5x12 = 60 MARKS )

Answer all the following questions

9. a) Draw the indifference curve with the help of indifference schedule and
explain the properties of indifference curve.
(or)
b) Explain the separation of price effect into income and substitution effects
by compensating variation method.
10. a) Explain producer's equilibrium through iso-product curves.
(or)
b) Explain the theory of returns to scale.
11. a) Define average cost and marginal cost and explain the relationship
between average and marginal cost.
(or)
b) Define average revenue and marginal revenue and explain the relationship
between average revenue, marginal revenue and price elasticity of
demand.
12. a) Explain the short run equilibrium of the firm under monopolistic competition
market.
(or)
b) Define price rigidity and explain price rigidity with the help of kinky
demand curve.
13. a) Define business firm and explain the characteristics of a business firm.
(or)
b) Explain the traditional and modern objectives of a business firm.

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 INDEX
1. Consumer Behaviour ................................................. 01 - 24
1.1 Ordinal Utility Analysis .................................................... 03
1.2 Indifference Curve Analysis .............................................. 04
1.3 Assumptions of Indifference Curve Analysis ................... 04
1.4 Properties of Indifference Curve ....................................... 05
1.5 The Marginal Rate of Substitution (MRSxy) .................... 09
1.6 Concept of Budget Line ..................................................... 10
1.7 Consumer's Equilibrium .................................................... 12
1.8 Price Consumption Curve ................................................. 13
1.9 Income Consumption Curve .............................................. 15
1.10 Derivation of Demand Curve ............................................ 17
1.11 Deriving Demand Curve for a Giffen Good ...................... 18
1.12 The Substitution Effect - Hicks ......................................... 19
1.13 Substitution Effect - Slutsky ............................................. 20
1.14 Price Effect-Income and Substitution Effects-Hicks .................. 22
1.15 Price Effect-Income and Substitution Effects-Slutsky ............... 23
2. Production Analysis ................................................. 25 - 46
2.1 Production Function ........................................................... 27
2.2 Short Run Production Function ......................................... 27
2.3 Long Run Production Function ......................................... 28
2.4 The Law of Variable Proportion ......................................... 28
2.5 Iso-Quant Curves ............................................................... 31
2.6 Properties of Iso-Product Curves ....................................... 32
2.7 Concept of Factors Pricing Line- Iso-Cost Line ................ 36
2.8 Iso Quant & Iso-Cost Curves ............................................. 37
2.9 Least Cost Combination Analysis ...................................... 38
2.10 Expansion Path .................................................................. 40
2.11 Economic Region of production (Ridge Lines) .................. 41
2.12 Concept and Types of Returns to Scale ............................. 42
2.13 Linear Homogeneous Production Function ...................... 44
2.14. Properties of Cobb-Douglas Production Function ............. 45
3. Cost And Revenue Analysis ....... ............................ 47 - 62
3.1 Cost Concepts ..................................................................... 49
3.2 Short Run Costs and Cost Curves ..................................... 50
3.3 The Relation between the Average and Marginal Cost Curve ......... 53
3.4 Derivation of Long Run Average Cost (LAC) Curve ................... 54
3.5 Economies of scale .............................................................. 56
3.6 Concepts of Revenue ......................................................... 58
3.7 Relation between TR, AR, MR & Elasticity of Demand ............. 61

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4. Market Structure : Imperfect Competition ............. 63 - 80
4.1 Monopoly ............................................................................ 65
4.2 Monopoly: Price and Equilibrium ..................................... 66
4.3 Price Discrimination under Monopoly .............................. 69
4.4 Degrees of Price Discrimination ....................................... 69
4.5 Welfare Loss under Monopoly ........................................... 71
4.6 Monopolistic Competition: Characteristics ...................... 72
4.7 Equilibrium of a Firm under Monopolistic Competition .................. 73
4.8 Monopolistic competition: Selling Costs ........................... 74
4.9 Monopolistic Competition: Product Differentiation ................... 75
4.10 Resources Wastage under Monopolistic Competition ................. 76
4.11 Characteristics of Oligopoly Market ................................. 77
4.12 Non-Collusive Oligopoly .................................................... 78
4.13 Duopoly-Cournot Model ..................................................... 79

5. Analysis of Business Firm, Profit And Pricing Strategies 81 - 95

5.1 Profit Maximisation ........................................................... 83
5.2 Baumol's Model - Sales maximisation .............................. 85
5.3 Market Share Maximisation ............................................. 86
5.4 Growth Maximisation Theory of Marris ........................... 87
5.5 Accounting Profit and Economic Profit ............................ 88
5.6 Break-Even Point ............................................................... 89
5.7 Profit Volume Analysis ...................................................... 90
5.8 Cost-Plus Pricing ............................................................... 91
5.9 Marginal-cost pricing ......................................................... 92
5.10 Rate of Return Pricing ....................................................... 92
5.11 Price Skimming .................................................................. 93
5.12 Penetration Pricing ............................................................ 93
5.13 Loss Leader Pricing ........................................................... 94
5.14 Mark-up Pricing ................................................................. 95
5.15 Administered Price ............................................................ 95
Reference Books ......................................................................... 96

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1
John Richard Hicks
8th April 1904 - 20th May, 1989

CONSUMER BEHAVIOUR
1.1 Assumptions of Ordinal Utility Approach
1.2 Indifference Curve Analysis
1.3 Assumptions of Indifference Curve Analysis
1.4 Properties of Indifference Curve
1.5 The Marginal Rate of Substitution (MRSxy)
1.6 Concept of Budget Line
1.7 Consumer's Equilibrium
1.8 Price Consumption Curve
1.9 Income Consumption Curve
1.10 Derivation of Demand Curve
1.11 Deriving Demand Curve for a Giffen Good
1.12 The Substitution Effect - Hicks
1.13 Substitution Effect - Slutsky
1.14 Price Effect-Income and Substitution Effects-Hicks
1.15 Price Effect-Income and Substitution Effects-Slutsky

1
2
1.1 Ordinal Utility Analysis
The Ordinal Utility approach is based on the fact that the utility of a commodity
cannot be measured in absolute quantity, but however, it will be possible for a consumer
to tell subjectively whether the commodity derives more or less or equal satisfaction
when compared to another.

The modern economists have discarded the concept of cardinal utility and instead
applied ordinal utility approach to study the behaviour of the consumers. While the neo-
classical economists believed that the utility can be measured and expressed in cardinal
numbers, but the modern economists maintain that the utility being the psychological
phenomena cannot be measured theoretically, quantitatively and even cardinally.

The modern economist, Hicks, in particular, have applied the ordinal utility concept
to study the consumer behaviour. He introduced a tool of analysis called “Indifference
Curve” to analyze the consumer behaviour. An indifference curve refers to the locus of
points each showing different combinations of two substitutes which yield the same level
of satisfaction and utility to the consumer.

Assumptions of Ordinal Utility Approach :

1. Rationality : It is assumed that the consumer is rational who aims at maximizing

his level of satisfaction for given income and prices of goods and services, which he
wish to consume. He is expected to take decisions consistent with this objective.

2. Ordinal Utility: The indifference curve assumes that the utility can only be
expressed ordinals. This means the consumer can only tell his order of preference
for the given goods and services.

3. Transitivity and Consistency of Choice: The consumer’s choice is expected to be

either transitive or consistent. The transitivity of choice means, if the consumer
prefers commodity X to Y and Y to Z, then he must prefer commodity X to Z. In
other words, if X = Y, Y = Z, then he must treat X = Z. The consistency of choice
means that if a consumer prefers commodity X to Y at one point of time, he will not
prefer commodity Y to X in another period or even will not consider them as equal.

3
4. Nonsatiety: It is assumed that the consumer has not reached the saturation point
of any commodity and hence, he prefers larger quantities of all commodities.

5. Diminishing Marginal Rate of Substitution (MRS) :

The marginal rate of substitution refers to the rate at which the consumer is ready
to substitute one commodity (X) for another commodity (Y) in such a way that his
total satisfaction remains unchanged. The MRS is denoted as -ΔY/ΔX. The ordinal
approach assumes that -ΔY/ΔX goes on diminishing if the consumer continues to
substitute X for Y.

1. 2. Indifference Curve Analysis :

Indifference curves are formulated based on ordinal utility analysis. They were
originally introduced by British economist F.Y Edgeworth in the book Mathematical
Physics - 1881 and American economist Irving Fisher (1892). Indifference curves were
improved by the Italian economist Parito in 1906. It was developed by British economists
J.R. Hicks and R.G.D. Allen in 1934. The indifference curve is the locus of the points
where the customer gets equal satisfaction by consuming different combination of X and
Y goods.

1. 3 Assumptions of Indifference Curve Analysis :

The indifference curve analysis retains some of the assumptions of the cardinal
theory, rejects others and formulates its own. The assumptions of the ordinal theory are
the following:

1. The consumer acts rationally so as to maximise satisfaction.

2. There are two goods X and Y.
3. The consumer possesses complete information about the prices of the goods
in the market.
4. The prices of the two goods are given.
5. The consumer’s tastes, habits and income remain the same throughout the
analysis.
6. The consumer arranges the two goods in a scale of preference which means
that he has both ‘preference’ and ‘indifference’ for the goods. He is supposed
to rank them in his order of preference and can state if he prefers one
combination to the other or is indifferent between them.
7. Both preference and indifference are transitive.

4
1.4. Properties of Indifference Curve
1. The slope of an indifference curve is negative, downward sloping,
and from left to right.
2. An indifference curve is convex to the origin.
3. A higher indifference curves to the right gives higher level of satisfaction.
4. In between two indifference curves there can be a number of other indifference
curves.
5. The numbers IC1, IC2, IC3, IC4 .. etc. given to indifference curves are absolutely arbitrary.
6. Indifference curves can neither touch nor intersect each other.
7. An indifference curve cannot touch either axis.
8. Indifference curves are not necessarily parallel to each other.
9. If the two goods are perfect complements the indifference curve is L shaped.
10. If two goods are perfect substitutes, the indifference curve is a straight line with
negative slope.
1. The slope of an indifference curve is negative, downward sloping, and from left
to right. It means that the consumer to be indifferent to all the combinations on an
indifference curve must leave less units of good Y in order to have more of good X. To
prove this property, let us take indifference curves contrary to this assumption. In the
below Figure 1.1 (A) combination B of OX1 +OY1 is preferable to combination A which has
a smaller amount of the two goods. Therefore, an indifference curve cannot slope upward
from left to right.

In Figure 1.1 (B) combination B is preferable to combination A, for combination B has more
of X and the same quantity of Y. So an indifference curve cannot be horizontal.
In Figure 1.1 (C) the indifference curve is shown as vertical and combination B is preferred
to A as the consumer has more of Y and the same quantity of X. Therefore, an indifference
curve cannot be vertical either.
Consequently, an indifference curve will be of negative slope, as shown in Figure (D) where A
and B combinations give equal satisfaction to the consumer. As he moves from combination A
to B he gives up less quantity of Y in order to have more of X.
5
2. An indifference curve is convex to the origin. The convexity rule implies that as
the consumer substitutes X for Y, the marginal rate of substitution diminishes. It
means that as the amount X is increased by equal amounts that of Y diminish by
smaller amounts. The slope of the curve becomes smaller as we move to the right.
To prove this, let us take a concave curve where the marginal rate of substitution
of X for Y increases instead of diminishing, i.e., more of Y is given up to have
additional units of X.
In Figure 1.2 (A), If we take a straight line indifference curve, the marginal rate of
substitution between the two goods will be constant, as in figure 1.2 panel (B)
Thus an indifference curve cannot be a straight line.

In figure 1. 2 panel (C) shows an indifference curve convex to the origin. Here the
consumer is giving up less and less units of Y in order to have equal additional
units of X Thus an indifference curve is always convex to the origin because the
marginal rate of substitution between the two goods declines.
3. A higher indifference curves to the right of another represents a higher level of
satisfaction and preferable combination of the two goods. In the adjoining figure
1.3 consider the indifference curves IC1 and IC2
and combinations N and A respectively on them.
Since A is on a higher indifference curve and to
the right of N. the consumer will be having more
of both the goods X and Y. Even if the two points
on these curves are on the same plane as M and
A, the consumer will prefer the latter
combination, because he will be having more of
goods X though the quantity of goods Y is the
same.

6
 4. In between two indifference curves there can be
a number of other indifference curves: There are
number of indifference curves in between indifference
curves like adjoining figure 1.4
5. The Numbers given to indifference curves are
obsolutely orbitrary : The numbers IC1, IC2, IC3, IC4
etc. given to indifference curves are absolutely
arbitrary. Any numbers can be given to indifference
curves. The numbers can be in the ascending order.
6. Indifference curves can neither touch nor
intersect each other : Indifference curves can neither
touch nor intersect each other so that one indifference curve passes through only one
point on an indifference map. What absurdity follows from such a situation can be shown
with the help of adjoining figure
1. 5 (A) where the two curves IC1
and lC2 intersect each other. Point
A on the IC 1 curve indicates a
higher level of satisfaction than
point B on the IC2 curve, as it lies
farther away from the origin. But
point B which lies on both the
curves yields the same level of
satisfaction as point A and B.
Thus on the curve IC1 : A = C and
on the curve lC2: B = C, A = B. This
is absurd because A is preferred to B, being on a higher indifference curve IC1. Since each
indifference curve represents a different level of satisfaction, indifference curves can
never intersect at any point. The same reasoning applies
if two indifference curves touch each other at point B in
panel (B) of the figure 1.5.
7. An indifference curve cannot touch either axis: If it
touches X-axis, as IC1; in adjoining figure 1. 6 at M, the
consumer will be having OM quantity of good X and none
of Y. Similarly, if an indifference curve IC2 touches the Y-
axis at L, the consumer will have only OL of Y good and
no amount of X. Such curves are in contradiction to the
assumption that the consumer buys two goods in
combinations.
7
8. Indifference curves are not necessarily
parallel to each other : Though they are falling,
negatively inclined to the right, yet the rate of
fall will not be the same for all indifference
curves. In other words, the diminishing
marginal rate of substitution between the two
goods is essentially not the same in the case of
all indifference schedules. The two curves lC1
and lC2shown in adjoining figure 1.7 (A) are
not parallel to each other.

9. If the two goods are perfect complements

the indifference curve is L shaped : As shown
in Figure 7 (B). The vertical portion of the IC1
curve reveals that no amount of reduction in
good Y will lead even to a slight increase in good
X. For example, point's A, M and B are all on
the curve IC1 but point B involves the same
amount of Y but more of X than point M. Thus
MRSXY is zero. The two goods X and Y are
consumed in the desired ratio, as indicated by
the slope of the ray OR at point M. Such
complementary goods are left and right shoes
which are used in the 1:1 fixed ratio.

10. If two goods X and Y are perfect

substitutes, the indifference curve is a
straight line with negative slope : As shown
in Figure 1.7 (C) because the MRSXY is constant.
The value of this slope is throughout minus 1,
and MRSXY =1.

In the figure, ab of Y = bc of X, and cd of Y=

de of X. In this case, the consumer does not
distinguish between these two goods and
regards them as the same commodity, such as
two brands of tea. The consumer is obsessed
with the purchase of only one good. This is
called monomania for that good.

8
1.5 The Marginal Rate of Substitution (MRSxy)
The marginal rate of substitution is the rate of exchange between some units of goods
X and Y which are equally preferred. The marginal rate of substitution of X for Y (MRS)xy is
the amount of Y that will be given up for obtaining each additional unit of X. This rate is
explained below in the following indifference schedule of Table and Figure in 1. 8.

In the table all the 5 combinations gives same level of satisfaction to the consumer.
In the A combination consumer is consuming 1, X commodity and 12, Y commodities. To
have the B combination and yet to be at the same level of satisfaction, the consumer is
prepared to forgo 4 units of Y for obtaining an extra unit of X. The marginal rate of
substitution of X for Y is 4:1. The rate of substitution will then be the number of units of
Y for which one unit of X is a substitute. As the consumer proceeds to have additional
units of X, he is willing to give away less and less units of Y so that the marginal rate of
substitution falls from 4:1 to 1:1.
In the above figure at point B on the indifference curve IC1, the consumer is willing
to give up 4 units of Y to get an additional unit of X. As he moves along the curve, the
consumer acquires more of X and less of Y. The amount of Y he is prepared to give up to
get additional units of X becomes smaller and smaller. This behaviour of the consumer is
known as the principle of diminishing marginal rate of substitution. The marginal rate
of substitution of X for Y (MRSXY) is in fact the slope of the curve at a point on the
indifference curve.
- ΔY
Thus MRSxy = ΔX
The principle of diminishing marginal rate of substitution is superior to the law of
diminishing marginal utility. Because the Marshallian analysis is based on introspective
cardinalism in which utility is measured quantitatively and is a single-commodity
analysis. The principle of diminishing marginal rate of substitution is, however, scientific
and realistic because it is free from the psychological quantitative measurement of utility
analysis.
9
1.6 Concept of Budget Line
The knowledge of the concept of budget line is essential for understanding the
theory of consumer's equilibrium. A higher indifference curve shows a higher level of
satisfaction than a lower one. Therefore, a consumer in his attempt to maximize his
satisfaction will try to reach the highest possible indifference curve.
But in his pursuit of buying more and more goods and thus obtaining more and
more satisfaction he has to work under two constraints; first, he has to pay the prices for
the goods and, secondly, he has a limited
money income with which to purchase the
goods. Thus, how far he would go in for his
purchases depends upon the prices of the
goods and the money income which he has to
spend on the goods. In order to explain
consumer's equilibrium there is also the need
for introducing into the indifference diagram
the budget line which represents the prices
of the goods and consumer's money income.
Suppose our consumer has got income of
Rs. 50 to spend on goods X and Y. Let the price
of the good X in market be Rs. 10 per unit
and that of Y Rs. 5 per unit. If the consumer
spends his whole income of Rs. 50 on good X,
he would buy 5 units of X; if he spends his whole income of Rs. 50 on good Y he would buy
10 units of Y. If a straight line joining 5X and 10Y is drawn, we will get what is called the
price line or the budget line. This budget line shows all those combinations of two goods
which the consumer can buy spending his given money income on the two goods at their
given prices. In the figure 1.9 with Rs. 50 and the prices of X and Y being Rs. 10 and Rs.
5 respectively the consumer can buy 10 - Y and 0 (zero) - X, or 8 - Y and 1 - X; or 6 - Y and
2 - X, or 4 - Y and 3 -X etc.
In other words, he can buy any combination that lies on the budget line with his
given money income and given prices of the goods. It is also important to remember that
the intercept OB on the Y-axis in Fig. equals the amount of his entire income divided by
the price of commodity Y. That is, OB = M/Py. Likewise, the intercept OL on the X-axis
measures the total income divided by the price of commodity X. Thus OL = M/Px.

10
 The budget line can be written algebraically as follows: PxX + PyY = M , Where Px
and Py denote prices of goods X and Y respectively and M stands for money income. The
budget-line equation implies that, given the money income of the consumer and prices
of the two goods, every combination lying on the budget line will cost the same amount
of money and can therefore be purchased with the given income. The budget line can be
defined as a set of combinations of two commodities that can be purchased if whole of a
given income is spent on them and its slope is equal to the negative of the price ratio.

Slope of the Budget Line and Prices of two Goods :

It is also important to remember that the slope of the budget line is equal to the
ratio of the prices of two goods. This can be proved with the aid of figure 1.9. Suppose
the given income of the consumer is M and the given prices of goods X and Y are Px and
Py respectively. The slope of the budget line BL is OB/OL. We intend to prove that slope
OB/OL is equal to the ratio of the price of goods X and Y.

The quantity of good X purchased if whole of the given income M is spent on it is

OL.

Therefore,
OL × Px = M
OL = M/( Px) …..(i)
Now, the quantity of good Y purchased if whole of the given income M is spent on it is
OB.
OB × Py =M
OB = M/( Py) ….(ii)
Dividing( ii) by (i)
OB/OL = M/Py ÷ M/Px = M/Py × Px/M = Px/Py
Thus slope of budget line
= OB/OL = Px/Py
It is thus proved that the slope of the budget line BL represents the ratio of the prices of
two goods.

11
1.7 Consumer's Equilibrium
Consumer equilibrium refers to a situation, in which a consumer derives maximum
satisfaction, with no intention to change it and subject to given prices and his given
income. The point of maximum satisfaction is achieved by studying indifference map
and budget line together. On an indifference map, higher indifference curve represents a
higher level of satisfaction than any lower indifference curve. So, a consumer always
tries to remain at the highest possible indifference curve, subject to his budget constraint.

Conditions of Consumer's Equilibrium: The consumer's equilibrium under the

indifference curve theory must meet the following two conditions:

(i) MRSXY = Ratio of prices or PX/PY : Let the two goods be X and Y. The first condition for
consumer's equilibrium is that, MRSXY = PX/PY

(ii) MRS continuously falls: The second condition for consumer's equilibrium is that MRS
must be diminishing at the point of equilibrium, i.e. the indifference curve must be convex
to the origin at the point of equilibrium. Unless MRS continuously falls, the equilibrium
cannot be established. Thus, both the conditions need to be fulfilled for a consumer to be
in equilibrium.

Let us now understand this with the help of a diagram:

In the figure 1.10, IC1, IC2 and IC3 are the three indifference curves and AB is the budget
line. With the constraint of budget line, the
highest indifference curve, which a
consumer can reach, is IC2. The budget line
is tangent to indifference curve IC2 at point
'E'. This is the point of consumer
equilibrium, where the consumer purchases
OM quantity of commodity 'X' and ON
quantity of commodity 'Y. The other points
on the budget line to the left (F) or right (G)
of point 'E' will lie on lower indifference
curve IC1 and thus indicate a lower level of
satisfaction. Whereas point (H) on IC 3
indifference curve is far away from
consumer budget line AB. The budget line
AB is tangent to IC2 indifference curve at
point 'E', consumer maximizes his satisfaction at this point, when both the conditions of
consumer's equilibrium are satisfied.
12
1.8 Price Consumption Curve
When, the price of good changes, the consumer would be either better off or worse
off than before, depending upon whether the price falls or rises. In other words, as a
result of change in price of a good, his equilibrium position would lie at a higher
indifference curve in case of the fall in price and at a lower indifference curve in case of
the rise in price.
Price effect is shown in adjoining figure 1.11. With given prices of goods X and Y, and a
given money income as represented by the budget line PL1, the consumer is in equilibrium at Q
on indifference curve IC1. In this equilibrium position at Q, he is buying OM1 of X and ON1 of Y.
Let price of good X fall, price of Y and his money income remaining unchanged.
As a result of this price change, budget line
shifts to the position PL2. The consumer is now
in equilibrium at R on a higher indifference curve
IC2 and is buying OM2 of X and ON2 of Y. He has
thus become better off, that is, his level of
satisfaction has increased as a consequence of the
fall in the price of good X. Suppose that price of X
further falls so that PL3 is now the relevant price
line. With budget line PL3 the consumer is in
equilibrium at S on indifference curve IC3 where
he has OM3 of X and ON3 of Y. If the price of good
X falls still further so that budget line now takes
the position of PL4, the consumer now attains
equilibrium at T on indifference curve IC4 and has OM4 of X and ON4 of Y.

When all the equilibrium points such as Q, R, S, and T are joined together, we get
what is called Price Consumption Curve (PCC). Price consumption curve traces out the
price effect. It shows how the changes in price of good X will affect the consumer's
purchases of X, price of Y, his tastes and money income remaining unaltered. In figure
price consumption curve (PCC) is sloping downward. Downward sloping price
consumption curve for good X means that as the price of good X falls, the consumer
purchases a larger quantity of good X and a smaller quantity of good Y. This is quite
evident from figure.

In elasticity of demand, we obtain downward-sloping price consumption curve for

good X when demand for it is elastic (i.e., price elasticity is greater than one). But
downward sloping is one possible shape of price consumption curve. Price consumption
curve can have other shapes also.
13
 In adjoining figure 1.12 upward-sloping price
consumption curve is shown. Upward-sloping price
consumption curve for X means that when the price
of good X falls, the quantity demanded of both goods
X and Y rises. We obtain the upward-sloping price
consumption curve for good X when the demand for
good is inelastic, (i.e., price elasticity is less than one).

Price consumption curve can also have a backward-

sloping shape, which is depicted in adjoining figure
1.13. Backward-sloping price consumption curve for
good X indicates that when price of X falls, after a
point smaller quantity of it is demanded or purchased.
This is true in case of exceptional type of goods called
Giffen Goods.

Price consumption curve for a good can take

horizontal shape too. It means that when the price of
the good X declines, its quantity purchased rises
proportionately but quantity purchased of Y remains
the same. Horizontal price consumption curve is
shown in figure 1.14. We obtain horizontal price
consumption curve of good X when the price elasticity
of demand for good X is equal to unity.

It is rarely found that price consumption curve

slopes downward throughout or slopes upward
throughout or slopes backward throughout. More
generally, price consumption curve has different slopes
at different price ranges. At higher price levels it
generally slopes downward, and it may then have a
horizontal shape for some price ranges but ultimately
it will be sloping upward. For some price ranges it
can be backward sloping as in case of Giffen goods. A
price consumption curve which has different shapes
or slopes at different price ranges is drawn in figure
1.15

14
1.9 Income Consumption Curve :
With given money income to spend on goods, given prices of the two goods and
given an indifference map, the consumer will be in equilibrium at a point in an indifference
map. We are interested in knowing how the consumer will react in regard to his purchases
of the goods when his money income changes,
prices of the goods and his tastes and preferences
remaining unchanged. Income effect shows this
reaction of the consumer. Thus, the income effect
means the change in consumer's purchases of the
goods as a result of a change in his money income.
Income effect is illustrated in adjoining figure 1.16
With given prices and a given money income
as indicated by the budget line P1L1 the consumer
is initially in equilibrium at point Q 1 on the
indifference curve IC1 and is having OM1 of X and
ON1 of Y. Now suppose that income of the consumer
increases. With his increased income, he would be
able to purchase larger quantities of both the goods.
As a result, budget line will shift upward and will be parallel to the original budget line
P1L1. Let us assume that the consumer's money income increases by such an amount
that the new budget line is P2L2, the consumer is in equilibrium at point Q2 on indifference
curves IC2 and is buying OM2 of X and ON2 of Y.
Thus as a result of the increase in his income the consumer buys more quantity of
both the goods Since he is on the higher indifference curve IC2 he will be better off than
before i.e., his satisfaction will increase. If his income increases further so that the budget
line shifts to P3L3, the consumer is in equilibrium at point Q3 on indifference curve IC3
and is having greater quantity of both the goods than at Q2.
Consequently, his satisfaction further increases. In the figure the consumer's
equilibrium is shown at a still further higher level of income and it will be seen that the
consumer is in equilibrium at Q4 on indifference curves IC4 when the budget line shifts
to P4L4. As the consumer's income increases, he switches to higher indifference curves
and as a consequence enjoys higher levels of satisfaction.
If now various points Q1, Q2, Q3 and Q4 showing consumer's equilibrium at various
levels of income are joined together, we will get what is called Income Consumption
Curve (ICC). Income consumption curve is thus the locus of equilibrium points at various
levels of consumer's income. Income effect can either be positive or negative.
Income effect for a good is said to be positive when with the increase in income of
the consumer, his consumption of the good also increases. This is the normal good case.
When the income effect of both the goods represented on the two axes of the figure is
positive, the income consumption curve ICC will slope upward to the right as in the
figure. Only the upward- sloping income consumption curve can show rising consumption
of the two goods as income increases.
15
 However, for some goods, income effect is negative. Income effect for a good is
said to be negative when with the increases in his income, the consumer reduces his
consumption of the good. Such goods for which income
effect is negative are called Inferior Goods. This is
because the goods whose consumption falls as income
of the consumer rises are considered to be some way
'inferior' by the consumer and therefore he substitutes
superior goods for them when his income rises.

In case of inferior goods, indifference map would

be such as to yield income consumption curve which
either slopes backward (i.e., toward the left) or
downward to the right as in figure 1.17. It would be
noticed from the figure that income effect becomes
negative only after a point. If income effect for good X
is negative, income consumption curve will slope backward to the left as ICC1 in figure.
If good Y happens to be an inferior good and income consumption curve will bend towards
X-axis as shown by ICC2 in figure.
Normal goods can be either necessities or luxuries depending upon whether the
quantities purchased of the goods by the consumers increase less than or more than
proportionately to the increases in income. If the
quantity purchased of a commodity rises less than
proportionately to the increases in consumer's
income, the commodity is known as a necessity.
On the other hand, if the quantity purchased of
a commodity increases more than proportionately to
the increases in income, it is called a luxury. In figure
1.18, the slope of income consumption curve ICC1 is
increasing which implies that the quantity purchased
of the commodity X increases less than
proportionately to the increases in consumer's
income. Therefore, in this case of ICC1 good X is a
necessity and good Y is luxury.
On the other hand, the slope of income consumption curve ICC3 is decreasing
which implies that the quantity purchased of good X increases more than proportionately
to increases in income and therefore in this case good X is luxury and good Y is necessity.
It will be seen from figure that the income consumption curve ICC2 is a linear curve
passing through the origin which implies that the increases in the quantities purchased
of both the goods are rising in proportion to the increase in income and therefore neither
good is a luxury or a necessity.
16
1.10 Derivation of Demand Curve :
A demand curve shows how much quantity of a good will be purchased or
demanded at various prices, assuming that tastes and preferences of a consumer, his
income, prices of all related goods remain constant. This demand curve showing
relationship between price and quantity demanded can be derived from price consumption
curve of indifference curve analysis.

Let us suppose that a consumer has got income of Rs. 300 to spend on goods. In
Fig. 1.19 money is measured on the Y-axis, while the quantities of the good X whose
demand curve is to be derived is measured
on the X-axis. An indifference map of a
consumer is drawn along with the various
budget lines showing different prices of
the good X. Budget line PL1 shows that
price of the good X is Rs. 15 per unit. As
price of good X falls from Rs. 15 to Rs. 10,
the budget line shifts to PL2. Budget line
PL2 shows that price of good X is Rs. 10.
With a further fall in price to Rs. 7.5 the
budget line takes the position PL3. Thus
PL3 shows that price of good X is Rs. 7.5.
When price of good X fall further Rs. 6,
PL4 is the relevant budget line.

With the budget line PL 1 the

consumer is in equilibrium at point Q1 on
the price consumption curve PCC at which
the budget line PL 1 is tangent to
indifference curve IC1. In his equilibrium
position at Q1 the consumer is buying OA units of the good X. In other words, it means
that the consumer demands OA units of good X at price Rs. 15. When price falls to Rs. 10
and thereby the budget line shifts to PL2, the consumer comes to be in equilibrium at
point Q2 the price-consumption curve PCC where the budget line PL2 is tangent to
indifference curve IC2. At Q2, the consumer is buying OB units of good X.

Likewise, with budget lines PL3 and PL4, the consumer is in equilibrium at points
Q3 and Q4 of price consumption curve and is demanding OC units and OD units of good X
at price Rs. 7.5 and Rs. 6 respectively. It is thus clear that from the price consumption
curve we can get information which is required to draw the demand curve showing directly
the amounts demanded of the good X against various prices.

17
1.11 Deriving Demand Curve for a Giffen Good
1.11
The demand curve DD in Fig. 1.19 is sloping downward. The demand curve slopes
downward because of two forces, namely, income effect and substitution effect. Both the
income effect and substitution effect usually work towards increasing the quantity
demanded of the good when its price falls and this makes the demand curve slope downward.
But in case of Giffen good, the demand curve slopes upward from left to right.
This is because in case of a Giffen
good income effect, which is negative and
works in opposite direction to the
substitution effect, outweighs the
substitution effect. This results in the fall
in quantity demanded of the Giffen good
when its price falls and therefore the
demand curve of a Giffen good slopes
upward from left to right. In Fig. 1.20 the
derivation of demand curve of a Giffen
good from indifference curves diagram is
explained.
In Fig. 1.20 the Indifference curves
of a Giffen good are drawn along with the
various budget lines showing various
prices of the good. Price consumption
curve of a Giffen good slopes backward.
In order to simplify the discussion in this
figure we have avoided the numerical
values of prices and have instead used
symbols such as, P1, P2, P3 and P4 for various levels of the price of good X. It is evident
from Fig. 1.20 (the upper portion) that with budget line PL1 (or price P1) the consumer is
in equilibrium at Q1 on the price consumption curve PCC and is purchasing OM1 amount
of the good. With the fall in price from P1 to P2 and shifting of budget line from PL1to PL2,
the consumer goes to the equilibrium position Q3 at which he buys OM2 amount of the
good. OM2 is less than OM1. Thus with the fall in price from P1 to P2 the quantity demanded
of the good falls. Likewise, the consumer is in equilibrium at Q3 with price line PL3 and
is purchasing OM3 at price P3. With this information we can draw the demand curve, as
is done in the lower portion of Fig. 1.20 It will be seen from Fig. 1.20 (lower part) that the
demand curve of a Giffen good slopes upward to the right indicating that the quantity
demanded varies directly with the changes in price. With the rise in price, quantity
demanded increases and with the fall in price quantity demanded decreases.
18
1.12 The Substitution Effect - Hicks
The substitution effect relates to the change in the quantity demanded resulting
from a change in the price of good due to the substitution of relatively cheaper good for a
dearer one, while keeping the price of the other good and real income and tastes of the
consumer as constant. Prof. Hicks has explained the substitution effect independent of
the income effect through compensating variation in income. "The substitution effect is
the increase in the quantity bought as the price of the commodity falls, after adjusting
income so as to keep the real purchasing power of the consumer the same as before. This
adjustment in income is called compensating variations and is shown graphically by a
parallel shift of the new budget line until it become tangent to the initial indifference
curve."
Thus on the basis of the methods of compensating variation, the substitution
effect measure the effect of change in the relative price of a good with real income constant.
The increase in the real income of the consumer as a result of fall in the price of, say good
X, is so withdrawn that he is neither better off nor worse off than before.

The substitution effect is explained in Figure 1.21 where the original budget line
is PQ with equilibrium at point R on the
indifference curve IC1. At R, the consumer
is buying OB of X and BR of Y. Suppose
the price of X falls so that his new budget
line is PQ1. With the fall in the price of X,
the real income of the consumer increases.
To make the compensating variation in
income or to keep the consumer's real
income constant, take away the increase
in his income equal to PM of good Y or
Q1N of good X so that his budget line PQ1
shifts to the left as MN and is parallel to
it. At the same time, MN is tangent to the
original indifference curve lC1 but at point
H where the consumer buys OD of X and
DH of Y. Thus PM of Y or Q 1 N of X
represents the compensating variation in income, as shown by the line MN being tangent
to the curve IC1 at point H. Now the consumer substitutes X for Y and moves from point
R to H or the horizontal distance from B to D. This movement is called the substitution
effect. The substitution affect is always negative, the relation between price and quantity
demanded being inverse, the substitution effect is negative.
19
1.13 Substitution Effect - Slutsky
The concept of substitution effect put forward by J.R. Hicks. There is another
important version of substitution effect put forward by E. Slutsky. The treatment of the
substitution effect in these two versions has a significant difference. In Slutsky's version
of substitution effect when the price of good changes and consumer's real income or
purchasing power increases, the income of the consumer is changed by the amount equal
to the change in its purchasing power which occurs as a result of the price change. His
purchasing power changes by the amount equal to the change in the price multiplied by
the number of units of the good which the individual used to buy at the old price.

In other words, in Slutsky's approach, income is reduced or increased (as the

case may be), by the amount which leaves the consumer to be just able to purchase the
same combination of goods, if he so desires, which he was having at the old price. That is,
the income is changed by the difference between the cost of the amount of good X purchased
at the old price and the cost of purchasing the same quantity if X at the new price.
Income is then said to be changed by the cost difference. Thus, in Slutsky substitution
effect, income is reduced or increased not by compensating variation as in case of the
Hicksian substitution effect but by the cost difference.

Now, an important question is how to determine the exact magnitude of cost

difference by which money income of the consumer has to be adjusted to arrive at Slutsky
substitution effect. The reduction in price of a commodity, say X, can be represented as
?Px. If the consumer is buying quantity Qx of commodity X before the reduction in price
of the commodity, then ΔPx. Qx will represents the cost difference by which money income
of the consumer is to be adjusted so as to enable him to buy the quantity Qx of commodity
X (and the same original quantity of Y) which he was buying before the change in price.
Suppose, with a given money income, a consumer is buying Qx of X and Qy of Y at given
prices of Px1 and Py1 respectively. Now, if the price of X falls from Px1 to Px2, the money
income and price of Y remaining the same, the cost difference will thus be equal to

Px1Qx - Px2Qx = ΔPx Qx

Let us give a numerical example. If at a price of Rs. 10, a consumer is buying 15
units of the commodity X along with a certain quantity of Y at the given price of Y. If now
the price of X falls to Rs. 8, the cost difference will be

10 × 15 - 8 × 15 = 2 × 15 = 30

20
 Slutsky substitution effect is illustrated in adjoining Fig. 1.22. With given money
income and the given prices of two goods as represented by the price line PL1 the consumer
is in equilibrium at Q on the indifference curve IC1 buying OM of X and ON of Y. Now
suppose that price of X falls, price of Y and money income of the consumer remaining un-
changed. As a result of this fall in price of X, the price line will shift to PL1 and the real
income or the purchasing power of the consumer will increase. Now, in order to find out
the Slutsky substitution effect, consumer's money income must be reduced by the cost-
difference or, in other words, by the amount which will leave him to be just able to purchase
the old combination Q, if he so desires. For this, a price line GH parallel to PL1 has been
drawn which passes through the point Q. It means that income equal to PG in terms of Y
or L1H in terms of X has been taken away from the consumer and as a result he can buy
the combination Q, if he so desires, since Q also lies on the price line GH.

Actually, he will not now buy the combination Q since X has now become relatively
cheaper and Y has become relatively dearer than before. The change in relative prices
will induce the consumer to rearrange his purchases of X and Y. He will substitute X for
Y. But in this Slutsky substitution effect, he will not move along the same indifference
curve IC1, since the price line GH, on which the
consumer has to remain due to the new price-income
circumstances is nowhere tangent to the indifference
curve IC1.

The price line GH is tangent to the indifference curve

IC2 at point S. Therefore, the consumer will now be
in equilibrium at a point S on a higher indifference
curve IC2. This movement from Q to S represents
Slutsky substitution effect according to which the
consumer moves not on the same indifference curve,
but from one indifference curve to another.

A noteworthy point is that movement from Q to S as

a result of Slutsky substitution effect is due to the
change in relative prices alone, since the effect due
to the gain in the purchasing power has been eliminated by making a reduction in money
income equal to the cost-difference. At S, the consumer is buying OK of X and O W of Y; MK
of X has been substituted for NW of Y. Therefore, Slutsky substitution effect on X is the
increase in its quantity purchased by MK and Slutsky substitution effect on Y is the decrease
in its quantity purchased by NW.

21
1.14 Price Effect - Income and Substitution Effects - Hicks
Hicks has separated the substitution effect and the income effect from the price
effect through compensating variation in income by changing the relative price of a good
while keeping the real income of the consumer constant. Suppose initially the consumer
is in equilibrium at point R on the budget line PQ where the indifference curve IC1, is
tangent to it at point R in Figure 1.23.

Let the price of good X fall. As a result, his budget line rotates outward to PQ,
where the consumer is in equilibrium at point T on the higher indifference curve IC2
.The movement from R to T or B to E on the horizontal axis is the price effect of the fall
in the price of X. With the fall in the price of X, the consumer's real income increases. To
make the compensating variation in income in order to isolate the substitution effect,
the consumer's money income is reduced equivalent to PM of Y or Q1N of X by drawing
the budget line MN parallel to PQ1,
so that it is tangent to the original
indifference curve IC1 at point H.

The movement from R to H on the

IC1, curve is the substitution effect
whereby the consumer increases his
purchases of X from B to D on the
horizontal axis by substituting X for
Y because it is cheaper.

It may be noted that when there is a

fall (or rise) in the price of good X, the
substitution effect always leads to an
increase (or decrease) in its quantity demanded. Thus the relation between price and
quantity demanded being inverse, the substitution effect of a price change is always
negative, real income being held constant.

22
1.15 Price Effect - Income and Substitution Effects - Slutsky
In our discussion of substitution effect we explained that Slutsky presented a
slightly different version of the substitution and income effects of a price change from
the Hicksian one. His way of breaking up the price effect is shown in figure 1.24. With a
certain price- income situation, the consumer is in equilibrium at Q on indifference curve
IC1.

With a fall in price of X, other things remaining the same, budget line shifts to
PL2. With budget line PL2, the consumer would now be in equilibrium at R on the
indifference curve IC3. This movement
from Q to R represents the price effect
(PCC). As a result of this he buys MN
quantity of good X more than before.
Now, in order to find out the substitution
effect his money income be reduced by
such an amount that he can buy, if he so
desires, the old combination Q. Thus, a
line AB, which is parallel to PL2, has
been so drawn that it passes through
point Q. Thus PA in terms of good Y, L2B
in terms of X represents the cost
difference. With budget line AB, the
consumer can have combination Q if he
so desires, but actually he will not buy
combination Q because X is now
relatively cheaper than before. It will
pay him to substitute X for Y.

With budget line AB he is in equilibrium at S on indifference curve IC2. The

movement from Q to S represents Slutsky substitution effect which induces the consumer
to buy MH quantity more of good X. If now the money taken away from him is restored to
him, he will move from S on indifference curve IC2 to R on indifference curve IC3.

This movement from S to R represents income effect (ICC). Thus, movement from
Q to R as a result of price effect can be divided into two steps. First, movement from Q to
S as a result of substitution effect and secondly, movement from S to R as a result of
income effect. It may be pointed out here again that, unlike the Hicksian method, Slutsky
substitution effect causes movement from a lower indifference curve to a higher one.

23
24
2
Alfred Marshall
26 July 1842 - 13th July, 1924
th

PRODUCTION ANALYSIS
2.1 Production Function
2.2 Short Run Production Function
2.3 Long Run Production Function
2.4 The Law of Variable Proportions
2.5 Iso-Quant Curves
2.6 Properties of Iso-Product Curves
2.7 Concept of Factors Pricing Line- Iso-Cost Line
2.8 Iso Quant & Iso-Cost Curves
2.9 Least Cost Combination Analysis
2.10 Expansion Path
2.11 Economic Region of production (Ridge Lines)
2.12 Concept and Types of Returns to Scale
2.13 Linear Homogeneous Production Function
2.14. Properties of Cobb-Douglas Production Function

25
26
2.1 Production Function
The processes and methods used to transform tangible inputs (raw materials, semi-
finished goods, subassemblies) and intangible inputs (ideas, information, knowledge)
into goods or services. Resources are used in this process to create an output that is
suitable for use or has exchange value.

Production function is the technological relationship between inputs and output

in physical terms. It specifies the maximum quantity of a commodity that can be produced
per unit of time with given quantities of inputs and technology. A production function
may take the form of a schedule, a graphical line or curve, an algebraic equation or a
mathematical model. The general form a production function may be algebraically
expressed as:

Q = f (K, L, N, O)

Where Q = the quantity of output

K = capital, and

L = labour.

N = Land

O = Organisation

2.2 Short Run Production Function

The short run production function is one in which at least is one factor of
production is thought to be fixed in supply, i.e. it cannot be increased or decreased, and
the rest of the factors are variable in nature. In general, the firm's capital inputs are
assumed as fixed, and the production level can be changed by changing the quantity of
other inputs such as labour, raw material, labour and so on. Therefore, it is quite difficult
for the firm to change the capital equipment, to increase the output produced, among all
factors of production.

In such circumstances, the law of variable proportion operates, which states the
consequences when extra units of a variable input are combined with a fixed input. In
short run, increasing returns are due to the indivisibility of factors and specialization,
whereas diminishing returns are due to the perfect elasticity of substitution of factors.

27
2.3 Long Run Production Function
Long run production function refers to that time period in which all the inputs of
the firm are variable. It can operate at various activity levels because the firm can change
and adjust all the factors of production and level of output produced according to the
business environment. So, the firm has the flexibility of switching between two scales.

In such a condition, the law of returns to scale operates which discusses, in what
way, the output varies with the change in production level, i.e. the relationship between
the activity level and the quantities of output. The increasing returns to scale is due to
the economies of scale and decreasing returns to scale is due to the diseconomies of scale.

2.4. The Law of Variable Proportions

Variable
The law of variable proportions states that as the quantity of one factor is
increased, keeping the other factors fixed, the marginal product of that factor will
eventually decline. This means that up to the use of a certain amount of variable factor,
marginal product of the factor may increase and after a certain stage it starts diminishing.
When the variable factor becomes relatively abundant, the marginal product may become
negative.

Assumptions :

1. Constant Technology : The state of technology is assumed to be given and constant.

Technology
If there is an improvement in technology the production function will move upward.

2. Factor Proportions are V ariable : The law assumes that factor proportions are
Variable
variable. If factors of production are to be combined in a fixed proportion, the law
has no validity.

3. Homogeneous Factor Units : The units of variable factor are homogeneous. Each
unit is identical in quality and amount with every other unit.

4. Short-Run : The law operates in the short-run when it is not possible to vary all
factor inputs.

28
 The law of variable proportion is illustrated in the following table 2.1 (A) and figure.
2.1(A). Suppose there is a given amount of land in which more and more labour (variable
factor) is used to produce wheat. It can be seen from the table that up to the use of 3rd
units of labour, total product increases at an increasing rate and beyond the 3rd unit
total product increases at a diminishing rate. This fact is shown by the marginal product
which addition is made to Total Product as a result of increasing the variable factor i.e.
labour.

It can be seen from the table that the marginal product of labour initially rises and
beyond the use of 3rd units of labour, it starts diminishing. The use of 6th units of labour
does not add anything to the total production of wheat. Hence, the marginal product of
labour has fallen to zero. Beyond the use of 6th units of labour, total product diminishes
and therefore marginal product of labour becomes negative. Regarding the average
product of labour, it rises up to the use of 3rd unit of labour and beyond that it is falling
throughout.

29
Three Stages of the Law of Variable Proportions : These stages were illustrated
Variable
in figure 2.1 (A) where labour is measured on the X-axis and output on the Y-axis.

1st Stage of Increasing Returns : In this stage, total product increases at an increasing
rate up to a point. This is because the efficiency of the fixed factors increases as additional
units of the variable factors are added to it. In the figure, from the origin to the point F,
slope of the total product curve TP is increasing i.e. the curve TP is concave upwards
upto the point F, which means that the marginal product MP of labour rises. The point F
where the total product stops increasing at an increasing rate and starts increasing at a
diminishing rate is called the point of inflection. Corresponding vertically to this point of
inflection marginal product of labour is maximum, after which it diminishes. This stage
is called the stage of increasing returns because the average product of the variable
factor increases throughout this stage. This stage ends at the point where the average
product curve reaches its highest point.

2nd Stage of Diminishing Returns : In this stage, total product continues to increase
but at a diminishing rate until it reaches its maximum point H where the second stage
ends. In this stage both the marginal product and average product of labour are
diminishing but are positive. This is because the fixed factor becomes inadequate relative
to the quantity of the variable factor. At the end of the second stage, i.e., at point M
marginal product of labour is zero which corresponds to the maximum point H of the
total product curve TP. This stage is important because the firm will seek to produce in
this range.

3rd Stage of Negative Returns : In stage 3, total product declines and therefore the TP
curve slopes downward. As a result, marginal product of labour is negative and the MP
curve falls below the X-axis. In this stage the variable factor (labour) is too much relative
to the fixed factor.

Importance and Applicability of the Law of Variable Proportion :

Variable
The Law of Variable Proportion has universal applicability in any branch of
production. It forms the basis of a number of doctrines in economics. The Malthusian
theory of population stems from the fact that food supply does not increase faster than
the growth in population because of the operation of the law of diminishing returns in
agriculture.

Ricardo also based his theory of rent on this principle. According to him rent arises
because the operation of the law of diminishing return forces the application of additional
doses of labour and capital on a piece of land. Similarly the law of diminishing marginal
utility and that of diminishing marginal physical productivity in the theory of distribution
are also based on this theory.
30
2. 5 Iso-Quant Curves
The term Iso-quant or Iso-product is composed of two words, Iso means equal,
and quant means quantity or product. Thus it means equal quantity or equal product.
Different factors are needed to produce a good. These factors may be substituted for one
another. A given quantity of output may be produced with different combinations of factors.
Iso-quant curves are also known as Equal-product or Iso-product or Production
Indifference curves.

Thus, an Iso-product or Iso-quant curve is that curve which shows the different
combinations of two factors yielding the same total product. Like, indifference curves,
Iso- quant curves also slope downward from left to right. The slope of an Iso-quant curve
expresses the marginal rate of technical substitution (MRTS).

Assumptions :

1. Only two factors are used to produce a commodity.

2. Factors of production can be divided into small parts.

3. Technique of production is constant or is known before hand.

4. The substitution between the two factors is technically possible. That is, production
function is of 'variable proportion' type rather than fixed proportion.

5. Under the given technique, factors of production can be used with maximum
efficiency.

31
Iso-Product Schedule: Let us suppose that there are two factor inputs-labour and
capital. An Iso-product schedule shows the different combination of these two inputs
that yield the same level of output as shown in table 2.1. The table shows that the five
combinations of labour units and units of capital yield the same level of output, i.e., 200
meters of cloth.

Iso-Quant (Product) Curve: From the above schedule iso-product curve can be drawn
with the help of the table 2.1 in figure 2.1. An equal product curve represents all those
combinations of two inputs which are capable of producing the same level of output. The
Figure 2.1 shows the various combinations of labour and capital which give the same
amount of output i.e. 200 meters of cloth at points A, B, C, D and E.

2.6 Properties of Iso-Product Curves

1. Iso-Product Curves Slope Downward from Left to Right.

2. Iso-quants are Convex to the Origin.

3. Two Iso-Product Curves Never Cut Each Other.

4. A higher iso-product curve represents a higher level of output.

5. Iso-quants Need Not be Parallel to Each Other.

6. No Iso-quant can Touch Either Axis.

7. Each Iso-quant is Oval-Shaped.

1. Iso-Product Curves Slope Downward from Left to Right : They slope downward
because MTRS of labour for capital
diminishes. When we increase labour, we
have to decrease capital to produce a given
level of output. The downward sloping
iso-product curve can be explained with the
help of the following figure:

The Figure 2.2 shows that when the

amount of labour is increased from OL to
OL1, the amount of capital has to be
decreased from OK to OK1, The iso-product
curve (IQ) is falling as shown in the figure.

32
The possibilities of horizontal, vertical, upward sloping curves can be ruled out with the
help of the following figure 2. 3

The figure 2.3 (A) shows that the amounts of both the factors of production are
increased- labour from L to L1 and capital from K to K1. When the amounts of both
factors increase, the output must increase. Hence the IQ curve cannot slope upward
from left to right.

The figure 2.3 (B) shows that the amount of labour is kept constant while the
amount of labour is increased. The amount of capital is increased from K to K1. Then the
output must increase. So, IQ curve cannot be a vertical straight line.

The figure 2.3 (C) shows a horizontal curve. If it is horizontal the quantity of labour
increases, although the quantity of capital remains constant. When the amount of capital is
increased, the level of output must increase. Thus, an IQ curve cannot be a horizontal line.

2. Iso-quants are Convex to the Origin : Like indifference curves, iso-quants are
convex to the origin. In order to understand this
fact, we have to understand the concept of
diminishing marginal rate of technical substitution
(MRTS), because convexity of an iso-quant implies
that the MRTS diminishes along the iso-quant. The
marginal rate of technical substitution between L
and K is defined as the quantity of K which can be
given up in exchange for an additional unit of L. It
can also be defined as the slope of an iso-quant.

It can be expressed as :
MRTSLK = _ ΔK/ΔL = _ dK/ dL
Where ΔK is the change in capital and ΔL is
the change in labour.

33
 Equation states that for an increase in the use of labour, fewer units of capital
will be used. In other words, a declining MRTS refers to the falling marginal product of
labour in relation to capital. To put it differently, as more units of labour are used, and as
certain units of capital are given up, the marginal productivity of labour in relation to
capital will decline.

This fact can be explained in Fig.2.4 As we move from point A to B, from B to C

and from C to D along an iso-quant, the marginal rate of technical substitution (MRTS)
of capital for labour diminishes. Every time labour units are increasing by an equal
amount (LL1) but the corresponding decrease in the units of capital (KK1) decreases.
Thus it may be observed that due to falling MRTS, the iso-quant is always convex to the
origin.

3. Two Iso-Product Curves Never Cut Each

Two
Other : As two indifference curves cannot cut
each other, two iso-product curves cannot cut
each other. In Fig.2.5 two Iso-product curves
intersect each other. Both curves IQ1 and IQ2
represent two levels of output. But they
intersect each other at point A. Then
combination A = B and combination A= C.
Therefore B must be equal to C. This is absurd.
B and C lie on two different iso-product curves.
Therefore two curves which represent two
levels of output cannot intersect each other.

4. A higher iso-product curve represents a higher

level of output : A higher iso-product curve
represents a higher level of output as shown
in the figure 2.6 given below.

In the Fig. 2.6 units of labour have been

taken on OX axis while on OY, units of capital.
IQ1 represents an output level of 100 units
whereas IQ2 represents 200 units of output.

34
5. Iso-quants Need not be Para llel to Each Other : It so happens because the rate of
Parallel
substitution in different iso-quant schedules need not
be necessarily equal. Usually they are found different
and, therefore, iso-quants may not be parallel as shown
in Fig. 2.7. We may note that the iso-quants Iq1 and
Iq2 are parallel but the iso-quants Iq3 and Iq4 are not
parallel to each other.

6. No Iso-quant can touch Either Axis : If an

iso-quant touches X-axis, it would mean that the
product is being produced with the help of labour alone without using capital at all.
These logical absurdities for OL units of labour alone
are unable to produce anything. Similarly, OC units
of capital alone cannot produce anything without the
use of labour. Therefore as seen in figure 2.8, IQ and
IQ1 cannot be iso-quants.

7. Each Iso-quant is Oval-Shaped : It means that

at some point it begins to recede from each axis. This
shape is a consequence of the fact that if a producer
uses more of capital or more of labour or more of both
than is necessary, the total product will eventually
decline. The firm will produce only in those segments of the iso-quants which are convex
to the origin and lie between the ridge lines. This is the economic region of production.
In Figure 2.9 oval shaped iso-quants are shown. Curves OA and OB are the ridge lines
and in between them only feasible units of capital and
labour can be employed to produce 100, 200, 300 and
400 units of the product. For example, OT units of
labour and ST units of the capital can produce 100 units
of the product, but the same output can be obtained by
using the same quantity of labour OT and less quantity
of capital VT.

35
2.7 Concept of Factors Pricing Line - Iso - Cost Line
A firm can produce a given level of output using efficiently different combinations
of two inputs. For choosing efficient combination of the inputs, the producer selects that
combination of factors which has the lower cost of production. The information about the
cost can be obtained from the iso-cost lines.

An iso-cost line is also called outlay line or price line or factor cost line. An
iso-cost line shows all the combinations of labour and capital that are available for a
given total cost to the producer. Just as there are infinite numbers of iso-quants, there
are infinite numbers of iso-cost lines, one for every possible level of a given total cost.
The greater the total cost, the further from origin is the iso-cost line.

The iso-cost line is similar to the price or budget line of the indifference curve
analysis. It is the line which shows the various combinations of factors that will result in
the same level of total cost. It refers to those different combinations of two factors that a
firm can obtain at the same cost. Just as there are various iso-quant curves, so there are
various iso-cost lines, corresponding to different levels of total output.

Explanation : The concept of iso-cost line can be explained with the help of the following
table 2. 2 and Figure
2.10 Suppose the
producer's budget for
the purchase of labour
and capital is fixed at
Rs. 100. Further
suppose that a unit of
labour cost the producer
Rs. 10 while a unit of
capital Rs. 20.

From the table cited above, the producer can adopt the following options :

1. Spending all the money on the purchase of labour, he can hire 10 units of labour.

2. Spending all the money on the capital he may buy 5 units of capital.

3. Spending the money on both labour and capital, he can choose between various possible
combinations of labour and capital such as (4, 3) (2, 4) etc.

36
 In Fig. 2.10 labour is given on OX-axis and capital on OY-axis. The points A, B, C
and D convey the different combinations of two factors, capital and labour which can be
purchased by spending Rs. 100. Point A indicates 5 units of capital and no unit of labour,
while point D represents 10 units of labour and no unit of capital. Point B indicates 4
units of capital and 2 units of labour. Likewise, point C represents 4 units of labour and
3 units of capital.

2. 8 Iso-Quant & Iso-Cost Curves

After knowing the nature of isoquant which represent the output possibilities of
a firm from a given combination of two inputs. We further extend it to the prices of the
inputs as represented on the isoquant map by the iso-cost curves. These curves are also
known as outlay lines, price lines, input-price lines, factor-cost lines, constant-outlay
lines, etc. Each iso-cost curve represents the different combinations of two inputs that a
firm can buy for a given sum of money at the given price of each input.

Figure 2.11(A) shows three iso-cost curves each represents a total outlay of 50, 75
and 100 respectively. The firm can hire OC of capital or OD of labour with Rs. 75.

The line CD
represents the price
ratio of capital and
labour. Prices of factors
remaining the same, if
the total outlay is
raised, the iso-cost curve
will shift upward to the
right as EF parallel to
CD, and if the total
outlay is reduced it will
shift downwards to the
left as AB. The iso-costs
are straight lines because factor prices remain the same whatever the outlay of the firm
on the two factors.

The iso-cost curves represent the locus of all combinations of the two input factors
which result in the same total cost. If the unit cost of labour (L) is w and the unit cost of
capital (K) is r, then the total cost: TC = wL + rK. The slope of the iso-cost line is the ratio
of prices of labour and capital i.e., w/r.
37
 The point where the iso-cost line is tangent to an isoquant shows the least cost
combination of the two factors for producing a given output. If all points of tangency like
LMN are joined by a line, it is known as an output-factor curve or least-outlay curve or
the expansion path of a firm.

It shows how the proportions of the two factors used might be changed as the
firm expands. For example, in Figure 2.11(A) the proportions of capital and labour used
to produce 200 (IQ1) units of the product are different from the proportions of these
factors used to produce 300 (IQ2) units or 100 (IQ) units at the lowest cost. Like the price-
income line in the indifference curve analysis, a relative cheapening of one of the factors
to that of another will extend the iso-cost line to the right. If one of the factors becomes
relatively dearer, the iso-cost line will contract inward to the left.

Given the price of capital, if the price of labour falls, the isocost line EF in Panel
(B) of figure 2.11 will extend to the right as EG and if the price of labour rises, the
iso-cost line EF will contract inward to the left as EH, if the equilibrium points L, M, and
N are joined by a line. It will be called the price-factor curve.

2.9 Least Cost Combination Analysis

In simple words, producer's equilibrium implies to that situation in which producer
maximizes his profit. In short, the producer is producing given amount of output with
least cost combination of factors. It is also known as optimum combination of the factors.

Optimum combination is that combination at which either :

1. The output derived from a given level of inputs is maximum or

2. The cost of producing given output is minimum.

For producer's equilibrium or optimum combination, it must fulfill following two

conditions as:
1. At the point of equilibrium the iso-cost line must be tangent to isoquant curve.
2. At point of tangency i.e., iso-quant curve must be convex to the origin or MRTSLK
must be falling.

38
 With a given outlay and prices of two factors, the firm obtains least cost
combination of factors, when the iso-cost line becomes tangent to an iso-product curve.
Let us explain it with the following Fig. 2.12.

In Figure 2.12, P1L1 iso-cost line has become tangent to iso-product curve
(representing 500 units of output) at point E. At this point, the slope of the iso-cost line
is equal to the iso-product curve. The slope of the iso- product curve represents MRTS of
labour for capital. The slope of the iso-cost line represents the price ratio of the two
factors.

Slope of Iso-quant curve = Slope of Iso-cost curve

MRTSLk = −ΔK/ΔL = MPL/MPK = PL/PK

Where ΔK change in capital, ΔL

change in labour, MP L Marginal
Physical Product of Labour, MPk Marginal
Physical Product of capital, PL Price of
Labour, and PK Price of capital, MRTSLK
=Marginal Rate of Technical Substitution
of labour and capital.

The firm employs OM units of

labour and ON units of capital. The
producing firm is in equilibrium. It obtains
least cost combination of the two factors to
produce 500 units of the commodity. The
points such as H, K, R and S lie on higher iso-cost lines. They require a larger outlay,
which is beyond the financial resources of the firm.

39
2.10 Expansion Path
As financial resources of a firm increase, it would like to increase its output. The
output can only be increased if there is no increase in the cost of the factors. In other
words, the level of total output of a firm increases with increase in its financial resources.

By using different
combinations of factors a firm can
produce different levels of output.
Which of the optimum
combinations of factors will be
used by the firm is known as
Expansion Path. It is also called
Scale-line.

"Expansion path is that line

which reflects least cost method
of producing different levels of
output." Stonier and Hague
Expansion path can be explained
with the help of Fig. 2.13. On OX-
axis units of labour and on OY-
axis units of capital are given.

The initial iso-cost line of the

firm is AB. It is tangent to IQ at point E1 which is the initial equilibrium of the firm.
Supposing the cost per unit of labour and capital remains unchanged and the financial
resources of the firm increase.

As a result, firm's new iso-cost-line shifts to the right as CD. New iso-cost line
CD will be parallel to the initial iso-cost line. CD touches IQ1 at point E1 which will
constitute the new equilibrium point. If the financial resources of the firm further increase,
but cost of factors remaining the same, the new iso - cost line will be GH.

It will be tangent to Iso-quant curve IQ2 at point E2 which will be the new
equilibrium point of the firm. By joining together equilibrium points E, E1 and E2, one
gets a line called scale-line or Expansion Path. It is because a firm expands its output or
scale of production in conformity with this line.

40
2.11 Economic Region of production (Ridge Lines)
2.11
An isoquant represents combinations of two inputs that yield the same level of
output. However, not all points of an isoquant are relevant for production. Such points
may be called infeasible points. If the isoquant is backward bending and upward sloping,
marginal product of any input will be negative, and, hence, this portion of the isoquant
may be considered aseconomically non-sensible region of production. Only the negatively
sloped segment of the isoquant is relevant for production or economically feasible.

This is shown in Fig. 2.14 where we

have drawn three isoquants showing
different levels of output for different
labour-capital combinations. This
diagram separates economic region of
production from uneconomic region of
production. Region in which marginal
products of all inputs are positive
constitutes economic region of
production.

At point A on IQ1, the firm employs

certain units of labour and capital. Since
the tangent to IQ1 at point A is parallel
to the vertical axis, marginal product of
capital (MPK) is zero. If more capital is used, marginal product of capital should be
negative. In other words, beyond point A, MPK is negative. At point B on IQ1, MPL is zero
and beyond point B on IQ1, MPL is negative.

Thus, points between A and B represent positive marginal productivities of both

labour and capital. Here substitution between two inputs takes place. Similarly, points
A1 and A2 on IQ2 and IQ3describe zero MPK while points beyond A1 and A2 describe negative
MPL. Points B1and B2 on IQ2 and IQ3 represent zero MPK and beyond B1 and B2 describe
negative MPL.

A rational producer will produce in that region where marginal productivities of

inputs are positive. By joining points A, A1 and A2, we get OR line and by joining points
B, B1 and B2 we get OL line. These lines are called ridge lines. They give the boundaries
of the economic region of production where input substitution takes place.

41
2.12 Concept and Types of Returns to Scale
Types
The changes in output on account of the change in the factors of production in the
same proportion are called the returns to scale. In the long run all the factors of production
are variable and even the scale of production can be changed according to the demand for
various goods and services in the economy. The returns to scale are concerned with long
run production function. They are studied with the help of iso-product curves and iso-
cost curves. Returns to scale are of three types as follows:

1. Increasing Returns to Scale: When the change in output is more than in proportion
to the equi-proportional change in all the factors of production, then the operating law is
called the increasing returns to scale. Thus, the rate of increase in output is faster than
the increase in factors of production.

The distance between various iso-product curves decreases on the expansion path
or scale line then the increasing returns to scale will operate. It reveals that the increase
in output in the same proportion requires fewer ratios of labour and capital. Thus, output
increases more than in proportion to the units of factors of production employed under
this law. It can be explained with the help of Figure 2.15.

Capital and labour are shown on OY-

axis and OX-axis respectively. IP, IP1, IP2
and IP 3 are different iso-product curves
showing different levels of output, viz., 10
units, 20 units, 30 units and 40 units. The
distance between successive iso-product
curves diminishes as output is expanded by
increasing the scale. The distance
EE1>E1E2>E2E3 which reveals that for equal
increase in output, firm has to employ less
and less amount of labour and capital. The
increasing returns to scale operate on
account of the following causes or reasons:

1.Indivisibilities of Inputs: There are some factors of production which are indivisible.
Indivisibility means that they are available in a given shape or they cannot be divided
into small pieces. Machine, managers, research, finance and marketing are such examples
of individualities. With the increase in the scale of production the efficiency increases
and the output increases more than in proportion to the change in inputs.

42
2. Division of Labour and Specialisation: When the scale of production is increased the
division of labour and specialisation is introduced. A process of production is divided
into sub-processes and each process is completed by each group of workers and at the
same time the specialist are appointed for different departments, viz., finance manager,
marketing manager, personnel manager, purchasing manager and so on and so forth.
Their services lead to increase in the production and the increasing returns to scale
operates.
3. Dimensional Efficiency : Increasing returns to scale is the result of operating
dimensional efficiency in a business firm which is on account of the large size. The size
increases the efficiency of all inputs and the increasing returns operates. Thus the
investment in capital assets after a point will increase the output due to increased
dimension of efficiency.
4. Economies of Large Scale: When the scale of production is increased the internal and
external economies of scale will operate and on account of it the increasing returns to
scale will also operate.

Internal economies are on account of firm's size and organisation while external
economies are caused by the concentration and localisation of industries. All these
economies lead to increase in output more than in proportion to the change in the ratio
of two inputs.
2. Constant Returns to Scale : When the output
of a firm increases in the same proportion in
which the change in inputs takes place the law is
called constant returns to scale. The proportion
of two inputs remains constant. When all iso-
product curves showing the same level of output
have the equal distance between them on the
expansion path or scale line, the law operating is
called constant returns to scale. It is explained
with the following figure 2.16
Capital and labour are shown on OY - axis
and OX-axis respectively. IP, IP1, IP2 and IP3 are
different iso-product curves showing different
levels of output, viz., 10 units, 20 units, 30 units and 40 units. The distance between iso-
product curves is indicated by E, E1, E2 and E3. The distance on scale line (OP) are equal.
EE1 = E1E2 = E2E3. The distance between all iso-product curves remains constant which
reveal that the production increases in the same proportion in which inputs are changed.
Hence, it is constant returns to scale. This law operates at the point where neither
the internal and external economies nor internal and external diseconomies are enjoyed
by the firm during long period.
43
3. Diminishing Returns to Scale: When proportionate change in output is less than the
proportionate change in all the factors of production their (inputs) ratio being equal, the
diminishing returns to scale will operate. The distance between various iso-product curves
on the scale line increases because for
getting the same level of output we have
to employ more of all inputs. It is
explained with the help of the following
figure 2.17.

Labour and capital are employed on

OX-axis an OY-axis. OP is the scale line
on which E, E 1 , E 2 and E 3 different
iso-product curves are showing different
levels of output. The distance between
these curves are increasing on the scale
line which show that we have to employ
more of inputs and the resultant output
is less than in proportion to the change in inputs. EE 1<E 1 E 2<E 2 E 3 which show the
diminishing returns to scale.

2.13 Linear Homogeneous Production Function

The Linear Homogeneous Production Function implies that with the proportionate
change in all the factors of production, the output also increases in the same proportion.
Such as, if the input factors are doubled the output also gets doubled. This is also known
as constant returns to a scale.

The production function is said to be homogeneous when the elasticity of

substitution is equal to one. The linear homogeneous production function can be used in
the empirical studies because it can be handled wisely. That is why it is widely used in
linear programming and input-output analysis. This production function can be shown
symbolically:

nP = f (nK, nL)
Where, n = number of times nP = number of times the output is increased
nK= number of times the capital is increased nL = number of times the
labour is increased

44
 Thus, with the increase in labor and capital by "n" times the output also increases
in the same proportion. The concept of
linear homogeneous production function
can be further comprehended through the
illustration given below figure 2.18

In the case of a linear homogeneous

production function, the expansion is
always a straight line through the origin,
as shown in the figure. This means that the
proportions between the factors used will
always be the same irrespective of the
output levels, provided the factor prices
remain constant.

2.14. Properties of Cobb-Douglas Production Function

Charles W. Cobb and Paul H. Douglas studied the relationship of inputs and outputs
and formed an empirical production function, popularly known as Cobb-Douglas production
function. Originally, C-D production function applied not to the production process of an
individual firm but to the whole of the manufacturing production. The Cobb-Douglas
production function is expressed by
α β
Q = AL K
Where Q is output. L and K are inputs of labour and capital respectively. A, α and β
are positive parameters where α > 0, β > 0. The equation tells that output depends directly
on L and K and that part of output which cannot be explained by L and K is explained by A
which is the 'residual', often called technical change.
Properties of the Cobb-Douglas (C-D) Production Function :
1. Degree of Homogeneity: C-D production function is a homogeneous function, the degree of
homogeneity of the function being α + β. For here we obtain
A (tL)α (tK)β = tα +β A Lβ Kβ = tα +β Q
where t is a positive real number.
We obtain from that if L and K are increased by the factor t, Q would increase by the factor
tα +β. Also gives us that the condition for the C-D function to become homogeneous of degree
one (or linearly homogeneous) is
α + β = 1.
In that case, would give us that if L and K are increased by the factor t, then Q would also
increase by the factor t. If the C-D production function is homogeneous of any degree α + β as
in and then may be called the generalized version of the C-D function.
2. Return of Scales : The returns to scale is measured by the sum of exponents of
Cobb-Douglas production function i.e., α + β
If α + β = 1, returns to scale are constant.
If α + β > 1, returns to scale are increasing.
If α + β < 1 , returns to scale are decreasing.
45
3. Marginal Production Labour and Capital
Capital: In the case of C-D production function, the
APL and MPL curves and the APK and MPK curves, all would be downward sloping. That
is, if the firm increases the use of one of the inputs, that of the other remaining unchanged,
then the AP and the MP of the former input would decrease. Let us establish this property.
_α
MPL = α A (K/L)1 = α APL
..
MPL < APL ( . 0 < α < 1)

Similarly, we may establish that both APK and MPK curves would be downward sloping
and the MPK curve would lie below the APK curve.

4. Elasticity of substitution : In the case of C-D production function, coefficient of partial

elasticity of Q w.r.t. a change in L, K remaining constant, would be EQL = a = constant,
and the coefficient of partial elasticity of Q w.r.t. a change in K, L remaining constant,
would be EQL = 1 - α = constant. We may establish this property in the following way
By definition, we have

5. Mariginal Rate of Technical Substitution : We have obtained both MPL and MPK to be
Technical
functions of L-K ratio, this function have the following property also :

MRTSL.K = MPL/MPK = function of L/K ratio.

As we know, MRTSLK is the marginal rate of technical substitution of L for K.

46
3
David Ricardo
18 April, 1772 - 11th Sept,1823
th

COST AND REVENUE ANALYSIS

3.1 Cost Concepts
3.2 Short Run Costs and Cost Curves
3.3 The Relation between the Average and Marginal Cost Curve
3.4 Derivation of Long Run Average Cost (LAC) Curve
3.5 Economies of scale
3.6 Concepts of Revenue
3.7 Relation between TR, AR, MR and Elasticity of Demand

47
48
3.1 Cost Concepts
Cost has been defined by the Committee on Cost Terminology of the American
Accounting Association as "the foregoing, in monetary terms, incurred or potentially to
be incurred in the realisation of the objective of management which may be manufacturing
of a product or rendering of a service."

From the above, it may be stated that cost means the total of all expenses incurred
for a product or a service. Thus, cost of an article means the actual outgoings or ascertained
changes incurred in its production and sale activities. In short, it is the amount of
resources used up in exchange for some goods or services.

1. Accounting costs: Accounting costs are those for which the entrepreneur pays direct
cash for procuring resources for production. These include costs of the price paid for raw
materials and machines, wages paid to workers, electricity charges, the cost incurred in
hiring or purchasing a building or plot, etc. Accounting costs are treated as expenses.
Chartered accountants record them in financial statements.

2. Real Cost: The real cost of production has been variously interpreted. Adam Smith
regarded pains and sacrifices of labour as real cost of production. Marshall included
under it the "real cost of efforts of various qualities", and "real cost of waiting." This
Marshall called as the social cost of production.

3. Opportunity Cost: In modern economic analysis, the term real cost is interpreted in
the sense of opportunity cost. It is also called 'alternative cost' or 'transfer cost'.
Opportunity cost of a commodity is the alternative sacrificed in order to obtain it. Since
productive resources are limited, if they are used in the production of one commodity,
they are not available for the production of another. The commodity which is sacrificed
or not produced is the real cost of the commodity that is produced. Thus, the cost of
production, in the sense of opportunity cost, means not the efforts and sacrifices
undergone, but the most attractive alternative foregone or the next best choice sacrificed.

49
4. Explicit Costs and Implicit Costs: Costs of production can be classified as Explicit
Costs and Implicit Costs. Explicit costs are also called paid-out costs. These costs the
entrepreneur has to pay to those persons from whom he has obtained factors of production
or services. For instance, he has to pay wages to the labour he has employed, interest on
the capital that he has borrowed and rent of land or factory or business premises. These
are explicit costs. Implicit costs, on the other hand, are costs which have not to be paid
out to others but the costs which the entrepreneur pays to himself, as it were. Perhaps
he himself is the owner of the business premises, he may have invested his own capital
side by side the capital he may have borrowed from others. He may be a whole-time
worker in the business, for instance he may be a managing director for which he may not
be drawing any salary. If he had lent out these factors to others, he would have received
remuneration from them. Hence they must be taken into account while calculating profit.
But since they are not actually paid out to anybody, they are called implicit costs.

3.2 Short Run Costs and Cost Curves

Conceptually, in the short run, the quantity of at least one input is fixed and the
quantities of the other inputs can be varied. In the short-run period, factors, such as
land and machinery, remain the same. On the other hand, factors, such as labor and
capital, vary with time. In the short run, the expansion is done by hiring more labor and
increasing capital. The existing size of the plant or building cannot be increased in case
of the short run. Following are the cost concepts that are taken into consideration in the
short run:

1. Total Fixed Costs (TFC): Refer to the costs that remain fixed in the short period.
Total
These costs do not change with the change in the level of
output. For example, rents, interest, and salaries. In the
words of Ferguson, "Total fixed cost is the sum of the 'short
run explicit fixed costs and implicit costs incurred by the
entrepreneur." Fixed costs have implication even when the
production of an organization is zero. These costs are also
called supplementary costs, indirect costs, overhead costs,
historical costs, and unavoidable costs.

TFC remains constant with respect to change in the level

of output. Therefore, the slope of TFC curve is a horizontal straight line. As shown in
Figure 3.1, TFC curve is horizontal to x- axis. From Figure-3.1 it can be seen that TFC
remains the same at all the levels with respect to change in the level of output.
50
2. Total V
Total ariable Costs (TVC): Refer to costs that change with the change in the level of
Variable
production. For example, costs incurred on purchasing raw
material, hiring labor, and using electricity. According to
Ferguson, "total variable cost is the sum of amounts spent for
each of the variable inputs used" If the output is zero, then the
variable cost is also zero. These costs are also called prime
costs, direct costs, and avoidable costs. In Figure 3.2 it can be
seen that TVC curve changes with the change in the level of
output.

3. Total Cost (TC) : Involves the sum of TFC and TVC. It can be calculated as follows:
Total
Total Cost = TFC + TVC. TC also changes with the changes in
the level of output as there is a change in TVC. Figure 3.3
shows the total cost curve derived from sum of TVC and TFC:
It should be noted that both TVC and TC increase initially at
decreasing rate and then they increase at increasing rate. Here
decreasing rate implies that the rate at which cost increases
with respect to output is less, whereas increasing rate implies
the rate at which cost increases with respect to output is more.

4. Average Fixed Costs (AFC): Refers to the per unit fixed costs of production. In other
words, AFC implies fixed cost of production divided by the quantity of output produced.
It is calculated as: AFC = TFC/Output.

TFC is constant as production increases, thus AFC falls. Figure

3.4 shows the AFC curve.

In Figure 3.4 AFC curve is shown as a declining curve, which

never touches the horizontal axis. This is because fixed cost
can never be zero. The curve is also called rectangular
hyperbola, which represents that total fixed costs remain same
at all the levels.

51
5. Average Variable Costs (A
Variable VC): Refer to the per unit variable cost of production. It
(AVC):
implies organization's variable costs divided by the
quantity of output produced. It is calculated as:

AVC = TVC/ Output

Initially, AVC decreases as output increases. After a certain

point of time, AVC increases with respect to increase in
output. Thus, it is a U- shaped curve, as shown in Figure
3.5

6. Average Cost (AC): Refer to the total costs of production

per unit of output. AC is calculated as: AC = TC/ Output

AC is also equal to the sum total of AFC and AVC. AC

curve is also U-shaped curve as average cost initially
decreases when output increases and then increases when
output increases. Figure 3.6 shows the AC curve.

7. Marginal Cost: Refer to the addition to the total cost

for producing an additional unit of the product. Marginal
cost is calculated as: MC = TCn = TCn-1

n = Number of units produced It is also calculated

as: MC = ΔTC/ΔOutput

MC curve is also a U-shaped curve as marginal cost

initially decreases as output increases and afterwards,
rises as output increases. This is because TC increases at
decreasing rate and then increases at increasing rate.
Figure 3.7 shows the MC curve.

Let us learn the aforementioned cost concepts numerically

with the help of Table: 3.1

52
3.3 The Relation between the Average and Marginal Cost Curve
The relationship between the marginal cost and average cost is the same as that
between any other marginal-average quantities. When marginal cost is less than average
cost, average cost falls and when marginal cost is greater than average cost, average cost
rises.

The relationship between average and marginal cost can be easily understood with
the help of Figure 3.8, where short-run average cost curve AC and marginal cost curve
MC are drawn. As long as short-run marginal cost curve MC lies below short-run average
cost curve, the average cost curve AC is falling. When marginal cost curve MC lies above
the average cost curve AC, the latter is rising.

At the point of intersection L where MC is

equal to AC, AC is neither falling nor rising,
that is, at point L, AC has just ceased to fall
but has not yet begun to rise. It follows that
point L, at which the MC curve crosses the AC
curve to lie above the AC curve is the minimum
point of the AC curve. Thus, marginal cost curve
cuts the average cost curve at the latter's
minimum point. It is important to note that we
cannot generalise about the direction in which
marginal cost is moving from the way average
cost is changing, that is, when average cost is
falling we cannot say that marginal cost will be falling too. When average cost is falling,
what we can say definitely is only that the marginal cost will be below it but the marginal
cost itself may be either rising or falling.

Likewise, when average cost is rising, we cannot deduce that marginal cost will be
rising too. When average cost is rising, the marginal cost must be above it but the marginal
cost itself may be either rising or falling. Consider Fig.3.8 where up to the point K,
marginal cost is falling as well as below the average cost.

But beyond point K and up to point L marginal cost curve lies below the average
cost curve with the result that the average cost curve is falling. But it will seen that
between K and L where the marginal cost is rising, the average cost is falling. This is
because though MC is rising between K and L, it is below AC. It is therefore clear that
when the average cost is falling, marginal cost may be falling or rising.

53
3.4 Derivation of Long Run Average Cost (LAC) Curve
Long run is that time period when a firm can change all its inputs. In fact, there
are no fixed inputs in the long run; all inputs are variable. Thus, in the long run, there is
no fixed cost; all costs are variable. That is why, in the long run, a firm can change its
scale of production according to its needs.

In the short run, size of a plant or the scale remains fixed while, in the long run, changes
in plant size can be made. In the long run, a firm can move from one plant to another
plant thereby giving rise to different cost relationships. If the situation demands, it can
build up a large- sized plant or a smaller one.

Suppose the demand for the firm's product has increased. To meet this firm can
expand the existing plant or install new ones. Each plant is suitable for a particular
range of output. The firm will therefore make use of the various plants up to that level
where the average cost fall with increase in output. It will not produce beyond the
minimum average cost of producing various outputs from all the plants used together.

In the figure 3.9 there are three plants represented by their average cost curves
SAC1, SAC2, SAC3. Each curve represents the scale of the firm. SAC1 depicts is lower
scale while the movement from SAC1, SAC2, shows the firm to be a large size. For
producing ON output, the firm can use SAC1 or SAC2 plant.

The firm will, however, use the scale

of plant represented by SAC 1 since the
average cost of production ON output is NB
which is less than NA, the cost of producing
this output on the SAC2. If the firm is to
produce OL output, it would produce at
either of the two plants. But it would be
advantageous for the firm to use the plant
SAC2 for OL level of output because the
larger output OM can be obtained at the
lowest average cost ME from this plant.
However, for output OH, the firm would use
the SAC3 plant where the average cost HG
is lower than HF of the SAC2 plant. Thus in the long-run in order to produce any level of
output the firm will use that plant which has the minimum unit cost.
54
 But in the log-run average cost curve LAC is usually shown as a smooth curve
fitted to the SAC curves so that it is tangent to each of them at some point However,
let us assume that the industry faces a large number of plant sizes represented by,
say, five SAC curves, as shown in Fig. 3.10. These curves will generate a smooth and
continuous curve called the 'planning curve' or the LAC curve.

Each point on this curve shows the least possible cost for producing the
corresponding level of output. The LAC curve is a planning curve because it is the
curve which helps a firm to decide which plant is to be established in order to produce
an output level consistent with the optimal cost.

The firm selects that short run

plant which yields the
minimum cost of producing the
anticipated output level. To
produce a particular output in
the long run, the firm must
select a point on the LAC curve
corresponding to that output,
and it will then build a relevant
short run plant and operate on
the corresponding SAC curve.

This was shown at point E on

plant SAC3

55
3.5 Economies of scale
Economies of scale are cost reductions that occur when companies increase
production. The fixed costs, like administration, are spread over more units of production.
Sometimes the company can negotiate to lower its variable costs as well. Economies of
scale not only benefit the organization. Consumers can enjoy lower prices. The economy
grows as lower prices stimulate increased demand. Economies of scale give a competitive
advantage to large entities over smaller ones. The larger the business, non-profit, or
government, the lower its per-unit costs.

There are two main types of economies of scale : internal and external. Internal
economies are controllable by management because they are internal to the company.
External economies depend upon external factors. These factors include the industry,
geographic location, or government.

1. Internal Economies of Scale : Internal economies result from a larger volume of

production. For example, large companies have the ability to buy in bulk. This lowers
the cost per unit of the materials they need to make their products. As a firm expands its
scale of operations, it is said to move into its long run. The benefits arising from expansion
depend upon the effect of expansion on productive efficiency, which can be assessed by
looking at changes in average costs at each stage of production. A firm can increase its
scale of operations in two ways.

1. Internal growth, also called organic growth

2. External growth, also called integration - by merging with other firms, or by

acquiring other firms.

There are five main types of internal economies of scale.

1. Technical Economies : Technical economies are the cost savings a firm makes as it
grows larger, and arise from the increased use of large scale mechanical processes
and machinery. For example, a mass producer of motor vehicles can benefit from
technical economies because it can employ mass production techniques and benefit
from specialisation and a division of labour.

2. Marketing or Purchasing Economies : Purchasing economies are gained when

larger firms buy in bulk and achieve purchasing discounts. For example, a large
supermarket chain can buy its fresh fruit in much greater quantities than a small
fruit and vegetable supplier.

56
3. Administrative Economies : Administrative savings can arise when large firms
spread their administrative and management costs across all their plants,
departments, divisions, or subsidiaries. For example, a large multi-national can
employ one set of financial accountants for all its separate businesses.

4. Financial Economies : Large firms can gain financial savings because they can
usually borrow money more cheaply than small firms. This is because they usually
have more valuable assets which can be used as security (collateral), and are seen
to be a lower risk, especially in comparison with new businesses.

5. Risk bearing Economies : Risk bearing economies are often derived by large firms
who can bear business risks more effectively than smaller firms. For example, a
large record company can more easily bear the risk of a 'flop' than a smaller record
label.

2. External Economies : External economies refer to all those benefits which accrue
to all the firms operating in a given industry. Generally, these economies accrue due to
the expansion of industry and other facilities expanded by the government. In the opinion
of Prof. Chapman, 'The external economies are those in which all business firms in an
industry can share". Prof. Cairn Cross has divided the external economies into three
parts, as:

1. Economies of Concentration: As the number of firms in an area increases, each firm

enjoys some benefits like, transport and communication, availability of raw materials,
research and invention etc. Further, financial assistance from banks and non-bank
institutions easily accrue to firms. We can therefore conclude that concentration of
industries lead to economies of concentration.
2. Economies of Information: When the number of firms in an industry expands they
become mutually dependent on each other. In other words, they do not feel the need of
independent research on individual basis. Many scientific and trade journals are
published. These journals provide information to all the firms, which relate to new
market, sources of raw materials, latest techniques of production etc.
3. Economies of Disintegration: As the industry develops, all the firms engaged in it
decide to divide and sub-divide the process. For instance, in case of moped industry,
some firms specialize in rims, hubs and still others in chains, pedals, tyres etc.
It is of two types : (i) Horizontal - disintegration (ii) Vertical - disintegration.
In case of horizontal disintegration each firm in the industry tries to specialize in one
particular item whereas, under vertical disintegration every firm endeavors to specialize
in different types of items.
57
3.6 Concepts of Revenue
The term revenue refers to the income obtained by a firm through the sale of
goods at different prices. In the words of Dooley, 'the revenue of a firm is its sales, receipts
or income'. The revenue concepts are concerned with Total Revenue, Average Revenue
and Marginal Revenue.

1. Total Revenue : The income earned by a seller or producer after selling the output
Total
is called the total revenue. In fact, total revenue is the multiple of price and output. The
behavior of total revenue depends on the market where the firm produces or sells.
Thus,
Where TR = AP × Q
TR = Total Revenue
AR = Average Revenue or Price per unit
Q = Output
For exmple if the price of a commodity is Rs. 100 and Total unit sold are 20 in that case
total revenue will be
TR = 100 X 20 = 2000
TR = 2000
2. Average Revenue: Average revenue refers to the revenue obtained by the seller by
selling the per unit commodity. It is obtained by dividing the total revenue by total output.
"The average revenue curve shows that the price of the firm's product is the same at
each level of output." Stonier and Hague
Thus :
AR = TR/Q
AR = Average Revenue
TR = Total Revenue
Q = Output
According to McDonnell, “ Average Revenue is the per unit revenue recived from
the sale of one unit of a Commodity.”
TR = Price x Output
TR = PQ
AR = PQ /Q = P
and P = f (Q) is an average curve which shows that price is a function of quantity demanded
it is also a demand curve.

58
3. Marginal Revenue : Marginal revenue is the net revenue obtained by selling an
additional unit of the commodity. "Marginal revenue is the change in total revenue which
results from the sale of one more unit of output." Ferguson. Thus, marginal revenue is
the addition made to the total revenue by selling one more unit of the good. In algebraic
terms, marginal revenue is the net addition to the total revenue by selling n units of a
commodity instead of n -1.

Therefore,
MR = ΔTR/ΔQ
MRn = TRn - TRn-1
Whereas TRn = Total Revenue of ‘n’ units
TRn-1 = Total Revenue from (n-1) units
MRnth = Marginal Revenue from nth unit
n = any given number

"The marginal revenue is the change in total revenue resulting from selling an
additional unit of the commodity."

If total revenue from n units is 110 and from (n - 1) units is 100.

in that case
MRnth = TRn - TRn -1 = 110 - 100

MRnth = 10
MR in mathematical terms is the ratio of change in total revenue
to change in output
MR = Δ TR/ Δ q or dR/dq = MR

Total Revenue, Average Revenue and Marginal Revenue : The relation of total revenue,
average revenue and marginal revenue can be explained with the help of table 3.2 and
fig 3.11.

Table Representation: The relationship between TR, AR and MR can be expressed with
the help of a table 3.2 From the table 3.2 we can draw the idea that as the price falls
from Rs. 10 to Rs. 1, the output sold increases from 1 to 10. Total revenue increases from
10 to 30, at 5 units. 0However, at 6th unit it becomes constant and ultimately starts
falling at next unit i.e. 7th. In the same way, when AR falls, MR falls more and becomes
zero at 6th unit and then negative. Therefore, it is clear that when AR falls, MR also falls
more than that of AR: TR increases initially at a diminishing rate, it reaches maximum
and then starts falling.
59
 In figure 3.11 three concepts of revenue have been explained. The units of output
have been shown on horizontal axis while revenue on vertical axis. Here TR, AR, MR are
total revenue, average revenue and marginal
revenue curves respectively.

In figure 3.11 (A), a total revenue

curve is sloping upward from the origin to
point K. From point K to K1 total revenue is
constant. But at point K1 total revenue is
maximum and begins to fall. It means even
by selling more units total revenue is falling.
In such a situation, marginal revenue becomes
negative.

Similarly, in the figure 1 (B) average

revenue curves are sloping downward. It
means average revenue falls as more and more
units are sold. In fig. 3.11(B) MR is the
marginal revenue curve which slopes
downward. It signifies the fact that MR with
the sale of every additional unit tends to
diminish. Moreover, it is also clear from the
fig. that when both AR and MR are falling,
MR is less than AR. MR can be zero, positive
or negative but AR is always positive.

60
3.7 Relation between TR, AR, MR and Elasticity of Demand
Being a price-maker, a monopolist can select or set the price of his own product.
The demand curve faced by a monopoly firm is the industry (or market) demand curve as
there is only one firm in the industry. Thus the demand curve (or the AR curve) of a
monopoly seller is a downward sloping curve. Its corresponding MR curve is also
downward sloping and lies below AR curve (i.e., AR > MR).

As the monopolist desires to increase output, TR may increase, and may decrease
after reaching a maximum. Whether TR will increase or decrease depends on whether
MR is positive or zero or negative, which, in
turn, depends on whether demand is elastic
or unitary elastic or inelastic. In Figure 3.12
we have shown such relationship between
TR, AR, MR and elasticity of demand (ep).
There is close relationship among AR, MR
and ep as:

In this figure 3.12 TR curve has been

drawn in the bottom part, while AR and MR
curves have been drawn in the upper panel.
As the monopolist expands output, TR rises,
reaches maximum at point H (corresponding
to output ON) and, thereafter, TR declines.
AR curve or BD curve has been drawn as a
negatively sloped straight line. Elasticity of demand varies from point to point on this
demand curve. At the mid-point (point C) of BD or AR curve, coefficient of elasticity of
demand is unity (ep = 1). The corresponding MR is zero. Thus, a monopolist earns
maximum TR by producing and selling ON units of output. In other words, at output
ON, TR is maximum, MR is zero and elasticity of demand is unity.
Below ON output level, TR increases as output expands. Consider any point to the
left of point C on the AR curve where ep > 1. Note that at this output level, MR is positive.
Thus, when TR rises, MR > 0 and ep > 1. Beyond ON output, since TR declines as output
expands, elasticity declines. Elasticity of demand becomes less than one to the right of
point C on the AR curve. Consequently, MR becomes negative. Thus, TR declines, MR<0
and ep<1. Obviously, a producer should produce in that region where MR is positive.

61
62
4
E.H. Chamberlin
18 May 1899 – 16th July 1967
th

MARKET STRUCTURE :
IMPERFECT COMPETITION
4.1 Monopoly
4.2 Monopoly: Price and Equilibrium
4.3 Price Discrimination under Monopoly
4.4 Degrees of Price Discrimination
4.5 Welfare Loss under Monopoly
4.6 Monopolistic Competition: Characteristics
4.7 Equilibrium of a Firm under Monopolistic Competition
4.8 Monopolistic competition: Selling Costs
4.9 Monopolistic Competition: Product Differentiation
4.10 Resources Wastage under Monopolistic Competition
4.11 Characteristics of Oligopoly Market
4.12 Non-Collusive Oligopoly
4.13 Duopoly-Cournot Model

63
64
4.1 Monopoly
The word monopoly has been derived from the combination of two words i.e., 'Mono'
and 'Poly'. Mono refers to a single and poly to control. In this way, monopoly refers to a
market situation in which there is only one seller of a commodity. There are no close
substitutes for the commodity it produces and there are barriers to entry. The single
producer may be in the form of individual owner or a single partnership or a joint stock
company. In other words, under monopoly there is no difference between firm and industry.

Monopolist has full control over the supply of commodity. Having control over the
supply of the commodity he possesses the market power to set the price. Thus, as a
single seller, monopolist may be a king without a crown. If there is to be monopoly, the
cross elasticity of demand between the product of the monopolist and the product of any
other seller must be very small. Pure or absolute monopoly exists when a single firm is
the sole producer for a product for which there are no close substitutes. We may state the
features of monopoly as:

1. One Seller and Large Number of Buyers: The monopolist's firm is the only firm; it
is an industry. But the number of buyers is assumed to be large.

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

3. Difficulty of Entry of New Firms: There are either natural or artificial restrictions
on the entry of firms into the industry, even when the firm is making abnormal
profits.

4. Monopoly is also an Industry: Under monopoly there is only one firm which
constitutes the industry. Difference between firm and industry comes to an end.

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

65
5. Nature of Demand and Revenue under Monopoly : Under monopoly, it becomes
essential to understand the nature of demand curve facing a monopolist. In a
monopoly situation, there is no difference between firm and industry. Therefore,
under monopoly, firm's demand curve constitutes the industry's demand curve.
Since the demand curve of the consumer slopes downward from left to right, the
monopolist faces a downward sloping demand curve. It means, if the monopolist
reduces the price of the product, demand
of that product will increase and vice-versa.

In Fig. 4.1 average revenue curve of

the monopolist slopes downward from left
to right. Marginal revenue (MR) also falls
and slopes downward from left to right. MR
curve is below AR curve showing that at
OQ output, average revenue (= Price) is PQ
where as marginal revenue is MQ. That
way AR > MR or PQ > MQ.

7. Costs under Monopoly: Under monopoly,

shape of cost curves is similar to the one
under perfect competition. Total fixed costs
curve is parallel to OX-axis whereas
average fixed cost is rectangular hyperbola.
Moreover, average variable cost, marginal
cost and average cost curves are of U-shape. Under monopoly, marginal cost curve as in
the perfect competition. Price is higher than marginal cost.

4.2 Monopoly: Price and Equilibrium

Under monopoly, for the equilibrium and price determination there are two
different conditions which are: 1. Marginal revenue must be equal to marginal cost. 2.
MC must cut MR from below.

1. Short Run Equilibrium under Monopoly: Short period refers to that period in which
the monopolist has to work with a given existing plant. In other words, the monopolist
cannot change the fixed factors like, plant, machinery etc. in the short period. Monopolist
can increase his output by changing the variable factors. In this period, the monopolist
can enjoy super-normal profits, normal profits and sustain losses.

66
i) Super Normal Profits : If the price determined by the monopolist in more than AC, he
will get super normal profits. The monopolist will produce up to the level where MC =
MR. This limit will indicate equilibrium output.

In Figure 4.2 output is measured on X-axis and

price on Y-axis. SAC and SMC are the short run
average cost and marginal cost curves while AR or MR
are the average revenue or marginal revenue curves
respectively. The monopolist is in equilibrium at point
E because at point E both the conditions of equilibrium
are fulfilled i.e., MR = MC and MC intersects the MR
curve from below. At this level of equilibrium the
monopolist will produce OQ1 level of output and sells
it at CQ1 price which is more than average cost DQ1
by CD per unit. Therefore, in this case total profits of
the monopolist will be equal to shaded area ABDC.

ii) Normal Profits : A monopolist in the short run would enjoy normal profits when average
revenue is just equal to average cost. It is important to know average cost of production
is inclusive of normal profits. This situation can be illustrated with the help of fig 4.3.

In figure the firm is in equilibrium at point

E. Here marginal cost is equal to marginal revenue.
The firm is producing OM level of output. At OM
level of output average cost curve touches the
average revenue curve at point R. Therefore, at
point 'R' price MR is equal to average cost of the
total product. In this way, monopoly firm enjoys
the normal profits.

iii) Minimum Losses : In the short run, the

monopolist may have to incur losses. This situation
occurs if in the short run price falls below the
variable cost. In other words, if price falls due to depression and fall in demand, the
monopolist will continue to produce as long as price covers the average variable cost.
Once the price falls Below the average variable cost, monopolist will stop production.
Thus, a monopolist in the short run equilibrium has to bear the minimum loss equal to
fixed costs. Therefore, equilibrium price will be equal to average variable cost. This
situation can also be explained with the help of Fig. 4.4.

67
In Fig. 4.4 monopolist is in equilibrium at point E. At point E marginal cost is equal to
marginal revenue and he produces OM level of output. At OM level of output, equilibrium
price fixed by the monopolist is OP1.
At OP1 price, SAVC touches the AR
curve at point A. It signifies that the
firm will cover only average variable
cost from the prevailing price. At OP1
price, firm will bear loss of fixed cost
i.e., AN per unit. The firm will bear the
total loss equal to the shaded area
PNAP1. Now if the price falls below
OP 1 , the monopolist will stop
production. It is so because if he
continues production, he will have to
bear the loss of variable costs along
with fixed costs.

2. Long Run Equilibrium under Monopoly: Long-run is the period in which output can
be changed by changing the factors of
production. In other words, all variable
factors can be changed and monopolist
would choose that plant size which is
most appropriate for specific level of
demand. Here, equilibrium would be
attained at that level of output where the
long-run marginal cost cuts marginal
revenue curve from below. This can be
shown with the help of Fig. 4.5. In Figure
monopolist is in equilibrium at OM level
of output. At OM level of output marginal
revenue is equal to long run marginal
cost and the monopolist fixes OP price.
Price OP (JM) being more than LAC i.e., HM which fetch the monopolist super normal
profits. Accordingly, the monopolist earns JM - HM = JH super normal profit per unit.
His total super normal profits will be equal to shaded area PJHP1.

68
4.3 Price Discrimination under Monopoly
In monopoly, there is a single seller of a product called monopolist. The monopolist
has control over pricing, demand, and supply decisions, thus, sets prices in a way, so that
maximum profit can be earned. The monopolist often charges different prices from
different consumers for the same product. This practice of charging different prices for
identical product is called price discrimination. According to Robinson, "Price
discrimination is charging different prices for the same product or same price for the
differentiated product."

Types of Price Discrimination : Price discrimination is a common pricing strategy'

used by a monopolist having discretionary pricing power. This strategy is practiced by
the monopolist to gain market advantage or to capture market position.

1. Personal : Refers to price discrimination when different prices are charged from
different individuals. The different prices are charged according to the level of
income of consumers as well as their willingness to purchase a product. For example,
a doctor charges different fees from poor and rich patients.

2. Geographical : Refers to price discrimination when the monopolist charges different

prices at different places for the same product. This type of discrimination is also
called dumping.

3. On the basis of use : Occurs when different prices are charged according to the use
of a product. For instance, an electricity supply board charges lower rates for
domestic consumption of electricity and higher rates for commercial consumption.

4.4 Degrees of Price Discrimination

Price discrimination has become widespread in almost every market. In economic
jargon, price discrimination is also called monopoly price discrimination or yield
management. There are three degrees of price discrimination explained as follows:

1. First-degree Price Discrimination : Refers to a price discrimination in which a

monopolist charges the maximum price that each buyer is willing to pay. This is
also known as perfect price discrimination as it involves maximum exploitation of
consumers. In this, consumers fail to enjoy any consumer surplus. First degree is
practiced by lawyers and doctors.

69
2. Second-degree Price Discrimination : Refers to a price discrimination in which
buyers are divided into different groups and different prices are charged from these
groups depending upon what they are willing to pay. Railways and airlines practice
this type of price discrimination.

3. Third-degree Price Discrimination : Refers to a price discrimination in which the

monopolist divides the entire market into submarkets and different prices are
charged in each submarket. Therefore, third-degree price discrimination is also
termed as market segmentation.

Assume that a monopolist has divided market into two submarkets, A and B. He
found that the elasticity of demand is greater in market B than in market A. The
monopolist would earn maximum profits where MR=MC and MC curve cuts MR curve
from below, which
is shown in Figure
4.6. In Figure 4.6,
in case of total
market, output
OQ a has to be
distributed in such
a way that AMR
equals MC at E.

Thus, a monopolist will sell output OQa in market A and OQb in market B as at
these levels of output equals OQ that is an equilibrium output. The price charged in both
the markets will be equal to AAR or demand curve.

Thus, price in market A is OPa and price in market B is OPb. It should be noted
that the price charged in market A is greater than the price charged in market B. This is
because the elasticity of demand is greater in market B than A. Since price in market A
is higher, the output sold is low that is OQa than OQb in market B.

Thus, there must be two conditions for a discriminating monopolist to attain equilibrium
given as follows:
1. Marginal Cost of Total Output = Combined Marginal Revenue.
2. Marginal Revenue in Market A = Marginal Revenue in Market B=Marginal Cost.

70
4.5 Welfare Loss under Monopoly
Welfare
We shall now try to measure the net welfare loss due to monopoly or inefficiency of
monopoly. In Fig.4.6, the price-output solution under perfect competition is Ec(pc, qc) and
that under monopoly is Em (pm, qm). The level of output of the perfectly competitive industry
is the efficient level of output because here the willingness to pay for an extra unit of
output just equals the cost of producing the extra unit P=MC.

Under monopoly, on the other hand, activity stops at a point where p is greater
than MC, i.e., the willingness to pay for an extra unit is greater than the cost of producing
the extra unit. That is why the monopoly output level is inefficient.

If we move from the competitive output

level qc to the monopoly output level qm, i.e.,
if we move from the point Ec to the point A
along the demand curve there occurs a loss
in consumers' surplus, which is measured by
BAEc, and the producer's surplus decreases
by BEmEc. It appears, therefore, that as we
move from perfect competition to monopoly,
the surplus equal to pcpmAB is transferred
from the consumers to the monopolist
producer.

The loss in producer's surplus equal to

BEmEc and the BAEc portion of the loss in
consumers' surplus cannot be accounted for
as having been transferred to any other group(s) of individuals in the society.

Therefore, the sum of these two areas, i.e., AEmEc, represents the net loss in welfare
to the society due to monopoly, or, the deadweight loss of monopoly, as it is called. The
greater the deadweight loss caused by a change in the organisation of an industry from
perfect competition to monopoly, the greater would be the inefficiency of monopoly.

71
4.6 Monopolistic Competition : Characteristics
The two important subdivisions of imperfect competition are monopolistic
competition and oligopoly. Most of the economic situations "are composites of both perfect
competition and monopoly". Chamberlin's monopolistic competition is an amalgam or
an admixture of perfect competition and monopoly.

1. Large Number of Sellers : Like perfect competition, there are a large number of
sellers and buyers. But the 'number' is not too large like perfect competition. As a
result, each firm has an insignificant share in the market so that action of one
seller does not affect rival sellers to any great extent.

2. Differentiated Products : Sellers sell differentiated products, but they are close
but not perfect substitutes. It is the degree of differentiation that creates both
monopoly and competitive elements. Every product is unique to the buyers. So
every seller enjoys some degree of monopoly of his own product over other sellers.

3. Elastic Demand Curve : Since product of each seller is slightly different from his
rivals he enjoys some degree of monopoly power and, hence, can raise the price of
his product without losing most customers. But as other rival firms produce closely
related goods, every firm faces competition and its influence over the price of the
product is rather limited. Thus, each firm has a downward sloping demand curve
implying that it behaves as a price-maker.

4. Non-Price Competition : Besides price competition, Chamberlin suggested cases

of non-price competition that arise due to product variation and selling activities.
Seller always tries to establish the fact that his product is superior to others by
improving the quality of his product. And in doing so, he incurs selling costs or
makes advertisement to attract more customers in his fold.

5. Free Entry-Exit : Like perfect competition, there is complete freedom of entry and
exit.

6. Product Group : Chamberlin used the term 'group' rather than industry. An industry
is a set of firms that produces homogeneous goods. But under monopolistic
competition, goods are heterogeneous or slightly differentiated. Thus, the term
'industry' cannot be applied here. That is why Chamberlin used 'product group'
which is defined as a collection of firms producing almost similar goods, but not
identical goods.

72
4. 7 Equilibrium of a Firm under Monopolistic Competition
Short Run Equilibrium: Equilibrium of a firm under monopolistic competition is often
understood in terms of short period and long period. In the short run, Chamberlin's
model of monopolistic competition comes closer to monopoly.

That is to say, there is virtually no difference

between monopolistic competition and monopoly
in the short run. Thus, Chamberlin's firm may
earn supernormal profit, normal profit, or incur
loss in the short run, since entry and exit are not
allowed during this time period.

In Fig. 4.8, the short run marginal cost

curve, SMC, is equal to MR at point E. Thus E is
the equilibrium point. Corresponding to this
equilibrium point, the firm produces OQ output
and sells it at a price OP. Thus, the firm earns
supernormal profit to the extent of PARB since total revenue (OPAQ) exceeds total cost
of production (OBRQ).
A firm, in the short run, may earn only normal profit if MC = MR < AR = AC
occurs. A loss may result in the short run if MC = MR < AR < AC happens

Long Run Equilibrium: In the long run, monopolistic competition comes closer to perfect
competition because the freedom of entry and exit allows firms to enjoy only normal
profit. Whenever some firms earn supernormal profit in the long run some other firms
may be attracted to join this product group,
thereby shifting the demand curve or AR curve
downward and to the left. Thus, entry of new firms
would cause decline in market share by reducing
the demand for its product.
Long run equilibrium is achieved at point
E where LMC equals MR (Fig. 4.9). The
equilibrium output thus determined is OQ. At this
output, AR equals AC. The firm gets normal profit
by selling OQ output at the price OP. Note that a
monopolistically competitive firm always operates
somewhere to the left of the minimum point (R) of
its AC curve.
73
4.8 Monopolistic Competition : Selling Costs
Selling costs play the key role in monopolistic competition and oligopoly. Under
these market forms, the firms have to compete to promote their sale by spending on
advertisements and publicity. Moreover, producer has not only decides price and output
and he also keeps in view how to maximize the profit.

Thus, cost on advertisement publicity and salesmanship adds to the demand of

the product. We do not find perfect competition or monopoly in the real world but
monopolistic competition or oligopoly. In short, selling costs is a broader concept than
the advertisement expenditures. Advertisement expenditures are part of selling costs.

In selling costs we include the salaries of sales persons, allowances to retailers to

display the products etc. besides the advertisements. Advertisement expenditure includes
costs incurred for advertising in newspapers and magazines, televisions, radio, cinema
slides etc. It was Chamberlin who introduced the analysis of selling costs and
distinguished it from the production costs. The production costs include all those expenses
which are spent on the manufacturing of the commodity, its transportation cost of
handling, storing and delivering of the commodity to actual customers because these
add utilities to a commodity. On the other hand, all selling costs include all expenditures
in order to raise demand for a commodity. In short, selling costs are those which are
made to create the demand for the product.

Average Selling Cost Curve : The curve of selling

cost is a tool of economic analysis. It is a curve of
average selling cost per unit of product. It is akin
to the average cost curves. In other words, like the
cost curves, selling costs are also of U-shape.

In Figure 4.10 ASC is the average selling

cost. In the initial stage, the curve falls and later it
starts rising. It means in the beginning
proportionate increase in sale is more than the
increase in selling costs, but after a point
proportionate increase in sale is less than the
selling cost. It signifies the fact that up to a certain
level per unit selling cost go on to diminish but after
that the same tend to increase. But, the ASC neither will touch the X-axis nor it will be
zero. In other words, the ASC will form the shape of rectangular hyperbola.

74
4.9 Monopolistic Competition: Product Differentiation
According to Chamberlin product differentiation is one of the most important
feature of monopolistic competition. Product differentiation indicates that goods are close
substitutes but are not homogeneous. They differ in colour, name, packing, size etc. The
main peculiarities of product differentiation are as under :

1. Due to product differentiation, goods are not homogeneous.

2. Product differentiation aims at to control price and increase profits.
3. Product differentiation satisfies people's urge for variety.
4. Product differentiation may be real or artificial.
5. Product differentiation provides the producer name and brand legally patented.

Demand Curve under Product Differentiation: The credit goes to Prof. Piero Sraffa to
introduce the concept of product differentiation under monopolistic competition on the
basis of downward sloping demand curve. But Chamberlin introduced it on the basis of
price and output determination. Chamberlin opined that demand for product is influenced
not by price only but also the style of the product and selling costs. It is so because aim of
product differentiation is to inspire the consumer to demand a particular product.

Equilibrium and Product Differentiation: Product differentiation also affects the

equilibrium of the firm under monopolistic competition. Supposing there are two types
of products X and Y and no selling costs are incurred for the sale of these products. The
producer has to decide about the quality of the product so as to maximize his profit. If
the price of the product is already fixed, then the firm
has to choose the product which has larger sales and
will bring maximum profits.

In Fig. 4.11, X and Y are the cost curves for products

X and Y. The cost curve of Y is highest which shows that
Y product is of a better quality. Both the products can
be sold at price OP. At price OP, ON amount of X
commodity can be sold and the profit is CDTP. At price
OP, ON1 amount of Y commodity can be sold and the
profit is BMKP which is higher than the profit which
can be earned by sale of X commodity. Hence, the
producer will choose to produce Y commodity.

75
4.10 Resources Wastage under Monopolistic Competition
Wastage
The following points highlight the six major wastes of monopolistic competition.
The wastes are:

1. Competitive Advertisements: One of the important wastes of monopolistic competition

is the incurring of expenditure on competitive advertisement by firms. Excess
advertisement adds to costs and prices. Expenditure on packing, colour, flavours, etc.
and on media like TV, radio, cinema, newspapers, etc. create unnecessary product
differentiation.

2. Product Differentiation: Another waste of competition is the production of varieties of

a product which each firm produces. This is done by creating artificial or imaginary
product differentiation so as to distinguish the product of one seller from those of
another. This is done by changing the colour, design, fragrance, packing, etc. of the
same product by the same producer.

3. Expenditure on Cross Transportation: The expenditure on cross transport is another

Transportation
waste of monopolistic competition. Each producer tries to sell his products in the far-
off markets rather than in the markets near its place of manufacture. This involves
huge transport costs and also expenses on advertisement and propaganda. Rather
than save these expenses and reduce prices, firms under monopolistic competition
prefer to incur expenses on transportation and advertisement. This is apparently
wastage of resources.

4. Inefficient Firms: Under monopolistic competition, there are a large number of

inefficient firms. The price charged by each firm exceeds the long-run marginal cost
because both the AR and MR curves are downward sloping under monopolistic
competition. The firm's equilibrium condition is Price = LAC>LMC = MR. Therefore,
resources are under allocated to firms in the market and misallocated in the economy.

5. Excess Capacity: All firms under monopolistic competition possess excess capacity.
Since the demand curve (AR) of a monopolistic competitive firm is downward sloping,
its tangency point with the LAC curve will always occur to the left of its minimum
point. Thus when the firm is in long-run equilibrium, it underutilizes its optimum
scale plant. This leads to the existence of more firms in the industry than required.

6. Unemployment: As a result to the above, unutilized resources lead to unemployment

when firms under monopolistic competition try to maintain the price of their product
instead of maintaining production.
76
4.11 Characteristics of Oligopoly Market
4.11
An oligopoly is a market structure in which a few firms dominate. When a market
is shared between a few firms, it is said to be highly concentrated. Although only a few
firms dominate, it is possible that many small firms may also operate in the market.
Oligopoly as a market structure is distinctly different from other market forms. Its main
characteristics are discussed as follows:
1. Interdependence : The foremost characteristic of oligopoly is interdependence of the
various firms in the decision making. This fact is recognized by all the firms in an
oligopolistic industry.
2. Advertising: Under oligopoly a major policy change on the part of a firm is likely to
have immediate effects on other firms in the industry. Therefore, the rival firms remain
all the time vigilant about the moves of the firm which takes initiative and makes
policy changes. Thus, advertising is a powerful instrument in the hands of an
oligopolist.
3. Group Behaviour: In oligopoly, the most relevant aspect is the behaviour of the group.
Whatever the number, it is quite small so that each firm knows that its actions will
have some effect on other firms in the group.
4. Competition: This leads to another feature of the oligopolistic market, the presence of
competition. Since under oligopoly, there are a few sellers, a move by one seller
immediately affects the rivals. So each seller is always on the alert and keeps a close
watch over the moves of its rivals in order to have a counter-move.
5. Barriers to Entry of Firms: As there is keen competition in an oligopolistic industry,
there are no barriers to entry into or exit from it. However, in the long-run, there are
some types of barriers to entry which tend to restrain new firms from entering the
industry.
6. Lack of Uniformity: Another feature of oligopoly market is the lack of uniformity in
the size of firms. Firms differ considerably in size. Some may be small, others very
large. Such a situation is asymmetrical.
7. Existence of Price Rigidity: In oligopoly situation, each firm has to stick to its price. If
any firm tries to reduce its price, the rival firms will retaliate by a higher reduction in
their prices. This will lead to a situation of price war which benefits none. On the
other hand, if any firm increases its price with a view to increase its profits; the other
rival firms will not follow the same. Hence, no firm would like to reduce the price or to
increase the price. The price rigidity will take place.
8. Indeterminateness of Demand Curve : Usually in market structures, the demand
curve faced by a firm is determined. However, due to mutual interdependence in
oligopoly, it is impossible to draw the demand curve for sellers. This demand curve is
therefore indeterminate.
77
4.12 Non - Collusive Oligopoly
One of the important features of oligopoly market is price rigidity. And to explain
the price rigidity in this market, conventional demand curve is not used. The idea of
using a non-conventional demand curve to represent non-collusive oligopoly was best
explained by Paul Sweezy in 1939. Sweezy uses kinked demand curve to describe price
rigidity in oligopoly market structure.

The kink in the demand curve stems from the asymmetric behavioural pattern
of sellers. If a seller increases the price of his product, the rival sellers will not follow
him so that the first seller loses a
considerable amount of sales. In other
words, every price increase will go
unnoticed by rivals.

On the other hand, if one firm

reduces the price of its product other
firms will follow the first firm so that
they must not lose customers. In other
words, every price will be matched by an
equivalent price cut. As a result, the
benefit of price cut by the first firm will
be inconsiderable. As a result of this
behavioural pattern, the demand curve
will be kinked at the ruling market price.

Suppose the prevailing price of an

oligopoly product in the market OP of
Fig. 4.12. If one seller increases the price
above OP, rival sellers will keep the prices of their products at OP. As a result of high
price charged by the firm, buyers will shift to products of other sellers who have kept
their prices at the old level. Consequently, sales of the first seller will drop considerably.

That is why demand curve in this zone (dK) is relatively elastic. On the other
hand, if a seller reduces the price of his product below P others will follow him so that
demand for their products does not decline. Thus, demand curve in this region (KD) is
relatively inelastic. This behavioural pattern thus explains why prices are inflexible in
the oligopoly market, even if demand and costs change. The kink in the demand curve at
point K results in a discontinuous MR curve (AB).
78
4.13 Duopoly - Cournot Model
Augustin Cournot, a French economist, published this theory of duopoly in 1838.
Let us first state the assumptions which are made by Cournot in his analysis of price
and output under duopoly. First, Cournot takes the case of two identical mineral springs
operated by two owners who are selling the mineral water in the same market. Secondly
it is assumed cost of production is zero. Thirdly, the duopolists fully know the market
demand for the mineral water, they can see every point on the demand curve, the demand
curve assumed to be linear, that is, market demand curve facing the two producers is a
straight line. Lastly it is assumed, the duopolists will decide about the amount of output
which is most profitable for him to produce in the light of his rival's present output and
assumes that it remains constant.
Suppose the demand curve confronting the two
producers of the mineral water is the straight line
MD as shown in figure 4.13. Further suppose that
ON=ND is the maximum daily output of each mineral
spring. Thus, the total output of both springs OD=
ON + ND. It will be seen from the figure that when
the total output OD of both the springs is offered for
sale in the market, the price will be zero. This is
because cost of production assumed to be zero.
Assume for the moment that one producer A of
the mineral water starts the business first. Thus, to
begin with he will be monopolist. He will then produce
daily ON output which is his maximum daily output,
because his profits will be maximized at output ON and will be equal to ONKP. The price
charge by producer A will be OP. Supposes now that the owner of other spring B enters
into the market and starts operating his spring. New producer B sees that the former
producer A is producing ON amount of output. The producer B believes that the former
producer A will continue to produce ON (=1/2 OD) amount of output. Given the belief, the
best that the new producer B can do is to regard segment KD as the demand curve
confronting him, produces NH (= ½ ND) amount of output. The total output now is ON+NH
=OH and the price will fall to OP1 or HL per unit.
The total profits made by two producers will be OHLP1 .This is less than ONKP.
Out of total profits OHLP1 Profits of producer A will be ONGP1 And profits of B will be
NHLG. The producer A will reconsider the situation, assuming that producer B will
continue to produce output NH. A can produce ½ (OD-NH). He will accordingly, reduce
his output. Now B has been surprised by the reduction of output by producer A and he
will also rearrange his output believing that producer A will continue producing its new
current level of output, now B will produce ½ (OD- new output A). Producer B, accordingly,
will increase his output and producer A will decreases his output until the total production
equal to OT. OT = (2/3 OD), and each is producing 1/3 OD. In the final position producer A
produces OC amount of output and producer B produces CT amount of output, and OC=CT.
79
80
5
William J. Baumol
26th Feb 1922 - 4th May, 2017

ANALYSIS OF BUSINESS FIRM,

PROFIT AND PRICING STRATEGIES
5.1 Profit Maximisation
5.2 Baumol's Model - Sales maximisation
5.3 Market Share Maximisation
5.4 Growth Maximisation Theory of Marris
5.5 Accounting Profit and Economic Profit
5.6 Break-Even Point
5.7 Profit Volume Analysis
5.8 Cost-Plus Pricing
5.9 Marginal-cost pricing
5.10 Rate of Return Pricing
5.11 Price Skimming
5.12 Penetration Pricing
5.13 Loss Leader Pricing
5.14 Mark-up Pricing
5.15 Administered Price

81
82
5.1 Profit Maximisation
In the neo-classical theory of the firm, the main objective of a business firm is
profit maximisation. The firm maximises its profits when it satisfies the two rules. MC =
MR and the MC curve cuts the MR curve from below. Maximum profits refer to pure
profits which are a surplus above the average cost of production. It is the amount left
with the entrepreneur after he has made payments to all factors of production, including
his wages of management. In other words, it is a residual income over and above his
normal profits.

Profit Maximisation under Perfect Competition: Under perfect competition, the firm is
one among a large number of producers. It cannot influence the market price of the
product. It is the price-taker and quantity-adjuster. It can only decide about the output
to be sold at the market price. Therefore, under
conditions of perfect competition, the MR curve
of a firm coincides with its AR curve. The MR
curve is horizontal to the X-axis because the
price is set by the market and the firm sells its
output at that price. The firm is, thus, in
equilibrium when MC = MR = AR (Price).

The equilibrium of the profit maximisation firm

under perfect competition is shown in Figure
5.1. Where the MC curve cuts the MR curve
first at point A. It satisfies the condition of MC
= MR, but it is not a point of maximum profits
because after point A, the MC curve is below
the MR curve. It does not pay the firm to produce the minimum output when it can earn
larger profits by producing beyond OM.

It will, however, stop further production when it reaches the OM1 level of output
where the firm satisfies both conditions of equilibrium. If it has any plans to produce
more than OM1 it will be incurring losses, for the marginal cost exceeds the marginal
revenue after the equilibrium point B. Thus the firm maximises its profits at M1B price
and at the output level OM1

83
Profit Maximisation under Monopoly: There being one seller of the product under
monopoly, the monopoly firm is the industry itself. Therefore, the demand curve for its
product is downward sloping to the right, given the tastes and incomes of its customers.
It is a price-maker which can set the price to its maximum advantage. But it does not
mean that the firm can set both price and output. It can do either of the two things.

If the firm selects its output level, its price is determined by the market demand
for its product. Or, if it sets the price for
its product, its output is determined by
what consumers will take at that price.
In any situation, the ultimate aim of the
monopoly firm is to maximise its profits.
The conditions for equilibrium of the
monopoly firm are (1) MC = MR< AR
(Price), and (2) the MC curve cuts the MR
curve from below.

In Figure 5.2, the profit maximising

level of output is OQ and the profit
maximisation price is OP (=QA). If more
than OQ output is produced, MC will be higher than MR, and the level of profit will fall.
If cost and demand conditions remain the same, the firm has no incentive to change its
price and output. The firm is said to be in equilibrium.

84
5. 2 Baumol's Model - Sales maximisation
Sales maximisation of oligopoly is another important alternative to profit
maximisation model. This has been propounded by W.J. Baumol, an American Economist.
According to Baumol, revenue or sales maximisation rather than profit maximisation is
consistent with the actual behaviour of firms. He thinks that managers are more interested
in maximising sales than profit. By sales maximisation, Baumol means maximisation of
total revenue. It does not imply the sale of large quantities of output, but refers to the
increase in money
sales.

Baumol's
model is illustrated
in Figure 5.3 where
TC is the total cost
curve, TR the total
revenue curve, TP
the total profit curve
and MP the
minimum profit or
profit constraint
line. The firm
maximises its profits at OQ level of output corresponding to the highest point B on the
TP curve. But the aim of the firm is to maximise its sales rather than profits. Its sales
maximisation output is OK where the total revenue KL is the maximum at the highest
point of TR. This sales maximisation output OK is higher than the profit maximisation
output OQ. But sales maximisation is subject to minimum profit constraint. Suppose the
minimum profit level of the firm is represented by the line MP. The output OK will not
maximise sales as the minimum profits OM are not being covered by total profits KS.
For sales maximisation, the firm should produce that level of output which not only
covers the minimum profits but also gives the highest total revenue consistent with it.
This level is represented by OD level of output where the minimum profits DC (=OM)
are consistent with DE amount of total revenue at the price DE/OD, (i.e., total revenue/
total output).

85
5.3 Market Share Maximisation
Market share represents the percentage of an industry, or a market's total sales
that is earned by a particular company over a specified time period. Market share is
calculated by taking the company's sales over the period and dividing it by the total
sales of the industry over the same period. This metric is used to give a general idea of
the size of a company in relation to its market and its competitors. Gains or losses in
market share can have significant impacts on a company's stock performance, depending
on industry conditions.

A company's market share is its portion of total sales in relation to the market or
industry in which it operates. To calculate a company's market share, first determine a
period you want to examine. It can be a fiscal quarter, year or multiple years. Next,
calculate the company's total sales over that period. Then, find out the total sales of the
company's industry. Finally, divide the company's total revenues by its industry's total
sales. Investors and analysts monitor increases and decreases in market share carefully
as this can be a sign of the relative competitiveness of the company's products or services.
As the total market for a product or service grows, a company that is maintaining its
market share is growing revenues at the same rate as the total market. A company that
is growing its market share will be growing its revenues faster than its competitors.

Market share increases can allow a company to achieve greater scale with its
operations and improve profitability. A company can try to expand its share of the market,
either by lowering prices, using advertising or introducing new or different products. In
addition, it can also grow the size of its market size by appealing to other audiences or
demographics.

Innovation is one method by which a company may increase market share. By

strengthening customer relationships, companies protect their existing market share by
preventing current customers from jumping ship when a competitor rolls out a hot new
offer. Better still, companies can grow market share using the same simple tactic, as
satisfied customers frequently speak of their positive experience to friends and relatives
who then become new customers. Gaining market share via word of mouth increases a
company's revenues without concomitant increases in marketing expenses.

86
5.4 Growth Maximisation Theory of Marris
Robin Marris in his book The Economic Theory of 'Managerial' Capitalism (1964)
has developed a dynamic balanced growth maximising model of the firm. He concentrates
on the proposition that modern big firms are managed by managers and the shareholders
are the owners who decide about the management of the firms.

The managers aim at the maximisation of the growth rate of the firm and the
shareholders aim at the maximisation of their dividends and share prices. To establish a
link between such a growth rate and the share prices of the firm, Marris develops a
balanced growth model in which the manager chooses a constant growth rate at which
the firm's sales, profits, assets, etc. grow.

If he chooses a higher growth rate, he will have to spend more on advertisement

and on Research & Development in order to create more demand and new products. He
will, therefore, retain a higher proportion of total profits for the expansion of the firm.
Consequently, profits to be distributed to shareholders in the form of dividends will be
reduced and the share prices will fall. The threat of take-over of the firm will loom large
among the managers.

As the managers are concerned more about their job security and growth of the
firm, they will choose that growth rate which maximises the market value of shares, give
satisfactory dividends to shareholders, and avoid the take-over of the firm. On the other
hand, the owners (shareholders) also want balanced growth of the firm because it ensures
fair return on their capital. Thus the goals of the managers may coincide with that of
owners of the firm and both try to achieve balanced growth of the firm.

The goal of the firm in Marris's model is the maximization of the balanced rate of
growth of the firm; that is, the maximization of the rate of growth of demand for products
of the firm, and of the growth of its capital supply.

Maximise G = Gd = Gc

Where G = balanced growth rate

Gd = growth of demand for the products of the firm

Gc = growth of the supply of capital.

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5.5 Accounting Profit and Economic Profit
Profit is one of the most widely watched financial metrics in evaluating the financial
health of a company. Accounting profit and economic profit share similarities, but there
are distinct differences between the two metrics.

1. Accounting Profit: Accounting profit is also known as the net income for a company
or the bottom line. It's the profit after various costs and expenses are subtracted from
total revenue or total sales as stipulated by generally accepted accounting principles
(GAAP). Those costs include : 1. Labor costs, such as wages 2. Inventory needed for
production 3. Raw materials 4. Transportation costs 5. Sales and marketing costs
6. Production costs and overhead costs.

Accounting profit is the amount of money left over after deducting the explicit
costs of running the business. Explicit costs are merely the specific amounts that a
company pays for those costs in that period, for example, wages. Typically, accounting
profit or net income is reported on a quarterly and annual basis and is used to measure
the financial performance of a company.

2. Economic Profit: Economic profit is similar to accounting profit in that it deducts

explicit costs from revenue. However, economic profit also includes the opportunity
costs for taking one action versus another in the period. Economic profit is determined
by economic principles, not by accounting principles. Economic profit also uses implicit
costs, which are typically the costs of a company's resources.

Examples of implicit costs include :

1. Company-owned buildings.
2. Plant and equipment.
3. Self-employment resources

Economic profit is the profit from producing goods and services while factoring
in the alternative uses of a company's resources. For example, a company may choose
Project A versus Project ‘B’. The profit from Project ‘A’ after deducting expenses and costs
would be the accounting profit. The economic profit would include the opportunity cost
of choosing Project ‘A’ versus Project ‘B’. In other words; economic profit would consider
how much more or less profit would have been generated, by using the company's
resources, had management chosen Project B. Economic profit is more of a theoretical
calculation based on alternative actions that could have been taken, while accounting
profit calculates what actually occurred and the measurable results for the period.

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5.6 Break - Even Point
The break-even point can be defined as a point where total costs (expenses) and
total sales (revenue) are equal. Break-even point can be described as a point where there
is no net profit or loss. The firm just "breaks even. "Any company which wants to make
abnormal profit, desires to have a break-even point. Graphically, it is the point where
the total cost and the total revenue curves meet.

The origins of break-even point can be found in the economic concepts of "the point
of indifference." The break-even analysis, in its simplest form, facilitates an insight into
the fact about revenue from a product
or service incorporates the ability to
cover the relevant production cost of
that particular product or service or not.
Moreover, the break-even point is also
helpful to managers as the provided info
can be used in making important
decisions in business, for example
preparing competitive bids, setting
prices, and applying for loans. Break
even shown in figure 5.4

Adding more to the point, break-

even analysis is a simple tool defining
the lowest quantity of sales which will
include both variable and fixed costs.
Moreover, such analysis facilitates the
managers with a quantity which can be used to evaluate the future demand. If, in case,
the break-even point lies above the estimated demand, reflecting a loss on the product,
the manager can use this info for taking various decisions. He might choose to discontinue
the product, or improve the advertising strategies, or even re-price the product to increase
demand.

In the figure 5.4 total revenue and total cost intersect each other at point E, by
producing OQ output. The business firm produces less than OQ output; in this stage
total revenue is less than total cost. The business firm incurring losses up to point E.
When the firm is producing OQ of output the total cost equal to total revenue hence
point is E Break even point.

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5.7 Profit Volume Analysis
Volume
The Cost-Volume-Profit (CVP) analysis helps management in finding out the
relationship of costs and revenues to output. The aim of an undertaking is to earn profit.
Profit depends upon a large number of factors, the most important of which are the cost
of manufacture, selling price, and the volume of sales effected.

The three factors cost, volume and profit are interdependent-profit depends upon
sales, selling price to a large extent depends upon cost, volume of sales depends upon the
volume of production which, in turn, is related to costs. Cost, again, is the resultant of
the operation of a number of varying factors. Factors Affecting Cost-Volume-Profit
Analysis:

Such factors affecting cost are :

1. Volume of production
2. Product mix
3. Internal efficiency
4. Methods of production, and
5. Size of plant etc.

Of all these, volume is perhaps the largest single factor which influence cost. Often,
outside factors, over which the management has no control, necessitate changes in volume,
and costs do not always vary in proportion to changes in levels of output. This type of
situation poses special problems for the management.

Thus, cost-volume-profit analysis furnishes a complete picture of the profit structure

which enables the management to distinguish between the effect of sales volume
fluctuations and the results of selling price or cost changes upon profits.

This analysis helps in understanding the behaviour of profits in relation to Output.

Fixed costs do not change with production, the amount per unit declines as output rises.
On the other hand, variable costs react proportionately with production changes.

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5.8 Cost - Plus Pricing
Prof. Andrews in his study, Manufacturing Business, 1949, explains how a
manufacturing firm actually fixes the selling price of its product on the basis of the full-
cost or average cost. The firm finds out the average direct costs (AVC) by dividing the
current total costs by current total output. These are the average variable costs which
are assumed to be constant over a wide range of output.

In other words, the AVC curve is a straight line parallel to the output axis over a
part of its length if the prices of direct cost factors are given. The price which a firm will
normally quote for a particular
product will equal the estimated
average direct costs of production
plus a costing-margin or mark-up.
The costing-margin will normally
tend to cover the costs of the
indirect factors of production
(inputs) and provide a normal level
of net profit, looking at the
industry as a whole.

The Andrews version of full-

cost pricing is illustrated in Figure
5.5 where AC is the average
variable or direct costs curve which is shown as a horizontal straight line over a wide
range of output. MC is its corresponding marginal cost curve. Suppose the firm chooses
OQ level of output. At this level of output, QC is the full-cost of the firm made up of
average direct cost QV plus the costing-margin VC. Its selling price OP will, therefore,
equal QC.

The firm will continue to charge the same price OP but it might sell more depending
upon the demand for its product, as represented by the curve DD. In this situation, it
will sell OQ1 output. "This price will not be altered in response to changes in demand,
but only in response to changes in the prices of the direct and indirect factors."

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5. 9 Marginal - Cost Pricing
Marginal-cost pricing, in economics, the practice of setting the price of a product
to equal the extra cost of producing an extra unit of output. By this policy, a producer
charges, for each product unit sold, only the addition to total cost resulting from materials
and direct labour. Businesses often set prices close to marginal cost during periods of
poor sales. If, for example, an item has a marginal cost of Rs. 100 and a normal selling
price is Rs. 200, the firm selling the item might wish to lower the price to Rs. 120 if
demand has waned. The business would choose this approach because the incremental
profit of Rs 20 from the transaction is better than no sale at all.

In the mid-20th century, proponents of the ideal of perfect competition a scenario

in which firms produce nearly identical products and charge the same price favoured
the efficiency inherent in the concept of marginal cost pricing. Economists such as Ronald
Coase, however, upheld the market's ability to determine prices. They supported the
way in which market pricing signals information about the goods being sold to buyers
and sellers, and they observed that sellers who were required to price at marginal cost
would risk failing to cover their fixed costs.

5.10 Rate of Return Pricing

Rate of return pricing is a method by which a company fixes the price of the
product in such a way that it ultimately helps organizations in achieving the ultimate
goal or return on the capital employed. This is a common practice, but can only be effective
in cases or products which have very little competition.

The concept of rate of return pricing is similar to return on investment. The only
difference is that in this approach, manufacturer or the company can manipulate or
change the price of the product to achieve the ultimate goal of the organisation. The rate
of return pricing helps the company in achieving a certain level of profit which is required
to keep the liquidity intact. The price is set in such a way that the ultimate goal of
achieving corporate profit objective is met if sales continue to run at a given rate. The
process becomes easy if there is little competition, as compared to a situation when
there is competition.

The target return price can be defined as: Target return price = unit cost + (desired
return × invested capital) / unit sales.

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 Pricing the product by rate of return can also have some short comings. It does not
take into the account the price elasticity and the pricing of the competition which are
two important things to consider before the final pricing is set. Let's understand the
concept of rate of return pricing with the help of an example. A company X Ltd has an
objective of achieving a required rate of return of say 20% on goods that they sell. The
company manufactures pencils and have already invested Rs 10,00,000 in the business.
The cost of each pencil is Rs 16. Here, we are assuming that sales can hit 50,000 units in
a year. The target return price would be = 16 (cost) + (20%*10,00,000 (investment))/
50,000 (sales) = Rs 20. So, to achieve the required rate of return, the company should
sell the pencil at Rs 20 each.

5.11 Price Skimming

5.11
Price skimming, also known as skim pricing, is a pricing strategy in which a firm
charges a high initial price and then gradually lowers the price to attract more price-
sensitive customers. The pricing strategy is usually used by a first mover who faces
little to no competition. Price skimming is not a viable long-term pricing strategy as
competitors eventually launch rival products and put pricing pressure on the first
company.
Price skimming is used to maximize profits when a new product or service is
deployed. Therefore, the pricing strategy is largely effective in a breakthrough product
where the firm is the first to enter the marketplace. In such a strategy, the goal is to
generate the maximum profit in the shortest time possible rather than maximum sales.
It allows a firm to quickly recover its sunk costs before increased competition and pricing
pressure.
Consider the diffusion of innovation, a theory that explains the rate at which a
product spreads throughout a social system. Innovators are those who want to be the
first to get a new product or service. They are risk takers and price insensitive. A price
skimming strategy tries to get the highest possible profit from innovators and early
adopters.

5.12 Penetration Pricing

Penetration pricing is a pricing strategy that is used to quickly gain market share
by setting an initially low price to attract customers to purchase from the company.
Such pricing strategy is generally used by new entrants into a market. An extreme form
of penetration pricing is called predatory pricing.

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 It is common for a new entrant to use a penetration pricing strategy to compete
effectively in the marketplace. Price is one of the easiest ways to differentiate new entrants
among existing market players.

The overarching goal of the pricing strategy is to:

1. Capture market share

2. Create brand loyalty
3. Switch customers from competitors
4. Generate significant demand and utilize economies of scale
5. Drive competitors out of the market

Situations where penetration pricing works effectively:

1. When there is little product differentiation

2. Demand is price-elastic
3. Where the product is suitable for a mass market (utilizing economies of scale)

5.13 Loss Leader Pricing

Loss leaders are high volume, high profile brands or products that are sold by
retailers with the intention to attract customers into their premises, with the hope that
those customers will end up buying other goods as well, once inside. Examples could be
steeply discounted electronics, or consumer goods, or garments. A zero percent loan for
cars is a loss leader example for the dealer.

Loss leader brands or products are sold at very slim margins or at a loss, with the
conscious understanding that other products in the retail outlet will make up for the
loss. A mix of loss leader pricing and usual pricing could make up the overall margins.

Loss leader pricing is a marketing strategy that involves selecting one or more retail
products to be sold below cost - at a loss to the retailer - in order to get customers in the door.
The loss leaders are the products being sold at such low prices as a temptation to buyers to
step foot in the store. Pricing a product at a loss can still be profitable if the customer can be
persuaded to purchase other items at full price during the same shopping trip.

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5.14 Mark-Up Pricing
The Mark-up pricing is the method of adding a certain percentage of a markup to
the cost of the product to determine the selling price. In order to apply the mark-up
pricing, firstly, the companies must determine the cost of a product and decide on the
amount of profit to be earned over and above it and then add that much markup in the
cost. Let's understand the mark-up pricing through an example. Suppose, there is X
commodity manufacturer who has the following cost and sales expectations:

Variable cost per unit : Rs. 30

Fixed Cost : Rs. 5,00,000

Expected Unit Sales : 50,000
The manufacturer's unit cost is given by :
Unit Cost = Variable cost + Fixed cost/unit sales
Thus, Unit cost = 30 + 500000/50000 = Rs 40
Once the cost is determined, the manufacturer decided to add a 20% markup on sales.
The mark-up price is given by:
Mark-up price = unit Cost/1-desired return on sales
Thus, mark-up price = 40/ 1-0.2 = 50
Hence, the manufacturer must charge Rs 50 to earn a profit of Rs 10.
The benefit of using the mark-up pricing is that it is very simple to calculate and
understand. Also the same type of pricing used by all the firms in the industry, the price
tends to be similar and hence, the price competition reduces in the market.

5.15 Administered Price

The price of a commodity which is dictated by an independent agency and not
arrived at through negotiations between buyers and sellers is called administered price.
In most of the cases, the independent agency is the government but it may also be the
management of a firm who enjoys a considerable market share or monopoly in the market.
Thus, administered price is not a function of the market forces of supply and demand.

In Economics terms, administered prices are generally above or below the

equilibrium prices and therefore are undesirable. These prices are also called Price ceiling
or price floor often set by the government. Price Ceiling is the highest price that can be
charged for a product. Price floor is the lowest price that can be charged for a product.
The main motto behind setting these prices is to stabilize the market in times of excess
demand over supply or vice-versa.

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 Reference Books
1. Principles of Microeconomics: Steven A Greenlaw,
David Shapiro - 2017
2. Micro Economics: A Very Short Introduction: Avinash Dixit
3. Micro Economics: Theory And Applications: D.N. Dwivedi
4. Micro Economics: A Modern Approach: Andrew Schotter
5. Principles of Microeconomics: PeterElse, Peter Curwen
6. Principles of Microeconomics: N Mankiw
7. Micro Economics: Paul Krugman, Robin Wells
8. Micro Economics made Simple: Basic Micro Economics
Principles: Austin Frakt, Mike Piper
9. Micro Economics Principles: D.D Tqwari
10. Micro Economics: William Boyes, Michael Malvin
11. Advanced Economic Theory: H.L Hahuja
12. Principles of Microeconomics: H.L Hahuja
13. Modern Micro Economics: H.L Hahuja
14. Modern Microeconomics: A. Koutsoyiannis
15. Microeconomics: Jhingan M.L.
16. www.economicsdiscussin.net
17. www.economics-ejournel.org

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