Managerial Economics INIMS

1.6 Managerial Economics

1.Managerial Economics: introduction, basic concepts, application in
business decision-making. Demand and Supply Analysis,determinants ,
equilibrium, elasticity, demand forecasting and estimating methods
2.Theory of consumer behavior: consumer preferences, indifference
curves, budget constraint, utility maximization and the derivation of the
consumer demand curve.
3.Production and Cost Analysis: production functions-cost functions,
and profit functions, total, average and marginal costs, returns to factors
and scale, short run v/s long run decisions, derivation of the supply
curve.
4.Market Analysis: market forms, perfect competition, monopoly,
monopolistic, oligopoly. Output and price determination. Cartels and
collusion, mergers and acquisitions and government regulations in the
form of price directives, taxes, subsidies, anti-trust action and
competition polices.
5.National Income Accounting: concepts of GDP, NI, per capita income,
PPP National income accounting in India. Business cycles and business
forecasting. Measuring business cycles using trend analysis, macro
economic indicators in business cycle measurement.

References:
•Managerial Economics- Dominick Salwatore.
•Managerial Economics- Gupta and Mote
•Economics- Samuelson &Nordhaus
•Managerial Economics by Peterson and Lewis
•Micro Economics – Dominick Salvatore
•Macro Economics – Palmer and others
•Macro Economics - Koutinyas

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 UNIT I

Introduction, basic concepts, application in

business decision-making. Demand and Supply
Analysis, determinants , equilibrium, elasticity,
demand forecasting and estimating methods.

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1.1 Introduction to Managerial Economics

1.1.1 What is economics?

Meaning of economics: It is the study of use of scarce resources that have

alternate uses.

The word economy is derived from the greek word "OKIOS" which means
management of household or household rules.Its basic function is to study how
people - individuals, households, firms and nations- maximize their gains from their
limited resources and opportunities.

1.1.2 Definition of managerial economics

“ managerial economics id concerned with the application of economic concepts and

economics to the problems of formulation rational decision making”
- Mansfield

“Managerial Economics … is the integration of economic theory with business

practice for the purpose of facilitating decision making and forward planning by
management”

1.1.3 Business Process

Business Process mainly consists of two main aspects:
1. Decision Making
2. Forward Planning
1. Decision Making: Decision making is not something which is related to
managers only or it is related to the corporate world only, but it is something
which is related to everyone’s life. Whether a person is working or
nonworking, irrespective of his/her field decision making is important to
everyone.
You need to make decision irrespective of work you are
doing. As a student also you have to take so many decisions. Suppose you want to go
for a movie at the same time you want go for shopping then what will you do. You
can’t do two things at the same time you have to decide what to do first and what to
do next. Therefore decision making can be called as choosing the right option from
the given one. To decide is to choose. Decision making is the most important
function of a business process. Decision making is the central objective of the
Managerial Economics.
Decision making may be defined as the process of selecting the suitable
action from among several alternative courses of action.

Forward Planning: Forward planning the term ‘planning’ implied a

consciously directed activity with certain predetermined goals and means to carry
them out. It is a deliberate activity. It is a programmed function. Basically planning is
concerned with tackling future situations in a systematic manner. Forward planning
implied planning in advance for the future. It is associated with deciding the future
course of action of a firm. It is preparedonthebasis of past and
current experience ofa firm. It is prepared in thebackground of uncertain and

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unpredictable environment and guess work.  Future events and happenings  cannot 
be predicted accurately.  The success  or failure of the future plan depends  on a
number of factors and forces which are unknown in nature.  Much
of economic activity  is forward looking.  Every time we build a new factory, add to
the stocks of inputs, trucks, computers or improvements  in  R&D,  our intension
is to enhance the future productivity  of the firm.  Growing firms  devote a significant 
share of  their current output  to net  capital  formation to bolster future
economic output. A business executive must be sufficiently intelligent enough to
think in advance,prepare a soundplan and takeall possibleprecautionary measures to 
meet all types of challenges of the future business.  Hence, forward planning
has acquired greater significance in business circles.

1.2 Basic concepts:

1.2.1 CHARACTERISTICS OF MANAGERIAL ECONOMICS
The following characteristics of managerial economics will indicate its nature:

1. Micro economics: Managerial Economics :s micro economic in character.

This is so because it studies the problems of an individual business unit. It does not
study the problems of the entire economy.

2. Normative science: Managerial Economics is a normative science. It is

concerned with what management should do under particular circumstances. It
determines the goals of the enterprise. Then it develops the ways to achieve these
goals.

3. Pragmatic: Managerial Economics is pragmatic. It concentrates on

making economic theory more application oriented. It tries to solve the
managerial problems in their day-today functioning.

4. Prescriptive: Managerial Economics is prescriptive rather than descriptive.

It
prescribes solutions to various business problems.

5. Uses macro economics: Marco economics is also useful to Managerial

Economics. Macro-economics provides an intelligent understanding of the
environment in which the Business operates. Managerial Economics takes the help
of macro-economics to understand the external conditions such as business cycle,
national income, economic policies of Government etc.

6. Uses theory of firm: Managerial Economics largely uses the body of

economic concepts and principles towards solving the business problems.
Managerial Economics is a special branch of economics to bridge the gap between
economic theory and managerial practice.

7. Management oriented: The main aim of Managerial Economics is to help

the management in taking correct decisions and preparing plans and policies for
future. Managerial Economics analyses the problems and give solutions just as

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doctor tries to give relief to the patient.

8. Multi disciplinary: Managerial Economics makes use of most modern tools

of mathematics, statistics and operation research. In decision making and planning
principles such accounting, finance, marketing, production and personnel etc.

9. Art and science: Managerial Economics is both a science and an art. As a

science, it establishes relationship between cause and effect by collecting, classifying
and analyzing the facts on the basis of certain principles. It points out to the
objectives and also shows the way to attain the said objectives.

1.2.2 OBJECTIVES OF BUSINESS ECONOMICS

The basic objective of Business economics is to analyse economic problems of
Business and suggest solutions and help the managers in decision-making. The
objectives of business economics are outlined as below:

1. To integrate economic theory with business practice.

2. To apply economic concepts: and principles to solve business problems.
3. To employ the most modern instruments and tools to solve business Problems.
4. To allocate the scarce resources in the optimal manner.
5. To make overall development of a firm.
6. To help achieve other objectives of a firm like attaining industry leadership,
expansion of the market share etc.
7. To minimize risk and uncertainty
8. To help in demand and sales forecasting.
9. To help in operation of firm by helping in planning, organizing, controlling etc.
10. To help in formulating business policies.
11. To help in profit maximization.

1.2.3 Business economics is useful because:

(i) It provides tools and techniques for managerial decisions,
(ii) It gives answers to the basic problems of business management,
(iii) It supplies data for analysis and forecasting,
(iv) It provides tools for demand forecasting and profit planning,
(v) It guides the managerial economist. -Thus, Business economics offers a
number of benefits to business managers. It is also useful to individuals,
society and government.

Managerial Economics has been described as economics applied to decision- making.

It may be viewed as a special branch of economics bridging the gulf between pure
economic theory and managerial practice.
Economics has two main divisions: microeconomics and macroeconomics.
Microeconomics has been defined as that branch where the unit of study is an
individual or a firm. Macroeconomics, on the other hand, is aggregate in character
and has the entire economy as a unit of study.
Microeconomics, also known as price theory (or Marshallian economics.) Is
the main source of concepts and analytical tools for Managerial Economics. To
illustrate various micro-economic concepts such as elasticity of demand, marginal
cost, the short and the long runs, various market forms, etc. are all of great

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significance to Managerial Economics. The chief contribution of macro-economics is
in the area of forecasting. The modern theory of income and employment has direct
implications for forecasting general business conditions. As the prospects of an
individual firm often depend greatly on general business conditions, individual firm
forecasts depend on general business forecasts.

Managerial Economics Economics

1. Deals with application of economic
principles to the problem faced by the
firm
2. Micro in Nature i.e., it deals with the
problem concerning a particular firm.
3. It is mainly concerned with profit
theories
4. Its scope is limited
5. Provides solution to the firm with the
help of other subjects like statistics,
mathematics, accounting etc.
1. It is concerned with the body of
principles itself.
2. It includes both micro and macro
economics.
3. It deals with different theories such as
wages, interest and profit theories.
4. It has wider scope
5. Economic theories are based on
assumption and hence they cannot
give practical solution to business
problems.

1.2.4 Nature of Managerial Economics

Managerial Economics and Managerial Economics are the two terms, which, at times
have been used interchangeably. Of late, however, the term Managerial Economics
has become more popular and seems to displace progressively the term Managerial
Economics.
The prime function of a management executive in a business organization is
decision-making and forward planning. Decision-making means the process of
selecting one action from two or more alternative courses of action whereas forward
planning means establishing plans for the future. The question of choice arises
because resources such as capital, land, labour and management are limited and can
be employed in alternative uses. The decision-making function thus becomes one of
making choices or decisions that will provide the most efficient means of attaining a
desired end, say, profit maximization. Once decision is made about the particular
goal to be achieved, plans as to production, pricing, capital, raw materials, labour,
etc., are prepared. Forward planning thus goes hand in hand with decision-making.
A significant characteristic of the conditions, in which business organizations
work and take decisions, is uncertainty. And this fact of uncertainty not only makes
the function of decision-making and forward planning complicated but adds a
different dimension to it. If knowledge of the future were perfect, plans could be
formulated without error and hence without any need for subsequent revision. In the
real world, however, the business manager rarely has complete information and the
estimates about future predicted as best as possible. As plans are implemented over
time, more facts become known so that in their light, plans may have to be revised,
and a different course of action adopted. Managers are thus engaged in a continuous

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process of decision-making through an uncertain future and the overall problem
confronting them is one of adjusting to uncertainty.
In fulfilling the function of decision-making in an uncertainty framework,
economic theory can be pressed into service with considerable advantage. Economic
theory deals with a number of concepts and principles relating, for example, to profit,
demand, cost, pricing production, competition, business cycles, national income,
etc., which aided by allied disciplines like Accounting. Statistics and Mathematics can
be used to solve or at least throw some light upon the problems of business
management. The way economic analysis can be used towards solving business
problems. Constitutes the subject-matter of Managerial Economics.

1.2.5 SCOPE OF Managerial Economics

Managerial Economics is a developing science which generates the countless
problems to determine its scope in a clear-cut way. From the following fields, we can
examine the scope of Managerial Economics.
1. Demand analysis and forecasting: The foremost aspect regarding
scope is demand analysis and forecasting. A business firm is an economic unit which
transforms productive resources into saleable goods. Since all output is meant to be
sold, accurate estimates of demand help a firm in minimizing its costs of production
and storage. A firm must decide its total output before preparing its production
schedule and deciding on the resources to be employed. Demand forecasts serves as a
guide to the management for maintaining its market share in competition with its
rivals, thereby securing its profit.
2. Cost and production analysis: A firm's profitability depends much on
its costs of production. A wise manager would prepare cost estimates of a range of
output, identify the factors causing variations in costs and choose the cost-
minimizing output level, taking also into consideration the degree of uncertainty in
production and cost calculations. Production process are under the charge of
engineers but the business manager works to carry out the production function
analysis in order to avoid wastages of materials and time. Sound pricing policies
depend much on cost control. The main topics discussed under cost and production
analysis are: Cost concepts, cost-output relationships, Economies and Diseconomies
of scale and cost control.
3. Pricing decisions, policies and practices: Another task before a
business manager is the pricing of a product. Since a firm's income and profit depend
mainly on the price decision, the pricing policies and all such decisions are to be
taken after careful analysis of the nature of the market in which the firm operates.
The important topics covered in this field of study are : Market Structure Analysis,
Pricing Practices and Price Forecasting.
4. Profit management: Each and every business firms are tended for earning
profit; it is profit which provides the chief measure of success of a firm in the long
period. An economist 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 at different levels of output. The more successful a
manager is in reducing uncertainty, the higher are the profits earned by him. It is
therefore, profit-planning and profit measurement constitutes the most challenging
area of Managerial Economics.
5. Capital management: Still another most challenging problem for a

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modern business manager is of planning capital investment. Investments are made
in the plant and machinery and buildings which are very high. Therefore, capital
management requires top- level decisions. It means capital management i.e.,
planning and control of capital expenditure. It deals with Cost of capital, Rate of
Return and Selection of projects.
6. Inventory management: A firm should always keep an ideal quantity of
stock. If the stock is too much, the capital is unnecessarily locked up in inventories at
the same time if the level of inventory is low, production will be interrupted due to
non-availability of materials. Hence, a firm always prefers to have an optimum
quantity of stock. Therefore, Managerial Economics will use some methods such as
ABC analysis, inventory models with a view to minimizing the inventory cost.
7. Environmental issues: There are certain issues of macroeconomics which
also form a part of Managerial Economics. These issues relate to general business,
social and political environment in which a business enterprise operates.
8. Business cycles: Business cycles affect business decisions. They refer to
regular fluctuations in economic activities in the country. The different phases of
business cycle are depression, recovery, prosperity, boom and recession. Thus,
Managerial Economics comprises both micro and macro-economic theories. The
subject matter of Managerial Economics consists of all those economic concepts,
theories and tools of analysis which can be used to analyse the business environment
and to find out solution to practical business problems.

1.3 Application in business decision-making

Managerial economics is concerned with the application of economic theory and

methods of decision sciences to analyse decision-making problems faced by business
firms. The first and most important problem faced by a business firm is the choice of
a product to be produced or service to be provided. The second important problem
dealt with in managerial economics is to decide by a firm about price and output of
the product so as to maximise profits or to attain some other desired goal.
The decisions regarding these require careful analysis of the demand for its product
and costs of its production. The other important decision-making problems facing
business firms relate to what methods or techniques of production are to be used in
the production of commodities, and how much advertisement expenditure is to be
incurred for promoting the sales of their products. In deciding about all these
problems, a firm has to decide how it can use its limited resources to achieve its
objective most efficiently.
The science of economics is concerned with the allocation of scarce resources
to alternative uses so as to achieve maximum possible satisfaction of the people.
Thus, Lord Robins defines economics as a “Science which studies human behaviour
as a relationship between ends and scarce means which have alternative uses”. The
type of decision-making by managers of business firms also usually involves
question of resource allocation within a firm or organisation.
The resources at the disposal of a firm are scarce or limited. What product to
be produced, what price should be fixed, how much quantity of it should be
produced, and what factor combination or production technique be used for the
production of goods involve resource allocation by a firm. It is the task of a manager
of a firm that it should take decisions regarding these resource allocation problems

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in a way that ensure most efficient use of resources. Only this will enable the firm to
achieve the goal of maximisation of profits.
Thus, management science is concerned with the allocation of scarce
resources at the disposable of the firm. While economics is primarily concerned with
the allocation of scarce resources so as to achieve maximum social welfare
management science deals particularly with organising and allocating a firm’s scarce
resources so as to achieve the objective of the individual firm which generally
happens to be maximisation of its profits. Therefore, management science’s is
intimately related to economics.
Besides economic theory, managerial economics draws heavily on the
decisions sciences for the techniques used for decision making. The techniques of
decision sciences used especially for business decision making are optimisation
techniques, particularly differential calculus and mathematical programming. These
optimisation techniques are used in the analysis of alternative courses of action and
the evaluation of results obtained so that best alternative which helps in attaining
the objective efficiently is chosen.
In addition to the optimisation techniques, methods of statistical estimation,
game theory of decision sciences are extensively used in managerial economics for
developing decision rules that can help managers in achieving firm’s objectives. It
may however be noted that these techniques of decision sciences have now become a
part of modern economic theory. Thus, the role of economics and decision sciences
in managerial decision-making is illustrated in Figure 1.1. To conclude, managerial
economics refers to the application of economic theory and methods of decision
sciences to arrive at the optimal solution to the various decision-making problems
faced by managers of business firms.
It is important to note that managerial economics has both descriptive and
prescriptive roles. Managerial economics not only explains how various economic
forces affect the working of a firm but also predicts the consequences of the
decisions made by it. This is its positive or descriptive role. In addition to this,
managerial economics prescribes the rules for the improvement of decision making
by firms or their managers so that they can achieve their objectives efficiently. This
is its prescriptive role.

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It may be noted that managerial economics deals with not only private firms but also
public enterprises. Further, the technique, approach or way of thinking of
managerial economics can also be profitably used in non-profit making
organisations such as colleges, universities. This is because managers of all types of
organisations face similar problems. In the last about three decades managerial
economics has grown rapidly because it has been increasingly realised that economic
theory and its methods and concepts can be used by managers to efficiently achieve
the desired objectives of the firm.

1. Managerial Economics and Economic Theory:

Managerial economics uses economic theory to solve business decision-making
problems. Economic theory has been broadly divided into microeconomics and
macroeconomics. Briefly, microeconomics deals with the theory of decision-making
by individual consumers, resource owners and business firms in a free market
economy. Macroeconomics, on the other hand, focuses on the study of economy as
whole and its various aggregates such as national income, aggregate level of
employment, general price level. It is important to note that though managerial
economics draws on both microeconomics and macroeconomics.

Managerial economics is however essentially a course in applied microeconomics,

macroeconomic conditions of the economy such as level of aggregate demand (which
determines whether recessionary or boom conditions prevail in the economy), rate
of inflation, rate of economic growth, that make up macroeconomic environment

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within which firms work are also very important for decision making by business
firms.

Microeconomics has built models which explain how an individual consumer

chooses among goods so as to maximise his satisfaction and individual business firm
decides to fix price and output of its products to maximise profits and what factor
combination it uses for producing them so as to minimise cost for a given level of
output.

The parts of microeconomics which deal with demand theory, analysis of cost and
production, theory of determination of price and output under different market
structures are particularly useful in making business decisions about such matters.

The study of macroeconomics which focuses on the economy as a whole is also

highly useful for management economist who is faced with various decision-making
problems. This is because firms do not work in a vacuum. The level of overall
economic activity, national income and employment, aggregate demand conditions,
government policies (both fiscal and monetary), interest rate, the changes in price
level greatly affect business firms.

These aggregates of the economy make up the macroeconomic environment which

affects business decisions of managers. Therefore, in recent years macroeconomics
for management which is particularly relevant for business decision making has
been developed.

Forecasts of future demand, investment decisions by business firms are especially

based on the overall situation of the economy and its growth prospects. Macro-
theories of consumption, investment demand, the general price level and business
cycles are particularly relevant for making capital investment expenditure which
yields returns in future years.

2. Managerial Economics and Decision Sciences:

Managerial economics depends on economic theory for theoretical framework for
analysing the problems of business decision-making. On the other hand, decision
sciences provide tools and techniques for constructing decision models and for
evaluating the effect and results of alternative courses of action (i.e., alternative
business strategies). Business economics uses optimisation techniques including
differential calculus, linear and other types of mathematical programming for
deriving decision rules which assist managers for achieving the objectives of
business firms.

Further statistical tools of the decision sciences are used to estimate the relationship
between important variables which help in decision making. Besides, forecasting
techniques of decision sciences are also widely used in business economics. Since
most of business decisions require forecasting of future demand, and yield from

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capital investment, forecasting techniques play an important role in managerial
decision-making.

Thus, business economics draws heavily on decision sciences.Optimisation

techniques, statistical estimation, and forecasting methods have now become an
integral part of modern economic theory.

Source: http://www.economicsdiscussion.net/

1.4 Demand and Supply analysis:

Demand and analysis

1.4.1 Meanings and Definition of Demand:
The word 'demand' is so common and familiar with every one of us that it seems
superfluous to define it. The need for precise definition arises simply because it is
sometimes confused with other words such as desire, wish, want, etc.
Demand in economics means a desire to possess a good supported by willingness and
ability to pay for it. If you have a desire to buy a certain commodity, say a car, but you
do not have the adequate means to pay for it, it will simply be a wish, a desire or a
want and not demand. Demand is an effective desire, i.e., a desire which is backed by
willingness and ability to pay for a commodity in order to obtain it. In the words of
Prof. Hibdon:
"Demand means the various quantities of goods that would be purchased per time
period at different prices in a given market".

Demand = Desire + Ability to pay + Willingness to Pay

1.4.2 Characteristics of Demand:

There are thus three main characteristic's of demand in economics.
(i) Willingness and ability to pay. Demand is the amount of a commodity for which a
consumer has the willingness and also the ability to buy.
(ii) Demand is always at a price. If we talk of demand without reference to price, it
will be meaningless. The consumer must know both the price and the commodity. He
will then be able to tell the quantity demanded by him.
(iii) Demand is always per unit of time. The time may be a day, a week, a month, or a
year.
Example: For instance, when the milk is selling at the rate of Rs.15.0 per liter, the
demand of a buyer for milk is 10 liters a day. If we do not mention the period of time,
nobody can guess as to how much milk we consume? It is just possible we may be
consuming ten liters of milk a week, a month or a year.
Summing up, we can say that by demand is meant the amount of the
commodity that buyers are able and willing to purchase at any given price over some
given period of time. Demand is also described as a schedule of how much a good
people will purchase at any price during a specified period of time.

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1.4.3 DETERMINANTS OF DEMAND
The factors that determine the size and amount of demand are manifold. The term
"function" is employed to show such "determined" and "determinant" relationship.
For instance, we say that the quantity of a good demanded is a function of its price

i.e., Q = f(p)
Where Q represents quantity demanded
f means function, and
p represents price of the good.

There are many important determinants of the demand for a commodity:

1. Price of the goods: The first and foremost determinant of the demand for
good is price. Usually, higher the price of goods, lesser will be the quantity demanded
of them.

2. Income of the buyer: The size of income of the buyers also influences the
demand for a commodity. Mostly it is true that "larger the income, more will be the
quantity
demanded".
3. Prices of Related Goods: The prices of related goods also affect the
demand for a good. In some cases, the demand for a good will go up as the price of
related good rises. The goods so inter-related arc known as substitutes, e.g. radio and
gramophone. In some other cases, demand for a good will comes down as the price of
related good rises. The goods so inter-related are complements, e.g. car and petrol,
pen and ink, cart and horse, etc.

4. Tastes of the buyer: This is a subjective factor. A commodity may not be

purchased by the consumer even though it is very cheap and useful, if the commodity
is not up to his taste or liking. Contrarily, a good may be purchased by the buyer,
even though it is very costly, if it is very much liked by him.

5. Seasons prevailing at the time of purchase; In winter, the demand

for woolen clothes will rise; in summer, the demand for cool drinks rises
substantially; in the rainy season, the demand for umbrellas goes up.

6. Fashion: When a new film becomes a success, the type of garments worn by
the hero or the heroine or both becomes an article of fashion and the demand goes
up for such garments.

7. Advertisement and Sales promotion: Advertisement in newspapers

and magazines, on outdoor hoardings on buses and trains and in radio and
television broadcasts, etc. have a substantial effect on the demand for the good and
thereby improves sales.
The need to have clarity in demand analysis makes us adopt a 'ceteris
paribus' assumption, i.e. all other things remain the same except one. This
enables us to consider the relation between demand and each of the variable
factors considered in isolation.

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14
 Determinants of Demand

Price of
the
goods Income
of the
buyer

Advertising
and sales
promotion

Prices of
Determinants of Related
Demand Goods

Fashion
Tastes
of the
Seasons
prevailing
buyer
at the time
of purchase

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1.4.4 Law of Demand

Definition and Explanation of the Law:

 
We have stated earlier that demand for a commodity is related to price per unit of
time. It is the experience of every consumer that when the prices of the commodities
fall, they are tempted to purchase more. Commodities and when the prices rise, the
quantity demanded decreases. There is, thus, inverse relationship between the price
of the product and the quantity demanded. The economists have named this inverse
relationship between demand and price as the law of demand.
 
Statement of the Law:
 
Some well known statements of the law of demand are as under:
 
According to Prof. Samuelson:
 
"The law of demand states that people will buy more at lower prices and buy less at
higher prices, other things remaining the same".
 
E. Miller writes:
 
"Other things remaining the same, the quantity demanded of a commodity will be
smaller at higher market prices and larger at lower market prices".
 
"Other things remaining  the same, the quantity demanded increases with every fall
in the price and decreases with every rise in the price".
 
In simple we can say that when the price of a commodity rises, people buy less of that
commodity and when the price falls, people buy more of it ceteris paribus (other
things remaining the same). Or we can say that the quantity varies inversely with its
price. There is no doubt that demand responds to price in the reverse direction but it
has got no uniform relation between them. If the price of a commodity falls by 1%, it
is not necessary that may also increase by 1%. The demand can increase by 1%, 2%,
10%, 15%,  as the situation demands. The functional relationship between demanded
and the price of the commodity can be expressed in simple mathematical language as
under:
 
Formula For Law of Demand:
 
Qdx = f (Px, M, Po, T,..........)
 
Here:
 
Qdx = A quantity demanded of commodity x.
 
f = A function of independent variables contained within the parenthesis.
 

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Px = Price of commodity x.
 
Po = Price of the other commodities.
 
T = Taste of the household.
 
The bar on the top of M, Po, and T means that they are kept constant. The demand
function can also be symbolized as under:
 
Qdx = f (Px) ceteris paribus
 
Ceteris Paribus. In economics, the term is used as a shorthand for indicating
the effect of one economic variable on another, holding constant all other variables
that may affect the second variable.
 
1.4.5 Schedule of Law of Demand:
 
The demand schedule of an individual for a commodity is a Iist or table of the
different amounts of the commodity that are purchased the market at different prices
per unit of time. An individual demand schedule for a good say shirts is presented in
the table below:
Individual Demand Schedule for Shirts:
 
(In Rupees)
Price per shirt 100 80 60 40 20 10
Quantity demanded
5 7 10 15 20 30
per year Qdx

According to this demand schedule, an individual buys 5 shirts at Rs.100 per shirt
and 30 shirts at Rs.10 per shirt in a year.
 
Law of Demand Curve/Diagram:
 
Demand curve is a graphic representation of the demand schedule. According to
Lipsey:
 "This curve, which shows the relation between the price of a commodity and the
amount of that commodity the consumer wishes to purchase is called demand
curve".
 
It is a graphical representation of the demand schedule.
 

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In the figure (4.1), the quantity. demanded of shirts in plotted on horizontal axis OX
and "price is measured on vertical axis OY. Each price- quantity combination is
plotted as a point on this graph. If we join the price quantity points a, b, c, d, e and f,
we get the individual demand curve for shirts. The DD / demand curve slopes
downward from left to right. It has a negative slope showing that the two variables
price and quantity work in opposite direction. When the price of a good rises, the
quantity demanded decreases and when its price decreases, quantity demanded
increases, ceteris paribus.
           
1.4.6 Assumptions of Law of Demand:
 
According to Prof. Stigler and Boulding:
 
There are three main assumptions of the Law:
        
(i) There should not be any change in the tastes of the consumers for goods (T).
 
(ii) The purchasing power of the typical consumer must remain constant (M).
 
(iii) The price of all other commodities should not vary (P o).
 
Example of Law of Demand:
 
If there is a change, in the above and other assumptions, the law may not hold true.
For example, according to the law of demand, other things being equal quantity
demanded increases with a fall in price and diminishes with rise to price. Now let us
suppose that price of tea comes down from Rs.40 per pound to Rs.20 per pound. The
demand for tea may not increase, because there has taken place a change in the taste
of consumers or the price of coffee has fallen down as compared to tea or the
purchasing power of the consumers has decreased, etc., etc. From this we find that
demand responds to price inversely only, if other thing remains constant. Otherwise,
the chances are that, the quantity demanded may not increase with a fall in price or
vice-versa.
 
Demand, thus, is a negative relationship between price and quantity.
 
In the words of Bilas:
 
"Other things being equal, the quantity demanded per unit of time will be greater,

18
lower the price, and smaller, higher the price".
 
1.4.7 Limitations/Exceptions of Law of Demand:
 
Though as a rule when the prices of normal goods rise, the demand them decreases
but there may be a few cases where the law may not operate.
 
(i) Prestige goods: There are certain commodities like diamond, sports cars
etc., which are purchased as a mark of distinction in society. If the price of these
goods rise, the demand for them may increase instead of  falling. 
 
(ii) Price expectations: If people expect a further rise in the price particular
commodity, they may buy more in spite of rise in price. The violation of the law in
this case is only temporary.
(3) Ignorance of the consumer: If the consumer is ignorant about the rise
in price of goods, he may buy more at a higher price.
 
(iv) Giffen goods: If the prices of basic goods, (potatoes, sugar, etc) on which
the poor spend a large part of their incomes declines, the poor increase the demand
for superior goods, hence when the price of Giffen good falls, its demand also falls.
There is a positive price effect in case of Giffen goods.
 
1.4.8 Importance of Law of Demand:
 
(i) Determination of price. The study of law of demand is helpful for a
trader to fix the price of a commodity. He knows how much demand will fall by
increase in price to a particular level and how much it will rise by decrease in price of
the commodity. The schedule of market demand can provide the information about
total market demand at different prices. It helps the management in deciding
whether how much increase or decrease in the price of commodity is desirable.

(ii) Importance to Finance Minister. The study of this law is of great

advantage to the finance minister. If by raising the tax the price increases to such an
extend than the demand is reduced considerably. And then it is of no use to raise the
tax, because revenue will almost remain the same. The tax will be levied at a higher
rate only on those goods whose demand is not likely to fall substantially with the
increase in price.
 
(iii) Importance to the Farmers. Goods or bad crop affects the economic
condition of the farmers. If a goods crop fails to increase the demand, the price of the
crop will fall heavily. The farmer will have no advantage of the good crop and vice-
versa.
 
Market Demand

The market demand reflects the total quantity purchased by all consumers at
alternative hypothetical prices. It is the sum-total of all individual demands. It is
derived by adding the quantities demanded by each consumer for the product in the

19
market at a particular price. The table presenting the series of quantities demanded
of all consumers for a product in the market at alternative hypothetical prices is
known as the Market Demand Schedule. If the data are represented on a two
dimensional graph, the resulting curve will be the Market Demand Curve. From the
point of view of the seller of the product, the market demand curve shows the various
quantities that he can sell at different prices. Since the demand curve of an individual
is downward sloping, the lateral addition of such curves to get market demand curve
will also result in downward sloping curve.
1.4.9 WHY THE DEMAND CURVE SLOPES DOWNWARD OR REASONS
FOR THE LAW OF DEMAND

Truly, the demand curve slopes left downward to right, throughout its length
although the slope may be much steeper in some parts. It means, demand increases
with the fall in price and contracts with an increase in price. There are several
reasons responsible for the inverse price demand relationship which has been
explained as under:

1. Law of Diminishing Marginal Utility. The law of demand is based on

the law of diminishing marginal utility which states that as the consumer purchases
more and more units of a commodity, the utility derived from each successive unit
goes on decreasing. It means as the price of the commodity falls, consumer purchases
more of the commodity so that his marginal utility from the commodity falls to be
equal to the reduced price and
vice versa.

Effect. Substitution effect also leads the demand curve to slope from left downward
to right. As the price of a commodity falls, prices of its substitute goods remain the
same, the consumer will buy more of that commodity. For instance, tea and coffee
are the substitute goods. If the price of tea goes down, the consumers may substitute
tea for coffee, although price of coffee remains the same. Therefore, with a fall in
price, the demand will increase due to favourable substitution effect. On the other
hand with the rise in price, the demand falls due to unfavourable substitution effect.
This is
nothing but the application of Law of Demand.

3. Income Effect. Another reason for the downward slope of demand curve is
the income effect. As the price of the commodity falls, the real income of the
consumer goes up. Real income is that income which is measured in terms of goods
and services. For example, a consumer has Rs.20, he wants to buy oranges whose
price is Rs.20 per dozen. It means the consumer can buy one dozen of oranges with
his fixed income. Now, suppose, the price of the oranges falls to Rs.15 per dozen
which leads to an increase in his real income by Rs.5. In this case, either the
consumer will buy more quantity of oranges than before or he will buy some other
commodity with his increased income.

4. New Consumers. When the price of commodity falls, many other consumers
who were not consuming that commodity previously will start consuming the
commodity. As a result, total market demand goes up. For example, if the price of
radio set falls, even the poor man can buy the radio set. Consequently, the total

20
demand for radios goes up.

5. Several Uses. Some commodities can be put to several uses which lead to
downward slope of the demand curve. When the price of such commodities goes up
they will be used for important purposes, so their demand will be limited. On the
other hand, when the price falls, the commodity in question will extend its demand.
For instance, when the price of coal increases, it will be used for important purposes
but as the price falls its demand will increase and it will be used for many other uses.

6. Psychological Effects. When the price of a commodity falls, people favour

to buy
more which is natural and psychological. Therefore, the demand increases with the
fall in prices. For example, when the price of silk falls, it is purchased for all the
members of the family.

1.4.10 TYPES OF DEMAND

Types of Demand 
Demand is generally classified on the basis of various factors, such as nature of a
product, usage of a product, number of consumers of a product, and suppliers of a
product. The demand for a particular product would be different in different
situations. Therefore, organizations should be clear about the type of demand for
their products.

Figure-1 shows the different classifications of demand:

Source: http://www.economicsdiscussion.net/

i. Individual and Market Demand:

Refers to the classification of demand of a product based on the number of
consumers in the market. Individual demand can be defined as a quantity demanded
by an individual for a product at a particular price and within the specific period of

21
time. For example, Mr. X demands 200 units of a product at Rs. 50 per unit in a
week.

The individual demand of a product is influenced by the price of a product, income

of customers, and their tastes and preferences. On the other hand, the total quantity
demanded for a product by all individuals at a given price and time is regarded as
market demand.

In simple terms, market demand is the aggregate of individual demands of all the
consumers of a product over a period of time at a specific price, while other factors
are constant. For example, there are four consumers of oil (having a certain price).
These four consumers consume 30 liters, 40 liters, 50 liters, and 60 liters of oil
respectively in a month. Thus, the market demand for oil is 180 liters in a month.

ii. Organization and Industry Demand:

Refers to the classification of demand on the basis of market. The demand for the
products of an organization at given price over a point of time is known as
organization demand. For example, the demand for Toyota cars is organization
demand. The sum total of demand for products of all organizations in a particular
industry is known as industry demand.

For example, the demand for cars of various brands, such as Toyota, Maruti Suzuki,
Tata, and Hyundai, in India constitutes the industry’ demand. The distinction
between organization demand and industry demand is not so useful in a highly
competitive market.

This is due to the fact that in a highly competitive market, organizations have
insignificant market share. Therefore, the demand for an organization’s product is of
no importance. However, an organization can forecast the demand for its products
only by analyzing the industry demand.

iii. Autonomous and Derived Demand:

Refers to the classification of demand on the basis of dependency on other products.
The demand for a product that is not associated with the demand of other products
is known as autonomous or direct demand. The autonomous demand arises due to
the natural desire of an individual to consume the product.

For example, the demand for food, shelter, clothes, and vehicles is autonomous as it
arises due to biological, physical, and other personal needs of consumers. On the
other hand, derived demand refers to the demand for a product that arises due to the
demand for other products.

For example, the demand for petrol, diesel, and other lubricants depends on the
demand of vehicles. Apart from this, the demand for raw materials is also derived

22
demand as it is dependent on the production of other products. Moreover, the
demand for substitutes and complementary goods is also derived demand.

iv. Demand for Perishable and Durable Goods:

Refers to the classification of demand on the basis of usage of goods. The goods are
divided into two categories, perishable goods and durable goods. Perishable or non-
durable goods refer to the goods that have a single use. For example, cement, coal,
fuel, and eatables. On the other hand, durable goods refer to goods that can be used
repeatedly.

For example, clothes, shoes, machines, and buildings. Perishable goods satisfy the
present demand of individuals. However, durable goods satisfy both present as well
as future demand of individuals. Therefore, consumers purchase durable items by
considering its durability.

In addition, durable goods need replacement because of their continuous use. The
demand for perishable goods depends on the current price of goods and customers’
income, tastes, and preferences and changes frequently, while the demand for
durable goods changes over a longer period of time.

v. Short-term and Long-term Demand:

Refers to the classification of demand on the basis of time period. Short-term
demand refers to the demand for products that are used for a shorter duration of
time or for current period. This demand depends on the current tastes and
preferences of consumers.

For example, demand for umbrellas, raincoats, sweaters, long boots is short term
and seasonal in nature. On the other hand, long-term demand refers to the demand
for products over a longer period of time.

Generally, durable goods have long-term demand. The long-term demand of a

product depends on a number of factors, such as change in technology, type of
competition, promotional activities, and availability of substitutes. The short-term
and long-term concepts of demand are essential for an organization to design a new
product.

1.4.11 Extension and Contraction of Demand

The change in demand due to change in price only (when other factors remain
constant) is called extension and contraction of demand. Increase in demand due to
fall in price is called extension of demand. Decrease in demand due to rise in price is
called contraction of demand. Extension and Contraction of demand results in
movement on the same demand curve. It is shown in the following diagram.

23
 Source : Previous notes

When price is OP, the quantity demanded is OQ. Suppose the price falls from OP2 to
0P2 demand will be increased to OQ2. This is a downward movement along the
demand curve DD from a to c. This indicates extension of demand. When the price
rises to OP1, the demand will be decreased to OQ2 this is an upward movement along
the demand curve from a to b. This indicates contraction of demand.

1.5 Elasticity of Demand:

The concept of price-elasticity of demand was first of all introduced in economics by
Dr. Marshall. In simple words, price elasticity of demand is the ratio of percentage
change in quantity demanded to the percentage change in price. In other words,
price elasticity of demand is a measure of the relative change in quantity purchased
of a good in response to a relative change in its price.
It is, thus a rate at which the demand changes to the given change in prices.
So, it means the rate or the degree of response in demand to the change in price.
Thus, the co-efficient of price-elasticity of demand can be expressed as under:

1.5.1 Types of Elasticity of demand:

There are three types of elasticity of demand:

A) Price Elasticity of demand
B) Income elasticity of demand
C) Cross Elasticity of demand

A) Price Elasticity of demand

Definitions of Price Elasticity of Demand

The concept of price elasticity of demand has been defined by different economists as
under :

24
According to Alfred Marshall: "Elasticity of demand may be defined as the
percentage change in quantity demanded to the percentage change in price."

According to A.K. Cairncross : "The elasticity of demand for a commodity is the

rate at which quantity bought changes as the price changes."

According to J.M. Keynes : "The elasticity of demand is a measure of the relative

change in quantity to a relative change in price."

According to Kenneth Boulding : "Elasticity of demand measures the responsiveness

of demand to changes in price."

DEGREES OF PRICE ELASTICITY

Different commodities have different price elasticities. Some commodities have more
elastic demand while others have relative elastic demand. Basically, the price
elasticity of demand ranges from zero to infinity. It can be equal to zero, less than
one, greater than one and equal to unity.

According to Dr. Marshall : "The elasticity or reponsiveness of demand in a market

is great or small according as the amount demanded increases much or little for a
given fall in price and diminishes much or little for a given rise in price."

However, some particular values of elasticity of demand have been explained as

under ;

1. Perfectly Elastic Demand:

Perfectly elastic demand is said to happen when a little change in price leads to an
infinite change in quantity demanded. A small rise in price on the part of the seller
reduces the demand to zero. In such a case the shape of the demand curve will be
horizontal straight line as shown in figure 1.

The figure 1 shows that at the ruling price OP, the demand is infinite. A slight rise in
price will contract the demand to zero. A slight fall in price will attract more
consumers but the elasticity of demand will remain infinite (ed=∞). But in real world,

25
the cases of perfectly elastic demand are exceedingly rare and are not of any practical
interest.

2. Perfectly Inelastic Demand:

Perfectly inelastic demand is opposite to perfectly elastic demand. Under the
perfectly inelastic demand, irrespective of any rise or fall in price of a commodity,
the quantity demanded remains the same. The elasticity of demand in this case will
be equal to zero (ed = 0).

In diagram 2 DD shows the perfectly inelastic demand. At price OP, the quantity
demanded is OQ. Now, the price falls to OP1, from OP, the demand remains the
same. Similarly, if the price rises to OP2 the demand still remains the same. But just
as we do not see the example of perfectly elastic demand in the real world, in the
same fashion, it is difficult to come across the cases of perfectly inelastic demand
because even the demand for, bare essentials of life does show some degree of
responsiveness to change in price.

3. Unitary Elastic Demand:

The demand is said to be unitary elastic when a given proportionate change in the
price level brings about an equal proportionate change in quantity demanded. The
numerical value of unitary elastic demand is exactly one i.e. Marshall calls it unit
elastic.

26
In figure 3, DD demand curve represents unitary elastic demand. This demand curve
is called rectangular hyperbola. When price is OP, the quantity demanded is OQ\.
Now price falls to OP1 the quantity demanded increases to OQ2. The area OQ\RP =
area OP\SQ2 in the fig. denotes that in all cases price elasticity of demand is equal to
one.

4. Relatively Elastic Demand:

Relatively elastic demand refers to a situation in which a small change in price leads
to a big change in quantity demanded. In such a case elasticity of demand is said to
be more than one (ed > 1). This has been shown in figure 4.

In fig. 4, DD is the demand curve which indicates that when price is OP the quantity
demanded is OQ1. Now the price falls from OP to OP1, the quantity demanded
increases from OQ1 to OQ2 i.e. quantity demanded changes more than change in
price.’

5. Relatively Inelastic Demand:

Under the relatively inelastic demand, a given percentage change in price produces a
relatively less percentage change in quantity demanded. In such a case elasticity of
demand is said to be less than one (ed < 1). It has been shown in figure 5.

27
All the five degrees of elasticity of demand have been shown in figure 6. On OX axis,
quantity demanded and on OY axis price is given.

It shows:

1. AB — Perfectly Inelastic Demand

2. CD — Perfectly Elastic Demand

3. EG — Less than Unitary Elastic Demand

4. EF — Greater Than Unitary Elastic Demand

5. MN — Unitary Elastic Demand.

Source: http://www.economicsdiscussion.net/

1.5.1.c FACTORS DETERMINING PRICE ELASTICITY OF

DEMAND
The factors that determine elasticity of demand are numberless. But the most
important among them are the nature, uses and prices of related goods and the level
of income. They are stated below:

I. Nature of the commodity: Generally, all commodities can be dividend into

three categories i.e.

(i) Necessaries of Life. For necessaries of life the demand is inelastic because
people buy the required amount of goods whatever their price. For example,
necessaries such as rice, salt, cloth are purchased whether they are dear or cheap.

(ii) Conventional Necessaries. The demand for conventional necessaries is less

elastic or inelastic. People are accustomed to the use of goods like intoxicants which
they purchase at any price. For example, drunkards consider opium and wine almost
as a necessity as food and water. Therefore, they buy the same amount even when

28
their prices are higher and highest.

(iii) Luxury Commodities. The demand for luxury is usually elastic as people
buy more of them at a lower price and less at a higher price. For example, the
demand of luxuries like silk, perfumes and ornaments increases at a lower price and
diminishes at a higher price. Here, we must keep in mind that luxury is a relative
term, which varies from person to person, place to place and from time to time. For
example, what is a luxury to a poor man is a necessity to the rich. The luxury of the
past may become a necessity of today. Similarly a commodity which is a necessity to
one class may be a luxury to another. Hence, the elasticity of demand in such cases
should have to be carefully expressed.

2. Substitutes. Demand is elastic for those goods which have substitutes and
inelastic for those goods which have no substitutes. The availability of substitutes,
thus, determines the elasticity of demand. For instance, tea and coffee are
substitutes. The change in the price of tea affects the demand for coffee. Hence, the
demand for coffee and tea is elastic.

3. Number of Uses. Elasticity of demand for any commodity depends on its

number of
uses. Demand is elastic; if a commodity has more uses and inelastic if it has only one
use. As coal has multiple uses, if its price falls it will be demanded more for cooking,
heating, industrial purposes etc. But if its price rises, minimum will be demanded for
every purpose.

4. Postponement. Demand is more elastic for goods the use of which can be
postponed.
For example, if the price of silk rises, its consumption can be postponed. The demand
for silk is, therefore, elastic. Demand is inelastic for those goods the use of which is
urgent and, therefore, cannot be postponed. The use of medicines cannot be put off.
Hence, the demand for medicines is inelastic.

5. Raw Materials and Finished Goods. The demand for raw materials is
inelastic but the demand for finished goods is elastic. For instance, raw cotton has
inelastic demand but cloth has elastic demand. In the same way, petrol has inelastic
demand but car itself has only elastic demand.

6. Price Level. The demand is elastic for moderate prices but inelastic for lower
and higher prices. The rich and the poor do not bother about the prices of the goods
that they buy. For example, rich buy Benaras silk and diamonds etc. at any price. But
the poor buy coarse rice, cloth etc. whatever their prices are.

7. Income Level. The demand is inelastic for higher and lower income groups and
elastic for middle income groups. The rich people with their higher income do not
bother about the price. They may continue to buy the same amount whatever the
price. The poor people with lower incomes buy always only the minimum
requirements and, therefore, they are induced neither to buy more at a lower price
nor less at a higher price. The middle income group is sensitive to the change in
price. Thus, they buy more at a lower price and less at higher price.

29
 8.Habits. If consumers are habituated of some commodities, the demand for such
commodities will be usually inelastic. It is because that the consumer will use them
even their prices go up. For example, a smoker does not smoke less when the price
of cigarette goes up.

9. Nature of Expenditure. The elasticity of demand for a commodity also

depends as to how much part of the income is spent on that particular commodity.
The demand for such commodities where a small part of income is spent is generally
highly inelastic i.e. newspaper, boot-polish etc. On the other hand, the demand of
such commodities where a significant part of income is spent, elasticity of demand
is very elastic.

10. Distribution of Income. If the income is uniformly distributed in the society,

a small change in price will affect the demand of the whole society and the demand
will be elastic. In case of unequal distribution of income and wealth, a change in price
will hardly influence the poor section of the society and the demand will be relatively
inelastic.

11. Influence of Diminishing Marginal Utility. We know that utility falls when
we consume more and more units but not in a uniform way. In case utility falls
rapidly, it means that the consumer has no other near substitutes. As a result,
demand is inelastic. Conversely, if the utility falls slowly, demand for such
commodity would be elastic and raises much for a fall in price.

Price elasticity of demand:

Numerical Value Terminology Description

e=α Perfectly Elastic Consumers have infinite
demand at a particular price and
none at all at even slightly
higher than this given price.
e=0 Perfectly Inelastic Demand remains unchanged
whatever may be the change in
price
e>1 Relatively elastic Quantity demanded changes by
a larger percentage than does
price
e<1 Relatively inelastic
Quantity demanded changes by
a smaller percentage than does
price
e =1 Unitary Elastic Quantity demanded changes by
exactly the same percentage as
does the price.

Activity:

Given below is a numerical example.Calculate the price elasticity of demand.show

diagramatically as well. Can you think of a product that suits this example? Also
explain why?

30
Price Quantity Demanded
10 20
8 25

Methods of measuring Price elasticity

There are 4 methods of measuring price elasticity:

1.Percentage Method:

The percentage method measures price elasticity of demand by dividing the

percentage change in amount demand by percentage change in price of commodity.
The elasticity of demand is unity, greater than unity and less than unity. Demand is
unity if change in demand is proportionate to the change in price. Demand is greater
than unity when change in demand is more than proportionate change in price. The
demand is less than unity if change is less than proportionate change in price. The
coefficient of price elasticity of demand is always negative because change in price
brings a change in demand in opposite direction. Negative signs are usually
disregarded.

The following formula is used for the measurement of price

elasticity of demand:

Ey = Δq/Δp × p/q
Elasticity less than unity:
A consumer buys 5 kg of commodity at Rs 10. If the price falls to Rs 6 the consumer buys 6 kilograms.
Elasticity in this case is less than 1.

Ey = Δq/Δp × p/q = 1/4 × 10/5 = 1/2 < 1 (less elastic)

Elasticity is unity:
A consumer buys 5 kg of commodity at $10. If the price rises to $12 the consumers buys 4 kilograms.
Elasticity in this case is1.

Ey = Δq/Δp × p/q = 1/2 × 10/5 = 1 (unity)

Elasticity is more than unity:

A consumer buys 5 kg of commodity at $10. if the price rises to $11 the consumers buys 4 kilograms.
Elasticity in this case is more than 1. Thus

Ey = Δ q /Δ p × p/q = 1/1 × 10/5 = 2 > 1 (elastic)

2. Total expenditure method

Marshal evolved total expenditure (outlay) of consumer or total revenue of seller as measure of
elasticity. Total expenditure of a producer is compared before and after change in price. Total outlay is
equal to price multiplied by quantity demanded. This method of the measurement of price elasticity of

31
demand tells us whether demand for a commodity is elastic or greater than unity. When fall in its
price leads to increase in total expenditure in it and a rise the price causes decrease in total
expenditure. Demand is equal to unity when total expenditure remains the same whether there is
increase in price or decrease in price of goods. Demand is said to be inelastic or less than unity when
total expenditure decrease with decrease in price and increase with increase in price.

Schedule for expenditure elastic demand

Price Quantity demanded Outlay

12 2 24
6 4 24
3 8 24

The total expenditure remains unchanged at Rs.24 in unitary elastic demand. There is fall in price
from Rs.12 to Rs.6 and Rs.3, the total expenditure remains unchanged at Rs.24. When there is rise in
price from Rs.3 to Rs.6 and Rs.12, the total expenditure remains unchanged at Rs.24. The elasticity of
price is = 1 or unitary elastic demand whether there is increase in price or decrease in price.

3. Point Elasticity Method:

Prof. Marshall devised a geometrical method for measuring elasticity at a point on

the demand curve. Let RS be a straight line demand curve in Figure 11.2. If the price
falls from PB(=OA) to MD(=OC). the quantity demanded increases from OB to OD.
Elasticity at point P on the RS demand curve according to the formula is: Ep =
∆q/∆p x p/q
.

32
Where ∆ q represents changes in quantity demanded, ∆p changes in price level while

p and q are initial price and quantity levels.

From Figure 11.2

∆ q = BD = QM

∆p = PQ

p = PB

q = OB

Substituting these values in the elasticity formula:

With the help of the point method, it is easy to point out the elasticity at any point
along a demand curve. Suppose that the straight line demand curve DC in Figure
11.3 is 6 centimetres. Five points L, M, N, P and Q are taken oh this demand curve.
The elasticity of demand at each point can be known with the help of the above
method. Let point N be in the middle of the demand curve. So elasticity of demand
at point.

33
4. Arc Elasticity :

We arrive at the conclusion that at the mid-point on the demand curve the elasticity
of demand is unity. Moving up the demand curve from the mid-point, elasticity
becomes greater. When the demand curve touches the Y-axis, elasticity is infinity.
Ipso facto, any point below the mid-point towards the X-axis will show elastic
demand.Elasticity becomes zero when the demand curve touches the X-axis.

We have studied the measurement of elasticity at a point on a demand curve. But

when elasticity is measured between two points on the same demand curve, it is
known as arc elasticity. In the words of Prof. Baumol, “Arc elasticity is a measure of
the average responsiveness to price change exhibited by a demand curve over some
finite stretch of the curve.”

Any two points on a demand curve make an arc. The area between P and M on the
DD curve in Figure 11.4 is an arc which measures elasticity over a certain range of
price and quantities. On any two points of a demand curve the elasticity coefficients
are likely to be different depending upon the method of computation. Consider the
price-quantity combinations P and M as given in Table 11.2.
Table 11.2: Demand Schedule:

34
If we move from P to M, the elasticity of demand is:

Table 11.2 Demand Schedule

Point Price Quantity
P 8 10
M 6 12

If we move from P to M, the elasticity of demand is:

If we move in the reverse direction from M to P, then

Thus the point method of measuring elasticity at two points on a demand curve gives
different elasticity coefficients because we used a different base in computing the
percentage change in each case.
To avoid this discrepancy, elasticity for the arc (PM in Figure 11.4) is calculated by
taking the average of the two prices [(p1, + p2 1/2] and the average of the two
quantities [(p1, + q2) 1/2]. The formula for price elasticity of demand at the mid-
point (C in Figure 11.4) of the arc on the demand curve is

35
On the basis of this formula, we can measure arc elasticity of demand when there is a
movement either from point P to M or from M to P.

From P to M at P, p1 = 8, q1, =10, and at M, P2 = 6, q2 = 12

Applying these values, we get

Thus whether we move from M to P or P to M on the arc PM of the DD curve, the

formula for arc elasticity of demand gives the same numerical value. The closer the
two points P and M are, the more accurate is the measure of elasticity on the basis of
this formula. If the two points which form the arc on the demand curve are so close
that they almost merge into each other, the numerical value of arc elasticity equals
the numerical value of point elasticity.

B) Income Elasticity of Demand

Income Elasticity of Demand: Measurement, Types and

Significance
Consumer’s income is one of the important determinants of demand for a product.

The demand for a product and consumer’s income are directly related to each other,
unlike price-demand relationship.

“Income elasticity of demand means the ratio of the percentage

change in the quantity demanded to the percentage in income”-
Watson.

For example, the demand for a product increases with increase in consumer s
income and vice versa, while keeping other factors of demand at constant. The
degree of responsiveness of demand with respect to change in consumer s income is
called income elasticity of demand. According to Watson, “Income elasticity of
demand means the ratio of the percentage change in the quantity demanded to the
percentage in income.”

Measurement of Income Elasticity of Demand:

The income elasticity of demand (ey) can be measured by the
following formula:

36
ey = Percentage change in quantity demanded/Percentage change in income

Percentage change in quantity demanded = New quantity demanded (∆Q)/Original

quantity demanded (Q)

Percentage change in income = New income (∆Y)/original income (Y)

Therefore, the income elasticity of demand can be symbolically

represented as:

ey = ∆Q/Q : ∆Y/Y

ey = ∆Q/Q * Y/∆Y

ey = ∆Q/∆Y * Y/Q

Change in demand (∆Q) is the difference between the new demand (Q1) and original
demand (Q).

It can be calculated by the following formula:

∆Q = Q1 – Q

Similarly, change in income is the difference between the new income (Y1) and
original income (Y).

It can be calculated by the following formula:

∆Y = Y1 – Y

The formula for measuring the income elasticity of demand is same as price
elasticity of demand. The only difference in the formula is that in the income
elasticity of demand, income (Y) is substituted as a determinant of demand in place
of price (P). Let us understand the concept of income elasticity of demand with the
help of an example.

Suppose the monthly income of an individual increases from Rs. 6,000 (Y) to Rs.
12,000 (Y1). Now, his demand for clothes increases from 30 units (Q) to 60 units
(Q1).

The income elasticity of demand can be calculated as follows:

ey = ∆Q/∆Y * Y/Q

∆Q = Q1 – Q = 60 – 30 = 30 units

∆Y = Y1 – Y = 12000 – 6000 = Rs. 6000

37
ey = 30/6000 * 6000/30 = 1 (equal to unity)

Types of Income Elasticity of Demand:

Like price elasticity of demand, the degree of responsiveness of demand with change
in consumer’s income is not always the same. The income elasticity of demand is
different for different products.

On the basis of numerical value, income elasticity of demand is classified

into three groups, which are as follows:

i. Positive Income Elasticity of Demand:

Refers to a situation when the demand for a product increases with increase in
consumer’s income and decreases with decrease in consumer’s income. The income
elasticity of demand is positive for normal goods.

It is explained with the help of Figure-12:

In Figure-12, the slope of the curve is upward from left to right, which indicates that
the increase in income causes increase in demand a nd vice versa. Therefore,
in such a case, the elasticity of demand is positive.
The positive income elasticity of demand can be of three
types, which are discussed as follows:
a. Unitary Income Elasticity of Demand:
Implies that positive income elasticity of demand would be unitary when the
proportionate change in the quantity demanded is equal to proportionate change in
income. For example, if income increases by 50% and demand also rises by 50%,
then the demand would be called as unitary income elasticity of demand. In such a
case, the numerical value of income elasticity of demand is equal to one (ey = 1).

38
b. More than Unitary Income Elasticity of Demand:
Implies that positive income elasticity of demand would be more than unitary when
the proportionate change in the quantity demanded is more than proportionate
change in income. For example, if the income increases by 50% and demand rises by
100%. In such a case, the numerical value of income elasticity of demand would be
more than one (ey>1).

c. Less than Unitary Income Elasticity of Demand:

Implies that positive income elasticity of demand would be less than unitary when
the proportionate change in, the quantity demanded is less than proportionate
change in income. For example, if the income increases by 50% and demand
increases only by 25%. In such a case, the numerical value of income elasticity of
demand would be less than one (ey<1).

ii. Negative Income Elasticity of Demand:

Refers to a kind of income elasticity of demand in which the demand for a product
decreases with increase in consumer’s income. The income elasticity of demand is
negative for inferior goods, also known as Giffen goods. For example, if the income
of a consumer increases, he would prefer to purchase wheat instead of millet. In
such a case, the millet would be inferior to wheat for the customer.

Negative income elasticity of demand is shown with the

help of Figure-13:

Figure-13 shows that when income is Rs. 10, then the demand for goods is 4 units.
On the other hand, when the income increases to Rs. 20, then the demand is 2 units.
In Figure-13, the slope of the curve is downward from left to right, which indicates
that the increase in income causes decrease in demand and vice versa. Therefore, in
such a case, the elasticity of demand is negative.

iii. Zero Income Elasticity of Demand:

39
Refers to the income elasticity of demand whose numerical value is zero. This is
because there is no effect of increase in consumer’s income on the demand of
product. The income elasticity of demand is zero (ey= 0) in case of essential goods.
For example, salt is demanded in same quantity by a high income and a low income
individual.

Figure-14 shows the zero income elasticity of demand:

Figure-14 shows that when income increases from Rs. 10 to Rs. 20, then the demand
for goods is remain same, 4 units. In Figure-14, the slope of the curve is parallel to Y-
axis (income side), which indicates that the increase in income causes no effect in
demand. Therefore, in such a case, the elasticity of demand is zero.

Significance of Income Elasticity of Demand:

While price elasticity plays a significant role in pricing of a product to maximize the
total revenue of an organization in the short run, income elasticity of demand is
important for production planning and management in the long run.

Following are some of the important uses of income

elasticity of demand:
i. Helping in investment decisions:
Refers to one of the major significance of income elasticity of demand. In developing
countries, such as India, the rate of growth of national income is not steady as it is in
case of developed countries. Moreover in developing countries, rise in national
income does not result in immediate increase in the demand for certain goods.

The concept of national income is very important for sellers as it helps them to
allocate their resources in different industries. Generally, sellers prefer to invest in

40
industries where the demand for goods is more with respect to proportionate change
in the income or where the income elasticity of demand is greater than zero (ey>1).

For example, the demand for durable goods, such as vehicles, furniture, and
electrical appliances, increases in response to increase in the national income. In
such industries, sellers earn high profits when there is increase in national income.
On the other hand, industries with low income elasticity (ey<1), there is a gradual
increase in demand for goods, whereas the demand for goods having negative
income elasticity declines when the national incomes grows.

ii. Forecasting demand:

Refers to the fact that income elasticity of demand help in anticipating the demand
for goods in future. If change in income is certain, there would be a major change in
the demand for goods. This is due to the fact that if consumers are aware of change
in income, they may change their tastes and preferences for certain goods.

On the other hand, if the change in income is temporary, there would be a slow
change in the demand. However, the demand for goods in future is also influenced
by various factors other than income.

iii. Categorizing goods:

Implies that income elasticity of demand helps in classifying goods, such as normal
goods, essential goods, or inferior goods. The classification of goods enables sellers
to select the goods to be produced and the quantity of goods to be produced. Apart
from this, it also helps sellers to decide the income group to whom the goods should
target.

Following assumptions are made while classifying goods:

a. A good would be a normal good, if the income elasticity of demand is positive.
b. A good would be an inferior good, if the income elasticity of demand is negative.
For example, millet is inferior to wheat; therefore, the demand for millet is negative.

c. A good would be a luxury good, if income elasticity of demand is positive and

greater that one (ey> 1). For example, the demand for cars and air conditioners is
income elastic.

d. A good would be an essential good, if income elasticity of demand is positive but

less than one (ey< 1). For example, food grains and clothes.

e. A good would be neutral, if the income elasticity of demand is zero (ey=0).

41
C) Cross Elasticity of Demand: Measurement, Types and
Significance
The study of the concept cross elasticity of demand plays a major role in forecasting
the effect of change in the price of a good on the demand of its substitutes and
complementary goods.

Therefore, it helps in deciding the price of a good by determining the change in the
demand of its substitutes and complementary goods.

The demand for a good is generally associated with the demand for another good.
Therefore, change in the price of one good produces change in the price of another
good. The extent of relationship between two related goods can be measured by
cross- elasticity of demand. In other words, cross-elasticity of demand measures the
receptiveness of quantity demanded of a good with respect to change in the price of
its substitute or complementary good.

Some of the definitions of cross-elasticity of demand are as

follows:

In the words of Leibhafsky, “the cross elasticity of demand is a measure of the

responsiveness of T to change in the price of X.”

According to Ferugson, “the cross-elasticity of demand is the proportional change in

the quantity of good-X demanded resulting from a given relative change in the price
of the related good-Y.”

It should be noted that the cross-elasticity of demand would be positive, when two
goods are substitute of each other. This is because the increase in the price of one
good increases the demand for the other. On the other hand, in case of
complementary goods, the cross-elasticity of demand would be negative as increase
in the price of one good decreases the demand for the other. For example, increase
in the price of tea would result in the increase in the demand for coffee, whereas
increase in the price of petrol would cause decrease in the demand for cars.

Measurement of Cross Elasticity of Demand:

Cross-elasticity of demand expresses the ratio of percentage change in demand of
good X produced due to the percentage change in price of related good Y.

Therefore, the formula for cross-elasticity (ec) of demand is as follows:

ec = Percentage change in quantity demanded of X/Percentage change in price of Y

42
Percentage change in quantity demanded of X= New demand for X (∆QX)/Original
demand for X (QX)

Percentage change in price of Y= New price for Y (∆PY/Original price for Y (PY)

The symbolic representation of the formula for cross elasticity of

demand is as follows:

ec = ∆QX/QX: ∆PY/PY

ec = ∆QX/QX */PY/∆PY

ec = ∆QX/∆PY */PY/QX

∆QX can be calculated by subtracting original demand for X (QX) from increase in

demand (QX1), which is as follows:

∆QX = QX1 – QX

Similarly, PY is the difference between the new price of Y (PY1) and original price for
Y (PY).

It can be calculated by the following formula:

∆PY = PY1 -PY

Types of Cross Elasticity of Demand:

The numerical value of cross-elasticity of demand is not same for every related
goods. It differs for different types of goods.

The various types of cross-elasticity of demand are as

follows:
i. Positive Cross Elasticity of Demand:
Implies that the cross elasticity of demand would be positive when increase in the
price of one good (X) causes increase in the demand for the other good (Y). In simple
terms, cross elasticity would be positive for substitutes. For example, the quantity
demanded for coffee has increased from 500 units to 550 units with increase in the
price of tea from Rs. 8 to Rs. 10. Calculate the cross elasticity of demand and state
the type of relationship between coffee (X) and tea(Y).

Solution:

QX1 =550 units

43
QX =500 units

PY1 = Rs. 10

PY = Rs. 8

Therefore, ∆QX = QX1 – QX = 550 – 500 = 50 units

Similarly, ∆PY = PY1 – PY = Rs. 2

Now ec = 50/2*8/500= 0.4

The cross elasticity of “demand is positive; therefore, X and Y are substitutes.

ii. Negative Cross Elasticity of Demand:

Refers to a situation when the rise in the price of one good (X) reduces the demand
for the other good (Y). The cross elasticity of demand would be negative for
complementary goods. For example, the quantity demanded for X decreases from
220 to 200 units with the rise in prices of Y from Rs. 10 to 12.

Now, the cross elasticity of demand would be as follows:

QX1 =200 units

QX =220 units

PY1 = Rs. 12

PY = Rs. 10

Therefore, ∆QX = QX1 – QX = 200 – 220= – 20 units

Similarly, ∆PY = PY1 – PY = Rs. 12 – Rs. 10 = Rs. 2

Now ec = – 20/2* 12/200= -0.6

The cross elasticity of demand is negative; therefore, X and Y are complementary to

each other.

iii. Zero Cross Elasticity of Demand:

Implies that the cross elasticity of demand would be zero when two goods X and Y
are not related to each other. In other words, the increase or decrease in the price of
one good (X) would not affect the demand of other good (Y).

Significance of Cross Elasticity of Demand:

44
The study of the concept cross elasticity of demand plays a major role in forecasting
the effect of change in the price of a good on the demand of its substitutes and
complementary goods. Therefore, it helps in deciding the price of a good by
determining the change in the demand of its substitutes and complementary goods.

Apart from this, cross elasticity of demand helps in determining the nature of
relationship between two goods whether they are substitutes, complementary to
each other or totally different from each other. In addition, it also enables an
organization to anticipate the intensity of monopoly and extent and type of
competition in the market.

Supply analysis

Definition of Supply:
 
Supply is of the scarce goods. It is the amount of a commodity that sellers are
able and willing to offer fore sale at different price per unit of time. 
In the words of Meyer:
 “Supply is a schedule of the amount of a good that would be offered fore sale at
all possible price at any period of time; e.g., a day, a week, and so on”.
 Definition of Stock:
 "Stock is meant the total quantity of a commodity this exists in a market and
can be offered for sale at a short notice".
 Difference/Distinction between Supply and Stock:
 Here it seems necessary that the meaning of the term ‘supply’ and ‘stock’ may
be made clear as they are often confused by the readers. Supply refers to that
quantity of the commodity which is actually brought into the market fore sale at
a given price per unit of time. While Stock is meant the total quantity of a
commodity this exists in a market and can be offered for sale at a short notice.
 
The supply and stock of a commodity in the market may or may not be equal if
the commodity is perishable, like vegetables, fruits, fish, etc; then the supply
and stock is generally the same. But in case of a product find that the price of
his product is low as compared to its cost of production, he tries to withhold the
entire or a part of a stock. In case of a favorable price, the producer may dispose
of large quantities or the entire stock of his commodity; it will all depend upon
his own valuation of the commodity at that particular time.

Definition of Law of Supply:

 
There is direct relationship between the price of a commodity and its quantity
offered ore sale over a specified period of time. When the price of a goods
rises, other things remaining the same, its quantity which is offered for sale

45
increases as and price falls, the amount available for sale decreases. This
relationship between price and the quantities which suppliers are prepared to
offer for sale is called the law of supply.
 

Explanation of Law of Supply:

 
The law of supply, in short, states that ceteris paribus sellers supply more goods
at a higher price than they are willing at a lower price.
 
Supply Function:
 
The supply function is now explained with the help of a schedule and a curve.
 
Market Supply Schedule:
 
Market Supply Schedule of a Commodity:
(In Dollars)
Px 4 3 2 1
Qx S
100 80 60 40
 
In the table above, the produce are able and willing to offer for sale 100 units of
a commodity at price of Rs.4. As the price falls, the quantity offered for sale
decreases. At price of Rs.1, the quantity offered for sale is only 40 units.
 
Law of Supply Curve/Diagram:
 
The market supply data of the commodity x as shown in the supply schedule is
now presented graphically.
 

46
 
In the figure (5.1) price is plotted on the vertical axis OY and the quantity
supplied on the horizontal axis OX. The four points d, c, b, and a show each
price quantity combination. The supply curve SS/ slopes upward from left to
right indicating  that  less quantity is offered  for sale at lower price and more at
higher prices by the sellers not supply curve is usually positively sloped.
 
Formula for Law of Supply/Supply Function:
 
The supply function can also be expressed in symbols.
 
QxS = Φ (Px Tech, Si, Fn, X,........)
Here:
 Qxs = Quantity supplied of commodity x by the producers.
 Φ =  Function of.
 Px =  Price of commodity x.
 Tech = Technology.
 S  =  Supplies of inputs.
 F  =  Features of nature.
 X  =  Taxes/Subsidies.
            =  Bar on the top of last four non-price factors indicates that these
variables also affect the supply but they are held constant.
 Example of Law of Supply:
 The law of supply is based on a moving quantity of materials available to meet
a particular need. Supply is the source of economic activity. Supply, or the lack
of it, also dictates prices. Cost of scarce supply goods increase in relation to the

47
shortages. Supply can be used to measure demand. Over supply results in lack
of customers. An over supply is often a loss, for that reason. Under supply
generates a demand in the form of orders, or secondary sales at higher prices.
 If ten people want to buy a pen, and there's only one pen, the sale will be based
on the level of demand for the pen. The supply function requires more pens,
which generates more production to meet demand.
 Assumptions of Law of Supply:
 (i) Nature of Goods. If the goods are perishable in nature and the seller cannot
wait for the rise in price. Seller may have to offer all of his goods at current
market price because he may not take risk of getting his commodity perished.
 
(ii) Government Policies. Government may enforce the firms and producers to
offer production at prevailing market price. In such a situation producer may not
be able to wait for the rise in price.
 
(iii) Alternative Products. If a number of alternative products are available in
the market and customers tend to buy those products to fulfill their needs, the
producer will have to shift to transform his resources to the production of those
products.
 
(iv) Squeeze in Profit. Production costs like raw materials, labor costs,
overhead costs and selling and administration may increase along with the
increase in price. Such situations may not allow producer to offer his products at
a particular increased price.
 
Limitations/Exceptions of Law of Supply:
 
Exceptions that affect law of supply may include:

(i) Ability to move stock.

(ii) Legislation restricting quantity.

(iii) External factors that influence your industry.

 
Importance of Law of Supply:

(i) Supply responds to changes in prices differently for different goods,

depending on their elasticity or inelasticity. Goods are elastic when a modest
change in price leads to a large change in the quantity supplied. In contrast,
goods are inelastic when a change in price leads to relatively no response to the
quantity supplied. An example of an elastic good would be soft drinks, whereas
an example of an inelastic service would be physicians' services. Producers will

48
be more likely to want to supply more inelastic goods such as gas because they
will most likely profit more off of them.

(ii) Law of supply is an economic principle that states that there is a direct
relationship between the price of a good and how much producers are willing to
supply.

(iii) As the price of a good increases, suppliers will want to supply more of it.
However, as the price of a good decreases, suppliers will not want to supply as
much of it. For producers to want to produce a good, the incentive of profit
must be greater than the opportunity cost of production, the total cost of
producing the good, which includes the resources and value of the other goods
that could have been produced instead.

(iv) Entrepreneurs enter business ventures with the intention of making a profit.
A profit occurs when the revenues from the goods a producer supplies exceeds
the opportunity cost of their production. However, consumers must value the
goods at the price offered in order for them to buy them. Therefore, in order for
a consumer to be willing to pay a price for a good higher than its cost of
production, he or she must value that good more than the other goods that could
have been produced instead. So supplier's profits are dependent on consumer
demands and values. However, when suppliers do not earn enough revenue to
cover the cost of production of the good, they incur a loss. Losses occur
whenever consumers value a good less than the other goods that could have
been produced with the same resources.

Determinants of Supply:
 
There are four important Determinants of Supply as under:
 
(i) Technology changes. Technology helps a producer to minimize his cost of
production.

(ii) Resource supplies. The producer also has to pay for other resources such as
raw materials and labor. if his money is short on supplying a certain number of
products because of an increase in resource supplies, then he has to reduce his
supply.
 
(iii) Tax/ Subsidy. A producer aims to maximize his profit, but an increase in
tax will only increase his expenses, decreasing his capacity to buy resource
supplies and forcing him to reduce his supply.
 
(iv) Price of other goods produced. A producer may not only produce on

49
product but other products as well. A producer's money is limited and if he
increases his supply in one product, he would have to decrease his supply in the
other product, no unless his sales increase.
 
Thus:
 Qxs = Φ (Px) Ceteris Paribus
Ceteris Paribus. In economics, the term is used as a shorthand for indicating
the effect of one economic variable on another, holding constant all other
variables that may affect the second variable.

1.6 Demand Forecasting:

1.6.1 Meaning of Demand Forecasting

Future is uncertain. There is great deal of uncertainty with regard to demand. Since
the demand is uncertain, production, cost, revenue, profit etc. are also uncertain.
Through forecasting it is possible to minimise the uncertainties. Forecasting simply
refers to estimating or anticipating future events. It is an attempt to foresee the
future by examining the past. Thus demand forecasting means estimating or
anticipating future demand on the basis of past data.

1.6.2 Objectives of Demand Forecasting

A. Short Term Objectives
1. To help in preparing suitable sales and production policies.
2. To help in ensuring a regular supply of raw materials.
3. To reduce the cost of purchase and avoid unnecessary purchase.
4. To ensure best utilization of machines.
5. To make arrangements for skilled and unskilled workers so that suitable labour
force may be maintained.
6. To help in the determination of a suitable price policy.
7. To determine financial requirements.
8. To determine separate sales targets for all the sales territories.
9. To eliminate the problem of under or over production.

B. Long term Objectives

1. To plan long term production.
2. To plan plant capacity.
3. To estimate the requirements of workers for long period and make arrangements.
4. To determine an appropriate dividend policy.
5. To help the proper capital budgeting.
6. To plan long term financial requirements.
7. To forecast the future problems of material supplies and energy crisis.

1.6.3 Factors Affecting Demand Forecasting

50
For making a good forecast, it is essential to consider the various factors governing
demand forecasting. These factors are summarized as follows.

1. Prevailing business conditions: While preparing demand forecast it

becomes necessary to study the general economic conditions very carefully. These
include the price level changes, change in national income, percapita income,
consumption pattern, savings and investment habits, employment etc.
2. Conditions within the industry: Every business enterprise is only a unit
of a particular industry. Sales of that business enterprise are only a part of the total
sales of
that industry. Therefore, while preparing demand forecasts for a particular business
enterprise, it becomes necessary to study the changes in the demand of the whole
industry, number of units within the industry, design and quality of product, price
policy, competition within the industry etc.

3. Conditions within the firm: Internal factors of the firm also affect the
demand forecast. These factors include plant capacity of the firm, quality of the
product, price of
the product, advertising and distribution policies, production policies, financial
policies etc.

4. Factors affecting export trade: If a firm is engaged in export trade also

it should onsider the factors affecting the export trade. These factors include import
and export control, terms and conditions of export, exim policy, export conditions,
export finance etc.

5. Market behaviour : While preparing demand forecast, it is required to

consider the
market behavior which brings about changes in demand.

6. Sociological conditions: Sociological factors have their own impact on

demand forecast of the company. These conditions relate to size of population,
density, change in age groups, size of family, family life cycle, level of education,
family income, social awareness etc.

7. Psychological conditions: While estimating the demand for the product,

it becomes
necessary to take into consideration such factors as changes in consumer tastes,
habits, fashions, likes and dislikes, attitudes, perception, life styles, cultural and
religious bents etc.

8. Competitive conditions: The competitive conditions within the industry

may change. Competitors may enter into market or go out of market. A demand
forecast prepared without considering the activities of competitors may not be
correct.

51
1.6.4 Process of Demand Forecasting/ Steps in Demand
Forecasting
Demand forecasting involves the following steps:
1. Determine the purpose for which forecasts are used.
2. Subdivide the demand forecasting programme into small I parts on the basis of
product or sales territories or markets.
3. Determine the factors affecting the sale of each product and their relative
importance.
4. Select the forecasting methods.
5. Study the activities of competitors.
6. Prepare preliminary sales estimates after, collecting necessary data.
7. Analyse advertisement policies, sales promotion plans, personal sales
arrangements etc. and ascertain how far these programmes have been successful in
promoting the sales.
8. Evaluate the demand forecasts monthly, quarterly, half yearly or yearly and
necessary adjustments should be done.
9. Prepare the final demand forecast on the basis of preliminary forecasts and the
results of evaluation.

1.6.5 Methods of demand forecasting

52
M ETHODS OF DEMAND FORECASTING (FOR ESTABLISHED
PRODUCTS)
There are several methods to predict the future demand. All methods can be
broadly classified into two. (A) Survey methods, (B) Statistical methods

A) Survey methods
Under this method surveys are conducted to collect information about the future
purchase plans of potential consumers. Survey methods help in obtaining
information about the desires, likes and dislikes of consumers through collecting the
opinion of experts or by interviewing the consumers. Survey methods are used for
short term forecasting. Important survey methods are :

(a) consumers interview method,

(b) collective opinion or sales force opinion methodic)

( c)experts opinion method,

(d) consumers clinic and

( e) end use method.

(a) Consumers' interview method (Consumers survey): Under this

method, consumers are interviewed directly and asked the quantity they would like
to buy. After collecting the data, the total demand for the product is calculated. This
is done by adding up all individual demands. Under the consumer interview method,
either all consumers or selected few are interviewed. When all the consumers are
interviewed, the method is known as complete enumeration method. When only a
selected group of consumers are interviewed, it is known as sample survey method

Advantages
1. It is a simple method because it is not based on past record.
2. It suitable for industrial products.
3. The results are likely to be more accurate.
4. This method can be used for forecasting the demand of a new product.

Disadvantages
1. It is expensive and time consuming.
2. Consumers may not give their secrets or buying plans.

53
3. This method is not suitable for long term forecasting.
4. It is not suitable when the number of consumer is large.

(b) Collective opinion method: Under this method the salesmen estimate
the expected sales in their respective territories on the basis of previous experience.
Then demand is estimated after combining the individual forecasts (sales estimates)
of the salesmen. This method is also known as sales force opinion method.

Advantages
This method is simple.
1. It is based on the first hand knowledge of Salesmen.
2. This method is particularly useful for estimating demand of new products.
3. It utilises the specialised knowledge of salesmen who are in close touch with the prevailing
market conditions.

Disadvantages
1. The forecasts may not be reliable if the salespeople are not trained.
2. It is not suitable for long period estimation.
3. It is not flexible.
4. Salesmen may give lower estimates that make possible easy achievement of sales
quotas fixed for each salesman.

(c)Experts' opinion method: This method was originally developed at Rand

Corporation in 1950 by Olaf Helmer, Dalkey and Gordon. Under this method,
demand is estimated on the basis of opinions of experts and distributors other than
salesmen and ordinary consumers. This method is also known as Delphi method.
Delphi is the ancient Greek temple where people come and prey for information
about their future.

Advantages
1. Forecast can be made quickly and economically
2.This is a reliable method because estimates are made on the basis of knowledge
and experience of sales experts.
3. The firm need not spare its time on preparing estimates of demand.
4. This method is suitable for new products.

Disadvantages
1. This method is expensive.
2. This method sometimes lacks reliability

(d)Consumer clinics: In this method some selected buyers are given certain
amounts of money and asked to buy the products. Then the prices are changed and
the consumers are asked to make fresh purchases with the given money. In this way
the consumers" responses to price changes are observed. Thus the behaviour of the
consumers is studied. On this basis demand is estimated. This method is an
improvement over consumer’s interview method.

Merits:
1. It provides an opportunity to study the behaviour of consumers directly.

54
2. It provides reliable and realistic picture about future demand.
3. It gives useful information to aid in the decision making process.

Demerits:
1. It is a time consuming method.
2. Selecting the participants is very difficult.
3. It is expensive.
4. Consumers may take it as a game. They may not reveal their preferences.

(e) End use method: This method is based on the fact that a product generally
has different uses. In the end use method, first a list of end users (final consumers,
individual industries, exporters etc.) is prepared. Then the future demand for the
product is found either directly from the end users or indirectly by estimating their
future growth. Then the demand of all end users of the product is added to get the
total demand for the product.

B.Statistical Methods
Statistical methods use the past data as a guide for knowing the level of future
demand. Statistical methods are generally used for long run forecasting. These
methods are used for established products. Statistical methods include:
(i) Trend projection method,
(ii) Regression and Correlation,
(iii)Method of moving averages
(iv) Barometric method.
( V) Other methods

(i)Trend projection method or Time series method : This method

is based on analysis of past sales patterns. A firm which has been in existence for
quite a long time will have accumulated considerable data regarding sales for a
number of years.such data is arranged chronologically with regular intervals of time.
This type of data is called time series.the time series shows effective demand for the
product during the period of past ten years or fifteen years. On the basis of the data, a
graph can be drawn and this is called a sales curve. The sales curve shows
fluctuations and turning points in demand. If the turning points are few and their
interval is widely spread over, firm forecasting becomes possible. Frequency of
turning points indicates uncertain demand conditions. When a turning point occurs,
the trend projection breaks down. If the turning points are few and spaced at long
intervals, accurate forecast is possible.

Time series has four types of components:

1.secular trends, 2. seasonal variations, 3. cyclical variations, 4. Random variations

1. secular trends: secular trends refers to the general tendency of the data and it is
known as long period or secular trend. This can be upward or downward, depending
upon the behaviour.
2. Seasonal variations: seasonal variations refer to changes which occur during a
climate season or a festival season. It may be that of festival season like deepavali, or
dussherra etc. Normally, these changes which are repetitive in charcter are related to
a 12 month period.

55
3. Cyclical variations: Cyclical variations refer to the changes arising out of booms
and depressions
4. Random variations : random variations refer to changes which occur unnoticed
like famines, floods, earthquake etc. These cannot be predicted.

The real problem in forecasting is to separate and measure each of these four factors.
When a forecast is made the seasonal cyalical and radnom factors are eliminated
from the data and only the secular trend is used.

The trend in time series can be estimated by using anyone of the following methods:
I)the least square method
II) the free hand method,
III) the moving average method
IV) the method of semi averages

Advantages of Statistical Methods

1 The method of estimation is scientific

2 Estimation is based on the theoretical relationship between sales (dependent
variable) and price, advertising, income etc. (independent variables)
3 These are less expensive.
4 Results are relatively more reliable.

Disadvantages of Statistical Methods

1 These methods involve complicated calculations.
2 These do not rely much on personal skill and experience.
3 These methods require considerable technical skill and experience in order to be
effective.

ii) Regression and correlation :

1. Correlation  Correlation is a measure of association between two variables. The

variables are not designated as dependent or independent.  The two most popular
correlation coefficients are: Spearman's correlation coefficient rho and Pearson's
product-moment correlation coefficient. When calculating a correlation coefficient
for ordinal data, select Spearman's technique. For interval or ratio-type data, use
Pearson's technique.  The value of a correlation coefficient can vary from minus
one to plus one. A minus one indicates a perfect negative correlation, while a plus
one indicates a perfect positive correlation. A correlation of zero means there is no
relationship between the two variables. When there is a negative correlation between
two variables, as the value of one variable increases, the value of the other variable
decreases, and vice versa. 
The standard error of a correlation coefficient is used to determine the
confidence intervals around a true correlation of zero. If your correlation coefficient
falls outside of this range, then it is significantly different from zero. The standard
error can be calculated for interval or ratio-type data (i.e., only for Pearson's product-
moment correlation).  The significance (probability) of the correlation coefficient is
determined from the t-statistic. The probability of the t-statistic indicates whether
the observed correlation coefficient occurred by chance if the true correlation is zero.

56
In other words, it asks if the correlation is significantly different than zero. When the
t-statistic is calculated for Spearman's rank-difference correlation coefficient, there
must be at least 30 cases before the t-distribution can be used to determine the
probability. If there are fewer than 30 cases, you must refer to a special table to find
the probability of the correlation coefficient.

2. Regression : Simple regression is used to examine the relationship between

one dependent and one independent variable. After performing an analysis, the
regression statistics can be used to predict the dependent variable when the
independent variable is known.  The regression line (known as the least squares
line) is a plot of the expected value of the dependent variable for all values of the
independent variable. Technically, it is the line that "minimizes the squared
residuals". The regression line is the one that best fits the data on a scatterplot. 
Using the regression equation, the dependent variable may be predicted from the
independent variable.
The slope of the regression line (b) is defined as the rise divided by the run. The y
intercept (a) is the point on the y axis where the regression line would intercept the y
axis.
The slope and y intercept are incorporated into the regression equation. The
intercept is usually called the constant, and the slope is referred to as the coefficient.
Since the regression model is usually not a perfect predictor, there is also an error
term in the equation. 
In the regression equation, y is always the dependent variable and x is always the
independent variable. 
Here is a way to mathematically describe a linear regression model:
y = a + bx + e 
The significance of the slope of the regression line is determined from the t-statistic.
It is the probability that the observed correlation coefficient occurred by chance if
the true correlation is zero. 
Some researchers prefer to report the F-ratio instead of the t-statistic. The F-ratio is
equal to the t-statistic squared.  The t-statistic is equal to the estimated coefficient
divided by its standard error. 2 
The t-statistic for the significance of the slope is essentially a test to determine if the
regression model (equation) is usable. If the slope is significantly different than zero,
then we can use the regression model to predict the dependent variable for any value
of the independent variable. 
On the other hand, take an example where the slope is zero. It has no prediction
ability because for every value of the independent variable, the prediction for the
dependent variable would be the same. Knowing the value of the independent
variable would not improve our ability to predict the dependent variable. Thus, if the
slope is not significantly different than zero, don't use the model to make
predictions. 
The coefficient of determination (r-squared) is the square of the correlation
coefficient. Its value may vary from zero to one. It has the advantage over the
correlation coefficient in that it may be interpreted directly as the proportion of
variance in the dependent variable that can be accounted for by the regression
equation. For example, an r-squared value of 0.49 means that 49% of the variance in
the dependent variable can be explained by the regression equation. The other 51%
is unexplained. 
The standard error of the estimate for regression measures the amount of variability

57
in the points around the regression line. It is the standard deviation of the data
points as they are distributed around the regression line. The standard error of the
estimate can be used to develop confidence intervals around a prediction.

iii) Method of moving averages:

This method can be used to determine the trend values for given data without going
into complex mathematical calculations. The calculations are based on some pre-
determined period in weeks, months, years etc. The period depends on the nature of
characteristics in the time series and can be determined by plotting the obsrvations
on graph paper. A moving average is an average of some fixed or pre-determined
number of observa tions (given by the period) which moves through the series by
dropping the top item of the previous averaged group and adding the net item below
in each successive average. The calculation depends upon the period to be odd or
even. In the case of odd order periods (3, 5, 7, ... ) the average of the observations is
calculated for the given period and the calculated value is write in front of central
value of the period e.g. for a period of 5 years, the averse of the values of five years is
calculated and is recorded against the third ear. Thus in case of five yearly moving
averages, first two years and last two years of the data will not have any average
value.

If period of observations is even e.g. four years, then the average of the our yearly
observations is written between second and 3rd year values. After this centering is
done by finding the average of the paired values.
The even order periods creates the problem of centering between the
periods. Due to this generally odd order periods are preferred. The calculated values
of the moving averages became the basis for determining the expected future sales. If
the underlying demand pattern is stationary i.e. at a constant mean demand level
except, of course, for the superimposed random fluctuations or node, the moving
averages method provides a simple and good estimate. In the method equal
weightage is assigned to all the periods chosen for averaging. The moving average
method for forecasting suffers from the
following defects:

(i) Records of the demand data have to be retained over a fairly long period.
(ii) If demand series depicts trend as against the stationary level the moving average
method would provide forecasts that lags the original series.

Merits of Moving Average Method :

(i) The method is simple and easy to apply in practice.

(ii) It is based on mathematical calculations.
(iii) More accurate than graphical method.

Demerits of Moving Average Method:

(i) Choice of period of moving average is difficult.

(ii) Cannot be applied if some observations are missing.
(iii) Some trend values for the periods in the beginning as well as in the end cannot

58
be determined.
(iv) When the period of the moving average coincides with the periodicity in the data,
if any, then the trend values may not be representative.

Iv) Barometric : barometric method is an improvement over trend projection

method. In the trend projection method, the future is some sort of an extension of
the past , while in the baromethic methos, events of the present are used to predict
the future demand. This is done by using certain economic and stastical indicators .
the barometric methos use time series to predict variables. The barometric
techniques using time series, which when combined in certain ways, provide
direction of change in the economy or in industries. These are called barometers of a
market change.

This method may also be called economic indicator method. The economic
indicators will help in estimating the demand for product at a future date. There are
three types in this.

I)Leading indicators
II) coincident indicators
III)Lagging indicators

Leading indicators:  These indicators as the name suggest move ahead of the

happening. In other words when an even that has already happened is used to
predict the future event, then the already happened even would act as a leading
indicator. For instance the data relating to working women would act as a leading
indicator for the demand of working women hostels. Though such leading indicators
provide a way to understand the future demand, their major drawback is that they
may not be always precise. What are the prominent examples of leading economic
indicators? They would be data related to mean week hours of work put in by the
workers, producers’ fresh orders for consumer goods, consumer expectations index,
producers’ fresh orders of capital goods etc. 
Coincident indicators: These are those indicators that take place simultaneously to
the happening. These coincident indicators would include data relating to people
employed in non-agricultural sectors, production of the industrial sector, personal
income etc. These indicators too depict the state of the economy. For instance if the
data related to industrial production show strong numbers, then it shows that the
economy is performing well. On the other hand disappointing industrial production
numbers would reflect poor state of the economy.
Lagging indicators:  These indicators are those which take place after the
happening. These indicators are essential to understand how the economy would
shape up in the future because these follow the economic cycle. In other words these
indicators show the way to the future. Hence lagging indicators are those which are
the most important ones and are extremely useful in predicting the future economic
events. Inflation and data relating to unemployment levels are the top indicators
that help in understanding or analysing the performance of the economy.

Methods of Demand Forecasting for New Products

Demand forecasting of new product is more difficult than forecasting for existing

59
product. The reason is that the product is not available. Hence, no historical data are
available. In these conditions the forecasting is to be done by taking into
consideration the inclination and wishes of the customers to purchase. For this a
research is to be conducted. But there is one problem that it is difficult for a customer
to say anything without seeing and using the product before. Thus it is very difficult
to forecast the demand for new products. Any way Prof. Joel Dean has suggested the
following methods for forecasting demand of new products:

1. Evolutionary approach: This method is based on the assumption that the

new product is the improvement and evolution of the old product. The demand is
forecasted on the basis of the demand of the old product. For example, the demand
for black and white TV should be taken in to consideration while forecasting the
demand for colour TV sets because the latter is an improvement of the former.

2. Substitute approach: Here the new product is treated as a substitute of an

existing product, e.g. polythene bags for cloth bags. Thus the demand for a new
product is analysed as a substitute for some existing goods or service.

3. Growth curve approach: Under this method the growth rate of demand
of a new product is estimated on the basis of the growth rate of demand of an existing
product. Suppose Pears soap is in use and a new cosmetic is to be introduced in the
market. In this case the average sale of Pears soap will give an idea as to how the new
cosmetic will be accepted by the consumers.

4. Opinion poll approach: Under this method the demand for a new product
is estimated on the basis of information collected from the direct interviews (survey)
with consumers.

5. Sales Experience approach: Under this method, the new product is

offered for sale in a sample market, i.e. by direct mail or through multiple shop or
departmental shop. From this the total demand is estimated for the whole market.

6. Vicarious approach: This method consists of surveying consumers'

reactions through the specialized dealers who are in touch with consumers. The
dealers are able to know as to how the customers will accept the new product. On the
basis of their reports demand can be estimated. The above methods are not mutually
exclusive. It is desirable to use a combination of two or more methods in order to get
better results.

60
 Unit II

Theory of consumer behavior: consumer

preferences, indifference curves, budget
constraint, utility maximization and the
derivation of the consumer demand curve.

61
2.Consumer Behavior

2.1 Consumer Sovereignty

Consumer sovereignty means the influence of consumers exercising freedom of
choice in a free market over the activities of producers of goods and services. In other
words, consumer sovereignty means the consumers freedom to select the product of
their choice or simply the free choice of consumption.

Meaning of consumer sovereignty: It is the supremacy of the consumer in

selecting and consuming any type of goods and services on the basis of his own
tastes and preferences.

In a capitalistic economy consumer occupies and important and strategic position.

The entire economic activity is guided by the choice and preference of consumer,
Prof.Benhan has rightly pointed out that “ Under capitalism, the consumer is the
king.” Consumer can express his likes and dislikes for specific goods and services in a
free and frank manner. He takes an independent decision without being influenced
by any other persons in the matter of selection and consumption. Hence consumer is
considered as a king.

2.1.1.Reasons for the loss of Consumer Sovereignty:

The main reasons for the loss of consumer sovereignty in the

present day world are as follows:
(a) There is a decline of perfect competition and introduction of multiplicity of
brands and the role played by the advertisements.
(b) There is a rise in producers power by increasing their monopoly power.
(c) Unequal income distribution among the people reduces their power and
freedom to select a product or service.
(d) In the case of public goods, individuals cannot purchase them in desired
quantity, since it can be provided only on a collective basis.

2.1.2 Limitations of Consumer Sovereignty:

Consumer sovereignty is a myth. The various factors which are responsible for
limiting the consumer’s sovereignty are as below:

1. Ignorance of consumers: Due to their ignorance about the availability of

different brands the consumers buy the same product.
2. External influence: consumers tend to imitate their friends or nieghbours or
they are influenced by demonstration effect in the marked.
3. Monopoly power and imperfect competition: Due to the monopoly-power
enjoyed by the producers and the prevalence of imperfect competition
restricts the supply in the market.
4. Government regulations: When the government imposes certain restrictions
such as rationing or prohibitions of certain commodities, consumer

62
 sovereignty to that extent is reduced.
5. Advertisement and sales propaganda: Advertisements and sales propaganda
given by various firms for their products influence the consumer to a greater
extent particularly children and women. They will change the demand pattern
of the consumer.
6. Level of income: the amount of freedom possessed by an individual is limited
by his size of money income.
7. Productive capacity of the economy: If the economy does not have the
necessary resources and ability to produce the commodity desired by the
consumer, freedom gets restricted to the available goods.
8. Level of technology: If the consumer desire for a commodity which cannot be
produced with the aid of present technology in the economy. Then his choice
is restricted to that level of technology available goods.
9. Taxation: Both direct and indirect taxes reduces the money income of the
consumer, thereby to that extent his freedom is affected.
10. Fashions and customs: Acceptance of new fashion, expenditure on social and
religious ceremonies also curtails consumer sovereignty.
11. Inflation: A high rate of inflation prevailing in the economy may induce the
consumer to revise his purchase plan.
12. Standardization of Production: The production of cheap standardized goods
on a large scale restricts the consumers’ choice and also his sovereignty.

2.2 Meaning of consumer:

Consumer is any individuals or households that use goods and services generated
within the economy. The "consumer" is the one who consumes the goods and
services produced.
Behaviour: Refers to the actions of a system or individual, usually in relation
to its environment.
Meaning of Consumer Behavior: Consumer behavior is the study of
when, why, how, and where people do or do not buy a product.

Goods which are demanded can be classified at various levels and on different
standards. These are:
(i) Consumers' Goods and Producers' Goods: The goods such as bread
and butter, clothes and houses which when used, render direct satisfaction
to their consumers are called consumers' goods. The goods such as
machine and raw cotton, which are used for the production of other goods
are called producers' goods.
(ii) Durable Goods and Non-durable Goods: This distinction is drawn
almost on similar lines as between single-use and durable use goods. Non-
durable goods mostly meet current demand. Durable goods may be used
to replace old stock and to expand new stock.

2.2.1 Approaches to consumer behavior

63
Consumer behavior refers to the study of consumer while he is engaged in the
process of consumption. Consumer behavior refers to the study of consumer while
engaged in the process of consumption. It tells us how a consumer with his limited
resources purchase different varieties of goods and services in the market and
compare price and utilities of different alternatives etc. The highest possible
satisfaction for him is possible when he reaches the equilibrium position. The process
of reaching the equilibrium position can be explained with the help of two
approaches:
(i) The Utility Approach
(ii) The Indifference Curve Approach

(i) The Utility Approach: The utility approach is also called as

cardinal theory of consumer behavior and it is also known as traditional
approach to the measurement of consumer behavior. Though this
approach was introduced by Jevons, Walras and Menger in early 1870s, it
was popularized by Alfred Marshall and it appeared in his book “Principle
of Economics”. Under this cardinal approach, the numerals like
1,2,3,4,5………etc. are used to measure utility. This approach is based on
the assumption that the volume of utility of a commodity can be measured
exactly in terms of numbers.

Utility is defined as a property of the commodity which satisfies the wants

of the consumers. Utility is purely subjective is character. It depends upon
the mental attitude of the commodity. The desire for a commodity by a
person depends upon the utility he expects from the commodity.If the
desire for a commodity is greater, than its utility to the person is also
higher.
Utility refers to want satisfying capacity of a commodity.
Take, for example, a chocolate bar. Let's say that after eating one chocolate
bar your sweet tooth has been satisfied. Your marginal utility (and total
utility) after eating one chocolate bar will be quite high. But if you eat
more chocolate bars, the pleasure of each additional chocolate bar will be
less than the pleasure you received from eating the one before - probably
because you are starting to feel full or you have had too many sweets for
one day.
Chocolate Marginal Total
Bars Eaten Chocolate Chocolate
Utility
Utility
0 0 0
1 70 70
2 10 80
3 5 85
4 3 88

The above table shows that total utility will increase at a much slower rate as
marginal utility diminishes with each additional bar. Notice how the first chocolate
bar gives a total utility of 70 but the next three chocolate bars together increase total

64
utility by only 18 additional units.

Definitions of Utility:
1. According to Prof.Hibdon, “Utility is the ability of a good to satisfy a
want”
2. According to J.S.Nicholson, “Utility may be the quality which makes a
thing desirable.”

Concepts of Utility:
The concept of utility can be explained on the basis of the consumption of
a commodity as:
1. Initial Utility: Means the utility derived from the consumption of
its first unit. In other words, when the consumption of a commodity is
made and the consumer gets the utility at the first stage, it is known as
initial utility. It is always positive.
2. Marginal Utility: By marginal utility we mean the addition made
to the total utility, by consuming one more unit of a commodity.
According to Prof. Boulding “The marginal utility which results from
a unit increase in consumption.

Types of marginal utility

Marginal utility can be of three kinds:
(i) Positive Marginal Utility: When total utility increases by the
consumption of a commodity, it is called positive marginal utility. Let us
supposed, when one eats roti, one gets total utility at every additional unit
as 10,18,24,28,30,----- we see that total utility increases constantly, this is
known as positive utility.
(ii) Zero Marginal Utility: Zero marginal utility is defined as no
addition to the total utility by the consumption of an additional unit. In
the above example as total utility reaches 30 by using the fifth unit of an
article, one gets the same total utility i.e., 30 at the next unit, thus, here
the consumer gets zero marginal utility.
(iii) Negative Marginal Utility: In the above examples, when
consumer uses the 7th unit, total utility diminishes by using one more unit
i.e., from 6th unit to 7th unit, total utility is 28 units. Therefore at this stage,
the consumer gets negative marginal utility after obtaining maximum
satisfaction from the commodity i.e., Roti ( 28-30=-2)

3.Total Utility: means the total satisfaction received by the consumer by the
consumption of all units taken together at a time. According to Prof.Leftwitch, “Total
utility refers to the entire amount of satisfaction obtained from consuming various
quantities of a commodity.

Features of Utility:
1. Utility is subjective : The utility of a commodity is always subjective
because it depends upon the consumer as much as on commodity.

65
 2. Utility is relative & Variable: since utility is subjective it is highly
relative and variable. It varies from person to person and sometimes from
time to time for the same person. Further when a commodity gives utility it
gives different amounts of utility to different people. The amount of utility
that a person derives from the consumption of a commodity depends not only
on his mental attitude but also on the intensity of his desire for the
commodity.
3. Utility & Usefulness: Utility is different from usefulness. It Means that
a good possesses utility even when it may not be useful. In other words, a
harmful good has utility.
4. Utility is not measurable: Utility is subjective and as such it cannot
be measured by any measuring rod. Unlike other magnitudes, it can be
quantified. Hence it cannot be added or subtracted. It is thus having an
immeasurable magnitude. However, Mashall in his analysis of consumption
assumes that utility can be measured with the measuring rod of money.
5. Utility & Pleasure: Utility and pleasure are two different things. It is
not necessary that a commodity possessing utility also gives pleasure
whenever it is consumed. As injection possesses utility for a patient though it
gives him some pain. In this way, we can say that there is no relationship
between utility and pleasure.
6. Utility and Morality: Utility is also different from morality. Utility does
not possess any moral or ethical importance. It is only related with the
satisfaction of human wants.

Approaches to the consumer Behavior

There are two approaches :

1) Cardinal Approach
2) Ordinal Approach.

1) Under cardinal approach there are two main laws i.e.,

a) The Law of Diminishing Marginal Utility
b) Law of Equi-marginal Utility

a) The Law of Diminishing Marginal Utility states that

“As a consumer consumes more and more units of a specific commodity, the
utility from the additional units goes on diminishing”.
 Mr. H. Gossen, a German economist, was first to explain this law in 1854.
Alfred Marshal later on restated this law in the following words:
 “The additional benefit which a person derives from an increase of his stock
of a thing diminishes with every increase in the stock that already has”.

The Law of DMU states that if a consumer consumes more of a

commodity the utility of additional unit consumed diminishes.

Assumptions of the Law of Diminishing Marginal Utility

66
 o Various units of a commodity are homogeneous.
o There is no time gap between the consumption of different units.
o Every consumer wants to maximize utility.
o The tastes and preferences of the consumer remain the same during
the period of consumption.
o Marginal utility of money remains the same.
o The Utility of a commodity depends on its own quantity.
o There is no change in the price of the commodity and its substitutes.

This law can be explained by taking a very simple example. Suppose, a man is very
thirsty. He goes to the market and buys one glass of sweet water. The glass of water
gives him immense pleasure or we say the first glass of water has great utility for
him. If he takes second glass of water after that, the utility will be less than that of the
first one. It is because the edge of his thirst has been blunted to a great extent. If he
drinks third glass of water, the utility of the third glass will be less than that of second
and so on.
The utility goes on diminishing with the consumption of every successive
glass water till it drops down to zero. This is the point of satiety. It is the position of
consumer’s equilibrium or maximum satisfaction. If the consumer is forced further
to take a glass of water, it leads to disutility causing total utility to decline. The
marginal utility will become negative. A rational consumer will stop taking water at
the point at which marginal utility becomes negative even if the good is free. In
short, the more we have of a thing, ceteris paribus, the less we want still more of
that, or to be more precise.
“In given span of time, the more of a specific product a consumer obtains, the
less anxious he is to get more units of that product” or we can say that as more units
of a good are consumed, additional units will provide less additional satisfaction than
previous units. The following table and graph will make the law of diminishing
marginal utility more clear.

Schedule of Law of Diminishing Marginal Utility:

Units Total Utility Marginal Utility

1 Glass
st
20 20
2 Glass
nd
32 32-20=12
3 Glass
rd
40 40-32=8
4 Glass
th
42 42-40=2
5 Glass
th
42 42-42=0
6 Glass
th
39 39-42= -3
From the above table, it is clear that in a given span of time, the first
glass of water to a thirsty man gives 20 units of utility. When he takes
second glass of water, the marginal utility goes on down to 12 units;
When he consumes fifth glass of water, the marginal utility drops down
to zero and if the consumption of water is forced further from this point,
the utility changes into disutility (-3).
Here it may be noted that the utility of then successive units
consumed diminishes not because they are not of inferior in quality than

67
that of others. We assume that all the units of a commodity consumed
are exactly alike. The utility of the successive units falls simply because
they happen to be consumed afterwards.

Curve/Diagram of Law of Diminishing Marginal Utility:

The law of diminishing marginal utility can also be represented by a diagram.

In the figure along OX we measure units of a commodity consumed and along OY is

shown the marginal utility derived from them. The marginal utility of the first glass
of water is called initial utility. It is equal to 20 units. The MU of the 5th glass of
water is zero. It is called satiety point. The MU of the 6th glass of water is negative (-
3). The MU curve here lies below the OX axis. The utility curve MM / falls left from
left down to the right showing that the marginal utility of the success units of glasses
of water is falling.

Limitations/Exceptions of Law of Diminishing Marginal

Utility:
1. Rare Things: The foremost exception of the law is that it does not apply in case of
certain rare things.If there are only two diamonds in the world, the possession of
2nd diamond will push up the marginal utility.
2. Homogeneity: It is assumed that the units of the commodity consumed must
be homogeneous. The size of the unit and the quality of the unit must be the
same. Unless the units are of suitable size and quality, the law will not hold good.
3. Suitable time : the time of consumption should not vary. The commodity is
consumed within a certain time. If you take the first cup of coffee at 8 a.m and
the next cup at 3 p.m there is no reason why the utility of the second cup of
coffee is less. If the second cup of coffee is taken at 8.10 a.m the third cup at 8.20
a.m and the fourth cup at 8.30 a.m then the law of diminishing marginal utility
will definitely operate.
4. No change in the taste of the consumer: this is an important assumption
in which the character of the consumer should not change. After taking a cup of
coffee at 8 a.m he takes a cup of tea at 9 a.m the utility increases.
5. Normal persons: the law of diminishing marginal utility applies to normal
persons and not to eccentric or abnormal persons. The law assumes that the
consumer behaves rationally. If in an irrational manner, the law does not
operate.
6. Constant income: The law assumes that the income of the consumer remains

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 the same during the period of consumption. Any change in income will falsify the
law. If the income of a consumer rises in the course of a given consumption time,
the presently consumed commodity becomes inferior and he goes in for a
superior commodity. Even here if the person buys more and more units of a
superior good, then the additional units of commodity brings less utility.

Uses of the law of diminishing marginal utility:

1. In determining the price of a commodity the concept of marginal utility plays

a crucial role.
2. The law has helped in explaining paradox of value namely water diamond
paradox though water is essential for life it has no price. On the other hand
diamond is not essential but has a high price. Water on account of its
plentiful supply is relative marginal utility is less. Therefore it has less price.
On the other hand diamonds are scarce and its marginal utility is very high
and hence it commands a high price.
3. The law of diminishing marginal utility explains the reason for the downward
sloping of a demand curve. Further, the concept of consumer’s surplus is
based upon the law of diminishing marginal utility.
4. Another important use of this concept in the field of direct taxation. For rich
people with higher income, marginal utility of money is low. On the other
hand the poor people with less income find marginal utility of money very
high. Hence higher direct taxes are levied on the rich while the poor are
exempted.

b) The law of Equi-Marginal Utility:

The law of Equi-Marginal Utility states that the consumer would
distribute his money income between the goods in such a way that the
utility derived from the last rupee spent on each good is equal. In other
words, a consumer attains equilibrium when marginal utility of money
expenditure on each goods is the same.

Marginal Utility of Marginal Utility of

‘X’ Commodity ‘Y’ Commodity
____________________ =
____________________
Price of ‘X’ Commodity Price of ‘Y’ Commodity

Assumptions of the law

(i) There is perfect competition in the market and the consumer has
to accept the prevailing price.
(ii) Utility is measurable in terms of money
(iii) The income of the consumer remains constant and it is limited.
(iv) The consumer behaves rationally.
(v) The marginal utility of money remains constant.
(vi) The utility schedule of one commodity is independent of the utility

69
 schedule of the other commodities.
(vii) The law of diminishing marginal utility operates.

Example and Explanation of Law of Equi-Marginal Utility:

 
The doctrine of equi-marginal utility can be explained by taking an example. Suppose
a person has Rs.5 with him whom he wishes to spend on two commodities, tea and
cigarettes. The marginal utility derived from both these commodities is as under
 
Schedule:
 
Units of Money MU of Tea MU of Cigarettes
1 10 12
2 8 10
3 6 8
4 4 6
5 2 3
Rs.5 Total Utility = 30 Total Utility = 30
 
A rational consumer would like to get maximum satisfaction from Rs.5.00. He can
spend money in three ways:
 
(i) Rs.5 may be spent on tea only.
(ii) Rs.5 may be utilized for the purchase of cigarettes only.
(iii) Some rupees may be spent on the purchase of tea and some on the purchase of
cigarettes.
 
If the prudent consumer spends Rs.5 on the purchase of tea, he gets 30 utility. If he
spends Rs.5 on the purchase of cigarettes, the total utility derived is 39 which are
higher than tea. In order to make the best of the limited resources, he adjusts his
expenditure.
 
(i) By spending Rs.4 on tea and Rs.1 on cigarettes, he gets 40 utility (10+8+6+4+12 =
40).
 
(ii) By spending Rs.3 on tea and Rs.2 on cigarettes, he derives 46 utility
(10+8+6+12+10 = 46).
 
(iii) By spending Rs.2 on tea and Rs.3 on cigarettes, he gets 48 utility
(10+8+12+10+8 = 48).
 
(iv) By spending Rs.1 on tea and Rs.4 on cigarettes, he gets 46 utility (10+12+10+8+6
= 46).
 
The sensible consumer will spend Rs.2 on tea and Rs.3 on cigarettes and will get
maximum satisfaction. When he spends Rs.2 on tea and Rs.3 on cigarette, the
marginal utilities derived from both these commodities is equal to 8. When the
marginal utilities of the two commodities are equalizes, the total utility is then

70
maximum, i.e., 48 as is clear from the schedule given above.
 
Curve/Diagram of Law of Equi-Marginal Utility:
 
The law of equi-marginal utility can be explained with the help of diagrams.
 

 
In the figure 2.3 MU is the marginal utility curve for tea and KL of cigarettes. When a
consumer spends OP amount (Rs.2) on tea and OC (Rs.3) on cigarettes, the marginal
utility derived from the consumption of both the items (Tea and Cigarettes) is equal
to 8 units (EP = NC). The consumer gets the maximum utility when he spends Rs.2
on tea and Rs.3 on cigarettes and by no other alternation in the expenditure.
 
We now assume that the consumer spends Rs.1 on tea (OC / amount) and Rs.4 (OQ/)
on cigarettes. If CQ/ more amounts are spent cigarettes, the added utility is equal to
the area CQ/ N/N. On the other hand, the expenditure on tea falls from OP amount
(Rs.2) to OC/ amount (Rs.1). There is a toss of utility equal to the area C /PEE. The
loss is utility (tea) is greater than that The loss in utility (tea) is maximum
satisfaction except the combination of expenditure of Rs.2 on tea and Rs.3 on
cigarettes.
 
This law is known as the Law of maximum Satisfaction because a consumer
tries to get the maximum satisfaction from his limited resources by so planning his
expenditure that the marginal utility of a rupee spent in one use is the same as the
marginal utility of a rupee spent on another use.
 
It is known as the Law of Substitution because consumer continuous substituting
one good for another till he gets the maximum satisfaction.
 
It is called the Law of Indifference because the maximum satisfaction has been

71
achieved by equating the marginal utility in all the uses. The consumer than becomes
indifferent to readjust his expenditure unless some change fakes place in his income
or the prices of the commodities, etc.
 
Limitations/Exceptions of Law of Equi-Marginal Utility:
 
(i) Effect on fashions and customs: The law of equi-marginal utility may
become inoperative if people forced by fashions and customs spend money on the
purchase of those commodities which they clearly knows yield less utility but they
cannot transfer the unit of money from the less advantageous uses to the more
advantageous uses because they are forced by the customs of the country.
 
(ii) Ignorance or carelessness: Sometimes people due to their ignorance
of price or carelessness to weigh the utility of the purchased commodity do not
obtain the maximum advantage by equating the marginal utility in all the uses.
 
(iii) Indivisible units: If the unit of expenditure is not divisible, then again the
law may become inoperative.
 
(iv)Freedom of choice: If there is no perfect freedom between various
alternatives, the operation of law may be impeded.
 
Importance of Law of Equi-Marginal Utility:
 
The law of equi-marginal utility is of great practical importance. The application of
the principle of substitution extends over almost every field of economic enquiry.
Every consumer consciously trying to get the maximum satisfaction from his limited
resources acts upon this principle of substitution. Same is the case with the producer.
In the field of exchange and in theory of distribution too, this law plays a vital role. In
short, despite its limitation, the law of maximum satisfaction is meaningful general
statement of how consumers behave.
 
In addition to its application to consumption, it applies equally to the theory of
production and theory of distribution. In the theory of production, it is applied on
the substitution of various factors of production to the point where marginal return
from all the factors are equal. The government can also use this analysis for
evaluation of its different economic prices.
 
The equal marginal rule also guides an individual in the spending of his saving on
different types of assets. The law of equal marginal utility also guides an individual in
the allocation of his time between work and leisure. In short, despite limitations the
law of substitution is applied to all problems of allocation of scarce resources.

Theory of Ordinal Utility/Indifference Curve Analysis

72
Definition and Explanation:
 
The indifference curve indicates the various combinations of two goods which
yield equal satisfaction to the consumer. By definition:
 "An indifference curve shows all the various combinations of two goods that give an
equal amount of satisfaction to a consumer".
The indifference curve analysis approach was first introduced by Slustsky, a Russian
Economist in 1915. Later it was developed by J.R. Hicks and R.G.D. Allen in the year
1928.These economist are the of view that it is wrong to base the theory of
consumption on two assumptions:
(i) That there is only one commodity which a person will buy at one time.
(ii) The utility can be measured.
Their point of view is that utility is purely subjective and is immeasurable. Moreover
an individual is interested in a combination of related goods and in the purchase of
one commodity at one time. So they base the theory of consumption on the scale of
preference and the ordinal ranks or orders his preferences.

Example:
 
For example, a person has a limited amount of income which he wishes to spend on
two commodities, rice and wheat. Let us suppose that the following commodities are
equally valued by him:
 
Various Combinations:
 
a)      16 Kilograms of Rice          Plus          2 Kilograms of Wheat
b)      12 Kilograms of Rice          Plus          5 Kilograms of Wheat
c)      11 Kilograms of Rice          Plus          7 Kilograms of Wheat
d)      10 Kilograms of Rice          Plus          10 Kilograms of Wheat
e)      9   Kilograms of Rice          Plus          15 Kilograms of Wheat
 It is matter of indifference for the consumer as to which combination he buys. He
may buy 16 kilograms of rice and 2 kilograms of wheat or 9 kilograms of rice and 15
kilograms of wheat. All these combinations are equally preferred by him.
 An indifference curve thus is composed of a set of consumption alternatives each of
which yields the same total amount of satisfaction. These combinations can also be
shown by an indifference curve.
An Indifference Schedule:
An indifference curve is drawn on the basis of indifference schedule. An indifference
schedule can be defined as an imaginary schedule of various combinations of two
goods that will equally satisfy the consumer.
An indifference schedule is a list of different combinations of two
goods which will give equal level of satisfaction to the consumer.

Combination Rice Wheat

a 16 2
b 12 5

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c 11 7
d 10 10
E 9 15

 Figure/Diagram of Indifference Curve:

The consumer’s preferences can be shown in a diagram with an indifference curve.
The indifference showing nothing about the absolute amounts of satisfaction
obtained. It merely indicates a set of consumption bundles that the consumer views
as being equally satisfactory.
 

 
In fig. 3.1 we measure the quantity of wheat along X-axis (in kilograms) and along Y-
axis, the quantity of rice (in kilograms). IC is an indifference curve.It is shown in the
diagram that a consumer may buy 12 kilograms of rice and 5 kilograms of wheat or 9
kilograms of rice and 15 kilogram of wheat. Both these combinations are equally
preferred by him and he is indifferent to these two combinations. When the scale of
preference of the consumer is graphed, by joining the points a, b, c, d, e, we obtain an
Indifference Curve IC. Every point on indifference curve represents a different
combination of the two goods and the consumer is indifferent between any two
points on the indifference curve. All the combinations are equally desirable to the
consumer. The consumer is indifferent as to which combination he receives. The
Indifference Curve IC thus is a locus of different combinations of two goods which
yield the same level of satisfaction.
An Indifference Map:
 
A graph showing a whole set of indifference curves is called an indifference map.
An indifference map, in other words, is comprised of a set of indifference curves.
Each successive curve further from the original curve indicates a higher level of total
satisfaction.
 

74
 
In the fig. 3.2 three indifference curves IC 1, IC2 and IC3 have been shown. The various
combinations of goods of wheat and rice lying on IC 1 yield the same level of
satisfaction to the consumer. The combinations of goods lying on higher indifference
curve IC2 contain more both the goods wheat and rice. The indifference curve IC 2
gives more satisfaction to the consumer than IC 1. Similarly, the set of combinations
of two goods on IC3 yields still higher satisfaction to the consumer than IC 2. In short,
the further away a particular curve is from the origin, the higher level of satisfaction
it represents.
 It may here be noted that while an indifference curve shows all those combinations
of wheat and rice which provide equal satisfaction to the consumer but it does not
indicate exactly how much satisfaction is derived by the consumer from these
combinations. It is because of the fact that the concept of ordinal utility does not
involve the qualitative measurement of utility.

Assumptions:
 
The ordinal utility theory or the indifference curve analysis is based on
following assumptions:
 
(i) Rational behavior of the consumer: It is assumed that individuals
are rational in making decisions from their expenditures on consumer goods.
 
(ii) Utility is ordinal: Utility cannot be measured cardinally. It can be,
however, expressed ordinally. In other words, the consumer can rank the basket of
goods according to the satisfaction or utility of each basket.
 
(iii) Diminishing marginal rate of substitution: In the indifference

75
curve analysis, the principle of diminishing marginal rate of substitution is assumed.
 
(iv) Consistency in choice: The consumer, it is assumed, is consistent in his
behavior during a period of time. For insistence, if the consumer prefers
combinations of A of good to the combinations B of goods, he then remains
consistent in his choice. His preference, during another period of time does not
change. Symbolically, it can be expressed as:
 
If A > B, then B > A
 
(v) Consumer’s preference not self contradictory: The consumer’s
preferences are not self contradictory. It means that if combinations A is preferred
over combination B is preferred over C, then combination A is preferred over
combination A is preferred over C. Symbolically it can be expressed:
 
If A > B and B > C, then A > C
 
(vi)Goods consumed are substitutable: The goods consumed by the
consumer are substitutable. The utility can be maintained at the same level by
consuming more of some goods and less of the other. There are many combinations
of the two commodities which are equally preferred by a consumer and he is
indifferent as to which of the two he receives.

Properties/Characteristics of Indifference Curve:

 Definition, Explanation and Diagram:
 
An indifference curve shows combination of goods between which a person is
indifferent. The main attributes or properties or characteristics of
indifference curves are as follows:
 
(1) Indifference Curves are Negatively Sloped:
 
The indifference curves must slope down from left to right. This means that an
indifference curve is negatively sloped. It slopes downward because as the consumer
increases the consumption of X commodity, he has to give up certain units of Y
commodity in order to maintain the same level of satisfaction.
 

76
In fig. 3.4 the two combinations of commodity cooking oil and commodity wheat is
shown by the points a and b on the same indifference curve. The consumer is
indifferent towards points a and b as they represent equal level of satisfaction.
 
At point (a) on the indifference curve, the consumer is satisfied with OE units of ghee
and OD units of wheat. He is equally satisfied with OF units of ghee and OK units of
wheat shown by point b on the indifference curve. It is only on the negatively sloped
curve that different points representing different combinations of goods X and Y give
the same level of satisfaction to make the consumer indifferent.
 
(2) Higher Indifference Curve Represents Higher Level:
 
A higher indifference curve that lies above and to the right of another indifference
curve represents a higher level of satisfaction and combination on a lower
indifference curve yields a lower satisfaction.
 
In other words, we can say that the combination of goods which lies on a higher
indifference curve will be preferred by a consumer to the combination which lies on a
lower indifference curve.
 

 
In this diagram (3.5) there are three indifference curves, IC 1, IC2 and IC3 which
represents different levels of satisfaction. The indifference curve IC 3 shows greater
amount of satisfaction and it contains more of both goods than IC 2 and IC1 (IC3 > IC2
> IC1).
 
(3) Indifference Curve are Convex to the Origin:
 
This is an important property of indifference curves. They are convex to the origin
(bowed inward). This is equivalent to saying that as the consumer substitutes
commodity X for commodity Y, the marginal rate of substitution diminishes of X for
Y along an indifference curve.
 

77
 
In this figure (3.6) as the consumer moves from A to B to C to D, the willingness to
substitute good X for good Y diminishes. This means that as the amount of good X is
increased by equal amounts, that of good Y diminishes by smaller amounts. The
marginal rate of substitution of X for Y is the quantity of Y good that the consumer is
willing to give up to gain a marginal unit of good X. The slope of IC is negative. It is
convex to the origin.

(4) Indifference Curve Cannot Intersect Each Other:

 
Given the definition of indifference curve and the assumptions behind it, the
indifference curves cannot intersect each other. It is because at the point of tangency,
the higher curve will give as much as of the two commodities as is given by the lower
indifference curve. This is absurd and impossible.
 

 
In fig 3.7, two indifference curves are showing cutting each other at point B. The
combinations represented by points B and F given equal satisfaction to the consumer
because both lie on the same indifference curve IC 2. Similarly the combinations
shows by points B and E on indifference curve IC 1 give equal satisfaction top the
consumer.
  If combination F is equal to combination B in terms of satisfaction and
combination E is equal to combination B in satisfaction. It follows that the
combination F will be equivalent to E in terms of satisfaction. This conclusion looks
quite funny because combination F on IC 2 contains more of good Y (wheat) than
combination which gives more satisfaction to the consumer. We, therefore, conclude

78
that indifference curves cannot cut each other.

 (5) Indifference Curves do not Touch the Horizontal or

Vertical Axis:
 
One of the basic assumptions of indifference curves is that the consumer purchases
combinations of different commodities. He is not supposed to purchase only one
commodity. In that case indifference curve will touch one axis. This violates the basic
assumption of indifference curves.
 

 
In fig. 3.8, it is shown that the in difference IC touches Y axis  at point C and X axis at
point E. At point C, the consumer purchase only OC commodity of rice and no
commodity of wheat, similarly at point E, he buys OE quantity of wheat and no
amount of rice. Such indifference curves are against our basic assumption. Our basic
assumption is that the consumer buys two goods in combination.

 Consumer Surplus:
Definition and Explanation:

The concept of consumer’s surplus was introduced by Alfred Marshall. According to

him:
"A consumer is generally willing to pay more for a given quantity of good than what
he actually pays at the price prevailing in the market".

For example, you go to the market for the purchase of a pen. You are mentally
prepared to pay Rs.25 for the pen which the seller has shown to you. He offers the
pen for Rs.10 only. You immediately purchase the pen and say ‘thank you’.You were
willing to pay Rs.25 for the pen but you are delighted to get it for Rs.10 only.
Consumer’s surplus is the difference between the maximum amount a consumer is
willing to pay for the good and the price he actually pays for the good. In our
example given above, the consumer’s surplus is Rs.15 (Rs.25 – Rs.10).

Consumer’s surplus is the difference between the total amount of

money the consumer would be willing to pay for a quantity of
commodity and the amount he actually had to pay for it.

79
Schedule:
 
The concept of consumer’s surplus is now explained with the help of a schedule and a
demand curve.
 
Quantity Willing to Pay (Rs.) Price (Rs.) Consumer’s
Surplus (Rs.)
1 25 10 15 = (25 – 10)
2 20 10 10 = (20 – 10)
3 15 10 5 = (15 – 10)
4 10 10 0
Total  75 10 x 4 = 40 30
 
Diagram/Figure:
 

In this figure 3.20, the individual demand curve DD/ shows the maximum amount a
consumer is willing to pay for each unit of the good. An individual is not willing to
purchase any pen at a price of Rs.30 per month. He will, however, is willing to
purchase one pen at a price of Rs.20 per pen, he is willing to purchase 2 pens. The
surplus diminishes with the decline in the marginal utility of pens.
 
In case the price comes down to Rs.15 per pen, the consumer purchases 3 pens. By
using this demand curve, we measure the surplus which a consumer gets from the
purchase of pens. The current market price of a pen Rs.10, which we have assumed
the purchaser cannot change. The consumer was willing to pay Rs.25 per pen but he
actually pay Rs.10 only, the consumer’s surplus for the first pen is Rs.15 = (25 – 10).
For the second pen, it is Rs.10 = (20 – 10) and for the third consumer’s surplus is
Rs.5 = (15 – 10).
 There is no surplus on the fourth unit as the market price for the pen is the same
what he would have paid for the pen. The total consumer’s surplus from the purchase
of four pens is Rs.15 + Rs.10 + Rs.5 = Rs.30. It is the sum of surpluses received from
each pen. The shaded area in the graph shows the total consumer’s surplus.
 Consumer’s surplus = Total Utility – (Price x Quantity)
In other words,
Consumer’s surplus (CS) = TU – ( P X Q)
Where, TU = Total Utility, P = Price, Q = Quantity of commodity

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Criticisms of Consumer’s Surplus:
Various economists have critisised the Marshallian doctrine consumers’ surplus.
They are:
(i) Unrealistic Assumptions:
(a) This concept is based on the unrealistic assumption of cardinal or
numerical measurement of utility i.e., consumer’s surplus cannot be
expressed numerically.
(b) Marginal utility of money does not remain constant
(c) This concept is not applicable in the case of substitutes.
(ii) Consumer’s surplus cannot be measured. Critics agrue that being a
subjective concept, it cannot be exactly measured in terms of money and
futher entire concept is hypothetical.
(iii) Meaningless of this concept in the case of necessaries: In case of
necessaries like water, a consumer derives infinite utility and would be
willing to pay anything rather than go without it. So, in case of water
consumer’s surplus may be infinite. Hence, it is not correct to say that
whenever a consumer drinks a glass of water, he enjoys great consumer
surplus.
(iv) The concept is imaginary: Consumer’s surplus is imaginary and
illusory and does not exist in reality.
(v) No evidence in support of this concept: Marshall has not
provided any data in support of this concept and it is not capable of
emperial testing also.
Importance of Consumer’s Surplus:
 The concept of consumer’s surplus has both theoretical as well as practical
importance.
 (i) Theoretical importance: The idea of consumer’s surplus reveals the benefits
which we derive from our purchase of the commodity in the market.
 For example, when we purchase salt, or a match box, we are willing to pay the
amount much higher than their market value. For example, a consumer would be
willing to pay Rs.10 for a match box rather than go without it but he actually pay Re
one only on the purchase of a match box. Consumer’s surplus on the purchase of
match box thus is Rs. 9.0.
 (ii) Practical importance: A monopolist can charge higher price for his product if
the consumers are enjoying large consumers surplus on the use of his product.
 (iii)The inhabitants of a country derive consumer's surplus when they import
commodities from abroad. They are usually prepared to pay more for than what they
actually pay.
 (iv)A finance minister imposes taxes of the commodities yielding consumer's
surplus. (v) An entrepreneur before investing capital in a project evaluates
the consumer's surplus to be derived from it. If the benefits to the obtained are
greater than the costs, the investment is undertaken.

81
 UNIT III

Production and Cost Analysis: production

functions-cost functions, and profit functions,
total, average and marginal costs, returns to
factors and scale, short run v/s long run
decisions, derivation of the supply curve.

82
Production analysis
1) Meaning and definition of production function
2) Types of production function
3) Production function through isoquant analysis
4) Law of variable proportions
5) The laws of returns to scale
6) Internal economies of scale
7) External economies of scale
8) Concept of Cost Function
9)

3.1 Meaning of Production

In economics, production theory explains the principles in which the business has to
take decisions on how much of each commodity it sells and how much it produces
and also how much of raw material ie.,fixed capital and labor it employs and how
much it will use. It defines the relationships between the prices of the commodities
and productive factors on one hand and the quantities of these commodities and
productive factors that are produced on the other hand.

Production refers to the creation of value .

Concept
Production is a process of combining various inputs to produce an output for
consumption. It is the act of creating output in the form of a commodity or a service
which contributes to the utility of individuals. In other words, it is a process in which
the inputs are converted into outputs.

Production Analysis
Production analysis basically is concerned with the analysis in which the resources
such as land, labor, and capital are employed to produce a firm’s final product. To
produce these goods the basic inputs are classified into two divisions −

Variable Inputs
Inputs those change or are variable in the short run or long run are variable inputs.

Fixed Inputs
Inputs that remain constant in the short term are fixed inputs.

3.1.1 Definitions:
“The production function is a technical or engineering relation between input and
output. As long as the natural laws of technology remain unchanged, the production
function remains unchanged.” Prof. L.R. Klein

“Production function is the relationship between inputs of productive services per

unit of time and outputs of product per unit of time.” Prof. George J. Stigler

“The relationship between inputs and outputs is summarized in what is called the
production function. This is a technological relation showing for a given state of

83
technological knowledge how much can be produced with given amounts of inputs.”
Prof. Richard J. Lipsey

Thus, from the above definitions, we can conclude that production function shows
for a given state of technological knowledge, the relation between physical quantities
of inputs and outputs achieved per period of time.

3.2) PRODUCTION FUNCTION

The production function shows a technical or engineering relationship between the

physical inputs and physical outputs of a firm, for a given state of technology. A
production function has the following attributes:
1. It indicates the functional relationship between physical inputs and physical
outputs of the firm, i.e. X=f (L,K)
2. The production function is always in relation to a period of time. This is because a
firm can increase output either by employing some additional factors of production
or increasing all the factors of production depending whether its short run or long
run.
3. The production function shows either the maximum output that can be produced
from a given set of inputs or the minimum quantity of inputs required to produce a
given level of output.
4. The production function includes all the technically efficient methods of
production as it is a purely technical relationship.
5. Output in production function is the result of joint use of factors of production.
Thus, the productivity of a factor is always measured in the context of this factor
being employed in combination with other factors.

3.2.1 Types of production function

Leontief Production Function
1. It implies that a fixed proportion in which factor inputs are to be used
X = Minimum (K/a, L/b)
Empirical Production Function:-
1. Linear Production Function
Q = a + bL
2. Quadratic Production Function
Q = a + bL - cL2
3. Cubic Production Function
Q = a + bL - cL2 – dL3 4.
4. Power Production Function
Q = a + aLb

There are three types of production function:

1) Fixed proportion and variable proportion production function
Fixed Proportion Production Function
Definition: The Fixed Proportion Production Function, also known as a Leontief
Production Function implies that fixed factors of production such as land, labor,
raw materials are used to produce a fixed quantity of an output and these
production factors cannot be substituted for the other factors.

84
In other words, fixed quantity of inputs is used to produce the fixed quantity of
output. All the factors of production are fixed and cannot be substituted for one
another. Suppose there are 50 workers required to produce 500 units of a
product, then the technical Coefficient of production will be 1/10. In the case of a
fixed proportion production function, this one tenth of labor must be employed
for the production of fixed output and no other factors of production can be
substituted in place of labor.

The concept of fixed proportion production function can be further understood

with the help of a figure as shown below:

source: http://businessjargons.com

In the given figure, OR shows the fixed labor-capital ratio, if a firm wants to
produce 100 units of a product, then 2 units of capital and 3 units of labor must
be employed to attain this output.
Similarly, for the production of 300 and 500 units of a product, 5 units of capital
and 6 units of labor and 7 units of capital and 9 units of labor must be employed
respectively.
It may be noticed that along the isoquant curve the marginal product of a factor is
zero, lets say, for the production of 300 units of a product, the capital is fixed (say
5 units), then any additional units of a labor won’t make any difference in the
total production, hence, the marginal product of labor is zero.

Read more: http://businessjargons.com

Variable Proportion Production Function

Definition: The Variable Proportion Production Function implies that the ratio in
which the factors of production such as labor and capital are used is not fixed,
and it is variable. Also, the different combinations of factors can be used to
produce the given quantity, thus, one factor can be substituted for the other.

85
 In the case of variable proportion production function, the technical Coefficient of
production is variable, i.e. the required quantity of output can be achieved
through the combination of different quantities of factors of production, such as
these factors can be varied by substituting other factor/ factors in its place.

Suppose 40 workers are required to produce 200 units of a product, then

technical Coefficient of production will be 1/5. In the case of a variable proportion
production function, one fifth of labor is not necessarily to be employed, but
however, the different combinations of factors of production can be used to
produce a given level of output. Thus, the labor can be substituted for any other
factors.

The concept of variable proportion production function can be further

understood from an isoquant curve, as shown in the figure below:

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In the figure, the isoquant curves show that the different combinations of factors
of technical substitution can be employed to get the required amount of output.
Thus, for the production of a given level of product, the input factors can be
substituted for the other.

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2) Short period and long period production function

The Short Run and Long Run Production Function in the Market
Structures
       The production function provides information about the quantity of factor
inputs as to the result of the quantity of outputs and this is measured by total
product; average product; and marginal product
1. The total product is generated from the total output from the factors of
production employed by the firm. It is the quantity of output produced per time

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period given the inputs. The total product can easily be determined when applied to
manufacturing industries for the production of cars, appliances, cellphones and
other products because of clear cut measure as to the volume of production as to the
tangible costs on labor and capital inputs.
2. The average product is computed through the total output divided by the
number of units of the variables of the factor of production. For example, the 10
factory workers produce 1000 units of electronic components of a computer,
therefore the average product of labor is 10 units of electronic components per
worker. This example is generated by the output per worker employed in the factory.
3. The marginal product is the change of the total product when there is an
additional unit of the input in the factors of production. The additional labor
(increased in the number of workers) as an input product may increase the total
product. For example, the factory intends to hire two additional workers then the 10
workers with a product of 1000 units may now increase to 1200 units. Therefore ,
the marginal product is computed by the one-unit change may result to the increase
of the total product.

The Period of Production

1. Short Run Production
      The short run is a period in which at least one input of the factors of production
is fixed. It should be noted that usually factory facilities, equipment and machinery
including land are fixed, however, the supply can be altered by changing the demand
for labor, raw material, factory components and etc.
      Usually a firm or producers have to pay certain production cost form the
expenses such as the construction of building for the management office,
manufacturing facilities, salaries or wages of the labor and other overhead costs. In
the short run,the firm cost structure has to consider the fixed costs (FC) in a given
period of time regardless of production level. The variable cost is associated with the
production cost.
1. Fixed Costs- The cost of production of the investment utilized by the
firm. The fixed cost does not vary regardless of the production output.
These are overhead cost, rent of offices and buildings, property tax,
amortization and interest.
1. Variable Cost- This indicates cost of the direct labor, raw materials,
supplies and materials. The variable cost is associated in the
production of goods.
      It must be noted that the Total Costs (TC) presents the sum of the of Total
Variable Costs (TVC) and Total Variable Costs (TVC). This is the economic
calculation of this presentation and the average cost with that of the Total Costs:

AC=(TFC+TVC)/Q=AFC+AVC
AC: average costs
TFC: total fixed costs
TVC: total variable costs
AFC: average fixed costs
AVC: average variable costs

     In the short run, the total product usually responds to the increase on the use of a
variable input. However, you cannot simply add factory workers just to increase the
production output. There is a certain point when the marginal product could no

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longer increase the production output because there are too many workers to work
on a fixed capital input just like machinery, equipment and facilities.
      This is the reason why the Law of Diminishing Returns is present in the
study of production function because the additional units of a variable inputs such as
labor and raw material with a fixed land and capital may have consequence on the
initial change in total output will at first rise and then fall. The marginal product of
labor starts to fall when there are already so many workers producing products with
fixed land, capital, equipment and etc. It can reduce the diminishing returns once
there is an expansion of the land, equipment, machinery and even the increase of
capital, however, we must always consider the average product and marginal
product with the standard workers needed in a given number of production output.
        The concept of law of diminishing returns is shown above with the production
function variables of capital outlay, labor input, total output, marginal product and
average product of labor. Let us assume that the fixed capital input in the short run
analysis is 30 units available for the production of certain product. There is a certain
point of the capital input that could maximized the marginal product, however, once
it reaches the peak point the marginal product falls which may show the sign of
diminishing return.
       Let us take this example in the production function, the fixed capital input of 30
units may need a labor input of 6 workers that may produce 233 for the total output
with a marginal product of 60 and average product of labor of 39. The marginal
product of 60 is the maximize change of product for 6 workers, however, an
additional workers may result to diminishing return to marginal product and
eventually to the average product output.

2. Long Run Production

       The period of production in the long run shows the production operation of a
certain period of time. Normally, the firm expansion on the average cost of
production may result the increase of production inputs. However, there are some
conditions that:
a) If the firm increases or expand its production operation, is it always increases its
production output.
b) Is it possible that the average cost of production may follow the same increase (to
let say 50-50%) in the production input and output.
c) If the firm increases by its production input, however, the production output
decreases.
      The long run production for the expansion of the firm through the economies of
scale illustrates the importance of capital intensive ( more equipment per worker)
in mass production; increased specialization and division of labor .

Three (3) Possible Cases in Long Run Period of Production

       The long run period of production usually analyzes the economies of scale which
studies the increasing returns to scale or economies of mass production. It tends to
provided information about the unit cost and the size of operation in the production
of goods. The economies of scale primarily directed to reduce the unit costs from the
increasing size of the operation. That is why the larger firms are more economically
viable in the long run production as it diminishes the production cost. Take note that
the economies of scale tends to increase in specialization and division of labor. This
may lead to increase production inputs and expands the production output.
1. Decreasing Returns to Scale (Increasing Cost)

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     When the firm becomes large it is likely to encounter problem in the production
of a particular product because of the increase average cost of operation. This is the
problem of management when increase of production input by 60% the production
output reaches only to 40%. In this notion the production is less cheap at a certain
scale when it is already large in scale. It requires large-scale machinery or division of
labor to produce greater production output.Hence, the Decreasing Returns to
scale occur when the percent change in output is greater in percent for the change in
inputs.
2. Constant Returns to Scale (Constant Cost)
     There is a time for a firm to enjoy a long range of production output for which the
average cost is the same proportion to both production input and output. If there is
an increase of the number of machines by 50% then there is also an increase of the
number of units produced by 50%. This is a constant returns in machinery
production.Hence, the Constant Returns to scale occur when the average cost do
not increase as a result of diseconomies of scale.
3. Increasing Return to Scale ( Decreasing Cost)
     This is known as the economies of scale wherein the firm’s increase in all
production inputs and outputs. Supposing a firm increases the inputs by 50% the
return of scale increases to 60%.The economies scale expands productive capacity in
the long run as it operated by machines and other sophisticated technology that may
reduce the overhead cost in producing the products. This is more on capital-
intensive production wherein there are more equipment utilize than workers in the
production process. In the long run, the manufacturing sectors with high capital
investment of equipment results to higher production output that expands the
profitability of the firms.The economies of scale is the reduction of unit cost in
the long run of operation. The expansion of the firm through a mass production
provides greater units of output.

Cobb-Douglas Production Function

Definition: The Cobb-Douglas Production Function, given by Charles W. Cobb

and Paul H. Douglas is a linear homogeneous production function, which implies,
that the factors of production can be substituted for one another up to a certain
extent only.

With the proportionate increase in the input factors, the output also increases in
the same proportion. Thus, there are constant returns to a scale. In Cobb-Douglas
production function, only two input factors, labor, and capital are taken into the
consideration, and the elasticity of substitution is equal to one. It is also assumed
that, if any, of the inputs, is zero, the output is also zero.

Likewise, in the linear homogeneous production function, the expansion path

generated by the cobb-Douglas function is also a straight line passing through the
origin. The CD function can be expressed as follows:

Q = ALαKβ

Where, Q = output
A = positive constant
K = capital employed

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 L = Labor employed
α and β = positive fractions shows the elasticity coefficients of outputs for inputs
labor and capital, respectively.
Β = 1-α

This algebraic form of Cobb-Douglas function can be changed in a log linear form,
with the help of regression analysis:

Log Q = log A + α log L + β log K

The homogeneity of the Cobb-Douglas production function can be checked by

adding the values of α and β. If the sum of these parameters is equal to one, then
it shows that the production function is linearly homogeneous, and there are
constant returns to a scale. If the sum of these parameters is less or more than
one, then there is a decreasing and increasing returns to a scale respectively.

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3.3 ) Production function through ISO-QUANT analysis.

Iso-Quant Curve: Definitions, Assumptions and Properties!

The term Iso-quant or Iso-product is composed of two words, Iso = equal, quant =
quantity or product = output.

Thus it means equal quantity or equal product. Different factors are needed to
produce a good. These factors may be substituted for one another.

A given quantity of output may be produced with different combinations of factors.

Iso-quant curves are also known as Equal-product or Iso-product or Production
Indifference curves. Since it is an extension of Indifference curve analysis from the
theory of consumption to the theory of production.

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

Definitions:
“The Iso-product curves show the different combinations of two resources with
which a firm can produce equal amount of product.” Bilas

“Iso-product curve shows the different input combinations that will produce a given
output.” Samuelson

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“An Iso-quant curve may be defined as a curve showing the possible combinations of
two variable factors that can be used to produce the same total product.” Peterson

“An Iso-quant is a curve showing all possible combinations of inputs

physically capable of producing a given level of output.”

Assumptions:
The main assumptions of Iso-quant curves are as follows:
1. Two Factors of Production:
Only two factors are used to produce a commodity.

2. Divisible Factor:
Factors of production can be divided into small parts.

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

4. Possibility of Technical Substitution:

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

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

Iso-Product Schedule:

Let us suppose that there are two factor inputs—labour and capital. An Iso-product
schedule shows the different combination of these two inputs that yield the same
level of output as shown in table 1.

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The table 1 shows that the five combinations of labour units and units of capital yield
the same level of output, i.e., 200 metres of cloth. Thus, 200 metre cloth can be
produced by combining.

(a) 1 units of labour and 15 units of capital

(b) 2 units of labour and 11 units of capital

(c) 3 units of labour and 8 units of capital

(d) 4 units of labour and 6 units of capital

(e) 5 units of labour and 5 units of capital

Iso-Product Curve:
From the above schedule iso-product curve can be drawn with the help of a diagram.
An. equal product curve represents all those combinations of two inputs which are
capable of producing the same level of output. The Fig. 1 shows the various
combinations of labour and capital which give the same amount of output. A, B, C, D
and E.

Iso-Product Map or Equal Product Map:

An Iso-product map shows a set of iso-product curves. They are just like contour
lines which show the different levels of output. A higher iso-product curve
represents a higher level of output. In Fig. 2 we have family iso-product curves, each
representing a particular level of output.

92
The iso-product map looks like the indifference of consumer behaviour analysis.
Each indifference curve represents particular level of satisfaction which cannot be
quantified. A higher indifference curve represents a higher level of satisfaction but
we cannot say by how much the satisfaction is more or less. Satisfaction or utility
cannot be measured.

An iso-product curve, on the other hand, represents a particular level of output. The
level of output being a physical magnitude is measurable. We can therefore know the
distance between two equal product curves. While indifference curves are labeled as
IC1, IC2, IC3, etc., the iso-product curves are labelled by the units of output they
represent -100 metres, 200 metres, 300 metres of cloth and so on.
Properties of Iso-Product Curves:
The properties of Iso-product curves are summarized below:
1. Iso-Product Curves Slope Downward from Left to Right:
They slope downward because MTRS of labour for capital diminishes. When we
increase labour, we have to decrease capital to produce a given level of output.

The downward sloping iso-product curve can be explained with the help
of the following figure:

93
The Fig. 3 shows that when the amount of labour is increased from OL to OL 1, the
amount of capital has to be decreased from OK to OK 1, The iso-product curve (IQ) is
falling as shown in the figure.
The possibilities of horizontal, vertical, upward sloping curves can be
ruled out with the help of the following figure 4:

(i) The figure (A) shows that the amounts of both the factors of production are
increased- labour from L to Li and capital from K to K 1. When the amounts of both
factors increase, the output must increase. Hence the IQ curve cannot slope upward
from left to right.
(ii) The figure (B) shows that the amount of labour is kept constant while the
amount of capital is increased. The amount of capital is increased from K to K 1. Then
the output must increase. So IQ curve cannot be a vertical straight line.
(iii) The figure (C) shows a horizontal curve. If it is horizontal the quantity of labour
increases, although the quantity of capital remains constant. When the amount of

94
capital is increased, the level of output must increase. Thus, an IQ curve cannot be a
horizontal line.

2. Isoquants are Convex to the Origin:

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

It can be expressed as:

MRTSLK = – ∆K/∆L = dK/ dL
Where ∆K is the change in capital and AL is the change in labour.

Equation (1) states that for an increase in the use of labour, fewer units of capital will
be used. In other words, a declining MRTS refers to the falling marginal product of
labour in relation to capital. To put it differently, as more units of labour are used,
and as certain units of capital are given up, the marginal productivity of labour in
relation to capital will decline.

This fact can be explained in Fig. 5. As we move from point A to B, from B to C and
from C to D along an isoquant, the marginal rate of technical substitution (MRTS) of
capital for labour diminishes. Everytime labour units are increasing by an equal
amount (AL) but the corresponding decrease in the units of capital (AK) decreases.

95
Thus it may be observed that due to falling MRTS, the isoquant is always
convex to the origin.
3. Two Iso-Product Curves Never Cut Each Other:
As two indifference curves cannot cut each other, two iso-product curves cannot cut
each other. In Fig. 6, two Iso-product curves intersect each other. Both curves IQ1
and IQ2 represent two levels of output. But they intersect each other at point A.
Then combination A = B and combination A= C. Therefore B must be equal to C.
This is absurd. B and C lie on two different iso-product curves. Therefore two curves
which represent two levels of output cannot intersect each other.

4. Higher Iso-Product Curves Represent Higher Level of Output:

A higher iso-product curve represents a higher level of output as shown
in the figure 7 given below:

96
In the Fig. 7, units of labour have been taken on OX axis while on OY, units of
capital. IQ1 represents an output level of 100 units whereas IQ2 represents 200 units
of output.
5. Isoquants Need Not be Parallel to Each Other:
It so happens because the rate of substitution in different isoquant schedules need
not be necessarily equal. Usually they are found different and, therefore, isoquants
may not be parallel as shown in Fig. 8. We may note that the isoquants Iq 1 and
Iq2 are parallel but the isoquants Iq3 and Iq4 are not parallel to each other.

6. No Isoquant can Touch Either Axis:

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

97
7. Each Isoquant is Oval-Shaped.
It means that at some point it begins to recede from each axis. This shape is a
consequence of the fact that if a producer uses more of capital or more of labour or
more of both than is necessary, the total product will eventually decline. The firm
will produce only in those segments of the isoquants which are convex to the origin
and lie between the ridge lines. This is the economic region of production. In Figure
10, oval shaped isoquants are shown.

Curves OA and OB are the ridge lines and in between them only feasible units of
capital and labour can be employed to produce 100, 200, 300 and 400 units of the
product. For example, OT units of labour and ST units of the capital can produce 100
units of the product, but the same output can be obtained by using the same quantity
of labour T and less quantity of capital VT.

Thus only an unwise entrepreneur will produce in the dotted region of the iso-quant
100. The dotted segments of an isoquant are the waste- bearing segments. They form

98
the uneconomic regions of production. In the up dotted portion, more capital and in
the lower dotted portion more labour than necessary is employed. Hence GH, JK,
LM, and NP segments of the elliptical curves are the isoquants.

Difference between Indifference Curve and Iso-Quant Curve:

The main points of difference between indifference curve and Iso-quant
curve are explained below:
1. Iso-quant curve expresses the quantity of output. Each curve refers to given
quantity of output while an indifference curve to the quantity of satisfaction. It
simply tells that the combinations on a given indifference curve yield more
satisfaction than the combination on a lower indifference curve of production.

2. Iso-quant curve represents the combinations of the factors whereas indifference

curve represents the combinations of the goods.

3. Iso-quant curve gives information regarding the economic and uneconomic region
of production. Indifference curve provides no information regarding the economic
and uneconomic region of consumption.

4. Slope of an iso-quant curve is influenced by the technical possibility of

substitution between factors of production. It depends on marginal rate of technical
substitution (MRTS) whereas slope of an indifference curve depends on marginal
rate of substitution (MRS) between two commodities consumed by the consumer.

Principle of Marginal Rate of Technical Substitution [June-2005]:

The principle of marginal rate of technical substitution (MRTS or MRS) is based on
the production function where two factors can be substituted in variable proportions
in such a way as to produce a constant level of output. The marginal rate of technical
substitution between two factors C (capital) and L (labour), MRTS LC is the rate at
which L can be substituted for C in the production of good X without changing the
quantity of output.
As we move along an isoquant downward to the right each point on it represents the
substitution of labour for capital. MRTS is the loss of certain units of capital which
will just be compensated for by additional units of labour at that point. In other
words, the marginal rate of technical substitution of labour for capital is the slope or
gradient of the isoquant at a point. Accordingly, slope = MRTS LC = AC/AL. This can
be understood with the aid of the isoquant schedule, in Table 2.

99
The above table 2 shows that in the second combination to keep output constant at
100 units, the reduction of 3 units of capital requires the addition of 5 units of labour,
MRTSLC = 3 : 5. In the third combination, the loss of 2 units of capital is compensated
for by 5 more units of labour, and so on.

In Fig. 11 at point B, the marginal rate of technical substitution is AS/SB, t point G, it

is BT/TG and at H, it is GR/RH. The isoquant AH reveals that as the units of labour
are successively increased into the factor- combination to produce 100 units of good
X, the reduction in the units of capital becomes smaller and smaller.

It means that the marginal rate of technical substitution is diminishing. This concept
of the diminishing marginal rate of technical substitution (DMRTS) is parallel to the
principle of diminishing marginal rate of substitution in the indifference curve
technique. This tendency of diminishing marginal substitutability of factors is
apparent from Table 2 and Figure 11.

The MRTSLc continues to decline from 3: 5 to 1: 5 whereas in the Figure 11 the

vertical lines below the triangles on the isoquant become smaller and smaller as we
move downward so that GR < BT < AS. Thus, the marginal rate of technical
substitution diminishes as labour is substituted for capital. It means that the
isoquant must be convex to the origin at every point.
Iso-Cost Line:

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The iso-cost line is similar to the price or budget line of the indifference curve
analysis. It is the line which shows the various combinations of factors that will
result in the same level of total cost. It refers to those different combinations of two
factors that a firm can obtain at the same cost. Just as there are various isoquant
curves, so there are various iso-cost lines, corresponding to different levels of total
output.
Definition:
Iso-cost line may be defined as the line which shows different possible combinations
of two factors that the producer can afford to buy given his total expenditure to be
incurred on these factors and price of the factors.

Explanation:
The concept of iso-cost line can be explained with the help of the following table 3
and Fig. 12. Suppose the producer’s budget for the purchase of labour and capital is
fixed at Rs. 100. Further suppose that a unit of labour cost the producer Rs. 10 while
a unit of capital Rs. 20.

From the table cited above, the producer can adopt the following
options:
(i) Spending all the money on the purchase of labour, he can hire 10 units of labour
(100/10 = 10)

(ii) Spending all the money on the capital he may buy 5 units of capital.

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

Diagram Representation:

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In Fig. 12, labour is given on OX-axis and capital on OY-axis. The points A, B, C and
D convey the different combinations of two factors, capital and labour which can be
purchased by spending Rs. 100. Point A indicates 5 units of capital and no unit of
labour, while point D represents 10 units of labour and no unit of capital. Point B
indicates 4 units of capital and 2 units of labour. Likewise, point C represents 4 units
of labour and 3 units of capital.

Iso-Cost Curves:
After knowing the nature of isoquants which represent the output possibilities of a
firm from a given combination of two inputs. We further extend it to the prices of the
inputs as represented on the isoquant map by the iso-cost curves.

These curves are also known as outlay lines, price lines, input-price lines, factor-cost
lines, constant-outlay lines, etc. Each iso-cost curve represents the different
combinations of two inputs that a firm can buy for a given sum of money at the given
price of each input.

Figure 13 (A) shows three iso-cost curves each represents a total outlay of 50, 75 and
100 respectively. The firm can hire OC of capital or OD of labour with Rs. 75. OC is
2/3 of OD which means that the price of a unit of labour is 1/2 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 iso-cost curve will shift upward
to the right as EF parallel to CD, and if the total outlay is reduced it will shift
downwards to the left as AB.

The iso-costs are straight lines because factor prices remain the same whatever the
outlay of the firm on the two factors.

102
The iso-cost curves represent the locus of all combinations of the two input factors
which result in the same total cost. If the unit cost of labour (L) is w and the unit cost
of capital (C) is r, then the total cost: TC = wL + rC. The slope of the iso-cost line is
the ratio of prices of labour and capital i.e., w/r.

The point where the iso-cost line is tangent to an isoquant shows the least cost
combination of the two factors for producing a given output. If all points of tangency
like LMN are joined by a line, it is known as an output-factor curve or least-outlay
curve or the expansion path of a firm.

It shows how the proportions of the two factors used might be changed as the firm
expands. For example, in Figure 13 (A) the proportions of capital and labour used to
produce 200 (IQ1) units of the product are different from the proportions of these
factors used to produce 300 (IQ2) units or 100 units at the lowest cost.
Like the price-income line in the indifference curve analysis, a relative cheapening of
one of the factors to that of another will extend the iso-cost line to the right. If one of
the factors becomes relatively dearer, the iso-cost line will contract inward to the
left.

Given the price of capital, if the price of labour falls, the isocost line EF in Panel (B)
of figure 13 will extend to the right as EG and if the price of labour rises, the iso-cost
line EF will contract inward to the left as EH, if the equilibrium points L, M, and N
are joined by a line. It will be called the price-factor curve.

Ridge Lines:
One knows from the iso-quant curves the extent to which production should be
carried out. Lines which represent the limits of the economic region of production
are called ridge lines. Ridge lines join those points on different iso-quant curves

103
which determine the economic limits of production. The importance of ridge lines is
explained with the help of Figure 14.

Iso-quant curves at point A and D; B and E; and C and F begin to recede from each
axes. The segments above or below these points A B C and D E F, one gets OL and
OR lines. OR and OL lines are called Ridge Lines. These ridge lines show the
economical limits for the firm to produce only in those segments of the iso-quants
which lie between the ridge lines.

It can be explained with the help of an example. In fig. 14, combination of OL3 units
of labour and ON3 units of land can produce 60 quintals of wheat, ON3 amount of
land is the minimum required to produce 60 quintals of wheat.

While using ON3 amount of land, at point C, if more than OL 3 units of labour are
used, total output will be less than 60 quintals of wheat. It means beyond OL3 units
of labour, their marginal productivity will become negative causing total output to be
less than 60 quintals. In other words, after OL 3, marginal productivity of labour will
be zero.
If at point ‘C’ more than OL 3 units of labour are used then to keep the total output of
60 quintals of wheat constant, more than ON3 units of land will have to be used. It
will be unwise and irrational decision. It will unnecessarily increase the cost of
production. Thus to produce outside point ‘C’ will be uneconomic. At point ‘C’
marginal productivity of labour will be zero.
In the same way, we can find out point A and B on iso-quant curves IP) and IP2
where marginal productivity of labour will be zero. The lines joining these points are
called ridge lines. Ridge line OL, therefore, is the locus of points where marginal
productivity of labour is zero. Point F of IP3 indicates that to produce 60 quintals of
wheat, OR3 units of labour and OM3 units of land are required. OR3 units of labour
are the minimum units to produce this level of output. If keeping OR3 units of

104
labour constant, more than OM3 units of labour are used, the total output will be
less than 60 quintals of wheat. It implies that after point ‘F’.

Accordingly, points ‘D’ and ‘E’ on IPi and IP2 curves represent zero marginal
productivity of land. Production thus, will be done on the segment below point ‘D’,
‘E’ and ‘F’. These points have been joined by OR ridge line.

Producer’s Equilibrium or Optimum Combination of Factors or Least

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

Optimum combination is that combination at which either:

(i) The output derived from a given level of inputs is maximum or

(ii) The cost of producing given output is minimum.

For producer’s equilibrium or optimum combination, it must fulfill

following two conditions as:
(i) At the point of equilibrium the iso-cost line must be tangent to isoquant curve.

(ii) At point of tangency i.e., iso-quant curve must be convex to the origin or
MRTSLk must be falling.
The iso-cost line gives information regarding factor prices and financial
resources of the firm.
With a given outlay and prices of two factors, the firm obtains least cost combination
of factors, when the iso-cost line becomes tangent to an iso-product curve. Let us
explain it with the following Fig. 15.

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In Figure 15, P1L1 iso-cost line has become tangent to iso-product curve
(representing 500 units of output) at point E. At this point, the slope of the iso-cost
line is equal to the iso-product curve. The slope of the iso- product curve represents
MRTS of labour for capital. The slope of the iso-cost line represents the price ratio of
the two factors.
Slope of Iso-quant curve = Slope of Iso-cost curve

MRTSLk = – ∆L/∆L = MPL/MPK = PL/PK

[where ∆K → change in capital, ∆L → change in labour, MPL → Marginal Physical
Product of Labour, MPk – Marginal Physical Product of capital, P L Price of Labour,
and PK → Price of capital, MRTSLK =Marginal Rate of Technical Substitution of
labour and capital.]
The firm employs OM units of labour and ON units of capital. The producing firm is
in equilibrium. It obtains least cost combination of the two factors to produce 5 00
units of the commodity.

The points such as H, K, R and S lie on higher iso-cost lines. They require a larger
outlay, which is beyond the financial resources of the firm.

The same can be explained with the help of a numerical example. Suppose the firm
decides to produce 10 units of output. The two factors are labour and capital. The
price of labour per hour is Rs. 10 and the price of machine use per hour is Rs. 10.
The following table shows the various combinations of labour and machine capital
hours required to produce 10 units of output.

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It is clear from this table that the least cost of production is P2. A rational producer
will chose this combination of factors, given the factor prices. Expansion path means
locus of all such points that shows least cost combination of factors corresponding to
different levels of output.

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

By using different combinations of factors a firm can produce different levels of

output. Which of the optimum combinations of factors will be used by the firm is
known as Expansion Path. It is also called Scale-line.

“Expansion path is that line which reflects least cost method of producing different
levels of output.” Stonier and Hague

Expansion path can be explained with the help of Fig. 16. On OX-axis units of labour
and on OY-axis units of capital are given.

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

As a result, firm’s new iso-cost-line shifts to the right as CD. New iso-cost line CD
will be parallel to the initial iso-cost line. CD touches IQ 1 at point E1 which will
constitute the new equilibrium point. If the financial resources of the firm further
increase, but cost of factors remaining the same, the new iso-cost line will be GH.
It will be tangent to Iso-quant curve IQ2 at point E 2 which will be the new
equilibrium point of the firm. By joining together equilibrium points E, E 1 and E2,
one gets a line called scale-line or Expansion Path. It is because a firm expands its
output or scale of production in conformity with this line.
Isoquant Curve and Returns to a Factor:
Returns to a factor refers to the behavior of output in response to changing
application of one factor of production while other factors remaining constant. As in
the case of returns to scale, there are three different aspects of returns to a factor,
viz., increasing returns, constant returns and diminishing returns.

The returns to a factor can be explained using isoquant techniques. It is assumed

that capital is a fixed input and labour is a variable input.

Different Stages of Returns to a Factor:

The different returns to a factor can be explained as follows:
(i) Increasing Returns to a Factor:
It occurs when additional application of the variable factor i.e., labour increases total
output at increasing rate. Fig. 17 explains the situation of increasing returns to a
factor.

In Fig. 17 capital is taken constant at OR units. The line RP shows how larger
quantities of labour can be employed to expand production. It is called output path.

The isoquant curves for 100, 200, 300 and 400 units of output shows that output is
increasing by a constant amount by 100 units. These isoquants intersect the output
path RP at point E, F, G and H.

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We see here that the distance between successive isoquant curves is decreasing, that
is, less and less labour is needed for every additional 100 units of output. This means
an increasing marginal product of labour. However, the distance EF is greater than
FG and FG is greater than GH i.e.

EF = FH = GH

This means that 100 units increase in output can be obtained by employing
successively lesser increments of labour. Let us suppose that EF is 20 units of labour
and FG is 10 units of labour. Then from E to F the additional 100 units of output are
obtained by employing additional 20 units of labour. From F to G additional 100
units of output is obtained by employing only 10 more units of labour. In short, the
marginal product of labour increases when output is expanded along the output path
RP.

(ii) Diminishing Returns to a Factor. Diminishing returns to a factor is a situation

when increasing application of the variable factor increases total output only at the
diminishing rate.

Fig. 18 illustrates the situation of diminishing rate. When capital is taken constant at
OR and production is expanded by adding more labour, the distance between
successive Isoquants becomes increasingly greater, that is even more and more
labour is needed for every additional 100 units of output. This shows a diminishing
marginal product of labour. The distance EF is less than FG and FG is less than GH.

EF < FG < GH Thus, 100 units increase in output can be obtained only by employing
successively greater increments of labour. Between E to F additional 100 units of
output is obtained by applying additional 10 units of labour. Between F to G
additional 100 units of output is obtained by applying additional 20 units of labour.

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Therefore, the marginal product of labour diminishes when output is expanded
along the output path RP.

(iii) Constant Returns to a Factor:

A constant return to a factor occurs when increasing application of the variable
factor increases total output only at a constant rate. Fig. 19, we see that when capital
is taken constant at OR and production is increased by adding more labour, the
distance between isoquants remains constant, so that same amount of labour is
needed for every additional 100 units of output.

This means a constant marginal product (MP) of labour. In other words, 100 units
increase in output can be obtained by employing equal increment of labour. The
distance between different iso-quants remains equal. It can be written as;

EF = FG = GH

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Difference between Returns to Scale and Returns to a Factor:
With the help of Isoquant diagram, we can draw the difference between returns to
scale and returns to factor. Returns to scale implies that output is increased as all the
inputs are increased in the same proportion. However, Fig. 20 shows difference
between returns to scale and returns a factor.

In Fig. 20 on OX-axis labour is measured and on OY-axis capital. We draw straight

lines OA, OB and OC through the origin. These lines or rays show that both labour
and capital are increased to expand output. Moreover, since the lines OA, OB and
OC are straight lines passing through the origin, the ratio between labour and capital
remains same along each one of these lines.

Moving along a ray like OA means to increase production or scale always with the
same ratio of inputs. For instance the isoquants in Fig. 20 show constant returns to
scale. The isoquants for 100, 200, 300 and 400 units of output intersect the straight
lines OA, OB and OC at equal distance.

Thus; it requires twice as much of both capital and labour to produce 200 units
instead of 100 units; 50 percent further more to produce 300 instead of 200 and so
on. In other words the rays show the returns to scale which implies that to increase
output both the inputs should be increased in the same proportion.

Returns to a factor or change in proportion refers one input is held constant while
production is expanded by increasing the quantity of the other input. The horizontal
straight line RP is drawn on the assumption that capital is kept constant at OR and
production expanded by adding more labour. The vertical straight line LM is drawn
on the assumption that labour is held constant at OL and output is expanded by
adding more capital.

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As we move along these lines the amount of one input varies while of the other
remains constant. Thus proportion between the two outputs undergoes a change.
The returns to a factor can be explained either by RP line or LM line depending
whether capital is held constant or labour is held constant. With capital constant at
R; the producer moves from to E, from E to F to G.

Therefore, the successive difference between the isoquants is increasing (FG > EF).
This means that 100 units of additional output can be obtained by employing
successively greater increments of labour. This means diminishing marginal product
of labour. This is the case of diminishing returns to a factor. In short, both the
concepts of returns to scale and returns to a factor (change in factor proportions)
can be explained by using the technique of Isoquants.

3.4) The law of variable proportions

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

1. Constant State of Technology: First, the state of technology is assumed to

be given and unchanged. If there is improvement in the technology, then the
marginal product may rise instead of diminishing.
2. Fixed Amount of Other Factors: Secondly, there must be some inputs whose
quantity is kept fixed. It is only in this way that we can alter the factor
proportions and know its effects on output. The law does not apply if all factors
are proportionately varied.
3. Possibility of Varying the Factor proportions : 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 if the factors must be
used in fixed proportions to yield a product.

Illustration of the Law: The law of variable proportion is illustrated in the

following table and figure. Suppose there is a given amount of land in which more
and more labour (variable factor) is used to produce wheat.

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Units of Labour Total Product Marginal Product Average Product

1 2 2 2

2 6 4 3

3 12 6 4

4 16 4 4

5 18 2 3.6

6 18 0 3

7 14 -4 2

8 8 -6 1

It can be seen from the table that upto the use of 3 units of labour, total product
increases at an increasing rate and beyond the third unit total product increases at a
diminishing rate. This fact is shown by the marginal product which is the addition
made to Total Product as a result of increasing the variable factor i.e. labour.
It can be seen from the table that the marginal product of labour initially rises and
beyond the use of three units of labour, it starts diminishing. The use of six units of
labour does not add anything to the total production of wheat. Hence, the marginal
product of labour has fallen to zero. Beyond the use of six units of labour, total
product diminishes and therefore marginal product of labour becomes negative.
Regarding the average product of labour, it rises up to the use of third unit of labour
and beyond that it is falling throughout.
Three Stages of the Law of Variable Proportions: These stages are illustrated
in the following figure where labour is measured on the X-axis and output on the Y-
axis.
Stage 1. Stage of Increasing Returns: In this stage, total product increases at
an increasing rate up to a point. This is because the efficiency of the fixed factors
increases as additional units of the variable factors are added to it. In the figure,
from the origin to the point F, slope of the total product curve TP is increasing i.e.
the curve TP is concave upwards upto the point F, which means that the marginal
product MP of labour rises. The point F where the total product stops increasing at
an increasing rate and starts increasing at a diminishing rate is called the point of
inflection. Corresponding vertically to this point of inflection marginal product of
labour is maximum, after which it diminishes. This stage is called the stage of
increasing returns because the average product of the variable factor increases
throughout this stage. This stage ends at the point where the average product curve
reaches its highest point.

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Stage 2. Stage of Diminishing Returns: In this stage, total product continues
to increase but at a diminishing rate until it reaches its maximum point H where the
second stage ends. In this stage both the marginal product and average product of
labour are diminishing but are positive. This is because the fixed factor becomes
inadequate relative to the quantity of the variable factor. At the end of the second
stage, i.e., at point M marginal product of labour is zero which corresponds to the
maximum point H of the total product curve TP. This stage is important because the
firm will seek to produce in this range.
Stage 3. Stage of Negative Returns: In stage 3, total product declines and
therefore the TP curve slopes downward. As a result, marginal product of labour is
negative and the MP curve falls below the X-axis. In this stage the variable factor
(labour) is too much relative to the fixed factor.
Importance and Applicability of the Law of Variable Proportion:
The Law of Variable Proportion has universal applicability in any branch of
production. It forms the basis of a number of doctrines in economics. The
Malthusian theory of population stems from the fact that food supply does not
increase faster than the growth in population because of the operation of the law of
diminishing returns in agriculture.
Ricardo also based his theory of rent on this principle. According to him rent arises
because the operation of the law of diminishing return forces the application of
additional doses of labour and capital on a piece of land. Similarly the law of
diminishing marginal utility and that of diminishing marginal physical productivity
in the theory of distribution are also based on this theory.
The law is of fundamental importance for understanding the problems of
underdeveloped countries. In such agricultural economies the pressure of

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population on land increases with the increase in population. This leads to declining
or even zero or negative marginal productivity of workers. This explains the
operation of the law of diminishing returns in LDCs in its intensive form. Ragnar
Nurkse have suggested ways to make use of these disguisedly unemployed labour by
withdrawing them and putting them in those occupations where the marginal
productivity is positive.
Source: http://www.trcollege.net/

3.5 )Law of Return to Scale and It’s Types (With Diagram)

The law of returns to scale explains the proportional change in output with respect
to proportional change in inputs.

In other words, the law of returns to scale states when there are a proportionate
change in the amounts of inputs, the behavior of output also changes.

The degree of change in output varies with change in the amount of inputs. For
example, an output may change by a large proportion, same proportion, or small
proportion with respect to change in input.

On the basis of these possibilities, law of returns can be classified into

three categories:
i. Increasing returns to scale

ii. Constant returns to scale

iii. Diminishing returns to scale

1. Increasing Returns to Scale:

If the proportional change in the output of an organization is greater than the
proportional change in inputs, the production is said to reflect increasing returns to
scale. For example, to produce a particular product, if the quantity of inputs is
doubled and the increase in output is more than double, it is said to be an increasing
returns to scale. When there is an increase in the scale of production, the average
cost per unit produced is lower. This is because at this stage an organization enjoys
high economies of scale.

Figure-13 shows the increasing returns to scale:

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In Figure-13, a movement from a to b indicates that the amount of input is doubled.
Now, the combination of inputs has reached to 2K+2L from 1K+1L. However, the
output has Increased from 10 to 25 (150% increase), which is more than double.
Similarly, when input changes from 2K-H2L to 3K + 3L, then output changes from
25 to 50(100% increase), which is greater than change in input. This shows
increasing returns to scale.

There a number of factors responsible for increasing returns to scale.

Some of the factors are as follows:

i. Technical and managerial indivisibility:
Implies that there are certain inputs, such as machines and human resource, used
for the production process are available in a fixed amount. These inputs cannot be
divided to suit different level of production. For example, an organization cannot use
the half of the turbine for small scale of production.

Similarly, the organization cannot use half of a manager to achieve small scale of
production. Due to this technical and managerial indivisibility, an organization
needs to employ the minimum quantity of machines and managers even in case the
level of production is much less than their capacity of producing output. Therefore,
when there is increase in inputs, there is exponential increase in the level of output.

ii. Specialization:
Implies that high degree of specialization of man and machinery helps in increasing
the scale of production. The use of specialized labor and machinery helps in
increasing the productivity of labor and capital per unit. This results in increasing
returns to scale.

iii. Concept of Dimensions:

Refers to the relation of increasing returns to scale to the concept of dimensions.
According to the concept of dimensions, if the length and breadth of a room
increases, then its area gets more than doubled.

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For example, length of a room increases from 15 to 30 and breadth increases from 10
to 20. This implies that length and breadth of room get doubled. In such a case, the
area of room increases from 150 (15*10) to 600 (30*20), which is more than
doubled.

2. Constant Returns to Scale:

The production is said to generate constant returns to scale when the proportionate
change in input is equal to the proportionate change in output. For example, when
inputs are doubled, so output should also be doubled, then it is a case of constant
returns to scale.

Figure-14 shows the constant returns to scale:

In Figure-14, when there is a movement from a to b, it indicates that input is

doubled. Now, when the combination of inputs has reached to 2K+2L from IK+IL,
then the output has increased from 10 to 20.

Similarly, when input changes from 2Kt2L to 3K + 3L, then output changes from 20
to 30, which is equal to the change in input. This shows constant returns to scale. In
constant returns to scale, inputs are divisible and production function is
homogeneous.

3. Diminishing Returns to Scale:

Diminishing returns to scale refers to a situation when the proportionate change in
output is less than the proportionate change in input. For example, when capital and
labor is doubled but the output generated is less than doubled, the returns to scale
would be termed as diminishing returns to scale.

Figure-15 shows the diminishing returns to scale:

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In Figure-15, when the combination of labor and capital moves from point a to point
b, it indicates that input is doubled. At point a, the combination of input is 1k+1L
and at point b, the combination becomes 2K+2L.

However, the output has increased from 10 to 18, which is less than change in the
amount of input. Similarly, when input changes from 2K+2L to 3K + 3L, then output
changes from 18 to 24, which is less than change in input. This shows the
diminishing returns to scale.

Diminishing returns to scale is due to diseconomies of scale, which arises because of

the managerial inefficiency. Generally, managerial inefficiency takes place in large-
scale organizations. Another cause of diminishing returns to scale is limited natural
resources. For example, a coal mining organization can increase the number of
mining plants, but cannot increase output due to limited coal reserves.

3.6 ) Internal economies of scale

Economies of Scale: Internal and External

Prof. Stigler defines economies of scale as synonyms with returns to scale.
As the scale of production is increased, up to a certain point, one gets economies of scale.
Beyond that, there are its diseconomies to scale Marshall has classified economies to scale
into two parts as under:

I. Internal Economies:
As a firm increases its scale of production, the firm enjoys several economies named
as internal economies. Basically, internal economies are those which are special to
each firm. For example, one firm will enjoy the advantage of good management; the
other may have the advantage of specialisation in the techniques of production and
so on.

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“Internal economies are those which are open to a single factory, or a single firm
independently of the action of other firms. These result from an increase in the scale
of output of a firm and cannot be achieved unless output increases.” Cairncross

Prof. Koutsoyannis has divided the internal economies into two parts:
A. Real Economies

B. Pecuniary Economies

A. Real Economies:
Real economies are those which are associated with the reduction of physical
quantity of inputs, raw materials, various types of labour and capital etc.

These economies are of the following types:

1. Technical Economies:
Technical economies have their influence on the size of the firm. Generally, these
economies accrue to large firms which enjoy higher efficiency from capital goods or
machinery. Bigger firms having more resources at their disposal are able to install
the most suitable machinery.

Therefore, a firm producing on large scale can enjoy economies by the use of
superior techniques.

Technical economies are of three kinds:

(i) Economies of Dimension:
A firm by increasing the scale of production can enjoy the technical economies.
When a firm increases its scale of production, average cost of production falls but its
average return will be more.

(ii) Economies of Linked Process:

A big firm can also enjoy the economies of linked process. A big firm carries all
productive activities. These activities get economies. These linked activities save
time and transport costs to the firm.

(iii) Economies of the Use of By-Products:

All the large sized firms are in a position to use its by-products and waste-material to
produce another material and thus, supplement to their income. For instance, sugar
industries make power, alcohol out of the molasses.

2. Marketing Economies:

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When the scale of production of a firm is increased, it enjoys numerous selling or
marketing economies. In the marketing economies, we include advertisement
economies, opening up of show rooms, appointment of sole distributors etc.
Moreover, a large firm can conduct its own research to effect improvement in the
quality of the product and to reduce the cost of production. The other economies of
scale are advertising economies, economies from special arrangements with
exclusive dealers. In this way, all these acts lead to economies of large scale
production.

3. Labour Economies:
As the scale of production is expanded their accrue many labour economies, like new
inventions, specialization, time saving production etc. A large firm employs large
number of workers. Each worker is given the kind of job he is fit for. The
personnel .officer evaluates the working efficiency of the labour if possible. Workers
are skilled in their operations which save production, time and simultaneously
encourage new ideas.

4. Managerial Economies:
Managerial economies refer to production in managerial costs and proper
management of large scale firm. Under this, work is divided and subdivided into
different departments. Each department is headed by an expert who keeps a vigil on
the minute details of his department. A small firm cannot afford this specialisation.
Experts are able to reduce the costs of production under their supervision. These
also arise due to specialization of management and mechanisation of managerial
functions.

5. Economies of Transport and Storage:

A firm producing on large scale enjoys the economies of transport and storage. A big
firm can have its own means of transportation to carry finished as well as raw
material from one place to another. Moreover, big firms also enjoy the economies of
storage facilities. The big firm also has its own storage and go down facilities.
Therefore, these firms can store their products when prices are unfavorable in the
market.

B. Pecuniary Economies:
Pecuniary economies are those which can be had after paying less prices for the
factors used in the process of production and distribution. Big firms can get raw
material at the low price because they buy the same in the large bulk. In the same
way, they enjoy a lot of concessions in bank borrowing and advertisements.

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These economies occur to a large firm in the following:
(i) The firms producing output on a large scale purchase raw material in bulk
quantity. As a result of this, the firms get a special discount from suppliers. This is a
monetary gain to the firms.

These economies occur to a large firm in the following:

(i) The firms producing output on a large scale purchase raw material in bulk
quantity. As a result of this, the firms get a special discount from suppliers. This is a
monetary gain to the firms.

(ii) The large-scale firms are offered loans by the banks at a low interest rate and
other favourable terms.

(iii) The large-scale firms are offered concessional transportation facilities by the
transport companies because of the large-scale transportation handling.

(iv) The large-scale firms advertise their products on large scales and they are
offered advertising facilities at lower prices by advertising firms and newspapers.

3.7) External Economies:

External economies refer to all those benefits which accrue to all the firms operating
in a given industry. Generally, these economies accrue due to the expansion of
industry and other facilities expanded by the Government. According to Cairncross,
“External economies are those benefits which are shared in by a number of firms or
industries when the scale of production in any industry increases.” Moreover, the
simplest case of an external economy arises when the scale of production function of
a firm contains as an implicit variable the output of the industry. A good example is
that of coal mines in a locality.

Prof. Cairncross has divided the external economies into the following
parts as:
1. Economies of Concentration:
As the number of firms in an area increases each firm enjoys some benefits like,
transport and communication, availability of raw materials, research and invention
etc. Further, financial assistance from banks and non-bank institutions easily accrue
to firm.

We can, therefore, conclude that concentration of industries lead to economies of

concentration.

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2. Economies of Information:
When the number of firms in an industry expands they become mutually dependent
on each other. In other words, they do not feel the need of independent research on
individual basis. Many scientific and trade journals are published. These journals
provide information to all the firms which relates to new markets, sources of raw
materials, latest techniques of production etc.

3. Economies of Disintegration:
As an industry develops, all the firms engaged in it decide to divide and sub-divide
the process of production among themselves. Each firm specializes in its own
process. For instance, in case of moped industry, some firms specialize in rims, hubs
and still others in chains, pedals, tires etc. It is of two types-horizontal disintegration
and vertical disintegration.

In case of horizontal disintegration each firm in the industry tries to specialize in one
particular item whereas, under vertical disintegration every firm endeavors to
specialize in different types of items. Material of one firm may be available and
useable as raw materials in the other firms. Thus, wastes are converted into by-
products.

The selling firms reduce their costs of production by realizing something for their
wastes. The buying firms gain by getting other firms’ wastes as raw materials at
cheaper rates. As a result of this, the average cost of production declines.

Significance of Economies of Scale:

The significance of economies of scale is discussed as under:
(a). Nature of the Industry:
The foremost significance of economies of scale is that it plays an important role in
determining the nature of the industry i.e. increasing cost industry, constant cost
industry or decreasing cost industry.

(b). Analysis of Cost of Production:

When an industry expands in response to an increase in demand for its products, it
experiences some external economies as well as some external diseconomies. The
external economies tend to reduce the costs of production and thereby causing an
upward shift in the long period average cost curve, whereas the external
diseconomies tend to raise the costs and thereby causing an upward shift in the long
period average cost curve. If external diseconomies outweigh the external

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economies, that is, when there are net external diseconomies, the industry would be
an Increasing cost industry.

3.8 Concept of Cost Function:

The relationship between output and costs is expressed in terms of cost function. By
incorporating prices of inputs into the production function, one obtains the cost
function since cost function is derived from production function. However, the
nature of cost function depends on the time horizon. In microeconomic theory, we
deal with short run and long run time.

A cost function may be written as:

Cq = f(Qf Pf)

Where Cq is the total production cost, Qf is the quantities of inputs employed by the
firm, and Pf is the prices of relevant inputs. This cost equation says that cost of
production depends on prices of inputs and quantities of inputs used by the firm.

Importance of Cost Function:

The study of business behaviour concentrates on the production process—the
conversion of inputs into outputs—and the relationship between output and costs of
production.

We have already studied a firm’s production technology and how inputs are
combined to produce output. The production function is just a starting point for the
supply decisions of a firm. For any business decision, cost considerations play a
great role.

Cost function is a derived function. It is derived from the production function which
captures the technology of a firm. The theory of cost is a concern of managerial
economics. Cost analysis helps allocation of resources among various alternatives. In
fact, knowledge of cost theory is essential for making decisions relating to price and
output.

Whether production of a new product is a wiser one on the part of a firm greatly
depends on the evaluation of costs associated with it and the possibility of earning
revenue from it. Decisions on capital investment (e.g., new machines) are made by
comparing the rate of return from such investment with the opportunity cost of the
funds used.

The relevance of cost analysis in decision-making is usually couched in terms of

short and long periods of time by economists. In all market structures, short run
costs are crucial in the determination of price and output. This is due to the fact that
the basis for cost function is production and the prices of inputs that a firm pays.

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 On the other hand, long run cost analysis is used for planning the optimal scale of
plant size. In other words, long run cost functions provide useful information for
planning the growth as well as the investment policies of a firm. Growth of a firm
largely depends on cost considerations.

The position of the U-shaped long run AC of a firm is suggestive of the direction of
the growth of a firm. That is to say, a firm can take a decision whether to build up a
new plant or to look for diversification in other markets by studying its existence on
the long run AC curve. Further, it is the cost that decides the merger and takeover of
a sick firm.

Non-profit sector or the government sector must also have a knowledge of cost
function for decision-making. Whether the Narmada Dam is to be built or not, it
should evaluate the costs and benefits ‘flowing’ from the dam.

Profit Function

Economics – profit and revenue

Total revenue (TR): This is the total income a firm receives.  This will equal price ×
quantity

Average revenue (AR) = TR / Q

Marginal revenue (MR) = the extra revenue gained from selling an extra unit of a
good

Profit = Total revenue (TR) – total costs (TC) or (AR – AC) × Q

Profit maximisation

 In classical economics it is assumed that firms will seek to maximise their

profits. This occurs when the difference between TR – TC is the greatest.

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 Profit maximisation will also occur at an output where MR = MC
 When MR> MC the firms is increasing its profits and Total Profit is increasing.
 When MR< MC total profit starts to fall
 Therefore profit is maximised where MR = MC

Definition normal profit

This occurs when TR = TC. This is the break-even point for a firm (P2). It is the
minimum profit level to keep the firm in the industry in the long run.

Definition supernormal profit

This occurs when total revenue  > total cost.

Whether to produce at all

 If AR > ATC The firm is making supernormal profits

 If AR= ATC The firm is making normal profits. This is the ‘break-even’ price.
 If AR< ATC but AR > AVC. it is making an operating profit, and is covering its
variable costs. However it is making an economic loss because it can not cover its
fixed costs as well. At this level (P1-P2) In the short run it is best to keep producing
because it has already paid for its fixed costs. It is at least making a contribution to
its fixed costs
 If AR < AVC The firm is likely to shut down in the short run.

125
 Evaluation

 In the real world it is more difficult for firms to maximise profits because they do not
have access to costs and marginal revenue data easily, it is difficult to predict.
 The firm may not close down at price of less than P1 – if they expect fall in demand
to be temporary and they are hopeful that they can cut costs. A firm will try to avoid
shutting down, because it will lose market share and long-term customers.

Short Run Production Function: In the short run, some inputs (land, capital) are
fixed in quantity. The output depends on how much of other variable inputs are
used. For example if we change the variable input namely (labour) the production
function shows how much output changes when more labour is used. In the short
run producers are faced with the problem that some input factors are fixed. The
firms can make the workers work for longer hours and also can buy more raw
materials. In that case, labour and raw material are considered as variable input
factors. But the number of machines and the size of the building are fixed. Therefore
it has its own constraints in producing more goods. 50 In the long run all input
factors are variable. The producer can appoint more workers, purchase more
machines and use more raw materials. Initially output per worker will increase up to
an extent. This is known as the Law of Diminishing Returns or the Law of Variable
Proportion. To understand the law of diminishing returns it is essential to know the
basic concepts of production.

Measures Of Productivity
Total production (TP): the maximum level of output that can be produced with a
given amount of input.
Average Production (AP): output produced per unit of input AP = Q/L
Marginal Production (MP): the change in total output produced by the last unit of an
input Marginal production of labour =
Δ Labour TP AP MP Q / Δ L (i.e. change in the quantity
1 20 20 0 produced to a given change in the
2 54 27 34 labour)
Marginal production of capital = Δ Q /
Δ 3 81 27 27 K (i.e. change in the quantity produced
to a given change in the capital)
4 104 26 23

5 125 25 21

6 138 23 13

7 147 21 9

8 152 19 5

9 153 17 1

10 150 15 -3

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The firm has a set of fixed variables. As long with that it increases the labour force
from 1 unit to 10 units. The increase in input factor leads to increase in the output up
to an extent. After that it start declining. Marginal production increases in the initial
period and then it starts declining and it become negative. The firm should stop
increasing labour force if the marginal production is zero- that is the maximum
output that can be derived with the available fixed factors. The 9th labour does not
contribute to any output. In case the firm wants to increase the output beyond 153
units it has to improve its fixed variable. That means purchase of new machinery or
building is essential. Therefore the firm understands that the maximum output is
153 units with the given set of input factors.

The graphical representations of the production function are as shown in the

following graph.

The graphical presentations of the values are shown in the graph. The ‘X” axis
denotes the labour and the ‘Y’ axis indicates the total production (TP), average
production (AP) and marginal production (MP). From the given table and graph we
can understand  all the three curves in the graph increased in the beginning and the
marginal product (MP) first fell, then the average product (AP) finally total
production (TP).  The marginal production curve MP cuts the AP at its highest point.
Total production TP falls when marginal production curve cuts the ‘X’ axis. The law
of diminishing returns states that if increasing quantity of a variable input are
combined with fixed, eventually the marginal product and then average product will
decline.
When the production function is expressed as an equation it shall be as follows:
Q = f (Ld, L, K, M, T )
It can be expressed as Q = f1, f2, f3, f4, f5 > 0
Where,

127
Q = output in physical units of good X
Ld = land units employed in the production of Q
L = Labour units employed in the production of Q
K = Capital units employed in the production of Q
M = Managerial Units employed in the production of Q
T = Technology employed in the production of Q
f = unspecified function
fi = Partial derivative of Q with respect to ith input.
 This equation assumes that output is an increasing function of all inputs.

The Law Of Diminishing Returns

In the combination of input factors when one particular factor is increased
continuously without changing other factors the output will increase in a
diminishing manner. Let us assume that a person preparing for an examination
continuously prepares without any break. The output or the understanding and the
coverage of the syllabus will be more in the beginning rather than in the later stages.
There is a limit to the extent to which one factor of production can be substituted for
another. The total production increases up to an extent and it gets saturated or there
won’t be any change in the output due to the addition of the input factor and further
it leads to negative impact on the output. That means the marginal production
declines up to an extent and it reaches zero and becomes negative. The point at
which the MP becomes zero is the maximum output of the firm with the given set of
input factors. This law is applicable in all human activities and business activities.

For example with two sewing machines and two tailors, a firm can produce a
maximum of 14 pairs of curtains per day. The machines are used only from 9 AM to
5 PM and the machines lie idle from 5 pm onwards. Therefore the firm appoints 2
more tailors for the second shift and the production goes up to 28 units. Then
adding two more labour to assist these people will increase the output to 30 units.
When the firm appoints two more people, then there won’t be any change in their
production because their Marginal productivity is zero. There is no addition in the
total production. That means there is no use of appointing two more 54 tailors.
Therefore, there is a limit for output from a fixed input factors but in the long run
purchase of one more sewing machine alone will help the firm to increase the
production more than 30 units.

The Law Of Returns To Scale

In the long run the fixed inputs like machinery, building and other factors will
change along with the variable factors like labour, raw material etc. With the equal
percentage of increase in input factors various combinations of returns occur in an
organization. Returns to scale: the change in percentage output resulting from a
percentage change in all the factors of production. They are increasing, constant and
diminishing returns to scale. Increasing returns to scale may arise: if the output of a
firm increases more than in proportionate to an increase in all inputs. For example
the input factors are increased by 50% but the output has doubled (100%). Constant

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returns to scale: when all inputs are increased by a certain percentage the output
increases by the same percentage. For example input factors are increased by 50%
then the output has also increased by 50 percentages. Let us assume that a laptop
consists of 50 components we call it as a set. In case the firm purchases 100 sets they
can assemble 100
laptops but it is not possible to produce more than 100 units.

Diminishing returns to scale: when output increases in a smaller

proportion than the increase in inputs it is known as diminishing return to scale. For
example 50% increment in input factors lead to only 20% increment in the output.
From the graph given below we can see the total production (TP) curve and the
marginal production curve (MP) and average production curve (AP). It is classified
into three stages; let us understand the stages in terms
of returns to scale

Stage I: The total production increased at an increasing rate. We refer to this as

increasing stage where the total product, marginal product and average production
are increasing.

Stage II: The total production continues to increase but at a diminishing rate until it
reaches the next stage. Marginal product, average product are declining but are
positive. The total production is at the maximum level at the end of the second stage
with a zero marginal product.

Stage III: In this third stage total production declines and marginal product becomes
negative. And the average production also started decline. Which implies that the
change in input factors there is a decline in the over all production along with the
average and marginal. In economics, the production function with one variable input
is illustrated with the well known law of variable proportions. (below graph) it shows
the input-output relationship or production function with one factor variable while
other factors of production are kept constant. To understand a production function
with two variable inputs, it is necessary know the concept iso-quant or iso-product
curve.

Definition and Meaning:

 
By "Cost of Production" is meant the total sum of money required for the
production of a specific quantity of output. In the word of Gulhrie and Wallace:
 
"In Economics, cost of production has a special meaning. It is all of the payments or
expenditures necessary to obtain the factors of production of land, labor, capital and
management required to produce a commodity. It represents money costs which we
want to incur in order to acquire the factors of production".
 
In the words of Campbell:
 
"Production costs are those which must be received by resource owners in order to
assume that they will continue to supply them in a particular time of production".
 
Elements of Cost of Production:

129
 
The following elements are included in the cost of production:
 
(a) Purchase of raw machinery, (b) Installation of plant and machinery, (c) Wages of
labor, (d) Rent of Building, (e) Interest on capital, (f) Wear and tear of the
machinery and building, (g) Advertisement expenses, (h) Insurance charges, (i)
Payment of taxes, (j) In the cost of production, the imputed value of the factor of
production owned by the firm itself is also added, (k) The normal profit of the
entrepreneur is also included In the cost of production.
 
Normal Profit:
 
By normal profit of the entrepreneur is meant in economics the sum of money
which is necessary to keep an entrepreneur employed in a business. This
remuneration should be equal to the amount which he can earn in some other
alternative occupation. If this alternative return is not met, he will leave the
enterprise and join alternative line of production.
 
Types/Classifications of Cost of Production:
  
Prof, Mead in his book, "Economic Analysis and Policy" has classified these costs
into three main sections:
 
(1) Production Costs:
 
It includes material costs, rent cost, wage cost, interest cost and normal profit of the
entrepreneur.
 
(2) Selling Costs:
 
It includes transportation, marketing and selling costs.
 
(3) Sundry Costs:
 
It includes other costs such as insurance charges, payment of taxes and rate, etc., etc.
Concept of Economic Costs:
 
We have discussed the important types of cost which a firm has to face. The cost of
production from the point of view of an individual firm is split up into the following
parts. 
                   
(1) Explicit Cost:
 
Explicit cost is also called money cost or accounting cost. Explicit cost
represents all such expenditure which are incurred by an entrepreneur to pay for the
hired services of factors of production and in buying goods and services directly. In
other words, we can say that they are the expenses which the business manager must
take into account of because they must actually be paid by the firm.
 
Example:

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The explicit cost includes wages and salary payments, expenses on the purchase of
raw material, light, fuel, advertisements, transportation, taxes and depreciation
charges.
                       
(2) Implicit Cost:
 
The implicit costs are the imputed value of the entrepreneur's own resources and
services. Implicit costs can be defined as:
 
"Expenses that an entrepreneur does not have to pay out of his own pocket but are
costs to the firm because they represent an opportunity cost".
 
Example:
 
For instance, if a person is working as a manager in his own firm or has invested his
own capital or has built the factory at his own land, the reward of all these factors of
production at least equal to their transfer prices is, included in the expenses of a
business.
 
Implicit costs, thus, are the alternative costs of the self-owned and self-employed
resources of a firm. The total costs of a business enterprise is the sum total of explicit
and implicit costs. If the implicit costs are not included in the firm's total cost, the
cost of the firm will be understated and it will result in serious error.
                                   
(3) Real Cost:
 
Real costs are the pains and inconveniences experienced by labor to produce a
commodity. These costs are not taken in the costing of a commodity by the firm.
Real cost has been defined differently by different economists.
 
Classical economists understood by real costs the pains and sacrifices of labor.
Alfred Marshall calls real cost as social cost and describes it:
 
"Real costs of efforts of various qualities and real costs of waiting".
 
The Austrian School of Economists have criticized the meaning given to real cost by
the classical economists and new classical economists. They say that to give a
subjective value to cost is a hopeless task as when real cost is expressed in terms of
sacrifices or pains, it is not amenable to precise measurement and thus it fails to
explain the phenomenon of prices.
 
(4) Opportunity Cost:
 
The concept of opportunity cost has a very important place in economic analysis.
It is defined as:
 
"The value of a resource in its next best use. It is the amount of income or yield that
could have been earned by investing in the next best alternative".
 

131
Example:
 
The opportunity cost of a good can be given a money value. For instance, a labor is
working in a factory and is getting $2000 P.M. The entrepreneur is paying him this
amount because he can earn this amount in the next best alternative employment. If
he pays less than this amount, he will move to next best alternative occupation,
where he can get $2000 P.M.
 
So in order to obtain a productive service say labor in the present occupation, the
cost should be equal to the amount which he can get in some alternative occupation.
Similarly, a piece of land or capital must be paid as much as they could earn in their
next best alternative use. The total alternative earnings of the various factors
employed in the production of a good constitute the opportunity cost of a good. In a
money economy, opportunity or transfer cost is defined as the amount of money
which a firm must make to resource suppliers m order to attract these resources
away from alternative lines of production. In the words of Lipsay:
 
"The opportunity cost of using any factor is what is currently foregone by using it".
 
The idea of opportunity cost has an important bearing on the decisions involving
scarcity of resources, their alternative uses and the choice.

Analysis of Short Run Cost of Production:

 
Definition of Short Run:
 
Short run is a period of time over which at least one factor must remain fixed. For most of the firms,
the fixed resource or factors which cannot be increased to meet the rising demand of the good is
capital i.e., plant and machinery.
 
Short run, then, is a period of time over which output can be changed by adjusting the quantities of
resources such as labor, raw material, fuel but the size or scale of the firm remains fixed.
 
Definition of Long Run:
 
In the long run there is no fixed resource. All the factors of production are variable. The length of the
long run differs from industry to industry depending upon the nature of production.
 
For example, a balloon making firm can change the size of firm more quickly than a car
manufacturing firm.
 
Categories/Types of Costs in the Short Run:
 
The total cost of a firm in the short run is divided into two categories (1) Fixed cost and (2) Variable
cost. The two types of economic costs are now discussed in brief.
      
(1) Total Fixed Cost (TFC):
 
Total fixed cost occur only in the short run. Total Fixed cost as the name implies is the cost of the
firm's fixed resources, Fixed cost remains the same in the short run regardless of how many units of
output are produced. We can say that fixed cost of a firm is that part of total cost which does not vary

132
with changes in output per period of time. Fixed cost is to be incurred even if the output of the firm is
zero.
 
For example, the firm's resources which remain fixed in the short run are building, machinery and
even staff employed on contract for work over a particular period.
 
(2) Total Variable Cost (TVC): 
  
Total variable cost as the name signifies is the cost of variable resources of a firm that are used
along with the firm's existing fixed resources. Total variable cost is linked with the level of output.
When output is zero, variable cost is zero. When output increases, variable cost also increases and it
decreases with the decrease in output. So any resource which can be varied to increase or decrease
with the rate of output is variable cost of the firm.
 
For example, wages paid to the labor engaged in production, prices of raw material which a firm.
incurs on the production of output are variable costs. A firm can reduce its variable cost by lowering
output but it cannot decrease its fixed cost. These expenses remain fixed in the short run. In the long
run there are no fixed resources. All resources are variable. Therefore, a firm has no fixed cost in the
long run. All long run costs are variable costs.
 
(3) Total Cost (TC):
           
Total cost is the sum of fixed cost and variable cost incurred at each level of output. Total cost of
production of a firm equals its fixed cost plus its:
 
Formula:
 
TC = TFC + TVC
 
Where:
 
TC = Total cost.
 
TFC = Total fixed cost.
 
TVC = Total variable cost.
 
Explanation:
 
Short run costs of a firm is now explained with the help of a schedule and diagrams. 

Total
Units of Output (in
Fixed Total Variable Cost Total Cost
Hundred)
Cost
0 1000 0 1000
1 1000 60 1060
2 1000 100 1100
3 1000 150 1150
4 1000 200 1200
5 1000 400 1400
6 1000 700 1700
7 1000 1100 2100

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The short run cost data of the firm shows that total fixed cost TFC (column 2) remains constant at
$1000/- regardless of the level of output.
 
The column 3 indicates variable cost which is associated with the level of output. Total variable cost is
zero when production is zero. Total variable cost increases with the increase in output. The variable
does not increase by the same amount for each increase in output. Initially the variable cost increases
by a smaller amount up to 3rd unit of output and after which it increases by larger amounts.
 
Column (4) indicates total cost which is the sum of TFC + TVC. The total cost increases for each level
of output. The rise in total cost is more sharp after the 4 th level of output. The concepts of costs, i.e.,
(1) total fixed cost (2) total variable cost and (3) total cost can be illustrated graphically.
 

In this diagram (13.1) the total fixed cost of a firm is assumed to be $1000 at various levels of output.
It remains the same even if the firm's output is zero.
 
(ii) Total Variable Cost Curve/Diagram:

134
In the figure (13.2), the total variable cost curve (TVC) increases with the higher level of output. It
starts from the origin. Then increases at a diminishing rate up to the 4th units of output. It then
begins to rise at an increasing rate.
 
Total Cost Curve Curve/Diagram:

In the figure (13.3), total cost curve which is the sum of the total fixed cost and variable cost at various
levels of output has nearly the same shape. The difference between the two is by only a fixed amount
of $1,000. The total variable cost curve and the total cost curve begin to rise more rapidly as
production is increased. The reason for this is that after a certain
output, the business has passed its most efficient use of its fixed costs machinery, building etc., and
its diminishing return begins to set in.
 
Average Cost:
 
Definition and Explanation:
 
The entrepreneurs are no doubt interested in the total costs but they are equally concerned in
knowing the cost per unit of the product. The unit cost figures can be derived from the total fixed cost,
total variable cost and total cost by dividing each of them with corresponding output.
 
Types/Classifications:
 

135
(1) Average Fixed Cost (AFC):
 
Average fixed cost refers to fixed cost per unit of output. Average fixed Cost is found out by
dividing the total fixed cost by the corresponding output.

Formula:AFC = TFC
                     Output (Q)

For instance, if the total fixed cost of a shoes factory is $5,000 and it produces 500 pairs of shoes,
then the average fixed cost is equal to $10 per unit. If it produces 1,000 pairs of shoes, the average
fixed cost is $5 and if the total output is 5,000 pairs of shoes, then the average fixed cost is $1 pair of
shoe.
 
From the above example, it is clear, that the fixed cost, i.e., $5,000 remains the same whether the
output is 1,000 or 5,000 units.
 
Behavior of Average Fixed Cost (AFC):
 
The average fixed cost begins to fall with the increase in the number of units produced, In our
example stated above, average fixed cost in the beginning was $10. As the output of the firm
increased, it gradually came down to $1. The AFC diminishes with every increase in the quantity of
output produced but it never becomes zero.
 
Diagram/Curve

The concept of average fixed cost can be explained with the help of the curve, in the diagram (13.4)
the average fixed cost curve gradually falls from left to right showing the level of output. The larger
the level of output, the lower is the average fixed cost and smaller the level of output, the greater is
the average fixed cost. The AFC never becomes zero.
 

136
(2) Average Variable Cost (AVC):
 
Average variable cost refers to the variable expenses per unit of output Average variable cost is
obtained by dividing the total variable cost by the total output.
 
For instance, the total variable cost for producing 100 meters of cloth is $800, the average variable
cost will be $8 per meter.
 
Formula:
AVC = TVC
                                                                                    (Q)
 
Behavior of Average Variable Cost:
 
When a firm increases its output, the average variable cost decreases in the beginning, reaches a
minimum and then increases. Here, a question can be asked as to why AVC decreases in the
beginning reaches a minimum and then increases. The answer to this question is very simple.
 
When in the beginning, a firm is not producing to its full capacity, then the various factors of
production employed for the manufacture of a particular commodity remain partially absorbed. As
the output of the firm is increased, they are used to its fullest extent. So the AVC begins to decrease.
When the plant works to its full capacity, the AVC is at its minimum. If the production is pushed
further from the plant capacity, then less efficient machinery and less, efficient labour may have to be
employed. This results in the rise of AVC. It is in this way we say that as the output of a firm
increases, the AVC decreases in the beginning, reaches a minimum and then increases. The AVC can
also be represented in the form of a curve.
 
Diagram/Curve:

The shape of the average variable cost curve (Fig. 13.5) is like a flat U-shaped curve. It shows that
when the output is increased, there is a steady fall in the average variable cost due to increasing
returns to variable factor. It is minimum when 500 meters of doth are produced. When production is
increased to 600 meters, of cloth or more, the average variable cost begins to increase due to
diminishing returns to the variable factor.
 
(3) Average Total Cost (ATC):
 
Average total cost refers to cost (both fixed and variable) per unit of output. Average total cost is
obtained by dividing the total cost by the total number of commodities produced by the firm or when

137
the total sum of average variable cost and average fixed cost is added together, it becomes equal to
average total cost.
 
Formula:
   
ATC =  Total Cost (TC)
                                                                             Output (Q)
 
Behavior of Average Total Cost:
 
As the output of a firm increases, average total cost like the average variable cost decreases in the
beginning reaches a minimum and then it increases. The reasons for decline of ATC in the beginning
are that it is the sum of AFC and AVC.
 
Average fixed cost and average variable costs have both the tendency to fall as output is increased.
Average total cost will continue falling so long average variable cost does not rise. Even if average
variable cost continues rising, it is not necessary that the average total cost will rise. It can be due to
the fact that the increase in average variable cost is less than the fall in average fixed cost. The
increase in average variable cost is counterbalanced by a rapid fall of average fixed cost. If the rise in
the average variable cost is greater than the fall in average fixed cost, then the average total cost will
rise.
 
The tendency to rise on the part of average total cost-in the beginning is slow, after a certain point it
begins to increase rapidly.
 
Diagram/Curve:

Short Run and Long Run Average Cost Curves:

 
Relationship and Difference:
 
Short Run Average Cost Curve:
 
In the short run, the shape of the average total cost curve (ATC) is U-shaped. The,  short
run average cost curve falls in the beginning, reaches a minimum and then begins to rise. The
reasons for the average cost to fall in the beginning of production are that the fixed factors of a firm
remain the same. The change only takes place in the variable factors such as raw material, labor, etc.

138
 
As the fixed cost gets distributed over the output as production is expanded, the average cost,
therefore, begins to fall. When a firm fully utilizes its scale of operation (plant size), the average cost
is then at its minimum. The firm is then operating to its optimum capacity. If a firm in the short-run
increases its level of output with the same fixed plant; the economies of that scale of production
change into diseconomies and the average cost then begins to rise sharply.
 
Long Run Average Cost Curve:
 
In the long run, all costs of a firm are variable. The factors of production can be used in varying
proportions to deal with an increased output. The firm having time-period long enough can build
larger scale or type of plant to produce the anticipated output. The shape of the long run average
cost curve is also U-shaped but is flatter that the short run curve as is illustrated in the following
diagram:
 
Diagram/Figure:

In the diagram 13.7 given above, there are five alternative scales of plant SAC 1 SAC2, SAC3, SAC4 and,
SAC5. In the long run, the firm will operate the scale of plant which is most profitable to it.
 
For example, if the anticipated rate of output is 200 units per unit of time, the firm will choose the
smallest plant It will build the scale of plant given by SAC 1 and operate it at point A. This is because of
the fact that at the output of 200 units, the cost per unit is lowest with the plant size 1 which is the
smallest of all the four plants. In case, the volume of sales expands to 400, units, the size of the plant
will be increased and the desired output will be attained by the scale of plant represented by SAC 2 at
point B, If the anticipated output rate is 600 units, the firm will build the size of plant given by
SAC3 and operate it at point C where the average cost is $26 and also the lowest The optimum output
of the firm is obtained at point C on the medium size plant SAC3.
 
If the anticipated output rate is 1000 per unit of time the firm would build the scale of plant given by
SAC5 and operate it at point E. If we draw a tangent to each of the short run cost curves, we get the
long average cost (LAC) curve. The LAC is U-shaped but is flatter than tile short run cost curves.
Mathematically expressed, the long-run average cost curve is the envelope of the SAC curves.
 
In this figure 13.7, the long-run average cost curve of the firm is lowest at point C. CM is the
minimum cost at which optimum output OM can be, obtained.

139
Marginal Cost (MC):
 
Definition:
 
Marginal Cost is an increase in total cost that results from a one unit increase in output. It is
defined as:
 
"The cost that results from a one unit change in the production rate".
 
Example:
 
For example, the total cost of producing one pen is $5 and the total cost of producing two pens is $9,
then the marginal cost of expanding output by one unit is $4 only (9 - 5 = 4).
 
The marginal cost of the second unit is the difference between the total cost of the second unit and
total cost of the first unit. The marginal cost of the 5th unit is $5. It is the difference
between the total cost of the 6th unit and the total cost of the, 5th unit and so forth.
 
Marginal Cost is governed only by variable cost which changes with changes in
output. Marginal cost which is really an incremental cost can be exp ressed in symbols.
 
Formula:
Marginal Cost = Change in Total Cost = ΔTC
                                                                          Change in Output        Δq
 
The readers can easily understand from the table given below as to how the marginal cost is
computed:
 
Schedule:
 
Units of Output Total Cost (Dollars) Marginal Cost (Dollars)
1 5 5
2 9 4
3 12 3
4 16 4
5 21 5
6 29 8
 
Graph/Diagram:
 

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MC curve, can also be plotted graphically. The marginal cost curve in fig. (13.8) decreases sharply
with smaller Q output and reaches a minimum. As production is expanded to a higher level, it begins
to rise at a rapid rate. 
 
Long Run Marginal Cost Curve:
 
The long run marginal cost curve like the long run average cost curve is U-shaped. As production
expands, the marginal cost falls sharply in the beginning, reaches a minimum and then rises sharply.
 
Relationship Between Log Run Average Cost and Marginal Cost:
 
The relationship between the long run average total cost and log run marginal cost can be understood
better with the help of following diagram:
 

t is clear from the diagram (13.9), that the long run marginal cost curve and the long run average total
cost curve show the same behavior as the short run marginal cost curve express with the short run
average total cost curve. So long as the average cost curve is falling with the increase in output, the
marginal cost curve lies below the average cost curve.
 
When average total cost curve begins to rise, marginal cost curve also rises, passes through the
minimum point of the average cost and then rises. The only difference between the short run and long
run marginal cost and average cost is that in the short run, the fall and rise of curves LRMC is sharp.
Whereas In the long run, the cost curves falls and rises steadily.     

141
 Unit IV

Market Analysis: market forms, perfect competition,

monopoly, monopolistic, oligopoly. Output and price
determination. Cartels and collusion, mergers and
acquisitions and government regulations in the form of
price directives, taxes, subsidies, anti-trust action and
competition polices.

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4 Market Structure:

Contents :
1. Meaning of Market
2. Characteristics of Market
3. Market Structure
4. Forms of Market Structure
 
4.1 Definition of Market:
 
A market is a set of conditions in which buyers and sellers meet each other for the
purpose of exchange of goods and services for money.
 
Elements of Market:
 
The essentials of a market are:
 
(i) Presence of goods and services to be exchanged.
(ii) Existence of one or more buyers and sellers.
(iii) A place or a region where buyers and sellers of a good get in close touch with
each other.
    
Market Structure: Meaning, Characteristics and Forms | Economics
Market structure refers to the nature and degree of competition in
the market for goods and services. The structures of market both
for goods market and service (factor) market are determined by
the nature of competition prevailing in a particular market.

Meaning of Market:
Ordinarily, the term “market” refers to a particular place where goods are purchased
and sold. But, in economics, market is used in a wide perspective. In economics, the
term “market” does not mean a particular place but the whole area where the buyers
and sellers of a product are spread.
This is because in the present age the sale and purchase of goods are with the help of
agents and samples. Hence, the sellers and buyers of a particular commodity are
spread over a large area. The transactions for commodities may be also through
letters, telegrams, telephones, internet, etc. Thus, market in economics does not
refer to a particular market place but the entire region in which goods are bought
and sold. In these transactions, the price of a commodity is the same in the whole
market.
According to Prof. R. Chapman, “The term market refers not necessarily to a place
but always to a commodity and the buyers and sellers who are in direct competition
with one another.” In the words of A.A. Cournot, “Economists understand by the
term ‘market’, not any particular place in which things are bought and sold but the
whole of any region in which buyers and sellers are in such free intercourse with one
another that the price of the same goods tends to equality, easily and quickly.” Prof.
Cournot’s definition is wider and appropriate in which all the features of a market
are found.

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4.2 Characteristics of Market:
The essential features of a market are:
(1) An Area:
In economics, a market does not mean a particular place but the whole region where
sellers and buyers of a product ate spread. Modem modes of communication and
transport have made the market area for a product very wide.
(2) One Commodity:
In economics, a market is not related to a place but to a particular product.
Hence, there are separate markets for various commodities. For example, there are
separate markets for clothes, grains, jewellery, etc.
(3) Buyers and Sellers:
The presence of buyers and sellers is necessary for the sale and purchase of a
product in the market. In the modem age, the presence of buyers and sellers is not
necessary in the market because they can do transactions of goods through letters,
telephones, business representatives, internet, etc.
(4) Free Competition:
There should be free competition among buyers and sellers in the market. This
competition is in relation to the price determination of a product among buyers and
sellers.
(5) One Price:
The price of a product is the same in the market because of free competition among
buyers and sellers.
On the basis of above elements of a market, its general definition may be
as follows:
The market for a product refers to the whole region where buyers and sellers of that
product are spread and there is such free competition that one price for the product
prevails in the entire region.
4.3 Market Structure:
Meaning:
Market structure refers to the nature and degree of competition in the market for
goods and services. The structures of market both for goods market and service
(factor) market are determined by the nature of competition prevailing in a
particular market.
Determinants:
There are a number of determinants of market structure for a particular good.
They are:
(1) The number and nature of sellers.
(2) The number and nature of buyers.
(3) The nature of the product.
(4) The conditions of entry into and exit from the market.
(5) Economies of scale.
They are discussed as under:
1. Number and Nature of Sellers:
The market structures are influenced by the number and nature of sellers in the
market. They range from large number of sellers in perfect competition to a single
seller in pure monopoly, to two sellers in duopoly, to a few sellers in oligopoly, and
to many sellers of differentiated products.
2. Number and Nature of Buyers:
The market structures are also influenced by the number and nature of buyers in the
market. If there is a single buyer in the market, this is buyer’s monopoly and is called

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monopsony market. Such markets exist for local labour employed by one large
employer. There may be two buyers who act jointly in the market. This is called
duopsony market. They may also be a few organised buyers of a product.
This is known as oligopsony. Duopsony and oligopsony markets are usually found
for cash crops such as rice, sugarcane, etc. when local factories purchase the entire
crops for processing.
3. Nature of Product:
It is the nature of product that determines the market structure. If there is product
differentiation, products are close substitutes and the market is characterised by
monopolistic competition. On the other hand, in case of no product differentiation,
the market is characterised by perfect competition. And if a product is completely
different from other products, it has no close substitutes and there is pure monopoly
in the market.
4. Entry and Exit Conditions:
The conditions for entry and exit of firms in a market depend upon profitability or
loss in a particular market. Profits in a market will attract the entry of new firms and
losses lead to the exit of weak firms from the market. In a perfect competition
market, there is freedom of entry or exit of firms.
But in monopoly and oligopoly markets, there are barriers to entry of new firms.
Usually, governments have a monopoly in public utility services like postal, air and
road transport, water and power supply services, etc. By granting exclusive
franchises, entries of new supplies are barred. In oligopoly markets, there are
barriers to entry of firms because of collusion, tacit agreements, cartels, etc. On the
other hand, there are no restrictions in entry and exit of firms in monopolistic
competition due to product differentiation.
5. Economies of Scale:
Firms that achieve large economies of scale in production grow large in comparison
to others in an industry. They tend to weed out the other firms with the result that a
few firms are left to compete with each other. This leads to the emergency of
oligopoly. If only one firm attains economies of scale to such a large extent that it is
able to meet the entire market demand, there is monopoly.
4.4 Forms of Market Structure:
On the basis of competition, a market can be classified in the following
ways:
1. Perfect Competition
2. Monopoly
3. Duopoly
4. Oligopoly
5. Monopolistic Competition
1. Perfect Competition Market:
A perfectly competitive market is one in which the number of buyers and sellers is
very large, all engaged in buying and selling a homogeneous product without any
artificial restrictions and possessing perfect knowledge of market at a time. In the
words of A. Koutsoyiannis, “Perfect competition is a market structure characterised
by a complete absence of rivalry among the individual firms.” According to R.G.
Lipsey, “Perfect competition is a market structure in which all firms in an industry
are price- takers and in which there is freedom of entry into, and exit from,
industry.”
Characteristics of Perfect Competition:
The following are the conditions for the existence of perfect competition:

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(1) Large Number of Buyers and Sellers:
The first condition is that the number of buyers and sellers must be so large that
none of them individually is in a position to influence the price and output of the
industry as a whole. The demand of individual buyer relative to the total demand is
so small that he cannot influence the price of the product by his individual action.
Similarly, the supply of an individual seller is so small a fraction of the total output
that he cannot influence the price of the product by his action alone. In other words,
the individual seller is unable to influence the price of the product by increasing or
decreasing its supply.
Rather, he adjusts his supply to the price of the product. He is “output adjuster”.
Thus no buyer or seller can alter the price by his individual action. He has to accept
the price for the product as fixed for the whole industry. He is a “price taker”.
(2) Freedom of Entry or Exit of Firms:
The next condition is that the firms should be free to enter or leave the industry. It
implies that whenever the industry is earning excess profits, attracted by these
profits some new firms enter the industry. In case of loss being sustained by the
industry, some firms leave it.

(3) Homogeneous Product:

Each firm produces and sells a homogeneous product so that no buyer has any
preference for the product of any individual seller over others. This is only possible if
units of the same product produced by different sellers are perfect substitutes. In
other words, the cross elasticity of the products of sellers is infinite.

No seller has an independent price policy. Commodities like salt, wheat, cotton and
coal are homogeneous in nature. He cannot raise the price of his product. If he does
so, his customers would leave him and buy the product from other sellers at the
ruling lower price.

The above two conditions between themselves make the average revenue curve of
the individual seller or firm perfectly elastic, horizontal to the X-axis. It means that a
firm can sell more or less at the ruling market price but cannot influence the price as
the product is homogeneous and the number of sellers very large.

(4) Absence of Artificial Restrictions:

The next condition is that there is complete openness in buying and selling of goods.
Sellers are free to sell their goods to any buyers and the buyers are free to buy from
any sellers. In other words, there is no discrimination on the part of buyers or
sellers.

Moreover, prices are liable to change freely in response to demand-supply

conditions. There are no efforts on the part of the producers, the government and
other agencies to control the supply, demand or price of the products. The
movement of prices is unfettered.

(5) Profit Maximisation Goal:

Every firm has only one goal of maximising its profits.

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(6) Perfect Mobility of Goods and Factors:

Another requirement of perfect competition is the perfect mobility of goods and

factors between industries. Goods are free to move to those places where they can
fetch the highest price. Factors can also move from a low-paid to a high-paid
industry.

(7) Perfect Knowledge of Market Conditions:

This condition implies a close contact between buyers and sellers. Buyers and sellers
possess complete knowledge about the prices at which goods are being bought and
sold, and of the prices at which others are prepared to buy and sell. They have also
perfect knowledge of the place where the transactions are being carried on. Such
perfect knowledge of market conditions forces the sellers to sell their product at the
prevailing market price and the buyers to buy at that price.

(8) Absence of Transport Costs:

Another condition is that there are no transport costs in carrying of product from
one place to another. This condition is essential for the existence of perfect compe-
tition which requires that a commodity must have the same price everywhere at any
time. If transport costs are added to the price of the product, even a homogeneous
commodity will have different prices depending upon transport costs from the place
of supply.

(9) Absence of Selling Costs:

Under perfect competition, the costs of advertising, sales-promotion, etc. do not

arise because all firms produce a homogeneous product.
Perfect Competition vs Pure Competition:
Perfect competition is often distinguished from pure competition, but they differ
only in degree. The first five conditions relate to pure competition while the
remaining four conditions are also required for the existence of perfect competition.
According to Chamberlin, pure competition means, competition unalloyed with
monopoly elements,” whereas perfect competition involves perfection in many other
respects than in the absence of monopoly.” The practical importance of perfect
competition is not much in the present times for few markets are perfectly
competitive except those for staple food products and raw materials. That is why,
Chamberlin says that perfect competition is a rare phenomenon.”
Though the real world does not fulfil the conditions of perfect competition, yet
perfect competition is studied for the simple reason that it helps us in understanding
the working of an economy, where competitive behaviour leads to the best allocation
of resources and the most efficient organisation of production. A hypothetical model
of a perfectly competitive industry provides the basis for appraising the actual
working of economic institutions and organisations in any economy.
2. Monopoly Market:
Monopoly is a market situation in which there is only one seller of a product with
barriers to entry of others. The product has no close substitutes. The cross elasticity
of demand with every other product is very low. This means that no other firms
produce a similar product. According to D. Salvatore, “Monopoly is the form of
market organisation in which there is a single firm selling a commodity for which

147
there are no close substitutes.” Thus the monopoly firm is itself an industry and the
monopolist faces the industry demand curve.
The demand curve for his product is, therefore, relatively stable and slopes
downward to the right, given the tastes, and incomes of his customers. It means that
more of the product can be sold at a lower price than at a higher price. He is a price-
maker who can set the price to his maximum advantage.

However, it does not mean that he can set both price and output. He can do either of
the two things. His price is determined by his demand curve, once he selects his
output level. Or, once he sets the price for his product, his output is determined by
what consumers will take at that price. In any situation, the ultimate aim of the
monopolist is to have maximum profits.

Characteristics of Monopoly:
The main features of monopoly are as follows:

1. Under monopoly, there is one producer or seller of a particular product and there
is no difference between a firm and an industry. Under monopoly a firm itself is an
industry.

2. A monopoly may be individual proprietorship or partnership or joint stock

company or a cooperative society or a government company.

3. A monopolist has full control on the supply of a product. Hence, the elasticity of
demand for a monopolist’s product is zero.

4. There is no close substitute of a monopolist’s product in the market. Hence, under

monopoly, the cross elasticity of demand for a monopoly product with some other
good is very low.

5. There are restrictions on the entry of other firms in the area of monopoly product.

6. A monopolist can influence the price of a product. He is a price-maker, not a

price-taker.

7. Pure monopoly is not found in the real world.

8. Monopolist cannot determine both the price and quantity of a product

simultaneously.

9. Monopolist’s demand curve slopes downwards to the right. That is why, a

monopolist can increase his sales only by decreasing the price of his product and
thereby maximise his profit. The marginal revenue curve of a monopolist is below
the average revenue curve and it falls faster than the average revenue curve. This is
because a monopolist has to cut down the price of his product to sell an additional
unit.

3. Duopoly:
Duopoly is a special case of the theory of oligopoly in which there are only two
sellers. Both the sellers are completely independent and no agreement exists
between them. Even though they are independent, a change in the price and output

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of one will affect the other, and may set a chain of reactions. A seller may, however,
assume that his rival is unaffected by what he does, in that case he takes only his
own direct influence on the price.
If, on the other hand, each seller takes into account the effect of his policy on that of
his rival and the reaction of the rival on himself again, then he considers both the
direct and the indirect influences upon the price. Moreover, a rival seller’s policy
may remain unaltered either to the amount offered for sale or to the price at which
he offers his product. Thus the duopoly problem can be considered as either
ignoring mutual dependence or recognising it.
4. Oligopoly:
Oligopoly is a market situation in which there are a few firms selling homogeneous
or differentiated products. It is difficult to pinpoint the number of firms in
‘competition among the few.’ With only a few firms in the market, the action of one
firm is likely to affect the others. An oligopoly industry produces either a
homogeneous product or heterogeneous products.
The former is called pure or perfect oligopoly and the latter is called imperfect or
differentiated oligopoly. Pure oligopoly is found primarily among producers of such
industrial products as aluminium, cement, copper, steel, zinc, etc. Imperfect
oligopoly is found among producers of such consumer goods as automobiles,
cigarettes, soaps and detergents, TVs, rubber tyres, refrigerators, typewriters, etc.
Characteristics of Oligopoly:
In addition to fewness of sellers, most oligopolistic industries have
several common characteristics which are explained below:
(1) Interdependence:
There is recognised interdependence among the sellers in the oligopolistic market.
Each oligopolist firm knows that changes in its price, advertising, product
characteristics, etc. may lead to counter-moves by rivals. When the sellers are a few,
each produces a considerable fraction of the total output of the industry and can
have a noticeable effect on market conditions.
He can reduce or increase the price for the whole oligopolist market by selling more
quantity or less and affect the profits of the other sellers. It implies that each seller is
aware of the price-moves of the other sellers and their impact on his profit and of the
influence of his price-move on the actions of rivals.
Thus there is complete interdependence among the sellers with regard to their price-
output policies. Each seller has direct and ascertainable influences upon every other
seller in the industry. Thus, every move by one seller leads to counter-moves by the
others.
(2) Advertisement:
The main reason for this mutual interdependence in decision making is that one
producer’s fortunes are dependent on the policies and fortunes of the other
producers in the industry. It is for this reason that oligopolist firms spend much on
advertisement and customer services.
As pointed out by Prof. Baumol, “Under oligopoly advertising can become a life-and-
death matter.” For example, if all oligopolists continue to spend a lot on advertising
their products and one seller does not match up with them he will find his customers
gradually going in for his rival’s product. If, on the other hand, one oligopolist
advertises his product, others have to follow him to keep up their sales.
(3) Competition:
This leads to another feature of the oligopolistic market, the presence of com-
petition. Since under oligopoly, there are a few sellers, a move by one seller

149
immediately affects the rivals. So each seller is always on the alert and keeps a close
watch over the moves of its rivals in order to have a counter-move. This is true
competition.
(4) Barriers to Entry of Firms:
As there is keen competition in an oligopolistic industry, there are no barriers to
entry into or exit from it. However, in the long run, there are some types of barriers
to entry which tend to restraint new firms from entering the industry.
They may be:
(a) Economies of scale enjoyed by a few large firms; (b) control over essential and
specialised inputs; (c) high capital requirements due to plant costs, advertising costs,
etc. (d) exclusive patents and licenses; and (e) the existence of unused capacity
which makes the industry unattractive. When entry is restricted or blocked by such
natural and artificial barriers, the oligopolistic industry can earn long-run super
normal profits.
(5) Lack of Uniformity:
Another feature of oligopoly market is the lack of uniformity in the size of firms.
Finns differ considerably in size. Some may be small, others very large. Such a
situation is asymmetrical. This is very common in the American economy. A
symmetrical situation with firms of a uniform size is rare.
(6) Demand Curve:
It is not easy to trace the demand curve for the product of an oligopolist. Since under
oligopoly the exact behaviour pattern of a producer cannot be ascertained with
certainty, his demand curve cannot be drawn accurately, and with definiteness. How
does an individual seller s demand curve look like in oligopoly is most uncertain
because a seller’s price or output moves lead to unpredictable reactions on price-
output policies of his rivals, which may have further repercussions on his price and
output.
The chain of action reaction as a result of an initial change in price or output, is all a
guess-work. Thus a complex system of crossed conjectures emerges as a result of the
interdependence among the rival oligopolists which is the main cause of the
indeterminateness of the demand curve.
If the oligopolist seller does not have a definite demand curve for his product, then
how does he affect his sales. Presumably, his sales depend upon his current price
and those of his rivals. However, a number of conjectural demand curves can be
imagined.
For example, in differentiated oligopoly where each seller fixes a separate price for
his product, a reduction in price by one seller may lead to an equivalent, more, less
or no price reduction by rival sellers. In each case, a demand curve can be drawn by
the seller within the range of competitive and monopoly demand curves.
Leaving aside retaliatory price movements, the individual seller’s demand curve
under oligopoly for both price cuts and increases is neither more elastic than under
perfect or monopolistic competition nor less elastic than under monopoly. It may
still be indefinite and indeterminate.
This situation is shown in Figure 1 where KD1 is the elastic demand curve and MD is
the less elastic demand curve. The oligopolies’ demand curve is the dotted kinked
KPD. The reason is quite simple. If a seller reduces the price of his product, his rivals
also lower the prices of their products so that he is not able to increase his sales.

150
Price and Output Determination under Perfect Competition
Perfect competition refers to a market situation where there are a large number of
buyers and sellers dealing in homogenous products.

Moreover, under perfect competition, there are no legal, social, or technological

barriers on the entry or exit of organizations.

In perfect competition, sellers and buyers are fully aware about the current market
price of a product. Therefore, none of them sell or buy at a higher rate. As a result,
the same price prevails in the market under perfect competition.

Under perfect competition, the buyers and sellers cannot influence the market price
by increasing or decreasing their purchases or output, respectively. The market price
of products in perfect competition is determined by the industry. This implies that in
perfect competition, the market price of products is determined by taking into
account two market forces, namely market demand and market supply.

In the words of Marshall, “Both the elements of demand and supply are required for
the determination of price of a commodity in the same manner as both the blades of
scissors are required to cut a cloth.” As discussed in the previous chapters, market
demand is defined as a sum of the quantity demanded by each individual
organizations in the industry.

On the other hand, market supply refers to the sum of the quantity supplied by
individual organizations in the industry. In perfect competition, the price of a
product is determined at a point at which the demand and supply curve intersect
each other. This point is known as equilibrium point as well as the price is known as
equilibrium price. In addition, at this point, the quantity demanded and supplied is
called equilibrium quantity. Let us discuss price determination under perfect
competition in the next sections.

Demand under Perfect Competition:

Demand refers to the quantity of a product that consumers are willing to purchase at
a particular price, while other factors remain constant. A consumer demands more
quantity at lower price and less quantity at higher price. Therefore, the demand
varies at different prices.

Figure-1 represents the demand curve under perfect competition:

151
As shown in Figure-1, when price is OP, the quantity demanded is OQ. On the other
hand, when price increases to OP1, the quantity demanded reduces to OQ1.
Therefore, under perfect competition, the demand curve (DD’) slopes downward.

Supply under Perfect Competition:

Supply refers to quantity of a product that producers are willing to supply at a
particular price. Generally, the supply of a product increases at high price and
decreases at low price.

Figure-2 shows the supply curve under perfect competition:

In Figure-2, the quantity supplied is OQ at price OP. When price increases to OP1,
the quantity supplied increases to OQ1. This is because the producers are able to
earn large profits by supplying products at higher price. Therefore, under perfect
competition, the supply curves (SS’) slopes upward.

Equilibrium under Perfect Competition:

152
As discussed earlier, in perfect competition, the price of a product is determined at a
point at which the demand and supply curve intersect each other. This point is
known as equilibrium point. At this point, the quantity demanded and supplied is
called equilibrium quantity.

Figure-3 shows the equilibrium under perfect competition:

In Figure-3, it can be seen that at price OP1, supply is more than the demand.
Therefore, prices will fall down to OP. Similarly, at price OP2, demand is more than
the supply. Similarly, in such a case, the prices will rise to OP. Thus, E is the
equilibrium at which equilibrium price is OP and equilibrium quantity is OQ.

Price and Output Determination under Monopoly

Monopoly refers to a market structure in which there is a single producer or seller
that has a control on the entire market.

This single seller deals in the products that have no close substitutes and has a direct
demand, supply, and prices of a product.

Therefore, in monopoly, there is no distinction between an one organization

constitutes the whole industry.

Demand and Revenue under Monopoly:

In monopoly, there is only one producer of a product, who influences the price of the
product by making Change m supply. The producer under monopoly is called
monopolist. If the monopolist wants to sell more, he/she can reduce the price of a
product. On the other hand, if he/she is willing to sell less, he/she can increase the
price.

As we know, there is no difference between organization and industry under

monopoly. Accordingly, the demand curve of the organization constitutes the

153
demand curve of the entire industry. The demand curve of the monopolist is Average
Revenue (AR), which slopes downward.

Figure-9 shows the AR curve of the monopolist:

In Figure-9, it can be seen that more quantity (OQ2) can only be sold at lower price
(OP2). Under monopoly, the slope of AR curve is downward, which implies that if
the high prices are set by the monopolist, the demand will fall. In addition, in
monopoly, AR curve and Marginal Revenue (MR) curve are different from each
other. However, both of them slope downward.

The negative AR and MR curve depicts the following facts:

i. When MR is greater than AR, the AR rises

ii. When MR is equal to AR, then AR remains constant

iii. When MR is lesser than AR, then AR falls

Here, AR is the price of a product, As we know, AR falls under monopoly; thus, MR

is less than AR.

Figure-10 shows AR and MR curves under monopoly:

In figure-10, MR curve is shown below the AR curve because AR falls.

Table-1 shows the numerical calculation of AR and MR under monopoly:

154
As shown in Table-1, AR is equal to price. MR is less than AR and falls twice the rate
than AR. For instance, when two units of
Output are sold, MR falls by Rs. 2, whereas AR falls by Re. 1.

Monopoly Equilibrium:
Single organization constitutes the whole industry in monopoly. Thus, there is no
need for separate analysis of equilibrium of organization and industry in case of
monopoly. The main aim of monopolist is to earn maximum profit as of a producer
in perfect competition.
Unlike perfect competition, the equilibrium, under monopoly, is attained at the
point where profit is maximum that is where MR=MC. Therefore, the monopolist
will go on producing additional units of output as long as MR is greater than MC, to
earn maximum profit.
Let us learn monopoly equilibrium through Figure-11:

In Figure-11, if output is increased beyond OQ, MR will be less than MC. Thus, if
additional units are produced, the organization will incur loss. At equilibrium point,
total profits earned are equal to shaded area ABEC. E is the equilibrium point at
which MR=MC with quantity as OQ.

It should be noted that under monopoly, price forms the following

relation with the MC:

Price = AR
MR= AR [(e-1)/e]

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e = Price elasticity of demand
As in equilibrium MR=MC
MC = AR [(e-1)/e]
Exhibit-2:
Determining Price and Output under Monopoly:
Suppose demand function for monopoly is Q = 200-0.4Q
Price function is P= 1000-10Q
Cost function is TC= 100 + 40Q + Q2
Maximum profit is achieved where MR=MC
To find MR, TR is derived.
TR= (1000-10Q) Q = 1000Q-10Q2
MR = ∆TR/∆Q= 1000 – 20Q
MC = ∆TC/∆Q = 40 + 2Q
MR = MC
1000 – 20Q = 40 + 2Q
Q = 43.63 (44 approx.) = Profit Maximizing Output
Profit maximizing price = 1000 – 20*44 = 120
Total maximum profit= TR-TC= (1000Q – 10Q2) – (100+ 40Q+Q2)
At Q = 44
Total maximum profit = Rs. 20844

Monopoly Equilibrium in Case of Zero Marginal Cost:

In certain situations, it may happen that MC is zero, which implies that the cost of
production is zero. For example, cost of production of spring water is zero. However,
the monopolist will set its price to earn profit.

Figure-12 shows the monopoly equilibrium when MC is zero:

In Figure-12, AR is the average revenue curve and MR is the marginal revenue curve.
In such a case, the total cost is zero; therefore, AR and MR are also zero. As shown in
Figure-12, equilibrium position is achieved at the point where MR equals zero that is
at output OQ and price P.We can see that point M is the mid-point of AR curve,
where elasticity of demand is unity. Therefore, when MC = 0, the equilibrium of the
monopolist is established at the output (OQ) where elasticity of demand is unity.
Short-Run and Long-Run View under Monopoly:

156
Till now, we have discussed monopoly equilibrium without taking into consideration
the short-run and long- run period. This is because there is not so much difference
under short run and long run analysis in monopoly.
In the short run, the monopolist should make sure that the price should not go
below Average Variable Cost (AVC). The equilibrium under monopoly in long-run is
same as in short-run. However, in long-run, the monopolist can expand the size of
its plants according to demand. The adjustment is done to make MR equal to the
long run MC.
In the long-run, under perfect competition, the equilibrium position is attained by
entry or exit of the organizations. In monopoly, the entry of new organizations is
restricted.
The monopolist may hold some patents or copyright that limits the entry of other
players in the market. When a monopolist incurs losses, he/she may exit the
business. On the other hand, if profits are earned, then he/she may increase the
plant size to gain more profit.

Price and Output Determination under Oligopoly

Price and Output Determination under Oligopoly!
A diversity of specific market situations works against the development of a single,
generalized explanation of how an oligopoly determines price and output.
Pure monopoly, monopolistic competition and perfect competition, all refer to
rather clear cut market arrangements; oligopoly docs not.
It consists of the ‘tight’ oligopoly situation in which two or three firms dominate the
entire market and the ‘loose’ oligopoly situation where six or seven firms occupy the
maximum share of the market.
Other firms share the balance. It includes both differentiation and standardization.
It encompasses the cases in which firms are acting in collusion and in which they are
acting independently. Therefore, the existence of various forms of oligopoly prevents
the development of a general theory of price and output. The element of mutual
interdependence in oligopolistic market further complicates the determination of
price and output.

In-spite of these difficulties, two interrelated characteristics of

oligopolistic pricing stand out:
1. Oligopolistic prices tend to be inflexible or Sticky Price change less frequently in
Oligopoly than they happen under other competitions like perfect, competition,
monopoly and monopolistic competition.
2. When oligopolistic prices change, firms are likely to change their prices together
they act in collusion in setting and changing prices.
Keeping these facts in mind, the price and output determination under
oligopoly is in the following situations:
1. Price Determination in Non-Collusive Oligopoly:
In this case, each firm follows an independent price and output policy on the basis of
its judgment about the reactions of his rivals. If the firms are producing
homogeneous products, price war may occur. Each firm has to fix the price at the
competitive level. On the contrary, in case of differentiated oligopoly, due to product
differentiation, each firm has some monopoly control over the market and therefore
charge near monopoly price.
Thus the actual price may fall between the two limits:

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(i) The Upper Limit of Monopoly Price and,
(ii) The Linear limit of Competitive Price.
Practically, there is every possibility to determine the exact price within
these limits. However there may be the following possibilities:
(i) There may be complete price instability in the market which results in price war.
(ii) The price may settle down at intermediate level due to the working of the market
forces.
(iii) The firm may accept the prevailing price and adjust itself according to prevailing
price.
So long as the firm earns adequate profits at the prevailing price, it may not try to
change it. Any effort to change it may create uncertainties in the market. A firm will
stick to that price to avoid uncertainties. Thus the price tends to be rigid where
oligopolist takes independent action.
B. Equilibrium under Collusion:
The modern economists are of the view that independent price determination
cannot exist for long in oligopoly. It leads to uncertainty and insecurity and to
overcome them there is a tendency among oligopolists to act collectively by tacit
collusion. In addition, the firms can gain the economics of production. All the firms
in oligopoly tend to enlarge their size and lower their costs of production per unit
and capture maximum share of the market.
Collusive oligopoly is a situation in which firms in a particular industry decide to
join together as a single unit for the purpose of maximising their joint profits and to
negotiate among themselves so as to share the market.
The former is known as:
(i) The joint profit maximisation cartel and
(ii) The latter as the market-sharing cartel. There is another type of collusion, known
as leadership, which is based on tacit agreements.
Under it, one firm acts as the price leader and fixes the price for the product while
other firms follow it. Price leadership is of three types: low-cost firm, dominant firm,
and barometric.

Cartels Types: Joint profit Maximisation and Market-Sharing

Cartel!
A cartel is an association of independent firms within the same
industry.

The cartel follows common policies relating to prices, outputs, sales and profit
maximization and distribution of products.
Cartels may be voluntary or compulsory and open or secret depending upon the
policy of the government with regard to their formation. They are of many forms and
use many devices in order to follow varied common policies depending upon the
type of the cartel.
Here, we discuss two most common types of cartels:
(1) Joint profit maximisation or perfect cartel; and
(2) Market-sharing cartel.
1. Joint Profit Maximisation Cartel under Perfect Collusion:
The uncertainty is found in an oligopolistic market which provides an incentive to
rival firms to form a perfect cartel. Perfect cartel is an extreme form of perfect

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collusion. Under it, firms producing a homogeneous product form a centralized
cartel board in the industry.
The individual firms surrender their price-output decisions to this central board.
The board determines for its members the output, quotes the price to be charged
and the distribution of industry profits. The central board acts like a single
monopoly whose main aim is to maximize the joint profits of the oligopolistic
industry.
Assumptions:
The analysis of joint profit maximisation cartel is based on the following
assumptions:
1. Only two firms A and B are assumed in the oligopolistic industry that form the
cartel.
2. Each firm produces and sells a homogeneous product that is a perfect substitute
for each other.
3. The market demand curve for the product is given and is known to the cartel.
ADVERTISEMENTS:
4. The number of buyers is large.
5. The price of the product determines the policy of the cartel.
6. The cost curves of the firm’s are different but are known to the cartel.
7. The cartel aims at joint profit maximisation.

Joint Profit Maximisation Solution:

Given these assumptions, and given the market demand curve and its corresponding
MR curve, joint profits will be maximized when the industry MR equals the
industry’s MC. Figure 10 shows the situation where D is the market (or cartel)
demand curve and MR is its corresponding marginal revenue curve. The aggregate
marginal cost curve of the industry ΣMC is drawn by the lateral summation of the
MC curves of firms A and B, so the ΣMC = MCa + MCb,.

The cartel solution-that maximizes joint profit is determined at point Σ where the Σ
MC curve intersects the industry MR curve. Consequently, the total output is OQ
which will be sold at OP = (QF) price. As under monopoly, the cartel board will
allocate the industry output by equating the industry MR to the marginal cost of
each firm. The share of each firm in the industry output is obtained by drawing a
straight line from E0 to the vertical axis which passes through the curves MCb, and
MCa of firms B and A at points Eb, and Ea respectively.

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Thus the share of firm A is OQa and that of firm B is OQb which equal the total
output OQ (= OQb + OQA). The price OP and the output OQ distributed between A
and B firms in the ratio of OQa: OQb, is the monopoly solution.

Firm A with the lower costs sells a larger output OQb than the firm B with higher
costs so that OQa > OQb,. But this does not mean that A will be getting more profit
than B. The joint maximum profit is the sum of RSTP and ABCP earned by A and B
respectively. It will be pooled into a fund and distributed by the cartel board
according to the agreement arrived at by the two firms at the time of the formation
of the cartel.

Advantages:
Perfect collusion by oligopolistic firms in the form of a cartel has many advantages.
It avoids price wars among rivals. The firms forming a cartel gain at the expense of
customers who are charged a high price for the product. The cartel operates like a
monopoly organization which maximizes the joint profit of firms. Generally, joint
profits are high than the total profits earned by them if they were to work
independently.

Problems of a Cartel:
The problems of cartels are stated below:
1. It is difficult to make an accurate estimate of the market demand curve.
2. The estimation of the market MC curve may be inaccurate because of the supply of
wrong data about their MC by individual firms to the cartel.
3. The formation of a cartel is a slow process which takes a long time for the
agreement to arrive at by firms especially if their number is very large.
4. The larger the number of firms in a cartel, the less is its chances of survival for
long because of the distrust. The cartel will, therefore, break down.
5. In theory, the cartel-members agree on joint profit maximisation. But in practice,
the seldom agree on profit distribution.
6. The price of the product fixed by the cartel cannot be changed even if the market
conditions require it to be changed. This is because it takes a long time for the
members to arrive at an agreed price.
7. Prices tackiness gives rise to ‘chislers’ who scarcely cut the price or violate the
quota agreement.
8. Unless all member firms in the cartel are strongly committed to cooperation,
outside disturbances, such as a sharp fall in demand, may lead to the breakdown of
the cartel.
9. Some high-cost uneconomic firms may refuse to shut down or leave the cartel
despite the cartel board’s request.
2. Market-Sharing Cartel:
Another type of perfect collusion in an oligopolistic market is found in practice
which relates to market-sharing by the member firms of a cartel.
There are two main methods of market-sharing:
(a) Non-price competition; and
(b) Quota system.
They are discussed as under:
(a) Non-Price Competition Cartel:
The non-price competition agreement among oligopolistic firms is a loose form of
cartel. Under this type of cartel, the low-cost firms press for a low price and the high-
cost firms for a high price. But ultimately, they agree upon a common price below

160
which they will not sell. Such a price must allow them some profits. The firms can
compete with one another on a non-price basis by varying the colour, design, shape
packing etc. of their product and having their own different advertising and other
selling activities. Thus each firm shares the market on a non-prices basis while
selling the product at the agreed common price.
(b) Market Sharing by Quota Agreement:
The second method of market sharing is the quota agreement among firms. (All
firms in an oligopolistic industry enter into collusion for charging an agreed uniform
price. But the main agreement relates to the sharing of the market equally among
member firms so that each firm gets profits on its sales.
Assumptions:
This analysis is based on the understated assumptions:
1. Only two firms can enter into market-sharing agreement on the basis of the quota
system.
2. Each firm produces and sells a homogeneous product.
3. The number of buyers is large.
4. The market demand curve for the product is given and known to the cartel.
5. Each firm has its own demand curve having the same elasticity as that of the
market demand curve.
6. Both firms share the market equally.
7. Cost curves of the two firms are identical.
8. There is no threat of entry by new firms.
9. Each sells the product at the agreed uniform price.

Market-Sharing Solution:
With these assumptions, the equal market sharing between the two firms is
explained in Figure 11 where D is the market demand curve and rf/MR is its
corresponding MR curve. ZMC is the aggregate MC curve of the industry. The ZMC
curve intersects the rf/MR curve at point E which determines QA (= OP) price and
total output OQ for the industry. This is the monopoly solution in the market-
sharing cartel.

How will the industry output be shared equally between the two firms? Let us
assume that the d/MR is the demand curve of each firm and mr is its corresponding
MR curve. AC and MC are their identical cost curves. The MC curve intersects the mr
curve at point e so that the profit maximization output of cache firm is Oq. Since the
total output of the industry is OQ which is equal to 2 x Oq = (OQ = 20q), it is equally

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shared by the two firms as per the quota agreement. Thus cache sells Oq output at
the same price qB (= OP) and earns RP per unit profit. The total profit earned by
each firm is RP x Oq and by both is RP x 20q or RP x OQ.
In practice, there are more than two firms in an oligopolistic industry which do not
share the market equally. Moreover, their cost curves are also not identical. In case
their cost curves differ, their market shares will also differ. Each firm will charge an
independent price in accordance with its own MC and MR curves.
They may not sell the same quantity at the agreed common price. They may be
charging a price slightly above or below the profit maximisation price depending
upon its cost conditions. But cache will try to be nearest the profit maximisation
price. This will lead to the breaking up of the market sharing agreement.
With Threat of Entry:
Suppose there is a constant threat of entry into the oligopolistic industry. In that
case if the firms agree on the price OP, new firms will enter the industry, reduce
their sales and profits. This may ultimately lead to excess capacity and uneconomic
firms in the industry. The existence of excess capacity and uneconomic firms will
raise the average costs and the firms will be earning only normal profits.
If the existing oligopolists are wiser, they may forestall entry by charging a price
lower than the profit maximisation price OP. In this way the collusive oligopolists by
charging a lower price will be earning larger profits in the long-run, and continue
their exclusive control over the market by keeping the new entrants out for ever.
Therefore, we can conclude that under perfect collusive oligopoly pricing has not any
set pattern of price behaviour. The resultant price and output will depend upon the
reaction of the collusive oligopolists towards the profit maximisation price and their
attitude towards the existing and potential rivals.

Imperfect Collusion in Oligopoly:

The eases of perfect collusion (centralized cartel and Market- Sharing cartel) do not
exist in the real world. The case of a perfect collusion stands as a polar extreme
where the maximisation of joint profits is emphasized. But mutual distrust among
member firms and their unwillingness to give up all of their sovereignty make it
most unlikely that eases of perfect collusion could long endure.
In fact, collusion is always imperfect. The eases of imperfect collusion also try to
raise prices and profits, but they never assume the position of monopoly. We may
find a number of cases of imperfect collusion, but in the present section, we shall
discuss the important ease of price leadership.
Collusion is an agreement between two or more parties, sometimes illegal and
therefore secretive, to limit open competition by deceiving, misleading, or
defrauding others of their legal rights, or to obtain an objective forbidden
by law typically by defrauding or gaining an unfair market advantage. It is an
agreement among firms or individuals to divide a market, set prices, limit
production or limit opportunities.
[1] It can involve "wage fixing, kickbacks, or misrepresenting the independence of
the relationship between the colluding parties".
[2] In legal terms, all acts effected by collusion are considered void.

Definition
In the study of economics and market competition, collusion takes place within
an industry when rival companies cooperate for their mutual benefit. Collusion most
often takes place within the market structure of oligopoly, where the decision of a

162
few firms to collude can significantly impact the market as a whole. Cartels are a
special case of explicit collusion. Collusion which is overt, on the other hand, is
known as tacit collusion, and is legal.
Variations[edit]
According to neoclassical price-determination theory and game theory, the
independence of suppliers forces prices to their minimum, increasing efficiency and
decreasing the price determining ability of each individual firm.[citation
needed] However, if firms collude to all increase prices, loss of sales is minimized, as
consumers lack alternative choices at lower prices.[citation needed] This benefits
the colluding firms at the cost of efficiency to society.[citation needed]
One variation of this traditional theory is the theory of kinked demand. Firms face a
kinked demand curve if, when one firm decreases its price, other firms will follow
suit in order to maintain sales, and when one firm increases its price, its rivals are
unlikely to follow, as they would lose the sales' gains that they would otherwise get
by holding prices at the previous level. Kinked demand potentially fosters supra-
competitive prices because any one firm would receive a reduced benefit from
cutting price, as opposed to the benefits accruing under neoclassical theory and
certain game theoretic models such as Bertrand competition.[citation needed]
Indicators[edit]
Practices that suggest possible collusion include:
 Uniform prices
 A penalty for price discounts
 Advance notice of price changes
 Information exchange
Examples[edit]
Collusion is largely illegal in the United States, Canada and most of the EU due
to competition/antitrust law, but implicit collusion in the form of price
leadership and tacit understandings still takes place. Several examples of collusion
in the United States include:
 Market division and price-fixing among manufacturers of
heavy electrical equipment in the 1960s, including General Electric.[4]
 An attempt by Major League Baseball owners to restrict players' salaries in the
mid-1980s.
 The sharing of potential contract terms by NBA free agents in an effort to help a
targeted franchise circumvent the salary cap
 Price fixing within food manufacturers providing cafeteria food to schools and
the military in 1993.
 Market division and output determination of livestock feed additive, called lysine,
by companies in the US, Japan and South Korea in 1996, Archer Daniels
Midland being the most notable of these.[5]
 Chip dumping in poker or any other high stake card game.
There are many ways that implicit collusion tends to develop:

 The practice of stock analyst conference calls and meetings of industry

participants almost necessarily results in tremendous amounts of strategic and
price transparency. This allows each firm to see how and why every other firm is
pricing their products.
 If the practice of the industry causes more complicated pricing, which is hard for
the consumer to understand (such as risk-based pricing, hidden taxes and fees in
the wireless industry, negotiable pricing), this can cause competition based on

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 price to be meaningless (because it would be too complicated to explain to the
customer in a short advertisement). This causes industries to have essentially the
same prices and compete on advertising and image, something theoretically as
damaging to consumers as normal price fixing.[citation needed]
See also: Disney litigation

Barriers[edit]
There can be significant barriers to collusion. In any given industry, these may
include:

 The number of firms: As the number of firms in an industry increases, it is more

difficult to successfully organize, collude and communicate.
 Cost and demand differences between firms: If costs vary significantly between
firms, it may be impossible to establish a price at which to fix output.
 Cheating: There is considerable incentive to cheat on collusion agreements;
although lowering prices might trigger price wars, in the short term the defecting
firm may gain considerably. This phenomenon is frequently referred to as
"chiseling".
 Potential entry: New firms may enter the industry, establishing a new baseline
price and eliminating collusion (though anti-dumping laws and tariffs can
prevent foreign companies entering the market).
 Economic recession: An increase in average total cost or a decrease in revenue
provides incentive to compete with rival firms in order to secure a larger market
share and increased demand.
 Anticollusion legal framework and collusive lawsuit.

Mergers

Merger is a financial tool that is used for enhancing long-term profitability by

expanding their operations. Mergers occur when the merging companies have their
mutual consent as different from acquisitions, which can take the form of a hostile
takeover. 

The business laws in US vary across states and hence the companies have
limited options to protect themselves from hostile takeovers. One way a company
can protect itself from hostile takeovers is by planning shareholders rights, which is
alternatively known as - poison pill. If we trace back to history, it is observed that
very few mergers have actually added to the share value of the acquiring company.
Corporate mergers may promote monopolistic practices by reducing costs, taxes etc.

Such activities may go against public welfare. Hence mergers are regulated d
supervised by the government, for instance, in US any merger required\s the prior
approval of the Federal Trade Commission and the Department of Justice. In US
regulation son mergers began with the Sherman Act in 1890. Mergers may be
horizontal, vertical, conglomerate or congeneric, depending or the nature of the
merging companies.

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Acquisitions
Acquisitions or takeovers occur between the bidding and the target company. There
may be either hostile or friendly takeovers. Reverse takeover occurs when the target
firm is larger than the bidding firm. In the course of acquisitions the bidder may
purchase the share or the assets of the target company.
Mergers and Acquisitions Laws
Business firms opt for mergers and acquisitions mostly for consolidating a
fragmented market and also for increasing their operational efficiency, which give
them a competitive edge. Nations across the globe have promulgated Mergers and
Acquisitions Laws to monitor the functioning of the business units therein. An
estimate made in 2007 put the number of global competition laws at 106. They
possess merger control provisions. 

While most mergers and acquisitions increase the operational efficiency of business
firms some can also lead to a building up of monopoly power. The anti-competitive
effects are achieved either through coordinated effects or unilateral effects.
Sometimes mergers and acquisitions tend to create a collusive market structure.
However, free and fair competition is seen to maximize the consumers' interests
both in terms of quantity and price.
Mergers and Acquisitions Laws: the Global Perspective
As per global experience around 85% of acquisitions and mergers are devoid of any
competitive concerns. They get approval within a period of 30 to 60 days. The
remaining percentage of firms usually has a substantially long gestation period for
getting the legal approval. These cases are relatively complex and need a close
examination of the various aspects by the regulatory bodies. As per the guidelines
from "The International Competition Network" simple merger and acquisitions
cases should receive approval within a period of 6 weeks. The comparable time
frame for complex cases is 6 months. 

It may be noted that the 'Competition Network' mentioned above is actually an

association of international competition authorities.
Mergers and Acquisitions Laws: the Indian Perspective
Indian competition law grants a maximum time period of 210 days for the
determination of the combination, which comprises acquisitions, mergers,
amalgamations and the like. One needs to take note of the fact that this stated time
frame is clearly distinct from the minimum compulsory wait period for applicants.
As per the law, the compulsory period of waiting for applicants can either be 210
days starting from the day of notice filing or receipt of the Commission's order,
whichever occurs earlier. The threshold limits for firms entering business
combinations are substantially high under the Indian law. The threshold limits are
set either in terms of the asset value or in terms the firm's turnover. Indian threshold
limits are greater than those for the EU. They are twice as high when comp ared with
UK.
The Indian law also provides for the modern day phenomenon of merger and
acquisitions, which are cross border in nature. As per the law domestic nexus is a
pre-requisite for notification on this type of combinations.
It can be noted that Competition Act, 2002 has undergone a recent amendment.
This has replaced the the voluntary notification regime with a mandatory regime. Of
the total number of 106 countries, which possess competition laws only 9 are
thought to be credited with a voluntary notification regime. Voluntary notification
regimes are generally associated with business uncertainties. Post-combination, if

165
firms are seen to be involved in anti-competitive practices de-merger shows the way
out.
More on Indian Mergers and Acquisitions Laws
Indian Income Tax Act has provision for tax concessions for mergers/demergers
between two Indian companies. These mergers/demergers need to satisfy the
conditions pertaining to section 2(19AA) and section 2(1B) of the Indian Income Tax
Act as per the applicable situation. 

In case of an Indian merger when transfer of shares occurs for a company they are
entitled to a specific exemption from the capital gains tax under the "Indian I-T tax
Act". These companies can either be of Indian origin or foreign ones. 

A different set of rules is however applicable for the 'foreign company mergers'. It is
a situation where an Indian company owns the new company formed out of the
merger of two foreign companies. It can be noted that for foreign company mergers
the share allotment in the merged foreign company in place of shares surrendered
by the amalgamating foreign company would be termed as a transfer, which would
be taxable under the Indian tax law. 

Also as per conditions set under section 5(1), the 'Indian I-T Act' states that, global
income accruing to an Indian company would also be included under the head of
'scope of income' for the Indian company.
Benefits of Mergers and Acquisitions
Merger refers to the process of combination of two companies, whereby a new
company is formed. An acquisition refers to the process whereby a company simply
purchases another company. In this case there is no new company being formed.
Benefits of mergers and acquisitions are quite a handful.
Mergers and acquisitions generally succeed in generating cost efficiency through the
implementation of economies of scale. It may also lead to tax gains and can even
lead to a revenue enhancement through market share gain.
The principal benefits from mergers and acquisitions can be listed as increased value
generation, increase in cost efficiency and increase in market share. 

Mergers and acquisitions often lead to an increased value generation for the
company. It is expected that the shareholder value of a firm after mergers or
acquisitions would be greater than the sum of the shareholder values of the parent
companies. 

An increase in cost efficiency is effected through the procedure of mergers and

acquisitions. This is because mergers and acquisitions lead to economies of scale.
This in turn promotes cost efficiency. As the parent firms amalgamate to form a
bigger new firm the scale of operations of the new firm increases. As output
production rises there are chances that the cost per unit of production will come
down.
An increase in market share is one of the plausible benefits of mergers and
acquisitions. In case a financially strong company acquires a relatively distressed
one, the resultant organization can experience a substantial increase in market
share. The new firm is usually more cost-efficient and competitive as compared to its
financially weak parent organization. It can be noted that mergers and acquisitions
prove to be useful in the following situations:

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Firstly, when a business firm wishes to make its presence felt in a new market.
Secondly, when a business organization wants to avail some administrative benefits.
Thirdly, when a business firm is in the process of introduction of new products. New
products are developed by the R&D wing of a company.
Recent Mergers and Acquisitions
Mergers and Acquisitions have been very common incidents since the turn of the
20th century. These are used as tools for business expansion and restructuring.
Through mergers the acquiring company gets an expanded client base and the
acquired company gets additional lifeline in the form of capital invested by the
purchasing company. Recent mergers and acquisitions authenticate such a view.
The Long Success International (Holdings) Ltd merged with City Faith Investments
Ltd on the 8th of April 2008. The value of the merger was US $3.2 million. The
agency in this instance was Bermuda Monetary Authority, Hong Kong Stock
Exchange and other regulatory authority that was unspecified.
Novartis AG acquired 25% stake in Alcon Inc. This acquisition was worth 73,666
million common shares of the company. They bought this stake from Nestle SA for
$10.547 billion by paying $143.18 for every share. It was a privately negotiated
transaction that needed to have a regulatory approval. Simultaneously, Novartis AG
also received an offer of 52% interest that was equivalent of 153.225 million common
shares of Alcon Inc. 

Kinetic Concepts acquired each and every remaining common stock of LifeCell Corp
for $51 for each share. Their total offer was $1.743 billion. The deal was done in
accordance to regulatory approvals and the conventional closing conditions. 

Kapstone Paper & Packaging Corp acquired the kraft paper mill as well as other
assets of MeadWestVaco.Corp. They paid them $485 million. The deal was
conducted as per the regulatory approvals, receipt of financing and conventional
closing conditions. This deal included a lumber mill in Summerville, hundred
percent interest in Cogen South LLC. The Chip mills in Kinards, Elgin, Andrews and
Hampton in South Carolina are also parts of this deal.
Petrofalcon Corp acquired the remaining shares of Anadarko Venezuela Co from
Anadarko Petroleum Corp. The deal was worth 428.46 million Venezuelan bolivar or
US $200 million. The deal was completed as per the regulatory approvals. 

Discover Financial Services, LLC acquired Diners Club International Ltd from
Citigroup Inc. The deal was worth US $165 million. The deal was subjected to
regulatory approvals and normal closing conditions. Cobham PLC took over MMI
Research Ltd. The deal was worth ?16.6 million or $33.099 million. In this deal ?
12.2 was paid in cash, ?1.4 million in loan notes and almost ?3 million in payments
related to profits. 
WNS (Holdings) Ltd from India, took over the total share capital of Chang Ltd. The
deal was worth ?9.6 million. Of this amount ?8 million was to be paid in cash and
the rest was to be paid in payments related to profits.
AptarGroup Inc acquired the Advanced Barrier System wing of the CCL Industries
Inc. The deal was worth almost 9.4 million Canadian dollars. The entire amount was
paid on cash. Varian Inc from USA took over 23% stakes of Oxford Diffraction Ltd.
The deal was worth ? 4.6 million pounds. ? 3.5 million was paid in cash, and the rest
was to be paid from the profits made by the company. 

167
Spice PLC took over Melton Power Services Limited. The deal was worth? 4.5
million. ?2.5 million was paid in cash and the rest was to be paid from the profits
made by the company. Spice PLC also got Utility Technology Ltd., GIS Direct Ltd,
and Line Design Solutions Ltd as part of the deal.
Atlas Iron Ltd. Took over a 19.9% stake in the Warwick Resources Ltd. This was
equivalent of 15.124 million new common stock of the Warwick Resources Ltd. They
paid A$ 3.781 million in a transaction that was privately negotiated. The transaction
was executed as per the approval from the shareholders. The selling price of the
shares was A$ 0.23 and it was based on the value of each share that stood at A$ 0.25
on 4th of April 2008. 

Republic Gold Ltd of Australia took over the remaining stocks of Vista Gold
(Antigua) from Vista Gold Corp. The deal was worth $3 million. Republic Gold also
got the Amayapampa project in Bolivia as a part of the deal. Manpower Software
PLC took over Key IT Systems Ltd. The deal was worth ?0.83 million. ?0.375 million
was paid in cash and the rest is supposed to be paid from profits. 

Spice PLC took over Utility Technology Ltd. The deal was worth ?0.2 million – ?0.1
million was to be paid in cash and the rest was to be paid from the profits. As part of
this deal Spice PLC also acquired Melton Power Services Ltd, GIS Direct Ltd and
Line Design Solutions Ltd.
Spice PLC took over Line Design Solutions Ltd and GIS Direct Ltd. The total deal
was worth ?0.1 million and the entire amount was paid in cash. Spice PLC also
acquired Utility Technology Ltd and Melton Power Services Ltd as part of the deal. 

Thomas Cook Group PLC acquired Elegant Resorts Ltd from Barbara Catchpole and
Geoff Moss. Australian Social Infrastructure Fund merged with API Fund. The deal
was subjected to regulatory approvals and shareholder. Greenbier Cos Inc took over
Roller Bearing Industries Inc., from AB SKF. Fijian Holdings Ltd has taken over
50.2% interest in RB Patel Group Ltd.
Honeywell International Inc has acquired Norcross Safety Products LLC from
Odyssey Investment Partners LLC. The deal was worth $1.2 billion. It was subjected
to various kinds of regular closing conventions and regulatory approvals.
Mergers can be categorized as follows:

Horizontal: Two firms are merged across similar products or services. Horizontal
mergers are often used as a way for a company to increase its market share by
merging with a competing company. For example, the merger between Exxon and
Mobil will allow both companies a larger share of the oil and gas market.

Vertical: Two firms are merged along the value-chain, such as a manufacturer
merging with a supplier. Vertical mergers are often used as a way to gain a
competitive advantage within the marketplace. For example, Merck, a large
manufacturer of pharmaceuticals, merged with Medco, a large distributor of
pharmaceuticals, in order to gain an advantage in distributing its products.
Conglomerate: Two firms in completely different industries merge, such as a gas
pipeline company merging with a high technology company. Conglomerates are
usually used as a way to smooth out wide fluctuations in earnings and provide more
consistency in long-term growth. Typically, companies in mature industries with
poor prospects for growth will seek to diversify their businesses through mergers

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and acquisitions. For example, General Electric (GE) has diversified its businesses
through mergers and acquisitions, allowing GE to get into new areas like financial
services and television broadcasting.

Reasons for M & A

Every merger has its own unique reasons why the combining of two companies is a
good business decision. The underlying principle behind mergers and acquisitions
( M & A ) is simple: 2 + 2 = 5. The value of Company A is $ 2 billion and the value of
Company B is $ 2 billion, but when we merge the two companies together, we have a
total value of $ 5 billion. The joining or merging of the two companies creates
additional value which we call "synergy" value.
Synergy value can take three forms:
1. Revenues: By combining the two companies, we will realize higher revenues then if
the two companies operate separately.

2. Expenses: By combining the two companies, we will realize lower expenses then if
the two companies operate separately.

3. Cost of Capital: By combining the two companies, we will experience a lower

overall cost of capital. For the most part, the biggest source of synergy value is lower
expenses. Many mergers are driven by the need to cut costs. Cost savings often come
from the elimination of redundant services, such as Human Resources, Accounting,
Information Technology, etc. However, the best mergers seem to have strategic
reasons for the business combination. These strategic reasons include: ! Positioning -
Taking advantage of future opportunities that can be exploited when the two
companies are combined.

For example, a telecommunications company might improve its position for the
future if it were to own a broad band service company. Companies need to position
themselves to take advantage of emerging trends in the marketplace. ! Gap Filling -
One company may have a major weakness (such as poor distribution) whereas the
other company has some significant strength. By combining the two companies,
each company fills-in strategic gaps that are essential for long-term survival. 3 !
Organizational Competencies - Acquiring human resources and intellectual capital
can help improve innovative thinking and development within the company. !
Broader Market Access - Acquiring a foreign company can give a company quick
access to emerging global markets. Mergers can also be driven by basic business
reasons, such as: ! Bargain Purchase - It may be cheaper to acquire another company
then to invest internally. For example, suppose a company is considering expansion
of fabrication facilities. Another company has very similar facilities that are idle. It
may be cheaper to just acquire the company with the unused facilities then to go out
and build new facilities on your own. ! Diversification - It may be necessary to
smooth-out earnings and achieve more consistent long-term growth and
profitability. This is particularly true for companies in very mature industries where
future growth is unlikely. It should be noted that traditional financial management
does not always support diversification through mergers and acquisitions. It is
widely held that investors are in the best position to diversify, not the management
of companies since managing a steel company is not the same as running a software
company. ! Short Term Growth - Management may be under pressure to turnaround

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sluggish growth and profitability. Consequently, a merger and acquisition is made to
boost poor performance. ! Undervalued Target - The Target Company may be
undervalued and thus, it represents a good investment. Some mergers are executed
for "financial" reasons and not strategic reasons. For example, Kohlberg Kravis &
Roberts acquires poor performing companies and replaces the management team in
hopes of increasing depressed values.

The Overall Process The Merger & Acquisition Process can be broken
down into five phases:

Phase 1 - Pre Acquisition Review: The first step is to assess your own situation and
determine if a merger and acquisition strategy should be implemented. If a company
expects difficulty in the future when it comes to maintaining core competencies,
market share, return on capital, or other key performance drivers, then a merger and
acquisition (M & A) program may be necessary. It is also useful to ascertain if the
company is undervalued. If a company fails to protect its valuation, it may find itself
the target of a merger. Therefore, the pre-acquisition phase will often include a
valuation of the company - Are we undervalued? Would an M & A Program improve
our valuations? The primary focus within the Pre Acquisition Review is to determine
if growth targets (such as 10% market growth over the next 3 years) can be achieved
internally. If not, an M & A Team should be formed to establish a set of criteria
whereby the company can grow through 4 acquisition. A complete rough plan should
be developed on how growth will occur through M & A, including responsibilities
within the company, how information will be gathered, etc.

Phase 2 - Search & Screen Targets: The second phase within the M & A Process is to
search for possible takeover candidates. Target companies must fulfill a set of
criteria so that the Target Company is a good strategic fit with the acquiring
company. For example, the target's drivers of performance should compliment the
acquiring company. Compatibility and fit should be assessed across a range of
criteria - relative size, type of business, capital structure, organizational strengths,
core competencies, market channels, etc. It is worth noting that the search and
screening process is performed in-house by the Acquiring Company. Reliance on
outside investment firms is kept to a minimum since the preliminary stages of M & A
must be highly guarded and independent.

Phase 3 - Investigate & Value the Target: The third phase of M & A is to perform a
more detail analysis of the target company. You want to confirm that the Target
Company is truly a good fit with the acquiring company. This will require a more
thorough review of operations, strategies, financials, and other aspects of the Target
Company. This detail review is called "due diligence." Specifically, Phase I Due
Diligence is initiated once a target company has been selected. The main objective is
to identify various synergy values that can be realized through an M & A of the
Target Company. Investment Bankers now enter into the M & A process to assist
with this evaluation. A key part of due diligence is the valuation of the target
company. In the preliminary phases of M & A, we will calculate a total value for the
combined company. We have already calculated a value for our company (acquiring
company). We now want to calculate a value for the target as well as all other costs
associated with the M & A. The calculation can be summarized as follows: Value of

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Our Company (Acquiring Company) $ 560 Value of Target Company 176 Value of
Synergies per Phase I Due Diligence 38 Less M & A Costs (Legal, Investment Bank,
etc.) ( 9) Total Value of Combined Company $ 765 .

Phase 4 - Acquire through Negotiation: Now that we have selected our target
company, it's time to start the process of negotiating a M & A. We need to develop a
negotiation plan based on several key questions: ! How much resistance will we
encounter from the Target Company? ! What are the benefits of the M & A for the
Target Company? ! What will be our bidding strategy? ! How much do we offer in the
first round of bidding? The most common approach to acquiring another company is
for both companies to reach agreement concerning the M & A; i.e. a negotiated
merger will take place. This negotiated arrangement is sometimes called a "bear
hug." The negotiated merger or bear hug is the preferred approach to a M & A since
having both sides agree to the deal will go a long way to 5 making the M & A work. In
cases where resistance is expected from the target, the acquiring firm will acquire a
partial interest in the target; sometimes referred to as a "toehold position." This
toehold position puts pressure on the target to negotiate without sending the target
into panic mode. In cases where the target is expected to strongly fight a takeover
attempt, the acquiring company will make a tender offer directly to the shareholders
of the target, bypassing the target's management. Tender offers are characterized by
the following: ! The price offered is above the target's prevailing market price. ! The
offer applies to a substantial, if not all, outstanding shares of stock. ! The offer is
open for a limited period of time. ! The offer is made to the public shareholders of
the target. A few important points worth noting: ! Generally, tender offers are more
expensive than negotiated M & A's due to the resistance of target management and
the fact that the target is now "in play" and may attract other bidders. ! Partial offers
as well as toehold positions are not as effective as a 100% acquisition of "any and all"
outstanding shares. When an acquiring firm makes a 100% offer for the outstanding
stock of the target, it is very difficult to turn this type of offer down. Another
important element when two companies merge is Phase II Due Diligence. As you
may recall, Phase I Due Diligence started when we selected our target company.
Once we start the negotiation process with the target company, a much more intense
level of due diligence (Phase II) will begin. Both companies, assuming we have a
negotiated merger, will launch a very detail review to determine if the proposed
merger will work. This requires a very detail review of the target company -
financials, operations, corporate culture, strategic issues, etc.

Phase 5 - Post Merger Integration: If all goes well, the two companies will announce
an agreement to merge the two companies. The deal is finalized in a formal merger
and acquisition agreement. This leads us to the fifth and final phase within the M &
A Process, the integration of the two companies. Every company is different -
differences in culture, differences in information systems, differences in strategies,
etc. As a result, the Post Merger Integration Phase is the most difficult phase within
the M & A Process. Now all of a sudden we have to bring these two companies
together and make the whole thing work. This requires extensive planning and
design throughout the entire organization. The integration process can take place at
three levels: 1. Full: All functional areas (operations, marketing, finance, human
resources, etc.) will be merged into one new company. The new company will use the
"best practices" between the two companies. 6 2. Moderate: Certain key functions or
processes (such as production) will be merged together. Strategic decisions will be

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centralized within one company, but day to day operating decisions will remain
autonomous. 3. Minimal: Only selected personnel will be merged together in order
to reduce redundancies. Both strategic and operating decisions will remain
decentralized and autonomous. If post merger integration is successful, then we
should generate synergy values. However, before we embark on a formal merger and
acquisition program, perhaps we need to understand the realities of mergers and
acquisitions.

Source :http://www.indianmba.com/

Laws Regulating Merger

Following are the laws that regulate the merger of the company:-
(I) The Companies Act , 1956 
Section 390 to 395 of Companies Act, 1956 deal with arrangements, amalgamations,
mergers and the procedure to be followed for getting the arrangement, compromise
or the scheme of amalgamation approved. Though, section 391 deals with the issue
of compromise or arrangement which is different from the issue of amalgamation as
deal with under section 394, as section 394 too refers to the procedure under section
391 etc., all the section are to be seen together while understanding the procedure of
getting the scheme of amalgamation approved. Again, it is true that while the
procedure to be followed in case of amalgamation of two companies is wider than
the scheme of compromise or arrangement though there exist substantial
overlapping.

The procedure to be followed while getting the scheme of amalgamation and the
important points, are as follows:-
(1) Any company, creditors of the company, class of them, members or the class of
members can file an application under section 391 seeking sanction of any scheme of
compromise or arrangement. However, by its very nature it can be understood that
the scheme of amalgamation is normally presented by the company. While filing an
application either under section 391 or section 394, the applicant is supposed to
disclose all material particulars in accordance with the provisions of the Act.

(2) Upon satisfying that the scheme is prima facie workable and fair, the Tribunal
order for the meeting of the members, class of members, creditors or the class of
creditors. Rather, passing an order calling for meeting, if the requirements of
holding meetings with class of shareholders or the members, are specifically dealt
with in the order calling meeting, then, there won’t be any subsequent litigation. The
scope of conduct of meeting with such class of members or the shareholders is wider
in case of amalgamation than where a scheme of compromise or arrangement is
sought for under section 391

(3) The scheme must get approved by the majority of the stake holders viz., the
members, class of members, creditors or such class of creditors. The scope of
conduct of meeting with the members, class of members, creditors or such class of
creditors will be restrictive some what in an application seeking compromise or
arrangement.

(4) There should be due notice disclosing all material particulars and annexing the
copy of the scheme as the case may be while calling the meeting.

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(5) In a case where amalgamation of two companies is sought for, before approving
the scheme of amalgamation, a report is to be received form the registrar of
companies that the approval of scheme will not prejudice the interests of the
shareholders.

(6) The Central Government is also required to file its report in an application
seeking approval of compromise, arrangement or the amalgamation as the case may
be under section 394A.

(7) After complying with all the requirements, if the scheme is approved, then, the
certified copy of the order is to be filed with the concerned authorities.
(II) The Competition Act ,2002
Following provisions of the Competition Act, 2002 deals with mergers of the
company:-
(1) Section 5 of the Competition Act, 2002 deals with “Combinations” which defines
combination by reference to assets and turnover 
(a) exclusively in India and 
(b) in India and outside India.

For example, an Indian company with turnover of Rs. 3000 crores cannot acquire
another Indian company without prior notification and approval of the Competition
Commission. On the other hand, a foreign company with turnover outside India of
more than USD 1.5 billion (or in excess of Rs. 4500 crores) may acquire a company
in India with sales just short of Rs. 1500 crores without any notification to (or
approval of) the Competition Commission being required.
(2) Section 6 of the Competition Act, 2002 states that, no person or enterprise shall
enter into a combination which causes or is likely to cause an appreciable adverse
effect on competition within the relevant market in India and such a combination
shall be void.

All types of intra-group combinations, mergers, demergers, reorganizations and

other similar transactions should be specifically exempted from the notification
procedure and appropriate clauses should be incorporated in sub-regulation 5(2) of
the Regulations. These transactions do not have any competitive impact on the
market for assessment under the Competition Act, Section 6.

25 Types of Taxes in India

ax is imposing financial charges on individual or company by central
government or state government. Collected Tax amount is used for building nation
(infrastructure & other development), to increase arms and ammunition for defense
of country and for other welfare related work. That’s why it is said that “Taxes are
paid nation are made”.
Type of Taxes in India:-
Direct Taxes:-
These types of taxes are directly imposed & paid to Government of India. There
has been a steady rise in the net Direct Tax collections in India over the years, which
is healthy signal. Direct taxes, which are imposed by the Government of India, are:
(1)   Income Tax:-

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 Income tax, this tax is mostly known to everyone. Every individual whose total
income exceeds taxable limit has to pay income tax based on prevailing rates
applicable time to time.
By doing investment in certain scheme you can save Income Tax.
Also Read:-  14 Tax Saving Options 2014
For FY 2016-17 Income tax rates are:-

(2)   Capital Gains Tax:-

Capital Gain tax as name suggests it is tax on gain in capital. If you sale property,
shares, bonds & precious material etc. and earn profit on it within predefined time
frame you are supposed to pay capital gain tax. The capital gain is the difference
between the money received from selling the asset and the price paid for it.
Capital gain tax is categorized into short-term gains and long-term gains. The
Long-term Capital Gains Tax is charged if the capital assets are kept for more than
certain period 1 year in case of share and 3 years in case of property. Short-term
Capital Gains Tax is applicable if these assets are held for less than the above-
mentioned period.
Rate at which this tax is applied varies based on investment class.
Example:-
If you purchase share at say 1000 Rs/- (per share) and after two months this
price increased to 1200 Rs/-(per share) you decide to sale this stock and earn profit
of 200 Rs/- per share. If you do so you have to pay Short term CGT (capital gain tax)
@ 10% +Education cess on profit as it is short term capital gain. If you hold same
share for 1 year or above it is considered as long term capital gain and you need not
to pay capital gain tax.it is considered as tax free.
Similarly if you purchase property after two year if you find that property price
in which you invested has increased and you decide to sale it you need to pay short
term capital gain tax.
For property it is considered as long term capital gain if you hold property for 3
years or above.
(3)   Securities Transaction Tax:-
A lot of people do not declare their profit and avoid paying capital gain tax, as
government can only tax those profits, which have been declared by people. To fight
with this situation Government has introduced STT (Securities Transaction Tax )
which is applicable on every transaction done at stock exchange. That means if you

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buy or sell equity shares, derivative instruments, equity oriented Mutual Funds this
tax is applicable.
This tax is added to the price of security during the transaction itself, hence you
cannot avoid (save) it. As this tax amount is very low people do not notice it much.
Current STT Rates are:-

(4)   Perquisite Tax:-
Earlier to Perquisite Tax we had tax called FBT (Fringe Benefit Tax) which was
abolished in 2009, this tax is on benefit given by employer to employee. E.g If your
company provides you non-monetary benefits like car with driver, club membership,
ESOP etc. All this benefit is taxable under perquisite Tax.
In case of ESOP The employee will have to pay tax on the difference between the
Fair Market Value (FMV) of the shares on the date of exercise and the price paid by
him/her.
Online Income Tax Calculator
(5)   Corporate Tax:-
Corporate Taxes are annual taxes payable on the income of a corporate
operating in India. For the purpose of taxation companies in India are
broadly classified into domestic companies and foreign companies.

In addition to above other taxes are also applicable on corporates.

 Indirect Taxes:-
 (6)   Sales Tax :-
Sales tax charged on the sales of movable goods. Sale tax on Inter State sale is
charged by Union Government, while sales tax on intra-State sale (sale within State)
(now termed as VAT) is charged by State Government.
Sales can be broadly classified in three categories. (a) Inter-State Sale (b) Sale
during import/export (c) Intra-State (i.e. within the State) sale. State Government
can impose sales tax only on sale within the State.
CST is payable on inter-State sales is @ 2%, if C form is obtained. Even if CST is
charged by Union Government, the revenue goes to State Government. State from
which movement of goods commences gets revenue. CST Act is administered by
State Government.
(7)   Service Tax:-
Most of the paid services you take you have to pay service tax on those services.
This tax is called service tax.  Over the past few years, service tax been expanded to
cover new services.
Few of the major service which comes under vicinity of service tax are telephone,
tour operator, architect, interior decorator, advertising, beauty parlor, health center,

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banking and financial service, event management, maintenance service, consultancy
service
Current rate of interest on service tax is 14.5%. This tax is passed on to us by
service provider.
(8)   Value Added Tax:-
The Sales Tax is the most important source of revenue of the state governments;
every state has their respective Sales Tax Act. The tax rates are also different for
respective states.
Tax imposed by Central government on sale of goods is called as Sales tax same
is called as Value added tax by state government.VAT is additional to the price of
goods and passed on to us as buyer (end user). Around 220+ Items are covered with
VAT.VAT rates vary based on nature of item and state.
Government is planning to merge service tax and sales tax in form of Goods
service tax (GST).
Also Read:- Download new 15G/15H Forms
(9)   Custom duty & Octroi (On Goods):-
Custom Duty is a type of indirect tax charged on goods imported into India. One
has to pay this duty , on goods that are imported from a foreign country into India.
This duty is often payable at the port of entry (like the airport). This duty rate varies
based on nature of items.
Octroi is tax applicable on goods entering in to municipality or any other
jurisdiction for use, consumption or sale. In simple terms one can call it as Entry
Tax.
(10) Excise Duty:-
An excise or excise duty is a type of tax charged on goods produced within the
country. This is opposite to custom duty which is charged on bringing goods from
outside of country. Another name of this tax is CENVAT (Central Value Added Tax).
If you are producer / manufacturer of goods or you hire labor to manufacture
goods you are liable to pay excise duty.
(11) Anti Dumping Duty:-
Dumping is said to occur when the goods are exported by a country to another
country at a price lower than its normal value. This is an unfair trade practice which
can have a distortive effect on international trade. In order to rectify this situation
Central Govt. imposes an anti dumping duty not exceeding the margin of dumping
in relation to such goods.
Other Taxes:-
(12) Professional Tax    :-
If you are earning professional you need to pay professional tax. Professional tax
is imposed by respective Municipal Corporations. Most of the States in India charge
this tax.
This tax is paid by every employee working in Private organizations. The tax is
deducted by the Employer every month and remitted to the Municipal Corporation
and it is mandatory like income tax.
The rate on which this tax is applicable is not same in all states.
(13) Dividend distribution Tax:-
Dividend distribution tax is the tax imposed by the Indian Government on
companies according to the dividend paid to a company’s investors. Dividend
amount to investor is tax free. At present dividend distribution tax is 15%.
(14) Municipal Tax:-

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 Municipal Corporation in every city imposed tax in terms of property tax. Owner
of every property has to pay this tax. This tax rate varies in every city.
(15) Entertainment Tax:-
Tax is also applicable on Entertainment; this tax is imposed by state government
on every financial transaction that is related to entertainment such as movie tickets,
major commercial shows exhibition, broadcasting service, DTH service and cable
service.
(16) Stamp Duty, Registration Fees, Transfer Tax:-
If you decide to purchase property than in addition to cost paid to seller. You
must consider additional cost to transfer that property on your name.
That cost include registration fees, stamp duty and transfer tax. This is required
for preparing legal document of property.
In simple sense this tax is imposed on the handing over of the title of property
ownership by one person to another. It incorporates a legal transaction fee & stamp
duty. This amount varies from property to property based on cost.
(17) Education Cess , Surcharge:-
Education cess is deducted and used for Education of poor people in INDIA. All
taxes in India are subject to an education cess, which is 3% of the total tax payable.
The education cess is mainly applicable on Income tax, excise duty and service tax.
Surcharge is an extra tax or fees that added to your existing tax calculation. This
tax is applied on tax amount.
(18) Gift Tax:-
If you receive gift from someone it is clubbed with your income and you need to
pay tax on it. This tax is called as gift tax.
This tax is applicable if gift amount or value is more than 50000 Rs/- in a year.
(19) Wealth Tax:-
Wealth tax is a direct tax, which is charged on the net wealth of the assessee.
Wealth tax is chargeable in respect of Net wealth corresponding to Valuation
date.Net wealth means all assets less loans taken to acquire those assets. Wealth tax
is 1% on net wealth exceeding 30 Lakhs (Rs 3,000,000). So if you have more money,
assets you are liable to pay tax.
Note:- Wealth tax is abolished by government in budget 2015.Now onwards
surcharge of 12% is applicable on individual earning 1 crore and above.
(20) Toll Tax:-
At some of places you need to pay tax in order to use infrastructure (road, bridge
etc.) build from your money given to government as Tax. This tax is called as toll tax.
This tax amount is very small amount but, to be paid for maintenance work and
good up keeping.
(21) Swachh Bharat Cess:- 
Swacch Bharat Cess is recently being imposed by the government of India. This
tax is applicable on all taxable services from 15thNovemeber, 2015. The effective rate
of Swachh Bharat Cess is 0.5%. After this tax we need to pay 14.5% service tax.
(22) Krishi Kalyan Cess:-
In budget 2016 finance minister has introduced new tax namely Krishi Kalyan
Cess. This cess is introduced in order to extend welfare to the farmers. The effective
rate of Krishi Kalyan Cess is 0.5%. This tax will be imposed on all taxable services.
Krishi Kalyan Cess would come in force with effect from June, 1, 2016. Once this cess
is applied we need to pay service tax @ 15%.
(23) Dividend Tax:-

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 In budget 2016 finance minister has introduced a new tax on the dividend
amount. It is proposed that 10% additional tax will be imposed on dividend income
above 10 Lac from 1st April 2016 onwards.
(24) Infrastructure Cess:- 
New Infrastructure cess on car and utility vehicle imposed recently in budget
2016. 1% infrastructure cess is applicable on petrol/LPG/CNG-driven motor vehicles
of length not exceeding 4 meters and engine capacity not exceeding 1200cc. 2.5%
cess on diesel motor vehicles of length not exceeding 4 meters and engine capacity
not exceeding 1500cc and 4% cess is applicable on big sedans and SUVs.
(25) Entry Tax:-
This entry tax is imposed by Gujarat, Madhya Pradesh, Assam, Delhi and
Uttarakhand state government recently. The tax rate is variable 5.5-10% depending
upon the state. All items entering in the state boundaries ordered via E-commerce
are under this tax boundary.
So in total you pay 25 different taxes in direct or indirect way. At the end in
order to make you laugh i will tell you one small joke on tax.

Subsidy
A subsidy, often viewed as the converse of a tax, is an instrument of fiscal policy.
Derived from the Latin word 'subsidium', a subsidy literally implies coming to
assistance from behind. However, their beneficial potential is at its best when they
are transparent, well targeted, and suitably designed for practical implementation.
Like indirect taxes, they can alter relative prices and budget constraints and
thereby affect decisions concerning production, consumption and allocation of
resources. Subsidies in areas such as education, health and environment at times
merit justification on grounds that their benefits are spread well beyond the
immediate recipients, and are shared by the population at large, present and future.
For many other subsidies, however the case is not so clear-cut. Arising due to
extensive governmental participation in a variety of economic activities, there are
many subsidies that shelter inefficiencies or are of doubtful distributional
credentials. Subsidies that are ineffective or distortionary need to be weaned out, for
an undiscerning, uncontrolled and opaque growth of subsidies can be deleterious for
a country's public finances.
In India, as also elsewhere, subsidies now account for a significant part of
government's expenditures although, like that of an iceberg, only their tip may be
visible. These implicit subsidies not only cause a considerable draft on the already
strained fiscal resources, but may also fail on the anvil of equity and efficiency as has
already been pointed out above.
In the context of their economic effects, subsidies have been subjected to an
intense debate in India in recent years. Issues like the distortionary effects of
agricultural subsidies on the cropping pattern, their impact on inter-regional
disparities in development, the sub-optimal use of scarce inputs like water and
power induced by subsidies, and whether subsidies lead to systemic inefficiencies
have been examined at length. Inadequate targeting of subsidies has especially been
picked up for discussion.
Subsidies, by means of creating a wedge between consumer prices and producer
costs, lead to changes in demand/ supply decisions. Subsidies are often aimed at 聽:
inducing higher consumption/ production
offsetting market imperfections including internalisation of externalities;

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 achievement of social policy objectives including redistribution of income,
population control, etc.
Transfers and Subsidies[edit]
Transfers which are straight income supplements need to be distinguished from
subsidies. An unconditional transfer to an individual would augment his income and
would be distributed over the entire range of his expenditures. A subsidy however
refers to a specific good, the relative price of which has been lowered because of the
subsidy with a view to changing the consumption/ allocation decisions in favour of
the subsidised goods. Even when subsidy is hundred percent, i.e. the good is
supplied free of cost, it should be distinguished from an income-transfer (of an
equivalent amount) which need not be spent exclusively on the subsidised good.
Transfers may be preferred to subsidies on the ground that i) any given
expenditure of State funds will increase welfare more if it is given as an income-
transfer rather than via subsidising the price of some commodities, and ii) transfer
payments can be better targeted at a specific income groups as compared to free or
subsidised goods.
Mode of administering a subsidy[edit]
The various alternative modes of administering a subsidy are:
Subsidy to producers
Subsidy to consumers
Subsidy to producers of inputs
Providing Incentives Instead of Subsidizing
Production/sales through public enterprises
Cross subsidisation
Subsidy targeting[edit]
Subsidies can be distributed among individuals according to a set of selected
criteria, e.g. 1) merit, 2) income-level, 3)social group etc. two types of errors arise if
proper targeting is not done, i.e. exclusion errors and inclusion errors. In the former
case, some of those who deserve to receive a subsidy are excluded, and in the latter
case, some of those who do not deserve to receive subsidy get included in the subsidy
programme.

Effects of subsidies
Economic effects of subsidies can be broadly grouped into
Allocative effects: these relate to the sectoral allocation of resources. Subsidies help
draw more resources towards the subsidised sector
Redistributive effects: these generally depend upon the elasticities of demands of the
relevant groups for the subsidised good as well as the elasticity of supply of the same
good and the mode of administering the subsidy.
Fiscal effects: subsidies have obvious fiscal effects since a large part of subsidies
emanate from the budget. They directly increase fiscal deficits. Subsidies may also
indirectly affect the budget adversely by drawing resources away from tax-yielding
sectors towards sectors that may have a low tax-revenue potential.
Trade effects: a regulated price, which is substantially lower than the market
clearing price, may reduce domestic supply and lead to an increase in imports. On
the other hand, subsidies to domestic producers may enable them to offer
internationally competitive prices, reducing imports or raising exports.

Antitrust and Competition Policy

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Perfect Commerce, (“Perfect”), requires that its officers and employees as well as all Company
Authorized Users of the Services comply with all applicable antitrust, competition and/or trade
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4. Company agrees that it will not, in connection with any use of the Services,
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 UNIT V

National Income Accounting: concepts of GDP, NI, per

capita income, PPP National income accounting in
India. Business cycles and business forecasting.
Measuring business cycles using trend analysis, macro
economic indicators in business cycle measurement.

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Concepts of National Income
There are various concepts of National Income. The main concepts of NI are: GDP,
GNP, NNP, NI, PI, DI, and PCI. These different concepts explain about the
phenomenon of economic activities of the various sectors of the various sectors of
the economy.

Gross Domestic Product (GDP)

The most important concept of national income is Gross Domestic Product. Gross
domestic product is the money value of all final goods and services produced within
the domestic territory of a country during a year.

Algebraic expression under product method is,

GDP=(P*Q)

where,
GDP=Gross Domestic Product
P=Price of goods and service
Q=Quantity of goods and service
denotes the summation of all values.

According to expenditure approach, GDP is the sum of consumption, investment,

government expenditure, net foreign exports of a country during a year.

Algebraic expression under expenditure approach is,

GDP=C+I+G+(X-M)

Where,
C=Consumption
I=Investment
G=Government expenditure
(X-M)=Export minus import

GDP includes the following types of final goods and services. They are:
1. Consumer goods and services.
2. Gross private domestic investment in capital goods.
3. Government expenditure.
4. Exports and imports.
Gross National Product (GNP)

Gross National Product is the total market value of all final goods and services
produced annually in a country plus net factor income from abroad. Thus, GNP is
the total measure of the flow of goods and services at market value resulting from
current production during a year in a country including net factor income from
abroad. The GNP can be expressed as the following equation:

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GNP=GDP+NFIA (Net Factor Income from Abroad) 
or, GNP=C+I+G+(X-M)+NFIA

Hence, GNP includes the following:

1. Consumer goods and services.
2. Gross private domestic investment in capital goods.
3. Government expenditure.
4. Net exports (exports-imports).
5. Net factor income from abroad.
Net National Product (NNP)

Net National Product is the market value of all final goods and services after
allowing for depreciation. It is also called National Income at market price. When
charges for depreciation are deducted from the gross national product, we get it.
Thus,

NNP=GNP-Depreciation
or, NNP=C+I+G+(X-M)+NFIA-Depreciation

National Income (NI)

National Income is also known as National Income at factor cost. National income at
factor cost means the sum of all incomes earned by resources suppliers for their
contribution of land, labor, capital and organizational ability which go into the years
net production. Hence, the sum of the income received by factors of production in
the form of rent, wages, interest and profit is called National Income. Symbolically,

NI=NNP+Subsidies-Interest Taxes
or,GNP-Depreciation+Subsidies-Indirect Taxes
or,NI=C+G+I+(X-M)+NFIA-Depreciation-Indirect Taxes+Subsidies

Personal Income (PI)

Personal Income i s the total money income received by individuals and households
of a country from all possible sources before direct taxes. Therefore, personal
income can be expressed as follows:

PI=NI-Corporate Income Taxes-Undistributed Corporate Profits-Social

Security Contribution+Transfer Payments

Disposable Income (DI)

The income left after the payment of direct taxes from personal income is called
Disposable Income. Disposable income means actual income which can be spent on
consumption by individuals and families. Thus, it can be expressed as: 

DI=PI-Direct Taxes

From consumption approach, 

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DI=Consumption Expenditure+Savings

Per Capita Income (PCI)

Per Capita Income of a country is derived by dividing the national income of the
country by the total population of a country. Thus, 

PCI=Total National Income/Total National Population

Definition of National Income:

National income of a country means the sum total of incomes earned by the citizens
of that country during a given period, say a year.
It should be noted that national income is not the sum of all incomes earned by all
citizens, but only those incomes which accrue due to participation in the production
process.
Individuals participate in the production process by supplying factors of production
which they possess.
There are four factors of production: natural resources or land; human resources or
labour; produced means of production or capital; and entrepreneurs or organisation.
The payment for the use of land is called rent. Payment for the use of labour is
known as wages and payment for the use of capital is known as interest. The factors
of production — land, labour and capital are primary factors of production and their
contractual payments are called factor incomes. The surplus—what is left after the
payment of these primary factors — is called the profit. This residual income is paid
to the organiser of production as profit.
Thus, income for the participation in the production process may take four forms:
rent, wages, interest and profit. By national income we mean the sum-total of all
rent, wages, interest and profit earned in the production process during a given
period by all the citizens, which is known as the factor payments total.
From this definition of national income, we exclude two types of personal income.
The first is transfer payments and the second is capital gains. When a citizen
receives a certain sum of money without participating in the production process it is
called transfer payments. For example, the unemployment benefit, income of a
beggar, etc. are personal incomes but not national income because they provide no
services against their receipts.
Again, when we sell out assets which has appreciated in value, and realise a gain it is
known as capital gain which is excluded from the calculation of national income
because it renders no productive service for reaping this gain.
Measurement Problems of National Income:
Problems arise in aggregation largely because of the difficulty of finding an
appropriate unit of measurement. In adding up the total output of a country, there is
no single physical unit of measurement that can be used: the millions of different
types of goods and services are all measured in different units, for example, steel is
measured in tonnes and cloth is measured in metres and it is, of course, impossible
to add tonnes to metres!
ADVERTISEMENTS:
The problem is partially overcome by using money as the unit of measurement —
this greatly simplifies the adding up, but it gives rise to the problem of distinguishing
between real and nominal values.

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In addition, there are many problems of measuring national income of an economy.
These problems may be stated as follows: Firstly, there is the problem of which
goods and services should be included. We know that gross domestic product (GDP)
is the money value of all goods and services currently produced within an economy
involving economic activity which means transforming scarce resources to satisfy
human wants.
We normally include those activities which generate goods and services to be sold in
the market for money. Thus, we exclude from national income accounting all
personal and household services which do not pass through the market. This way of
measuring is not correct because this excludes all goods that are not sold in the
market. In a developing economy a substantial part of the national income (or
output) is not marketed and, hence, these products are not included in the national
income account.
ADVERTISEMENTS:
The second problem is to exclude transfer payments and capital gains from national
income accounts. Receipts from illegal activities should also be excluded from the
national income calculation.
The third problem is associated with the valuation of inventories. The general rule is
that when a firm increases its inventory of goods, this investment in inventory is
counted both as past expenditure and as part of income. Thus, production of
inventory increases GDP just as production for final sale does.
There are mainly two methods of valuation of inventories: the market price method
and the cost price method. In the market price method imputed profits are included
which are unlikely to be realised in the same year. However, the cost price method
does not include imputed profit. Another problem of inventory valuation is that the
total quantity may remain the same, but this may not mean that each individual item
remains unchanged during the year.
Now, if prices are rising, the value of the new items are likely to rise faster than the
value of the old items. Similarly, if prices are falling, the value of the new items are
likely to fall less than that of the old items. Moreover, even if the size of the
inventories remains unchanged its value is likely to change, an adjustment may be
necessary to take account of the effect of price change. The adjustment is called the
inventory valuation adjustment.
The fourth problem is imputed values of the non-market goods, and services.
Although most goods and services are valued at their market prices when computing
GDP, some are not sold in the marketplace and, therefore, do not have market
prices. If GDP is to include the value of these goods and services, we must use an
estimate of their value. Such an estimate is called an imputed value. One in which
imputations are important is housing.
A person who rents a house is buying housing services and is providing income for
the landlord; the rent is part of GDP, both as expenditure by the renter and as
income of the landlord. However, many people live in their own homes. Although
they do not pay rent to a landlord, they are enjoying housing services similar to
those of renters.
To take account of the housing services enjoyed by homeowners, GDP includes (he
rent that these homeowners pay to themselves. Of course, homeowners do not in fact
pay themselves this rent but the market rent for a house could be imputed to be
included in GDP. This imputed rent is included both in the house-owner’s
expenditure and in the homeowner’s income.

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Another area in which imputations arise is in valuing the services provided by the
government. For example, law and order, fire fighters, defence, etc. provide services
to the public. Measuring the value of these services is difficult because they are not
sold in the marketplace and, therefore, do not have a market price. GDP includes
these services by valuing them at their cost. Thus, the wages of these public servants
are used as a measure of the value of their output.
In many circumstances, an imputation is called for in principle but is not made in
practice. Since GDP includes the imputed rent on owner-occupied houses, one might
expect it also to include the imputed rent on car, jewellery, and other durable goods
owned by households. Yet the value of these services is left out of GDP.
In addition, some of the output of the economy is produced and consumed at home
and never enters the marketplace. For example, meals cooked at home arc similar to
meals cooked at a restaurant, yet the value- added in meals at home is left out of
GDP.
Finally, no imputation is made for the value of goods and services sold in the
underground economy. The underground economy is that part of the economy that
people hide from the government either because they wish to evade taxation or
because the activity is illegal. Since the imputations necessary for computing GDP
are only approximations, and since the value of many goods and services is left out
altogether, GDP is an imperfect measure of economic activity.
These imperfections arc most problematic when comparing standards of living
across countries. The size of underground or black economy varies from country to
country. So long as the magnitude of these imperfections remains fairly constant
overtime, GDP is useful for comparing economic activity from year to year.
Total Output, National Product, National Income and National
Expenditure:
The value of the economy’s total output can be measured in three ways which can be
seen by examining Fig. 3.1. The figure shows the flows of income and expenditure in
this simple model. The two main economic agents are households and firms.
The households are the owners of factors of production, the services of which they
sell to firms in exchange for income (such as rent + wages + interest + profit). We
assume for simplicity that all profits to be distributed to households and not retained
by the firms.
The firms use the factors of production to produce many different goods and services
which they sell to households, foreigners, the government and other firms and
receive in return the values of goods and services they produced. The figure also
shows that the part of household income which is not spent on consumption is either
saved, spent on imports or is taken in taxes by the government.

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The government itself uses its tax revenue (as well as money from other sources) to
finance government spending, including transfer payments (such as pension,
unemployment benefit and student grants and loans). Before proceeding further we
want to define the terms consumption (C), investment (I) and savings (S).
Definition:
Consumption (C):
It is regarded as total expenditure by households on goods and services which yield
utility in the current period.
Savings (S) are that part of the disposable income which is not spent in the current
period. It follows that disposable income (Y -T) minus saving equals consumption.
Investment (I) is the production of or expenditure by firms on goods and services
which arc not for current consumption: that is, real capital goods, like factors-
machines, bridges and motorways, all goods which yield a flow of consumer goods
and services in future period.
There are three ways of measuring the annual value of total output in an economy —
are by calculating its national product, national expenditure and national income.
National Product:
This is found by adding up the value of all final goods and services produced by firms
during the year. It is to be noted that all final goods and services produced must be
included, whether they are to be sold to consumers or to the government, whether
they are to be sold to foreigners as exports, or whether they are capital goods to be
sold to other firms.
It is important to include only final goods and services: all intermediate goods must
be excluded so that double-counting is avoided. For example; in production of a
woollen coat, only the value of the final cost should be counted. The value of the raw
wool and woollen cloth are included in the value of the coat.
If we were to count them as well we should be guilty of double-counting. If all
intermediate goods were included in the calculation of the national product, we
would seriously overestimate the value of the country’s total output.
National Expenditure:
This is found by adding up all the spending on the final goods and services produced
by firms. Such an aggregate will only equal the value of total output if those goods
which are produced but not sold are also included—this item, which is called ‘net
changes in stocks and work in progress’, is normally counted as part of firms’
investment spending.

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National expenditure is the sum of consumption of domestically produced goods,
investment, government expenditure and exports (C + I + G + X). It must be noted
that, in order to avoid double-counting, only spending on final goods and services is
included.
National Income:
It is because goods and services are produced by factors of production that income is
created in the economy, so another way of calculating the value of total output is to
add up all the incomes paid out to the owners of the factors of production. Moreover,
it comes to the same thing to add the values- added by all firms at the different
stages of production.
This may be illustrated by a simple example in which production of
woollen coat involves the following three stages of production:
(a) A sheep farmer produces raw wool and sells it to a mill for £100. This represents
an income of £100.00 for the farmer. Value-added = £100.00.
(b) The mill uses the raw wool to produce cloth which it sells to a coat factory for
£210. This represents income of £110 for the mill — remember that £100.00 has had
to be paid for the raw wool. Value-added = £110.00.
(c) The coat factory produces the coat and sells it for £400. This includes £210 to
cover the cost of cloth and £190 to pay incomes including profits. Value-added =
£190.
The total value-added in this example (£400.00) is just equal to the value of the final
coat; it is also equal to the sum of all incomes paid at each stage of production. The
value of a country’s total output can be found either by adding the values-added by
all firms or by adding up the incomes (that is, wages + rents + interest + profits) of
all factors of production, those producing intermediate goods as well as those
producing final goods.
In either case, double- counting will be avoided. It is important to exclude all
transfer payments as these represent nothing more than a redistribution of income
from taxpayers to the transfer recipients, including them would involve double
counting.
Assuming:
(a) that all measures are calculated accurately; (b) that only final goods and services
are counted in the national expenditure and national product figures; (c) that any
change in unsold stocks are included in the national income figures; (d) that all
incomes (including profits but excluding transfer payments) are counted in the
national income figures, then it must follow that all three measures will provide an
identical figure for the value of national income and output. That is
National Income = National Expenditure = National Product In principle, these
three aggregates simply represent different ways of measuring the flow of output or
income being created in an economy over a period of time.
Components of Expenditure:
Economists and policymakers care not only about the economy’s total output of
goods and services but also about the allocation of this output among alternative
uses. National income accounts allocate GDP among four broad categories:
Consumption (C). Investment (I), Government expenditure (G), and Net exports (X
– M) or (NX).
Thus, let Y stand for GDP. Y=C + I + G + X- M or Y = C+ I + G + NX. Each pound of
GDP is placed in one of these categories. This equation is an identity. It is called the
national income accounts identity.

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We have already defined almost all of the components of GDP except NX, net
exports, that is, trade with other countries in an open economy. Here we will give the
definition of NX and explain in detail about open economy later on. Net exports are
the value of goods and services exported to other countries minus the value of goods
and services imported from other countries. It represents the net expenditure from
abroad for our goods and services, which provides income for domestic producers.

5 Phases of a Business Cycle (With Diagram)

Business cycles are characterized by boom in one period and collapse in the
subsequent period in the economic activities of a country.
These fluctuations in the economic activities are termed as phases of business cycles.
The fluctuations are compared with ebb and flow. The upward and downward
fluctuations in the cumulative economic magnitudes of a country show variations in
different economic activities in terms of production, investment, employment,
credits, prices, and wages. Such changes represent different phases of business
cycles.
The different phases of business cycles are shown in Figure-1:

There are basically two important phases in a business cycle that are prosperity and
depression. The other phases that are expansion, peak, trough and recovery are
intermediary phases.
Figure-2 shows the graphical representation of different phases of a
business cycle:

As shown in Figure-2, the steady growth line represents the growth of economy
when there are no business cycles. On the other hand, the line of cycle shows the

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business cycles that move up and down the steady growth line. The different phases
of a business cycle (as shown in Figure-2) are explained below.

1. Expansion:
The line of cycle that moves above the steady growth line represents the expansion
phase of a business cycle. In the expansion phase, there is an increase in various
economic factors, such as production, employment, output, wages, profits, demand
and supply of products, and sales.
In addition, in the expansion phase, the prices of factor of production and output
increases simultaneously. In this phase, debtors are generally in good financial
condition to repay their debts; therefore, creditors lend money at higher interest
rates. This leads to an increase in the flow of money.
In expansion phase, due to increase in investment opportunities, idle funds of
organizations or individuals are utilized for various investment purposes. Therefore,
in such a case, the cash inflow and outflow of businesses are equal. This expansion
continues till the economic conditions are favorable.

2. Peak:
The growth in the expansion phase eventually slows down and reaches to its peak.
This phase is known as peak phase. In other words, peak phase refers to the phase in
which the increase in growth rate of business cycle achieves its maximum limit. In
peak phase, the economic factors, such as production, profit, sales, and employment,
are higher, but do not increase further. In peak phase, there is a gradual decrease in
the demand of various products due to increase in the prices of input.
The increase in the prices of input leads to an increase in the prices of final products,
while the income of individuals remains constant. This also leads consumers to
restructure their monthly budget. As a result, the demand for products, such as
jewellery, homes, automobiles, refrigerators and other durables, starts falling.
3. Recession:
As discussed earlier, in peak phase, there is a gradual decrease in the demand of
various products due to increase in the prices of input. When the decline in the
demand of products becomes rapid and steady, the recession phase takes place.
In recession phase, all the economic factors, such as production, prices, saving and
investment, starts decreasing. Generally, producers are unaware of decrease in the
demand of products and they continue to produce goods and services. In such a case,
the supply of products exceeds the demand.
Over the time, producers realize the surplus of supply when the cost of
manufacturing of a product is more than profit generated. This condition firstly
experienced by few industries and slowly spread to all industries.
This situation is firstly considered as a small fluctuation in the market, but as the
problem exists for a longer duration, producers start noticing it. Consequently,
producers avoid any type of further investment in factor of production, such as
labor, machinery, and furniture. This leads to the reduction in the prices of factor,
which results in the decline of demand of inputs as well as output.
4. Trough:
During the trough phase, the economic activities of a country decline below the
normal level. In this phase, the growth rate of an economy becomes negative. In
addition, in trough phase, there is a rapid decline in national income and
expenditure.

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In this phase, it becomes difficult for debtors to pay off their debts. As a result, the
rate of interest decreases; therefore, banks do not prefer to lend money.
Consequently, banks face the situation of increase in their cash balances.
Apart from this, the level of economic output of a country becomes low and
unemployment becomes high. In addition, in trough phase, investors do not invest
in stock markets. In trough phase, many weak organizations leave industries or
rather dissolve. At this point, an economy reaches to the lowest level of shrinking.
5. Recovery:
As discussed above, in trough phase, an economy reaches to the lowest level of
shrinking. This lowest level is the limit to which an economy shrinks. Once the
economy touches the lowest level, it happens to be the end of negativism and
beginning of positivism.
This leads to reversal of the process of business cycle. As a result, individuals and
organizations start developing a positive attitude toward the various economic
factors, such as investment, employment, and production. This process of reversal
starts from the labor market.
Consequently, organizations discontinue laying off individuals and start hiring but
in limited number. At this stage, wages provided by organizations to individuals is
less as compared to their skills and abilities. This marks the beginning of the
recovery phase.
In recovery phase, consumers increase their rate of consumption, as they assume
that there would be no further reduction in the prices of products. As a result, the
demand for consumer products increases.
In addition in recovery phase, bankers start utilizing their accumulated cash
balances by declining the lending rate and increasing investment in various
securities and bonds. Similarly, adopting a positive approach other private investors
also start investing in the stock market As a result, security prices increase and rate
of interest decreases.
Price mechanism plays a very important role in the recovery phase of economy. As
discussed earlier, during recession the rate at which the price of factor of production
falls is greater than the rate of reduction in the prices of final products.
Therefore producers are always able to earn a certain amount of profit, which
increases at trough stage. The increase in profit also continues in the recovery phase.
Apart from this, in recovery phase, some of the depreciated capital goods are
replaced by producers and some are maintained by them. As a result, investment
and employment by organizations increases. As this process gains momentum an
economy again enters into the phase of expansion. Thus, a business cycle gets
completed.

Types of Indicators
The Conference Board, a global business research association, identifies three main
classes of business cycle indicators, based on timing: leading, lagging and coincident
indicators. The Conference Board website states that all these indicators are
designed to predict the peaks and troughs of business cycles in the United States and
10 other nations and regions around the world, including Britain, Australia, China,
Japan, the Euro area of Europe, Germany and France and Mexico.
Leading Indicators
Leading indicators consist of measures of economic activity in which shifts may
predict the onset of a business cycle. Examples of leading indicators include average
weekly work hours in manufacturing, factory orders for goods, housing permits and

192
stock prices. Increases or decreases in these measures could signal the beginning of
a business cycle. The Conference Board reports that leading indicators receive the
most attention because of their tendency to shift in advance of a business cycle.
Other leading indicators include the index of consumer expectations, average weekly
claims for unemployment insurance and the interest rate spread. The interest rate
spread is the difference between the rate on the 10-year Treasury Bond and the
Federal Funds Rate, the interest rate banks charge each other for overnight loans.
Lagging Indicators
If leading indicators signal the onset of business cycles, lagging indicators confirm
these trends. Lagging indicators consist of measures that change after an economy
has entered a period of fluctuation. Lagging indicators reported by the Conference
Board include the average length of unemployment, labor cost per unit of
manufacturing output, the average prime rate, the consumer price index and
commercial lending activity. Because lagging indicators change direction after the
economy enters a business cycle, they are sometimes dismissed as unimportant. The
Conference Board points out, however, that lagging indicators represent costs of
doing business and can provide valuable insight into structural problems in the
economy.
Coincident Indicators
Coincident indicators consist of aggregate measures of economic activity that change
as the business cycle progresses. Therefore, these indicators help define business
cycles themselves, according to the Conference Board. Examples of coincident
indicators include the unemployment rate, personal income levels and industrial
production

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