MANAGERIAL ECONOMICS

Unit-1 Significance and Scope of Managerial Economics: Role of Managers in Business, Economic
paradigms applicable to business analysis.
Unit-2 Market Demand: Determinants of Demand and Supply, Elasticity of Demand, Indifference
Curve Analysis, Consumer’s Equilibrium, Price, Income and Substitution Effects, Demand Forecasting.
Unit-3 Production Function: Production decision making, Short Run Long Run Production Functions.
Unit-4 Market Analysis: Cost Structure, Various Cost Concepts, Cost Estimation, Pricing and Output
decisions in Perfect Competition, Monopoly, Monopolistic Competition, Oligopoly.
Unit-5 Profit Analysis: Theories of Profit, Break Even Analysis, Managerial Decisions, Business Cycle.

Economics=Household mgt= Micro Economics

Applied microeconomics = Managerial economics
Basic problems of economy/nation
Scarcity (of supply) – resource constraint – subject to this if you yield that is managerial skill.
Aims at optimizing the goal of the organization i.e, maximizing the profit / minimizing the cost
We study managerial economics in order to know and apply them in managerial decision making.

Managerial economics is a discipline which deals with the application of economic theory to business
management. It deals with the use of economic concepts and principles of business decision making. Formerly it
was known as “Business Economics” but the term has now been discarded in favour of Managerial Economics.
Managerial Economics may be defined as the study of economic theories, logic and methodology which are
generally applied to seek solution to the practical problems of business. Managerial Economics is thus constituted
of that part of economic knowledge or economic theories which is used as a tool of analysing business problems
for rational business decisions. Managerial Economics is often called as Economics for Firms.
Definition: “Managerial economics is concerned with application of economic concepts and economic analysis to
the problems of formulating rational managerial decision.” – Mansfield
Nature of Managerial Economics:
 The primary function of management executive in a business organization is decision making and forward
planning. Decision making and forward planning go hand in hand with each other.
 The problem of choice arises because resources at the disposal of a business unit (land, labour, capital, and
managerial capacity) are limited and the firm has to make the most profitable use of these resources.
 The decision making function is that of the business executive, he takes the decision which will ensure the
most efficient means of attaining a desired objective, say profit maximisation. After taking the decision about
the particular output, pricing, capital, raw-materials and power etc., are prepared. Forward planning and
decision-making thus go on at the same time.
 A business manager’s task is made difficult by the uncertainty which surrounds business decision-making.
Nobody can predict the future course of business conditions. He prepares the best possible plans for the
future depending on past experience and future outlook and yet he has to go on revising his plans in the light
of new experience to minimise the failure.
 In fulfilling the function of decision-making in an uncertainty framework, economic theory can be, pressed into
service with considerable advantage as it deals with a number of concepts and principles which can be used to
solve or at least throw some light upon the problems of business management. Ex- profit, demand, cost,
pricing, production, competition, business cycles, national income etc. The way economic analysis can be used
towards solving business problems, constitutes the subject-matter of Managerial Economics.
 Thus in brief we can say that Managerial Economics is both a science and an art.
 Scope of Managerial Economics:
The scope of managerial economics is not yet clearly laid out because it is a developing science. Even then the
following fields may be said to generally fall under Managerial Economics:
    1.  Demand Analysis and Forecasting
    2.  Cost and Production Analysis
    3.  Pricing Decisions, Policies and Practices
    4.  Profit Management
    5.  Capital Management
   1. Demand Analysis and Forecasting: A business firm is an economic organisation which is engaged in transforming
productive resources into goods that are to be sold in the market. A major part of managerial decision making
depends on accurate estimates of demand. A forecast of future sales serves as a guide to management for
preparing production schedules and employing resources. It will help management to maintain or strengthen its
market position and profit base. Demand analysis also identifies a number of other factors influencing the demand
for a product. Demand analysis and forecasting occupies a strategic place in Managerial Economics.
  2. Cost and production analysis: A firm’s profitability depends much on its cost of production. A wise manager would
prepare cost estimates of a range of output, identify the factors causing are cause variations in cost estimates and
choose the cost-minimising output level, taking also into consideration the degree of   uncertainty in production
and cost calculations. Production processes are under the charge of engineers but the business manager is
supposed to carry out the production function analysis in order to avoid wastages of materials and time. Sound
pricing practices depend much on cost control. The main topics discussed under cost and production analysis are:
Cost concepts, cost-output relationships, Economics and Diseconomies of scale and cost control.
  3. Pricing decisions, policies and practices: Pricing is a very important area of Managerial Economics. In fact, price is
the genesis of the revenue of a firm ad as such the success of a business firm largely depends on the correctness of
the price decisions taken by it. The important aspects dealt with this area are: Price determination in various
market forms, pricing methods, differential pricing, product-line pricing and price forecasting.
    4. Profit management: Business firms are generally organized for earning profit and in the long period, it is profit
which provides the chief measure of success of a firm. Economics tells us that profits are the reward for
uncertainty bearing and risk taking. A successful business manager is one who can form more or less correct
estimates of costs and revenues likely to accrue to the firm at different levels of output. The more successful a
manager is in reducing uncertainty, the higher are the profits earned by him. In fact, profit-planning and profit
measurement constitute the most challenging area of Managerial Economics.
   5. Capital management: The problems relating to firm’s capital investments are perhaps the most complex and
troublesome. Capital management implies planning and control of capital expenditure because it involves a large
sum and moreover the problems in disposing the capital assets off are so complex that they require considerable
time and labour. The main topics dealt with under capital management are cost of capital, rate of return and
selection of projects.
Conclusion: The various aspects outlined above represent the major uncertainties which a business firm has to
reckon with, viz., demand uncertainty, cost uncertainty, price uncertainty, profit uncertainty, and capital
uncertainty. We can, therefore, conclude that the subject-matter of Managerial Economics consists of applying
economic principles and concepts towards adjusting with various uncertainties faced by a business firm.

Role of Manager
The modern manager needs to get work done through engaged, self-managing knowledge workers, who are a far
cry from the “hired hands” of the industrial age. The role of today’s manager can be illustrated by four analogies.
Today’s managers need to behave something like:
1. investors
2. customers
3. sports coaches

4. partners
Analogies are approximations; otherwise they would be identical to their comparison objects and not analogies at
all. Thus, managers share some attributes with investors, customers, sports coaches and partners without being
identical to any of them.
1. Managers as investors: Managers allocate resources to obtain the best return, like investors. Their
effectiveness is based on how well they use their resources. But managers differ from investors in two
respects. First, knowledge workers want a say in what work they do, so any allocation needs to be negotiated,
not decided unilaterally, as an investor would do with his or her money. Second, managers actively develop
people, so they are not as arms-length from the people they manage as are investors.
2. Managers as customers: As employees become more engaged their status changes, from simply being hired
hands to being more like self-employed business people supplying services to internal customers. In this
relationship, employees can be more proactive and able to identify the needs of managers. Indeed, astute
employees might see needs that managers overlook. This interaction involves two-way communication and
negotiation, not one-way, top-down directing. Also, enterprising employees might devise new services to
“sell” to their managers as a way of advancing their careers (building their business).For example, whenever
employees contribute ideas for process improvements to their bosses, they can be framed, condescendingly,
as suggestion-box material or, more appropriately, as attempts by employees to sell their services to
management. Employees who suggest a better way of managing some part of the business and offer to do it
themselves can, in steps, transform their roles into something new. By thinking of themselves as operators of
a business, and serving their bosses as customers, employees become more empowered to manage their own
careers. When high-demand knowledge workers are in short supply, they have more power than their
customer (the boss). Such employees can easily move to new customers and, being knowledgeable, they
might offer more advice to their boss (customer) rather than the other way around. So much for the belief
that power resides only at the top and all direction flows top-down.

3. Managers as sports coaches: Professional golfers have coaches and managers. The latter help them with their
business matters, sponsorships and travel arrangements. However, this manager cannot fire the golfer; it is
the other way around. A sports manager is a facilitator, coordinator and advisor, with no power to direct or
control the golfer. Modern business managers are moving in this direction, although they will always be able
to fire the employees they manage. Still, when managing rare, expensive talent, they cannot fire them without
carefully weighing the consequences. In any case, modern managers do more coaching and less directing, so
they need to behave more like coaches than industrial-age managers.

4. Managers as partners: As the power of knowledge workers grows, they become more like partners than
“hired hands.” Toyota and other smart companies forge partnerships with external suppliers. Employees are,
similarly, internal suppliers and partners. Still, suppliers and employees can be fired, unlike real partners, who
must agree on an appropriate severance.

Facilitating versus Directing

In the industrial age, managers directed and controlled the work of “hired hands.” In our post-industrial era,
managers operate more like facilitators. Instead of allocating resources like passive, hands-off investors – that is,
without much thinking — they bring the right people together, engage them in planning the work and coordinate
the execution. Like customers, they monitor the progress of projects, but they may listen more often than provide
one-way direction. In this context, the act of controlling morphs into coaching, facilitating, nurturing and
developing.
The conventional managerial functions of planning, organizing, directing and controlling become a shared activity
or ones that are completely delegated, depending on the context. Management adapts to meet current needs
rather than hangs on to obsolete industrial-age preconceptions.
The new business paradigms
Paradigm 1: Well-connected customer
Customers are the main focus of any successful business - including, today, public services as well as commercial
enterprises. If customers like us and our products and prices they come back for more - and tell some friends. If
they have a problem they may or may not come back (dependent on their range of choices) but they tell many
more people about bad service than they tell about good. New Business Paradigm #1 is the "well-connected
customer". As customers start to use the Internet they multiply their ability to find out about and compare
competitive products and services and they multiply their ability to "tell the world" about bad service, unreliably
products or rip-off pricing. They also develop the ability to "network" with other customers to tell each other what
they think about us and our products and - if we really upset them - to gang up to demand better treatment. The
Internet enables customers to communicate more easily and cheaply with consumer organisations, their member
of parliament, trading standards offices.
Response to the well-connected customer
There are two obvious responses to the well-connected customer:
 Better products and better services at lower costs - the general response to competitive and market
pressures, and
 Excellent two-way communication with customers
Paradigm 2: Workforce unchained
Most of our current labour market laws, regulations and employment practices are based on the circumstances,
ideas and needs of the industrial era, when most workers were "production line" workers. Workers were (at least
metaphorically) chained to their machine or their desk. They came and went at fixed hours decided by
management, undertook a relatively fixed set of tasks decided by management, and sought permission of their
supervisor before doing anything that broke the routine. A high proportion of workers stayed in the same
occupation or trade for their working life, many staying with the same company.
Today's and tomorrow's workers are relatively unchained. This is seen in two ways - the general structure of
companies, with fewer "production" workers and more people engaged in design, development, planning,
marketing, selling and customer relations; and general trend for less supervision and more self-reliance or team
working, even in production tasks. Workers in the newer occupations move readily from employer to employer
and from sector to sector. Like customers, they have greatly increased communication capabilities - they can
network with each other electronically across the company and with contacts in other companies. They are
expected to think and respond to circumstances and opportunities rather than slavishly follow a pattern. An
increasing proportion is self-employed or has more than one employer.
Response to the unchained workforce
The whole idea of flexible working is at least partly a response to the idea of an unchained workforce. If workers
have to be motivated rather than supervised, why should they not decide for themselves where and when to work
as well as what to do on a day to day, hour to hour basis? This approach may be disliked and rejected by some
managers and by some workers. It needs two-way trust - trust by the manager that an employee who is not
physically present really is getting the job done; trust by the employee that being out of sight will not mean being
left out of career opportunities, important gossip, or social connection with colleagues. It also needs all the people
in the enterprise to understand and support the enterprise's business goals and to connect their own success to
the success of the business - fully flexible working cannot coexist with old-style "them and us" styles of
management or industrial relations. When these basics are achieved, self-motivated, self-managing people deliver
better results for the business as well as being better able to manage the relationship between work and other
aspects of life.
Open communications within the enterprise is an important element of trust-building, as well as being important
in ensuring that everyone shares a common understanding of the enterprise's goals and priorities. New network
technologies play an essential part in open and effective communications, especially in the context of managers
and staff who no longer occupy the same physical space from 9 to 5.
Paradigm 3: Asset less enterprises
From an economic standpoint the most interesting new paradigm of the new networked economy is that of new
business enterprises being developed without any of the assets we have traditionally associated with industry. The
new business may own no buildings (the people work at home), no inventory (websites and all the means of
communication are paid for on an as-used basis) and no physical plant (the newest enterprises focus on knowledge
and information not physical goods or services). Such a business can be started from a very low capital base since
its only initial assets are the energy and knowhow of the person or team starting the business. This doesn't mean
that business generally becomes asset-free; we do still and will continue to buy and use a very wide range of
physical goods and services. However, the example of the new asset-free enterprises does point the direction for
all organizations: an increasing dependence on the skills, experience, knowhow and motivation of people, coupled
with a relatively reduced significance of tangible assets. Increasingly, we see a trend for the more tangible aspects
of enterprises to be outsourced - buildings are leased or rented rather than owned; logistics of warehousing and
distribution are contracted out to specialist companies; ownership, maintenance and management of information
systems and networks are contracted to other specialists.
Response to the shift from tangible assets to know-how assets
There are three main responses:
 Better valuation and management of people - emphasized by the semantic change from "personnel
management" to "human resources management"; this is tied in with the idea of the unchained
workforce;
 Techniques to convert at least some of the skills, experience, knowhow of today's people into assets that
can be owned and re-used; this is the basis for today's very high interest in concepts of knowledge
management, and
 Innovation watch - a routinely operated market scanning activity that provides early detection of real or
potential new forms of competition
Networking technologies and systems are the basis of knowledge management. Only when an enterprise and all its
knowledge workers are effectively networked can we hope to start the process of knowledge sharing and
knowledge accumulation. Networking methods are also at the heart of effective, low cost innovation watch, the
results of which are, of course, added to the corporate knowledge base!
Paradigm 4: Reversing values
The idea of reversing values is one of the least recognized and least understood of the new business paradigms.
Value reversal occurs when a value chain changes direction. Put most simply, the "supplier" pays for the
"customer", rather than the customer paying the supplier. Actually it is not so very new: value reversal has been a
commonplace of newspapers and the broadcast media for many years. The new aspects are its much wider
application, linked with the development of a networked economy, and the way that it can occur rather suddenly,
changing market conditions and expectations in a sector. The shift in the newspaper industry occurred slowly and
almost imperceptibly. Initially, the whole costs of a newspaper were reflected in its cover price, paid by the reader.
Then advertising started to cover some of the costs. Today, there are many magazines and newspapers delivered
free of charge to the reader and funded entirely by advertising. But it took a hundred years from the general
acceptance of advertising to the wide availability of free-to-the-reader journals. Today a dominant majority of
websites - networked economy equivalents of newspapers - are either entirely free to the user or carry a high
proportion of free content so as to attract users. "Free" internet services. Many software suppliers offer some of
their range free of charge - including almost all suppliers of web browsers. New technologies will enable almost
every product or service to be networked. At no cost or effort the customer can disclose deep information about
behaviors and preferences - the lifeblood of marketing, new product development and social planning.
Response to value reversal
What is happening is a shift in our understanding of values. Instead of customers providing money, they are
providing their time and attention or information about themselves and their activities. The new value generated is
almost always intangible. The balance of values shifts from tangible in favour of intangible. The new network
technologies enable this shift to be applied in new ways that can have a sharp impact on markets. Traditionally a
particular product or service has a market price that stays within a narrow range of values - the market has had
low-price suppliers and premium-price suppliers but the difference has usually been marginal. Today we see much
wider gaps opening up - the low-price level becomes zero or near-zero or "dressed up as zero", while the premium
price may well remain where it was. Value reversal has a potential impact in every sector of business and of public
services. All businesses should be at least aware of the possibilities so that innovation - when it arises - will not be a
total shock. Entrepreneurial managers and businesses should think through their own chain of values - from
production to consumption - and consider how the informational values created or unlocked by networked
connections between customers, products and makers can be used to innovate in their own market.
Paradigm 5: Infinite variety
Proliferation of choice is the fifth of our new business paradigms. As individuals and as organisations the most
significant effect of new networking technologies is to broaden our range of choices - what to do, how to do it, and
where. Each of these choices has a two-way effect. As an employee I can choose whether to work at home or to
travel to an office; but the same technologies give my employer the choice of whether to recruit local people who
can and will wish to come to the office or more distant people - in another town, another country or another
continent. Similar new choices apply in almost all aspects of business. As a publisher, I can "stick with books" in the
belief that the traditional book has survived the advent of movies, radio, TV and that there will still be a market for
books whatever happens in the networked economy. Or I can branch out into multimedia, or online publishing.
Response to infinite variety
History - and today's businesses - abound with examples of people and organisations resisting change or
apprehensive about the potential effects of change. But the history of technological and marketing innovation
shows that innovation is almost always accompanied and followed by growth, and that most innovations expand
the range of choices rather than displacing existing methods. We still use pencils and paper, a century after the
introduction of the typewriter and half a century into the information technology era. But innovation does favour
the innovator and does put new pressure on the business that watches innovation rather than welcoming and
embracing it. The key response to proliferating innovation and apparently infinite variety is to:
 expect it, rather than being surprised;
 watch for innovation in and related to your own markets (see Paradigm 3 above), and
 unless you are a "leading edge technology" company with deep pockets, or a young and very flexible
business, seek to innovate in marketing and management, using the new technologies in your business
process, rather than innovating in products.
Becoming an effectively networked enterprise is one of the keys to innovation in management and marketing. The
networked enterprise is more aware of change, responds faster to change and to new ideas, and is more resilient
to shocks.

Demand is the amount of goods that consumers or buyers are willing and capable to buy at a specific price
in a specific time period while everything else remains the same. Demand is an economic principle that describes
the willingness and desire of consumers to purchase specific goods or services at a specific ceteris.
Meaning of Demand:
We know that people have numerous wants which vary in intensity and quality. Just desiring or wanting things is
not enough to create a demand. Suppose a mill worker desires or wants to have a car but he does not have the
necessary means to buy it. His desire is ineffective and will not become a demand. Likewise a miser desires to have
a car.
He has the means to purchase it but is not willing to part with it. His desire also would not constitute demand.
Thus, we define ‘demand for a commodity or service’ as an effective desire i.e., a desire backed by means well as
willingness to pay for it.
A consumer’s desire can become ‘effective desire’ or ‘demand’ only when the following conditions are fulfilled:
(1) Desire to possess a commodity;
(2) Means (i.e., money) to purchase it; and
(3) Willingness to part with the means for purchasing it.
It must be remembered that ‘demand’ in economics is always at a price. Any change in price will normally bring
about a change in the quantity demanded. In addition to price, demand is also used in reference to a particular
period of time. For example, demand for umbrellas will not be as high in winter during rains. The demand for any
commodity or service, therefore, must be stated with reference to the price and the relevant point of time.
What is demand in economics?
People demand goods and services in an economy to satisfy their wants. All goods and services have wants
satisfying capacity which is known as “UTILITY” in economics. Utility is highly subjective concept; it is different from
person to person. Utility (level of satisfaction) is measured by means of introspection. By demand for goods and
services economists essentially mean is willingness as well as ability of the consumer in procuring and consuming
the goods and services. Thus, demand for a commodity or service is dependent upon (a) its utility to satisfy want or
desire (b) capability of the prospective consumer to pay for the good or service. In nutshell therefore we can state
that -
When desire is backed by willingness and ability to pay for a good ot service then it becomes Demand for the
good or service
Demand is one of the most important decisions making variables in present globalised, liberlised and privatized
economy. Under such type of an economy consumers and producers have wide choice. There is full freedom to
both that is buyers and sellers in the market. Therefore Demand reflects the size and pattern of the market. The
future of a producer is depends upon the well analyzed consumer’s demand. Even the firm does not want to make
profit as such but want to devote for ‘customer services’ or ‘social responsibilities’. That is also not possible
without evaluating the consumer’s tastes, preferences, choice etc. All these things are directly built into the
economic concept of demand.
The survival and the growth of any business enterprise depends upon the proper analysis of demand for its
product in the market. Demand analysis has profound significance to management for day today functioning and
expansion of the business. Thus the short term and long term decisions of the management are depend upon the
trends in demand for the product. Any rise or fall in demand for the product has to be to find out reasons and
revised production plans, technology or change in advertisement, packaging, quality etc.
The market system works in an orderly manner because it is governed by certain Fundamental Laws of Market
known as Law of Demand and Supply The demand and supply forces determine the price of goods and services in
the market. The laws of demand and supply plays very important role in economic analysis.

Law of Demand:
Law of demand states that whenever price of a product increases then the demand for that product decreases and
vice versa provided other things remain constant. Here these other things are Income of the individual, Price of
related goods, Tastes and preferences, Population, Advertisement etc. While studying the law of demand the
direct relationship between price and demand is studied. This is because under the economic theory price of a
product is considered as the main determinant of demand in the short run period.
The Law of Demand describes the inverse relationship of price and the quantity demanded all else remaining
constant.
Substitution Effect: In substitution effect, when the price of a good or product decreases, the relative price of
that product makes the buyer more eager to buy that good or product. When the price of a good increases, the
relative price of that good makes the buyer less eager to buy that good or product. The  price of one product is
contrasted with the prices of other products, thus causing the substitution effect. Consumers usually substitute
towards the cheap or less expensive product.
Income Effect: Income can be measured in terms of the services and goods that one can purchase. If the  price
of goods and services decreases and nominal income remains constant, REAL INCOME increases. In this way, when
one can buy goods at the cheapest rate, then one’s income goes furthest and thus increases in real terms.
Change in Consumer Income: Changes in consumer income (NOMINAL INCOME) causes demand to fluctuate on
par to the change in one’s income. If income increases, demand for normal goods will increase. If income
decreases, demand for normal goods will decrease. Contrary to that, if income increases, demand for inferior
goods decreases and if the income decreases, the demand for inferior goods will increase.
Change in Related Goods Price: Price change in one good can change the demand of other related goods.
For example, if the price of one good is increased, more consumers will buy the other relative good and if the price
of the first good decreases, more consumers will buy it.
Change in Consumer Expectations : Any change in consumer expectations affects demand. If
a consumer expects his or her income to rise in the future, the existing demand will increase and if the consumer
expects his or her income to reduce in the future, the existing demand will decrease accordingly.

Demand Function
As per the law of demand, demand is function of price provided other things remain constant
Dx = f (Px) 
Dx is demand for commodity X,( which is dependent variable, )
Px is the price of X, (which is independent variable.)
 The demand function if considered as linear or straight line function can be expressed in the form of following
equation:

Dx = a + bPx
Where a and b are constants. 'a' is intercept and 'b' quantifies the relationship between Dx and Px.
The demand price relationship can be both linear and non-linear.
The relationship between demand and the price can also be expressed as follows:
∆Px → ∆Qdx
↑ Px → ↓ Qdx
↓ Px → ↑ Qdx
Here Qdx indicates the change in the quantity of demand if the price changes and as per the law of demand an
inverse or opposite relationship between price and quantity demanded of a commodity is assumed. In simple
words, if the price of a product is high then its demand will be low and vice versa. This relationship is also exhibited
in the diagrammatic representation of the demand curve. To state more clearly, if we are diagrammatically
representing demand by taking demand on the X axis and the price of the product on the Y axis then we always get
a demand curve sloping downwards from the left to right indicating the price demand relationship as expressed by
the law of demand.

Demand Schedule
A demand schedule is the a tabular presentation of the different levels of prices at corresponding levels
of quantity demanded of that commodity. It shows at different levels of prices higher or lower how the
quantity demanded is different. This shows the relation ship between price and quantity demanded of a
commodity i. e. law of demand.
Demand Schedule of Note Books
Price per Notebook (Px) Quantity of Notebooks Demanded (Dx)
25 2
20 4
15 8
10 10
8 12
Demand Curve
Demand curve is the graphical representation of the demand schedule. Demand curve is obtained by plotting a
demand schedule on a graph. As discussed earlier, demand curve slopes downward from left to right. It has a
negative slope. It shows there is inverse relationship between price and quantity demanded of a commodity.
Again, as discussed earlier, Demand curve can be both Linear or Non-linear - If the Demand Curve is Non-linear
then the eaquation of Demand is as follows:
Dx = aPx -b
If Demand Curve is Linear, then the equation of Demand curve is taken as follows:
Dx = a – bPx
The diagrammatic representation of the Demand Curve can be as follows:
Variation in Demand/Shift in Demand
Expansion and Contraction of Demand
When demand changes due to change in price of that commodity then the phenomenon is known as variation or
expansion or contraction in demand whereas when demand changes due to other factor that is known as change
in demand.
When we say the variation in demand takes place in the market for a particular product or service means this
phenomenon occurs ( that is rise or fall in demand) only because of change in its price. Here consumer remains on
the same demand curve. He shifting up or down on the same demand curve . Therefore law of demand is
concerned with the phenomenon that is VARIATION IN DEMAND which is accompanied by Rise and Fall in price, or
known as expansion and contraction in demand.
Change in Demand
When we say the change in demand takes place in the market for a particular product or service means due
change in its other factors like income, taste, preferences etc and not because of its price. Thus due to rise or fall in
income of a consumer or change in preferences, taste etc there is rise or fall in demand for a commodity or
services. Here quantity demanded of a commodity is more or less at same or higher or lower price. Here consumer
shift on higher demand curve to the right or lower demand curve to the left. This phenomenon is known as Change
in Demand which is accompanied by increase and decrease in demand.

Why does the demand curve slope downward from Left to Right?
The reasons behind the law of demand and the shape of demand curve are following.
 Income Effect When price of a commodity falls, real income (i.e. purchasing power) of a consumer
increases in terms of that commodity. So our rational will consume more of relatively cheaper. Such increase
in demand due to increase in real income is called as income effect.
 Substitution Effect When price of commodity falls, its becomes relatively cheaper compare to its other
close substitutes Rational consumer will definitely buy more units of relatively cheaper good than relatively
dearer whose price has remain same to maximize the satisfaction. On account of this factor is known as
substitution effect.
 Diminishing Marginal Utility This also responsible for the increase in demand for a commodity when its
price falls. When a person buys a commodity he exchanges his money income with the commodity in order to
maximize his satisfaction. He continues to buy goods and services so long as marginal utility of money is less
than marginal utility of commodity. (MUm<MUx )
Therefore general shape of demand curve is negatively sloping downward from left to right. It positively slopes
upward from left to right in case of inferior, Giffen or complimentary goods.

Determinants of Demand
Along with price there are many other factors which also influence the demand for a commodity. They are prices
of its close substitutes, income of consumer, wealth, size of population, fashion, taste of consumer etc.
Therefore new demand function for long run is :
Dx = f (Px, Py,_Pn, Y , W, A, F ,Zp, T, etc ) Where: Dx = Demand for a commodity
Px = Price of a commodity
Py = Price of a Y good which is close substitute for X good
Pn = Prices of n number of close substitutes
Y = Income of a consumer and Engle curves
W = Wealth of a consumer
A = Advertisement and Publicity
F = Fashion or demonstration effect
Zp = Size and composition of population of population
T = Taste and Preferences of a consumer
Exp = Expected price and utility at equilibrium
Cr = Existing short- term credit facilities
And there can be many more similar factors that may impact demand. All the above factors play very important
role in the determining demand for a commodity or service if all the above stated factors are taken as variable.
Here, it is important to understand that Law of Demand assumes partial equilibrium which means that if other
things remains constant then whenever the price of a commodity changes then the demand for that commodity
changes in the opposite direction.
If on the other hand, general equilibrium analysis is used in explaining the demand then impact of some of these
other factors can be explained as follows:
 Price of a commodity – As the price of commodity falls a commodity becomes cheaper in a market and
rational consumer will try to demand more units of the same to maximize his satisfaction and vice- versa when
price rises. Therefore rise in price fall in demand and fall in price rise in demand.
Marginal utility = change in total utility/change in demand (dTU/qd)
Purchase incr M Utility decr Price decr = so diminishing MU causes –ve slope
 Prices of Close substitute - Demand for a commodity is also depend upon the prices of its close substitutes. If
price of close substitute falls then demand for that commodity also falls and vice-versa. Therefore demand is
also depends upon the number and degree of close substitutes available in market and the range of price
change.
Qty dem incr Price (tea) incr Qty (tea) decr Price (coffee) decr Qty (coffee) incr
 Income of a consumer - Consumer’s income is the basic determinant of the quantity demanded of the
product. Generally the people with higher disposable income spend a larger amount of income than those
with the lower income. Income demand relationship is more varied nature than that between demand and its
other determinants. To explain the varied relationship between income and demand we classify goods and
services into four broad categories, viz.(a)essential consumer goods; (b) inferior goods; (c) normal goods; and
(d)prestige good or luxury goods. This is shown through Engels law of family expenditure.
Price incr Real income decr Qty dem decr

This study is known as demand analysis which serves the following objectives:
(1) It aids in forecasting sales and revenues.
(2) It provides guidance for manipulation of demand.
(3) It provides basis for analyzing market influences on different products manufactured by a business unit and
helps in adjusting and adapting such influences.
(4) It provides basis for appraising salesman’s performance and for setting his sales quote.
(5) It is also used to match the competitive strength of a business unit.
(6) It also helps in planning for inventory control, and assessing working capital requirements.
Utility is a measure of the satisfaction that we get from purchasing and consuming a good or service. Want
satisfying capacity of a commodity. Utility is an idea that people get a certain level of satisfaction / happiness /
utility from consuming goods and service.
 Total utility: The total satisfaction from a given level of consumption
 Marginal utility: The change in satisfaction from consuming an extra unit
Marginal utility refers to the additional satisfaction or benefit (utility) that a consumer derives from buying an
additional unit of a commodity or service. The concept implies that the utility or benefit to a consumer of an
additional unit of a product is inversely related to the number of units of that product he already owns. Marginal
utility is the benefit from consuming an extra unit. Marginal utility theory examines the increase in satisfaction
consumers’ gain from consuming an extra unit of a good.
Quantity (Q) Total Utility Marginal Utility
1 100 100
2 170 70
3 190 20
4 180 -10
5 140 -40
Standard economic theory believes in the idea of diminishing returns i.e. the marginal utility of extra units declines
as more is consumed
Marginal utility and willingness to pay
 Marginal utility is the change in total satisfaction from consuming an extra unit of a good or service
 Beyond a certain point, marginal utility may start to fall (diminish)
 In our example, this happens with the 4th unit where MU falls to 12
 The 8th unit carries zero marginal utility i.e. total utility stays the same
 If marginal utility is falling, then consumers will only be prepared to pay a lower price
 This helps to explain the downward sloping demand curve
Law of diminishing marginal utility (DMU) states that as we consume more and more units of a
commodity, the utility derived from each successive unit goes on decreasing.
Assumptions of Law of Diminishing Marginal Utility:
1. Cardinal measurement of utility: It is assumed that utility can be measured and a consumer can express his
satisfaction in quantitative terms such as 1, 2, 3, etc.
2. Monetary measurement of utility: It is assumed that utility is measurable in monetary terms.
3. Consumption of reasonable quantity: It is assumed that a reasonable quantity of the commodity is consumed.
For example, we should compare MU of glassfuls of water and not of spoonful’s. If a thirsty person is given water
in a spoon, then every additional spoon will yield him more utility. So, to hold the law true, suitable and proper
quantity of the commodity should be consumed.
4. Continuous consumption: It is assumed that consumption is a continuous process. For example, if one ice-cream
is consumed in the morning and another in the evening, then the second ice-cream may provide equal or higher
satisfaction as compared to the first one.
5. No change in Quality: Quality of the commodity consumed is assumed to be uniform. A second cup of ice-cream
with nuts and toppings may give more satisfaction than the first one, if the first ice-cream was without nuts or
toppings.
6. Rational consumer: The consumer is assumed to be rational who measures, calculates and compares the
utilities of different commodities and aims at maximizing total satisfaction.
7. Independent utilities: It is assumed that all the commodities consumed by a consumer are independent. It
means, MU of one commodity has no relation with MU of another commodity. Further, it is also assumed that one
person’s utility is not affected by the utility of any other person.
8. MU of money remains constant: As a consumer spends money on the commodity, he is left with lesser money
to spend on other commodities. In this process, the remaining money becomes dearer to the consumer and it
increases MU of money for the consumer. But, such an increase in MU of money is ignored. As MU of a commodity
has to be measured in monetary terms, it is assumed that MU of money remains constant.
9. Fixed Income and prices: It is assumed that income of the consumer and prices of the goods which the
consumer wishes to purchase remain constant.
The law of diminishing marginal utility can be explained by the following diagram –

Exceptions or Limitations:
The limitations or exceptions of the law of diminishing marginal utility are as follows:
1. The law does not hold well in the rare collections. For example, collection of ancient coins, stamps etc.
2. The law is not fully applicable to money. The marginal utility of money declines with richness but never falls to
zero.
3. It does not apply to the knowledge, art and innovations.
4. The law is not applicable for precious goods.
5. Historical things are also included in exceptions to the law.
6. Law does not operate if consumer behaves in irrational manner. For example, drunkard is said to enjoy each
successive peg more than the previous one.
7. Man is fond of beauty and decoration. He gets more satisfaction by getting the above merits of the
commodities.
8. If a dress comes in fashion, its utility goes up. On the other hand its utility goes down if it goes out of fashion.
9. The utility increases due to demonstration. It is a natural element.
Importance of the Law of Diminishing Marginal Utility:
The importance or the role of the law of diminishing marginal utility is as follows:
1. By purchasing more of a commodity the marginal utility decreases. Due to this behavior, the consumer cuts his
expenditures to that commodity.
2. In the field of public finance, this law has a practical application, imposing a heavier burden on the rich people.
3. This law is the base of some other economic laws such as law of demand, elasticity of demand, consumer
surplus and the law of substitution etc.
4. The value of commodity falls by increasing the supply of a commodity. It forms a basis of the theory of value.
In this way prices are determined

Demand Curve
A demand curve provides an economic agent's price to quantity relationship related to a specific good or service.
Movements along a demand curve are related to a change in price, resulting in a change in quantity; shifts is
demand (D1 to D2) are specific to changes in income, preferences, availability of substitutes and other factors.
A change in preferences could result in an increase (outward shift) or decrease (inward shift) in the quantity level
desired for a specific price; while a change in the price of a substitute, could result in an outward shift if the price
of the substitute increases and an inward shift if the substitute's price decreases. The demand curve for a good will
shift in parallel with a shift in the demand for a complement.

Limitations/Exceptions of law of demand

Inferior goods/ Giffen goods - Some special varieties of inferior goods are termed as giffen goods.  Cheaper
varieties of goods like low priced rice are examples of giffen goods, low priced bread, etc. are some examples of
giffen goods. This exception was pointed out by Robert Giffen who observed that when the price of bread
increased, the low paid British workers purchased more bread and not less of it, which is against the law of
demand. Thus, in case of giffen goods, there is direct relationship between price and quantity demanded.
Goods having prestige value
This exception is associated with the name of the economist, T.Velben and his doctrine of conspicuous conception.
A few goods like diamond, etc. can be purchased by only the rich class of the society. The prices of these goods are
so high that they are beyond the capacity of common people. The higher the price of the diamond the higher the
prestige value of it. In this case, a consumer will buy less of the diamonds at a low price because with the fall in
price, its prestige value goes down. On the other hand, when price of diamonds increases, the prestige value goes
up and therefore, the quantity demanded of it will increase.
Price expectation
When the consumer expects that the price of the commodity is going to fall in the near future, they do not buy
more even if the price is lower. On the other hand, when they expect further rise in price of the commodity, they
will buy more even if the price is higher. Both of these conditions are against the law of demand.
Fear of shortage
When people feel that a commodity is going to be scarce in the near future, they buy more of it even if there is a
current rise in price. For example: If the people feel that there will be shortage of L.P.G. gas in the near future, they
will buy more of it, even if the price is high. 
Change in income
The demand for goods and services is also affected by change in income of the consumers. If the consumers’
income increases, they will demand more goods or services even at a higher price. On the other hand, they will
demand less quantity of goods or services even at lower price if there is decrease in consumers’ income. It is
against the law of demand.
Change in fashion
The law of demand is not applicable when the goods are considered as out of fashion. If the commodity goes out
of fashion, people do not buy more even if the price falls. For example: People do not purchase old fashioned shirts
and pants nowadays even though they become cheap. On the other hand, people buy fashionable goods though
the price is rising.
Basic necessities of life
In case of basic necessities of life such as salt, rice, medicine, etc. the law of demand is not applicable as the
demand for such necessary goods does not change with the rise or fall in price

Elasticity of Demand
In economics, the demand elasticity refers to how sensitive the demand for a good is to changes in other economic
variables. Demand elasticity is important because it helps firms model the potential  change in demand due to
changes in price of the good, the effect of changes in prices of other goods and many other important market
factors. A firm grasp of demand elasticity helps to guide firms toward more optimal competitive behavior.
Elasticities greater than one are called "elastic," elasticities less than one are "inelastic," and elasticities equal to
one are "unit elastic."
Types of Elasticity:
1. Price Elasticity (Ped) =is the responsiveness of demand to change in price
2. Income Elasticity (Ied)=means a change in demand in response to a change in the consumer’s income
3. Cross Elasticity (Ced)=means a change in the demand owing to change in the price of another commodity
4. Promotional /Adv elasticity (Adv ted)=change in the demand for a commodity owing to advertisement.
Degrees of Elasticity of Demand:
We have seen above that some commodities have very elastic demand, while others have less elastic demand. Let
us now try to understand the different degrees of elasticity of demand with the help of curves.
(a) Infinite or Perfect Elasticity of Demand:
Let as first take one extreme case of elasticity of demand, viz., when it is infinite or perfect. Elasticity of demand is
infinity when even a negligible fall in the price of the commodity leads to an infinite extension in the demand for it.
In Fig. 10.1 the horizontal straight line DD’ shows infinite elasticity of demand. Even when the price remains the
same, the demand goes on changing.

Horizontal & parallel to X-axis

Not realistic
Ped = infinite = delta Q/ delta P = 0/ deltaP= infinite

(b) Perfectly Inelastic Demand:

The other extreme limit is when demand is perfectly inelastic. It means that howsoever great the rise or fall in the
price of the commodity in question, its demand remains absolutely unchanged. In Fig. 10.2, the vertical line DD’
shows a perfectly inelastic demand. In other words, in this case elasticity of demand is zero. No amount of change
in price induces a change in demand.

Vertical & parallel to Y-axis

Not realistic
Ped = infinite = delta Q/ delta P = delta Q / 0 = 0

In the real world, there is no commodity the demand for which may be absolutely inelastic, i.e., changes in its price
will fail to bring about any change at all in the demand for it. Some extension/contraction is bound to occur that is
why economists say that elasticity of demand is a matter of degree only. In the same manner, there are few
commodities in whose case the demand is perfectly elastic. Thus, in real life, the elasticity of demand of most
goods and services lies between the two limits given above, viz., infinity and zero. Some have highly elastic
demand while others have less elastic demand.
(c) Very Elastic Demand/ Relatively more elastic:
Demand is said to be very elastic when even a small change in the price of a commodity leads to a considerable
extension/contraction of the amount demanded of it. In Fig. 10.3, DD’ curve illustrates such a demand. As a result
of change of T in the price, the quantity demanded extends/contracts by MM’, which clearly is comparatively a
large change in demand.

Slope is flatter
Ped> 1
Small ch in price = greater Ch in demand
Ex- Luxury items

(d) Less Elastic Demand:

When even a substantial change in price brings only a small extension/contraction in demand, it is said to be less
elastic. In Fig. 10.4, DD’ shows less elastic demand. A fall of NN’ in price extends demand by MM’ only, which is

Slope is steeper
Ped<1
Biggerch in price = smallerCh in demand
Ex-

very small.
(e) Unitary elastic-

Both ends are parallel to axis

Rectangular hyperbola
unrealsitic
Ped = infinite = delta Q/ delta P = 1 / 1 = 1

Price elasticity of demand (Ped) shows the relationship between price and quantity demanded and
provides a precise calculation of the effect of a change in price on quantity demanded. Is a measure used in
economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in
its price, ceteris paribus? More precisely, it gives the percentage change in quantity demanded in response to a
one percent change in price (ceteris paribus, i.e. holding constant all the other determinants of demand, such as
income).

The following equation enables Ped to be calculated.

We can use this equation to calculate the effect of price changes on quantity demanded, and on
the revenue received by firms before and after any price change.

PED can also be:

 Less than one, which means Ped is inelastic.

 Greater than one, which is elastic.

 Zero (0), which is perfectly inelastic.

 Infinite (∞), which is perfectly elastic.

The above formula usually yields a negative value, due to the inverse nature of the relationship between price and
quantity demanded, as described by the "law of demand". [3] For example, if the price increases by 5% and quantity
demanded decreases by 5%, then the elasticity at the initial price and quantity = −5%/5% = −1. The only classes of
goods which have a PED of greater than 0 are Veblen and Giffen goods. Although the PED is negative for the vast
majority of goods and services, economists often refer to price elasticity of demand as a positive value (i.e.,
in absolute value terms).
This measure of elasticity is sometimes referred to as the own-price elasticity of demand for a good, i.e., the
elasticity of demand with respect to the good's own price, in order to distinguish it from the elasticity of demand
for that good with respect to the change in the price of some other good, i.e., a  complementary or substitute. The
latter type of elasticity measure is called a cross-price elasticity of demand.
When calculating elasticity of demands there are two possible ways.
1. Point elasticity of demand takes the elasticity of demand at a particular point on a curve (or between two
points)
2. Arc elasticity measures elasticity at the midpoint between the two selected points:
Point elasticity of demand method is used to determine change in demand within same demand curve,
basically a very small amount of change in demand is measured through point elasticity. One way to avoid the
accuracy problem described above is to minimize the difference between the starting and ending prices and
quantities. This is the approach taken in the definition of point-price elasticity, which uses differential calculus to
calculate the elasticity for an infinitesimal change in price and quantity at any given point on the demand curve.
Formula for point elasticity of demand is:
PED=
%ΔQ/Q
————-
%ΔP/P
To get more precision, you can use calculus and measure an Point elasticity
infinitesimal change in Q and Price  ( where ð = very small change)
This is the slope of the demand curve at that particular point in time.

Arc elasticity of demand

A second solution to the asymmetry problem of having a PED
dependent on which of the two given points on a demand curve is Arc elasticity
chosen as the "original" point and which as the "new" one is to
compute the percentage change in P and Q relative to the average of the two prices and the average of the two
quantities, rather than just the change relative to one point or the other. Loosely speaking, this gives an "average"
elasticity for the section of the actual demand curve—i.e., the arc of the curve—between the two points. As a
result, this measure is known as the arc elasticity, in this case with respect to the price of the good. The arc
elasticity is defined mathematically

 Formula for Arc Elasticity of demand is: Arc Ped =

Arc elasticity measures the midpoint between the two selected points: Q2-Q1 X Q2+Q1
P2-P1 P2+P1
This method for computing the price elasticity is also known as the "midpointsQ1- originalbecause
formula", demandthe average price
and average quantity are the coordinates of the midpoint of the straight lineQ2- Changethe
between demand
two given points.  This
P1- Original
formula is an application of the midpoint method. However, because this formula implicitlyprice
assumes the section of
the demand curve between those points is linear, the greater the curvatureP2-Change
of the actual demand curve is over
price
that range, the worse this approximation of its elasticity will be.
Elasticities of demand are interpreted as follows:
Value Descriptive Terms
Ed =0 Perfectly inelastic demand
-1 < Ed < 0 Inelastic or relatively inelastic demand % change in quantity demanded is less
 than the % change in price
Ed = -1 Unit elastic, unit elasticity, unitary elasticity, or % change in quantity demanded is equal to the
unitarily elastic demand % change in price
- infinite < Ed < % change in quantity demanded is greater
Elastic or relatively elastic demand
-1 than the % change in price
Ed = - infinite Perfectly elastic demand

As the two accompanying diagrams show, perfectly elastic demand is represented graphically as a horizontal line,
and perfectly inelastic demand as a vertical line. These are the only cases in which the PED and the slope of the
demand curve (∆P/∆Q) are both constant, as well as the only cases in which the PED is determined solely by the
slope of the demand curve (or more precisely, by the inverse of that slope).

Price Elasticity of Demand and Total Revenue/Income

The relationship between elasticity of demand and a firm's total revenue is an important one.
 When demand is inelastic – a rise in price leads to a rise in total revenue – a 20% rise in price might cause
demand to contract by only 5% (Ped = -0.25)
 When demand is elastic – a fall in price leads to a rise in total revenue - for example a 10% fall in price
might cause demand to expand by only 25% (Ped = +2.5)
 When demand is perfectly inelastic (i.e. Ped = zero), a given price change will result in the same revenue
change, e.g. a 5 % increase in a firm's prices results in a 5 % increase in its total revenue
The table below gives an example of the relationships between prices; quantity demanded and total
revenue. As price falls, the total revenue initially increases, in our example the maximum revenue occurs
at a price of £12 per unit when 520 units are sold giving total revenue of £6240.
Price Quantity Total Revenue Marginal Revenue
per unit Units Rs Rs
20 200 4000
18 280 5040 13
16 360 5760 9
14 440 6160 5
12 520 6240 1
10 600 6000 -3
8 680 5440 -7
6 760 4560 -11

Ped > 1 Ped < 1 Ped = 1

Price Rises TR decr TR incr TR Unchanged
Price Falls TR incr TR decr TR unchanged

where P is the good’s price in dollars and q is the quantity demanded. 

Total revenue, TR, equals price times quantity or TR=P.Q ,

P=TR/Q = AR
The Usefulness of Price Elasticity of Demand for Producers
Firms can use PED estimates to predict:
 The effect of a change in price on total revenue of sellers
 The price volatility in a market following changes in supply – this is important for commodity producers who
suffer big price and revenue shifts from one time period to another.
 The effect of a change in an indirect tax on price and quantity demanded and also whether the business is able
to pass on some or all of the tax onto the consumer.
 Information on the PED can be used by a business for price discrimination. This is where a supplier decides to
charge different prices for the same product to different segments of the market e.g. peak and off peak rail
travel or prices charged by many of our domestic and international airlines.
 Usually a business will charge a higher price to consumers whose demand for the product is price inelastic

Cross elasticity of demand or cross-price elasticity of demand measures the responsiveness of the quantity

demanded for a good to a change in the price of another good, ceteris paribus..
Substitutes:
 With substitute goods such as brands of cereal, an increase in the price of one good will lead to an
increase in demand for the rival product. The cross price elasticity for two substitutes will be positive. .
Complements:
 Complements are in joint demand
 The value of CPED for two complements is negative
 The stronger the relationship between two products, the higher is the co-efficient of cross-price
elasticity of demand
 When there is a strong complementary relationship, the cross elasticity will be highly negative. An
example might be games consoles and software games
 Unrelated products
 Unrelated products have a zero cross elasticity for example the effect of changes in taxi fares on the
market demand for cheese!
Pricing for substitutes:
 If a competitor cuts the price of a rival product, firms use estimates of CPED to predict the effect on
demand and total revenue of their own product.

Pricing for complementary goods:

 Popcorn, soft drinks and cinema tickets have a high negative value for cross elasticity– they are strong
complements. Popcorn has a high mark up i.e. pop corn costs pennies to make but sells for more than a
pound. If firms have a reliable estimate for CPed they can estimate the effect, say, of a two-for-one
cinema ticket offer on the demand for popcorn.
 The additional profit from extra popcorn sales may more than compensate for the lower cost of entry into
the cinema. For some movie theatres, the revenue from concessions stalls selling popcorn; drinks and
other refreshments can generate as much as 40 per cent of their annual turnover.
Brand and cross price elasticity
 When consumers become habitual purchasers of a product, the cross price elasticity of demand against
rival products will decrease.
 This makes demand less sensitive to price. The result is that firms may be able to charge a higher price,
increase their total revenue and achieve higher profits
 The cross-price elasticity of demand measures the responsiveness of the quantity demanded of one good
when compared with a change in the price of another good.
E  =   change in quantity demanded of good A
 change in price of good B

Assumptions-
If there are 2 goods = x & y and both are independent to each other
 If the relationship is positive then = Substitute
If the relationship is Negative then = Complementary
Characterizing Cross-Price Elasticity
Substitutes (E>0). Are goods that can be used in exchange for one another? For instance, if the price of Pepsi were
to increase, the demand for Coca Cola would increase because people generally see these two goods as substitutes
for one another.
Compliments (E<0). Are goods that people tend to consume hand in hand? For example, if the price of hamburger
meat increases, the demand for American cheese will decrease. This is because people commonly use American
cheese to make cheeseburgers.
Independent (E=0). These are goods that show no relationship. An example of independent goods is Halloween
costumes and marble flooring.

Promotional/Advertising elasticity of demand (or simply advertising elasticity, often shortened to AED)

is an elasticity measuring the effect of an increase or decrease in advertising on a market. Although traditionally
considered as being positively related, demand for the good that is subject of the advertising campaign can be
inversely related to the amount spent if the advertising is negative.
Good advertising will result in a positive shift in demand for a good. AED is used to measure the effectiveness of
this strategy in increasing demand versus its cost. Mathematically, then, AED measures the percentage change in
the quantity of a good demanded induced by a given percentage change in spending on advertising in that sector:

In other words, the percentage by which sales will increase after a 1% increase in advertising expenditure assuming
all other factors remain equal (ceteris paribus).[2]AED is usually positive.  Negative advertising may, however, result
in a negative AED.

Demand forecasting is the art and science of forecasting customer demand to drive holistic execution of such
demand by corporate supply chain and business management. Demand forecasting involves techniques including
both informal methods, such as educated guesses, and quantitative methods, such as the use of historical sales
data and statistical techniques or current data from test markets. Demand forecasting may be used in production
planning, inventory management, and at times in assessing future capacity requirements, or in making decisions
on whether to enter a new market for a product or a service on the basis of the past events and prevailing trends
in the present.
Forecasts can be broadly classified into:
(i) Passive Forecast- prediction about future is based on the assumption that the firm does not change the course
of its action
(ii) Active Forecast- prediction is done under the condition of likely future changes in the actions by the firms.

According to ‘time span’-.

1. Short term demand forecasting: In a short run forecast, seasonal patterns are of much importance. It may
cover a period of three months, six months or one year. It is one which provides information for tactical
decisions.
2. Long term demand forecasting: Long term forecasts are helpful in suitable capital planning. It is one which
provides information for major strategic decisions. It helps in saving the wastages in material, man hours,
machine time and capacity. Planning of a new unit must start with an analysis of the long term demand
potential of the products of the firm.
There are basically two types of forecast, viz.
 External or national group of forecast: deals with trends in general business. It is usually prepared by a
company’s research wing or by outside consultants. Internal forecast includes all those that are related to
the operation of a particular enterprise such as sales group, production group, and financial group.
 Internal or company group forecast: The structure of internal forecast includes forecast of annual sales,
forecast of products cost, forecast of operating profit, forecast of taxable income, forecast of cash
resources, forecast of the number of employees, etc.

Different levels forecasting -

 Macro-level forecasting,
 Industry- level forecasting,
 Firm- level forecasting and
 Product-line forecasting.
Macro-level forecasting is concerned with business conditions over the whole economy. It is measured by an
appropriate index of industrial production, national income or expenditure. Industry-level forecasting is prepared
by different trade associations.
This is based on survey of consumers’ intention and analysis of statistical trends. Firm-level forecasting is related to
an individual firm. It is most important from managerial view point. Product-line forecasting helps the firm to
decide which of the product or products should have priority in the allocation of firm’s limited resources.
Forecast may be classified into (i) general and (ii) specific. The general forecast may generally be useful to the firm.
Many firms require separate forecasts for specific products and specific areas, for this general forecast is broken
down into specific forecasts.
For different types of products -
 Nondurable consumer goods,
 Durable consumer goods,
 Capital goods, and
 New-products.
Non-Durable Consumer Goods:
These are also known as ‘single-use consumer goods’ or perishable consumer goods. These vanish after a single act
of consumption. These include goods like food, milk, medicine, fruits, etc. Demand for these goods depends upon
household disposable income, price of the commodity and the related goods and population and characteristics.
Symbolically,
Dc =f(y, s, p, pr) where
Dc = the demand for commodity с
у = the household disposable income (after dedn of tax) = purchasing power
s = population (can also be classified on the basis of sex, income, literacy and social status.)
p = price of the commodity с
pr = price of its related goods
Durable Consumer Goods:
These goods can be consumed a number of times or repeatedly used without much loss to their utility. These
include goods like car, T.V., air-conditioners, furniture etc. After their long use, consumers have a choice either
these could be consumed in future or could be disposed of.

The choice depends upon the following factors:

(i) Whether a consumer will go for the replacement of a durable good or keep on using it after necessary repairs
depends upon his social status, level of money income, taste and fashion, etc. Replacement demand tends to grow
with increase in the stock of the commodity with the consumers. The firm can estimate the average replacement
cost with the help of life expectancy table.
(ii) Most consumer durables are consumed in common by the members of a family. For instance, T.V., refrigerator,
etc. are used in common by households. Demand forecasts for goods commonly used should take into account the
number of households rather than the total size of population. While estimating the number of households, the
income of the household, the number of children and sex- composition, etc. should be taken into account.
(iii) Demand for consumer durables depends upon the availability of allied facilities. For example, the use of T.V.,
refrigerator needs regular supply of power, the use of car needs availability of fuel, etc. While forecasting demand
for consumer durables, the provision of allied services and their cost should also be taken into account.
(iv) Demand for consumer durables is very much influenced by their prices and their credit facilities. Consumer
durables are very much sensitive to price changes. A small fall in their price may bring large increase in demand.
Forecasting Demand for Capital Goods:
Capital goods are used for further production. The demand for capital good is a derived one. It will depend upon
the profitability of industries. The demand for capital goods is a case of derived demand. In the case of particular
capital goods, demand will depend on the specific markets they serve and the end uses for which they are bought.
The demand for textile machinery will, for instance, be determined by the expansion of textile industry in terms of
new units and replacement of existing machinery. Estimation of new demand as well as replacement demand is
thus necessary.
Three types of data are required in estimating the demand for capital goods:
(a) The growth prospects of the user industries must be known,
(b) The norm of consumption of the capital goods per unit of each end-use product must be known, and
(c) The velocity of their use.
Forecasting Demand for New Products:
The methods of forecasting demand for new products are in many ways different from those for established
products. Since the product is new to the consumers, an intensive study of the product and its likely impact upon
other products of the same group provides a key to an intelligent projection of demand.
Joel Dean has classified a number of possible approaches as follows:
(a) Evolutionary Approach:
It consists of projecting the demand for a new product as an outgrowth and evolution of an existing old product.
(b) Substitute Approach:
According to this approach the new product is treated as a substitute for the existing product or service.
(c) Growth Curve Approach:
It estimates the rate of growth and potential demand for the new product as the basis of some growth pattern of
an established product.
(d) Opinion-Poll Approach:
Under this approach the demand is estimated by direct enquiries from the ultimate consumers.
(e) Sales Experience Approach:
According to this method the demand for the new product is estimated by offering the new product for sale in a
sample market.
(f) Vicarious Approach:
By this method, the consumers’ reactions for a new product are found out indirectly through the specialized
dealers who are able to judge the consumers’ needs, tastes and preferences.
The various steps involved in forecasting the demand for non-durable consumer goods are the following:
(a)First identify the variables affecting the demand for the product and express them in appropriate forms, (b)
gather relevant data or approximation to relevant data to represent the variables, and (c) use methods of
statistical analysis to determine the most probable relationship between the dependent and independent
variables.

Forecasting Techniques:
Demand forecasting is a difficult exercise. Making estimates for future under the changing conditions is a
Herculean task. Consumers’ behavior is the most unpredictable one because it is motivated and influenced by a
multiplicity of forces. There is no easy method or a simple formula which enables the manager to predict the
future.
Economists and statisticians have developed several methods of demand forecasting. Each of these methods has
its relative advantages and disadvantages. Selection of the right method is essential to make demand forecasting
accurate. In demand forecasting, a judicious combination of statistical skill and rational judgement is needed.
Mathematical and statistical techniques are essential in classifying relationships and providing techniques of
analysis, but they are in no way an alternative for sound judgement. Sound judgement is a prime requisite for good
forecast.
The judgment should be based upon facts and the personal bias of the forecaster should not prevail upon the
facts. Therefore, a mid way should be followed between mathematical techniques and sound judgment or pure
guess work.

The more commonly used methods of demand forecasting are discussed below:
The various methods of demand forecasting can be summarised in the form of a chart as shown in Table 1.

Survey Methods : 
Expert’s Opinion Method: Obtaining views from a group of specialists outside the firm has the advantages of
speed and less expensive. Under the Delphi technique, panel members are asked by letters to give their
predictions. After getting replies from all the experts, they are being informed by letters about the outcomes and
particulars of the consensus. Those who dissent are requested to give reasons or else modify their forecasts.
In this method, the experts are requested to give their ‘opinion’ or ‘feel’ about the product. These experts, dealing
in the same or similar product, are able to predict the likely sales of a given product in future periods under
different conditions based on their experience. If the number of such experts is large and their experience-based
reactions are different, then an average-simple or weighted –is found to lead to unique forecasts. Sometimes this
method is also called the ‘hunch method’ but it replaces analysis by opinions and it can thus turn out to be highly
subjective in nature.
Reasoned Opinion-Delphi Technique: This is a variant of the opinion poll method. Here is an attempt to arrive at a
consensus in an uncertain area by questioning a group of experts repeatedly until the responses appear to
converge along a single line. The participants are supplied with responses to previous questions (including
seasonings from others in the group by a coordinator or a leader or operator of some sort). Such feedback may
result in an expert revising his earlier opinion. This may lead to a narrowing down of the divergent views (of the
experts) expressed earlier. The Key characteristics-Delphi method are-
 Anonymity of the participants
Usually all participants remain anonymous. Their identity is not revealed, even after the completion of the final
report. This prevents the authority, personality, or reputation of some participants from dominating others in the
process. Arguably, it also frees participants (to some extent) from their personal biases, minimizes the "bandwagon
effect" or "halo effect", allows free expression of opinions, encourages open critique, and facilitates admission of
errors when revising earlier judgments.
 Structuring of information flow
The initial contributions from the experts are collected in the form of answers to questionnaires and their
comments to these answers. The panel director controls the interactions among the participants by processing the
information and filtering out irrelevant content. This avoids the negative effects of face-to-face panel discussions
and solves the usual problems of group dynamics.
 Regular feedback
Participants comment on their own forecasts, the responses of others and on the progress of the panel as a whole.
At any moment they can revise their earlier statements. While in regular group meetings participants tend to stick
to previously stated opinions and often conform too much to the group leader; the Delphi method prevents it.
(2) Consumer’s Survey Methods: This method uses the most direct approach to demand forecasting by directly
asking the consumers about their future consumption plans. It is of three types:
 Complete Enumeration Method: Under this, the forecaster undertakes a complete survey of all
consumers whose demand he intends to forecast, Once this information is collected, the sales forecasts
are obtained by simply adding the probable demands of all consumers. The principle merit of this method
is that the forecaster does not introduce any bias or value judgment of his own. He simply records the
data and aggregates. But it is a very tedious and cumbersome process; it is not feasible where a large
number of consumers are involved. Moreover if the data are wrongly recorded, this method will be totally
useless.
 Sample Survey Method: Under this method, the forecaster selects a few consuming units out of the
relevant population and then collects data on their probable demands for the product during the forecast
period. The total demand of sample units is finally blown up to generate the total demand forecast.
Compared to the former survey, this method is less tedious and less costly, and subject to less data error;
but the choice of sample is very critical. If the sample is properly chosen, then it will yield dependable
results; otherwise there may be sampling error. The sampling error can decrease with every increase in
sample size
 End-user Method: Under this method, the sales of a product are projected through a survey of its end-
users. A product is used for final consumption or as an intermediate product in the production of other
goods in the domestic market, or it may be exported as well as imported. The demands for final
consumption and exports net of imports are estimated through some other forecasting method, and its
demand for intermediate use is estimated through a survey of its user industries
The advantages of this method are: It gives an unbiased information If all consumers indicate their demands
accurately, the forecast will be accurate. More suitable for the sales forecasts for products having a few consumers
However, the disadvantages of this method are: Contact with a large number of consumers Tedious and
cumbersome. The authenticity of the data is doubtful.
Under the sample survey method, the probable demand expressed by each selected unit is summed up to get the
total demand of the sample units for the forecast period. It is then blown up to find out the total demand in the
market. Total sample demand x ratio of the number of consuming units in the population/number of consuming
units in the sample.
Complex Statistical Methods
1. Time Series Analysis or Trend Method
Under this method, the time series data on the under forecast are used to fit a trend line or curve either
graphically or through statistical method of Least Squares. The trend line is worked out by fitting a trend equation
to time series data with the aid of an estimation method. The trend equation could take either a linear or any kind
of non-linear form. The trend method outlined above often yields a dependable forecast. The advantage in this
method is that it does not require the formal knowledge of economic theory and the market, it only needs the
time series data. The only limitation in this method is that it assumes that the past is repeated in future. Also, it is
an appropriate method for long-run forecasts, but inappropriate for short-run forecasts. Sometimes the time series
analysis may not reveal a significant trend of any kind. In that case, the moving average method or exponentially
weighted moving average method is used to smoothen the series.
2. Barometric Techniques or Lead-Lag Indicators Method
This consists in discovering a set of series of some variables which exhibit a close association in their movement
over a period or time.
For example, it shows the movement of agricultural income (AY series) and the sale of tractors (ST series). The
movement of AY is similar to that of ST, but the movement in ST takes place after a year’s time lag compared to
the movement in AY. Thus if one knows the direction of the movement in agriculture income (AY), one can predict
the direction of movement of tractors’ sale (ST) for the next year. Thus agricultural income (AY) may be used as a
barometer (a leading indicator) to help the short-term forecast for the sale of tractors.
3. Correlation and Regression
These involve the use of econometric methods to determine the nature and degree of association between/among
a set of variables. Econometrics, you may recall, is the use of economic theory, statistical analysis and
mathematical functions to determine the relationship between a dependent variable (say, sales) and one or more
independent variables (like price, income, advertisement etc.). The relationship may be expressed in the form of a
demand function, as we have seen earlier. Such relationships, based on past data can be used for forecasting. The
analysis can be carried with varying degrees of complexity. Here we shall not get into the methods of finding out
‘correlation coefficient’ or ‘regression equation’; you must have covered those statistical techniques as a part of
quantitative methods. Similarly, we shall not go into the question of economic theory. We shall concentrate simply
on the use of these econometric techniques in forecasting.

We are on the realm of multiple regressions and multiple correlations. The form of the equation may be:

DX = a + b1 A + b2PX + b3Py

You know that the regression coefficients b 1, b2, b3 and b4 are the components of relevant elasticity of demand. For
example, b1 is a component of price elasticity of demand. The reflect the direction as well as proportion of change
in demand for x as a result of a change in any of its explanatory variables. For example, b 2< 0 suggest that DX and
PX are inversely related; b4 > 0 suggest that x and y are substitutes; b 3 > 0 suggest that x is a normal commodity with
commodity with positive income-effect.
Given the estimated value of and bi, you may forecast the expected sales (D X), if you know the future values of
explanatory variables like own price (P X), related price (Py), income (B) and advertisement (A). Lastly, you may also
recall that the statistics R2 (Co-efficient of determination) gives the measure of goodness of fit. The closer it is to
unity, the better is the fit, and that way you get a more reliable forecast.
The principle advantage of this method is that it is prescriptive as well descriptive. That is, besides generating
demand forecast, it explains why the demand is what it is. In other words, this technique has got both explanatory
and predictive value. The regression method is neither mechanistic like the trend method nor subjective like the
opinion poll method. In this method of forecasting, you may use not only time-series data but also cross section
data. The only precaution you need to take is that data analysis should be based on the logic of economic theory.
4. Simultaneous Equations Method
Here is a very sophisticated method of forecasting. It is also known as the ‘complete system approach’ or
‘econometric model building’. In your earlier units, we have made reference to such econometric models.
Presently we do not intend to get into the details of this method because it is a subject by itself. Moreover, this
method is normally used in macro-level forecasting for the economy as a whole; in this course, our focus is limited
to micro elements only. Of course, you, as corporate managers, should know the basic elements in such an
approach.
The method is indeed very complicated. However, in the days of computer, when package programmes are
available, this method can be used easily to derive meaningful forecasts. The principle advantage in this method is
that the forecaster needs to estimate the future values of only the exogenous variables unlike the regression
method where he has to predict the future values of all, endogenous and exogenous variables affecting the
variable under forecast. The values of exogenous variables are easier to predict than those of the endogenous
variables. However, such econometric models have limitations, similar to that of regression method.
Criteria of a Good Forecasting Method:
There are thus, a good many ways to make a guess about future sales. They show contrast in cost, flexibility and
the adequate skills and sophistication. Therefore, there is a problem of choosing the best method for a particular
demand situation.
There are certain economic criteria of broader applicability. They are:
(i) Accuracy, (ii) Plausibility, (iii) Durability, (iv) Flexibility, (v) Availability, (vi) Economy, (vii) Simplicity and (viii)
Consistency.
(i) Accuracy:
The forecast obtained must be accurate. How is an accurate forecast possible? To obtain an accurate forecast, it is
essential to check the accuracy of past forecasts against present performance and of present forecasts against
future performance. Accuracy cannot be tested by precise measurement but buy judgment.
(ii) Plausibility:
The executive should have good understanding of the technique chosen and they should have confidence in the
techniques used. Understanding is also needed for a proper interpretation of results. Plausibility requirements can
often improve the accuracy of results.
(iii) Durability:
Unfortunately, a demand function fitted to past experience may back cost very greatly and still fall apart in a short
time as a forecaster. The durability of the forecasting power of a demand function depends partly on the
reasonableness and simplicity of functions fitted, but primarily on the stability of the understanding relationships
measured in the past. Of course, the importance of durability determines the allowable cost of the forecast.
(iv) Flexibility:
Flexibility can be viewed as an alternative to generality. A long lasting function could be set up in terms of basic
natural forces and human motives. Even though fundamental, it would nevertheless be hard to measure and thus
not very useful. A set of variables whose co-efficient could be adjusted from time to time to meet changing
conditions in more practical way to maintain intact the routine procedure of forecasting.
(v) Availability:
Immediate availability of data is a vital requirement and the search for reasonable approximations to relevance in
late data is a constant strain on the forecasters patience. The techniques employed should be able to produce
meaningful results quickly. Delay in result will adversely affect the managerial decisions.
(vi) Economy:
Cost is a primary consideration which should be weighted against the importance of the forecasts to the business
operations. A question may arise: How much money and managerial effort should be allocated to obtain a high
level of forecasting accuracy? The criterion here is the economic consideration.
(vii) Simplicity:
Statistical and econometric models are certainly useful but they are intolerably complex. To those executives who
have a fear of mathematics, these methods would appear to be Latin or Greek. The procedure should, therefore,
be simple and easy so that the management may appreciate and understand why it has been adopted by the
forecaster.
 (viii) Consistency:
The forecaster has to deal with various components which are independent. If he does not make an adjustment in
one component to bring it in line with a forecast of another, he would achieve a whole which would appear
consistent.
Conclusion:
In fine, the ideal forecasting method is one that yields returns over cost with accuracy, seems reasonable, can be
formalized for reasonably long periods, can meet new circumstances adeptly and can give up-to-date results. The
method of forecasting is not the same for all products.
There is no unique method for forecasting the sale of any commodity. The forecaster may try one or the other
method depending upon his objective, data availability, the urgency with which forecasts are needed, resources he
intends to devote to this work and type of commodity whose demand he wants to forecast.
Importance of demand forecasting-
1. Fulfilling the objectives
2. Preparing the budget
3. Stabilizing employment & production
4. Expanding organization
5. Taking management decisions
6. Evaluating performance
7. Helping government
Objectives-
Short term
1. Formulating production policy
2. Formulating price policy
3. Controlling sales
4. Arranging finance
Long Term
1. Deciding the production capacity
2. Planning long term activities
Indifference Curve Analysis
Modern economists disregarded the concept of ‘cardinal measure of utility’. They were of the opinion that utility is
a psychological phenomenon and it is next to impossible to measure the utility in absolute terms. According to
them, a consumer can rank various combinations of goods and services in order of his preference. For example, if a
consumer consumes two goods, Apples and Bananas, then he can indicate:
1. Whether he prefers apple over banana; or
2. Whether he prefers banana over apple; or
3. Whether he is indifferent between apples and bananas, i.e. both are equally preferable and both of them give
him same level of satisfaction.
This approach does not use cardinal values like 1, 2, 3, 4, etc. Rather, it makes use of ordinal numbers like 1 st, 2nd,
3rd, 4th, etc. which can be used only for ranking. It means, if the consumer likes apple more than banana, then he
will give 1st rank to apple and 2nd rank to banana. Such a method of ranking the preferences is known as ‘ordinal
utility approach’.
Before we proceed to determine the consumer’s equilibrium through this approach, let us understand some useful
concepts related to Indifference Curve Analysis.
Meaning of Indifference Curve:
When a consumer consumes various goods and services, then there are some combinations, which give him
exactly the same total satisfaction. The graphical representation of such combinations is termed as indifference
curve.
Alternately, indifference curve is a locus of points that show such combinations of two commodities which give the
consumer same satisfaction. Let us understand this with the help of following indifference schedule, which shows
all the combinations giving equal satisfaction to the consumer.
Table 2.5: Indifference Schedule
Combination of Apples Apples Bananas
 and Bananas (A) (B)
P 1 15
Q 2 10
R 3 6
S 4 3
T 5 1

As seen in the schedule, consumer is indifferent between five combinations of apple and banana. Combination ‘P’
(1A + 15B) gives the same utility as (2A + 10B), (3A + 6B) and so on. When these combinations are represented
graphically and joined together, we get an indifference curve ‘IC 1’ as shown in Fig. 2.4.
In the diagram, apples are measured along the X-axis and bananas on the Y-axis. All points (P, Q, R, S and T) on the
curve show different combinations of apples and bananas. These points are joined with the help of a smooth
curve, known as indifference curve (IC 1). An indifference curve is the locus of all the points, representing different
combinations that are equally satisfactory to the consumer.
Every point on IC1, represents an equal amount of satisfaction to the consumer. So, the consumer is said to be
indifferent between the combinations located on Indifference Curve ‘IC 1’. The combinations P, Q, R, S and T give
equal satisfaction to the consumer and therefore he is indifferent among them. These combinations are together
known as ‘Indifference Set’.
Monotonic Preferences:
Monotonic preference means that a rational consumer always prefers more of a commodity as it offers him a
higher level of satisfaction. In simple words, monotonic preferences imply that as consumption increases total
utility also increases. For instance, a consumer’s preferences are monotonic only when between any two bundles,
he prefers the bundle which has more of at least one of the goods and no less of the other good as compared to
the other bundle.
Example: Consider 2 goods:
Apples (A) and Bananas (B).
(a) Suppose two different bundles are: 1st: (10A, 10B); and 2nd: (7A, 7B).
Consumer’s preference of 1 st bundle as compared to 2 nd bundle will be called monotonic preference as 1 st bundle
contains more of both apples and bananas.
(b) If 2 bundles are: 1st: (1OA, 7B); 2nd: (9A, 7B).
Consumer’s preference of 1 st bundle as compared to 2 nd bundle will be called monotonic preference as 1 st bundle
contains more of apples, although bananas are same.
Indifference Map:
Indifference Map refers to the family of indifference curves that represent consumer preferences over all the
bundles of the two goods. An indifference curve represents all the combinations, which provide same level of
satisfaction. However, every higher or lower level of satisfaction can be shown on different indifference curves. It
means, infinite number of indifference curves can be drawn.
In Fig. 2.5, IC1 represents the lowest satisfaction,
IC2 shows satisfaction more than that of IC 1 and the highest level of
satisfaction is depicted by indifference curve IC 3. However, each
indifference curve shows the same level of satisfaction individually.
It must be noted that ‘Higher Indifference curves represent higher
levels of satisfaction’ as higher indifference curve represents larger
bundle of goods, which means more utility because of monotonic
preference.
Marginal Rate of Substitution (MRS):
MRS refers to the rate at which the commodities can be substituted with each other, so that total satisfaction of
the consumer remains the same. For example, in the example of apples (A) and bananas (B), MRS of ‘A’ for ‘B’, will
be number of units of ‘B’, that the consumer is willing to sacrifice for an additional unit of ‘A’, so as to maintain the
same level of satisfaction.
MRSAB = Units of Bananas (B) willing to Sacrifice / Units of Apples (A) willing to Gain
MRSAB = ∆B/∆A
MRSAB is the rate at which a consumer is willing to give up Bananas for one more unit of Apple.
It means, MRS measures the slope of indifference curve.
It must be noted that in mathematical terms, MRS should always be negative as numerator (units to be sacrificed)
will always have negative value. However, for analysis, absolute value of MRS is always considered.
The concept of MRSAB is explained through Table 2.6 and Fig. 2.6
Table 2.6: MRS between Apple and Banana:
Banana Apples
Combination (B) (A) MRSAB
P 15 1 –
Q 10 2 5B:1 A
R 6 3 4B:1A
S 3 4 3B:1A
T 1 5 2B:1 A

As seen in the given schedule and diagram, when

consumer moves from P to Q, he sacrifices 5 bananas for 1
apple. Thus, MRSAB comes out to be 5:1. Similarly, from Q to R, MRS AB is 4:1. In combination T, the sacrifice falls to
2 bananas for 1 apple. In other words, the MRS of apples for bananas is diminishing.
Why MRS diminishes?
MRS falls because of the law of diminishing marginal utility. In the given example of apples and bananas,
Combination ‘P’ has only 1 apple and, therefore, apple is relatively more important than bananas. Due to this, the
consumer is willing to give up more bananas for an additional apple. But as he consumes more and more of apples,
his marginal utility from apples keeps on declining. As a result, he is willing to give up less and less of bananas for
each apple.
Properties of Indifference Curve:
1. Indifference curves are always sloping downward:
It implies that as a consumer consumes more of one good, he must consume less of the other good. It happens
because if the consumer decides to have more units of one good (say apples), he will have to reduce the number
of units of another good (say bananas), so that total utility remains the same.
2.. Indifference curves are always convex to the origin:
An indifference curve is convex to the origin because of diminishing MRS. MRS declines continuously because of
the law of diminishing marginal utility. As seen in Table 2.6, when the consumer consumes more and more of
apples, his marginal utility from apples keeps on declining and he is willing to give up less and less of bananas for
each apple. Therefore, indifference curves are convex to the origin (see Fig. 2.6). It must be noted that MRS
indicates the slope of indifference curve.
3. Higher Indifference curves represent higher levels of satisfaction:
Higher indifference curve represents large bundle of goods, which means more utility because of monotonic
preference. Consider point ‘A’ on IC X and point ‘B’ on IC2 in Fig. 2.5. At ‘A’, consumer gets the combination (OR, OP)
of the two commodities X and Y. At ‘B’, consumer gets the combination (OS, OP). As OS > OR, the consumer gets
more satisfaction at IC2.
4. Indifference curves can never intersect each other:
As two indifference curves cannot represent the same level of satisfaction, they cannot intersect each other. It
means, only one indifference curve will pass through a given point on an indifference map. In Fig. 2.7, satisfaction
from point A and from B on IC1will be the same.
Similarly, points A and C on IC2 also give the same level of satisfaction. It means, points B and C should also give the
same level of satisfaction. However, this is not possible, as B and C lie on two different indifference curves, IC 1 and
IC2 respectively and represent different levels of satisfaction. Therefore, two indifference curves cannot intersect
each other.
Assumptions of Indifference Curve
The various assumptions of indifference curve are:
1. Two commodities:
It is assumed that the consumer has a fixed amount of money, whole of which is to be spent on the two goods,
given constant prices of both the goods.
2. Non Satiety:
It is assumed that the consumer has not reached the point of saturation. Consumer always prefer more of both
commodities, i.e. he always tries to move to a higher indifference curve to get higher and higher satisfaction.
3. Ordinal Utility:
Consumer can rank his preferences on the basis of the satisfaction from each bundle of goods.
4. Diminishing marginal rate of substitution:
Indifference curve analysis assumes diminishing marginal rate of substitution. Due to this assumption, an
indifference curve is convex to the origin.
5. Rational Consumer:
The consumer is assumed to behave in a rational manner, i.e. he aims to maximize his total satisfaction.

Price line / Budget line-

Locus of various points represents the combination of goods in such a
way that whatever combination you want to purchase it is on the
same price line ~ within the same income. Slope of the price line is
the ratio of the prices of the two goods. I,e. slope of PL = -Px/Py
Properties-
1. The slope is always downward sloping
2. A parallel shift in price line indicates incr./decr. in income.

Income remaining constant if the price of good incr./decr. Then

Consumer will always try to derive maximum satisfaction out of his
there will be less or more amount of purchase.
income/expenditure.
OL quantity if the price incr. & OL2 if decr. (change in real income)
1. Buying at IC1 he saves money and at IC3 he runs short of money.
2. Buying at IC2 he gets his money rightly utilized and gets max
satisfaction. ~ the price line is tangent to the IC 2 curve.
Consumers Equilibrium- 3. Pt E is the equilibrium point where the combination of the goods
and income matches to get max satisfaction.
Conditions of Equilibrium-
1. Necessary condition(1st order) – slope of IC = slope of PL
MRS x-y = Px/Py ,MUx/ MUy = Px/Py
2. Secondary (2nd order) condition - IC must be convex to origin.
MRS x-y must be diminishing.
MRS means the more of a good you purchase the importance of that
good decreases & vice versa
 When Px remains constantPy varies
Price Effect-
We get different ICs
More the Price decr. ~ Higher the IC

Price Consumption Curve (PCC)

IC1
IC3
IC2
L2 L1

Income Effect-

Substitution Effect- Real income incr due to fall in PY ~ purchase increases from OL1 to OL2.
If withdrawn the income potential to P2L2 ~ P1L2 II P2L2
original position got substituted = Pt C got substituted by Pt B due to
withdrawn of excess income.
Pt A got substituted to Pt B = satisfaction remaining same ~ same IC
Combination of goods changed but satisfaction remains same
Substitution effect of a price change indicates that after withdrawing the real
income (which was excess due to the decr in Py) the consumer will be at the
different combination point on the original IC but getting the same
PRODUCTION FUNCTION- satisfaction. In other words, despite the substitution of the combination the
satisfaction level remains same.
Q = f ( K , L ) this is a two input production function where Q=output,f=function of, K=input/capital,L=labor

Production function implies the technical transformation of input to output.

 Q = f ( K , L ) this is a Short Run Production Function (SRPF) where Q=output, K=fixed capital, L=variable labor

Q = f ( K , L ) this is a Long Run Production Function (LRPF) where Q=output, K=variable, L=variable

Technique used to study the behavior of SRPF is called Law of Variable Proportion/Diminishing Marginal Prodt.

Technique used to study the behavior of LRPF is called Returns To Scale.

Production Function
Short Run Production Function SRPF Long Run Production Function LRPF
Q = f ( K, L)
Returns To Scale
Law of variable proportion
Constant
Or
Increasing
Law of Diminishing MPL ( Marginal Product of Labor)
Decreasing
Producers Equilibrium(under Iso-quaint & Iso-cost line)
SRPF/Law of variable proportion- (mostly used in agricultural economics)

It is the study of behavior of output (Q)

Example – study of the change in total output (TP L)/ due to change in unit addition of labour input
Determine the wage policy under SRPF
Unit Labor TPL MPL APL=TPL/L
1 12 TPL incr at incr rate 12 MPL incr 12/1
2 26 Stage I 14 Then decr 26/2
Incr Return to Variable proportion
To stop here is not justified for a rational producer
Capital capacity is underutilized (MPK is –ve)
K=capital
TPL =30 means the highest output
3 29 TPL incr at decr rate 03 29/3
4 30 Stage II 01 30/4
Decr Return to Variable proportion
MPL is decr but +ve so, it is called Law of
Diminishing MPL
5 30 TPL goes – ve 00 Max – highest capacity 30/5
Stage III Disguise unemployment
6 28 At TPL 28 capital is over utilized -02 Unemployment 28/6
MPL is –ve(-2) rather using this unit of labor you
get –ve output due to 1) Wage payment 2) Wear &
tear of machinery 3) Litigation/breach of delivery
contract

Law of variable proportions examines the production function with one factor variable, keeping the quantities of
other factors fixed. In other words, it refers to the input-output relation when output is increased by varying the
quantity of one input.
When the quantity of one factor is varied, keeping the quantity of other factors con stant, the proportion between
the variable factor and the fixed factor is altered; the ratio of employment of the variable factor to that of the fixed
factor goes on increasing as the quantity of the variable factor is increased.
Since under this law we study the effects on output of variation in factor proportions, this is also known as the law
of variable proportions. Thus law of variable proportions is the new name for the famous”Law of Diminishing
Returns” of classical economics.

Assumptions of the Law:

1. First, the state of technology is assumed to be given and unchanged. If there is improvement in the technology,
then marginal and average products may rise instead of diminishing.
2. Secondly, there must be some inputs whose quantity is kept fixed. This is one of the ways by which we can alter
the factor proportions and know its effect on output. This law does not apply in case all factors are proportionately
varied. Behavior of output as a result of the variation in all inputs is discussed under “returns to scale”.
3. Thirdly the law is based upon the possibility of varying the proportions in which the various factors can be
combined to produce a product. The law does not apply to those cases where the factors must be used in fixed
proportions to yield a product.
Three Stages of the Law of Variable Proportions:
The behaviour of output when the varying quantity of one factor is combined with a fixed quantity of the other can
be divided into three distinct stages. In order to understand these three stages it is better to graphically illustrate
the production function with one factor variable.
In this figure, on the X-axis the quantity of the variable factor is measured and on the Y-axis the total product,
average product and marginal product are measured. How the total product, average product and marginal
product function when a variable factor change as a result of the increase in its quantity, that is, by increasing the
quantity of one factor to a fixed quantity of the others.

Stage 1:
Upto highest point of AP curve
F – Point of inflection- TP curve incr @ incr rate(concave upward)-MP is highest
After ‘F’ - MP declines & meets AP curve at its highest point ‘S’, TP curve incr@decr rate (concave downward) Law
of diminishing returns starts operating in stage 1 from point ‘D’
Thus, in the first stage marginal product of the fixed factor is negative.
Stage -2
Begins where MP touches AP at its highest point - ‘S’. Continues up to highest point of TP and MP touches X-axis
(at point M marginal product of the variable factor is zero) and AP still positive
Both the MP and the AP of the variable factor are diminishing but remain positive.
Stage 3:
TP curve slopes downward. MP is negative – MP curve goes below the X-axis.
In this stage the variable factor is too much relative to the fixed factor.
This stage is called the stage of negative returns, (MP is –ve)
The Stage of Operation:
In which stage a rational producer will seek to produce.
A rational producer will never choose to produce in stage 3 where MP of the variable factor is negative.
Producer can always increase his output by reducing the amount of the variable factor.
Even if the variable factor is free, the rational producer will stop at the end of the second stage.
At the end point M of the second stage where the MP=0, , TP=max, maximum use of the variable factor.
A rational producer will also not choose to produce in stage 1 where the marginal product of the fixed factor is
negative.
A producer producing in stage 1 means that he will not be making the best use of the fixed factor and further that
he will not be utilising fully the opportunities of increasing production by increasing quantity of the variable factor
whose average product continues to rise throughout the stage 1. Thus, a rational entrepreneur will not stop in
stage 1 but will expand further.
Even if the fixed factor is free (i.e., costs nothing), the rational entrepreneur will stop only at the end of stage 1
(i.e., at point N) where the average product of the variable factor is maximum. At the end point N of stage 1, the
producer they will be making maximum use of the fixed factor.
It is thus clear from above that the rational producer will never be found producing in stage 1 and stage 3. Stage 1
and 3 may, therefore, be called stages of economic absurdity or economic non-sense. The stages 1 and 3 represent
non-economic regions in production function.
A rational producer will always seek to produce in stage 2 where both the marginal product and average product
of the variable factor are diminishing. At which particular point in this stage, the producer will decide to produce
depends upon the prices of factors. The stage 2 represents the range of rational production decisions.
We have seen above how output varies as the factor proportions are altered at any given moment. We have also
noticed that this input-output relation can be divided into three stages. Now, the question arises as to what causes
increasing marginal returns to the variable factor in the beginning, diminishing marginal returns later and negative
marginal returns to the variable factor ultimately.
Causes of Initial Increasing marginal Returns to a Factor:
In the beginning, the quantity of the fixed factor is abundant relative to the quantity of the variable factor.
Therefore, when more and more units of a variable factor are added to the constant quantity of the fixed factor,
the fixed factor is more intensively and effectively utilised.
This causes the production to increase at a rapid rate. When, in the beginning the variable factor is relatively
smaller in quantity, some amount of the fixed factor may remain unutilised and therefore when the variable factor
is increased fuller utilisation of the fixed factor becomes possible with the result that increasing returns are
obtained.
The question arises as to why the fixed factor is not initially taken in an appropriate quantity which suits the
available quantity of the variable factor. Answer to this question is provided by the fact that generally those factors
are taken as fixed which are indivisible. Indivisibility of a factor means that due to technological requirements a
minimum amount of that factor must be employed whatever the level of output.
Thus, as more units of variable factor are employed to work with an indivisible fixed factor, output greatly
increases in the beginning due to fuller and more effective utilisation of the latter. Thus, we see that it is the
indivisibility of some factors which causes increasing returns to the variable factor in the beginning.
The second reason why we get increasing returns to the variable factor in the initial stage is that as more units of
the variable factor are employed the efficiency of the variable factor itself increases. This is because when there is
a sufficient quantity of the variable factor, it becomes possible to introduce specialisation or division of labour
which results in higher productivity. The greater the quantity of the variable factor, the greater the scope of
specialisation and hence the greater will be the level of its productivity or efficiency.
Causes of Diminishing marginal Returns to a Factor:
The stage of diminishing marginal returns in the production function with one factor variable is the most
important. The question arises as to why we get diminishing marginal returns after a certain amount of the
variable factor has been added to a fixed quantity of the other factor.
As explained above, increasing returns to a variable factor occur initially primarily because of the more effective
and fuller use of the fixed factor becomes possible as more units of the variable factor are employed to work with
it.
Once the point is reached at which the amount of the variable factor is sufficient to ensure the efficient utilisation
of the fixed factor, then further increases in the variable factor will cause marginal and average products of a
variable factor to decline because the fixed factor then becomes inadequate relative to the quantity of the variable
factor.
In other words, the contributions to the production made by the variable factor after a point become less and less
because the additional units of the variable factor have less and less of the fixed factor to work with. The
production is the result of the co-operation of various factors aiding each other. Now, how much aid one factor
provides to the others depends upon how much there is of it.
Eventually, the fixed factor is abundant relative to the number of the variable factor and the former provides much
aid to the later. Eventually, the fixed factor becomes more and more scarce in relation to the variable factor so
that as the units of the variable factor are increased they receive less and less aid from the fixed factor. As a result,
the marginal and average products of the variable factor decline ultimately.
The phenomenon of diminishing marginal returns, like that of increasing marginal returns, rests upon the
indivisibility of the fixed factor. As explained above, the important reason for increasing returns to a factor in the
beginning is the fact that the fixed factor is indivisible which has to be employed whether the output to be
produced is small or large.
When the indivisible fixed factor is not being fully used, successive increases in a variable factor add more to
output since fuller and more efficient use is made of the indivisible fixed factor. But there is generally a limit to the
range of employment of the variable factor over which its marginal and average products will increase.
There will usually be a level of employment of the Variable factor at which indivisible fixed factor is being as fully
and efficiently used as possible. It will happen when the variable factor has increased to such an amount that the
fixed indivisible factor is being used in the “best or optimum proportion” with the variable factor.
Once the optimum proportion is disturbed by further increases in the variable factor, returns to a variable factor
(i.e., marginal product and average product) will diminish primarily because the indivisible factor is being used too
intensively, or in other words, the fixed factor is being used in non-optimal proportion with the variable factor.
Just as the marginal product of the variable factor increases in the first stage when better and fuller use of the
fixed indivisible factor is being made, so the marginal product of the variable factor diminishes when the fixed
indivisible factor is being worked too hard.
If the fixed factor was perfectly divisible, neither the increasing nor the diminishing returns to a variable factor
would have occurred. If the factors were perfectly divisible, then there would not have been the necessity of taking
a large quantity of the fixed factor in the beginning to combine with the varying quantities of the other factor.
In the presence of perfect divisibility, the optimum proportion between the factors could have always been
achieved. Perfect divisibility of the factors implies that a small firm with a small machine and one worker would be
as efficient as a large firm with a large machine and many workers.
The productivity of the factors would be the same in the two cases. Thus, we see that if the factors were perfectly
divisible, then the question of varying factor proportions would not have arisen and hence the phenomena of
increasing and diminishing marginal returns to a variable factor would not have occurred. Prof. Bober rightly
remarks: “Let divisibility enter through the door, law of variable proportions rushes out through the window.”
Joan Robinson goes deeper into the causes of diminishing returns. She holds that the diminish ing marginal returns
occur because the factors of production are imperfect substitutes for one another. As seen above, diminishing
returns occur during the second stage since the fixed factor is now inadequate relatively to the variable factor.
Now, a factor which is scarce in supply is taken as fixed.
When there is a scarce factor, quantity of that factor cannot be increased in accordance with the varying quantities
of the other factors, which, after the optimum proportion of factors is achieved, results in diminishing returns.
If now some factors were available which perfect substitute of the scarce fixed factor was, then the paucity of the
scarce fixed factor during the second stage would have been made up by the increase in supply of its perfect
substitute with the result that output could be expanded without diminishing returns.
Thus, even if one of the variable factors which we add to the fixed factor were perfect substitute of the fixed
factor, then when, in the second stage, the fixed factor becomes relatively deficient, its deficiency would have
been made up the increase in the variable factor which is its perfect substitute.
Thus, Joan Robinson says, “What the Law of Diminishing Returns really states is that there is a limit to the extent to
which one factor of production can be substituted for another, or, in other words, that the elasticity of substitution
between factor is not infinite.
If this were not true, it would be possible, when one factor of production is fixed in amount and the rest are in
perfectly elastic supply, to produce part of the output with the aid of the fixed factor, and then, when the optimum
proportion between this and other factors was attained, to substitute some other factor for it and to increase
output at constant cost.” We, therefore, see that diminishing returns operate because the elasticity of substitution
between factors is not infinite.
Explanation of Negative Marginal Returns to a Factor:
As the amount of a variable factor continues to be increased to a fixed quantity of the other factor, a stage is
reached when the total product declines and the marginal product of the variable factor becomes negative.
This phenomenon of negative marginal returns to the variable factor in stage 3 is due to the fact that the number
of the variable factor becomes too excessive relative to the fixed factor so that they obstruct each other with the
result that the total output falls instead of rising.
Besides, too large a number of the variable factor also impairs the efficiency of the fixed factor. The proverb “too
many cooks spoil the broth” aptly applies to this situation. In such a situation, a reduction in the units of the
variable factor will increase the total output

Long Run Production Function (LRPF)-

All factors of production are variable. Q = f ( K, L)
The technique used to study the behavior of LRPF is called Returns To Scale

Returns to scale-

1. Constant RTS  % ch I = % ch Q
2. Incr RTS  % ch I < % ch in Q / % ch in Q > % ch I
3. Decr RTS  % ch I > % ch in Q / % ch in Q < % ch I

NB: No inverse relationship between input and output is possible.

Cobb–Douglas production function is a particular functional form of the production function, widely used to
represent the technological relationship between the amounts of two or more inputs, particularly physical capital
and labor, and the amount of output that can be produced by those inputs.
In its most standard form for production of a single good with two factors, the function is

where:
  Y = total production (the real value of all goods produced in a year)
 L = labor input (the total number of person-hours worked in a year)

 K = capital input (the real value of all machinery, equipment, and buildings)

 A = total factor productivity

 α and β are the output elasticities of capital and labor, respectively. These values are constants
determined by available technology.

 Constant RTS  alpha + beta = 1

 Increasing RTS  alpha + beta > 1
 Decreasing RTS  alpha + beta < 1

Producer’s Equilibrium:
Equilibrium refers to a state of rest when no change is required. A firm (producer) is said to be in equilibrium when
it has no inclination to expand or to contract its output. This state either reflects maximum profits or minimum
losses.
Choice of Optimal Factor Combination or Least Cost Combination of Factors or Producer’s Equilibrium:
A profit maximization firm faces two choices of optimal combination of factors (inputs):
1. First, to minimize its cost for a given output; and
2. Second, to maximize its output for a given cost.
Thus the least cost combination of factors refers to a firm producing the largest volume of output from a given cost
and producing a given level of output with the minimum cost when the factors are combined in an optimum
manner.
Cost-Minimization for a Given Output:
In the theory of production, the profit maximization firm is in equilibrium when, given the cost-price function, it
maximizes its profits on the basis of the least cost combination of factors. For this, it will choose that combination
which minimizes its cost of production for a given output. This will be the optimal combination for it.
Assumptions:
This analysis is based on the following assumptions:
1. There are two factors, labour and capital.
2. All units of labour and capital are homogeneous.
3. The prices of units of labour (w) and that of capital (r) are given and constant.
4. The cost outlay is given.
5. The firm produces a single product.
6. The price of the product is given and constant.
7. The firm aims at profit maximization.
8. There is perfect competition in the factor market.
Given these assumptions, the point of least-cost combination of factors for
a given level of output is where the isoquant curve is tangent to an isocost
line. In Figure 24.17, the isocost line GH is tangent to the isoquant 200 at
point M. The firm employs the combination of ОС of capital and OL of labor
to produce 200 units of output at point M with the given cost- outlay GH.
At this point, the firm is minimizing its cost for producing 200 units. Any
other combination on the isoquant 200, such as R or T, is on the higher
isocost line KP which shows higher cost of production. The isocost line EF
shows lower cost but output 200 cannot be attained with it. Therefore, the
firm will choose the minimum cost point M which is the least-cost factor
combination for producing 200 units of output. M is thus the optimal
combination for the firm.
The point of tangency between the isocost line and the isoquant is an important first order condition but not a
necessary condition for the producer’s equilibrium.
There are two essential or second order conditions for the equilibrium of the firm.
1. The first condition is that the slope of the isocost line must equal the slope of the isoquant curve.
The Slope of the isocost line is equal to the ratio of the price of labour (w) to the price of capital (r) i.e., w/r.
The slope of the isoquant curve is equal to the marginal rate of technical substitution of labour and capital
(MRTSLC) which is, in turn, equal to the ratio of the marginal product of labour to the marginal product of capital
(MPL/MPC). Thus the equilibrium condition for optimality can be written as:
2. The second condition is that at the point of tangency, the isoquant curve must he convex to the origin. In
other words, the marginal rate of technical substitution of labour for capital (MRTS LC) must be diminishing at
the point of tangency for equilibrium to be stable. In Figure 24.18, S cannot be the point of equilibrium, for the
isoquant IQ1, is concave where it is tangent to the isocost line GH. At point S, the marginal rate of technical
substitution between the two factors increases if move to the right m or left on the curve lQ 1.

Moreover, the same output level can be produced at a lower cost CD or EF and there will be a corner solution
either at C or F. If it decides to produce at EF cost, it can produce the entire output with only OF labour. If, on the
other hand, it decides to produce at a still lower cost CD, the entire output can be produced with only ОС capital.
Both the situations are impossibilities because nothing can be produced either with only labour or only capital.
Therefore, the firm can produce the same level of output at point M where the isoquant curve IQ is convex to the
origin and is tangent to the isocost line GH. The analysis assumes that both the isoquants represent equal level of
output, IQ = IQ1.

Output-Maximization for a Given Cost:

The firm also maximizes its profits by maximizing its output, given its cost outlay and the prices of the two factors.
This analysis is based on the same assumptions, as given above. The conditions for the equilibrium of the firm are
the same, as discussed above.
1. The firm is in equilibrium at point P where the isoquant curve 200 is tangent to the isocost line CL. At this point,
the firm is maximizing its output level of 200 units by employing the optimal combination of OM of capital and ON
of labour, given its cost outlay CL. But it cannot be at points E or F on the isocost line CL, since both points give a
smaller quantity of output, being on the isoquant 100, than on the isoquant 200. The firm can reach the optimal
factor combination level of maximum output by moving along the isocost line CL from either point E or F to point
P. This movement involves no extra cost because the firm remains on the same isocost line. The firm cannot attain
a higher level of output such as isoquant 300 because of the cost constraint.
Thus the equilibrium point has to be P with optimal factor combination OM + ON. At point P, the slope of the
isoquant curve 200 is equal to the slope of the isocost line CL. It implies that w/r = MPL / MPC = MRTSLC
2. The second condition is that the isoquant curve must be convex to the origin at the point of tangency with the
isocost line, as explained above in terms of Figure 24.18.
Properties of Isoquants-
1) Slopes downward
2) Convex to origin => diminishing MRTS
3) Higher Isoquant gives higher production & vice versa
4) Two Isoquants can’t intersect to each other
5) Cannot be circular

Isocost Curves:
These curves are also known as outlay lines, price lines, input-price lines, factor-cost lines, constant-outlay lines,
etc. Each isocost 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, 24.8 (A) shows three isocost curves AB, CD and EF, each represents a total outlay of 50, 75 and 100
respectively. The firm can hire ОС of capital or OD of labour with Rs. 75. ОС is 2/3 of OD which means that the
price of a unit of labour is 1½ times less than that of a unit of capital. The line CD represents the price ratio of
capital and labour.
Prices of factors remaining the same, if the total outlay is raised, the isocost 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 isocosts are straight
lines because factor prices remain the same whatever the outlay of the firm on the two factors. The isocost 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 (C) is r, then the total cost: TC = wL + rC.
The slope of the isocost line is the ratio of prices of labour and capital i.e., w/r.

The point where the isocost line is tangent to an isoquant represents 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. Salvatore defines expansion path as
“the locus of points of producer’s equilibrium resulting from changes in total outlays while keeping factor prices
constant.” It shows how the proportions of the two factors used might be changed as the firm expands.

For example, in Figure 24.8 (A) the proportions of capital and labour used to produce 200 (IQ 1) units of the product
are different from the proportions of these factors used to produce 300 (IQ 2) units or 100 (OQ) 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 isocost line to the right. If one of the factors becomes relatively dearer, the isocost 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) will
extend to the right as EG and if the price of labour rises, the isocost line EF will contract inward to the left as EH. if
the equilibrium points L, M, and N are joined by a line, it is called the price-factor curve.
Cost of Production-
 TC = FC + VC
 AC = TC/Q
 AVC = VC/Q
Opportunity cost is a cost associated with a decision that includes both the explicit and implicit costs. The unique
aspect of opportunity cost is that it also includes costs associated with making an alternate decision. The costs
associated with an alternative are called implicit costs. The accounting cost of making a decision is called the
explicit cost.

While explicit, or accounting, costs are fairly easy to calculate, implicit costs are not as easy. Measuring the cost of
the best foregone alternative can be not as easy as anticipated. By reading this Wiki right now, you are paying an
implicit cost of your next best alternative. This can and often will be different for everyone. For you, it may be that
the next best alternative instead of reading this is watching television. For someone else, it may be surfing the
internet.
IMPLICIT COST
A cost that is represented by lost opportunity in the use of a company's own resources, excluding cash. These are
intangible costs that are not easily accounted for. For example, the time and effort that an owner puts into the
maintenance of the company rather than working on expansion.
EXPLICIT COST
A business expense that is easily identified and accounted for. Explicit costs represent clear, obvious outflows from
a business that reduce its bottom-line profitability. This contrasts with less-tangible expenses such as goodwill
amortization, which are not as clear cut regarding their effects on a business's bottom-line value. Good examples
of explicit costs would be items such as wage expense, rent or lease costs, and the cost of materials that go into
the production of goods. With these expenses, it is easy to see the source of the cash outflow and the business
activities to which the expense is attributed.
 FC = fixed irrespective of level of production and subject to the capacity constraint
 MC = dTC/dQ (change in TC due to change in output)
All these are explicit cost (recorded in books of account and are visible)
 Profit = TR – TC
 Accounting Profit = TR – Explicit cost (FC,VC)
 Economic Profit = TR – TC (explicit + implicit)
 Opp cost = next best alternative forgone

Short run marginal cost(SMC) is a measurement of the cost a business firm will incur to produce a single unit
of output. The key to this concept is the fact that this cost is incurred in the short run, which assumes that certain
business inputs are fixed and only the cost of actually producing the items will change. It is important to
understand that the short run marginal cost may vary as production increases depending on the way production is
executed. This concept is important for businesses to understand when they are trying to determine whether
filling out a production order will be profitable or not. Associated with SRPF.
The Short Run: In the short run, marginal cost decreases due to increasing marginal returns and increases due to
decreasing marginal returns and the law of diminishing marginal returns. This also triggers changes in average
cost (variable and total).
Long-run marginal cost-(LMC)
The change in the long-run total cost of producing a good or service resulting from a change in the quantity of
output produced. Like all marginals, long-run marginal cost is an increment of the corresponding total. It is the
change in long-run total cost divided by, or resulting from, a change in quantity. Long-run marginal cost is guided
by returns to scale rather than marginal returns.
Long-run marginal cost is the incremental cost incurred by a firm in production when all inputs are variable. In
particular, it is the extra cost that results as a firm increases in the scale of operations by not only adding more
workers to a given factory but also by building a larger factory.
The Long Run: In the long run, there are no fixed inputs. As such, marginal returns and especially the law of
diminishing marginal returns do not operate and thus do not guide production and cost. Instead long-run
marginal cost is affected by increasing and decreasing returns to scale, which translates into economies of scale
and diseconomies of scale.
Conditions-
 AC decr MC decr
 MC min pt prior to AC min pt
 MC cuts AC at its min point
 AC incr MC incr but, incr in MC > incr in AC

Relationship between short-run and long-run costs.

Fig 7.7 shows the case where there are constant returns to scale in the
long-run.
If the firm were expected to produce Q 1 units of output, then it should
build the smallest plant where
LAC = SAC1 = SMC1 if the firm is to produce Q2 units of output, the
middle-sized plant whose LAC = SAC2 = SMC2 and so on.
With constant returns to scale, the LAC equals the minimum points of
the SAC curves.

In the long-run, the firm can change the size of the plant, so if it was initially producing Q 1, and wanted to increase
output to Q2 or Q3, it could do so without increasing cost.
The LAC curve is given the minimum point of the SAC curves because this show the minimum cost of producing any
level of output The LAC curve is the envelope of the SAC curves .
Now, suppose there are many choices of plant size, each of which has a SAC curve that has its minimum — LAC
curve is a straight line. Whatever the firm wants to produce, it can choose the plant size that allows it to produce
that output at the minimum average cost.

Fig. 7.8 illustrates the increasing and decreasing returns to

scale where the LAC curve is no longer a horizontal line and,
therefore, of the three plants, the minimum average cost is
lowest for a medium-sized plant. The LAC curve exhibits
increasing returns to scale initially, but higher output level
shows decreasing returns. We can see the envelope associated
with the three plants.

If the firm wants to produce Q1 output, as in Fig. 7.8, building a small plant is relevant (SAC 1) plant), so that the &
SAC1 is at B. A small plant is a better choice than a medium-sized plant with an AC of production SAC 2 at A. Point B
would become one point on the long-run cost function when only three plant sizes are possible.
If plants of other sizes could be built, and one size allowed the firm to produce Q 1, at less than SAC1, than B would
no longer be on the long- run cost curve.
In Fig. 7.8, the envelope that would arise if plants of any size could be built is given by the LACC, which is U-shaped.
Note that the LAC curve never lies above any of the SAC curves. Also that the minimum points of the AC of the
smallest and largest plants do not lie on the LAC curve because a large plant can take advantage of increasing
returns to scale to produce a lower average cost.
Finally, the LMC curve is not an envelope of the SMC curves. SMCs apply to a particular plant; LMC apply to all
possible plant size. Each point on the LMC curve is the SMC associated with the most efficient plant.

Decr in LAC => IRS (Incr Returns to Scale)

IRS = % ch Q > % ch I

Incr in LAC => DRS (Decr Returns to Scale)

Factors responsible for – Decr in LAC => IRS (Incr Returns to Scale)

 Due to Economies of Scale

- Internal
- external
Economies of scale are the cost advantages that enterprises obtain due to size, output, or scale of operation, with
cost per unit of output generally decreasing with increasing scale as fixed costs are spread out over more units of
output.
Internal and External Economies of Scale
When a company reduces costs and increases production, internal economies of scale have been achieved.
External economies of scale occur outside of a firm, within an industry. Thus, when an industry's scope of
operations expands due to, for example, the creation of a better transportation network, resulting in a subsequent
decrease in cost for a company working within that industry, external economies of scale are said to have been
achieved. With external ES, all firms within the industry will benefit.
But Diseconomies Can Also Occur…As we mentioned before, diseconomies may also occur. They could stem from
inefficient managerial or labor policies, over-hiring or deteriorating transportation networks (external DS).
Furthermore, as a company's scope increases, it may have to distribute its goods and services in progressively
more dispersed areas. This can actually increase average costs resulting in diseconomies of scale.

The Break-Even Chart

A firm using breakeven analysis determines the smallest output level that leads to zero economic profit.
Recall that zero economic profit doesn’t mean that the firm’s owners receive nothing — it means that
the firm’s owners are receiving a normal rate of return. In other words, the firm’s owners are receiving
exactly as much as they would in their next best alternative.
In breakeven pricing, your total revenue equals total cost — hence, zero profit. Because the focus is on
the point where you earn zero profit, it’s unlikely that breakeven analysis maximizes your profit.
However, breakeven analysis is a useful managerial tool. Managers use breakeven analysis to determine
how a price change affects profit. If you lower price, how many more units do you have to sell in order
to achieve zero profit — or to break even? If your firm has a large fixed cost, breakeven analysis enables
you to determine the quantity of output you must sell in order to avoid losses.
In either of these situations, as a manager, you can then determine whether or not sales of that amount
are feasible.
Break-even analysis depends on the following variables:
1. Selling Price per Unit: The amount of money charged to the customer for each unit of a product or
service.
2. Total Fixed Costs: The sum of all costs required to produce the first unit of a product. This amount
does not vary as production increases or decreases, until new capital expenditures are needed.
3. Variable Unit Cost: Costs that vary directly with the production of one additional unit.
 Total Variable Cost The product of expected unit sales and variable unit cost, i.e., expected unit
sales times the variable unit cost.
4. Forecasted Net Profit: Total revenue minus total cost. Enter Zero (0) if you wish to find out the
number of units that must be sold in order to produce a profit of zero (but will recover all associated
costs)
Each of these variables is interdependent on the break-even point analysis. If any of the variables
changes, the results may change.
Total Cost: The sum of the fixed cost and total variable cost for any given level of production, i.e., fixed
cost plus total variable cost.
Total Revenue: The product of forecasted unit sales and unit price, i.e., forecasted unit sales times unit
price.
The breakeven point is useful in the following situations:
 To determine the amount of remaining capacity after the breakeven point is reached, which tells
you the maximum amount of profit that can be generated.
 To determine the impact on profit if automation (a fixed cost) replaces labor (a variable cost)

 To determine the change in profits if product prices are altered

 To determine the amount of losses that could be sustained if the business suffers a sales
downturn

 It’s a simple calculation to determine how many units must be sold at a given price to cover
one’s fixed costs. You’re typically solving for the Break-Even Volume (BEV).

BEP = FC / (SP – VC) = FC / Contribution/unit

Margin of Safety = Actual sales - Sale at BEP

Your company has total fixed cost of Rs300,000, and its average variable cost (variable cost per unit of
output) is Rs 2.00. In addition, you sell the good at a price of Rs 5.00 per unit. The following steps are
used to determine the breakeven point:
1. Set total revenue equal to total cost.
Remember that total revenue equals price multiplied by the quantity sold, and total cost equals total
fixed cost plus total variable cost.
TR = TC
P X q = TFC + TVC
Profit = TR – TC
Targeted Profit = FC + Profit
SP-VC
2. Substitute AVC × q for TVC.
 Recall that total variable cost equals average variable cost multiplied by the number of units
produced q.
P X q = TFC + AVC X q

3. Subtract AVC × q from both sides of the equation in Step 2 and simplify.
P X q – AVC X q = TFC
(P – AVC ) X q = TFC

4. Divide both sides of the equation by (P – AVC).

This step enables you to solve for the breakeven quantity, q.

5. Substitute the values for TFC, P, and AVC and solve for q.

Your breakeven quantity is 100,000 units.

"the market" denotes the abstract mechanisms whereby supply and demand confront each other
and deals are made. A market is one of the many varieties of systems, institutions, procedures, social
relations and infrastructures whereby parties engage in exchange. While parties may exchange goods
and services by barter, most markets rely on sellers offering their goods or services (including labor) in
exchange for money from buyers. It can be said that a market is the process by which the prices of
goods and services are established. Markets facilitate trade and enables the distribution and allocation
of resources in a society. Markets allow any trade-able item to be evaluated and priced. A market
emerges more or less spontaneously or may be constructed deliberately by human interaction in order
to enable the exchange of rights (cf. ownership) of services and goods.
The interaction of supply and demand results in pricing the products over a free play of supply and
demand called Market mechanism.
The market and equilibrium pricing
The market combines in exchange, both buyers and sellers. For economics it combines the demand and
the supply curve to determine price. This price is called an equilibrium price, since it balances the two
forces of supply and demand. An equilibrium price is the price at which the quantity demanded is equal
to the quantity supplied. The quantity supplied and demanded is also referred to as the equilibrium
quantity/output. Figure 5, shows both demand and supply determining equilibrium price and quantity.
 
Figure 5, Demand and supply and equilibrium

A market will be named and renamed as per its characters and features prevailing.
A perfectly competitive market is a hypothetical market where competition is at its greatest possible
level.  
Perfectly competitive markets exhibit the following characteristics:

1. Existence of large number of buyers and sellers

2. Firms produce homogeneous, identical, units of output that are not branded.
3. Free entry and exit of firms

4. No Govt interference in trade

5. Perfect mobility of factor of production (labor, capital etc.)

6. There is perfect knowledge, with no information failure or time lags in the flow of information.  
Knowledge is freely available to all participants,

7. Information is cost less.

NB: No single firm can influence the market price, or market conditions. The single firm is said to be
a price taker, taking its price from the whole industry. The single firm will not increase its price
independently given that it will not sell any goods at all. Neither will the rational producer lower price
below the market price given that it can sell all it produces at the market price. The demand curve of a
firm is parallel to X-axis in perfect competition situation..

Equilibrium Condition of a Firm under short run-

At equilibrium point-
MC = MR
MC cuts MR from below => slope of MC > slope of MR
OQ = equilibrium output
OP = equilibrium price
Profit or Loss depends upon the positioning of the Avg
cost curve
TR = OQEP , TC = OQMC , TR > TC = Profit = CMEP
TC = FC + VC
AC = AFC + AVC
 Profit or Loss depends upon the positioning of the
Avg cost curve
TR = OQEN , TC = OQMP , TR < TC = Loss = PMEN
M

Economic loss
N
E

Below figure shows the firm is under loss and continues with a hope of making profit. Magnitude of loss
is such that whatever resources available it is only sufficient for managing the Avg variable cost. No
money for fixed costs. The firm has to be shut down in this condition. AR = AVC

Equilibrium Condition of a Firm under Long run- under Perfect Competition

The long run is a period of time which is sufficiently long to allow the firms to make changes in all factors of
production. In the long run, all factors are variable and none fixed. The firms, in the long run, can increase their
output by changing their capital equipment; they may expand their old plants or replace the old lower-capacity
plants by the new higher-capacity plants or add new plants.
Besides, in the long run, new firms can enter the industry to compete the existing firms. On the contrary, in the
long run, the firms can contract their output level by reducing their capital equip ment; they may allow a part of the
existing capital equipment to wear out without replacement or sell out a part of the capital equipment.
Moreover, the firms can leave the industry in the long run. The long-run equilibrium then refers to the situation
when free and full adjustment in the capital equipment as well as in the number of firms has been allowed to take
place. It is therefore long-run average and marginal cost curve which are relevant for deciding about equilibrium
output in the long run. Moreover, in the long run, it is the average total cost which is of determining importance,
since all costs are variable and none fixed.
As explained above, a firm is in equilibrium under perfect competition when marginal cost is equal to price. But for
the firm to be in long-run equilibrium, besides marginal cost being equal to price, the price must also be equal to
average cost.
For, if the price is greater or less than the average cost, there will be tendency for the firms to enter or leave the
industry. If the price is greater than the average cost, the firms will earn more than normal profits. These
supernormal profits will attract outer firms into the industry.
With the entry of new firms in the industry, the price of the product will go down as a result of the increase in
supply of output and also the cost will go up as a result of more intensive competition for factors of production.
The firms will continue entering the industry until the price is equal to average cost so that all firms are earning
only normal profits.
On the contrary, if the price is lower than the average cost, the firms would make losses. These losses will induce
some of the firms to quit the industry. As a result, the output of the industry will fall which will raise the price.
On the other hand, with some firms going out of the industry, cost may go down as a result of fall in the demand
for certain specialized factors of production. The firms will continue leaving the industry until the price is equal to
average cost so that the firms remaining in the field are making only normal profits. It, therefore, follows that for a
perfectly competitive firm to be in long-run equilibrium, the following two conditions must be fulfilled.
1) LMC = LMR = LAC = SAC = LMC 2) MC must cut MR from below

Fig. above represents long-run equilibrium of firm under perfect competition. The firm cannot be in the long-run
equilibrium at a price greater than OP in Fig. above. This is because if price is greater than OP, then the price line
(demand curve) would lie somewhere above the minimum point of the average cost curve so that marginal cost
and price will be equal where the firm is earning abnormal profits.
Since there will be tendency for new firms to enter and compete away these abnormal profits, the firm cannot be
in long-run equilibrium at any price higher than OP. Likewise, the firm cannot be in long-run equilibrium at a price
lower than OP in Fig. above under perfect competition.
If price is lower than OP, the average and marginal revenue curve will lie below the average cost curve so that the
marginal cost and price will be equal at the point where the firm is making losses. Therefore, there will be
tendency for some of the firms in the industry to go out with the result that price will rise and the firms left in the
industry make normal profits.
Monopoly –
Conditions -
1) A market where there is a single seller and large no of buyers
2) No close substitute of the monopolist product is available
3) Entry and exit to the market is restricted.
So unlike the Perfect competition condition the Firm here is not the price taker rather it becomes the ‘price
maker’.
So in this case the demand curve is sloping downward.
MR cuts X axis ½ way as to AR as regards to distance from origin.
Equilibrium Conditions-
1) MC = MR
2) MC cuts MR from below (slope of MC > slope of MR)
Monopolists have no supply curve rather the supply curve is
a point.
E = point of equilibrium
OQe = Eq Output
OPe = Eq Price
Total Revenue = O Qe M P2
At this equilibrium price whether the firm will make loss
or earn profit depends on the positioning of the AC curve.
If the AC curve is AC (below the AR curve) as seen the figure
then,
Total Cost = O Qe D P1
Total Revenue = O Qe M P2
TR > TC
Profit = D M P2 P1

If the AC curve is AC1 (above the AR curve) as seen the

figure then,
Total Cost = O Qe B P3
Total Revenue = O Qe M P2
TR < TC
Loss = P2 M B P3
Difference between – PC and Monopoly mkt firms-
1) Monopolist cannot sustain under loss condition
2) Monopolist price is always higher than PC firm
3) Output supply of a monopoly firm is always less than PC firm
4) Demand curve of a perfectly competitive firm is horizontal &
Monopoly case it is downward sloping.
5) Firm in a PC mkt is price taker but in Monopoly mkt condition is
Price maker.

Monopolistic Competition refers to a market situation in which there are large numbers of firms
which sell closely related but differentiated products. Markets of products like soap, toothpaste AC, etc. are
examples of monopolistic competition.
Realistic market structure. Happy blending of Monopoly & Perfect competition.
Monopoly + Competition = Monopolistic Competition
Features of Monopolistic Competition:
1. Large Number of Buyers and Sellers:
There are large numbers of firms selling closely related, but not homogeneous products. Each firm acts
independently and has a limited share of the market. So, an individual firm has limited control over the market
price. Large number of firms leads to competition in the market.
2. Product Differentiation:
Each firm is in a position to exercise some degree of monopoly (in spite of large number of sellers) through product
differentiation. Product differentiation refers to differentiating the products on the basis of brand, size, colour,
shape, etc. The product of a firm is close, but not perfect substitute of other firm.(Heterogeneous products but the
Degree of Differentiation is less (close substitutes products)Ex- toothpaste, soap etc
Implication of ‘Product differentiation’ is that buyers of a product differentiate between the same products
produced by different firms. Therefore, they are also willing to pay different prices for the same product produced
by different firms. This gives some monopoly power to an individual firm to influence market price of its product.
3. Flexibility of Entry and Exit:
Under monopolistic competition, firms are free to enter into or exit from the industry at any time they wish. It
ensures that there are neither abnormal profits nor any abnormal losses to a firm in the long run. However, it must
be noted that entry under monopolistic competition is not as easy and free as under perfect competition.(because
of Govt interventions)
4. Selling costs:
Under monopolistic competition, products are differentiated and these differences are made known to the buyers
through selling costs. Selling costs refer to the expenses incurred on marketing, sales promotion and adver -
tisement of the product. Such costs are incurred to persuade the buyers to buy a particular brand of the product in
preference to competitor’s brand. Due to this reason, selling costs constitute a substantial part of the total cost
under monopolistic competition. Competitive Advt. Not Informative/Promotional activities/Advt expenses.
It must be noted that there are no selling costs in perfect competition as there is perfect knowledge among buyers
and sellers. Similarly, under monopoly, selling costs are of small amount (only for informative purpose) as the firm
does not face competition from any other firm.
5. Pricing Decision: with price retaliation & without price retaliation
A firm under monopolistic competition is neither a price- taker nor a price-maker. However, by producing a unique
product or establishing a particular reputation, each firm has partial control over the price. The extent of power to
control price depends upon how strongly the buyers are attached to his brand.
In addition to price competition, non-price competition also exists under monopolistic competition. Non-Price
Competition refers to competing with other firms by offering free gifts, making favourable credit terms, etc.,
without changing prices of their own products.
Firms under monopolistic competition compete in a number of ways to attract customers. They use both Price
Competition (competing with other firms by reducing price of the product) and Non-Price Competition to promote
their sales.

Short Run Production Function under Monopolistic Market condition-

Corresponding to Equilibrium
point
Whether there is loss / profit
Depends upon the position of
the cots curve (AC)
In case of SAC
TR = OQAP
TC = OQMN
TC > TR => Loss = PAMN
In case of SAC1
TC = OQDR
TC < TR => Profit = RDAP
In case of SAC2
SAC2 is tangentially to AR curve
AC = AR => Normal Profit (in
long run Normal Profit is a must)

Long Run Production Function under Monopolistic Market condition-

In the long run, a monopolistically competitive firm adjusts plant size/plant capacity, or the quantity of capital, to
maximize long-run profit. In addition, the entry and exit of firms into and out of a monopolistically competitive
market eliminates economic profit and guarantees that each monopolistically competitive firm earns nothing more
or less than a normal profit.
Monopolistic competition is a market structure characterized by a large number of small firms producing similar
but not identical products with relatively good resource mobility and extensive knowledge. These conditions mean
that each firm has some degree of market control and faces a negatively-sloped demand curve. As such, the entry
and exit of firms into and out of the industry (amalgamation of many firms) eliminates economic profit. Moreover,
the pursuit of profit maximization by individual firms facing negatively-sloped demand curves results in economic
inefficiency.

Q1 = output at least
price, but the plant is
asked to produce OQ at
lesser price/best possible
Long-Run Adjustment
The two adjustments undertaken by a monopolistically competitive industry in the pursuit of long-run equilibrium
are:
1. Firm Adjustment: Each firm in the monopolistically competitive industry adjusts short-run production and
long-run plant size to achieve profit maximization. This adjustment entails producing the quantity that equates
marginal revenue to short run marginal cost for a given plant size as well as selecting the plant size that
equates marginal revenue to long-run marginal cost.
2. Industry Adjustment: Firms enter and exit a monopolistically competitive industry in response to economic
profit and loss. If firms in the industry earn above-normal profit or receive economic profit, then other firms
are induced to enter. If firms in the industry receive below-normal profit or incur economic loss, then existing
firms are induced to exit. The entry and exit of firms causes the market price to change, which eliminates
economic profit and loss, and leads to exactly normal profit.
NB: if some firm exits the rest is asked to produce more utilizing the excess production capacity to cater to the
need of the order.
The group equilibrium under Monopolistic competition is always under suboptimal level but on the
decreasing portion of the LAC
With marginal revenue (MR) equal to marginal cost (MC and LRMC), each firm maximizes profit and has no reason
to adjust its quantity of output or plant size. With price (P) equal to average cost (ATC and LRAC), each firm in the
industry is earning only a normal profit. Economic profit is zero and there is no economic loss.
The six specific equilibrium conditions achieved by long-run equilibrium of monopolistically
competitive industry are:
(1) Economic inefficiency (P > MC),
(2) Profit maximization (MR = MC),
(3) Market control (P = AR > MR),
(4) Breakeven output (P = AR = ATC),
(5) Excess capacity (ATC > MC), and
(6) Economies of scale (LRAC > LRMC).
These conditions are only satisfied by the tangency of the negatively-sloped demand (average revenue) curve
facing a monopolistically competitive industry and the economies of scale portion of the long-run average cost
curve. This means that a monopolistically competitive firm does not achieve long-run economic efficiency.

The Oligopoly Market:

The term oligopoly is derived from two Greek words: ‘oligi’ means few and ‘polein’ means to sell. Oligopoly refers
to a market situation in which there are a few firms (but more than two) selling homogeneous or differentiated
products. Oligopoly is, sometimes, also known as ‘competition among the few’ as there are few sellers in the
market and every seller influences and is influenced by the behavior of other firms. So, oligopoly lies in between
monopolistic competition and monopoly.
Example of Oligopoly:
In India, markets for automobiles, cement, steel, aluminum, etc, are the examples of oligopolistic market. In all
these markets, there are few firms for each particular product.

DUOPOLY is a special case of oligopoly, in which there are exactly two sellers. Under duopoly, it is assumed that
the product sold by the two firms is homogeneous and there is no substitute for it. Examples where two
companies control a large proportion of a market are: (i) Pepsi and Coca-Cola in the soft drink market; (ii) Airbus
and Boeing in the commercial large jet aircraft market; (iii) Intel and AMD in the consumer desktop computer
microprocessor market.

Types of Oligopoly:
1. Pure or Perfect Oligopoly:
If the firms produce homogeneous products, then it is called pure or perfect oligopoly. Though, it is rare to find
pure oligopoly situation, yet, cement, steel, aluminum and chemicals producing industries approach pure
oligopoly.
2. Imperfect or Differentiated Oligopoly:
If the firms produce differentiated products, then it is called differentiated or imperfect oligopoly. For example,
passenger cars, cigarettes or soft drinks. The goods produced by different firms have their own distinguishing
characteristics, yet all of them are close substitutes of each other.
3. Collusive Oligopoly:
If the firms cooperate with each other in determining price or output or both, it is called collusive oligopoly or
cooperative oligopoly.
4. Non-collusive Oligopoly:
If firms in an oligopoly market compete with each other, it is called a non-collusive or non-cooperative oligopoly.

Market structure of oligopoly -Oligopoly is a market structure where there are a few firms producing all or most of
the market supply of a particular good or service and whose decisions about the industry's output can affect
competitors. Examples of oligopolistic structures are supermarket, banking industry and pharmaceutical industry. 
Characteristics of the oligopoly are: 
  Small number of large firms dominate the industry 
 High degree of interdependence: the behavior of firms are affected by what they believe other rivalry
firms might do 
 High barriers to entry that restrict new firms to enter the industry e.g. control of technology 
 Price stability within the markets 
 Goods are highly differentiated or standardized
 Non –price competitive e.g. free deliveries and installation, extended warranties 
 Restricted information. 

Oligopolies do not compete on prices. Price wars tend to lead to lower profits, leaving a little change to market
shares. However, Oligopolies firms tend to charge reasonably premium prices but they compete through
advertising and other promotional means. Existing companies are safe from new companies entering the market
because barriers to entry to the market are high. For example, if products are heavily promoted and producers
have a number of existing successful brands, it will be very costly and difficult for new firms to establish their own
new brand in an oligopoly market.

Because there are few firms in an oligopoly industry, each firms output is a large share of the market. As a result,
each firm's pricing and output decisions have a substantial effect on the profitability of other firms. In addition,
when making decisions relating to price or output, each firm has to take into consideration the likely reaction of
rival firms. Because of this interdependence, oligopoly firms engage in strategic behavior. Strategic behavior means
when the best outcome of a firm is determined by the actions of other firms. 

Oligopolists are drawn in two different directions, either to compete with each other or to collude with each other.
If they collude, they end up acting as monopoly and thereby maximizing the industry's profits. However they are
often tempted to compete with each other in order to gain a bigger share of the profit of the industry. 

There are two ways in which firms collude in oligopoly. These are: 

Collusive oligopoly: This is an explicit or implicit agreement between existing firms to avoid or limit competition
with one another.  Because the actions and profits of oligopolists are controlled by mutual interdependence, there
is a great temptation for firms to collude; to get together and agree to act jointly in pricing and other matters.
Firms are tempted to collude because they believe that they can increase their prices by organizing their actions.
There are two types of collusive oligopoly. 

Open (cartel)  Tacit Open (cartel) collusion Firms under oligopoly engage in collusion, when they do this, they
agree on sale, pricing, market share, advertising and other decisions. This type of collusion reduces uncertainty
they face and increase the potential for monopoly profits. When this happens the existing businesses decide to
engage in price fixing agreements or cartels. The aim of forming cartels is to maximize joint profits and allows firms
to act as if they were in a pure monopoly. 

Non-collusive oligopoly This can be defined as a situation where firms have no agreement between themselves, be
it formal, informal or tacit. Oligopolists are not able to communicate with themselves and they behave as
competitors. Game theory ( The kinked demand curve)  is a method of analyzing strategic behavior. The behavior
of a firm depends on how it thinks its competitors will react to its policies. The game theory is usually effective
where there are just two firms whose costs, products and demand are identical. 

Features of Oligopoly:
1. Few firms: (few sellers and large no of buyers)
Under oligopoly, there are few large firms. The exact number of firms is not defined. Each firm produces a
significant portion of the total output. There exists severe competition among different firms and each firm try to
manipulate both prices and volume of production to outsmart each other. For example, the market for
automobiles in India is an oligopolistic structure as there are only few producers of automobiles.
The number of the firms is so small that an action by any one firm is likely to affect the rival firms. So, every firm
keeps a close watch on the activities of rival firms.
2. Interdependence:
Firms under oligopoly are interdependent. Interdependence means that actions of one firm affect the actions of
other firms. A firm considers the action and reaction of the rival firms while determining its price and output levels.
A change in output or price by one firm evokes reaction from other firms operating in the market.
For example, market for cars in India is dominated by few firms (Maruti, Tata, Hyundai, Ford, Honda, etc.). A
change by any one firm (say, Tata) in any of its vehicle (say, Indica) will induce other firms (say, Maruti, Hyundai,
etc.) to make changes in their respective vehicles.
The firms under oligopoly are interdependent in making decision. They are interdependent because the number of
competition is few and any change in price & product etc by an firm will have a direct influence on the fortune of
its rivals, which in turn retaliate by changing their price and output. Thus under oligopoly a firm not only considers
the market demand for its product but also the reactions of other firms in the industry. No firm can fail to take into
account the reaction of other firms to its price and output policies. There is, therefore, a good deal of
interdependences of the firm under oligopoly.
3. Non-Price Competition: (Price rigidity)
Under oligopoly, firms are in a position to influence the prices. However, they try to avoid price competition for the
fear of price war. They follow the policy of price rigidity. Price rigidity refers to a situation in which price tends to
stay fixed irrespective of changes in demand and supply conditions. Firms use other methods like advertising,
better services to customers, etc. to compete with each other.
If a firm tries to reduce the price, the rivals will also react by reducing their prices. However, if it tries to raise the
price, other firms might not do so. It will lead to loss of customers for the firm, which intended to raise the price.
So, firms prefer non- price competition instead of price competition.
4. Barriers to Entry of Firms:
The main reason for few firms under oligopoly is the barriers, which prevent entry of new firms into the industry.
Patents, requirement of large capital, control over crucial raw materials, etc, are some of the reasons, which
prevent new firms from entering into industry. Only those firms enter into the industry which is able to cross these
barriers. As a result, firms can earn abnormal profits in the long run.
5. Role of Selling Costs:
Due to severe competition and interdependence of the firms, various sales promotion techniques are used to
promote sales of the product. Advertisement is in full swing under oligopoly, and many a times advertisement can
become a matter of life-and-death. A firm under oligopoly relies more on non-price competition.
Selling costs are more important under oligopoly than under monopolistic competition.
The firms under oligopolistic market employ aggressive and defensive weapons to gain a greater share in the
market and to maximize sale. In view of this firms have to incur a great deal on advertisement and other measures
of sale promotion. Thus advertising and selling cost play a great role in the oligopolistic market structure. Under
perfect competition and monopoly expenditure on advertisement and other measures is unnecessary. But such
expenditure is the life-blood of an oligopolistic firm.
6. Group Behavior:
Under oligopoly, there is complete interdependence among different firms. So, price and output decisions of a
particular firm directly influence the competing firms. Instead of independent price and output strategy, oligopoly
firms prefer group decisions that will protect the interest of all the firms. Group Behavior means that firms tend to
behave as if they were a single firm even though individually they retain their independence.
7. Nature of the Product:
The firms under oligopoly may produce homogeneous or differentiated product.
i. If the firms produce a homogeneous product, like cement or steel, the industry is called a pure or perfect
oligopoly.
ii. If the firms produce a differentiated product, like automobiles, the industry is called differentiated or imperfect
oligopoly.
8. Indeterminate Demand Curve:
Under oligopoly, the exact behavior pattern of a producer cannot be determined with certainty. So, demand curve
faced by an oligopolist is indeterminate (uncertain). As firms are inter-dependent, a firm cannot ignore the
reaction of the rival firms. Any change in price by one firm may lead to change in prices by the competing firms. So,
demand curve keeps on shifting and it is not definite, rather it is indeterminate.
This characteristic is the direct result of the interdependence characteristic of an oligopolistic firm. Mutual
interdependence creates uncertainty for all the firms. No firm can predict the consequence of its price-output
policy. Under oligopoly a firm cannot assume that its rivals will keep their price unchanged if he makes charge in its
own price. As a result, the demand curve facing an oligopolistic firm losses its determinateness.

The demand curve as is well known, relates to the various quantities of the product that could be sold it different
levels of prices when the quantity to be sold is itself unknown and uncertain the demand curve can't be definite
and determinate.

Firms in Oligopoly
There are different possible ways that firms in oligopoly will compete and behave this will depend upon:
 The objectives of the firms e.g. profit maximization or sales
maximization
 The degree of contestability i.e. barriers to entry
 Government regulation

The Kinked Demand Curve Model

This model suggests that prices will be fairly stable and there is
little incentive to change prices. Therefore, firms compete using
non-price competition methods.
 This assumes that firms see k to maximize profits
 If they increase price, then they will lose a large share of the
market because they become uncompetitive compared to
other firms, therefore demand is elastic for price increases.
 If firms cut price then they would gain a big increase in
market share, however it is unlikely that firms will allow this. Therefore other firms follow suit and cut price as
well. Therefore demand will only increase by a small amount: Demand is inelastic for a price cut.

 Therefore this suggests that prices will be rigid in oligopoly

 The diagram suggests that a change in marginal Cost still leads to the same price, because of the kinked
demand curve  remember profit max occurs where MR = MC)
Evaluation of kinked demand curve
 Part of Non collusive oligopoly (In real world, prices do change)
 Firms may not seek to maximize profits,  but prefer to increase market share
 Some firms may have very strong brand loyalty and be able to increase price without demand being very price
elastic. Rigid pricing policy/Price rigidity – neither firm losses

 AK is flatter slope than KDb

 Price wars – Price at point ‘K’ is the rigid price(OP)
 Firm B is facing inelastic demand where as the firm A is having elastic
demand for the same product.
 Firm A can reduce price and earn more but that forces firm B who will face
loss due to inelastic demand, so increase in price by one firm may not be
followed by another.
 Firms in oligopoly may still be very competitive on price, especially if they are seeking to increase market
share.
 Collusion
 Another possibility for firms in oligopoly is for them to collude on price and set profit maximizing levels of
output.
 Collusion is illegal, but tacit collusion may be hard to spot.
The kinked demand curve model is based on the idea that there is price inflexibility in oligopoly. Each firm in the
oligopoly faces a demand curve that is kinked at the market price because there is a greater tendency for
competitors to follow price reductions instead of price increases. 

With the kinked demand curve, if demand or cost were to increase, firms will be tempted to increase their prices ,
but they will not because of the fear that competitors will not raise their prices and they will end up losing
customer sales. A price reduction by a firm forces other firms to cut prices in order to protect their sales, while an
increase does not require a readjustment, since other gain customers if one increases its price.  
In the kinked demand curve model, the MR curve is discontinuous at the point of the kink. The point at which the
demand curve changes slopes indicates the profit maximizing price. For higher prices, the demand curve is elastic
above P1, the firm will thereby lose its sales and market share to others who fail to follow the price increase. While
for lower prices, the demand curve is relatively inelastic and rival firms match the price reduction to maintain their
market share. 

Conclusion 
Kinked Demand curve envisages price rigidity in the Oligopoly market as explained by Paul Sweezy. The relatively
elastic and inelastic portions of the kinked demand curve responded in respective way to the price changes.
However, neither the increase nor the decrease in price by any of the firm with an expectation of similar response
from the other firm will be capable for an equilibrium price in oligopoly market because in both the cases as shown
in the figure. Either of the firm will be the looser. Thus ultimately both the firms are ready to accept the price
determined at the point of Kinked which is more stable for them to not to lose in the market.