NMIMS Microeconomics - Book

MICROECONOMICS
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COURSE DESIGN COMMITTEE
Chief Academic Officer

Dr. Shalini Kalia
NMIMS Global Access – School for Continuing Education
Content Reviewer TOC Reviewer

Prof. Ritu Tripathi Prof. Ritu Tripathi
Assistant Professor, NMIMS Global Assistant Professor, NMIMS Global
Access - School for Continuing Education Access - School for Continuing Education
Specialization: Finance Specialization: Finance
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Author : Ms. Ritika Israney

Reviewed By: Prof. Ritu Tripathi
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Copyright:
2020 Publisher
ISBN:
978-81-947804-7-2
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C O N T E N T S
CHAPTER NO. CHAPTER NAME PAGE NO.
1 Introduction To Economics 1
2 Working of Economy and its Basic Problems 19
3 Demand Analysis 41
Case Studies 1 to 3 63
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4 Supply Analysis 73
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6 Elasticity of Supply 121

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7 Consumer Demand Analysis 147
8 Production Theory: Short Run 183

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9 Production Theory: Long Run 203
10 Cost Analysis 231
11 Revenue Analysis 257
12 Market Structure 275

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MIC RO E CO N O MICS
C U R R I C U L U M
Introduction to Economics: An Overview of Economics; Nature of Economics; Branches of

Economics; Applications of Microeconomics and Macroeconomics; Microeconomics: A Positive or
Normative Approach; Uses and Limitations of Microeconomic Theories.
Working of Economy And Its Basic Problems: Concept of Economy; How an Economy Works?;
Problem of Scarcity; Choice as an Economic Problem; Choice and Opportunity Cost; Production
Possibility Curve (PPC); Government and the Economy.
Demand Analysis: Meaning of Demand; Types of Demand; Determinants of Demand; Law of
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Demand; Assumptions in the Law of Demand; Demand Schedule; Demand Curve; Exceptions to
the Law of Demand; Movement and Shift in Demand; Expansion and Contraction of Demand;
Increase and Decrease in Demand.
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Supply Analysis: Concept of Supply; Determinants of Supply; Law of Supply; Supply Schedule;
Supply Curve; Assumptions of the Law of Supply; Exceptions to the Law of Supply; Movement and
Shift in Supply; Expansion and Contraction of Supply; Increase and Decrease in Supply; Market
Equilibrium: Demand and Supply Equilibrium; Determination of Market Price; Shifts in Market
Equilibrium.
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Elasticity of Demand: Concept of Elasticity of Demand; Price Elasticity of Demand; Income

Elasticity of Demand; Cross Elasticity of Demand.
Elasticity of Supply: Types of Elasticity of Supply; Factors Determining Elasticity of Supply;

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Measurement of Elasticity of Supply.
Consumer Demand Analysis: Utility as a Basis of Consumer Demand; Concept of Cardinal Utility;
Total and Marginal Utility; Law of Diminishing Marginal Utility; Consumer Behaviour; Consumer
Preferences; Ordinal Utility Approach – Indifference Curve Analysis; Meaning of Indifference
Curve; Marginal Rate of Substitution; Properties of Indifference Curve; Criticism of Indifference
Curve; Consumer Equilibrium Effects; Income Effect; Substitution Effect; Price Effect.
Production Theory: Short Run: Basic Concepts of Production; Meaning of Production; Factors of
Production; Short Run and Long Run; Short-Run Production Function: Law of Variable Proportions.
Production Theory: Long Run: Long-Run Production Function: Isoquant Analysis; Isoquant
Curve; Iso-Cost Curves; Producer’s Equilibrium; Long-Run Production Function: Laws of Returns
to Scale; Increasing Returns to Scale; Constant Returns to Scale; Diminishing Returns to Scale.

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Cost Analysis: Basic Cost Concepts; Actual and Opportunity Costs; Implicit and Explicit Costs; Fixed
and Variable Costs; Accounting and Economic Costs; Private and Social Costs; Short-run and Long-run
Costs; Cost Function; Short-run Cost Function; Long-run Cost Function; Economies and Diseconomies
of Scale.
Revenue Analysis: Concept of Revenue; Total Revenue (TR); Average Revenue (AR); Marginal Revenue
(MR); Relationship between TR and MR; Relationship between AR and MR.
Market Structure: Perfect Competition; Features of Perfect Competition; Equilibrium of the Firm
and Industry under Perfect Competition; Profit Maximisation and Perfect Competition; Monopoly;
Characteristics of Monopoly; Price Discrimination under Monopoly; Monopolistic Competition;
Characteristics of Monopolistic Competition; Oligopoly; Features of Oligopoly.
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C H A
1 P T E R
INTRODUCTION TO ECONOMICS
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CONTENTS
1.1 Introduction
1.2 An Overview of Economics
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1.2.1 Nature of Economics
1.2.2 Branches of Economics
1.2.3 Applications of Microeconomics and Macroeconomics
Self Assessment Questions
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1.3 Microeconomics: A Positive or Normative Approach
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1.4 Uses and Limitations of Microeconomic Theories
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1.5 Summary
1.6 Multiple Choice Questions
1.7 Descriptive Questions
1.8 Higher Order Thinking Skills (HOTS) Questions
1.9 Answers and Hints
1.10 Suggested Readings & References

2 MICROECONOMICS
INTRODUCTORY CASELET
INFLUENCE OF MICROECONOMICS IN DAILY LIFE
Vinod Gawre, an investment banker, wants to rent an apartment

Case Objective in Mumbai. To do so, he must first set a budget after considering
his income and how much money he is looking to spend on hous-
This caselet illustrates the
influence of microeconomics ing. If he allocates too much of his income to rent, then he would
in daily life. not have sufficient money left for other expenses. He needs to de-
cide the maximum amount of money that he can spend on rent,
what amenities he must have in his apartment, and acceptable
neighbourhood. This requires him to make a decision to maximise
his satisfaction. In microeconomics, this principle is called maxi-
mising utility.
Vinod sets a budget to get the most satisfaction for the least possi-
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ble rent. He wants to rent a 2-BHK apartment in Versova. Howev-
er, there are others also interested in renting similar apartments
in that area. This might force him to increase his budget. To make
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up the budget, he might have to curtail his expenses in other ar-
eas, such as eating out, entertainment or travel. This decision
shows that money or capital is a limited resource and it should be
allocated among various expenses wisely.
At the other end of the spectrum, we have Maithri Rawat. She is

the owner of a 2-BHK flat in Versova. She wants to rent her flat
at the highest price possible. While setting a rent price, she takes
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into account the demand for her apartment and the neighbour-
hood. She decides to set a rent of ` 50,000 per month. At this price,
she finds that renters are not interested, as there are other land-
lords who are charging at least ` 10,000 – 20,000 less for similar
apartments. Thus, Maithri must make decisions based on supply
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and demand. Supply means the total number of apartments avail-

able in Versova, whereas demand means the total demand for a
2-BHK flat in Versova. The interaction of supply and demand de-
termines the rental price.
If the demand for a 2-BHK apartment in Versova is very high and

there is a limited supply for such apartments, then it will result
in a higher rental price. Although Maithri can attract more pro-
spective renters by setting a rental price that is at least ` 30,000
lower than what other neighbourhood landlords are charging, she
would be forgoing some rental income, which, in turn, will not
maximise her utility or satisfaction.
In conclusion, both Vinod and Maithri will make decisions to get

the best outcome for themselves given the constraints they face.
This study of how individuals and businesses make decisions on
how to best use the limited resources is called microeconomics.

Introduction to Economics 3
LEARNING OBJECTIVES
After studying this chapter, you will be able to:

>> Explain the meaning of economics
>> Discuss two main branches of economics
>> Explain whether microeconomics is positive or normative
>> Describe the uses and limitations of microeconomic theories
1.1 INTRODUCTION
Human wants are infinite or unlimited. However, not all wants are
equally urgent and important. Therefore, people have to make choices
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between wants with a limited amount of money. Economics deals with
the calculated decisions on how to use the limited money resources
to satisfy maximum of one’s needs. For example, Vinod Gawre (case-
let studied above) initially wanted to rent a 3-BHK flat in Mumbai.
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However, he could not afford the high rental price in the areas of his
choice. He liked the apartment of Maithri Rawat. Although it was a
2-BHK flat, he decided to rent it as he liked the neighbourhood. To
make up for the rental budget, he decided to reduce his expenses on
entertainment and eating out. Similarly, Maithri had initially set a
very high price of ` 50,000 per month for her apartment, but she did
not find anyone interested in that price. She subsequently reduced
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the price to ` 35,000 per month, which was closer to what other land-
lords in the area were charging.
Similarly, businesses also have limited time and money. They also
make thousands of big and small decisions to get the best outcome,
which usually is about maximising profit. These countless choices or
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decisions that individual consumers, households, businesses and gov-

ernments make on a daily basis to satisfy their wants with scarce re-
sources is the root of economics.
In this chapter, you will first understand the concept of economics – its
nature and branches. You will learn the differences between micro-
economics and macroeconomics. Next, you will understand whether
microeconomics is a positive or a normative science.
1.2 AN OVERVIEW OF ECONOMICS

People have infinite wants, but the resources are limited. Economics
is a social science that understands and examines the economic be-
haviour of people. In other words, economics attempts to study how
people allocate their limited resources to their alternative uses in or-
der to produce and consume goods to satisfy their unlimited wants
and maximise their gains. To do so, they make a number of choices
on how to use their resources and spend their earnings. A need for

4 MICROECONOMICS
making choices arises due to the following three fundamental eco-

nomic factors:
Human wants are infinite or unlimited: The three terms demand,
want, and desire are often used interchangeably. However, in eco-
nomics, each of these terms has a different meaning. Let us under-
stand the difference between these three terms with the help of an
example. Suppose an individual is willing to purchase a personal
computer for his/her work, it becomes his/her desire. If the indi-
vidual has purchasing power to buy the computer but is not will-
ing to sacrifice his/her money, it becomes a want. However, if the
individual is willing to use the money to purchase the computer, it
becomes demand. However, not all wants are equally urgent and
important. Satisfying some wants gives more pleasure than others.
Therefore, people have to make choices between wants.
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There are only scarce resources to satisfy human wants: These
resources can be natural resources (land), human resources (la-
bour), man-made resources (capital), entrepreneurship (those
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ness) time and information. All of these resources are limited with
respect to their demand. This scarcity of resources in relation to
infinite human wants gives rise to economic problems and forces
people to make choices. The problem of choices also arises due to
alternative uses of resources; each alternative use gives different
returns or earnings. For example, a land in Mumbai used to set up
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a factory will give more earnings or income than when used as a

residential building.
Humans want to maximise their gains: People make choices be-
tween alternative uses of their scarce resources with the objective
of maximising their gains. To do so, they evaluate the cost and ben-
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efit of alternative options while making their decisions.
In conclusion, economics is a social science because it deals with hu-

man behaviour i.e. how people deal with the economic problem of
scarcity. It studies economic behaviour of the people and its implica-
tions.
1.2.1 NATURE OF ECONOMICS
There are several schools of thought to understand the nature of eco-

nomics. Let us discuss these schools.
Classical view: This view defines economics as ‘the science of
wealth’. According to Adam Smith, the Father of Economics, eco-
nomics valuates those factors that determine the wealth produc-
tion and growth of a nation. In his view, wealth is regarded as an
end of itself. This view was later shifted from wealth production
to wealth distribution. J.B. Say, a French economist, said that eco-
nomics is ‘the science of production, distribution, and consumption

of wealth’. A drawback of the classical view is that economics is de-

fined as the science of only material wealth and not of non-materi-
al wealth, such as services provided by teachers or doctors. Such
services meet human wants and should be considered as part of
wealth. Another disadvantage is that it focusses on wealth rather
than human life.
Neo-classical view: According to Alfred Marshal, economics is
‘the science of material welfare’. It is also a social science because
it studies mankind in the ordinary business of life. It evaluates a
social action and the part of an individual which is deeply associ-
ated with the achievement and consumption of material well-be-
ing. Thus, it considers wealth as the source of human welfare. This
means that economics is associated with economic activities that
promote material welfare.
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Since this view differentiates between material and non-material
activities, some economists criticised the neo-classical view of
having narrow scope. According to them, all goods and services
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that command a price should be regarded as economic activities,
whether they are material or non-material. According to Lionel
Robbins, there are various material activities that do not promote
human welfare, such as production and sale of tobacco, drugs,
and alcohol, but these activities are considered to be economic
activities. Therefore, the word ‘welfare’ should not be used with
material activities. Moreover, human welfare is a subjective issue
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and cannot be objectively decided which activities promote it and

which do not.
Scarcity and choice definition: According to Lionel Robbins,
economics is ‘the science of human behaviour in a relationship
between ends and scarce means with alternative uses’. In other
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words, economics is a human science. It involves maximising sat-

isfaction from scarce resources. However, the means available to
satisfy these ends (wants) are limited (or scarce). Moreover, these
scarce means are capable of alternative uses. That implies that the
use of a scarce resource for one end will prevent its use for any
other purpose at that point of time. The ends have different im-
portance and, thus, humans may have a difficulty in selecting the
uses to which scarce resources can be put into. Therefore, humans
have to decide on the best allocation of resources. In a nutshell,
the scarcity and choice definition by Robbins has three main ele-
ments:
Unlimited wants
Scarcity of resources
Alternative use of resources
This definition does not differentiate between material and non-
material activities, as long as they satisfy human wants. It defines
economic problem as the difficulty in allocating scarce means in

6 MICROECONOMICS
relation to numerous ends. Although this viewpoint is popular, it

has been criticised as it also talks about ‘welfare’. It involves the
allocation of resources to maximise satisfaction, which, in fact, is
welfare only. Moreover, this definition does not describe the nature
of ‘end’ and difficulties associated with it. The end cannot be
definite due to the involvement of intermediaries to further ends.
Also, the end cannot be separated from means because immediate
ends may be the means to the accomplishment of further ends.
Samuelson’s growth-oriented definition: Economics is the ‘study
of how people and society select and use scarce resources (with
alternative uses) to produce different commodities over time and
distribute them for consumption for the present and future eco-
nomic growth’. The key aspects of this growth-oriented definition
by Samuelson are as follows:
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Economics is a social science that focusses on the problem of
scarce resources and the idea of alternative uses of these re-
sources.
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The distribution and consumption of commodities for the ex-
isting and forecoming economic growth underlines the study
of microeconomics.
The use of modern techniques, such as cost-benefit analysis
will help determine how to use scarce resources.
The inclusion of time element makes the scope of economics
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dynamics, which is a substantial improvement over Robbins’

definition of economics.
1.2.2 BRANCHES OF ECONOMICS

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The scope of economics as a subject continues to grow and expand.

Several economists claim that it is still in a growing stage and many
problems are yet to be addressed. However, it is also considered to be
the best developed social science that continues to expand in terms of
content and analytical richness. Regardless, conventional economics
is divided into the following two main branches:
Microeconomics: This branch of economics deals with the be-
haviour of individuals, businesses, commodities and prices at the
micro level. It answers the following questions:
How do individuals and businesses make choices?
How do their choices affect the demand and supply of goods
and services?
How do their choices impact the prices of goods and services
in the market?
How do markets function?

Macroeconomics: Macroeconomics is the branch of economics

that studies the economy as a whole. It analyses aggregates of in- ? DID YOU KNOW
dividuals, businesses, prices and outputs. It studies the impact of The two branches of economics
their choices on the aggregate or total level of economic activities. emerged after the Great
Depression of the 1930s. The
For instance, it studies the aggregate level of employment, general
terms ‘microeconomics’ and
price level, aggregate savings and investment in the economy. Its ‘macroeconomics’ were coined
main objectives are as follows: by a Norwegian economist,
Ragnar Frisch, in 1933. He
Full employment derived the prefixes ‘micro’
(meaning small) and ‘macro’
Economic growth
(meaning large) from the Greek
Favourable balance of payment language.
Stability of price
For example, the topic of general widespread recession due to ? DID YOU KNOW
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COVID-19 pandemic and decline in national economies comes The foundation of
under macroeconomics. macroeconomics was also set
in the year 1933 by the great
Microeconomics and macroeconomics are inter-related and cannot be economist John Maynard
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isolated from each other. What affects the one affects the other and Keynes in his revolutionary
vice versa. For example, national income of a country is the sum total book, ‘The General Theory
of Employment, Interest and
of the incomes of individuals, businesses, and industries. Money’.
1.2.3 APPLICATIONS OF MICROECONOMICS AND

MACROECONOMICS
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Microeconomics is the study of the behaviour of individuals and busi-

nesses. It is concerned with individual markets and small aspects of
the economy. It analyses how these individuals and businesses inter-
act with each other through markets and make decisions about the
allocation of resources and prices of goods and services. It focusses on
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demand and supply forces to determine the price levels in the econo-
my. It includes various key principles, such as:
Demand, supply and economic equilibrium: The supply and de-
mand factors for a good or service in a market determine its prices.
In a perfectly competitive market, suppliers of goods or services
offer the same price as demanded by consumers. This creates eco-
nomic equilibrium.
Production theory: This theory studies how goods and services
are produced.
Costs of production: This theory states how the cost of resources
used in its manufacturing or providing services changes with pro-
duction.
Microeconomics uses a bottom-up approach to analyse the economy.

Its rules are derived from a set of similar laws and theorems. On the
other hand, ‘macroeconomics’ deals with the analysis of behaviour
of entire industries and economies instead of analysing individu-
als or specific firms. Macroeconomics is concerned with the whole

8 MICROECONOMICS
aggregate economy. It studies the effects of government policies on the

national economy, such as inflation, economic growth and trade. It is
a top-down approach that examines economy-wide phenomena, such
as gross domestic product (GDP) and how it is influenced by changes
in employment level, rate of growth, national income and price level.
In other words, it studies how GDP would be affected by the rate of
unemployment or how the capital account of a country is affected by
the rise or fall of exports. Macroeconomics emphasises on aggregates
and economic correlations. Therefore, governments use macroeco-
nomics to draft their economic and fiscal policies.
SELF ASSESSMENT QUESTIONS
1. Economics is a _________ science.
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a. Physical b. Chemical
c. Perfect d. Social
2. The classical view of economics was proposed by:
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a. Adam Smith
b. Alfred Marshall
c. Lionel Robbins
d. Samuelson
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ACTIVITY
List the three microeconomics decisions that you make on a day-

to-day basis.
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MICROECONOMICS: A POSITIVE OR
1.3
NORMATIVE APPROACH
In general, there are two view points or approaches to economics
namely positive approach (or simply positive economics) and norma-
tive approach (or simply normative economics).
Consider the following two statements:
Statement I: The government has increased the minimum wages for

labourers.
Statement II: The government should increase the minimum wages

for labourers.
Statement I represents a fact or something that can be verified. This

fact is valid and can be verified. On the contrary, Statement II rep-
resents something that should be or ought to be done. It means that
Statement II represents an ideal situation of what needs to be done.

From these two statements, you will get the following ideas regarding
the two approaches to economics:
Positiveeconomics helps us in determining ‘what is’ whereas nor-
mative economics helps us in determining ‘what should be’ or
‘what needs to be done’.
Positive economics does not depend on any ethical or normative
position. But normative economics depends a great deal on posi-
tive economics.
Positive economics aims to develop a theory or hypothesis that
yields a valid and meaningful predictions about the phenomena
that have not been observed yet.
Positive economics represents actual facts whereas normative eco- NOTE
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nomics talks about idealistic situations. As a social science,
microeconomics is both positive
Positive economics aims to answer the following questions which as well as normative approach
are of positive nature: to examine economic events and
recommend suitable actions.
What
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is?: For example, what is the trend of commercial prop-
erty prices in India?
Why is it?: For example, why are property prices high despite a
decrease in demand for commercial property after COVID-19?
What will be?: What will be the demand for commercial prop-
erty if prices decrease?
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Microeconomics evaluates the following questions:

What economic decisions will individuals make under the given
conditions?
How would the individuals respond if the given economic condi-
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tions change?
Let us see how microeconomics is both positive as well as normative.
Answers to the above questions help in establishing a relation be-

tween the change in economic conditions and the economic decisions
of the people. It means that microeconomics helps in establishing the
cause-and-effect relationship between economic events and predicts
the consequences of change in events. Microeconomics helps in pre-
dicting economic phenomena by using microeconomic theories (or a NOTE
system of generalisations). This makes microeconomics a positive ap- Fundamentally, microeconomics
proach. Here, the positive does not imply that theoretical statements is a positive approach. It
are positively true, but that they have a tremendous possibility to oc- acquires the normative
cur if conditions are satisfied. character when microeconomic
theories are applied to evaluate
the economic phenomena
At times, positive economics related questions such as ‘what is’ or
from the social desirability
‘what happens in the market’ may not be desirable or in the interest of perspective, to demonstrate the
the society. For instance, production and sale of cigarettes and other need for a public policy action,
tobacco-based products may be a highly profitable business. Howev- and analyse the policy actions of
the government.

10 MICROECONOMICS
er, whether the production and sale of cigarettes and tobacco-based

products is desirable for the society is a normative question.
Under microeconomics, normative questions are asked from the an-

gle of social desirability for ensuring public interest. Normative eco-
nomics evaluates social costs and benefits of production and sale of
cigarettes and other tobacco products, and recommends the control
and regulatory measures. This makes it a normative approach.
Let’s take another example. House rents in India are already high.
Considering the high rate of population growth and supply of houses,
if house rents are not controlled, they will continue to shoot up.
Now a normative question will be ‘should house rents be allowed to

increase depending on the market demand and supply or should it
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NOTE be controlled and regulated in the interest of tenants? This question
Since microeconomics also is posed in the public interest. Here, microeconomics will take into
recommends methods to check account the interest of both landlords and tenants and recommend a
undesirable economic events, reasonable rate of house rents and measures to implement them. As a
it is also called a prescriptive
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normative approach, microeconomics evaluates values to decide what
approach.
is good or bad for the society. These values are derived from moral,
ethical, social and political goals of the society.
3. Which question below is a positive-approach question in mi-

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croeconomics?
a. What should be the employment rate of India?
b. Should online gambling be banned?
c. What is the trend of vehicle sales this quarter?
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d. Whether schools should be opened by July 2020?

4. If the COVID-19 pandemic continues for a long period, what
will be the demand for office space in Mumbai? This is a
__________ question.
a. Positive
b. Normative
c. Prescriptive
d. Negative
ACTIVITY
Evaluate the effect of Indo-China tension on the funding of start-

ups in India as both positive and normative microeconomics ap-
proach.

USES AND LIMITATIONS OF

1.4
MICROECONOMIC THEORIES
Being the most important branch of economics, microeconomics sets
the basic foundation for economic analysis. It has its uses and limita-
tions. Let’s first consider the uses.
Explains the economic behaviour of individuals: Microeco-
nomics helps understand the economic behaviour of billions of
individual decision-makers (including consumers, firms, industries
and factory owners). It derives the nature of relationship between
the dependent and independent variables of the economic system.
Economists can analyse the degree to which actual economic phe-
nomena deviate from ideal models constructed for accomplishing
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individual and social objectives. The more the economic system is
understood, the more efficient it will be to control and manage the
economy.
Predicts
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future economic events: Microeconomics helps estab-
lish the cause-and-effect relationship between economic events.
These relationships provide the foundation for forecasting the fu-
ture course of economic events. Economic forecasts are important
in planning the future course of economic activities by the peo-
ple (individual consumers, business firms, and the government).
However, economic forecast may be situational and inaccurate.
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For instance, the future price of a commodity (such as oil) may be

predicted as follows: If demand for the oil rises, then its price will
increase, provided other things remain stable. Although such a
forecast is conditional, the future trend of price will be known more
exactly than it would have been without any forecast. If someone
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knows the demand trend of oil and other associated factors, then
he/she can forecast the future trend in price with greater accura-
cy. Even an approximate forecast can help individual consumers
adjust their expense patterns, individual producers to plan their
production, and public policy-makers to draft policy regarding the
price of the commodity (which in this case is oil).
Frames and revises economic policies: A public economic policy
must adhere to economic laws in order to solve an economic prob-
lem. Microeconomics helps formulate effective economic policies.
Its theories help policy-makers to assess whether the prevalent
public economic policies are appropriate and effective. The poli-
cy-makers utilise relevant microeconomic theories to explain the
prevailing economic problem, evaluate the effects of alternative
policies on the problem, and then select the most appropriate one.
Helps in business decision-making: Microeconomic theories help
individual businesses make profitable business decisions. Using

12 MICROECONOMICS
these theories, a business can build analytical models to under-

stand the nature of managerial problems and determine appropri-
ate policy actions.
Provides the foundation for drafting propositions to maximise
social welfare: This is arguably the most important use of micro-
economics. Microeconomic theories evaluate market conditions
whether they are perfect or imperfect. They analyse the degree
to which imperfect market conditions disrupt the allocation of
resources, create inefficiency and reduce levels of production,
consumption and social welfare. The normative aspect of micro-
economics (i.e., welfare theories) prescribes conditions to achieve
resource allocation in order to maximise social welfare.
Most limitations in microeconomics arise from the foundational as-
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sumptions. These limitations restrict the applicability of microeco-
nomic theories. Let’s discuss some of them:
Assumption of a given level of economic factors: Microeconomic
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theories assume that economic factors (such as national income,
employment, savings, investment, supply and demand for money,
and general price level) are constant. In real life, however, these
factors are continuously changing, which limits the validity of mi-
croeconomic theories.
Assumption of a free enterprise system: Microeconomic theories
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assume that a free enterprise system exists, where invisible mar-

ket forces play their roles freely without government intervention.
This assumption is, however, far from reality. Governments con-
trol and regulate economic markets. Therefore, microeconomics
has limited applicability that is restricted within the boundary of
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the microeconomic model only.

Association with the behaviour of individuals: Microeconomics
focusses only on the behaviour of individual items of an economic
system, and not the entire system. This provides a partial analysis
of the economic phenomena and prevents microeconomic theories
from analysing complex economic system as a single unit.
The above limitations of microeconomics, however, do not diminish its

importance. By studying and using microeconomic theories, such as
the price theory, you can organise and classify ideas about economic
acitvities and shape the course of future economic actions. Thus, in a
nutshell, microeconomics provides various useful purposes, including:
NOTE Reasoning and techniques to forecast future implications of eco-
Microeconomics provides a
nomic activities
framework for logical economic
thinking to solve economic Guidelines to frame valid public policy actions to control and regu-
problems.
late economic activities for the purpose of social welfare

5. All of the following are uses of microeconomic theories except:

a. Economic forecasting
b. Economic behaviour analysis
c. Public welfare policies
d. Assumption of a free enterprise system
6. Which theory below is a microeconomic theory?
a. Price theory
b. Classical dichotomy
c. Demand-side economics
S
d. Buffer theory
ACTIVITY
IM
Recall any instance from your past where you have utilised the con-
cept of opportunity cost.
1.5 SUMMARY S
Economics is a social science that studies economic behaviour of
M
the people and economic phenomena.

There are various schools of thought to define economics, includ-
ing classical, neo-classical, scarcity and choice definition, and
Samuelson’s growth-oriented definition.
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The two main branches of economics are microeconomics and

macroeconomics.
Microeconomics deals with the economic phenomena at the micro
(small) level, whereas macroeconomics deals at the macro (large)
level.
Microeconomics is both a positive (theoretical) as well as a norma-
tive (value-based) approach.
Microeconomics explains the economic behaviour of individuals,
predicts future economic events, frames and reviews economic
policies, helps in business decision-making, and provides the basis
for creating propositions to maximise social welfare.
Microeconomics has its sets of limitations too, which are formed
from the assumptions that there are a given level of economic fac-
tors and that there is a free enterprise system. Another limitation
arises out of its very scope of study, which is its association with
the individual behaviour only.

14 MICROECONOMICS
KEY WORDS
Capital:The human-made tools used in the economy, such as

machinery, buildings, vehicles, etc.
Economy: A set of activities involved in the production and dis-
tribution of goods and services for the welfare of a human soci-
ety
Entrepreneurship: The bringing together of land, labour and
capital into productive units
Factors of production: Economic resources that are used in the
production and distribution of goods and services, such as land,
labour, capital and entrepreneurship
S
1.6 MULTIPLE CHOICE QUESTIONS
MCQ
1. Which of the following subject attempts to study how people al-
IM locate their limited resources to their alternative uses in order to
produce and consume goods to satisfy their unlimited wants and
maximise their gains?
a. Physics b. Economics
c. Ergonomics d. Civil Science
2. The deliberate choice and effort of the people to get maximum
M
gains from the use of limited resources and opportunities avail-

able:
a. Chemical behaviour
b. Social behaviour
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c. Economic behaviour
d. Selective behaviour
3. In comparison to human wants, resources are:
a. Infinite b. Considerable
c. Scarce d. Zero
4. Which view describes economics as the science of material wel-
fare?
a. Classical b. Neo-classical
c. Scarcity and choice d. Growth-oriented
5. Which economist said ‘economics is the science of human be-
haviour in a relationship between ends and scarce means with
alternative uses’?
a. Lionel Robbins b. Samuelson
c. Adam Smith d. Alfred Marshal

6. Which of the following are the limitations of microeconomics?

a. Assumption of a given level of economic factors
b. Assumption of a free enterprise system
c. Association with the behaviour of individuals only
d. All of these
7. Macroeconomics includes all the following key principles except:
a. Full employment
b. Economic growth
c. Production theory
d. Favourable balance of payments
S
8. Microeconomics approach is:
a. Both positive and normative
b. Only positive
IM
c. Only normative
d. Neither positive nor normative
9. Which branch of economics primarily studies the determination
of price in individual markets?
a. Microeconomics
b. Macroeconomics
M
c. Negative economics
d. Positive economics
10. Microeconomics assumes that employment in a country is:
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a. Continuously increasing
b. Stable
c. An independent variable
d. Controlled by government
1.7 DESCRIPTIVE QUESTIONS

?
1. ‘Human wants are infinite or unlimited’. Elaborate how these in-
finite wants gave birth to economics.
2. Discuss different definitions given to economics and how they
made the subject a rich subject.
3. What is microeconomics? How does it differ from macroeconom-
ics?
4. Is microeconomics a positive or a normative approach? Give rea-
sons for your answer.
5. Explain the uses and limitations of microeconomic theories.

16 MICROECONOMICS
HIGHER ORDER THINKING SKILLS

1.8
(HOTS) QUESTIONS
1. Suppose that you have to decide between watching a movie or
going to a concert on a particular Saturday evening. You have
` 500 in your hands. Movie ticket costs ` 250 and concert ticket
costs ` 400. In this case if you decide to attend the concert, what
would be the opportunity cost of going to the concert?
a. ` 500 b. ` 250
c. ` 400 d. None of these
2. Which is not a basic economic question?
a. What to produce? b. Who to produce it for?
S
c. How to produce it? d. How to stop its production?
3. Which statement below is a normative approach?
a. Increase in government spending will reduce poverty.
IM
b. The Indian economy is relatively stable as compared to other
South Asian countries.
c. The government should focus on increasing employment.
d. Higher taxes will lead to more tax evasion by the public.
4. All of the following are microeconomics topics, except:
M
a. Why engineers earn more than mechanics?

b. Why total employment may decrease?
c. Whether the army should purchase more tanks or guns?
d. The reasons for a rise in the price of onions?
N
1.9 ANSWERS AND HINTS
ANSWERS FOR SELF ASSESSMENT QUESTIONS
Topic Q. No. Answer

An Overview of Economics 1. d. Social
2. a. Adam Smith
Microeconomics: A Positive or 3. c. What is the trend of vehi-
Normative Approach cle sales this quarter?
4. a. Positive
Uses and Limitations of Microe- 5. d. Assumption of a free
conomic Theories enterprise system
6. a. Price theory

ANSWERS FOR MULTIPLE CHOICE QUESTIONS
Q. No. Answer
1. b. Economics
2. c. Economic behaviour
3. c. Scarce
4. b. Neo-classical
5. a. Lionel Robbins
6. d. All of these
7. c. Production theory
8. a. Both positive and normative
9. a. Microeconomics
S
10. b. Stable
HINTS FOR DESCRIPTIVE QUESTIONS

1. Human wants are infinite or unlimited. They go on increasing
IM
with the people’s ability to satisfy them. They only end with the
end of life of an individual. However, not all wants are equally ur-
gent and important. Satisfying some wants gives more pleasure
than others. Therefore, people have to make choices between
wants. Refer to Section 1.2 An Overview of Economics
2. There are several schools of thought to help us understand the
nature of economics. The classical view defines economics as
M
the science of wealth. According to Adam Smith, the Father of

Economics, economics evaluates the factors that determine the
wealth production and growth of a nation. In this view, wealth is
regarded as an end of itself. Refer to Section 1.2 An Overview of
Economics
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3. Microeconomics deals with the behaviour of individuals, busi-

nesses, commodities, and prices at the micro level. It analyses
how individuals and businesses make choices, how their choices
affect the demand and supply of goods and services, how their
choices impact the prices of goods and services in the market and
how markets function. The main objective of microeconomics is
to maximise utility and minimise cost. This theory is also called
the price theory. Refer to Section 1.2 An Overview of Economics
4. Positive economics helps in determining ‘what is’, whereas nor-
mative economics attempts to determine ‘what should be’ or
‘what needs to be done’. Refer to Section 1.3 Microeconomics: A
Positive or Normative Approach
5. Microeconomics helps understand the economic behaviour of
billions of individual decision-makers (including consumers,
firms, industries and factory owners) by creating simplified mod-
els of behaviour, which explain the actual economic phenomena.
Refer to Section 1.4 Uses and Limitations of Microeconomic
Theories

18 MICROECONOMICS
ANSWERS FOR HIGHER ORDER THINKING SKILLS (HOTS)

QUESTIONS
Q. No. Answer
1. b. ` 250
2. d. How to stop its production?
3. c. The government should focus on increasing employment.
4. b. Why total employment may decrease?
1.10 SUGGESTED READINGS & REFERENCES
SUGGESTED READINGS
S
Ison, S., & Wall, S. (2007). Economics. Harlow: Financial Times
Prentice Hall.
Samuelson, P., & Nordhaus, W. (2010). Microeconomics. Boston:
IM McGraw-Hill Irwin.
E-REFERENCES
How Microeconomics Affects Everyday Life: Renting an Apart-
ment. (2020). Retrieved 7 July 2020, from https://www.investope-
dia.com/articles/personal-finance/032615/how-microeconomics-af-
M
fects-everyday-life.asp
Overview of Economics: What Is Economics and Who Cares?.
(2020). Retrieved 7 July 2020, from https://www.infoplease.com/
homework-help/social-studies/overview-economics-what-eco-
nomics-and-who-cares
N
Theory and Applications of Economics - Table of Contents. (2020).

Retrieved 7 July 2020, from https://2012books.lardbucket.org/
books/theory-and-applications-of-economics/

C H A
2 P T E R
WORKING OF ECONOMY AND

ITS BASIC PROBLEMS
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CONTENTS
2.1 Introduction
2.2 Concept of Economy
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2.2.1 How an Economy Works?
Activity
2.3 Problem of Scarcity
Activity
M
2.4 Choice as an Economic Problem

2.4.1 Choice and Opportunity Cost
2.4.2 Production Possibility Curve (PPC)
Activity
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2.5 Government and the Economy

Activity
2.6 Summary

20 MICROECONOMICS
UNDERSTANDING ECONOMICS AND SCARCITY
What do you currently need: a new car, a bigger house, better

Case Objective meals, a more happening social life, more spending money, a va-
cation? Can you satisfy all of these desires? Even if you do, other
fundamental economic desires will emerge. Think of when you stepped into your college
problem of scarcity and the first time. Your parents have given you the admission fee and
choice. you had some saved pocket money to spare. Let us assume you
have ` 20,000. Now, with this money, you need to pay the semester
fee, purchase books and college supplies, buy a computer, rent a
room or spend on transport (if you are based in the same town),
purchase clothes and shoes (after all, you want to make a good
impression in college), get a haircut, and save some money for
S
entertainment. Will you be able to satisfy all of these wants with
` 20,000? In this case, you must make a decision on what you are
willing to sacrifice for what you can gain. What is more important:
Paying the semester fee or buying a computer? Renting a room
IM
or purchasing clothes? Buying a computer or saving money for
entertainment? The decision will be based on both the available
resources and the values with which you grew up.
The issue is that although we all have unlimited desires and wants
but the resources available to satisfy these wants are scarce. A re-
source is scarce when it is not freely available. Hence, we must se-
M
lect from among our several wants. We must make a choice based
on our happiness and satisfaction now and in the future. Whatever
we choose, we must let go of the enjoyment of some other wants.
Our unlimited wants and the scarcity of resources available to us

N
lead to economic problems. These economic problems exist for

every human being, every country in this world – rich or poor.
Economics analyses how we can use our scarce resources to gain
maximum satisfaction or utility. This chapter describes how an
economy works and its basic problems.

WORKING OF ECONOMY AND ITS BASIC PROBLEMS 21
LEARNING OBJECTIVES

>> Describe how an economy works
>> Explain the problems of scarcity
>> Explain the concepts of choice, opportunity cost and Pro-
duction Possibility Curve (PPC)
>> Describe the relationship between the government and the
economy
2.1 INTRODUCTION
S
In the previous chapter, you were introduced to the concept of eco- Quick Revision
nomics and its branches. You learned how microeconomics analyses
the economic behaviour of individuals, households, firms, and govern-
ments. The main purpose of economic activities is to produce goods
IM
and services to satisfy people’s wants and needs. In an economic sys-
tem, individuals, households, firms, etc., are interlinked and interde-
pendent on each other. Therefore, economic activities must be per-
formed as a part of an economic system. The economic system affects
the economic behaviour of the people. Hence, it is important to know
how an economic system works and its basic problems.
M
An economic system is a means by which countries and governments

distribute resources, and goods and services. The resources or factors
of production include labor, capital, entrepreneurs, physical resources
and information resources. In day to day life, these production fac-
tors involve employees and money an organisation has at its disposal,
N
as well as access to entrepreneurs, the people who want to run or-

ganisations or start their own businesses. The physical materials and
resources needed to run a business, along with the data and knowl-
edge organisations use to be successful, are also factors in production.
Different economic systems view the use of these factors in different
ways.
In this chapter, you will study about the concept of economy and how
it works. You will gain insights into the problems of economy i.e. scar-
city and choice. You will also learn about the concept of opportunity
cost and Production Possibility Curve (PPC).
2.2 CONCEPT OF ECONOMY

An economy is a social system that consists of individual consumers,
households, firms, financial intermediaries and governments. These
constituents participate and interact in economic activities to produce
and consume goods and services. For instance, households make their
living by putting their resources (land, labour, capital and skill) to their
alternative uses. Firms purchase or hire these resources, also known

22 MICROECONOMICS
as factors of production. These firms include businesses, farms, fac-

tories, etc., and are called producers. The producers organise the fac-
tors of production in the production process to produce final goods
and services.
? DID YOU KNOW
Entrepreneurial ability is a Production of goods and services requires:
special kind of human capital.
It is the talent required to think Labour: This is defined as human effort, both physical and mental,
of an innovative concept or that is used to manufacture or produce a good or a service. Work-
find a better way to produce ers are paid wages in exchange of labour used to produce goods
an existing good or service. An
entrepreneur discovers and
and services.
acts on profitable opportunities Capital: This involves all human creations that are used to pro-
to produce a new or improved
good or service. He/she bears
duce goods and services. It can be further divided into:
the risk of business success or Physical capital: It involves tangible objects such as plant,
failure. Each profitable idea that
S
has emerged for the success
equipment, tools, airports, highways, railways and ports used
of the humankind was started by organisations to produce goods and services.
by entrepreneurs, such as Ford,
Human capital: The knowledge and skills are acquired by
Apple, Microsoft or Dell.
workers to enhance their productivity.
IM
Entrepreneurs and producers pay wages to resource owners for their
labour, interest for the use of their capital and rent for the use of their
natural resources. The effort of entrepreneurs or producers is reward-
ed through profit, which is:
Profit = Revenue from goods or services sold – Cost of resources

M
employed to produce goods or services
Sometimes the entrepreneur or the producer suffers a loss, if:
NOTE Revenue from goods or services sold < Cost of resources employed
Resource payments have a time to produce goods or services
N
dimension. For example:

yyWage of ` 35 per hour Entrepreneurs or producers produce goods and services and sell them
yyInterest of 6% per year to consumers at profit. Between a producer and a consumer, there are
yyRent of ` 10,000 per month intermediaries in the form of traders and shopkeepers. The goods or
yyProfit of ` 5 crore per year
services are transported from producers to intermediaries to consum-
ers through transport companies or distributors.
Now, let us understand the role of banks or financial institutions. They

collect savings from households, firms, businesses, traders, shopkeep-
ers, etc., and pay them interest. They then lend the collected money to
other users and collect interest in return. In this way, each entity plays
a role in the economic system to earn livelihood. The system works in
an organised manner and independently without any need for regu-
lation or control.
An economy is made up of the economic activities and interactions

among consumers, producers and resource owners. The economic
activities are interrelated and interdependent. This is because a pro-
ducer will produce only as many goods or services as per consumers,

demand, and the consumers can use only as many goods or services
as the producer can produce. This interdependence among economic
activities is reflected through interaction, collaboration and competi-
tion among consumers, producers and resource owners. The effect of
these activities can be direct or indirect, or positive or negative.
The role of a government is also critical in an economy. The govern-

ment intervenes with economic activities of the people through con-
trols and regulations to achieve certain social and economic goals. It
collects taxes from the people’s income, hires resources and produces
specific goods or services. The degree of intervention and participa-
tion of a government in an economic system will determine the type of
economy, which can be:
Capitalist or free enterprise economy: In this economy, the gov-
S
ernment’s intervention in economic activities is minimal. The mar-
ket forces of supply and demand determine products, prices and
services. Businesses are free from government control. The US
and Singapore are free enterprise economies.
IM
Socialistor command economy: In this economy (also known as
communist economy), the government has total and all-pervasive
control of economic activities. The erstwhile Soviet Union and
present-day Cuba are communist economies.
Mixed economy: In this economy, the government plays a partial
role in economic activities. This economic system combines both
M
capitalism and socialism. India, France are mixed economies.
You will study about these three types of economies in detail later in
this chapter.
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2.2.1 HOW AN ECONOMY WORKS?
Let us consider a simple model to understand how a simple economy

works. In this model, there are four types of participants (or decision
makers):
Households: They play the leading role in the following two ca-
pacities:
Suppliers or resource owners: They supply land, labour, capi-
tal, natural resources and entrepreneurial ability to the rest of
the players of the economy.
Consumers: They demand and consume the goods and ser-
vices produced.
Firms: They include all farms, factories and shops operated by
individual proprietors, partners and stock companies. They de-
mand resources supplied by the households and then use these
resources to convert them into final commodities, which they sell
to households as per their demand.

24 MICROECONOMICS
Government: The government collects taxes from households and

firms and uses the tax revenues to hire or purchase a part of social
resources to perform its administrative and economic functions. It
also employs labour from households and pays wages. It purchas-
es commodities from firms and makes payments. It makes transfer
payments to both the households and the firms through subsidies
and grants.
Rest of the world: This includes foreign households, firms and
governments that supply resources and products to domestic mar-
kets in the economy and demand resources and products from do-
mestic markets.
The above four entities interact and engage through markets. A mar-
ket is a set of arrangements through which buyers and sellers ex-
S
change resources, goods and services at mutually agreeable terms.
The price and quantity of the exchange is determined by the market
forces of demand and supply. There are two main types of markets:
Product market: A market where a good or a service is purchased
IM
and sold. Examples include supermarkets, departmental stores,
shopping malls or flea markets.
Resource market: A market where resources are bought and sold.
One common example is the labour or job market.
Figure 2.1 shows a simple circular-flow model in a two-sector econo-

M
my how these entities interact. This diagram illustrates the flow of re-
sources, products, income and revenue among economic participants:
N
Figure 2.1: Circular Flow Model: How an Economy Works

(Source: Economics: A Contemporary Introduction by William A. McEachern)

In Figure 2.1, on the left side are households, which supply input re-
sources or factors of production, such as land, labour, capital, natu-
ral resources and entrepreneurial ability. The households supply
these resources to firms (input demanders) through resource mar-
kets (lower part of the figure). In resource markets, the interaction
between households (input suppliers) and firms (input buyers) will
determine input prices, also known as resource or factor prices. Once
the factor prices are determined, inputs move from households to
firms.
In return, households demand finished goods and services from firms,

which are supplied through product markets (upper part of the fig-
ure). Firms demand inputs from households through resource mar-
kets and convert these inputs to finished products. Finished products
S
flow from firms to product markets. In these markets, the interaction
between the firms (product suppliers) and households (product buy-
ers) determines the prices of the finished products. Once product pric-
es are set, the products flow from the product markets to the house-
IM
holds. The households make payments to the firms in return of the
products. Thus, two circular flows are generated:
Real flow: Flow of inputs and final products (outer circle)
Money flow: Flow of money (inner circle)
Note that real flows move clockwise in the diagram, whereas money
M
flows go anticlockwise (in the opposite direction).
In this way, the economic system works in a systematic manner,

? DID YOU KNOW
meeting the needs and wants of all the participants. The house-
‘Needs’ are something essential
holds are able to sell their resources and earn their livelihood. They to survival (food, water, clothing,
N
use the income earned to purchase goods and services that they and shelter), whereas ‘wants’
need. The firms are able to purchase factors of production from are something you would like to
have, but are not essential for
the households and convert them into final products. They sell
survival (e.g., cars, mobile phone
their products in the product market at profit. The continuous en- and chocolate).
gagement between households and firms is a constant economic
cycle.
1. Workers are paid ___________________ in exchange of their

labour.
a. Revenues
b. Wages
c. Interest
d. Rent

26 MICROECONOMICS
2. The participants in an economic system that collect savings

from households and firms, and pay them interest are called:
a. Distributors
b. Governments
c. Producers
d. Banks
3. All of the following are mixed economies, except:
a. United Kingdom
b. France
c. Singapore
S
d. Germany
4. Which entity below supplies factors of production?
a. Households
IM
b. Firms
c. Governments
d. Rest of the world
5. In the circular flow model, products move ______________
from product market to households, while expenditure moves
M
_____________ from households to product market.

a. Anti-clockwise, anti-clockwise
b. Clockwise, clockwise
c. Clockwise, anti-clockwise
N
d. Anti-clockwise, clockwise
ACTIVITY
A small-scale textile manufacturing firm employs 50 persons and

uses machinery to produce ready-made garments. Prepare a sim-
ple economic model of the firm and mention all the participants.
2.3 PROBLEM OF SCARCITY

The root of the economic problem is the scarcity of resources while
our wants are infinite. This problem exists in all economies in the
world whether they are rich or poor. To meet the infinite wants of the
people by using scarce resources while trying to meet the people’s
desire to maximise gains, economies must try to achieve efficiency in
production and distribution of resources. Societies and governments

face three types of problems in achieving efficiency in production and

distribution:
What to produce: The first question that emerges while producing
and allocating resources is what goods and services to produce.
This is the problem of the choice of commodity. There are two rea-
sons for this problem:
Since resources are scarce, it is impossible to produce all goods
and services that people want.
All goods and services have different values in the eyes of con-
sumers from the perspective of utility. Some goods and services
give them more satisfaction (utility) than others.
Therefore, the problem of choice between goods and services aris-
S
es because all goods and services cannot be produced with the
available resources, and all that is produced may not be purchased
by the consumers. The objective of solving this problem is to satis-
fy the maximum needs of the maximum people.
IM
The next question within this context will be ‘how much to pro-
duce.’ You need to find the quantity of each product and service to
be produced. The root of this problem also lies in resource scarcity.
If surplus goods and services are produced, there will be wastage
of resources. Therefore, it is important to efficiently allocate input
resources.
How to produce: Once you have decided what to produce, you
M
need to decide ‘how to produce it.’ This is the problem of the choice
of technique. You have to decide the best combination of inputs
(labour and capital) to produce goods and services. The scarcity
of resources adds to the severity of the problem, as you cannot
afford to waste them in employing wrong production techniques.
N
If resources were infinite, then you could use any combination of

labour and capital to produce a commodity. However, due to the
scarcity of resources, you have to use the most economical produc-
tion techniques.
The problem ‘how to produce’ also arises because a specific quan-
tity of a good or a service can be produced with alternative com-
bination of inputs. For example, a given quantity of wheat can be
produced by using more labour (men) and less capital (machin-
ery). The same quantity of wheat can also be produced by employ-
ing less labour and more capital. Such alternative technologies
are available for most goods or services. However, each alternative
technology requires a different cost. This gives rise to the problem
of ‘how to produce.’
For whom to produce: This problem arises due to difficulties in
matching the supply pattern with the demand pattern. The aim is
to provide the good or service to those consumers only who have

28 MICROECONOMICS
the ability and the willingness to pay for it, and that there is no sur-
plus production leading to wastage. To determine demand pattern,
firms often use consumers’ pattern of selection, preference and in-
come distribution. The income distribution, in turn, is determined
by the employment pattern and resource (or factor) prices. The
resource prices are decided in the resource market by the demand
and supply forces for resources. The product of resource prices
and the number of resources gives the share of each resource in
the national income.
The resource owners who own a large quantity of expensive re-
sources are able to claim a higher share in the national output.
These households relatively consume a bigger chunk of the na-
tional output as compared to those who own low-priced resources.
In a capitalist or free enterprise economy, the supply (or produc-
S
tion) pattern should perfectly match with the demand pattern by
the ‘invisible’ hands of the market. However, that is seldom the
case due to all-pervasive market imperfections, such as:
MARK IT!
IM Unemployment of some resources, particularly labour
Due to the problem of resource Inefficient allocation and consumption of resources

scarcity, the decision makers in Coexistence of extreme poverty and wastage of resources
an economy must always make
choices about what, how and for
whom.
These problems of market imperfections exist in almost all the econ-
omies today.
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6. When a country produces more houses and fewer computers,

it is answering the _________ question.
a. “What to produce”
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b. “Where to produce”
c. “How to produce”
d. “For whom to produce”
7. The problem of ‘how to produce’ is the problem of:
a. Choice of commodity
b. Market imperfection
c. Match of demand and supply
d. Choice of technique
ACTIVITY
Mention any five scarce resources. Explain why they are scarce.
In that context, write your ideas on what to produce using these
resources, how to produce and for whom to produce.

2.4 CHOICE AS AN ECONOMIC PROBLEM

As you already know, resources are scarce and we have infinite wants MARK IT!
and needs. If we cannot have everything we want, then we have to The opportunity cost of
make choices. This creates the economic problem of ‘choice.’ Suppose something you decide to get is
you want to purchase a new headphones, but your motorcycle also the highest valued (next best)
alternative you give up to get
needs servicing. Now, you do not have the money to do both, so you
it. For example, from 6 to 8 PM,
must decide what you would like to do the most. If you service your you can either read a novel,
bike, it means that you cannot buy headphones; you must give up this watch a hockey match on TV, or
opportunity. The cost of this lost opportunity is called opportunity see an online movie. Suppose
you decide to watch a hockey
cost. You can therefore say that the opportunity cost of servicing your
match and think that if you
bike is buying a headphones. This means that when you have chosen do not watch the match, you
the bike, the next best alternative is the headphones. would read the novel. Then, the
opportunity cost of watching
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the hockey match is reading the
2.4.1 CHOICE AND OPPORTUNITY COST novel (next best alternative).
Opportunity cost is defined as the next best alternative that is given up

when you make a choice. It is a subjective issue. When you are making
IM
a choice only you can identify the most attractive alternative. Howev-
er, it should be kept in mind that you may rarely know the actual value
of the opportunity lost, because that opportunity is the one you did not NOTE
choose. For example, you give up on the opportunity of watching tele- It is not necessary that the
vision to read this chapter. Then, you will never know the exact value value of opportunity cost will
of the TV programme you missed. You know only what you expect- be measured in terms of money
ed, which was that the value of reading this chapter is more than the only. It can also be measured in
M
terms of time, satisfaction, etc.

value of watching the television. For example, assume that Vandana
has planned to go for a vacation to Goa and wants to purchase some
clothes and footwear for her stay in Goa. However, she has a limited
budget of ` 10,000. The average cost of one garment is ` 1,000 and the
average cost of one pair of footwear is ` 250. She has already selected
N
8 pairs of footwear and 8 garments. Then, she decides that since, she
has to travel for 9 days, she should have a new garment for each day.
Now, if Vandana wants to buy an extra garment, the opportunity cost
in this case will be 4 pairs of footwear that cost ` 1,000.
2.4.2 PRODUCTION POSSIBILITY CURVE (PPC)
Production Possibility Curve (PPC) is a curve that shows the alterna-

tive combinations of two goods and services by using all the available
factor resources, efficiently. PPC provides an overview of the maxi-
mum output of a good that can be produced in an economy by using
available resources with respect to quantities of other goods produced.
It is also known as Production Possibility Frontier (PPF) or transfor-
mation curve. The goods and resources plotted on the production pos-
sibility curve are considered as technically efficient, while the goods
and resources that are lying beneath the curve are regarded as inef-
ficient. The goods and services that lie beyond the curve are beyond

30 MICROECONOMICS
the scope of the economy. In the production possibility curve, only

two goods are taken into account as large number of goods cannot be
represented on a two-dimensional graph. Let us learn PPC with the
help of an example. Suppose an organisation decides to produce two
goods, i.e., A and B with its available resources. If all the resources are
used in producing A, then 100 lakh units of A can be produced, where-
as if all the resources are used in producing B, then 4000 units of B can
be produced. If both the goods are produced, then there is possibility
of various combinations as shown in Table 2.1:
Table 2.1: Production Possibilities

A (in lakh) B (in thousand)
100 0
90 1
S
70 2
40 3
0 4
IM
Let us draw the PPC from Table 2.1, as shown in Figure 2.2:
A F
100 B
90
M
C
70
A (In Lakhs) G
N
40 D
0 1 2 3 4
B(‘000)
Figure 2.2: Production Possibility Curve
As shown in Figure 2.2, the attainable combinations are A, B, C, D

and E from the given resources. A and E are the combinations that
produce only one good at a time. The unattainable combination is F
as it is outside the PPC. G is the inefficient combination, which is in-
side the PPC. It implies that the resources are underutilised. From
Figure 2.2, it can be noticed that PPC is concave to origin. It is because
the increase in production of one unit of good is accompanied by the
sacrifice of units of the other good. The rate at which an amount of
product is sacrificed for producing the amount of another product is

called Marginal Rate of Transformation (MRT). For example, in case

of A and B, the amount of product B that is sacrificed to produce the
amount of product A is termed as MRT. The slope of PPC is also MRT.
Increasing MRT implies increasing slope of PPC. Let us discuss some
important uses of PPC as follows:
It enables the planning authority of a developed nation to divert the

usage of its resources for the production of necessary goods to the
production of luxury goods and from consumer goods to producer’s
goods, after a certain point of time. It helps a democratic nation to fo-
cus and shift a major amount of resources in the production of public
sector goods instead of private sector goods. The public sector goods
are supplied and financed by government such as public utilities, free
education and medical facilities. On the other hand, private sector
goods are manufactured by privately owned organisations and are
S
purchased by individuals at a certain price. It helps in guiding the
movement of resources from consumer goods to capital goods, such
as machines, which, in turn, increases the productive resources of a
IM
country for achieving a high production level.
8. Due to scarcity, every choice involves:

a. Answering the question “what to produce”
b. Paying more money
M
c. An opportunity cost
d. Giving up something for nothing
9. On a Sunday morning, you rank your choices in the following
N
order:
Clean the house, go to the mall, watch a movie, and sleep late.
Suppose you decide to clean the house. What will be your op-
portunity cost?
a. Going to the mall, watching a movie, and sleeping late
b. Zero because you do not have to pay money to a cleaning
service
c. Going to the mall
d. None of the above
ACTIVITY
Describe an opportunity cost that you have experienced recently:

1. With your money
2. With your time

32 MICROECONOMICS
2.5 GOVERNMENT AND THE ECONOMY

Ideally, the invisible hands of supply and demand forces should ensure
smooth, efficient, and systematic run of market economies. Although
market economies are capable of bringing economic growth, they do
not ensure a stable, sustained, and balanced growth. Therefore, the
government’s intervention with the market mechanism is necessary to:
Aggregate demand
Reduce market distortions
Provide conditions for fair competition
Help the economy in achieving growth, stability, efficiency, and
fairness
S
The government can achieve this stimulus by directly increasing its
own spending, or indirectly through tax and subsidy measures to
stimulate consumption and investment.
? DID YOU KNOW
IM
The idea of government The government’s role in the economy can be broadly classified into
intervention in economy was three categories:
first proposed by John Keynes
in 1936. Most economists before Capitalist or free enterprise system: In this system (also known
him, including Adam Smith, as laissez faire system), the government’s main roles are to:
believed that depressions
were self-correcting. However, Maintain and foster free market mechanism to ensure compe-
Keynes argued that private tition
M
spending, especially business

investment, is erratic, and hence Remove all unnecessary restrictions on free working of a com-
governments should spend petitive market
more or tax less to stimulate
aggregate demand. Provide necessary controls to ensure effective competition in
the market
N
Control inflation and deflation through indirect measures (fis-

cal and monetary regulations)
Control and regulate monopolies of corporate organisations to
prevent unemployment and resource wastage
Create and own state monopoly of essential goods and services
(railways, electricity generation and distribution)
Promote equal educational opportunities and control restric-
tive activities of trade unions
In a nutshell, the government plays a limited role in the economy,
which is mainly to:
a. Rebuild and encourage essential conditions for efficient work-
ing of free market
b. Enter only those areas of production and distribution where
private entrepreneurship is insufficient or inefficient
Socialist system: In a socialist economy, the government’s role is
all pervasive. It plans, controls and regulates almost all economic

activities and owns all the country’s resources. The free enterprise
and market mechanism are abolished by law. The government at
the centre takes decisions regarding production and distribution
of resources, employment, pricing, etc. Individual freedom rights
of choice and decision making with respect to economic activities
are drastically reduced. Individuals can make their decisions only
within the policy framework of the state. Unlike a capitalist econ-
omy where the motivation force is private profit, the aim of a so-
cialist economy is maximisation of social welfare.
Mixed economy system: This economic system combines the fea-
? DID YOU KNOW
ture of the capitalist and socialist economies. It is divided into the India is a mixed economy. This
following two sectors: means that some firms are
run by the private individuals
Private sector: This sector operates on the free enterprise sys-
(private sector), while some are
S
tem within a wide political and economic policy. run by the government (public
sector). The public sector
Public sector: This sector is organised, owned and controlled includes railways, hospitals,
by the government. The government reserves certain indus- schools, which are managed and
tries, trade, services, and activities for the public sector and re- controlled by the government
IM
stricts private entry into this sector. The government can also to ensure maximum social
welfare. The private sector
nationalise private industries to increase the role of the public includes IT companies, press,
sector. airlines, hospitals, and schools,
which are managed by private
Thus, the role and responsibilities of the government in the mixed individuals or groups. Their main
economy system are much larger than in the free enterprise sys- objective is to make maximum
tem and much less than the socialist system. profit.
M
10. All of the following are the reasons behind the failure of so-
cialist economies of the Soviet Union and the Eastern Bloc,
N
except:
a. Profiteering
b. Fewer entrepreneurial opportunities
c. Lack of motivation by individuals
d. Slow economic growth
11. Which is a private sector business in India?
a. Bharat Dynamics b. Bharat Forge
c. Cochin Shipyard d. GAIL
ACTIVITY
List three public sector and private sector businesses in India.

Should the public sector organisations, which you listed, be priva-
tised? Give reasons to support your answer.

34 MICROECONOMICS
S 2.6 SUMMARY
An economy is a social system made up of households, firms, fi-
nancial intermediaries and governments. These constituents par-
ticipate and interact in economic activities to produce and con-
sume goods and services
The participants in the economy include households, firms, gov-
ernments, and rest of the world. These entities engage, collabo-
rate, and compete through markets (product and resource).
The three main problems arising out of scarcity of resource are
what to produce, how to produce, and for whom to produce.
Opportunity cost is defined as the next best alternative that is giv-
en up when you make a choice.
S
Production possibilities refer to the alternative combinations of
goods and services that can be produced with the given resources
and technology.
IM
The PPF is a concave curve that identifies all the possible alterna-
tive combinations of commodities that can be produced when all
the available resources are utilised fully and efficiently.
The government’s role in the economy can be classified into capi-
talist, socialist and mixed economy systems.
M
KEY WORDS
Economics: The study of how people use their limited resourc-

es to satisfy their unlimited needs
Resources: The inputs or factors of production that are used in
N
the production and distribution of goods and services

Labour: The physical and mental effort exerted by humans to
produce goods and services
Capital: All man-made creations used to produce goods and
services
Physical capital: Human creations such as factories, buildings,
equipment, machines, tools, airports, railways, ports and high-
ways to produce and transport goods and services
Human capital: The knowledge and skills acquired by the hu-
mans to become more productive
Natural resources: Also called gifts of nature, these resources
include water bodies, trees, oil reserves, minerals and even ani-
mals to produce goods and services
Renewable resources: Natural resources, such as forests, riv-
ers, fish, livestock, groundwater, grasslands and soil, which can
be drawn indefinitely if used or consumed conservatively

Exhaustible resources: Natural resources, such as coal, oil, or

copper ore, which are non-renewable and are thus available in
limited amount
Good: Any tangible thing that can be seen, touched, or felt,
which is produced using scarce resources to satisfy human
wants
Service: Anything intangible thing that cannot be seen, touched
or felt, but which is produced using scarce resources to satisfy
human wants

1. What is the most basic economic problem?
MCQ
S
a. Money
b. Population
c. Scarcity
IM
d. Trade deficit
2. All of the following are factors of production, except:
a. The effort of farmers raising a crop
b. The water used to irrigate crops
c. The wages paid to workers in a cooperative unit
M
d. The management skill of a small business owner

3. A factory worker is considered ____________ and is paid
________________.
N
a. Labour, rent
b. Labour, wages
c. Human capital, interest
d. Physical capital, wages
4. Human capital is:
a. Knowledge and skill of workers
b. Physical human effort
c. Mental human effort
d. Factories, equipment
5. What is the income earned by entrepreneurs called?
a. Profit
b. Rent
c. Interest
d. Wages

36 MICROECONOMICS
6. Which book was written by the father of economics, Adam

Smith?
a. The General Theory of Employment, Interest and Money
b. Das Kapital
c. First Principles of Economics
d. The Wealth of Nations
7. According to John Maynard Keynes, the intervention of which
entity is necessary in the economy to stop economic recession?
a. Households
b. Private business firms
c. Government
S
d. Rest of the world
8. The question, ‘Should Britannia produce more bread or more
biscuits?’ is an example of the:
IM
a. ‘What to produce’ question
b. ‘How to produce’ question
c. ‘Where to produce’ question
d. ‘For whom to produce’ question
9. You choose to take a holiday, which costs you ` 1 lakh (or
M
` 100,000). While you are on holiday, you do not report to work

where you could have earned ` 75,000. The opportunity cost of
the holiday is:
a. `175,000
N
b. `100,000
c. ` 75,000
d. `125,000
10. The effect of resource expansion on the PPC curve will:
a. Make the curve flat
b. Make the curve convex
c. Create an outward shift
d. Create an inward shift

?
1. Explain how an economy works using a simple circular-flow
model. Illustrate the flow of resources, products, income and
revenue in the model.
2. What are the fundamental problems of an economy? Why do
these problems arise?

3. How is choice an economic problem? Discuss the concept of

choice and opportunity cost.
4. What is meant by production possibility curve (PPC)? Why does
opportunity cost increase along the PPC? Explain with an exam-
ple.
5. Why does the government need to intervene in an economy?
What roles does the government play in a free enterprise econo-
my, socialist economy and mixed-economy?

2.9
(HOTS) QUESTIONS
1. According to economists, scarcity confronts:
S
a. The poor but not the rich
b. The rich but not the poor
c. Neither the rich nor the poor
IM
d. Both the rich and the poor
2. When India builds a road using a few machines and a great deal
of labour, it is answering the _________ question:
a. ‘What’
b. ‘How’
M
c. ‘Where’
d. ‘For whom’
3. When a private automaker decides to manufacture more motor-
cycles than cars, it is answering the __________ question:
N
a. ‘What’
b. ‘How’
c. ‘Where’
d. ‘For whom’
4. In India, people with higher incomes get to consumer more goods
and services. This statement answers the __________ question.
a. ‘What’
b. ‘How’
c. ‘Where’
d. ‘For whom’
5. Varun decides to attend summer school, which prevents him
from working at his usual summer job in which he normally
earns ` 10,000 for the summer. His tuition fee is ` 3000, books

38 MICROECONOMICS
and supplies cost ` 1000, and room and board cost `1500. The
opportunity cost of attending summer school is:
a. `5500
b. `15,500
c. `10,000
d. `0
Topic Q. No. Answer
S
Concept of Economy 1. b. Wages
2. d. Banks
3. c. Singapore
IM
4. a. Households
5. c. Clockwise, anti-clock-
wise
Problem of Scarcity 6. a. “What to produce”
7. d. Choice of technique
M
Choice as an Economic Problem 8. d. An opportunity cost

9. c. Going to the mall (be-
cause it is the highest
valued alternative you
N
give up to clean the

house)
Government and the Economy 10. a. Profiteering
11. b. Bharat Forge
Q. No. Answer
1. c. Scarcity
2. c. The wages paid to worked in a cooperative unit
3. b. Labour, wages
4. a. Knowledge and skill of workers
5. a. Profit
6. d. The Wealth of Nations
7. a. Government

Q. No. Answer
8. a. ‘What to produce’ question
9. a. INR 175,000 (INR 100,000 + 75,000 = INR 1,75,000.
Here, we add the direct cost of vacation and the
amount of money a person could not earn)
10. c. Create an outward shift

1. Let us consider a simplified model to see how a simple economy
works. In this model, there are four types of participants (or de-
cision makers) whose interaction determines how the resources
are allocated in the economy. Refer to Section 2.2 Concept of
Economy
S
2. The root of the economic problem is the scarcity of resources,
while our wants are infinite. This problem exists in all econo-
mies in the world, whether they are the rich or the poor. To meet
IM
the infinite wants of the people by using scarce resources while
trying to meet the people’s desire to maximise gains, economies
must try to achieve efficiency in production and distribution of
resources. Refer to Section 2.3 Problem of Scarcity
3. Resources are scarce and we have infinite wants and needs. If we
cannot have everything we want, then we have to make choices.
This creates the economic problem of ‘choice.’ Refer to Section
M
2.4 Choice as an Economic Problem

4. Production possibilities refer to the alternative combinations of
goods and services that can be produced with the given resourc-
es and technology. Refer to Section 2.4 Choice as an Economic
N
Problem
5. Ideally, the invisible hands of supply and demand forces should
ensure smooth, efficient, and systematic run of market econo-
mies. Although market economies are capable of bringing eco-
nomic growth, they do not ensure a stable, sustained and bal-
anced growth. Therefore, the government’s intervention with
the market mechanism is necessary. Refer to Section 2.5 Gov-
ernment and the Economy

QUESTIONS
Q. No. Answer
1. d. Both the poor and the rich
2. b. ‘How’
3. a. ‘What’
4. d. ‘For whom’

40 MICROECONOMICS
Q. No. Answer
5. b. INR 15,500 (INR 10,000 + 3,000 + 1000 + 1500 =
INR 15,500. Here, we add the amount of money Varun
could not earn with the various amounts he had to
spend to attend the summer school)
SUGGESTED READINGS
Dwivedi, D. Microeconomics theory and applications.
Mceachern, W. (2016). Macroeconomics + mindtap economics,
1-term access. [Place of publication not identified]: South-Western.
S
Vane, H., &Mulhearn, C. (2009). Milton Friedman, Robert E. Lucas,
Jr. and Edmund S. Phelps. Cheltenham, UK: Edward Elgar.
E-REFERENCES
IM
(2020). Retrieved 10 July 2020, from https://www.pearsonschool
sandfecolleges.co.uk/secondary/BusinessAndEconomics/14-
(2020). Retrieved 10 July 2020, from http://faculty.washington.edu/
cnelson/Chap01.pdf
Theory and Applications of Economics - Table of Contents. (2020).
M
Retrieved 10 July 2020, from https://2012books.lardbucket.org/

books/theory-and-applications-of-economics/
N

C H A
3 P T E R
DEMAND ANALYSIS
S
CONTENTS
3.1 Introduction
3.2 Meaning of Demand
IM
3.2.1 Types of Demand
Activity
3.3 Determinants of Demand
Activity
M
3.4 Law of Demand

3.4.1 Assumptions in the Law of Demand
3.4.2 Demand Schedule
3.4.3 Demand Curve
3.4.4 Exceptions to the Law of Demand
N

Activity
3.5 Movement and Shift in Demand
3.5.1 Expansion and Contraction of Demand
3.5.2 Increase and Decrease in Demand
Activity
3.6 Summary

42 MICROECONOMICS
DECLINE IN DEMAND DUE TO COVID 19 OUTBREAK
A study by Credit Analysis & Research Ltd. (CARE) conducted

Case Objective in January 2019 revealed that with increasing demand of hotel
rooms, the hotel rates tend to increase by 10 – 20%. Cut to 2020, af-
relationship between demand ter Coronavirus, the demand for hotels declined sharply. Most lux-
and price. ury hotels in India saw up to 60% dip in their bookings in March
– April 2020, and the situation is not expected to improve soon.
There is simply no demand among people to travel anywhere due
to fears of the virus, restrictions on movement, lockdowns and
economic uncertainly. The airline, tourism and hospitality indus-
tries have taken a severe hit – they are expected to lose billions
of dollars. Many companies will be forced to close down, putting
S
thousands of people around the world jobless. This is ironic if you
consider that in 2019, these industries were steeply growing in-
dustries, fuelled by the global demand for air travel and tourism.
The forces of demand and supply interact to determine the price
IM
of a commodity in a market. In fact, the main role of microeco-
nomics is to explain the laws of demand and supply. In this chap-
ter, you will study about the law of demand.
M
N

Demand Analysis 43
LEARNING OBJECTIVES

>> Explain the meaning and types of demand
>> Identify the determinants of demand
>> Explain the law of demand
>> Explain the shift and movement in demand
3.1 INTRODUCTION
In the previous chapter, you have studied about the critical role that Quick Revision
markets play in resolving economic problems. The chapter discussed
S
the concept of scarcity and choice as economic problems. It is pivotal
to know the working of an economic system and how the problems in
economic system affect the market condition.
IM
A market is an arrangement where individuals, households and busi-
nesses are engaged in the buying and selling of products and services
through various modes. The working of a market is governed by two
forces, which are demand and supply. These two forces play a crucial
role in determining the price of a product or service and size of the
market. The demand and supply forces operating in a market natural-
ly sets the price of goods and services traded in the market. Theoreti-
cally, demand can be defined as a quantity of a product an individual
M
is willing to purchase at a specific point of time. Demand for a product

implies a desire to acquire, willingness to pay and ability to buy it.
Therefore, it helps organisations to know how much quantity would
be demanded in the market as producers will produce only as many
goods or services as the consumers demand.
N
In this chapter, you will study the concept of demand. You will gain
insights into the factors that determine demand. Then, you will under-
stand the fundamental Law of Demand, including its assumptions,
demand schedule, demand curve and exceptions. Finally, you will
learn about the ‘shift’ and ‘movement’ in demand.
3.2 MEANING OF DEMAND

Demand for a commodity is defined as the quantity of the commodity, NOTE
which a consumer wants to buy, at a given price, per unit of time. In a
In 1776, Adam Smith, the father
market, the behaviour of buyers can be analysed by using the concept of economics, gave the concept
of demand. Demand is a relationship between various possible prices of demand and supply as
of a product and the quantities purchased by consumers at each price. invisible hand in his book named
In this relationship, price is an independent variable and the quantity “The Wealth of the Nations”.
According to Smith, this invisible
demanded is the dependent variable. In simple terms, demand can be hand guides the economy as a
defined as the quantity of a product that a buyer desires to purchase at whole by supporting the demand
a specific price and time. The demand for a product is influenced by a and supply of goods to reach at
the equilibrium level.

44 MICROECONOMICS
number of factors such as price of the product, change in customers’

preferences and standard of living of people. The demand for a prod-
uct is driven by three main components, which are:
1. Desire: The consumer must have a desire to buy a commodity at
the given quantity. For example, you want to buy an ice cream of
a specific flavor, brand, etc.
2. Ability: The consumer must have the sufficient money or the
ability to buy the commodity.
3. Willingness to pay: Finally, the consumer must be willing to pay
for the commodity.
The following points should be considered while defining the term

demand:
S
Desire, want and demand are different from each other.
The quantity demanded is the amount that a customer is willing to
purchase. However, the quantity demanded is not always equal to
IM the actual purchase. This is because the commodity or service may
not be available in the required quantity.
Demand is always referred to in terms of price and bears no mean-
ing if it is not expressed in relation to price. For example, an indi-
vidual may be willing to purchase a shirt at a price of ` 500 but may
not be willing to purchase the same shirt if it is valued at ` 1000.
In addition, different quantities of a commodity are demanded at
M
different prices.
Demand is always referred in terms of a time period and bears
no meaning if it is not expressed in relation to a time period. For
example, a garment manufacturer has a demand for 200 metres of
N
cloth in a month or 2400 metres of cloth in a year.
3.2.1 TYPES OF DEMAND
The demand for a particular product can be different under different

? DID YOU KNOW situations. Therefore, it is essential for organisations to be aware of
Demand is generally classified the type of demand that arise for their products under different situa-
based on various factors such tions. Demand can be categorised into the following types:
as the number of consumers for
a given product, the nature of Individual demand and market demand: Individual demand is
products, utility of products and the quantity of a product or a service that an individual consumer
interdependence of different is willing to purchase at a given price over a specific period (such
demands. as per day, per week, etc.). Market demand, on the other hand, is
the total quantity that all the consumers of a product are willing
to purchase at a given period over a specific period. The market
demand is the sum of individual demands.
Derived demand and direct demand: Derived demand is the
demand for the product, which is associated with the demand for
another product. For example, furniture demand for your house

Demand Analysis 45
is a direct demand, whereas the demand for wood would be con-

sidered as the derived demand for the manufacturing of the furni-
ture. Similarly, a rise in the demand for lithium is derived from the
rise in demand for mobile phones (as lithium is used to manufac-
ture mobile phone batteries). Direct demand for a product, on the
other hand, is independent of the demand for another product. For
example, the demand for furniture and mobile phones is autono-
mous and therefore direct demand.
1. Rahul is a self-made millionaire. In a mall, he sees an expensive

pair of Italian designer shoes. When he checked the price tag,
he moved on. This is not a real demand for the shoes because
Rahul does not have the:
S
a. Desire
b. Willingness to pay
c. Purchasing power
IM
d. Creditworthiness
2. During the festival of Diwali, the demand for sweets goes up.
Consequently, the demand for sugar will:
a. Decline
b. Increase
M
c. Remain the same

d. First increase and then fall sharply
N
ACTIVITY
Identify commodities in which demand is not affected by prices.
3.3 DETERMINANTS OF DEMAND

Determinants of demand are the factors that influence the decision of
consumers to purchase a commodity or service. It is essential for or-
ganisations to understand the relationship between the demand and
its each determinant to analyse and estimate the individual and mar-
ket demand for a commodity or service. The quantity demanded for a
commodity or service is influenced by various factors, such as price,
consumers’ income and preferences and growth of population. For ex-
ample, the demand for apparel changes with changes in fashion and
tastes and preferences of consumers.
According to the demand theory, the quantity demanded of a com-

modity is influenced by certain factors called the determinants of

46 MICROECONOMICS
demand. Therefore, demand for an item x (Dx) is a function of the fol-

lowing factors:
Price of the item x (Px)
Price of substitutes (Py)
Price of complements (PZ)
Price expectation of the consumer (E)
Income of the consumer (B)
Taste or preference of the consumer (T)
Advertisement expenditure (A)
Other factors (U)
S
This relationship can be expressed through the following equation:
Dx = f(Px, Py, Pz, E, B, T, A, U)

IM
Let us understand how these factors impact demand for an item x, i.e.,
(Dx).
Effect of the price of the item (Px) on demand (Dx): The price of
a commodity or service is generally inversely proportional to the
quantity demanded while other factors are constant. This implies
that when the price of the commodity or service rises, its demand
falls and vice versa. As the price of an item x will increase, its
M
demand will decrease. Thus, Dx is inversely related to Px:

1
Dx ∝
Px
N
This effect is also called the price effect on demand.

Effect of the price of the substitute (Py) on demand (Dx): The
price of a commodity or service is generally inversely proportional
to the quantity demanded while other factors are constant. This
implies that when the price of the commodity or service rises, its
demand falls and vice versa. If item y is a substitute of the item
x, then as the price of the item y increases, the demand for the
item x will increase. For example, y is coffee and x is tea. Both are
substitutes of each other. Therefore, if price of coffee will increase,
demand for tea will increase, as the coffee drinkers will switch
over to tea. Thus, Dx is directly related to Py:
Dx ∝ Py
This effect is also called the substitution effect on demand.

Effect of the price of the complement (Pz) on demand (Dx):
Complementary goods are used jointly; for example, car and pet-
rol. There is an inverse relationship between the demand and

Demand Analysis 47
price of complementary goods. This implies that an increase in the

price of one good will result in fall in the demand of the other good.
If item z is a complement of the item x, then as the price of the item
z decreases, its demand will increase. This in turn will increase the
demand for the item x. Let’s understand this through an exam-
ple. Bread and butter are complements. If the price of the bread
decreases, then its demand will increase. This in turn will trigger
increase the demand for butter. Thus, Dx is inversely related to Pz:
1
Dx ∝
Pz
This effect is also called the complementary effect on demand.

Effect of consumer’s price expectation (E) on demand (Dx):
S
Demand for commodities also depends on the consumers’ expec-
tations regarding the future price of a commodity, availability of
the commodity, changes in income, etc. Such expectations usually
cause rise in demand for a product. This relationship is subjective
IM
depending on the psychology of the consumer.
Effect of consumer’s income (B) on demand (Dx): The level
of income of individuals determines their purchasing power.
Generally, income and demand are directly proportional to each
other. This implies that rise in the consumers’ income results in
rise in the demand for a commodity. However, the relationship
depends on the type of commodities. As the consumer’s income
M
will rise, he/she will purchase more of normal goods, such as tea,
sugar, cornflakes, noodles, watches and branded clothes. This
effect is called positive effect. Thus, the demand for an item is
directly related to consumer’s income, if the item is a normal good:
N
Dx ∝ B, if x is a normal good
At the same time, the consumer will purchase less of inferior goods,
such as low quality rice, jowar and second-hand goods. This effect
is called negative effect. Thus, demand for an item x is inversely
related to consumer’s income, if the item is an inferior good:
? DID YOU KNOW
1 Increase in the Gross Domestic
Dx ∝ , if x is an inferior good Production (GDP) or national
B income of a country will have
a positive effect on demand.
Effect of consumer’s taste or preference (T) on demand (Dx): An increase in GDP means that
Consumers’ tastes or preferences are socio-psychological determi- the aggregate output of goods
nants of demand, and hence difficult to explain theoretically. and services in the country has
increased, signalling economic
Effect of advertisement expenditure (A) on demand (Dx): An growth. This will trigger an in-
increase in advertisement expenditure will increase the demand crease in the aggregate demand
for the item, but up to a certain point only. Therefore, demand for and consumption of products
and services.
an item x is directly related to advertisement expenditure:
Dx ∝ A

48 MICROECONOMICS
3. Which of the following determinants result in a fall in the

demand of a commodity?
a. Increase in income
b. Fall in the price of substitute goods
c. Favourable credit policy
d. Increase in population size
4. Which factor will increase the demand for a premium brand
of Biryani masala?
a. Increase in the price of premium rice grains
S
b. Increase in the price of lower quality rice grains
c. Increase in the consumers’ income
d. Cutting of advertising expenditure
IM
ACTIVITY
Identify any product of your choice. List its substitutes and comple-
ments. Over a period, observe and note the effects of all determi-
nants discussed in this section on the demand of the product.
M
3.4 LAW OF DEMAND

Among all the determinants that influence the demand for a com-
N
modity, the price factor is the most important. The law of demand
represents a functional relationship between the price and quantity
demanded of a commodity or service. The law states that the quanti-
ty demanded of a commodity increases with a fall in the price of the
commodity and vice versa while other factors like consumers’ prefer-
ences, level of income, population size, etc., are constant. Demand is a
dependent variable, while price is an independent variable.
Take the example of an individual, who needs to purchase soft drinks.

In the market, a pack of three soft drinks is priced at ` 120 and the in-
dividual purchases the pack. In the next week, the price of the pack is
reduced to ` 105. This time the individual purchases two packs of soft
drinks. In the third week, the price of the pack has risen to ` 130. This
time the individual does not purchase the pack at all. It is a common
observation that consumers purchase a commodity in greater quan-
tities when its price is low and vice versa. This inverse relationship
between the quantity demanded and price of a commodity is called
the law of demand.

Demand Analysis 49
Therefore, demand is a function of price and can be expressed as fol-

lows:
D= f (P)
Where,
D= Demand
P= Price
f = Functional Relationship
The law of demand is based on certain assumptions, which are dis-

cussed in the next section.
S
3.4.1 ASSUMPTIONS IN THE LAW OF DEMAND
The law of demand follows the assumption of ceteris paribus, which

means that the other factors remain unchanged or constant. As men-
tioned earlier, the demand for a commodity or service not only de-
IM
pends on its price but also on several other factors such as the price
of related goods, income, and consumer tastes and preferences. In the
law of demand, other factors are assumed to remain constant while
only the price of the commodity changes. The law of demand is based
on the following assumptions:
The income of the consumer remains constant.
M
Consumer tastes and preferences remain constant.

Price of related goods remains unchanged.
Population size remains constant.
Consumer expectations do not change.
N
Credit policies remain unchanged.

Income distribution remains constant.
Government policies remain unchanged.
The commodity is a normal commodity.
The law of demand can be understood with the help of certain con-
cepts, such as demand schedule, demand curve and demand function.
Let us discuss these concepts in detail in the upcoming sections.
3.4.2 DEMAND SCHEDULE
A demand schedule is a tabular representation of different quanti-

ties of commodities that consumers are willing to purchase at specific
price and time while other factors are constant. Table 3.1 shows an
imaginary demand schedule representing the price of sanitisers (Ps)

50 MICROECONOMICS
and the related number of sanitisers demanded (Qs) by a household

per month:
TABLE 3.1: DEMAND SCHEDULE FOR SANITISERS

Ps(Price) Qs(Quantity Demanded per month)
800 1
600 3
400 4
300 5
200 6
100 8
The data in Table 3.1 indicates that the demand for sanitisers (Qs) in-
S
creases as the price of sanitisers (Ps) increases. For example, at the
price of ` 800, only 1 sanitiser is demanded per month. When the price
declines to ` 400, the demand for sanitisers increases to 3 units per
month. When the price reduces to ` 100, the demand rises up to 8 units
IM
per month. This inverse relationship between the price and the quan-
tity demanded for the sanitisers per month is the demand schedule
for sanitisers.
The law of demand can also be represented graphically with the help
of a demand curve, which is discussed in the next section.
3.4.3 DEMAND CURVE

M
A demand curve is a graphical representation of the law of demand.

The demand schedule can be converted into a demand curve by
graphically plotting the different combinations of price and quantity
demanded of a product. Thus, it can be said that demand curve is the
N
pictorial representation of the demand schedule. The demand curve

represents different quantities of a commodity demanded at specific
price and time while other factors remain constant. Figure 3.1 shows
the demand curve that is obtained from plotting the demand schedule
(Table 3.1):
900
D
800
700
I
P 600
R 500
I K
C 400
E L
300
M
200
D’
100
0
1 3 4 5 6 8
Quantity Demanded
Figure 3.1: Demand Curve

Demand Analysis 51
In Figure 3.1, demand curve slopes downwards to the right, indicat-

ing an inverse relationship between the price and quantity demanded
of a commodity. The demand curve DD’ slope is negative, indicating
the inverse relationship between the price of sanitiser and its quanti-
ty demanded. The downward movement on the demand curve from
point D towards D’ indicates that the demand for sanitisers increases
with the decrease in its price. Similarly, an upward movement on the
demand curve from point D’ to D indicates that the demand for sani-
tisers falls as its price increases. The demand curve DD’ slopes down-
ward to the right because of the following reasons:
Income effect: Income effect is the increase in the demand of a
commodity due to increase in the real income of consumers. When
the price of sanitisers decreases, the real income or purchasing
power of its consumers increases because they need to pay less for
S
the same quantity. This induces them to buy more sanitisers. This
effect is called the income effect. However, note that this effect is
negative if the goods are inferior. If the price of an inferior good,
such as a lower quality sanitiser, falls substantially, then the real
IM
income of consumers increases. As a result, they substitute the
inferior good for a normal good, such as a good quality sanitiser.
Thus, the income effect on the demand for inferior goods becomes
negative.
Substitution effect: When the price of sanitisers decreases, it
becomes cheaper relative to its substitutes, provided their prices
remain constant. Consequently, the substitutes of the sanitiser will
M
become more expensive. This will induce rational consumers to

substitute the sanitiser in place of its normal substitutes, which
have become costlier. The increase in demand of sanitiser due to
this factor is called the substitution effect.
Diminishing marginal utility: Consumers purchase commodi-
N
ties to derive utility out of them. The law of Diminishing Marginal

Utility (DMU) states that as consumption increases, the utility that
a consumer derives from the additional units (marginal utility) of
a commodity diminishes constantly. Therefore, a consumer would
purchase a larger amount of a commodity when it is priced low
as the marginal utility of the additional units decreases. Marginal
utility is the satisfaction or the utility derived from the marginal
unit consumed of a commodity.
3.4.4 EXCEPTIONS TO THE LAW OF DEMAND
There are some instances when the fundamental law of demand does
not apply. Some of these exceptions are mentioned below:
Expectations regarding future prices of a commodity: When
consumers expect that the price of a durable commodity will keep
on increasing continuously, they will buy more of that commodity
despite increase in its price. They do so to avoid paying even higher
prices for that commodity in the future. Likewise, when consumers
expect a major decline in the price of a commodity in the future,

52 MICROECONOMICS
they will postpone buying it and wait for its price to come down
further. These decisions are contrary to the law of demand.
Veblen goods: Veblen goods are luxury or prestigious items such
as gold, precious stones, rare paintings and antiques. The law of
demand does not apply to these goods. Exceptionally rich consum-
ers buy Veblen goods because they serve as a status symbol. They
purchase these goods due to their exceptionally high prices so that
they can boost their social prestige by displaying them as symbols
of their wealth and affluence.
Giffen goods: These goods are cheap commodities that have a
very few close substitutes. It is considered to be opposite to a nor-
? DID YOU KNOW
mal good. It is mostly consumed by poor households and consti-
Veblen goods are named after
the American economist Thor-
tutes a substantial percentage of their income. The law of demand
does not apply to these goods. Therefore, if the price of a Giffen
S
stein Veblen. He first pointed
out the concept of “conspicu- good increases (and the price of its substitute remains constant),
ous consumption” as a way of its demand will increase instead of falling. For example, suppose a
status-seeking in his book The poor household consumes 30 kg of food grains per month, which
Theory of the Leisure Class.
includes 20 kg of bajra (an inferior goods) and 10 kg of wheat
IM
(a superior good). The price of bajra is ` 5 per kg, while that of
wheat is `10 per kg. At these prices, the monthly expenditure of
the household on food grains is ` 200. This is the maximum price
that the poor family can afford to spend. Now, suppose the price
of bajra increases to ` 6 per kg. This will compel the household to
reduce its consumption of wheat by 5 kg and increase that of bajra
by 5 kg to meet its minimum monthly consumption requirement of
M
` 200 per month. Thus, the quantity demanded by the household

for the bajra will increase from 20 kg to 25 kg per month, while that
for the wheat will decrease from 10 kg to 5 kg. This indicates that
the demand for the Giffen good, i.e., bajra, will increase despite
increase in its price, which is against the law of demand.
N
5. As the price of a commodity will increase, its quantity

demanded will:
a. Increase b. Reach zero
c. Be optimum d. Decrease
6. All of the following are the reasons for the negative slope of
the demand curve, except:
a. Income effect on ordinary goods
b. Substitution effect
c. Complementary effect
d. Diminishing marginal utility
7. Ram Guha is a watchman. He supports a family of six people –
his wife, two children, and his elderly parents. On every next
day, the family eats a breakfast of bread omelet. The price of

Demand Analysis 53
the bread has increased by ` 2. The family has reduced its

consumption of eggs but increased its demand of bread. What
is the reason for this exception to the law of demand?
a. Bread is a Giffen good
b. Eggs are Veblen goods
c. Family expects the bread price to increase in the future
d. Family has substituted eggs with bread
ACTIVITY
Suppose the price of toned milk is ` 20 for 500 ml pouch. You must
decide how many 500 ml pouches of toned milk you will buy in one
S
week when the price is at a specific level. In the following table, fill
in the number of pouches next to the price.
PRICE (IN `) NUMBER OF 500 ML POUCHES

IM
20
40
60
80
100
Now put your results into a graph. Plot the number of pouches on
M
the x axis and the price on the y axis. Join the dots together to make
a line graph. What is the shape of the line? Explain why it is so.
3.5 MOVEMENT AND SHIFT IN DEMAND

N
The demand for a good is affected by various factors such as price

of the commodity, income of consumers and price of other related
goods. These effects can be seen by observing the changes in the de-
mand curve. Broadly, there are two types of changes in demand curve,
which are:
Movement along the demand curve (or change in quantity
demanded): When the quantity demanded increases or decreases
in response to a change in the price of a good while other factors
are constant, there is a movement along the demand curve. There
can be two possibilities when the movement along the demand
curve takes place; namely expansion of demand and contraction
of demand.
Shift in demand curve (or change in demand): When the demand
for a good changes due to various determinants other than the
own price of the good (in this case, price is constant), there is a
shift in demand curve (a new demand curve is drawn on the left
or right of the original demand curve). These determinants can be

54 MICROECONOMICS
fall in consumers’ income, fall in the price of a related commod-

ity, changes in the tastes and preferences of consumers and so on.
There can be two possibilities when the shift in the demand curve
takes place; namely increase in demand and decrease in demand.
Let us understand the possibilities of movement and shift in demand

curve in the next sections.
3.5.1 EXPANSION AND CONTRACTION OF DEMAND
The change in the quantity demanded (increase or decrease) of a

product with change (increase or decrease) in its price, while other
factors are at constant, is called expansion or contraction of demand.
Expansion and contraction are represented by the movement along
the same demand curve. Consider the demand curve in Figure 3.2.
S
At the price OP, the quantity demanded is OQ units of a commodity,
keeping all the other factors constant.
y
IM
P2 C
Price (in rupees)
P A
B
P1
M
Demand
Curve
x
O Q2 Q Q1
Quantity Demanded
(in units)
N
Figure 3.2: Movement in Demand Curve

(Source: https://keydifferences.com/difference-between-movement-
and-shift-in-demand-curve.html)
Now, when the price of the commodity:

Falls from OP to OP1, the quantity demanded rises to OQ1 and the
demand curve moves downward (expansion of demand). This
indicates a rise in the quantity demanded due to a fall in its prices,
while other factors are constant.
Rises from OP to OP2, the quantity demanded drops to OQ2 and
the demand curve moves upward (contraction of demand). This
indicates a fall in quantity demanded of a commodity due to a rise
in its price, while other factors remain unchanged.
3.5.2 INCREASE AND DECREASE IN DEMAND
Increase and decrease in demand takes place due to changes in oth-

er factors, such as change in income, distribution of income, change

Demand Analysis 55
in consumer’s tastes and preferences, change in the price of related

goods. In this case, the price factor remains unchanged. Increase in
demand refers to the rise in demand for a product at a specific price i.e.
more of the quantity is demanded at the same price, while a decrease
in demand is the fall in demand for a product at a given price i.e. less of
the quantity demanded at the same price. When other factors change
other than price, the demand curve changes its position which is re-
ferred to as a shift in the demand curve, which is shown in Figure 3.3:
D3
D2
D1
P2
S
Px
P1
D3
D1 D2
O Q1
IM
Q2 Q3
Qx
Figure 3.3: Shift in Demand Curve

(Source: https://keydifferences.com/difference-between-movement-
and-shift-in-demand-curve.html)
M
Demand curve D2 is the original demand curve of commodity X. At

price OP2, the demand is OQ2 units of commodity X. When the con-
sumer’s income decreases owing to high income tax, he/she is able
to purchase only OQ1 unit of commodity X at the same price OP2.
Therefore, the demand curve, D2 shifts downwards to D1. Similarly, Study
N
when the consumer’s disposable income increases due to a reduction Hint

in taxes, he/she is able to purchase OQ3 units of commodity X at the To remember how the demand
price OP2.Therefore, the demand curve, D2 shifts upwards to D3. Such curve shifts, memorise the line
changes in the position of the demand curve from its original position ‘left is less.’
are referred to as a shift in the demand curve.
8. If the price of coffee increases, what would be its effect on the

demand for tea?
a. Increases b. Decreases
c. Remains constant d. None of these
9. If the price of a commodity drops, there will be __________ in
the demand curve.
a. Shift leftward b. Shift rightward
c. Upward movement d. Downward movement

56 MICROECONOMICS
ACTIVITY
Consider the demand curve for petrol and diesel. What effect will
the following cases will have on it? (You have 1 minute to answer
each option.)
1. The price of cars increases.
2. The percentage of the people owning cars increases.
3. The transport costs of shipping oil increases.
4. The environmental concerns regarding pollution-causing
petrol and diesel increase.
5. The Goods and Services Tax (GST) on petrol and diesel
increases.
S
Illustrate each case above showing the change to demand.
IM3.6 SUMMARY
S
Demand for a commodity is defined as the quantity of that com-
modity, which a consumer wants to buy, at a given price per unit
of time.
For a demand to be effective, it must have the consumer’s desire,
ability to buy, and willingness to pay.
M
Demand can be categorised as individual demand, market demand,

derived demand and direct demand.
Demand for a commodity is influenced by the price of the com-
modity, price of its substitutes and complements, price expectation
N
of the consumer, income of the consumer, taste or preference of

the consumer, advertising expenditure, and other factors.
Among all the determinants that influence the demand of a com-
modity, the price factor is the most important. The law of demand
represents a functional relationship between the price and quan-
tity demanded of a commodity or service.
A demand schedule is a tabular representation of different quanti-
ties of commodities that consumers are willing to purchase at spe-
cific price and time while other factors are constant.
The law of demand does not apply to future prices of a commodity,
Veblen goods and Giffen goods.
The demand curve shifts to the right due to favourable changes in
non-price determinants, whereas it shifts to the left due to unfa-
vourable changes in non-price determinants.

Demand Analysis 57
KEY WORDS
Quantity demanded: The amount demanded at a specific point,

which is shown by a point on the demand curve
Contractionof demand: The fall in the quantity demanded of a
commodity due to rise in the price of the commodity
Expansion of demand: The rise in the quantity demanded of a
commodity due to fall in the price of the commodity
Conspicuous consumption: The act of buying expensive luxury
products with the objective of displaying them to enhance one’s
status in society
S
1. Varun is a salaried employee from a middle-class family. Being MCQ
a man of modest means, however, did not prevent him from
dreaming big. Since he saw the latest model of the Harley
IM
Davidson bike in an auto show, he wants to purchase. He is even
willing to pay for it. However, this is not a demand for the bike
because Varun does not have the:
a. Purchasing ability b. Permit
c. Desire d. Willingness to pay
2. If you are given that Dx = f(Px, Py, Pz, E, B, T, A, U); and,
M
Price of the item x (Px)

Price of substitutes (Py)
Price of complements (PZ)
N
Price expectation of the consumer (E)

Income of the consumer (B)
Taste or preference of the consumer (T)
Advertisement expenditure (A)
Other factors (U)
Then, Dx ∝ Py represents which effect?
a. price effect on demand
b. complementary effect on demand
c. price effect on demand
d. None of these
3. Demand for water used in beverages like coca cola is _________
demand.
a. Derived demand b. Direct demand
c. Industry demand d. Income demand

58 MICROECONOMICS
4. Demand for labour is always a(n) ___________ demand.

a. Individual b. Direct
c. Derived d. Price
5. The relationship between the income of individuals and the
demand for normal goods is:
a. Inverse b. Positive
c. Conditional d. Negative
6. The price of the Ariel detergent goes up. Consequently, people
start to buy more of Tide detergent. This is due to:
a. Income effect
b. Advertisement effect
S
c. Consumer’s preference effect
d. Substitution effect
IM7. When the demand for printers increases, people start buying
more of ink cartridges. This is due to:
a. Substitution effect b. Complementary effect
c. Price effect d. Income effect
8. The normal demand curve has _______ slope.
a. Undefined b. Positive
M
c. Downward d. Zero
9. People demand certain goods at higher prices not because of
their worth but because of their prestige value. This effect is
called:
N
a. Giffen paradox b. Veblen effect

c. Substitution effect d. Price expectancy effect
10. In the following diagram, what does the downward movement of
the demand curve from A to B mean?
y
P2 C
Price (in rupees)
P A
B
P1
Demand
Curve
x
O Q2 Q Q1
Quantity Demanded
(in units)

Demand Analysis 59
a. Increase in price of commodity x

b. Increase in demand of commodity x
c. Expansion of demand
d. Contraction of demand

?
1. Explain the concept of demand. What makes a demand effective?
2. Differentiate between the following types of demands:
a. Individual demand vs. Market demand
b. Derived demand vs. Direct demand
S
3. Which factors impact demand for an item and how?
4. Explain the law of demand. Mention its assumptions. Illustrate
using the demand schedule and the demand curve of a commodity.
IM
5. Is the law of demand universal? Give reasons for your answers.
Also, mention the conditions where it does not apply.
6. Why is the slope of the demand curve negative? Explain the
reasons.

3.9
(HOTS) QUESTIONS
M
1. Expansion and contraction of demand means:

a. Movement along the same demand curve
b. Shift to a new demand curve
N
c. Increase in price of complements

d. Change in supply
2. Increase in demand means that the demand curve shifts
_________; decrease in demand means that the demand curve
shifts to _____________.
a. Left, right b. Right, left
c. Up, down d. Horizontally, vertically
3. The following table is called:
Price per Quantity Demanded
pizza Per week (millions)
a $15 8
b 12 14
c 9 20
d 6 26
e 3 32
(Source: Economics: A Contemporary Introduction by William A. McEachern

60 MICROECONOMICS
a. Demand schedule b. Supply schedule

c. Stock schedule d. None of the above
4. The price of mutton increases. The people buy more of chicken.
Therefore, chicken and mutton are:
a. Normal goods b. Inferior goods
c. Complements d. Substitutes
5. Demand for house is ________ demand, while demand for bricks
is _________ demand.
a. Individual, market b. Industry, market
c. Direct, derived d. Direct, indirect
S

IM
Topic Q. No. Answer
Meaning of Demand 1. b. Willingness to pay
2. b. Increase
Determinants of Demand 3. b. Fall in the price of substitute
goods
M
4. c. Increase in the consumer’s

income
Law of Demand 5. d. Decrease
6. c. Complementary effect
N
7. a. Bread is a Giffen good

Shift and Movement in 8. a. Increases
Demand
9. d. Downward movement
Q. No. Answer
1. a. Purchasing ability
2. d. None of these
3. a. Derived demand
4. c. Derived
5. b. Positive

Demand Analysis 61
Q. No. Answer
6. d. Substitution effect
7. b. Complementary effect
8. c. Downward
9. b. Veblen effect
10. c. Expansion of demand

1. Suppose you want to eat an ice cream. In normal sense, you may
say that you ‘demand’ an ice cream. But in economics, demand
means much more. You go to an ice cream vendor, browse the
S
flavors, and desire a Cornetto. Refer to Section 3.2 Meaning of
Demand
2. Demand can be categorized into the following types. Individual
IM
demand and market demand. Refer to Section 3.2 Meaning of
Demand
3. According to the demand theory, the quantity demanded
of a commodity is influenced by the certain factors called
determinants of demand. Refer to Section 3.3 Determinants of
Demand
M
4. Among all the determinants that influence the demand of a

commodity, the price factor is the most important. It is the only
determinant of demand in the short run. The law of demand
represents a functional relationship between the price and
quantity demanded of a commodity or service. Refer to Section
N
3.4 Law of Demand

5. There are some instances when the fundamental law of demand
does not apply. Refer to Section 3.4 Law of Demand
6. The demand curve DD’ slopes downward to the right because of
the following reasons. Refer to Section 3.4 Law of Demand
ANSWER FOR HIGHER ORDER THINKING SKILLS (HOTS)

QUESTIONS
Q. No. Answer
1. a. Movement along the same demand curve
2. b. Right, left
3. a. Demand schedule
4. d. Substitutes
5. c. Direct and derived

62 MICROECONOMICS
SUGGESTED READINGS
Hubbard, R., Garnett, A., & Lewis, P. (2017). Microeconomics.
Pearson Australia Pty Ltd.
Taylor, J., &Weerapana, A. (2012). Microeconomics. [Mason, Ohio?]:
South-Western Cengage Learning.
E-REFERENCES
Law of Demand: Schedule, Curve, Function, Assumptions and
Exception. (2020). Retrieved 11 July 2020, from https://www.eco-
nomicsdiscussion.net/law-of-demand/law-of-demand-schedule-
S
curve-function-assumptions-and-exception/3429
Movement along the Demand Curve and Shift of the Demand
Curve. (2020). Retrieved 11 July 2020, from https://www.toppr.com/
IM guides/business-economics/theory-of-demand/movement-along-
the-demand-curve-and-shift-of-the-demand-curve/
What are the types of Demand? - Business Jargons. (2020).
Retrieved 11 July 2020, from https://businessjargons.com/types-of-
demand.html
M
N

CASE STUDIES
1 TO 3
CONTENTS
Case Study 1 Is Lunch Ever Free?

Case Study 2 Choice Making between Environmental Quality and Economic Growth
Case Study 3 Reducing the Quantity of Smoking Demanded
S
IM
M
N

64 MICROECONOMICS
CASE STUDY 1
IS LUNCH EVER FREE?
There is a saying in economics, ‘There is no such thing as a free

Case Objective
lunch.’ This means that nothing in life is truly free and that things
This case study discusses the that appear to be free must be paid for by someone. This case
central economic problem of study explains this saying, linking it to the central economic prob-
scarcity. lem of scarcity.
BACKGROUND
In the 19th century, the American saloon keepers advertised that

‘free food’ would be offered to anyone who purchased drinks in
their saloons. However, this idea was criticised for the reason that
S
customers always ended up paying for the ‘free food’ in the price
of drinks that they had to buy. The food was high in salt and so
customers were induced to purchase more drinks. Thus, the sa-
IM
loon keepers deliberately offered free lunches with the expecta-
tion that they would generate enough revenue in extra drinks to
balance the cost of the lunch. In fact, some saloon keepers were
sued for false advertising of ‘free lunch,’ as some customers could
not participate in it without first paying money to the saloon.
In this context, the economists joined the argument and the say-
ing ‘there’s no such thing as a free lunch’ was coined. Although
M
it is not clear who initially said this phrase, theories suggest that
it was first used in response of the libertarian views of the US
Vice President Henry Wallace (1941-45). He wrote an article in a
newspaper where he had suggested a post-World War II economic
regime across the world, offering “minimum standards of food,
N
clothing and shelter.” He mentioned that “if we can afford tre-

mendous sums of money to win the war, we can afford to invest
whatever amount it takes to win the peace.” Responding to this
viewpoint, Paul Mallon, a journalist, wrote in an article in 1942:
“Mr Wallace neglects the fact that such a thing as a ‘free’ lunch
never existed. Until man acquires the power of creation, someone
will always have to pay for a free lunch.”
ANALYSIS
To analyse this saying, let us ask whether anything in the world

is truly free. Only things that are abundant in supply can be of-
fered free. But is there anything we desire that is really abun-
dant? Here, abundance means something where supply exceeds
demand at a zero price. This means that even if that good or ser-
vice is free, there is no shortage. Moreover, there must be no op-
portunity cost associated with its supply. For example, if a saloon
supplies free food to its customers, it is still scarce because there

Case study 1: IS LUNCH EVER FREE? 65
CASE STUDY 1
is a cost of drink associated with it, which the customers must

pay. Similarly, if a government supplies free healthcare to the sick
people, it is still scarce because there is a cost to the government,
which is ultimately paid by the taxpayer.
But what about resources, such as air and water, which seem to
be in abundant supply in nature? Let us analyse them.
AIR
Air is abundant in the atmosphere. There is no shortage of air to

breathe for most of us most of the time. However, if ‘air’ is defined
as clean, unpolluted air, then it is scarce in most parts of the world
including India. To clean polluted air in cities and urban areas, re-
S
sources have to be used to make clean air available to the citizens.
This will require cost. Although citizens may not directly pay for
the cleaned-up air, they will eventually end up paying for it as
taxpayers. Industries also have to pay for cleaned-up air through
IM
taxes. As consumers, citizens have to pay for cleaned-up air by
purchasing zero-emission vehicles or getting regular pollution
check certificates. When air purifiers or extractor fans have to be
installed to freshen up air in buildings, residents have to directly
pay for air. Even if someone lives in a non-polluted part of the
country, he/she may have spent money to move there to escape
the pollution. This is also an opportunity cost to get the clean air.
M
WATER
The abundance of water depends on the purpose for which wa-

ter is used. In India, water for growing crops is plentiful in the
N
parts which get abundant rainfall. However, it is scarce in arid

areas such as Rajasthan. If there is a shortfall of monsoon, water
becomes scarce. In such a case, resources have to be spent on ir-
rigation, which is a cost.
Pure drinking water is already not an abundant resource around

the world. To bring the water to your tap, resources have to be
spent in building reservoirs, laying out pipelines, purifying water
and pumping it to your houses.
RESULTS
The expression “There is no such thing as a free lunch” describes

the concept of opportunity costs, which states that for every choice
we make, there is an alternative that is not chosen. Every decision
in life requires trade-offs and there are no real free hand-outs in
society. Even when there is no one to directly pay for a product or
service, the society bears the burden.

66 MICROECONOMICS
CASE STUDY 1
CONCLUSION
Many businesses continue to use the proposal of a ‘free’ good or

service with the purchase of another good or service to entice cus-
tomers. However, goods or services that appear to be free always
have to be paid by an individual, even if that person is not directly
receiving the benefit.
(Source: https://books.google.co.in/books?id=XaIh7T6n4SQC&pg=PR24&dq=case+-
study+to+illustrate+the+concept+of+microeconomics+in+daily+life&hl=en&sa=X-
&ved=2ahUKEwixlczzxpDrAhWylEsFHcfcD9oQ6AEwBXoECAYQAg#v=onepage&q=-
case%20study%20to%20illustrate%20the%20concept%20of%20microeconomics%20
in%20daily%20life&f=false)
QUESTIONS
S
1. Can you recall any desirable good or service, which you
considered to be free? Identify the opportunity costs asso-
ciated with that good or service and justify whether it was
truly free.
IM
(Hint: Water, air, etc.)
2. Identify any ‘free’ election promises, which are promised
to people during elections. Find out the opportunity costs
associated with them and identify who in the end actually
paid for those things.
(Hint: Free healthcare, free transport, free water supply,
M
etc.)
N

CASE STUDY 2
CHOICE MAKING BETWEEN ENVIRONMENTAL QUALITY

AND ECONOMIC GROWTH
The former Prime Minister of Canada, Stephen Harper, was the Case Objective
head of the Conservative Party. In Canada’s parliamentary sys- This case study highlights
tem, he had walked a political tightrope for five years. During that the choice that the Canadian
time period, he worked as the leader of the minority government. citizens had to make between
His opponents were upset by some of the policies. One such pol- economic development as
promised by the Conservative
icy was a reduction in corporate tax rates. In 2011, his opponents Party and greater economic
strived for a no-confidence vote in parliament. It passed the par- growth as promised by the
liament tremendously. It not only brought down Harper’s govern- New Democratic Party (NDP).
ment but also forced national elections for a new parliament.
S
This political victory was momentary as the Conservative Par-
ty won the elections held in May 2011. This party had appeared
as the ruling party in Canada. This ruling party had allowed Mr
IM
Harper to continue practising the policy of deficit and tax reduc-
tion. This Conservative Party was opposed by the New Demo-
cratic Party (NDP) and the moderate Liberal Party at that time.
These opposition parties strived for higher corporate tax returns
and less deficit reduction as compared to the ruling party. In 2010,
the deficit had fallen by one-third under the rule of Mr Harper. At
that time, he had promised a surplus budget by 2015.
M
In 2011, the unemployment rate in Canada was 7.4% as compared

to the US rate, which was 9.1% in the month of May. In 2010, the
GDP growth rate was 3.1% in Canada. In the first quarter of 2011,
the Bank of Canada planned for 4.2% of growth rate as compared
N
to the US which planned for 1.8% of growth rate. In 2008, Canada

was dealing with the state of recession. To deal with this state,
Mr Harper had made great efforts in 2010 and 2011. These efforts
helped him in producing substantial reductions in the deficit.
All his efforts made Canadians decide and make a choice that re-
sulted in lower taxes and less spending. But this issue was not
considered to be prominent in the campaign held in 2011. With
the development of huge oil deposits in Alberta, Canada is at the
third place in the world for oil reserves. The NDP promised to
reduce the greenhouse gas emissions in Canada, whereas Mr
Harper and the Conservative Party had promised to work towards
the development of Canada’s economic growth.
(Source: https://2012books.lardbucket.org/books/macroeconomics-principles-v2.0/s04-eco-
nomics-the-studyof-choice.html)

68 MICROECONOMICS
CASE STUDY 2
QUESTIONS
1. What was the criterion for choice making in this case

study?
(Hint: Economic growth and environment quality)
2. What was the aim of Mr Harper?
(Hint: Reduction in tax and deficit and ultimately the
growth of the economy)
S
IM
M
N

CASE STUDY 3
REDUCING THE QUANTITY OF SMOKING DEMANDED
BACKGROUND
Case Objective
Use of tobacco is a major cause of deaths. Every year, smoking
This case study explores
kills more than seven million people. In addition to its huge toll of
two ways that public
disease, misery and death, smoking of tobacco also puts a burden policymakers can attempt to
of approximately $1.4 trillion on the global economy due to annual reduce demand for cigarettes;
costs in healthcare and the loss of productivity. thereby slashing the amount
that people smoke.
Today, there is a greater understanding of how to reduce the gi-
gantic burden of this deadly epidemic. Public policymakers have
implemented demand reduction policies such as higher taxes and
wide-ranging bans on tobacco marketing and smoking in public
S
to curb tobacco use and its consequent damage to health and eco-
nomic development.
METHODS
IM
Two principle cost-effective means to reduce smoking are:
Shifting the demand curve for cigarettes
Increasing the price of cigarettes
SHIFTING THE DEMAND CURVE

M
Public policymakers can develop and implement policies to shift

the demand curve for cigarettes and other tobacco products.
These policies may include:
Public service announcements
N
Mandatory health warnings on cigarette packages

Prohibition of cigarette advertising on television
If these policies are successful, they will shift the demand curve
for cigarettes to the left, as shown in Figure A:
Price of
Cigarettes, A policy to discourage
per Pack smoking shifts the demand
curve to the left.
B A
$ 2.00
D1
D2
0 10 20
Number of Cigarettes Smoked per Day
Figure A: Shift in Demand Curve

70 MICROECONOMICS
CASE STUDY 3
INCREASING THE PRICE OF CIGARETTES
Another cost-effective method through which policymakers can

reduce the amount of smoking is to increase the price of ciga-
rettes. They can increase the price of cigarettes by imposing or
raising taxes on the manufacturing of cigarettes. As a result, cig-
arette companies will pass much of this tax to consumers in the
form of higher prices of cigarettes. Due to higher prices, smokers
will be encouraged to reduce the amount of cigarettes they smoke
on a regular basis. Note that the reduced amount of smoking in
this case will not represent a shift in the demand curve. On the
contrary, it will represent a movement along the same demand
curve, as shown in Figure B:
S
Price of A tax that raises the price
Cigarettes, of cigarettes results in
per Pack a movement along the
demand curve.
IM $ 4.00 C
A
2.00
D1
M
0 12 20
Number of Cigarettes Smoked per Day
Figure B: Movement along the Demand Curve

N
RESULTS
Shift in demand curve: In Figure 1, the demand curve shifts
from D1 to D2. At a price of $2 per pack of cigarettes, the quanti-
ty demanded drops from 20 cigarettes per day to 10 cigarettes
per day, as represented by the shift from point A to point B in
Figure 1.
Movement along the demand curve: If the price of cigarettes
is increased due to taxes, then the demand curve does not
shift. Instead, there will be a movement to a different point
on the demand curve. In Figure 2, when the price of a pack
of cigarettes is raised from $2 to $4, the quantity demanded
decreases from 20 to 12 cigarettes in a day, as shown by the
movement from point A to point C.

Case study 3: REDUCING THE QUANTITY OF SMOKING DEMANDED 71
CASE STUDY 3
CONCLUSION
Economists have studied the amount by which smoking reduces

due to an increase in the price of cigarettes. If the price of ciga-
rettes is increased by 10%, there will be a 4% drop in the quantity
demanded. Teenagers particularly are extra sensitive to the price
of cigarettes. A 10% increase in the price of cigarettes will cause
a 12% reduction in the quantity demanded. Thus, public policy-
makers can use this data to make knowledgeable decisions on re-
ducing the amount of smoking in public.
(Source: https://books.google.co.in/books?id=xoztFMavGCcC&pg=PA69&dq=-
case+study+on+demand+schedule+and+demand+curve&hl=en&sa=X&ved=2a-
hUKEwiXi5aoxpLrAhVZVH0KHewwCPoQ6AEwBHoECAYQAg#v=onepage&q=-
case%20study%20on%20demand%20schedule%20and%20demand%20curve&f=false)
S
QUESTIONS
1. In most budgets, the Indian government raises tax on

cigarettes, which increases the price of cigarettes. Why
IM
do they do so? Illustrate your answer through demand
schedule and demand curve.
(Hint: When the price of cigarettes rises, the quantity de-
manded falls, while other factors being constant)
2. Tobacco companies oppose cigarette taxes, saying that
high prices of cigarettes will encourage the use of illicit
M
drugs, such as marijuana. What is the reason behind their

argument?
(Hint: Tobacco and marijuana are complements)
N

N
M
IM
S
C H A
4 P T E R
SUPPLY ANALYSIS
S
CONTENTS
4.1 Introduction
4.2 Concept of Supply
IM
4.2.1 Determinants of Supply
Activity
4.3 Law of Supply
4.3.1 Supply Schedule
4.3.2 Supply Curve
M
4.3.3 Assumptions of the Law of Supply

4.3.4 Exceptions to the Law of Supply
Activity
4.4 Movement and Shift in Supply
N
4.4.1 Expansion and Contraction of Supply

4.4.2 Increase and Decrease in Supply
Activity
4.5 Market Equilibrium: Demand and Supply Equilibrium
4.5.1 Determination of Market Price
4.5.2 Shifts in Market Equilibrium
Activity
4.6 Summary

74 MICROECONOMICS
SHORTAGE OF SUPPLIES DURING COVID-19
With the outbreak of Covid-19 Pandemic, there has been an

Case Objective increase in the demand for masks, gloves and hand sanitisers.
This caselet describes how Initially, there was a sudden rise in the demand for such goods
shortage in supplies affects which led to sudden increase in their prices. Dhairyashil Patil,
the prices of goods. national president at the All India Consumer Products Distributors
Federation (AICPDF), stated “Sanitizers and hand washes are a
very small category, at least the branded ones. But today, if you see
their demand, it’s up almost five-fold; so, companies don’t have so
much stock, plus export demand has been going up”
Medical stores faced a shortage of masks and sanitisers as people
S
resorted to panic buying. One of the medical store owners said
“Hand sanitizers have disappeared from the market. We have
given the order for it but it is difficult to get them. Masks that were
earlier sold for ` 50-60 are now being sold at `100-150.” Later, the
IM
government ensured that supply chain remains active and fulfils
the challenges faced in fulfilling the requirement of masks and
sanitisers. The Food and Drug Administration authorities speeded
up the licensing process of manufacturing these goods in order to
avoid the unethical price rise, hoarding and black marketing. Then,
regular supplies of masks and sanitisers result in the reduction in
the prices and there are many new manufacturing firms entering
M
in the market fulfilling the demand at the right price and at the
right time.
This caselet describes some challenging situations that can arise

in any economy due to shortage in supplies. In this chapter, you
N
will look at the part that producers play in the market, and how
they make decisions on what and how much to supply.

SUPPLY ANALYSIS 75
LEARNING OBJECTIVES

>> Explain the meaning of supply and its determinants
>> Discuss the law of supply
>> Describe the shift and movement in supply
4.1 INTRODUCTION
In the previous chapter, you have studied that a market is an Quick Revision
arrangement where buyers and sellers are engaged in exchanging
goods at certain prices. The behaviour of buyers is understood with
S
the help of the concept of demand. In a market, the two forces demand
and supply play a major role in influencing the decisions of consumers
and producers. It is correct that demand is the engine on which the
economy runs, but demand must be met with the related supply as
IM
well. The behaviour of sellers is analysed using the concept of supply.
Supply can be defined as the quantity of a good that a seller is willing

to offer in the market at a particular price within specific time. The
supply of a good is influenced by various determinants, such as price,
cost of production, government policies, and technology. It is governed
by the law of supply, which states a direct relationship between supply
and price of a good, while other factors remain the same. In simple
M
words, the law of supply states that the supply of a good increases with
an increase in its price, while other factors at constant and vice versa.
The interaction between demand and supply helps in determining
the market equilibrium price of a good. Equilibrium price is a price
where the quantity demanded of a good by buyers is equal to the
N
quantity supplied by sellers. In simple terms, equilibrium price is a

price when there is a balance between market demand and supply.
The equilibrium price of a good can change due to various reasons,
such as reduction in cost of production, fall in the price of substitutes,
and unfavourable climatic conditions.
In this chapter, you will study about the concept of supply and identify
its determinants. The chapter also describes the law of supply,
including the supply schedule, supply curve, basic assumptions and
exceptions. Moreover, you will study about market equilibrium price
at length. Also, you will study about the shifts and movements in
supply.
4.2 CONCEPT OF SUPPLY

A market economy is made up of buyers and sellers. The buyers
constitute the demand side of a good or service, whereas the sellers
constitute the supply side. Thus, supply is defined as the specific

76 MICROECONOMICS
quantity of a good that a producer is willing and is able to offer to

consumers at a specific price at a given time period. It can be defined
as an association between price and quantity supplied. The quantity
supplied is the amount of a good offered for sale at a given price for
a specific time period. It can be said that supply has three important
aspects, which are as follows:
1. Supply is always referred in terms of price. The price at which
quantities are supplied differs from one location to the other.
For example, fast moving consumer goods (FMCG) are usually
supplied at different places in different prices.
2. Supply is referred in terms of time. This means that supply is
the amount that suppliers are willing to offer during a specific
period of time (per day, per week, per month, biannually, etc.)
S
3. Supply considers the stock and market price of the good. The
stock of a good refers to the quantity of the good available in the
market for sale within a specified point of time. Both stock and
market price of a good affect its supply to a greater extent. If
IM
the market price of a good is more than its cost price, the seller
would increase the supply of the good in the market. However, a
decrease in the market price as compared to the cost price would
reduce the supply of goods in the market.
Let us understand the concept of supply with an example. For example,

a seller offers a good at ` 100 per piece in the market. In this case, only
M
good and price are specified; thus, it cannot be considered as supply.

However, there is another seller who offers the same good at ` 110 per
piece in the market for the next six months from now on. In this case,
goods, price and time are specified, thus it is supply.
N
Supply can be classified into two categories, namely individual supply

and market supply. Individual supply is the quantity of goods a single
producer is willing to supply at a particular price and time in the
market. In economics, a single producer is known as a firm. On the
other hand, market supply is the quantity of goods supplied by all firms
in the market during a specific time period and at a particular price.
Market supply is also known as industry supply as firms collectively
constitute an industry.
4.2.1 DETERMINANTS OF SUPPLY
Supply does not remain constant all the time in the market. There are
many factors that influence the supply of a good. Generally, the supply
of a good depends on its price and cost of production. Thus, it can be
said that supply is the function of price and cost of production. The
supply of a good is influenced by the following factors or determinants:
Input price: It is the cost incurred on the manufacturing of goods
that are to be offered to consumers. When the input prices reduce,

SUPPLY ANALYSIS 77
the use of inputs will rise. Increased use of inputs will increase
the supply of goods. Similarly, when the input prices increase, the
supply of goods will decrease.
Price of substitutes: The prices of substitutes and complementary
goods also influence the supply of a good to a large extent. For
instance, if the price of tea increases, the firm would produce more
tea and less coffee. As a result, there will be reduction in the supply
of coffee in the market.
Nature and size of the industry: If the industry of a good is
monopolised (i.e., under the hands of a few large players only),
the supply of the good will be limited. On the other hand, if the
industry is competitive (i.e., a healthy competition of small and
large companies), the supply of the good in the market will increase.
S
The supply of the good will also increase when new producers join
the industry, increasing the industry size. Therefore, the supply of
goods is also dependent on the structure of the industry in which
a firm operates.
IM
Government policy: The production of a good declines in the face
of restrictive policies by the government, such as import quota on
resources, rationing on the supply of resources, etc. Consequently,
the supply of the good decreases. Government’s tax policies also
act as a regulating force in supply. If the rates of taxes levied on
goods are high, the supply will decrease. This is because high tax
M
rates increase overall production costs, which makes it difficult for

suppliers to offer goods in the market. Similarly, reduction in taxes
on goods will lead to an increase in their supply in the market.
Natural conditions: The supply of certain goods is directly
N
influenced by climatic conditions. For instance, the supply of

agricultural goods increases when the monsoon comes well on
time. On the contrary, the supply of these goods reduces at the time
of drought. Some of the crops are climate specific and their growth
purely depends on climatic conditions. For example, Kharif crops
are well grown during summers, while Rabi crops are produced
well in the winter season.
Transportation conditions: Transport is always a constraint to
the supply of goods. Better transport facilities result in an increase
in the supply of goods. On the contrary, goods are not available on
time due to poor transport facilities. Therefore, even if the price of
a good increases, the supply would not increase.
Other factors: These factors include all those factors that adversely
affect the production and supply of goods. They include labour
strikes, lockdowns, lock out, wars, communal riots, drought, floods,
epidemics, pandemics, etc. These factors also include climatic and
weather conditions in case of agricultural goods.

78 MICROECONOMICS
1. Supply is the specific quantity of a good that a producer is

_______ and __________ to offer for sale to consumers.
a. wishing, unable b. exporting, franchising
c. willing, able d. reluctant, capable
2. Which of the following factors affect the supply of a good?
a. Government policy b. Input price
c. Price of substitutes d. All of these
ACTIVITY
S
Search on the Internet and find out the determinants that influence
the supply of cars in the Indian market.
IM
4.3 LAW OF SUPPLY
The law of supply explains the direct relationship between the price
and supply of a good. According to the law of supply, the quantity
supplied increases with a rise in the price of a good and vice versa
while other factors remain constant. The other factors may include
customer preferences, size of the market, size of population, price
M
of substitutes, input price, government policies etc. For example,

if the price of a good increases, sellers would prefer to increase the
production of that good to earn high profits. As a result, there will
be an increase in supply. Similarly, if the price of a good reduces, the
supplier also reduces the supply of the goods in the market and waits
N
for a rise in the price of the good in the future.
To understand the law of supply, it is important to discuss the concepts

of supply schedule and supply curve.
4.3.1 SUPPLY SCHEDULE
A supply schedule can be defined as a tabular representation of the

law of supply. It represents quantities of a good supplied by a supplier
at different prices and time periods, keeping all other factors constant.
There can be two types of supply schedules, namely individual supply
schedule and market supply schedule. These two types of supply
schedules are explained as follows:
1. Individual supply schedule: This schedule represents the
quantities of a good supplied by an individual firm or supplier at
different prices during a specific period of time, assuming other
factors remain unchanged. Let us understand the individual
supply schedule with the help of an example.

SUPPLY ANALYSIS 79
Table 4.1 shows the supply schedule of a firm supplying good A:
TABLE 4.1: INDIVIDUAL SUPPLY SCHEDULE

FOR GOOD A
Price of the Good A (` per Kg) Quantity Supplied (Kg per Week)
5 3,000
10 8,000
15 12,000
20 15,000
From Table 4.1, it is clear that the firm is supplying 3,000 kg per
week of good A at the price of ` 5 per kg. As the price rises from
NOTE
` 5 to ` 10 per kg, the firm also increased the supply to 8,000 An individual supply schedule
indicates different quantities of
S
per kg. Therefore, the individual supply schedule shown in Table a good (such as pizzas) offered
4.1 indicates that the quantity supplied increases with a rise in for sale by a single producer
price. (pizza maker) at different prices.
A market supply schedule is the
2. Market supply schedule: This schedule represents the quantities total quantity of the good (pizza)
IM
of a good supplied by all firms or suppliers in the market at offered for sale by all producers
different prices during a specific period, while other factors (pizza makers) at different prices
are constant. In other words, the market supply schedule can in a given period. Therefore,
market supply is an aggregate of
be defined as the summation of all individual supply schedules. all individual supplies of a good
Table 4.2 shows the market supply schedule of two firms X and at different prices in a given
Y for good A: period.
M
TABLE 4.2: MARKET SUPPLY SCHEDULE

FOR GOOD A
Price of Quantity Quantity Market Supply
Good A Supplied by Supplied by (1000 kg per
(` per kg) Firm X (in 1000 Firm Y (in 1000 week)
N
kg per week) kg per week)

5 3 7 10
10 8 12 20
15 12 15 27
20 15 17 32
In Table 4.2, market supply is calculated by combining the
quantities supplied by firm X and Y. It also shows when the good
is priced at `5 per kg, the market supply of good A is 10,000 kg
per week. When the price rises to ` 10 per kg, the market supply
also increases to 20,000 per kg. So, it can be observed that a rise
in the price of good A increases the market supply.
4.3.2 SUPPLY CURVE
Supply curve is the graphical representation of supply schedule. In

a graph, the price of a good is represented on Y-axis and quantity
supplied is represented on X-axis. Similar to supply schedule, supply

80 MICROECONOMICS
curve can be of two types, individual supply curve and market supply
curve. These two types of curves are explained as follows:
Individual supply curve: It is the graphical representation of
individual supply schedule. The individual supply schedule of
good A represented in Table 4.1, when plotted on a graph will
provide the individual supply curve, which is shown in Figure 4.1:
25
20
15
Price
10
S
5
0
0 5000 10000 15000 20000
IM
Quantity
Figure 4.1: Individual Supply Curve

The slope moving upwards to the right in individual supply curve
shows the direct relationship between supply and price, i.e.,
increase in supply along with the rise in price.
M
Market supply curve: It is the graphical representation of market

supply schedule. The market supply schedule of good A (supplied
by Firm X and Firm Y) represented in Table 4.2, when plotted on
graph will provide the market supply curve, which is shown in
Figure 4.2:
N
25
20
15
Price
10
5
0
0 10,000 20,000 30,000 40,000
Quantity
Figure 4.2: Market Supply Curve
In a nutshell, a higher price makes producers in an economy more

willing and more able to increase quantity supplied. They are more
willing because production of the higher-priced good becomes more
attractive than other uses of the inputs involved. They are more

SUPPLY ANALYSIS 81
able because they can afford to cover the higher marginal costs of
production, which results from increasing output. On the other hand,
the lower price of a good makes it less attractive to producers. Hence,
they are less willing and less able to supply the goods.
4.3.3 ASSUMPTIONS OF THE LAW OF SUPPLY
As mentioned earlier, the supply of a good is dependent on many

factors other than price, such as input price, price of substitutes, etc.
All the factors other than the price are assumed to be constant. The
higher the price of a good, the higher will be its quantity supplied.
The lower its price, the lower will be the supply. This law makes the
following assumptions:
The income of the producer (seller) or consumer (buyer) should
S
not change.
The production technique should not change. This assumption
is significant because the cost of production should remain fixed.
IM
If the production technique improves, the cost of production will
decrease, which will make producers more willing and more able
to supply more quantity even at falling prices.
Transportation costs should not change. Lower transportation
costs will reduce the cost of production, which will make producers
more willing and supply more quantity even at lower prices.
M
The cost of production (including prices of inputs) should remain

constant. This is because if the cost of production increases with
an increase in the price, producers will not find the profit incentive
to produce and supply more quantity.
The scale of production should remain constant during a given
N
period. This is because if the scale of production changes, the level

of supply will also change, regardless of changes in the price of the
good.
There should not be any speculation about future changes in
the price of the good among producers (or sellers). If producers
anticipate a rise in the price of the good in future, they may not
increase its supply with the current price rise.
The price of substitute goods should remain constant. If the price
of a substitute good increases more quickly than the given good,
the profit incentive might cause producers to shift their resources
to the production of the substitute good. If they do so, they will not
be able to supply the given good, even with the rising price.
The government policies (e.g., taxation policy, trade policy, etc.)
should remain constant. For example, if the government imposes
additional excise duties, it will increase the cost of production.
Therefore, the government policy does not change over a period
of time.

82 MICROECONOMICS
4.3.4 EXCEPTIONS TO THE LAW OF SUPPLY
As mentioned earlier, according to the law of supply, if the price of a

good rises, the supply of the good also rises and vice versa. However,
there are certain conditions where the law of supply is not applicable.
These conditions are known as exceptions to the law of supply. There
are some situations when the law of supply does not apply, i.e., the
quantity supplied does not tend to rise with the rise in price or decline
with fall in prices. Let us consider these exceptions:
Future price expectations: If producers (or sellers) expect that the
price of a good is likely to rise in the future, they might withhold
the good stock in anticipation of making even higher profits. Their
withholding of stocks will reduce the supply of the good in the
market, even at the current higher price. Likewise, if producers
S
expect that the price of a certain good is going to drop in the future,
they will try to dispose of the good. This will increase the supply of
the good in the market, even at a lower price.
Goods for auction: Auction goods are offered for sale through
IM
bidding. Auction can take place due to various reasons, for instance,
a bank may auction the assets of a customer in case of his failure
in paying off the debts over a period of time. Thus, supply of these
goods cannot increase or decrease beyond a limit. In case of these
goods, a rise or fall in price does not impact the supply.

M
3. According to the law of supply, if the price of a car increases,

its quantity supplied will ______, other factors being fixed.
a. decline
b. not be affected
N
c. increase
d. reduce by the factor of one
4. According to the supply curve, supply is a _____________
function of price.
a. positive
b. negative
b. zero
d. unitary
5. The supply curve has a ____________ slope.
a. backward
b. downward
c. flat
d. upward

SUPPLY ANALYSIS 83
ACTIVITY
Create a supply curve from the given supply schedule. Plot the
price on the x-axis and the quantity on the y-axis.
Price (`) Quantity

100 600
200 700
300 800
400 900
500 1000
S
Answer the following questions:
1. What do you notice about the supply curve?
IM
2. What does the supply curve indicate about the relationship
between the price and the quantity?
3. Why do you think this relationship exists?
4.4 MOVEMENT AND SHIFT IN SUPPLY

M
In economics, like demand, change in quantity supplied and change

in supply are two different concepts. Change in quantity supplied
occurs due to a rise or fall in the prices of goods while other factors are
constant. On the other hand, change in supply refers to an increase or
decrease in the supply of a good due to various determinants of supply
N
other than price (in this case, price is constant). Let us understand this
with the help of an example.
For instance, a bakery producing bread faces an increase in the price

of inputs such as egg and milk, it will impact the quantity of bread
produced and supplied in the market. The quantity supplied would
definitely decrease because of less profit. This case is an example of
change in quantity supplied. On the other hand, when supply of bread
is increased due to new technological advancements or ovens used by
the bakery, it would be the example of change in supply.
Change in quantity supplied can be measured by the movement on

the supply curve, while change in supply is measured by shifts in
the supply curve. The terms, change in quantity supplied refers to
expansion or contraction of supply, while change in supply means
increase or decrease in the supply. Let us discuss the expansion and
contraction of supply as well as increase and decrease in supply in the
next sections.

84 MICROECONOMICS
4.4.1 EXPANSION AND CONTRACTION OF SUPPLY
A change in the price of a good will cause a movement along the

supply curve, other factors being constant. This movement can be
either expansion or contraction of the supply curve. In such a case,
there will not be any new supply curve drawn. When there are large
quantities of a good supplied at higher prices, it is known as expansion
or extension of supply. On the other hand, contraction of supply
occurs when smaller quantities of goods are supplied even at reduced
prices. This type of movement is also called change in the quantity
supplied of the goods.
Figure 4.3 shows this movement along the supply curve:
S
PX
C S
15
IM
A Expansion
10
B
5
Contraction
0 10 20 30 Supply
M
Figure 4.3: Movement along Supply Curve

Source: Principles of Economics: Deepashree
Point A on the supply curve S is the original price-quantity supplied

N
point at the price ` 10. When the price increases to `15, the quantity
supplied will move upward from point A to point C, reflecting
expansion or more supply at the higher price. When the price lowers
to ` 5, the quantity supplied will move downward from point A to point
B, reflecting contraction or less supply at a lower price.
4.4.2 INCREASE AND DECREASE IN SUPPLY
An increase in supply takes place when a supplier is willing to offer

large quantities of goods in the market at the same price due to various
reasons, such as improvement in production techniques, fall in prices
of factors of production and reduction in taxes. On the other hand,
a decrease in supply occurs when a supplier is willing to offer small
quantities of goods in the market at the same price due to increase in
taxes, low agricultural production, high costs of labour, unfavourable
weather conditions, etc. If there is a change in any determinant of
supply other than the price of the good, it will cause the supply curve
to shift either to the right or to the left.

SUPPLY ANALYSIS 85
INCREASE IN SUPPLY
Consider the supply curve SS in Figure 4.4. At the original price OP,
OX units of the good are supplied.
PX S
S1
P1
S
S
S1
O X X1 Supply
IM
Figure 4.4: Increase in Supply – Right Shift of the Supply Curve
If there is an increase in supply, it will cause the supply curve to shift

right from SS to S1S1. An increase in supply indicates either of the
following situations:
At the original price OP, more units of the good (XX1) are supplied.
M
At a lower price OP1, the same units of the good (OX) are supplied.
DECREASE IN SUPPLY
Consider the supply curve SS again in Figure 4.5:

N
S1
PX
S
P1
S1
S
O X1 X Supply
Figure 4.5: Decrease in Supply – Left Shift of the Supply Curve


86 MICROECONOMICS
If there is a decrease in supply, it will cause the supply curve to

shift left from SS to S1S1. A decrease in supply indicates either of the
following situations:
At the original price OP, fewer units of the good (XX1) are supplied.
At a higher price OP1, the same units of the good (OX) are supplied.
6. If the price of onions falls, the supply curve of onions will:

a. Shift towards right b. Contract
c. Shift towards left d. Expand
7. The entry of more mobile sellers in a market will cause the
supply curve to:
S
IM 8. If the price of coffee increases, then the supply curve of the tea
will:
9. Covid-19 has caused the supply curves of airlines and hotels
to:
M

ACTIVITY
N
Due to Covid-19, the price of gasoline reduced due to reduction in

demand. How does it affect the supply of gasoline in the market?
Explain with the help of an example.
MARKET EQUILIBRIUM: DEMAND AND

4.5
SUPPLY EQUILIBRIUM
Buyers and sellers have different perspectives of price. Buyers
demand a good or a service and pay the price for it, while sellers
receive the price. Therefore, buyers want to pay the lowest possible
price, while sellers want the price to be as high as possible. As the
price of a good increases, the buyers reduce the quantity demanded
along the demand curve. On the contrary, the sellers increase their
quantity supplied along the supply curve with an increase in price.
This conflict between buyers and sellers is sorted out in markets.

A market consists of all arrangements used to purchase and sell a

SUPPLY ANALYSIS 87
specific good or service. Buyers (demanders) and sellers (suppliers)

come together in a market for a good or a service. The market
provides them information about the price, quantity and quality
of the good or service. In doing so, the market reduces the costs of
transaction of a good or service. For instance, you are looking for a
job. One approach is that you go from employer to employer asking for
opening. However, not only this approach is time-consuming, it may
not yield the desired results. A more efficient approach would be to go
to an online job site or classified ads in a local newspaper and look for
job openings. These online job sites and classified ads are elements of
the job market, which reduce your transaction costs by bringing you
closer to potential employers.
Markets allow these forces of demand and supply to coordinate and set
S
the price of a good or a service on their own. These impersonal market
forces are what the economist Adam Smith called the “invisible
hands” of demand and supply. A market where forces of demand and
supply take their own course without any external control on price,
IM
demand or supply is called a free market.
Let’s understand how demand and supply forces strike a balance in

a market. In economic terms, the term equilibrium means a state of
market in which:
Quantity demanded of a good = Quantity supplied of that good

NOTE
In other words, market equilibrium refers to a situation when the
M
quantity supplied equals the quantity demanded at the market price. The equilibrium price is also
called the market-clearing
At market equilibrium, the price and quantity do not tend to change. price because at this price
The price at market equilibrium is called equilibrium price and the there is neither unsold stock
quantity supplied and demanded is called equilibrium quantity. nor unsupplied demand, thus
clearing the market.
N
Let’s understand the concept of market equilibrium with the help

of an example. Table 4.3 shows the demand and supply schedule for
pizza:
TABLE 4.3: MARKET SCHEDULE FOR PIZZA

Price per Quantity Demanded Quantity Supplied Surplus or Effect on
Pizza per Month (in per Month Shortage Price of
(in `) thousands) (in thousands) Pizza
100 80 10 Shortage Rise
200 55 28 Shortage Rise
300 40 40 Equilibrium Stable
400 28 50 Surplus Fall
In the above market schedule, there is only one price of pizza (` 300)
at which demand and supply are at par. At all the remaining prices,
the pizza market is in a state of imbalance between demand and
supply. At all prices below ` 300, demand exceeds supply indicating

88 MICROECONOMICS
the shortage of pizzas in the market. At the prices above ` 300, supply
exceeds demand indicating the surplus of pizzas in the market.
Now this imbalance itself will create the condition for equilibrium
automatically. Let us see how.
The initial price of a pizza is at `100. At this price, the quantity

demanded exceeds the quantity supplied by 70,000 pizzas. This
shortage of pizzas will induce buyers to purchase the desired quantity
of pizzas at a higher price. This gives an incentive to the pizza makers
to raise the price of the pizza in anticipation of a higher profit. This
trend continues till the price of pizza reaches `300. At this price, the
buyers are willing and able to buy 40,000 pizzas, and the sellers are
willing and able to sell 40,000 pizzas. Therefore, `300 is the equilibrium
price where the market forces of demand and supply are in balance.
S
Likewise, at all prices about `300, there is surplus supply of pizzas in
the market, forcing the pizza sellers to reduce the price. Therefore,
fewer pizzas will be supplied in the market. On the other hand, more
customers will be attracted to purchase the pizza at lower price.
IM
Therefore, the price of the pizza continues to fall till it reaches `300
(equilibrium price). This process of interaction between the demand
and supply forces to determine the equilibrium price is called the
market mechanism.
4.5.1 DETERMINATION OF MARKET PRICE

M
Figure 4.6 illustrates how the equilibrium price is determined

graphically. This figure has been obtained by plotting the market
schedule given in Table 4.3. The demand schedule is plotted on the
price axis, while the supply schedule is plotted on the quantity axis.
Consequently, the demand curve DD’ and the supply curve SS’ have
N
been obtained.
D S’
700
600 A B
Surplus
500
400
Price
300 E
200
Shortage
100
S J K D
0
10 20 30 40 50 60 70 80 Q
Quantity
Figure 4.6: Equilibrium in Demand and Supply: Price Determination

(Source: Microeconomics: Theory and Applications by D. N. Dwivedi)

SUPPLY ANALYSIS 89
The demand curve DD’ and the supply curve SS’ intersect at point
E, which is the equilibrium price ` 300. At this price, the quantity
demanded (40,000 pizzas) is equal to the quantity supplied (40,000
pizzas). Therefore:
Equilibrium price = ` 300
Equilibrium quantity = 40,000 pizzas
If the price is set at any price other than the equilibrium price above,
there will be either surplus or shortage of pizzas in the market.
4.5.2 SHIFTS IN MARKET EQUILIBRIUM
The equilibrium point shifts whenever there is a shift in the demand

curve and/or the supply curve. Figure 4.7 shows the effect of shift on
S
the demand curve: IM
D
D S’
M
P
Price
D’’
M
S
D’
O Q N
Quantity
N
Figure 4.7: Shift in Demand Curve and Equilibrium

The original demand curve and the supply curve are DD’ and SS’,
respectively. These two curves intersect at point P. The equilibrium
price is determined at PQ and the equilibrium quantity is determined
at OQ. Now, if the demand curve DD’ shifts to DD”, while the supply
curve remains fixed, then the new intersection point of the two curves
will be M. Thus, the shift in the demand curve will shift the equilibrium
point from P to M. As a result, there will be:
Increase in the equilibrium price – From PQ to MN
Increase
in the equilibrium quantity demanded and supplied –
From OQ to ON
In conclusion, when the demand curve shifts to the right w the supply
curve remains constant, there will be an increase in the equilibrium

90 MICROECONOMICS
price and quantity. Now, let us consider the shift in the supply curve
with the demand curve remaining constant in Figure 4.8:
D
D S’
M
P
Price
D’’
S
D’
O Q N
Quantity
Figure 4.8: Shift in Supply Curve and Equilibrium
S
Consider Figure 4.8. Here, the supply curve SS’ shifts its position
rightward to SS”, with the demand curve DD’ remaining fixed. The
IM
two curves will now intersect at point M instead of point P. Therefore,
point M will be the new equilibrium point. As a result of the shift of the
supply curve, there will be:
Decrease in the equilibrium price – From PQ to MN
Increasein the equilibrium quantity demanded and supplied –
From OQ to ON
M
Table 4.4 summarises the effects of shifts in demand and supply curves
on the equilibrium price and equilibrium quantity:
TABLE 4.4: EFFECT OF SHIFTS

N
Demand Curve Supply Curve Effect on Effect on

Equilibrium Equilibrium
Price Quantity
Shifts Remains constant Increases Increases
Remains constant Shifts Decreases Increases
Shifts less Shifts more Decreases Decreases
Shifts more Shifts less Increases Increases
Shifts in equal measure Shifts in equal measure No change Increases
to supply curve to demand curve
10. `268 is the market-clearing price of cooling fans. At this price:

a. Quantity demanded > Quantity supplied
b. Quantity demanded = Quantity supplied
c. Quantity demanded < Quantity supplied
d. Quantity demanded = 0

SUPPLY ANALYSIS 91
11. If a seller tries to sell cooling fans at lower price than ` 268,
then he will have:
a. Unsupplied demand
b. Neither unsold stock nor unsupplied demand
c. Unsold stock
d. Both unsold stock and unsupplied demand
ACTIVITY
Consider any market and find out the market equilibrium price of
any three items of your choice. What happens to the equilibrium
price?
S
1. If there is an increase in demand, while supply is constant
2. If there is an increase in supply, while demand is constant
IM
3. If there is an increase in both demand and supply in equal
measures
4. If there is a larger increase in demand as compared to increase
in supply
5. If there is a larger increase in supply as compared to increase
in demand
M
Illustrate each case above in the graph showing the effect on

equilibrium price.
4.6 SUMMARY S
N
Supply is defined as the specific quantity of a good that a producer

is willing and able to offer for sale to consumers at a specific price
over a given period, other things being constant.
The determinants of supply are the price of inputs, technology,
price of good substitutes, nature and size of the industry, supplier
expectations, government policy, and other factors.
According to the law of supply, the quantity supplied is usually
directly related to its price and production cost, other factors being
constant.
The supply schedule displays different prices of a good and the
related quantity that is available for sale at those prices over a
given period.
The supply curve is formed by graphically plotting the supply
schedule.
The supply curve has the upward or positive slope.

92 MICROECONOMICS
The law of supply does not apply to future price expectations,

supply of labour, and rate of interest and savings.
The supply curve expands and contracts due to rise and fall in the
price of the good.
The supply curve shifts to the right if there is an increase in supply
due to favourable factors other than price. The supply curve shifts
to the left if there is a decrease in supply due to unfavourable
factors.
KEY WORDS
Supply: The amount of a good that a producer is willing and is

able to yield at a specific price in the given period of time
Transaction costs: The costs of time and information for buyers
S
and sellers to exchange goods or services
Function: A figurative statement of relationship between a
dependent and independent variable
IM
MCQ 1. A trader has 10 bags of sugar in his store. This represents:
a. Supply b. Quantity supplied
c. Effective supply d. Non-supply
M
2. Due to __________, Uber drivers in India are less inclined to

accept rides if they will not be allowed to set a price.
a. equilibrium price b. market-clearing price
c. price ceiling d. price floor
N
3. Price floor can be imposed by:

a. Governments b. Private businesses
c. Banks d. Households
4. According to the law of supply, more goods will be supplied at:
a. Lower price b. Lower demand
c. Higher price d. Higher demand
5. What is generated if the market price is lower than the equilibrium
level?
a. Price ceiling b. Equilibrium price
c. Shortage of good d. Black market
6. If the demand for a good increases and the supply is upward
sloping, it will lead to ____________ in equilibrium price and
______________ in equilibrium quantity.
a. increase, increase b. decrease, increase
c. decrease, decrease d. increase, decrease

SUPPLY ANALYSIS 93
7. If the technology to produce a good improves, then it will:

a. Expand the supply curve
b. Contract the supply curve
c. Shift the supply curve to the right
d. Shift the supply curve to the left
8. Increase in the wages of people will:
a. Shift the supply curve to the right
b. Shift the supply curve to the left
c. Expand the supply curve
d. Contract the supply curve
S
9. If the supply curve shifts to the right while the demand curve
remains constant, the market price of the good will:
a. Drop
IM
b. Rise
c. Not change
d. First rise and then drop
10. If there is a demand curve with a negative slope and a supply
curve with a positive slope, a higher equilibrium price will be
M
caused by:
a. Increase in price of good
b. Increase in demand of good
c. Increase in supply of good
N
d. Increase in substitute good price

?
1. Explain the concept of supply with suitable examples. Which
factors influence supply?
2. Explain the law of supply. Mention its assumptions. Illustrate
using the supply schedule and the supply curve of a good.
3. What do you mean by expansion and contraction of supply?
Which factors lead to movements in supply?
4. What will happen to the supply of a good if the price of its
substitute increases?
5. Explain the concept of market equilibrium using the demand
and supply curves.

94 MICROECONOMICS

4.9
(HOTS) QUESTIONS
1. What happens to the equilibrium price and output when an
indirect tax is imposed on sellers?
a. Higher equilibrium price, more output
b. Lower equilibrium price, less output
c. Lower equilibrium price, high output
d. Higher equilibrium price, less output
2. The Indian government decides to pay a subsidy to natural gas
producers. As a result, the producers will:
S
a. Increase the supply of natural gas
b. Decrease the supply of natural gas
c. Supply more quantity of natural gas
IM d. Supply less quantity of natural gas
3. At a price of ` 5000, a microwave oven manufacturer is willing to
produce 20,000 units in each quarter. If the price is increased to
` 6300, then the manufacturer may produce:
a. 20,000 units per quarter
b. 19,000 units per quarter
M
c. 21,000 units per quarter

d. It is impossible to predict the effect.
4. Both the equilibrium price and output will rise when:
N
a. Both the demand and the supply increase, but the rise in de-
mand is more than that in supply
b. Both the demand and the supply increase, but the rise in de-
mand is less than that in supply
c. Both the demand and the supply decrease, but the drop in
demand is more than that in supply
d. Both the demand and the supply decrease, but the drop in
demand is less than that in supply
Topic Q. No. Answer

Concept of Supply 1. c. willing, able
2. d. All of these

SUPPLY ANALYSIS 95
Topic Q. No. Answer

Law of Supply 3. c. increase
4. a. positive
5. d. upward
Movement and Shift in Supply 6. d. Contract
7. a. Shift towards right
8. c. Shift towards left
9. b. Contract
Market Equilibrium: Demand 10. b. Quantity demanded =
and Supply Equilibrium Quantity supplied
11. a. Unsupplied demand
S
Q. No. Answer
IM
1. d. Non-supply
2. c. price ceiling
3. a. Governments
4. c. Higher price
5. a. Price ceiling
M
6. a. increase, increase
7. c. Shift the supply curve to the right
8. b. Shift the supply curve to the left
9. a. Drop
N
10. b. Increase in demand of good

1. Supply is defined as the specific quantity of a good that a
producer is willing and able to offer for sale to consumers at a
specific price over a given period, other things being constant.
Refer to Section 4.2 Concept of Supply
2. According to the law of supply, the quantity supplied is usually
directly related to its price and production cost, other factors
being constant. Refer to Section 4.3 Law of Supply
3. A change in the price of a good will cause a movement along the
supply curve, other factors being constant. This movement can
be either expansion or contraction of the supply curve; there will
not be any new supply curve drawn. This type of movement is
also called change in the quantity supplied of the good. Refer to
Section 4.4 Shifts and Movement in Supply

96 MICROECONOMICS
4. If there is a change in any determinant of supply other than

the price of the good, then it will cause the supply curve to shift
either to the right or to the left. Refer to Section 4.4 Shifts and
Movement in Supply
5. The price at which both demand and supply intersect is known
equilibrium price. Refer to Section 4.5 Market Equilibrium:
Demand and Supply Equilibrium

QUESTIONS
Q. No. Answer
1. d. Higher equilibrium price, less output (This is because
S
since the price is fixed too low, there will be surplus de-
mand.)
2. a. Increase the supply of natural gas
3. c. 21,000 units per quarter
IM
4. a. Both the demand and the supply increase, but the rise in
demand is more than that in supply
SUGGESTED READINGS
M
Lipsey, R., & Chrystal, A. (2015). Economics. OXFORD: OXFORD

University Press.
Mceachern, W. (2016). Macroeconomics + mindtap economics,
1-term access. [Place of publication not identified]: South-Western.
N
E-REFERENCES
Supply | Boundless Economics. (2020). Retrieved 13 July 2020,
from https://courses.lumenlearning.com/boundless-economics/
chapter/supply/
The Law of Supply: Explanation, Assumption and Exception. (2020).
Retrieved 13 July 2020, from https://www.economicsdiscussion.
net/law-of-supply/the-law-of-supply-explanation-assumption-
and-exception/13703

C H A
5 P T E R
ELASTICITY OF DEMAND
S
CONTENTS
5.1 Introduction
5.2 Concept of Elasticity of Demand
IM
Activity
5.3 Price Elasticity of Demand
Activity
5.4 Income Elasticity of Demand
M

Activity
5.5 Cross Elasticity of Demand
Activity
N
5.6 Summary

98 MICROECONOMICS
RELATIONSHIP BETWEEN PRICE AND ELASTICITY

OF DEMAND
During the Covid-19 pandemic, there has been a large number of

Case Objective complaints registered against high electricity bills. Electricity bills
for residential, commercial and industrial consumers in Maha-
This caselet describes how
elasticity of demand plays an
rashtra went up as much as 20% last month. This hike came after
important role in our daily life. the Maharashtra Electricity Regulatory Commission (MERC)
increased per unit cost of electricity by 10%. Consequently, there
was a noticeable 2% drop in demand, as some consumers limited
their non-essential use of power. On the other hand, the prices of
packaged foods were also increased by 20% during the Covid-19
lockdown period. However, there was a huge 50% fall in demand,
S
as consumers switched to cooking more at home.
Do you notice the considerable difference in demand in response

to the same percentage of price hike? In this chapter, you will
IM
learn about this concept of elasticity of demand. The changes
observed in the quantity demanded during the pandemic are due
to limited expenditure of people. Therefore, in order to know the
responsiveness of consumers due to the change in determinants
of demand, one can study the elasticity of demand.
M
N

Elasticity of Demand 99
LEARNING OBJECTIVES

>> Explain the concept of demand
>> Describe the price elasticity of demand
>> Discuss the income elasticity of demand
>> Define the cross elasticity of demand
5.1 INTRODUCTION
In the previous chapter, you have studied about the concept of demand Quick Revision
and supply. The chapter also discussed the law of demand and supply
S
in detail. According to the law of demand, if the price of a good rises,
the quantity demanded falls. But by how much? This responsiveness
of demand is what elasticity measures. Elasticity is a measure of how
much the quantity demanded or supplied would be affected by a pro-
IM
portionate change in its determinants. The demand for a good can
be elastic or inelastic. Demand is said to be elastic when the quantity
demanded for a good changes with a change in any of its determinant.
On the other hand, inelastic demand does not change or remains con-
stant with a change in its determinants.
An organisation always considers the elasticity of demand before

determining the prices of different goods. Price elasticity of demand
M
is used to determine how demand for a good changes when its price
changes. It varies from good to good because some goods are more
essential to us than others such as electricity. If the price of electricity
in Maharashtra increases by 20%, there is only 2% drop in demand.
This is because electricity is a necessity to the consumers’ daily life,
N
particularly nowadays when people are staying and working from

home due to Covid-19 pandemic. Such goods where changes in price
result in only modest changes in demand are called inelastic goods.
On the other hand, when the price of packaged foods was increased
by 20%, the demand fell by half. This is because packaged foods are
non-essential consumer goods, which can easily be replaced in daily
life. Such goods are called elastic goods.
This chapter describes the concept of elasticity of demand, including

price elasticity, income elasticity and cross elasticity of demand.
5.2 CONCEPT OF ELASTICITY OF DEMAND ? DID YOU KNOW

The elasticity of demand is the degree of responsiveness of consum- The concept of elasticity was
first introduced by Dr. Alfred
ers to the change in any of the determinants of demand, including Marshall, who is regarded as
price of a good, consumers’ income and price of the substitutes and the major contributor of the
complements of the good. theory of demand, in his book
“Principles of Economics.”

100 MICROECONOMICS
Figure 5.1 displays the demand curve of electricity:
Price
1.92
1.6
Demand
Quantity
98 100
S
Figure 5.1: Demand Curve of Electricity
At the price of ` 1.6 per unit, the quantity of electricity demanded is

IM
100 million units. When the price increases by 20%, from ` 1.6 per unit
to ` 1.92 per unit, the quantity demanded drops by only 2%, i.e., from
100 million units to 98 million units. Electricity is an inelastic good
because changes in price witness only modest changes in the quantity
demanded. Such inelastic goods or services to price tend to be things
of daily use.
M
1. What does the elasticity of demand measure?

a. The rate of change in the price of a good
N
b. The responsiveness of the quantity demanded to change in

price
c. The slope of the demand curve
d. The supply of the quantity in response to change in price
2. The following figure shows two demand curves. Da is the
demand curve for cheese in France, while Db is the demand
curve for cheese in Belgium. At the price of $10, the quantity
of cheese demanded in both countries is 60 units. As the price
drops to $5, the change in demand is more in France as com-
pared to Belgium. From this situation, you can say that the
demand for cheese is:
Price/Unit
$10
$5 Db
Da
Q/Time
0 60 100


a. Equally elastic in both countries

b. Equally inelastic in both countries
c. More elastic in France than in Belgium
d. Less elastic in France than in Belgium
ACTIVITY
Consider the demand for a holiday package to Thailand. Post Covid-

19, the price of the holiday package has witnessed a drop. What is
likely to happen to its demand? Show this on a demand curve.
5.3 PRICE ELASTICITY OF DEMAND
S
The price elasticity of demand measures the responsiveness of the
quantity demanded of a good to change in its price, when other deter-
minants of demand are constant. In other words, it can be defined as MARK IT!
IM
the ratio of the percentage change in quantity demanded to the per- The demand for a good can be
centage change in price. elastic or inelastic, depending on
the rate of change in the demand
with respect to change in the
MEASUREMENT OF PRICE ELASTICITY OF DEMAND price of the good.
The formula for calculating the price elasticity of demand is as follows:
∆Q
M
Percentage change in quantity demanded Q NOTE

ep = =
Percentage change in price ∆P ed is the elasticity coefficient
that describes the elasticity of
P the demand curve.
Where,
N
ep= Price elasticity of demand
P = Initial price
ΔP = Change in price
Q = Initial quantity demanded
ΔQ = Change in quantity demanded
Example 1: Assume that a business firm sells a good at the price of `

450. The firm has decided to reduce the price of the good to ` 350. Con-
sequently, the quantity demanded for the good rose from 25,000 units
to 35,000 units. In this case, the price elasticity of demand is calculated
as follows:
Here,
P = ` 450

102 MICROECONOMICS
ΔP = ` 100 (a fall in price; ` 450 – ` 350 = ` 100)
Q = 25,000 units
ΔQ = 10,000 (35,000 – 25,000) units
By substituting these values in the above formula, we get:
10,000
Percentage change in quantity demanded
e p= = 100
Percentage change in price 450
25,000
= 9/5 = 1.8
Thus, the absolute value of elasticity of demand is greater than 1.
S
The extent of responsiveness of demand with change in the price does
not remain the same under every situation. Therefore, price elasticity
of demand is grouped into five main categories, which are shown in
IM
Figure 5.2:
Perfectly Elastic Demand
Perfectly Inelastic Demand

M
Relatively Elastic Demand
Relatively Inelastic Demand

N
Unitary Elastic Demand
Figure 5.2: Types of Price Elasticity
Let us study about these different types of price elasticity of demand

in detail.
Perfectly elastic demand: When a small change (rise or fall) in
the price results in a large change (fall or rise) in the quantity de-
manded, it is known as perfectly elastic demand. Under such type
of elasticity of demand, a small rise in price results in a fall in de-
mand to zero, while a small fall in price causes a rise in demand
to infinity. In such case, the demand is perfectly elastic or Elastic-
ity of Demand =∞.The extent or degree of elasticity of demand
defines the shape and slope of the demand curve. Therefore, the
elasticity of demand can be determined by the slope of the demand

curve. Flatter the slope of the demand curve, higher the elasticity
of demand. In perfectly elastic demand, the demand curve is rep-
resented as a horizontal straight line (in parallel to X-axis), which
is shown in Figure 5.3:
Price
D D
S
O Q1
IM Q2
X
Quantity
Figure 5.3: Perfectly Elastic Demand

In Figure 5.3, DD is the demand curve, the price of a good is shown
on Y-axis and the quantity of the good is shown on X-axis. When
M
the price of the good is fixed at OD, the demand for good rises from
OQ1 to OQ2. In such case, a slight fall in price will result in the rise
of demand to OX, whereas a slight rise in price will bring demand
to zero.
N
Example 2: If the demand schedule for gold jewellery is as follows:

Price of Gold Jewellery (in Quantity Demanded (per month,
thousand ` per gram) in grams)
75 120
75.02 100
Here,
ΔP = 75.02 – 75 = 0.02 ≈ 0
And,
ΔQ = 100 – 120 = –20
Let us calculate the price elasticity of demand as:
∆Q −20
Percentage change in quantity demanded Q
ep = = = 100 =∞
Percentage change in price ∆P 0
P 75

104 MICROECONOMICS
Perfectly inelastic demand: When a change (rise or fall) in the

price of a good does not bring any change (fall or rise) in the
quantity demanded, demand is called perfectly inelastic demand.
In this case, the elasticity of demand is zero and represented as
ep = 0. Graphically, perfectly inelastic demand curve is represent-
ed as a vertical straight line (parallel to Y-axis).
Figure 5.4 shows the perfectly inelastic demand curve:
Y D
Price
P1
P2
S
D
O Q1 X
Quantity
IM
Figure 5.4: Perfectly Inelastic Demand
In Figure 5.4, DD is the demand curve. Thus, it can be observed
that even when there is a change in the price from OP1 to OP2, the
quantity demanded remains the same at OQ1.
Example 3: The demand schedule for insulin consumed by diabetic
patients is as follows:
M
Price of Insulin (in `/unit) Quantity Demanded (Units/month)

2000 50
2500 50
N
Here,
ΔP = 2500 – 2000 = 500
And,
ΔQ = 50 – 50 = 0
∆Q 0
ep = = = 50 =0
P 2000
Note that the price elasticity of demand for insulin is 0. It means

that the demand for insulin is perfectly inelastic because a patient
will consume the prescribed number of units of insulin. Whether
cost increases or decreases does not affect the demand for insulin.
Relatively elastic demand: When a proportionate or percentage
change (fall or rise) in price results in greater than the proportion-

ate or percentage change (rise or fall) in the quantity demanded,

demand is said to be relatively elastic demand. In other words, a
change in demand is greater than the change in price. Therefore,
in this case, the elasticity of demand is greater than 1 and repre-
sented as ep > 1. The demand curve of relatively elastic demand is
gradually sloping, which is shown in Figure 5.5:
D
P
P1
D
S
Price
O Q Q1 X
Quantity
IM
Figure 5.5: Relatively Elastic Demand
In Figure 5.5, DD is the demand curve that slopes gradually down
with a fall in price. When price falls from OP to OP1, the demand
rises from OQ to OQ1. However, the rise in demand QQ1 is greater
M
than the fall in price PP1.

Example 4: The demand schedule for air tickets is as follows:
Price of Air Ticket Quantity Demanded
(Per Ticket) (tickets per month)
N
1,00,000 5,000
1,20,000 3,500
Here,
ΔP = 1,20,000 – 1,00,000 = 20,000
And,
ΔQ = 3,500 – 5,000 = –1500
1, 500 3
Percentage change in quantity demanded 5, 000 10 15
ep = = = = = 1.5
Percentage change in price 20, 000 1 10
1, 00, 000 5
Note that the price elasticity of demand for air tickets is greater
than 1. It means that the demand for air tickets is relatively elastic.
Also, it means that the percentage change in quantity demanded is
more than the percentage change in price of air tickets.

106 MICROECONOMICS
Relatively inelastic demand: When a percentage or proportionate

change (fall or rise) in price results in less than the percentage or
proportionate change (rise or fall) in demand, demand is said to be
relatively inelastic demand. In other words, a change in demand is
less than the change in price. Therefore, the elasticity of demand is
less than 1 and represented as ep < 1. The demand curve of relative-
ly inelastic demand is rapidly sloping, which is shown in Figure 5.6:
Y
D
S
P1
Price
D
IM
X
O Q Q1
Quantity
Figure 5.6: Relatively Inelastic Demand

In Figure 5.6, DD is the demand curve that slopes steeply with a
M
fall in price. When price falls from OP to OP1, the demand rises
from OQ toOQ1. However, the rise in demand QQ1 is less than the
fall in price PP1.
Example 5: The demand schedule for milk is as follows:
N
Price of Milk (`/litre) Quantity Demanded (litres)

50 1,000
58 900
Here,
ΔP = 58 – 50 = 8
And,
ΔQ = 900 – 1,000 = –100
∆Q 100
Percentage change in quantity demanded Q 1, 000
ep = = = = 0.625
P 50
Note that the price elasticity of demand for milk is less than 1.
It means that the demand for milk is relatively inelastic. Also, it
means that the percentage change in quantity demanded is less
than the percentage change in price of milk.

Unitary elastic demand: Unitary elastic demand occurs when a

change (rise or fall) in price results in equivalent change (fall or NOTE
rise) in demand. The numerical value for unitary elastic demand According to the law of demand,
is equal to one, i.e., ep =1. The demand curve for unitary elastic as price rises, demand falls.
Therefore, the demand curve
demand is a rectangular hyperbola, which is shown in Figure 5.7:
slopes down to the right. Since
price and quantity move in oppo-
site directions on the demand
Y
curve, the price elasticity of
demand is always negative.
D
Price
P2
P
S
P1
X
O Q2 Q Q1
IM
Quantity
Figure 5.7: Unitary Elastic Demand

In Figure 5.7, DD is the unitary elastic demand curve sloping uni-
formly from left to the right. Here, the demand falls from OQ to
OQ2 when the price rises from OP to OP2. On the contrary, when
M
price falls from OP to OP1, the demand rises from OQ to OQ1.

Example 6: The demand schedule for garments is as follows:
Price of Garment (`/piece) Quantity Demanded (Pieces)
100 200
N
300 600
Here,
ΔP = 300 – 100 = 200
And,
ΔQ = 600 – 200 = 400
∆Q 400
ep = = = 200 =1
P 100
Note that the price elasticity of demand for garment is equal to 1.

It means that the demand for garment is unitary elastic. Also, it
means that the percentage change in quantity demanded is equal
to the percentage change in price of garment.

108 MICROECONOMICS
3. The price elasticity of demand for a good or a service is the

ratio of:
a.
Percentage change in price
Absolute change in quantity demanded
b.
Absolute change in price
c. Percentagechange in price
Absolute change in price
d.
S
4. The elasticity coefficient for an inelastic demand curve is:
a. 1
b. 0
IM
c. Between 0 and 1
d More than 1
5. Which one of the following has the most elastic demand?
a. A pair of slippers
b. A dress from a high-brand store
M
c. A bottle of hair-oil
d. A mirror
N
ACTIVITY
Which type of elasticity is likely to be that of the supply of tickets

for an Indian Premier League (IPL) match? Why do you think it is?
Draw the elasticity curve to explain your reasons.
5.4 INCOME ELASTICITY OF DEMAND

In addition to the price of a good, the demand for the good is also
affected by the consumer’s income. The income elasticity of demand
measures the degree to which the quantity demanded for a good
responds to a change in the consumer’s disposable income, other fac-
tors being constant.
Disposable income or the Disposable Personal Income (DPI) refers to

the amount of money that an individual can spend as per his discre-
tion. DPI is calculated as the amount of money left with an individual

after deducting the personal income tax from personal income of the
individual.
DPI = Personal Income − Personal Income Taxes
For example, suppose your income increases by 5%. Now let us con-
sider how this percentage change in income will affect your demand for
two goods, salt and clothing. Due to increase in income, your demand
for clothing will increase relatively more than that for salt. This is
because salt is an item of necessity. An increase or decrease in your
income will not affect your consumption of salt. However, an increase
of income may persuade you to spend more on clothing so that your
dressing style reflects your improved lifestyle. Therefore, you can say
that clothing has more income elasticity of demand (responsiveness of
S
demand) as compared to salt.
Thus, income elasticity of demand enables you to compare the respon-

siveness (or sensitivity) of demand for various goods from the same
IM
change in income. From this definition, the formula of income elastic-
ity of demand for a good with respect to change in income is:
Percentage change in quantity demanded ∆Q / Q M ∆Q

ei = = = .
Percentage change in income ∆M / M Q ∆M
In the above equation,

M
M = Disposable money income
∆M= Change in disposable income
Q = Quantity demanded of the good

N
∆Q = Change in quantity demanded for the good
A notable difference between the price elasticity of demand and income

elasticity of demand is that the former is negative (except for Giffen
goods), whereas the latter is positive due to a positive relationship
between income and quantity demanded. However, in case of inferior
goods, the income elasticity of demand is negative. This is because
as the consumer’s income increases, his demand for inferior goods
decreases, as he/she replaces them with superior goods. For exam-
ple, when the income of a household increases, the household mem-
bers will start to buy more of rice and wheat (normal goods) rather
than bajra, ragi, etc. (inferior goods). Similarly, when the income of a MARK IT!
household increases, the members will start to use more of train and
airlines services and less of bus service for travelling long distances. Goods are not inferior or
superior rather the inferiority or
superiority of goods is decided
For normal goods (such as rice, wheat, clothing, cigarettes, etc.), the by consumers based on their
income elasticity of demand is positive. This is because the percent- income level, perceptions and
age increase in income causes a percentage increase in the quantity preferences.

110 MICROECONOMICS
demanded for a normal good and vice versa. Therefore, as income

rises, there will be an outward shift of the demand curve in the case of
normal goods.
However, for an inferior goods (such as bajra, poor quality rice, cheap
alcohol, artificial jewellery, etc.), the income elasticity of demand is
negative. This is because the percentage increase in income causes a
percentage decrease in the quantity demanded for inferior goods and
vice versa.
EXHIBIT
Types of Normal Goods
Normal consumer goods can be divided into three main groups:
S
Necessities: These are normal goods and services, which con-
sumers will buy irrespective of change in their income. Exam-
ples include water, electricity, etc. An increase in income will
IM result in less than a proportionate increase in the quantity de-
manded of necessities. Therefore, the coefficient of income elas-
ticity is between 0 and 1.
Comforts: If necessities make life possible, then comforts make
life pleasant and easy. Thus, comforts are those normal goods
and services, which are less urgent than necessities. Examples
include healthy and tasty meals, a well-furnished house, cloth-
M
ing for different occasions, television, mobile phone, Internet

service, etc. An increase in income will result in almost a pro-
portionate change in the quantity demanded of comfort goods.
Therefore, is equal to 1 in case of comforts.
Luxuries: These are normal goods that are merely purchased
N
to satisfy vanity or show off as status symbols. Examples include

expensive luxury brand clothes and accessories, rich cuisines,
luxury cars, big mansions, costly art and several domestic ser-
vants. The income elasticity of demand is greater than 1. There-
fore, as income increases, it will cause more than proportionate
increase in the demand for luxury goods.
The following table summarises the income elasticity of all types of

goods:
Type of goods Income Elasticity of Demand

Normal goods > 0 (Positive)
Necessity Between 0 and 1
Comfort 1
Luxury >1
Inferior goods < 0 (Negative)

Note that the above categories of goods are not rigid and fixed. The
income elasticity of demand may vary from household to household,
time to time and location to location, as per the consumers’ tastes and
preferences, levels of consumption, income levels and vulnerability to
‘show off.’ Another factor that may affect the normal pattern of income
elasticity is the frequency of increase in the consumers’ income. If
the income increases regularly and frequently, then income elasticity
will follow the general trend, otherwise not. Firms use the concept of
income elasticity to:
Predictthe future demand for goods, given the rate of increase in
income and income-elasticity of demand for the goods
Define whether a good is normal or inferior. A normal good is the
one whose income elasticity is positive for all levels of income,
S
whereas an inferior good is the one for which income elasticity is
negative after a specific income level.

IM
6. The disposable income of the Khatri family increases from
` 5000 to ` 15,000. As a result, the family’s demand for milk and
milk goods has increased from 30 litres to 60 litres per month.
What is the income elasticity of demand?
a. 2.25 b. 0.5
c. 0.25 d. 1
M
7. Which good below will likely have a negative income elastici-

ty?
a. Ghee b. Butter
c. Soybean oil d. Margarine
N
ACTIVITY
What is the income elasticity of demand for cricket in India? Com-

pare it with other sports, such as gilli-danda and golf. Explain the
reasons for your answer. NOTE
The concept of cross elasticity
of demand helps organisations
5.5 CROSS ELASTICITY OF DEMAND in forecasting the effect of
change in the price of a good on
The cross elasticity of demand can be defined as a measure of a pro- the demand for its substitutes
portionate change in the demand for goods as a result of change in the and complementary goods.
price of related goods. In the words of Ferguson, The cross elasticity Thus, it helps in making pricing
decisions by determining the
of demand is the proportional change in the quantity demanded of good
expected change in the demand
X divided by the proportional change in the price of the related good Y. for its substitutes and comple-
mentary goods. Moreover, it
The cross elasticity of demand is the measure of the responsiveness helps an organisation to antici-
of demand for a good to the changes in the price of its substitute and pate the degree of competition in
complementary goods, with other determinants being constant. If the the market.

112 MICROECONOMICS
given good is X and its substitute or complementary good is Y, then

the formula of cross elasticity of demand for X with respect to Y is:
% change in quantity demanded for X ∆Q X /Q X P ∆Q X
eX ,Y = = = Y .
% change in price of Y ∆PY /PY QX ∆PY
Similarly, the formula of cross elasticity of demand for Y with respect

to X is:
% change in quantity demanded for Y ∆Q Y /Q Y P ∆Q Y
eY , X = = = X.
% change in price of X ∆PX /PX QY ∆PX
Let us consider the cross elasticity of demand for two substitute
goods, such as tea and coffee. Suppose the price of tea increases from
` 225 to ` 235 per kg. As a result, the demand for coffee increases from
S
20,000 kg to 30,000 kg per week, the price of coffee remaining constant.
By substituting these values in the above equations, you get the cross
elasticity of demand for coffee with respect to tea, as follows:
PT ∆QC 225 –1000
IM
eC ,T = . = . = 11.25
QC ∆PT 20000 –10
Note that cross elasticity of demand for substitute goods will always
be positive. This is because an increase in the price of one good will
lead to an increase in the demand for the other. If the price of tea
increases, there will be fall in its demand, as consumers would readily
M
substitute it for coffee. Thus, the percentage increase in the price of

tea will cause the quantity demanded of coffee to move in the same
direction. Therefore, the coefficient of cross elasticity of demand for
substitutes is positive.
Now, let us consider cross elasticity of demand for two complementary

N
goods, such as bread and butter, electricity and electrical gadgets, pet-
rol and car, etc. The cross elasticity of demand for these complemen-
tary goods is always negative. This is because an increase in the price
of one good will lead to a decrease the demand for its complementary
good(s). For example, if the price of bread increases, then there will be
a drop in the quantity demanded of bread as well as in the quantity
demanded of butter. Thus, a change in the price of one good will cause
the quantity demanded of its complements to move in the opposite
direction. In conclusion, you can derive the following results:
If cross elasticity of demand between any two goods is positive,
these goods are substitutes. The higher their (positive) cross elas-
ticity, the closer the substitutes are to each other.
If cross elasticity of demand between two goods is negative, these
goods are complements for each other. The higher their (negative)
cross elasticity, the higher their degree of complementarity.
If cross elasticity of demand between two goods is zero, these
goods are unrelated to each other.

8. If petrol and car are two complementary goods P and C what

is cross elasticity of demand for petrol with respect to car?
PC ∆Q P PC ∆Q P
a. ∆P . ∆P b. Q . ∆P
C P P C
PC ∆QC PP ∆Q P
c. Q . ∆P d. Q . ∆P
P P C C
9. The cross-elasticity of demand for petrol and car is:

a. Always less than zero b. Always zero
c. Always between 0 and 1 d. Always 1
S
ACTIVITY
IM
Consider any toothpaste. Identify its substitutes and complements.
Explain how cross elasticity of demand will affect the quantity
demanded of toothpaste with respect to its substitutes and comple-
ments.
5.6 SUMMARY S
M
The elasticity of demand is the degree of responsiveness of con-

sumers to the change in any of the determinants of demand, in-
cluding price of a good, price of the substitutes and complements
of the goods and consumers’ income.
Elasticity of demand is an important indicator of how total reve-
N
nues of a firm change when a change in the price of a good induces

changes in quantity along the demand curve.
The price elasticity of demand measures the responsiveness of the
quantity demanded of a good to the change in its price, when other
determinants of demand are constant.
The five main type of prices elasticity of demand are perfectly in-
elastic demand (demand is completely unresponsive to a change
in price), inelastic demand (demand is not very responsive to a
change in price), unitary elastic demand (demand responds pro-
portionately to a change in price), elastic demand (demand is very
responsive to a change in price) and perfectly elastic demand (de-
mand is completely responsive to a change in price).
The income elasticity of demand measures the degree to which the
quantity demanded of a good responds to a change in the consum-
er’s income, other factors being constant.

114 MICROECONOMICS
The cross elasticity of demand is the measure of the responsive-

ness of demand for a good to the changes in the price of its substi-
tute and complementary goods, while other determinants being
constant.
KEY WORDS
Cross elasticity: The responsiveness of demand of one good to

a change in the price of another good
Elasticity: A measure of the responsiveness of demand (or sup-
ply) of a good to change in price, consumer’s income, price of
substitutes and other factors
Giffen goods: The low-income, non-luxury goods that are con-
sidered to be the opposite of the normal goods
S
Point elasticity: A measure of price elasticity of data is continu-
ous and allows only marginal changes
Total revenue: The amount of money a business firm receives
IM
on the sale of a good (disregarding total costs)

MCQ 1. The price of onion decreases by 20%. This results into a 10% in-
crease in its demand. What is the price elasticity of demand for
the onion?
M
a. 1
b. 2
c. 0.5
N
d. 10
2. A drop in the price of lemons from ` 100 per kg to ` 60 per kg in-
creases the quantity demanded from 1.75 to 7 kg per week. The
price elasticity of demand is
a. 7.5
b. 0.13125
c. 7.6
d. 0.133
3. If a 10% increase in the price results in _________ decrease in the
quantity demanded, then the price elasticity of demand is 5.
a. 2%
b. 15%
c. 20%
d. 50%

4. If the price elasticity is between 0 and 1, demand is:

a. Perfectly elastic
b. Perfectly inelastic
c. Relatively inelastic
d. Unitary elastic
5. The following demand curve illustrates the demand for a good
that has:
Price (dollars per unit)
S
D
O Quntity (units)
IM

a. Zero price elasticity of demand at all prices
b. Infinite price elasticity of demand
c. Different price elasticity of demand at all prices
d. Unit price elasticity of demand at all prices
M
6. The following demand curve belongs to which good?

Price (dollars per unit)
D
O Quntity (units)

a. Elasticity coefficient = 0
b. Elasticity coefficient = 1
c. Elasticity coefficient = 2
d. Elasticity coefficient = Infinity
7. Which of the following is not a possible base for calculating the
elasticity of demand?
a. Income of the consumer
b. Variable cost to consumer

116 MICROECONOMICS
c. Price of the goods

d. Price of related goods
8. Which good below has likely the least elastic demand?
a. Toothpicks
b. Diamond jewellery
c. Sports Utility Vehicles
d. iPhones
9. Income elasticity is negative for _____________ goods.
a. Normal
b. Complementary
S
c. Premium
d. Inferior
10. If the cross elasticity of demand between two goods is positive,
IM
then it means:
a. The goods are substitutes
b. The goods are complements
c. The demand for both goods is price elastic
d. The demand for both goods is price inelastic
M
? 5.8 DESCRIPTIVE QUESTIONS

1. Explain the concept of elasticity of demand with suitable exam-
ples. What are its applications?
N
2. Write a note on price elasticity of demand. Explain different

types of price elasticity of demand with the help of graphs.
3. Write a brief note on income elasticity of demand with suitable
examples.
4. Write a note on cross elasticity of demand between:
a. Butter and margarine
b. Bread and butter

5.9
(HOTS) QUESTIONS
1. A and B are two products. An economist calculates the cross-elas-
ticity of demand between A and B as 0.7. What kind of goods are
A and B?
a. Complements
b. Substitutes

c. Unrelated
d. Inferior
2. From the cross-elasticity of demand which two goods are the
closest substitutes to each other?
a. Tetley tea and Nescafe coffee (et,c= 7.3)
b. Tetley tea and Tata salt (et,t= 0)
c. Nescafe coffee and Bru coffee (ec,c= 22.9)
d. Amul milk and Nescafe coffee (ec,M= –5.3)
3. If a 4% increase in the price of soybean oil lowers the total reve-
nue received by the producers of soybean oil by 4%, the demand
for soybean oil:
S
a. Has an elasticity of 2 b. Is unitary elastic
c. Is elastic d. Is inelastic
4. The cross elasticity of demand between Mother Dairy milk and
IM
Amul milk is:
a. Positive, thus they are complements
b. Negative, thus they are complements
c. Positive, thus they are substitutes
d. Negative, thus they are substitutes
M

N
Topic Q. No. Answer

Concept of Elasticity of 1. b. The responsiveness of the quan-
Demand tity demanded to change in price
2. c. More elastic in France than in
Belgium
Price Elasticity of De- 3. % change in quantity demanded
mand a.
% change in price
4. c. Between 0 and 1
5. b. A dress from a high-brand store
Income Elasticity of 6. b. 0.5
Demand (Hint:
ei =
Percentage change in income
∆Q 60 − 30 30
Q 30 30
= = = = 0.5)
∆P 15, 000 − 5, 000 10, 000
P 5, 000 5, 000

118 MICROECONOMICS
Topic Q. No. Answer

7. d. Margarine
Cross Elasticity of De- 8. PC ∆QP
b. .
mand Q p ∆PC
9. a. Always less than zero

Q. No. Answer
1. c. 0.5
(Hint:
S
Percentage change in quantity demanded of onions
ep for onion=
Percentage change in price of onions
10%
= =0.5)
20%
IM
2. a. 7.5
7 − 1.75
(Hint: e p for lemons = 1.75
60 − 100
100
5.25
M
5250
= 1.75 = = 7.5)
−40 1750
100
3. d. 50%
N

(Hint: e p =
Percentage change in price of onions
Percentage change in quantity demanded .
5=
10%
Percentage change in quantity demanded = 50% )
4. c. Relatively inelastic
5. d. Unit price elasticity of demand at all prices
6. a. Elasticity coefficient = 0
7. b. Variable cost to consumer
8. a. Toothpicks
9. d. Inferior
10. a. The goods are substitutes


1. The elasticity of demand measures the degree of responsive-
ness of consumers to the change in any of the determinants of
demand, including price of a good, price of the substitutes and
complements of the good and consumers’ income. Refer to Sec-
tion 5.2 Concept of Elasticity of Demand
2. Price elasticity of demand measures the responsiveness of the
quantity demanded of a good to the change in its price, when
other determinants of demand are constant. Refer to Section 5.3
Price Elasticity of Demand
3. Income elasticity of demand measures the degree to which the
quantity demanded of a good responds to a change in the con-
sumer’s income, other factors being constant. Refer to Section
S
5.4 Income Elasticity of Demand
4. Cross elasticity of demand is the measure of the responsiveness
of demand for a good to the changes in the price of its substitute
IM
and complementary goods, with other determinants being con-
stant. Refer to Section 5.5 Cross Elasticity of Demand

QUESTIONS
Q. No. Answer
M
1. b. Substitutes
2. c. Nescafe coffee and Bru coffee (ec,c = 62.9)
3. c. Is elastic
4. c. Positive, thus they are substitutes
N
SUGGESTED READINGS
Boyes, W., Melvin, M., &Madariaga, B. (2008). Micro economics.
Boston: Houghton Mifflin.
Deepashree, D. (2011). Principles of micro economics. [Place of
publication not identified]: Ane Books.
Taylor, J., &Weerapana, A. (2012). Microeconomics. [Mason, Ohio?]:
E-REFERENCES
(2020).Retrieved 17 July 2020, from https://www.intelligentecono-
mist.com/price-elasticity-of-demand/

120 MICROECONOMICS
(2020).Retrieved 17 July 2020, from https://www.pearsonschool-

sandfecolleges.co.uk/Secondary/BusinessAndEconomics/14-16/
OCRGCSEEconomics/Samples/Samplechapters/GCSEOCREco-
nomicsChapter1.pdf
Price Elasticity of Demand. (2020). Retrieved 17 July 2020, from
https://www.investopedia.com/terms/p/priceelasticity.asp
S
IM
M
N

C H A
6 P T E R
ELASTICITY OF SUPPLY
S
CONTENTS
6.1 Introduction
6.2 Concept of Elasticity of Supply
IM
6.2.1 Types of Elasticity of Supply
6.2.2 Factors Determining Elasticity of Supply
Activity
6.3 Measurement of Elasticity of Supply
M
Activity
6.4 Summary
N


122 MICROECONOMICS
CHANGE IN ELASTICITY OF SUPPLY DUE TO PRICE

RISE
Suppose an apartment in Bengaluru rents for ` 15,500 per month.

Case Objective At this price, 10,000 units of apartments are rented as shown in
Figure 6.1:
This caselet introduces the
concept of elasticity of supply.
18000
17000
S
Price (` /month)
16000 H
15000
14000
A
IM 13000
12000
11000
10000
5 10 15 20
M
Quantity (1000 of rental units)
Figure 6.1: Supply Curve for Apartments

N
When the price increases from ` 15,500 to ` 16,000 per month,

13,000 more apartments are supplied into the market. By what
percentage does the apartment supply increase? How sensitive
is the supply of apartments in Bengaluru in response to the price
change? All these questions are answered by determining the
elasticity of supply of the apartments.

ELASTICITY OF SUPPLY 123
LEARNING OBJECTIVES

>> Explain the concept of elasticity of supply
>> Describe the types of elasticity of supply
>> State the factors determining elasticity of supply
>> Explain the measure(s) of elasticity of supply
6.1 INTRODUCTION
In the previous chapter, you have studied about the elasticity of de- Quick Revision
mand. Elasticity is a measure of how much the quantity demanded
S
or supplied would be affected by a proportionate change in its deter-
minants. In this chapter, you will study about the elasticity of supply.
According to the law of supply, if the price of a commodity increases,

IM
its quantity supplied will increase in the market. But by how much will
it increase? This is measured by the elasticity of supply. To put simply,
the elasticity of supply is a measurement of change in the quantity
supplied with a certain change in the price of a product. The concept
of elasticity of supply helps organisations to estimate the impact of
change in the supply of a product with respect to its price. Different
goods have different degrees of elasticity of supply. The elasticity of
supply is influenced by a number of factors such as nature of a good,
M
production technology, scale of production and time period.
Thus, the elasticity of supply is a responsiveness of quantity supplied

with respect to a change in the price of a product. This chapter de-
scribes the concept of elasticity of supply. You will study the different
N
types of elasticity of supply and its determinants. The chapter also

discusses how to measure the elasticity of supply.
6.2 CONCEPT OF ELASTICITY OF SUPPLY

The elasticity of supply is a measure of the degree of change in the
quantity supplied of a product in response to a change in its price.
The elasticity of supply measures the degree to which the quantity
supplied of a commodity will respond to a price change, while all other
factors being constant. For example, it measures the responsiveness
of the quantity supplied of apartments in Bengaluru in response to a
price rise. Suppose there is a sudden rise in demand of apartments in
Bengaluru, but the apartments are in short supply. As a result, rents
of the available apartments will rise. Consequently, within months,
more apartments will be available for rent/sale in Bengaluru to keep
up with the demand.
Contrast this with another scenario. You wanted to purchase tickets

of a World Cup Semi-final cricket match that was to be held in the

124 MICROECONOMICS
Chinnaswamy Stadium in Bengaluru. However, when you logged on

to the website, all tickets were sold out. The only option was to try and
purchase a ticket from someone else, but this was harder than you
thought. No one was willing to sell you a ticket even at 10-20 times the
original price.
The above two examples indicate the elasticity of supply. The elastic-
ity of supply of a product indicates how quickly its producers will be
willing and able to increase its supply in the market when its demand
and price increase. It measures the percentage change in the quantity
supplied at a given percentage change in price. Mathematically, the
elasticity of supply is expressed as:
Percentage change in quantity supplied of commodity X
es =
Percentage change in price of commodity X
S
Change in quantity (∆S)
Percentage change in quantity supplied =
Original quantity supplied (S)
The elasticity of supply can be calculated with the help of the follow-
IM
ing formula:
∆S P
es = ×
S ∆P
∆S P
es = ×
∆P S
M
Where,
∆S = S1 – S
∆P = P1 – P
N
Example 1: Assume that a business firm supplied 450 units at the price
of ` 4500. The firm has decided to increase the price of the product to
` 5500. Consequently, the supply of the product is increased to 600
units. Calculate the elasticity of supply.
Solution: Here,
P = ` 4500
ΔP = ` 1000 (an Increase in price, ` 5500 – ` 4500 = 1000)
S = 450 units
ΔS = 150 (600 – 450)
150 4500
es = × = 1.5
1000 450

6.2.1 TYPES OF ELASTICITY OF SUPPLY
Similar to the elasticity of demand, the elasticity of supply also does

not remain the same. The degree of change in the quantity supplied of
a product with respect to a change in its price varies under different
situations. Based on the rate of change, the price elasticity of supply
is grouped into five main categories, which are explained as follows:
1. Perfectly inelastic supply: In this situation, the quantity sup-
plied does not change with respect to a proportionate change
in the price of a product. In other words, the quantity supplied
remains constant at the change in price when supply is perfectly
inelastic. Thus, the elasticity of supply is equal to zero (=0). The
supply curve is represented by a straight vertical line, where,
S
Elasticity coefficient, es= 0.
Products with very limited quantities have perfectly inelastic
supply. For example, a rare painting from Leonardo da Vinci is
a product with perfectly inelastic supply. Land can be another
IM
example of a commodity with perfectly inelastic supply.
2. Relatively inelastic supply: When a percentage change in the
quantity supplied is less than the percentage change in the price
of a product, it is called relatively inelastic supply. In this case,
the elasticity of supply is less than 1, i.e., e < 1.
The shape of the supply curve is upward sloping originating from
M
X-axis. An example of a product with relatively inelastic supply

is nuclear power. Given the construction, technical know-how,
and long ramp-up process of nuclear plants, nuclear power has a
long lead time.
N
3. Unit elastic supply: When the proportionate change in the quan-

tity supplied is equal to the proportionate change in the price of
a product, the supply is unitary elastic. In this case, elastic sup-
ply is equal to one (es =1).
The shape of the supply curve is upward sloping originating
from the origin. Here, elasticity coefficient, es = 1. For example,
if the price of the apartment increases by 3%, then the quantity
supplied of apartments also increase by 3%.
4. Relatively elastic supply: When a percentage change in the
quantity supplied is more than a percentage change in the price
of a product, it is called relatively elastic supply. In this case, the
elasticity of supply is greater than 1, i.e., e > 1.
The shape of the supply curve is upward sloping originating from
Y-axis, where elasticity coefficient, es >1. A product that is easy
to make and distribute, such as a fidget spinner, has relatively
elastic supply. There are sufficient resources to make extra fid-
get spinners and the total cost of ramping up or ramping down
production is negligible.

126 MICROECONOMICS
5. Perfectly elastic supply: When a proportionate change (in-

crease/ decrease) in the price of a product results in an increase/
decrease of quantity supplied, it is called perfectly elastic supply.
In such a case, the numerical value of the elasticity of supply will
be infinite (es=∞).
The shape of the supply curve is represented by a horizontal
line, where elasticity coefficient, es=∞). This type of perfectly
elastic supply is an imaginary situation, where even a minimal
change in price would deter producers from supplying even a
single product.
6.2.2 FACTORS DETERMINING ELASTICITY OF SUPPLY
As discussed earlier, the elasticity of supply cannot be same under all
S
circumstances. This is because it is influenced by a number of factors.
Some of the important factors that influence the elasticity of supply
are explained as follows:
IM
Time factor: It affects the elasticity of supply to a great extent.
For instance, in the short run, the elasticity of supply is low due to
various factors such as obsolete production techniques. Therefore,
changes in prices do not affect the supply of products immediately.
If the price remains high for a longer period, the supply of prod-
ucts is increased.
Nature of the product: The product’s nature is an important fac-
M
tor that influences the elasticity of supply. For instance, products

that are perishable in nature have inelastic supply as their supply
cannot be increased or decreased in a short span of time. On the
other hand, products, such as antiques and old wines, which can-
not be reproduced in the same form, have a constant supply.
N
Production capacity: If the production of a product can easily be

increased, its supply will tend to be elastic. If the production ca
pacity is limited, then the supply will be inelastic.
NOTE Production methods: Production techniques used by organisa-
There are no fixed days, tions also have great influence on the supply of their products. If
months or years in short and organisations use the latest techniques of production, the supply
long periods. The time periods can be faster with respect to the change in the price of products. If
depend on the nature of the the production method is complex, the supply of the product will
product. For example:
yyMilk, fish, etc. – For such be relatively inelastic.
perishable products, supply Future price expectation: If the producers of a commodity expect
of 1 week is a short period.
that the price of the commodity will increase in future, they will
yyFood grains, rice, nuts, etc.
– For agricultural products, decrease its quantity supplied in the market. This will make the
supply of 1 year is a short supply inelastic. On the other hand, if they expect the price to fall
period. in future, then they will increase its supply making it elastic.
yyPetroleum products – Supply
of at least 5 years is a short Number of products: If a firm produces several products, the sup-
period. ply of products will be elastic, as the firm can easily switch on to

the production of other goods. On the other hand, if a firm produc-

es only a single product, then its supply will be inelastic.
1. The elasticity of supply measures the responsiveness of:

a. Quantity demanded to changes in price
b. Quantity supplied to change in income
c. Quantity supplied to change in price
d. Quantity demanded to changes in supplier expectations
2. A rare diamond worn by the late actress Elizabeth Taylor will
have the supply curve, which is:
S
a. Upward sloping from X-axis
b. Upward sloping from Y-axis
c. Straight horizontal line
IM
d. Straight vertical line
3. In a relatively elastic supply:
a. % quantity supply changes by a larger percentage than %
price
b. % quantity supply changes by a smaller percentage than %
M
price
c. % quantity supplied is infinite at a given price and zero at
a lower price
d. % quantity supplied is fixed to the change in price
N
ACTIVITY
Consider the cotton industry in India and calculate its price elastic-
ity of supply for the year 2015-16 as compared to the year 2014-2015.
(Hint: You can take the required data i.e., price per bale and sup-
ply/production from the official website of ‘The Cotton Corporation
of India Limited’.)
MEASUREMENT OF ELASTICITY OF
6.3
SUPPLY
An organisation is required to estimate the elasticity of supply for
making various business decisions under different situations such as
deciding the supply of products. Apart from this, the concept of elas-
ticity of supply is helpful for the government in deciding taxation pol-
icies. For instance, high taxes are levied on goods whose supply is in-

128 MICROECONOMICS
elastic to generate large revenues. Thus, a numerical value is required

to measure the elasticity of supply. The two most adopted methods of
measuring the elasticity of supply are explained as follows:
Percentage or Proportionate Method: In this method, the elas-
ticity of supply is calculated by dividing the percentage change
in quantity supplied with the percentage change in the price of a
product. Thus, the elasticity of supply is calculated as follows:
Percentage change in quantity supplied of commodity X
es =
Percentage change in price of commodity X
Change in quantity (∆S)

Percentage change in quantity supplied =
Original quantity supplied (S)
S
The elasticity of supply can be calculated with the help of the
following formula:
∆S P
es = ×
IM S ∆P
∆S P
es = ×
∆P S
Here, es= Coefficient of price elasticity of supply
P = Initial price of the good
M
Q = Initial quantity supplied

∆S = Change in quantity supplied
∆P = Change in price
Where,
N
∆S = S1 – S
∆P = P1 – P
The positive sign indicates a positive relationship between the
price and the quantity supplied. This indicates that the producers
will supply greater units of a commodity only at higher prices and
vice versa.
Example 2: Assume that a business firm supplied 450 units at
the price of ` 4500. The firm has decided to increase the price of
the product to ` 5500. Consequently, the supply of the product is
increased to 600 units. Calculate the elasticity of supply.
Solution: Here,
P = ` 4500
ΔP = ` 1000 (an Increase in price, ` 5500– ` 4500 = 1000)
S = 450 units
ΔS = 150 (600 – 450)


150 4500
es = × = 1.5
1000 450
Example 3: The quantity supplied of a product increases from
1000 units to 2000 units as the price changes from ` 50 to `60 per
unit. In such a case, the elasticity of supply would be calculated as:
P1 = ` 60, P = ` 50, S1 = 2000 units, S = 1000 units
Therefore, ∆S = S1 – S = 2000 – 1000 = 1000 units and ∆P = P1–P
= `60 – `50 = `10
1000 50
es = × =5>1
S
10 1000
Thus, es represents relatively elastic supply.
Point Method: Under this method, the elasticity of supply is mea-
IM
sured at the specific point of supply curve. In this method, we ap-
ply calculus (derivative) on the given supply equation to measure
the responsiveness of quantity supplied with change in price.
Thus, Q= a + bp (supply equation)
Percentage change in quantity

es =
M
P dq
= ×
Q dp
Where,
N
dq p
Slope of Q = = b and es = b ×
dp q
Let us understand how to calculate the price elasticity using supply

equation with the help of below examples:
Example 4: Given: P = 10 + 2Q or Q = (P – 10)/2
Case I
Price = `20
Now calculate the quantity demanded for price of ` 20.
Q = (20 – 10)/2
= 5 Units
p
es = b ×
q
q
20
=2×
5

130 MICROECONOMICS
es = 8 (es > 1 or elastic supply)

Case II
Price = `10
Now calculate the quantity demanded for price `10:
Q = (10 – 10)/2
= 0 units
p
es = b ×
q
10
=2×
0
S
es = ∞ (es =∞ or perfectly elastic supply)

IM 4. At the price of ` 50 per unit, 100 units of a good are supplied. If
the price increases to ` 55 per unit and the quantity increases
to 120 units, what is the elasticity of supply?
a. 1 b. 2
c. 0.2 d. 3
5. Supply is said to be ____________ when e < 1.
M
a. relative elastic supply b. relatively inelastic supply

c. unit elastic d. None of these
ACTIVITY
N
A producer supplies 500 units of a good at a price of ` 5 per unit.

The price elasticity of supply of the good is 2. At what price will the
producer supply 700 units?
S 6.4 SUMMARY
The elasticity of supply measures the degree to which the quantity
supplied of a commodity will respond to a price change, all other
factors being constant.
The elasticity of supply measures the percentage change in the
quantity supplied at a given percentage change in price.
The five main type of elasticity of supply are perfectly inelastic
supply (es = 0), inelastic supply (0 < es < 1), unitary elastic sup-
ply (es =1), elastic supply (1 < es < ∞) and perfectly elastic supply
(es = ∞).

The main determinants of elastic of supply are time factor, nature

of the goods, production capacity, production techniques, stages of
laws of return, future price expectation and number of products
being produced.
The two methods to measure elasticity of supply are the percent-
age method and the point method.
In the percentage method, the elasticity of supply is measured as
the ratio of percentage change in the quantity supplied to the per-
centage change in price.
Under the point method, the elasticity of supply is measured at the
specific point of supply curve. In this method, we apply calculus
(derivative) on the given supply equation to measure the respon-
siveness of quantity supplied with change in price.
S
KEY WORDS
Elasticity of supply: A measure of responsiveness of the quan-

IM
tity supplied for a product with respect to a change in its price
Quantity supplied: The quantity of a good that producers sell at
a particular price willingly
Slope: The surface of which one end or side is at a higher level
than another; a rising or falling surface
M

1. The price of a good increases by 4%. As a result, the quantity
MCQ
supplied increases by 8%. This means that supply is:
a. Perfectly elastic b. Relatively inelastic
N
c. Unitary elastic d. Relatively elastic

2. The supply of a good is likely to be more elastic:
a. If the production method is complicated
b. If inputs are relatively fixed between industries
c. If production capacity can easily be ramped up
d. If there are few producers in the market
3. If the supply curve starts at the origin, its elasticity of supply is:
a. 1 b. Infinite
c. Zero d. Between 0 and 1
4. If at a given unit of time, the producers of a product cannot
change the quantity supplied, irrespective of the price, the sup-
ply in that unit of time has:
a. Unit elasticity b. Infinite elasticity
c. Zero elasticity d. Relative elasticity

132 MICROECONOMICS
5. When es < 1, supply is said to be:

a. Relatively inelastic b. Elastic
c. Inelastic d. Perfectly elastic
6. If a 1% decrease in the price of a litre of petrol results in a larger
percentage decrease in the quantity supplied, then:
a. Supply is relatively elastic
b. Supply is perfectly elastic
c. Supply is relatively inelastic
d. Supply is perfectly inelastic
7. When a proportionate change in the price of a product re-
S
sults in a change in the quantity supplied, then, the supply is
_______________.
a. relatively inelastic b. elastic
IM c. inelastic d. perfectly elastic
8. The price elasticity of supply of a good is 0.7. This means that:
a. Supply is inelastic
b. Supply is elastic
c. Supply is perfectly inelastic
M
d. Supply is perfectly elastic

9. The elasticity of supply of a good is 0.4. Its price increases by
50%. What is the percentage increase in the supply of the good?
a. 20% b. 15%
N
c. 30% d. 50%
10. If es of a good is 2, and a firm supplies 200 units at a price of ` 8
per unit, then at what price will the firm supply 250 units?
a. ` 6 b. ` 7
c. ` 8 d. ` 9

?
1. Explain the concept of elasticity of supply with suitable exam-
ples.
2. Explain the different types of price elasticity of supply.
3. Which factors determine the elasticity of supply, and how?
4. Write a short note on the percentage method of elasticity of sup-
ply.


6.7
(HOTS) QUESTIONS
1. Elasticity of supply will be infinite in case of perfectly elastic sup-
ply of a commodity because:
a. Quantity supplied is less than percentage change in price
b. Quantity supplied expands or contracts to any degree with-
out any change or with minimal change in price
c. Quantity supplied remains constant irrespective of change in
price
d. Quantity supplied is more than percentage change in price
2. If a 15% increase in the price of soybean oil increases its supply
S
from 300 to 345 units, then the elasticity of supply is:
a. 2.4 b. 0.56
c. 0.34 d. 1
IM
3. When the price of Mother Dairy milk rises from ` 20 to ` 30 per
unit, the revenue of Mother Dairy increases from ` 100 to ` 300.
The price elasticity of supply is:
a. 0.4 b. 1
c. 2 d. 3.5
M
4. At a price of ` 4 per unit of a good, the total revenue is ` 480. If the

price of the good is increased by 25%, the total revenue increases
by ` 240. The price elasticity of supply is:
a. 0.4 b. 0.8
N
c. 2 d. 1
Topic Q. No. Answer

Elasticity of Supply 1. c. Quantity supplied to changes in price
2. d. Straight vertical line
3. a. % quantity supply changes by a larg-
er percentage than % price
Measurement of 4. b. 2
Elasticity of Supply Percentage change in quantity supplied
es =
∆S 120 − 100
= S = 100 = 2)
∆P 55 − 50
(Hint: P 50
5. b. relatively inelastic supply

134 MICROECONOMICS
Q. No. Answer
1. d. Relatively elastic
2. c. If production capacity can easily be ramped up
3. a. 1
4. c. Zero elasticity
5. a. Relatively inelastic
6. a. Supply is relatively elastic
7. d. perfectly elastic
8. a. Supply is inelastic
9. a. 20%
S
(Hint:
Percentage change in quantity supplied
es =
IM Percentage change in quantity supplied
0.5 = =
50%
= Percentage change in quantity supplied = 20%
10. d. `9
(Hint:
Percentage change in quantity supplied
M
es =
∆S
= S
∆P
P
N
250 − 200
2= 200
P1
P 1 −8
8
P1 – 8 = 1
P1 = 9)

1. The elasticity of supply measures the degree to which the quanti-
ty supplied of a commodity will respond to a price change, while
all other factors being constant. Refer to Section 6.2 Concept of
Elasticity of Supply
2. The degree of change in the quantity supplied of a product with
respect to a change in its price varies under different situations.
Based on the rate of change, the price elasticity of supply is

grouped into five main categories. Refer to Section 6.2 Elasticity

of Supply
3. The elasticity of supply is affected by the various determinants
like time factor, production capacity, production methods etc.
Refer to Section 6.2 Elasticity of Supply
4. An organisation is required to estimate the elasticity of supply
for making various business decisions under different situations,
such as deciding the supply of products. Refer to Section 6.3
Measurement of Elasticity of Supply

QUESTIONS
S
Q. No. Answer
1. b. Quantity supplied expands or contracts to any degree
without any change or with minimal change in price
2. d. 1
IM
(Hint: Percentage change in quantity supplied = (345-
300)/300 = 15%
Therefore,
Percentage change in quantity supplied 15%
es = = = 1)
Percentage change in price 15%
3. c. 2
M
(Hint: P = 20; P1 = 30
Therefore, ΔP/P = (30-20)/20 = 50%
Revenue = R
R= 100; R1 = 300
N
Q = R/P = 100/20 =5 and

Q1 = R1/P1 = 300/30 = 10
Therefore,
ΔQ/Q = (10-5)/5 = 100%
es = = = 2)
4. b. 0.8
(Hint: P = 4; P1 = 5 (25% increase); ΔP/P = 25%
R = 480; R1 = 480 + 240 = 720
Q = R/P = 480/4 =120 and
Q1 = R1/P1 = 720/5 = 144
Therefore,
ΔQ/Q = (144 – 120)/120 = 20%
es = = = 0.8 )

136 MICROECONOMICS
SUGGESTED READINGS
Friedman, M. (2000). Essays in positive economics. Chicago: Uni-
versity of Chicago Press.
Gillespie, A. (2016). Foundations of economics. Oxford: Oxford Uni-
versity Press.
Samuelson, P., & Nordhaus, W. (2010). Microeconomics. Boston:
McGraw-Hill Irwin.
E-REFERENCES
(2020).Retrieved 30 July 2020, from https://www.nr.edu/eco202/au-
S
thor_pps/pdf/econ2_micro_ch05.pdf
(2020). Retrieved 30 July 2020, from https://www.intelligentecono-
mist.com/price-elasticity-of-supply/
IM
How Does Price Elasticity Affect Supply?. (2020). Retrieved 30 July
2020, from https://www.investopedia.com/ask/answers/040615/
how-does-price-elasticity-affect-supply.asp
M
N

CASE STUDIES
4 TO 6
CONTENTS
Case Study 4 Finding the Demand-Supply Equilibrium for GHI’s Supercam

Case Study 5 The Price Elasticity of Demand for Refined Oils
Case Study 6 Reason Behind OPEC’s Failure to Keep the Oil Price High
S
IM
M
N

138 MICROECONOMICS
CASE STUDY 4
FINDING THE DEMAND-SUPPLY EQUILIBRIUM FOR

GHI’S SUPERCAM
GHI Electrical and Electronics Co. is a Delhi-based company that

Case Objective manufactures various electrical and electronic products. It was
This case study discusses established in the year 2000. It has a workforce of 500 people. Re-
how GHI SUPERCAM cently, GHI introduced a new electronic product into the market.
established its demand-supply The product is a home security camera that can store footage for
equilibrium. two weeks and can be fixed anywhere. The company has named
this camera as SUPERCAM. It has various unique features which
help in keeping homes safe and guarded. The camera has an abil-
ity to recognise family members. If any unknown person tries to
enter a home, it raises an alarm.
S
Since this was a newly introduced product with better features
than its competing products, GHI wanted to determine the price
at which the supply and demand would be equalised. Hence, GHI
analysed that the price of this product should be kept at 1.75 times
IM
the price of its competing products. Therefore, it was initially
priced at `3,500 per piece. At this price, GHI was supplying 10,000
pieces per month.
GHI is a successful and renowned company. Therefore, it thought

that SUPERCAM would be readily accepted in the market and
its demand would actually rise. However, things did not favour
M
GHI and it analysed that the demand for SUPERCAM was only
2,000 pieces per month. During this phase, GHI incurred a huge
amount of loss. To avoid such situations again, GHI reduced the
price of SUPERCAM to `2,800 per piece. Along with it, GHI also
reduced the supply to 7,000 pieces per month. Due to the reduced
prices, the demand went up to 5,000 pieces per month.
N
After this, GHI further reduced the price to `2,500 per piece and
increased the supply to 8,000 pieces per month. At this stage, the
demand and supply of SUPERCAM became equal. GHI also start-
ed earning high profits. It ultimately fixed the price and the sup-
ply quantity of SUPERCAM at `2,500 per piece and 8,000 pieces
per month, respectively.
QUESTIONS
1. After going through the above case study thoroughly,

complete the given table:
Price (in `) Demand Supply Surplus/ Price Rise
Shortage or Fall?
3,500 2,000 10,000 ? ?
? 5000 ? ? ?
2,500 8,000 8,000 ? ?

Case study 4: FINDING THE DEMAND-SUPPLY EQUILIBRIUM FOR GHI’S SUPERCAM 139
CASE STUDY 4
Hint:
Price (in `) Demand Supply Surplus/ Price Rise
Shortage or Fall?
3,500 2,000 10,000 Surplus Fall
2,800 5000 ? ? ?
2,500 8,000 8,000 ? ?
2. What was the price of the competing products of SUPER-
CAM?
(Hint: The price of competing products of SUPERCAM
was `3,500/1.75 = `2,000.)
S
IM
M
N

140 MICROECONOMICS
CASE STUDY 5
THE PRICE ELASTICITY OF DEMAND FOR REFINED OILS
The study analyses the effect of change in Sundrop sunflower oil

Case Objective
and subsequent change in the demand in Delhi NCR (Delhi, Gha-
This case study explains the ziabad, Gurugram, and Faridabad).
effect of percentage change
in the demand of Sundrop
sunflower refined oil with a
BACKGROUND
percentage change in price
and change in the demand of Sundrop is a premium brand of refined oil that is produced and
substitutes. marketed by Agro Tech Foods Ltd. (ATFL). ATFL is associated
to ConAgra Foods, Inc. of US, which is one of the largest food
companies in the world. Sundrop is one of their largest brands,
which started out in 1989 as sunflower oil. Before Sundrop, the
S
edible refined oil market in India was dominated by groundnut
and mustard oil brands. Today, Sundrop offers a wide range of
edible refined oils to suit different lifestyles of a wide variety of
IM
customers in the market.
Although Sundrop is the leader in sunflower species, ATFL has

decided to reduce the price range from the current ` 150-155 per
litre to ` 140-145 per litre. The actual change was introduced in
August 2018 – from ` 151.50 per litre to ` 144.95 per litre. Earlier,
Dhara Tetra was considered to be the most economical edible oil
at the price of ` 143.5 per litre.
M
The species-wise market structure of edible oils in August 2019 is

shown in Table A:
Table A: Species-wise Market Structure of Edible Oils (2018)

N
Segment Quantity Demanded (in metric tonnes)

1. Safflower 250
2. Groundnut 230
3. Sunflower 350
4. Soya 120
5. Mustard refined 500
Total 1450
The brand-wise market structure was as shown in Table B:
Table B: Brand-wise Market Structure of Edible Oils (2018)

Brand Name Segment Quantity Demanded (in
metric tonnes)
1. Saffola Safflower 250
2. Dalda Refined Oil Groundnut 80
3. Postman Groundnut 120

Case study 5: THE PRICE ELASTICITY OF DEMAND FOR REFINED OILS 141
CASE STUDY 5
Brand name Segment Quantity demanded (in

metric tonnes)
4. Vital Soya 120
5. Sweekar Sunflower 50
6. Dhara Mustard 500
refined
7. Sundrop Sunflower 180
Total 1450
The demand for Sundrop oil increased due to shift from other
edible oil species because of the following factors:
Price differential of only ` 1.45/litre
S
Market leadership among edible sunflower oils
Competition among other oil segments
IM
Since Sundrop was the first to reduce the price of edible oils, it
got a major advantage over competition in terms of shift from oth-
er oils. By the year end (until March 2019), the Sundrop brand re-
duced its selling price to ` 143 and even then it continued to gain
the market. Moreover, the company ATFL ran a price offer for
two months, which further reduced the effective price of Sundrop
oil in the market.
M
Table C: Brand-wise Market Structure of Edible Oils (2019)

Brand Name Quantity Demanded (in metric tonnes)
1 Saffola 220
2 Dalda Refined Oil 120
N
3 Postman 60
4 Vital 83
5 Sweekar 87
6 Flora 35
7 Dhara 350
8 Sundrop 250
Total 1205
ANALYSIS
To determine the price elasticity, three points need to be consid-

ered, which are as follows:
1. Availability of substitutes: This is a clear case of substitu-
tion, as evident in this case study.
2. Proportion of income spent: Consider that a family has
the disposable income of ` 4000 and it spends ` 1000 on

142 MICROECONOMICS
CASE STUDY 5
groceries. 20-25% of this amount will be spent on cooking

medium. Therefore, price plays a main role in determining
the type of oil to be purchased. A family of four purchases 5
litres of oil per month (normal consumption).
3. Time period: Demand is generally more elastic in the long
run than in the short run. For example, the average demand
of Sundrop oil was 250 metric tonnes by March 2019, which
increased to 375 metric tonnes by July 2019.
Despite the reduction in the price of Sundrop oil, ATFL compa-

ny’s revenues increased. Before August 2018, the contribution of
Sundrop to the company’s revenues was ` 10,000 for each metric
ton demanded.
S
Therefore, at 180 metric tons, the company’s total earnings were:
180 × 10,000 = ` 1,800,000

IM
After Sundrop reduced its price, the contribution decreased from
` 10,000 to ` 6,000 per metric ton.
However, the earnings of the company increased due to an in-

crease in demand from 180 to 375 metric tons.
Therefore, the company’s total earnings were 375 × 6,000 =

` 2,250,000
M
Thus, the quantity demanded of Sundrop oil increased due to

drop in its price.
Now, since elasticity of price is:

N
∆Q P
ep = ×
∆P Q
Q = 180; ∆Q = 250 − 180 = 70
P = 151.5; ∆P = 151.5 − 144.95 = 6.55

750 51.5
=
ep × = 3.05
6.55 180
RESULT
The price elasticity of demand for Sundrop oil was 3.05 by March
2019.

Case study 5: THE PRICE ELASTICITY OF DEMAND FOR REFINED OILS 143
CASE STUDY 5
CONCLUSION
Since the price elasticity value is considerably larger than 1,

Sundrop oil is highly elastic.
(Source: Managerial Economics-2nd, By Atmanand)
QUESTIONS
1. If the price of Sundrop oil is dramatically increased, then

what effect it would have on total revenue? How can
ATFL increase its total revenues from Sundrop oil?
Hint:
Price Elasticity Change in Price Change in Total
S
Coefficient Revenue
e=0 Increase Increase
Decrease Decrease
e<1 Increase
IM Increase
Decrease Decrease
e=1 Increase No change
Decrease No change
e>1 Increase Decrease
Decrease Increase
M
2. If the price of Sundrop is reduced by 10%, then will the

demand increase or decrease, and by how much percent-
age?
(Hint: In case of elastic demand, a decrease in price (such
as by 10%) leads to an increase in total revenue (by 25%),
N
if the price elasticity of demand is +2.5.)

144 MICROECONOMICS
CASE STUDY 6
REASON BEHIND OPEC’S FAILURE TO KEEP THE OIL

PRICE HIGH
In the 1970s, the Organization of Petroleum Exporting Countries

Case Objective
(OPEC) formed a cartel with the sole purpose of controlling the oil
This case study discusses supply and thereby increasing their income. This case study ex-
different behaviours of supply plains why they found it difficult to maintain a high price of oil in
and demand in the short and the long run, attributing it to the elasticity of demand and supply.
long run.
BACKGROUND
In the 1970s, OPEC decided to increase the world price of oil in

order to increase their incomes. To fulfil this goal, they collective-
ly reduced the quantity of oil supplied. Within a year (from 1973
S
to 1974), the price of oil in the world market shot up by more than
50%. OPEC pocketed the increased income.
Four years later, they applied the same tactic again. From 1978
IM
to 1979, the price of oil increased by 14%. From 1979 to 1980, it
increased by 34%, and then another 34% in 1981. However, the
party was soon going to be over.
The price of oil started to decline by about 10% every year from
1982 to 1985. Divisions crept up among OPEC countries and in
1986, their cooperation to jointly raise the price of oil disintegrat-
M
ed. Consequently, the price of oil fell by about 45%. It was only in
1990 that the price of oil regained the value that it had in 1970, and
that too after adjusting for overall inflation. Since then, the price
of oil remained more or less to that level throughout the 1990s.
N
ANALYSIS
This case study demonstrates different behaviours of supply and

demand in the short and long run.
Short run: The supply of oil is relatively inelastic because it
is not possible to quickly change the quantity of known oil re-
serves and the capacity for oil extraction. The demand for oil
is also relatively inelastic because customers do not instantly
change their purchasing habits in response to the changes in
the price of oil. For example, you are driving a large gas-guz-
zling SUV, and if the price of oil is suddenly increased, then
you will not sell off your vehicle overnight. You will just pay
the higher price for the oil and move on. Therefore, the supply
and demand curves in the short run are steep, as shown in
Figure A:

Case study 6: REASON BEHIND OPEC’S FAILURE TO KEEP THE OIL PRICE HIGH 145
CASE STUDY 6
Price of oil
1. In the short run, when
supply and demand are
inelastic, a shift in supply...
S2
S1
2
P
2. ...leads
to a large –
increase P1
in price.
Demand
0 Quantity of oil
S
Figure A: Oil Market in Short Run
Since both the supply and the demand of oil are relatively in-
elastic, when the supply of oil shifts from S1 to S2, the price of
oil increases significantly from P1 to P2.
IM
Long run: The supply and demand of oil in the long run are
relatively elastic. Supply is elastic because oil producing coun-
tries outside OPEC will respond to high prices of oil by increas-
ing their individual oil exploration capabilities and construct-
ing new extraction capacity. Demand of oil is relatively elastic
in the long run because customers will use oil conservatively.
M
They may switch over from gas-guzzling vehicles to newer,

more efficient cars or even electronic cars. Therefore, the sup-
ply and demand curves in the long run are more elastic. As
Figure B shows, the shift in the supply curve from S1 to S2 will
result in a relatively smaller increase in price from P1 to P2:
N
Price of oil
1. In the long run,
when supply and
demand are elastic,
a shift in supply...
S2
S1
2. ...leads
to a small P2
increase
P1
in price.
Demand
0 Quantity of oil
Figure B: Oil Market in Long Run

146 MICROECONOMICS
CASE STUDY 6
RESULTS
Figures A and B show why OPEC was able to maintain a high

price of oil only in the short run, and not in the long run. When
OPEC countries decided to reduce their oil production, they
shifted the supply curve to the left (as shown in both Figures).
Although each country in OPEC sold less oil, the price of oil in-
creased by so much percentage in the short run that their collec-
tive incomes increased.
On the contrary, both the supply and the demand are more elas-
tic in the long run. Therefore, when OPEC countries reduced the
supply of oil, the same shift on the supply curve from S1 to S2
caused much smaller increase in the price of oil. Therefore, the
S
OPEC countries’ coordinated tactic of reducing the supply of oil
proved to be less lucrative in the long run.
CONCLUSION
IM
Time and again, OPEC still continues and to some extent suc-
ceeded at reducing supply and increasing prices. However, after
being adjusted for overall inflation, the price of oil never touched
its peak value of 1981. Therefore, it is clear from this case study
that increasing oil prices is easier in the short run than in the long
run.
M
(Source: Microeconomics By N. Gregory Mankiw, Mark P. Taylor)
QUESTIONS
1. Explain the impact on the elasticity of demand on the

price of oil in response to Covid-19.
N
(Hint: As the Coronavirus pandemic spread around the

world, the global demand for oil fell sharply. Business clo-
sures, declines in domestic and international travel, and
the lockdowns and quarantines in several countries have
all reduced the demand for oil.)
2. Explain the impact of the elasticity of supply on the price
of oil in Covid-19.
(Hint: In early March 2020, OPEC proposed a 1.5 mbd
production cut for the second quarter of the year. Howev-
er, the next day, the Russian Federation rejected the pro-
posal. Consequently, Saudi Arabia also announced excep-
tional discounts by almost 20% in main markets, causing
30% drop in the price of oil.)

C H A
7 P T E R
CONSUMER DEMAND ANALYSIS
S
CONTENTS
7.1 Introduction
7.2 Utility as a Basis of Consumer Demand
IM
Activity
7.3 Concept of Cardinal Utility
Activity
7.4 Total and Marginal Utility
M

Activity
7.5 Law of Diminishing Marginal Utility
Activity
N
7.6 Consumer Behaviour

Activity
7.7 Consumer Preferences
Activity
7.8 Ordinal Utility Approach – Indifference Curve Analysis
7.8.1 Meaning of Indifference Curve
7.8.2 Marginal Rate of Substitution
7.8.3 Properties of Indifference Curve
7.8.4 Criticism of Indifference Curve
Activity

148 MICROECONOMICS
CONTENTS
7.9 Consumer Equilibrium Effects

7.9.1 Income Effect
7.9.2 Substitution Effect
7.9.3 Price Effect
Activity
7.10 Summary
S
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M
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CONSUMER DEMAND ANALYSIS 149
RELATIONSHIP BETWEEN UTILITY AND

DEMAND BEHAVIOUR
Vani likes to collect sarees and watch plays in theatre. In economic

terms, she derives ‘utility’ from collecting sarees and watching Case Objective
plays. Utility is described as the satisfaction or happiness that an
This caselet introduces the
individual gets from consuming a good or service. concept of consumer choice
and utility.
Suppose Vani measures her own utility with a unit called utils.
The following table shows how many utils she gets by consuming
sarees and plays:
Table: Total Utility
S
Sarees Total utility Plays Total utility
1 22 1 16
2 43 2 31
3 63 3 45
IM
4 81 4 58
5 97 5 70
6 111 6 81
7 123 7 91
8 133 8 100
The first column in the above table shows the quantity of sarees
M
bought, while the second column shows the total satisfaction she
derives from that quantity of sarees. This total amount of satisfac-
tion is called total utility. As you can see, consuming additional
units of sarees increases her total utility, but at a decreasing rate.
The other columns indicate the utility that she would get from
N
watching different units of plays.
Now, Vani has only $56 to spend. The price of sarees is $14 while
that of plays is $7. She has to decide how to spend her income on
these two goods so that she gets maximum satisfaction. What will
be this best combination, which gives her the highest utility pos-
sible? This will depend on her income, price of goods and prefer-
ences. This chapter describes the different approaches to explain
the demand behaviour of consumers like Vani.

150 MICROECONOMICS
LEARNING OBJECTIVES

>> Discuss the concept of utility as a basis of consumer demand
>> Explain the concept of cardinal utility
>> Differentiate between total and marginal utility
>> Describe the law of diminishing marginal utility
>> Discuss the concepts of consumer behaviour and prefer-
ences
>> Explain the concept of indifference curve
>> Describe the effect of income in case of normal goods
>> Explain the price consumption curve in case of normal goods
S
>> Discuss the income and substitution effects of price change
in normal goods
IM
7.1 INTRODUCTION
Quick Revision In the previous chapter, you have studied about the elasticity of sup-
ply and its various measures. It is important for producers to measure
the extent of utility or satisfaction received by a consumer after con-
suming a good in order to estimate the demand for their goods in the
future. A consumer is willing to buy a particular good to satisfy his/
M
her various needs and wants. Thus, it can be said that the demand for
a good is closely related to the level of satisfaction that the consumer
derives from that good.
The level of satisfaction derived by a consumer after consuming a good

or service is called utility. It can be defined as a measure of consum-
N
er satisfaction received on the consumption of a good or service. The

utility of a good differs from one consumer to the other at different
time periods depending on their tastes and preferences, income level,
standard of living, etc. Utility analysis is a systematic process of mea-
suring utility derived by a consumer after the consumption of a good.
It involves analysing factors that influence consumer behaviour for
a particular good. There are two approaches to the measurement of
utility, namely cardinal utility approach and ordinal utility approach.
You will study these approaches in this chapter.
In this chapter, you will study the consumer behaviour by associating

it with the concept of utility. It explains the meaning of utility, includ-
ing the difference between total utility and marginal utility, and be-
tween cardinal and ordinal utility. You will learn about the concept of
indifference curves. You will also learn how consumer’s income and
price changes influence his demand for normal goods. You will also
study the income and substitution effects of price change for normal
goods.

UTILITY AS A BASIS OF CONSUMER

7.2
DEMAND
As you have already studied in the previous chapters, demand is the
willingness or ability of a consumer to pay for a particular good. A
consumer purchases a good willingly as he/she derives utility from
the consumption of that good. Utility can be defined as a measure of
satisfaction received by a consumer on the consumption of a good or
service.
In economics, utility implies that a good has the power to satisfy a

want. However, ‘utility’ is a relative term that has different aspects,
which are explained as follows:
A good may give satisfaction to one individual while be of no use to
S
? DID YOU KNOW
the other. For example, a car can be of utility to an office goer but The concept of utility was
is of no use to a beggar. introduced by Jeremy Bentham
in 1789. He introduced utility as
Similarly, the same good may provide an individual with different a social thought by describing it
IM
levels of satisfaction depending on circumstances. For example, a as “that property in any object
cup of tea in the morning may provide more satisfaction to a con- whereby it tends to produce
benefit, advantage, pleasure,
sumer compared to when consumed at noon. good, or happiness or to prevent
Utilitycan also change with a change in time and place. For ex- the happening of mischief, pain,
evil, or unhappiness to the party
ample, utility from the use of an air conditioner will depend on whose interest is considered.”
whether the individual is in Nagpur during summers or in Sri-
nagar during winters.
M
1. Utility is:
a. The choice for a commodity
N
b. The want-satisfying power of a commodity

c. The quantity demanded for a commodity
d. An objective economic concept
2. The utility of a chocolate chip ice-cream is:
a. The price that you pay for it
b. The use that you have for it
c. The flavour that you select
d. The pleasure that you get from consuming it
ACTIVITY
Define any three wants you have in terms of utility.

152 MICROECONOMICS
7.3 CONCEPT OF CARDINAL UTILITY

Jevons, Menger and Walras introduced utility as the satisfaction that
an individual receives from consuming one commodity. They viewed
utility as a measurable quantity, just as weight, height or temperature.
They thought that it was possible to measure utility derived by each
individual in a society with respect to all commodities available in the
society. Such expression of utility in measurable or cardinal quantity
(which can be expressed in numbers) is called cardinal utility.
Cardinal utility is an actual measure of utility in ‘utils’. It is possible to

compare utils assigned to different goods or services. Cardinal utility
is a subjective measure of utility. For example, the utility gained from
the purchase of a saree by an avid saree-collector like Vani is 22 utils,
S
which is different from that of her friend Radha with a utility level of
11 utils. Similarly, the utility gained from watching a play by Vani will
be different from that of her husband Sachin, who is not a big fan of
the theatre.
IM
In contrast, ordinal utility represents utility from the consumption
of commodities based on a relative ranking of the commodity. For ex-
ample, Vani may prefer to purchase more sarees than suits, while her
friend Radha may prefer to purchase more suits than sarees.
Note that ordinal utility only ranks commodities in terms of more or

M
less preferences, it does not attempt to determine how much one com-
modity is preferred to another. As per the ordinal utility approach,
utility can be measured in relative terms such as less than and greater
than. The approach advocates that consumer behaviour can be ex-
plained in terms of preferences or rankings. For example, a consumer
N
may prefer ice-cream over soft drink. In such a case, ice-cream would
have 1st rank, while 2nd rank will be given to soft drink. Therefore, as
per the ordinal utility approach, a consumer identifies several pairs of
two commodities which would provide him/her the same level of sat-
isfaction. Among these pairs, he/she may prefer one commodity over
the other based on how he/she ranks them in order of utility. This
implies that utility can be ranked qualitatively and not quantitatively.
Modern economists prefer ordinal utility over cardinal utility. This is

because ordinal utility enables an individual to express the relative
satisfaction of a commodity over other commodities. In contrast, car-
dinal utility requires consumers to express the utility of a commodity
in absolute terms, which is not possible in real life. For example, Vani
may not be able to tell that a saree gives 22 utils and a play gives 16
utils. But she can always tell whether a saree gives more or less utility
than a play. This assumption is the foundation of the ordinal theory of
consumer behaviour.

3. Which utility only ranks consumption bundles?

a. Cardinal utility b. Ordinal utility
c. Total utility d. Marginal utility
4. ___________________ provides an actual index on measure of
satisfaction.
a. Total utility b. Ordinal utility
c. Marginal utility d. Cardinal utility
ACTIVITY
S
Express you three wants as cardinal utility and ordinal utility.
7.4 TOTAL AND MARGINAL UTILITY

IM
According to the cardinal utility approach, the utility of a commodity
is expressed in quantitative terms through two measures: total utility
and marginal utility.
Total utility (TU) from a single commodity is defined as the total sat-
isfaction obtained from consuming the given amount of the commod-
M
ity. It is the sum of the utility derived by a consumer from different

units of a commodity or service consumed at a given period of time.
For example, Sachin eats one apple per day. Table 7.1 indicates the TU
that he derives from the consumption of apples:
N
TABLE 7.1: TOTAL UTILITY

Units of apples consumed Total utility of apples
per day (in utils)
0 0
1 10
2 16
3 20
4 22
5 22
6 20
The above table indicates that eating one apple per day gives Sachin a
TU of 10 utils. If he eats four apples and derives 10, 15, 20 and 22 utils
from the successive apples eaten, then
TU = 10 + 16 + 20 + 22 = 68 utils

154 MICROECONOMICS
Thus, the TU can be expressed as an equation as follows:
TUn = U1 + U2 + … + Un
Now, the consumption of 1 apple gives Sachin TU of 10 utils. If he

consumes one more apple, his TU will increase to 16 utils, which is an
increase by 6 utils (16 – 10 utils). Thus, the marginal utility of consum-
ing the second apple is 6 utils, of the third apple is 4 utils, and of the
fourth apple is 2 utils. Thus, marginal utility (MU) can be defined as
the change in TU due to consumption of one extra unit of a commodi-
ty. MU can be expressed through the following equation:
MU = TUn – TUn-1
For example, MU of 1st apple = 10 – 0 = 10 utils
S
MU of 2nd apple = 16 – 10 = 6 utils
Another way to express MU is through the following formula:

IM
∆TU
MU =
∆C
Here, ∆TU Change in total utility
∆C= Change in consumption by one unit

10 − 0
M
Example 1: MU for 1st apple = = 10 utils

1− 0
16 − 10
Similarly MU for 2nd apple = = 6 utils
2−1
Table 7.2 shows the TU and MU of consumption of apples:
N
TABLE 7.2: TOTAL UTILITY AND MARGINAL UTILITY

Units of apples con- Total Utility Marginal Utility
sumed per day
0 0 -
1 10 10
2 16 6
3 20 4
4 22 2
5 22 0
6 20 -2
As the above table shows, the MU declines with an increase in the con-
sumption of apples. This is because after consuming a certain amount

of apples, Sachin’s desire to have more of apples becomes weaker.

This is shown in Figure 7.1:
TUX
22 MUX
Total utility of X
20
Marginal utility of X
16
TUX 12
10
10 8
6
4
2
5 6
0
0 1 2 3 4 5 6 QX 1 2 3 4 QX
−2
Quantity of X Quantity of X MUX
S
Figure 7.1: Total and Marginal Utility
Source: https://global.oup.com/us/companion.websites/9780195336108/pdf/Salvatore_Chap-
ter_3.pdf
In the left figure, the TU increases by smaller and smaller amounts

IM
(indicated by the blue shaded areas). As a result, the MU in the right
figure declines. Since TU remains fixed with the consumption of the
fifth apple, MU is zero at the 5th apple. After the fifth apple, TU de-
clines and MU becomes negative.

M
5. With more units of consumption, TU __________ and MU

____________.
a. increases, increases b. decreases, decreases
c. decreases, increases d. increases, decreases
N
6. When the marginal utility approaches zero, the total utility

reaches a ________ value.
a. negative b. zero
c. maximum d. minimum
ACTIVITY
Draw a TU curve and an MU curve for your consumption of golgap-

pas (pani puri). Identify the saturation point from both the curves.
LAW OF DIMINISHING MARGINAL

7.5
UTILITY
As shown in Figure 7.1, the TU of apples increases as Sachin con-
sumes more of apples. However, his MU will decrease with the con-

156 MICROECONOMICS
sumption of each extra apple. This decrease in MU with an increase

in the consumption of an apple represents the law of diminishing mar-
ginal utility.
According to the law of diminishing marginal utility, with an in-

crease in the consumption of a commodity, there is a decrease in the
marginal utility derived from the consumption of each extra unit of
the commodity. Thus, if Sachin consumes more and more apples per
unit of time, his utility derived from the successive apples will decline,
provided the consumption of other goods remains constant. Why does
this happen?
The utility obtained from a good depends on a consumer’s urgent need

to consume that good. As more and more amount of the commodity
MARK IT! is consumed, the consumer’s need for the commodity will decrease.
S
Therefore, the consumer’s utility derived from the marginal unit goes
The law of diminishing marginal
on declining as he consumes more and more of that unit. For example,
utility is universally true under
the following assumptions: suppose Sachin is hungry and he is offered an apple to eat. He will get
maximum satisfaction from the first apple because the intensity of his
yyThe unit of consumer goods
IM
is a standard such as an hunger is the highest. When he eats a second apple, he will get a lower
apple, a pair of shoes, a satisfaction because his intensity of hunger has reduced. As he goes
cup of tea and a piece of
sandwich,etc. The law may
on eating more apples, the intensity of his hunger goes on declining,
not be valid for extremely and therefore the satisfaction or utility derived from the successive
large or small units of goods. apples goes on decreasing. If he continues to eat apples, he will reach
yyThe consumer’s tastes and a point when his hunger is fully satisfied. Figure 7.1 shows that the
preferences are fixed during saturation point is the fifth apple, which gives him zero utility. Eating
M
the period of consumption. any more apples will give a negative utility in the form of discomfort
yyThe consumption period or stomach problems. This link between the units consumed and the
is continuous. Breaks in
consumption, if any, must be
utility obtained from each successive unit consumed is called the law
appropriately brief. of diminishing marginal utility.
yyThe consumer’s mental
N
condition is normal during Example 2: Consider Table 7.2 again. The total utility increases with
the consumption period. If increase in consumption of apples, but at a decreasing rate. The total
a consumer, for instance, utility reaches maximum at 22 at consumption of 5 apples. At the same
is eating and also drinking time, the marginal utility decreases with an increase in consumption
alcohol, then the utility
of apples. At the consumption of 5th apple, MU = 0. Consumption of
pattern will not be reliable.
the 6th apple yields negative utility and the total utility starts declining.
In some cases, the marginal
utility may initially increase Graphical illustration: Consider Figure 7.1 again. The TUx and MUx
rather than decrease, but it curves are obtained by plotting the data given in Table 7.2. The TUx
does increase eventually. These rises, at a diminishing rate, till the 5th apple is consumed. The MUx
cases are collection of money, curve diminishes and after the 5th apple, it turns negative. This means
collection of rare paintings, etc.
that extra consumption of an apple gives discomfort or disutility.
7. The total utility curve:

a. Constantly rises
b. First rises and then falls after reaching maximum value

c. Is bell-shaped
d. First falls and then rises after reaching zero
8. Total utility is maximum when marginal utility is:
a. Maximum
b. More than 1
c. Zero
d. Less than 1
ACTIVITY
Give at least three examples to show how the law of diminishing
S
marginal utility relates to everyday life. Do you think there are ex-
ceptions to this law? Explain your reasons through examples.
7.6 CONSUMER BEHAVIOUR

IM
An extension of the law of diminishing marginal utility is the law of
equi-marginal utility. This law explains the consumer behaviour as
in how an individual distributes a given income among various goods
to achieve maximum utility. The law is based on the following assump-
tions:
M
The consumer is rational and intends to maximise satisfaction

from the given income.
The consumer’s income and wants are fixed.
The utility is measured cardinally.
N
The law of diminishing marginal utility is applicable.

The marginal utility of money is fixed, and each unit of money has
utility equal to 1.
Suppose a consumer spends a limited income on only one good X.

Now, he can either spend the income on the good X or keep the in-
come with himself. If the marginal utility of the good X is MUX and the
price of the good is PX, then the consumer will exchange his income for
the good X as long as MUX > PX (MUm). Thus, the consumer reaches
his equilibrium with maximum utility where:MUX = PX (MUm): where
MUm= 1
Alternatively, the consumer reaches equilibrium where,
MU x
=1
Px ( MU m )

158 MICROECONOMICS
The above consumer’s equilibrium in case of a single good is illustrat-

ed in Figure 7.2:
Marginal utility
E
Px(MUm)
MUx
O Q
Quantity
S
Figure 7.2: Consumer’s Equilibrium – One-Good Case
Source: D. N. Dwivedi: Microeconomics: Theory and Applications
IM
In the above figure, Px(MUm) represents the continuous utility of mon-
ey weighed by the price of good X. MUx represents the diminishing
marginal utility of good X. These two curves intersect at point E,
where MUx = Px(MUm).
At any point above E, MUx > Px(MUm) → This indicates that if a con-
sumer exchanges his income for X, he increases utility per unit of
M
commodity.
At any point below E, MUx < Px(MUm) → This indicates that a consum-
er increases utility by reducing his purchase.
Thus, point E is the point of consumer’s equilibrium.

N
In real life, a consumer consumes more than one good. Some goods
give him higher utility than others. A rational consumer first chooses
a good that gives him the maximum utility, then he picks up the good
which gives him the second highest utility, and so on. In this way, he
continues to spend his given income until the marginal utility of each
good per unit of expenditure is the same. This is known as the law of
equi-marginal utility.
Suppose a consumer spends his given income on two goods, X and Y.

As per the consumer’s equilibrium rule, MUx = Px(MUm) and MUy =
Py(MUm)
MU x MU y
Alternatively, = 1 and =1
Px ( MU m ) Py ( MU m )
MU x MU y
Combining the above two equations, we get = 1=
Px ( MU m ) Py ( MU m )

MU x Px ( MU m )
Or =
MU y Py ( MU m )
Since MU of each unit of money is fixed, the above equation becomes
MU x Px
=
MU y Py
MU y MU
Or P = P = MU m
x
x y
According to the above equation, a consumer reaches his equilibrium

when the marginal utility obtained from each unit of money spent on
the two goods X and Y is the same. In reality, marginal utilities of
X and Y are not the same. Therefore, the consumer will purchase a
combination of goods X and Y that will give him the maximum mar-
S
ginal utility per unit of money of each good so that the entire income
is spent.
Example 3: Vani has a total income of $56. She has the option to spend
IM
it on saree-collection or watching plays. Table 7.3 shows the marginal
utility of each good.
TABLE 7.3: MARGINAL UTILITY OF SAREES (S)

AND PLAYS (P)
Sarees (S) TUs MUs Plays (P) TUp MUp
1 22 22 1 16 16
M
2 43 21 2 31 15
3 63 20 3 45 14
4 81 18 4 58 13
N
5 97 16 5 70 12
6 111 14 6 81 11
According to the equi-marginal principle, Vani will allocate her total

income ($56) between sarees and plays in such a way that the margin-
al utility of each good is the same. Thus,
MU s MU p
=
Ps Pp
9. In case of a single commodity, a consumer reaches equilibri-

um where MU x is:
Px ( MU m )
a. More than 1 b. Equal to 1

c. Between 0 and 1 d. Negative

160 MICROECONOMICS
10. A rational consumer will first pick up the good that gives:
a. Maximum utility b. Second highest utility
c. Zero expenditure d. Minimum value
ACTIVITY
You have the budget of ` 500 or 1000 to spend. Choose any two
goods X and Y on which you can allocate this income as per the law
of equi-marginal utility and show the relationship numerically and
graphically.
7.7 CONSUMER PREFERENCES
S
In real life, a consumer is unable to express his utility in cardinal or
quantitative terms. However, given any two goods, a consumer can
always state which of the two goods he prefers. For example, Vani may
IM
not be able to specify how much utility she derives by watching a play.
However, she can always tell what she prefers between watching a
play and watching a movie, between collecting a saree and a piece of
jewellery, and so on. Thus, a consumer can always list all commodi-
ties he consumes in the order of preference. Consumer preferences,
therefore, mark a significant departure on the analysis of consumer
behaviour from the cardinal utility approach to the ordinal utility ap-
M
proach.
The ordinal utility approach is based on the following assumptions:

Rationality: The consumer is rational in terms of maximising his
utility. He has full market information. He is a rational being who
N
aims at maximising his/her utility at the given income level and the
market price.
Ordinal utility: The utility is not measurable. A consumer can
only specify his preference for a specific combination of goods, but
not by how much.
Transitivity of choice: If a consumer prefers good X to Y and good
Y to Z, then he must prefer good X to Z. Alternatively, if the con-
sumer treats goods X and Y equally, and goods Y and Z equal-
ly, then he must treat goods X and Z equally. This behaviour of a
consumer is called transitivity of choice. Symbolically, this is ex-
pressed as follows:
If X > Y, and Y > Z, then X > Z
Consistency of choice: If a consumer prefers good X to good Y in
a period, he must not prefer good Y to good X in another period.
Symbolically, this consistency of choice is expressed as follows:
If X > Y in one period, then Y is not > X in another period

Non-satiety: A consumer always prefers a larger quantity of all

goods.
Diminishing marginal rate of substitution: The marginal rate of
substitution is the degree at which a consumer is willing to replace
one good X for another good Y so that his total utility remains
the same. Symbolically, this rate is represented as ∆Y / ∆X. As a
consumer continues to substitute X for Y, the marginal rate of sub-
stitution ∆Y / ∆X goes on decreasing. (This concept is covered in
detail in the next section.)
11. Consumer preferences are based on:
S
a. Absolute utility approach
b. Cardinal utility approach
c. Ordinal utility approach
IM
12. What is the assumption of non-satiety?
a. If X > Y, and Y > Z, then X > Z
b. As a consumer substitutes X for Y, ∆Y / ∆X goes on de-
creasing
M
c. If X > Y in one period, then Y is not greater than X in an-

other period
d. A consumer always prefers a larger quantity of goods.
N
ACTIVITY
Rank any five goods using the ordinal utility approach. Ensure that
all assumptions are covered as you list your preferences.
ORDINAL UTILITY APPROACH –

7.8
INDIFFERENCE CURVE ANALYSIS
As per the ordinal utility approach, a consumer ranks various con-
sumption bundles (combination of two goods) in terms of preference.
These consumption bundles can be plotted as points in a graph. These
points give the consumer equal utility and thus the consumer is said
to be indifferent on different consumption bundles. A curve is formed
by joining these points representing bundles along which the con-
sumer is indifferent. Thus, this curve is called an indifferent curve or
iso-utility curve or equal utility curve.

162 MICROECONOMICS
To simplify the concept of indifference curve and analyse the consum-

er’s demand through ordinal utility approach, some assumptions are
made:
Two goods: The consumer has a fixed income, which he wants to
spend on the purchase of only two goods.
Rationality: The consumer behaves rationally and wants to maxi-
mise his utility level.
Diminishing marginal rate of substitution: To obtain more units
of good X, the consumer will let go some units of the other goods Y.
This is the basic principle of the indifference curve.
Ordinal utility: The combinations of two goods are ranked as per
the consumer’s preference.
S
Non-satiety: The consumer will always seek a higher volume of
goods.
Transitivity: If the consumer prefers X to Y and Y to Z, then he
will prefer X to Z.
IM
7.8.1 MEANING OF INDIFFERENCE CURVE
An indifference curve can be defined as the locus of points each rep-

resenting a different combination of two substitutes, which yield the
same level of utility to a consumer. Therefore, the consumer is indif-
ferent to any combination of two commodities if he/she has to make a
M
choice between them. This is because an individual consumes a vari-

ety of goods over time and realises that one good can be substituted
with another without compromising on the satisfaction level. When
these combinations are plotted on the graph, the resulting curve is
called indifference curve. This curve is also called the iso-utility curve
N
or equal utility curve.
An indifference curve is a graphical curve that shows various com-

binations of two goods, which give equal satisfaction or utility to a
consumer. As a result, the consumer is indifferent between any two
combinations of goods. Choosing either of the combination will give
him the same utility. For example, if Vani is asked whether she prefers
combination 1 of sarees and plays (assuming that the market prices of
sarees and plays are fixed) or combination 2, she may give anyone of
the following answers:
1. She prefers combination 1 over 2.
2. She prefers combination 2 over 1.
3. She is indifferent to both combinations.
The third answer means that Vani prefers combination 1 as much as

combination 2. There may be some additional combinations of sarees
and plays, which are equally preferable to her. Let us assume there
are five different combinations of sarees and plays, which give her the
same utility.

Table 7.4 shows these five combinations:
TABLE 7.4: INDIFFERENCE COMBINATIONS OF SAREES

AND PLAYS
Combination Units of Sarees Units of Plays
1 3 21
2 4 15
3 5 11
4 6 8
5 7 6
If the above combinations are plotted on a graph, then an indifference

curve is created, as shown in Figure 7.3:
S
20
Unit of plays
15
IM
10
1 2 3 4 5 6 7
Unit of sarees
M
Figure 7.3: Indifference Curve
The indifference curve in Figure 7.3 shows all combinations of sarees

and plays, which yield the same level of satisfaction or utility to Vani.
Vani is indifferent about any two points lying on this curve. However,
N
she may identify a large number of such indifference curves, where

each curve represents a different level of satisfaction, as shown in
Figure 7.4:
30
20
I4
I3
10 I2
I1
5
0
5 10 15 20
Figure 7.4: Indifference Map
The locus of the above set of indifference curves I1, I2, I3, and I4 is called
the indifference map, which reflects the entire set of tastes and pref-

164 MICROECONOMICS
erences of the consumer (i.e., Vani). The higher an indifference curve,

the greater the level of satisfaction obtained by the consumer. Thus,
since the indifference curve I2 is higher than the indifference curve I1,
I2 gives a higher level of satisfaction than I1. Similarly, the higher curve
I3 gives more utility than the curve I2. The curve I4 gives the highest
level of utility, while curve I1 gives the lowest level of utility. However,
there is no way of knowing how much additional utility a higher indif-
ference curve provides.
7.8.2 MARGINAL RATE OF SUBSTITUTION
Marginal rate of substitution (MRS) refers to the rate at which one

commodity can be substituted for another commodity maintaining the
same level of satisfaction. The quantity of one good that a consumer
S
is willing to substitute for an extra unit of another good on the same
indifference curve is called the marginal rate of substitution (MRS).
For example, the marginal rate of substitute of saree for play (MRSSP)
is the number of plays that Vani is willing to exchange per unit of sa-
IM
ree and maintain the same level of satisfaction. Note that MRSSP mea-
sures the downward vertical distance (i.e. per additional unit of saree
required) to remain on the same indifference curve.
In other words, MRSSP = −∆P / ∆S
Due to decline in P, MRSSP is negative. Multiply it by -1 to express it as

a positive value.
M
In Figure 7.5, starting at point A on the indifference curve U1, Vani is

willing to give up 4 units of plays for one additional unit of saree and
reach point B on the indifference curve.
Thus, MRSSP = −(−4)/(1) = 4

N
QY
10 A
−4Y
Unit of plays
1X B
6
−3Y
2X C
3
−2Y F
3X
1 U1
1 2 4 6 7 QX
Unit of sarees
Figure 7.5: Marginal Rate of Substitution (MRS)

Hence, 4 is the absolute (positive value of the) slope of the chord from
point A to B on U1.
Similarly, you can calculate other absolute slopes on U1.
Absolute slope of the chord BC is: MRSSP = − ( −3) / ( 2) = 1.5
Absolute slope of the chord CF is: MRSSP = − ( −2) / ( 3) = 0.67
Thus, at a specific point on an indifference curve, the marginal rate of

substitution (MRS) is given by the absolute slope of the tangent to the
indifference curve at that point. Different consumers generally have
different indifference curves and different marginal rates of substitu-
tion at points where their indifference curves have different slopes.
S
For a consumer like Vani, all combinations of goods, such as saree
and play, on a given indifference curve refer to the same level of total
satisfaction or utility. Thus, for a downward movement along the indif-
ference curve, the gain in utility in consuming more of one good, such
IM
as saree, must be equal to the loss in utility in consuming less of plays.
Specifically, the increase in consumption of sarees (∆S) multiplied by
the marginal utility she receives from consuming each extra unit of
the saree (MUS) must be equal to the reduction in plays (∆P) multi-
plied by the marginal utility of plays (MUP).
That is, (∆S) (MUS) = − (∆P) (MUP)

M
So that (MUS)/ (MUP) = − ∆P / ∆S = MRSSP
Thus, MRSSP is equal to the absolute slope of the indifference curve

and to the ratio of the marginal utilities. As you move down the indif-
ference curve, MRSSP decreases. This is due to the convexity of indif-
N
ference curve. This means that as Vani moves down her indifference
curve, she is left with less and less plays and more and more sarees,
each remaining unit of play becomes more valuable to her and each
extra unit of saree becomes less valuable. Thus, she is willing to give
up less and less of plays to obtain each additional unit of saree. This
property makes MRSSP decline and indifference curves convex to the
origin.
7.8.3 PROPERTIES OF INDIFFERENCE CURVE
Indifference curves have four main properties, which reveal the con-
sumer’s preferences:
1. They are negatively sloped: Indifference curves have a negative
slope because if one combination of goods contains more of X,
then it will have to contain less of Y than another combination so
that the two bundles give the same level of utility and remain on

166 MICROECONOMICS
the same indifference curve. Consider the indifference curve in

Figure 7.6.
10 A
Unit of plays
6 B
3 C
S
1 U1
1 2 4 7
Unit of sarees
IM
Figure 7.6: Indifference Curve
Since combination B on the indifference curve U1 contains more
sarees (good X) than combination A, combination B must con-
tain fewer plays (good Y) to be on the indifference curve.
If the indifference curve were positive, as in Figure 7.7, then it
would have meant that one combination containing more of both
M
goods (combination B’) gives the same level of satisfaction to the

consumer as another combination with less of both goods (com-
bination A’). Such a curve could not possibly be an indifference
curve.
N
Unit of plays
B’
A’
Unit of sarees
Figure 7.7: Indifference Curve Cannot Be Positively Sloped

2. They are convex to the origin: Indifference curves lie above the
tangent to the curve. In other words, they are convex to the ori-
gin. The convexity is due to the decreasing marginal rate of sub-
stitution, which has been explained in the previous section.

3. They do not intersect or are tangent to each other: Indifference

curves cannot intersect, as it is fundamentally opposite to their
definition. Consider Figure 7.8:
2
Unit of plays
C*
B*
2
A*
1
S
Unit of sarees
Figure 7.8: Indifference Curves Cannot Intersect

IM
Suppose in Figure 7.8, 1 and 2 are indifference curves.
Since A* and C* are on curve 1, then it would mean that: A* = C*
Similarly, since B* and C* are on curve 2, then it would mean
that: B* = C*
By transitivity, this would mean than A* = B*
M
However, this is impossible because combination B* contains

more of both goods (sarees and plays) than combination A*.
Thus, indifference curves cannot intersect.
4. Upper indifference curve indicates a higher level of utility: A
higher indifference curve lying above and to the right of another
N
indifference curve implies a higher level of satisfaction and vice

versa. In simple words, the combination of commodities on the
higher IC is preferred by a consumer to the combination that lies
on a lower IC.
7.8.4 CRITICISM OF INDIFFERENCE CURVE
Although the concept of indifference curve is vital to explain the or-

dinal approach, it is criticised on various grounds. The main points of
criticism against indifference curve are as follows:
Ignorance towards market behaviour: Indifference curve anal-
ysis considers only two commodities in the market. However, the
market is full of a large number of commodities. Thus, it does not
consider market behaviour in the analysis of consumer behaviour.
For example, a change in the price of other commodities in the
market may affect the purchase of the commodities being consid-
ered.

168 MICROECONOMICS
Two commodities model: Indifference curve analysis is based on

the combinations of two commodities. Considering more than two
commodities in indifference curve analysis makes the calculations
more complex. This may further make it difficult to predict con-
sumer behaviour.
Ignorance towards demonstration effect: James Stemble Duesen-
berry (July 18, 1918- October 5, 2009), an American economist, pro-
posed the concept of demonstration effect. The demonstration ef-
fect states that an individual’s consumption pattern is affected by
the level of consumption of other individuals. This is ignored by
indifference curve analysis limiting its use to understand consum-
er behaviour.
Indifference towards risks and uncertainties: Risks and uncer-
S
tainties in the market and individual’s life are inevitable. John Von
Neumann and Oskar Morgenstern, authors of The Theory of Games
and Economic Behaviour point out that indifference curve analysis
has no ability to analyse consumer behaviour in the midst of sev-
IM eral risks and uncertainties that prevail in the market and real life.
Unrealistic assumptions: IC is based on an assumption that a con-
sumer is fully aware of his/her preference for various commodi-
ties. However, this is an unrealistic assumption as humans have
their limitations. A human brain cannot take quick decisions by
analysing different combinations of several commodities available
in the market.
M
13. The slope of the indifference curve is:

a. Marginal utility b. Ordinal utility
N
c. Demand curved d. Marginal rate of substitution

14. The consumer is _________ about any two points on the indif-
ference curve.
a. sanguine b. demanding
b. indifferent d. satisfied
15. The indifference curve cannot be:
a. negatively sloped b. convex to the origin
c. tangential to each other d. parallel to each other
ACTIVITY
Create an indifference curve of possible combinations for any two

goods of your preference. Notice the properties of the indifference
curve.

7.9 CONSUMER EQUILIBRIUM EFFECTS

So far, you have seen that a consumer’s tastes can be represented with
an indifference map. Now, let’s discuss the constraints that a consum-
er faces when he tries to satisfy his wants. One such constraint is the
consumer’s income and the price of goods are fixed, as they influence
the amount of goods that he can purchase over a given period. This
limitation is called the budget constraint.
Suppose a consumer spends all his income on goods X and Y, then the
budget constraint is:
P Q X + PYQ Y = I
X
Here, PX and PY are the price and QX and QY are the quantity of goods
S
X and Y, respectively. I is the income of the consumer.
The above equation states that the amount of money spent (price mul-
tiplied by quantity) on good X and the amount of money spent on good
IM
Y equal the given income of the consumer.
A budget line is a line that shows the different combinations of two

goods that a consumer can buy by spending all his given income.
QY
J
10
M
L
8
Quantity of Y
B G
6
N
H
3
M
2
K
0 1 2 4 5 QX
Quantity of X
Figure 7.9: Budget Line

(Source: https://global.oup.com/us/companion.websites/9780195336108/pdf/Salvatore_Chap-
ter_3.pdf)
NOTE
In Figure 7.9, JK is the budget line that shows the various combina- The slope of the budget line is
tions of good X and good Y that a person can buy by spending all his the rate at which the two goods
given income. The budget line is negatively sloped. X and Y can be substituted in the
market.
A consumer spends all the given income on the budget line only. At a
Thus, slope of the budget line
point below the budget line, the consumer does not spend all the given = PX/PY

170 MICROECONOMICS
income. Due to the income and price constraints, the consumer can-
? DID YOU KNOW not reach a combination of X and Y above the budget line. Here, we
If MRSXY > PX/PY, it means that assume that the consumer is rational and wants to maximize his total
the consumer is willing to pay a utility given the budget constraint. This can be achieved through the
more price for X than the market ordinal utility approach, provided the two fundamental conditions of
price. Thus, the consumer will consumer’s equilibrium are satisfied:
purchase more units of X, which
will decline MRS till it is equal 1. At the point of consumer’s equilibrium, the slope of the budget
to the ratio of the prices of X line and slope of the indifference curve should be the same. The
and Y, and the equilibrium is
reached. Similarly, if MRSXY < PX/
slope of the budget line is PX/PY. The slope of the indifference
PY, it means that the consumer curve is MRSXY. Thus, MRSXY = PX/PY
is willing to pay a less price for
X than the market price. Thus,
2. The indifference curve should be convex to the point of origin.
the consumer will purchase less This means that the MRS (slope of the indifference curve) must
units of X and more units of Y, decline from left to right at the point of equilibrium.
S
which will increase MRS till it is
equal to the ratio of the prices Let’s understand this with the help of Figure 7.10. It has three indiffer-
of X and Y, and the equilibrium is ence curves I1, I2, and I3 and the budget line AB.
reached.
IM
Y
B
D
C
I3
M
I2
I1
X
A
N
Figure 7.10: Superimposed Budget Line and Indifference Map
Now, the consumer can afford to purchase any combination of the

two good X and Y within the budget line AB only. Within the budget
constraint, the highest indifference curve that he can reach is I2. The
budget line AB is tangent to the indifference curve I2 at point C. This is
the point of the consumer’s equilibrium. At point C, both conditions
of the consumer’s equilibrium are satisfied, which are:
MRSXY = PX / PY

MRS is diminishing at point C (i.e. I2 is convex to the origin at point C)
Till now, we explained about consumer equilibrium based on assump-

tion that the income of the consumer and the market price of the goods
remained unchanged. However, these factors may vary from one time
period to another. And, any change in the income of the consumer or
the price of the goods leads to changes in equilibrium condition and
shifts the consumer’s budget line either upward or downward. Let us

now study about the effects of changes in income of consumer and

price of goods: NOTE
It must be noted that the impact
1. Income effect of a price change is divided into
2. Substitution effect two components namely substi-
tution effect and income effect.
3. Price effect
7.9.1 INCOME EFFECT
Refer back to Section 7.9 and recall that during the analysis of the con-
sumer’s equilibrium, we assumed that his income of consumer and
the prices of goods X and Y will remain unchanged. But what happens
to the consumer’s behaviour if his income changes? Given that the
prices of goods remains fixed, change in the consumer’s income influ-
S
ences his purchases. The analysis of the effect caused by changes in
consumer’s income on his/her purchases while the prices of commod-
ities remain unchanged is called as Income Effect.
IM
If the income of consumer increases, he will move to the higher indif-
ferent curve and the equilibrium position also shift towards the right.
On the other hand, if the income of consumer decreases then he will
move to the lower indifferent curve and his equilibrium position also
shift leftward. Also note that higher indifferent curve yields the higher
level of satisfaction and vice versa.
Assumptions for considering the income effect in case of normal goods

M
are as follows:
The prices of both normal goods X and Y are unchanged.
The consumer’s tastes and preferences remain the same.
N
The market condition and fashion remain the same.
The effect of change in the consumer’s income on his/her equilibrium

(income effect) is shown in Figure 7.11:
Y Income consumption
curve
I3
X2
I2
X1
X0 I1
O X
B1 B2 B3
Figure 7.11: Effect of Change in Income on Consumer’s Equilibrium

(Source:http://www.egyankosh.ac.in/bitstream/123456789/57621/1/Unit-5.pdf)

172 MICROECONOMICS
When the budget line is B1, the original consumer’s equilibrium point
is at X*. The budget line B1 touches the indifference curve I1 at X*. I1
is tangent to B1. Now, if the consumer’s income increases, B1 will shift
to the right. The new budget line will be B2. The new budget line B2
will touch the indifference curve I2 at X1, which will be the new equi-
librium point. As the consumer’s income increases more, the budget
line will again shift to the right. The new budget line B3 will touch the
indifference curve I3 at the new equilibrium point X2. Note that the
new budget lines B2 and B3 shift in parallel to the original budget line
B1. The slope of the budget line depends on the ratio of prices of goods
and hence remains constant.
These three-equilibrium points X*, X1, and X2 are joined together to

form a curve called the Income-Consumption Curve (ICC). The ICC
displays the change in the quantity purchased of two goods, X and Y,
S
when the consumer’s income changes, provided their relative prices
remain unchanged.
NOTE When the income of a consumer increases, he will buy more and more
IM
quantities of normal goods. Normal goods can be necessities (such as
The income effect is positive in
case of normal goods. salt) or luxuries (such as car):
7.9.2 SUBSTITUTION EFFECT
Assume that the income of a consumer is fixed and he purchases two

goods X and Y. If the price of Y increases and price of X decreases;
M
then, the consumer will purchase more of X and less of Y. It means

that the consumer substitutes X for Y. This effect is known as the sub-
stitution effect of price change. Figure 7.12 shows the substitution
effect:
N
N Q
Quantity of Y
B1
Q1
N1
IC
A
A1
O M M1
Quantity of X
Figure 7.12: Effect of Substitution on Consumer’s Equilibrium

In Figure 7.12, line AB represents the original budget line. Q is the

original point of consumer’s equilibrium, where AB is tangent to IC.
At Q, the consumer purchases OM quantity of commodity X and ON
quantity of commodity Y. If the price of commodity Y increases and
the price of commodity X decreases, the new budget line would shift
to B1A1. This new budget line is tangent to IC at Q1. Therefore, the
new equilibrium position of the consumer changes to Q1 from Q when
the price of a commodity changes. At Q1, the consumer cuts down the
units of commodity Y from ON to ON1 and purchases more units of X,
OM to OM1. However, the indifference curve remains the same. This
movement along the indifference curve from Q to Q1 is known as the
substitution effect.
7.9.3 PRICE EFFECT
S
Till now you have studied about the following two effects:
Income effect: Consumer’s equilibrium when income of consumer
changes keeping the prices of goods X and Y unchanged; and
IM
Substitution effect: Consumer’s equilibrium when income of con-
sumer is unchanged and the prices of both goods change.
In both these cases, the price of goods was unchanged. But what will
happen when the price of one normal good is changed?
Let us now study about the price effect wherein the price of only one
M
good changes and it leads to change in consumer equilibrium. In oth-

er words, price effect can be called as the effect of change in price on
consumer equilibrium when price of one good changes keeping all
other factors such as the income of a consumer, his taste, and price of
the other good fixed. Price effect is shown in Figure 7.13:
N
A1
Good Y (NormaL)
E3 PCC
E1 E2
I3
I1 I2
O X
X1 X2B1X3 B2 B3
Good X (NormaL)
Figure 7.13: Effect of Price on Consumer’s Equilibrium

(Source: https://books.google.co.in/books?id=zZ2ecu-AvakC&pg=PA83&dq=PCC+in+-
case+of+normal+goods&hl=en&sa=X&ved=2ahUKEwjEwKzSjc_qAhV74XMBHazyC-
2QQ6AEwA3oECAIQAg#v=onepage&q=PCC%20in%20case%20of%20normal%20goods&f=-
false)

174 MICROECONOMICS
In Figure 7.13, the budget line A1B1 represents the given prices of
goods X and Y and a given income. The consumer’s equilibrium point
is at point E1 on the indifference curve I1. At E1, the consumer pur-
chases OX1 of the good X.
Suppose the price of the good X falls, while the price of the good Y and
his income remain fixed. Then, the budget line will shift to the right as
A1B2. The consumer is now in equilibrium position at E2 on a higher
indifference curve I2. Now he will buy OB2 of X. Thus, his level of sat-
NOTE isfaction has increased due to fall in the price of the good X and he is
Any increase in the price of X purchasing more of X than before. If the price of X decreases further,
will move the budget line inward AB3 will be the relevant budget line. The consumer’s new equilibrium
to the left of the original budget position is at E3 on the indifference curve I3. He buys OB3 of X (more
line towards the origin. quantity of X).
S
If the equilibrium points E1, E2, and E3 are joined together, a new line
called the Price Consumption Curve (PCC) is drawn. The PCC is the
line that shows how the changes in the price of X will influence the
consumer’s purchase of X, given the price of Y, consumer’s income
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and tastes remain unchanged.
If the price of normal goods is changed, it will change:

Real income (or purchasing power) of the consumer: The change
in consumer’s demand for a normal good due to change in his real
income is called income effect or real income effect. The income
effect is positive in case of normal goods. This means that when
M
the price of a normal good falls, the consumer’s real income or

purchasing power rises and he will demand more of that good.
For example, given the income of $10, suppose the price of burger
decreases. As a result, a consumer’s purchasing power will rise.
Since burger is a normal good, its demand will also rise.
N
Relative price of goods: The change in consumer’s demand due to

change in the relative price of goods is called substitution effect.
The substitution effect is always positive irrespective of the nature
of goods. This means that when the price of a normal good X falls,
while that of its substitute Y remains the same, then the consumer
will shift some expenditure from Y to X. As a result, the demand
for X will increase. For example, when the price of burger drops,
the price of soft drink remains unchanged. Thus, the relative price
of burger (= Pburger/Psoft drink) declines. As a result, consumer will
want to purchase more of burger by transferring expenditure from
soft drinks.
It must be noted that: Price effect = Income effect + Substitution

effect
If the price of the normal good X decreases, then both income effect
and substitution effect will increase the demand for good X. Hence,
there is an inverse relation between price and demand.

16. The slope of the budget line is:

a. PX / PY
b. PX × PY
c. PX × QX
d. QX / PY
17. The price of tea falls and the price of coffee remains the same.
Vijay’s income is also the same. What will be the effect?
a. Vijay will demand more coffee
b. Vijay will demand more tea
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c. Vijay will demand less coffee
d. Vijay will demand less tea
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ACTIVITY
Study about the movement of the ICC when X is a normal good but
Y is an inferior good.
7.10 SUMMARY S
M
In economics, utility implies that a product has the power to sat-

isfy a want. However, utility is a relative term which means that a
product may give satisfaction to one individual while be of no use
to the other. The more the human want of a commodity, the greater
the utility derived from obtaining one commodity.
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This concept of utility as a measurable or cardinal quantity, which

can be expressed in numbers, is called cardinal utility.
Ordinal utility represents the utility from the consumption of
goods based on a relative ranking of the commodity.
Total utility from a single commodity (TU) is defined as the total
satisfaction obtained from consuming the given amount of the
commodity.
Marginal utility (MU) is the change in TU due to consumption of
one extra unit of a commodity.
According to the law of diminishing marginal utility, with the in-
crease in the consumption of a commodity there is a decrease in
the marginal utility derived from the consumption of each extra
unit of the commodity.
The law of equi-marginal utility explains the consumer behaviour
as in how he distributes a given income among various goods to
achieve maximum utility.

176 MICROECONOMICS
As per the ordinal utility approach, a consumer ranks various con-

sumption bundles (combination of two goods) in terms of prefer-
ence.
An indifference curve is a graphical curve that shows the various
combinations of two goods, which give equal satisfaction or utility
to a consumer. As a result, the consumer is indifferent between
any two combinations of goods. Choosing either of the combina-
tion will give him the same utility.
An indifference curve can be defined as the locus of points each
representing a different combination of two substitutes, which
yield the same level of utility to a consumer. Therefore, the quanti-
ty of one good that a consumer is willing to substitute for an extra
unit of another good on the same indifference curve is called the
S
marginal rate of substitution (MRS).
Indifference curve are negatively sloped, convex to the origin, and
do not intersect.
IM
A budget line shows the different combinations of two goods that a
consumer can buy by spending all his given income.
The effect of determining the influence of the changes in the con-
sumer’s income on his purchases, given the prices of goods re-
mains fixed, is called the income effect.
The Income-Consumption Curve (ICC) displays the change in the
quantity purchased of two goods, X and Y, when the consumer’s
M
income changes, provided their relative prices remain unchanged.

The price effect describes how a consumer reacts to changes in
the price of a good, given his income, taste, and price of the other
goods remain fixed.
N
The Price Consumption Curve (PCC) shows how the changes in

the price of X will influence the consumer’s purchase of X, given
the price of Y, consumer’s income and tastes remain unchanged.
The price effect is made up of the income effect and the substitu-
tion effect.
KEY WORDS
Utility: The ability of a commodity to satisfy a human want

Util: The subjective unit of measure of utility
Cardinal utility: An actual measure of utility (in util), just as
height, weight, etc.
Ordinal utility: The ranks of the utility derived from consum-
ing different quantities of a commodity
Total utility: The total utility received from consuming a com-
modity

Marginal utility: The extra utility derived from the consump-

tion of one more unit of a commodity
Law of diminishing marginal utility: The consumption of each
extra unit of a commodity ultimately gives less and less addi-
tional utility
Indifference curve: A curve that depicts the different combi-
nations of two goods, which give a consumer the same level of
utility
Indifference map: The complete set of indifference curves
showing the tastes and preferences of a consumer
S
1. Who introduced the concept of utility? MCQ
a. Hicks and Allen b. Alfred Marshall
c. Jeremy Bentham d. John Maynard Keynes
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2. Marginal utility is:
a. An actual measure of utility
b. The utility based on relative ranking of the commodity
c. The aggregate utility derived from consuming a given quan-
tity of a good
M
d. The utility derived from one more unit

3. When total utility increases at a diminishing rate, the marginal
utility is:
a. Unchanged b. Zero
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c. Increasing d. Decreasing
4. What is the marginal utility of a commodity at saturation point?
a. 0 b. Less than 0
c. More than 0 d. Increasing
5. A consumer reaches equilibrium point when:
a. Total utility = Price of good
b. Marginal utility > Price of good
c. Marginal utility < Price of good
d. Marginal utility = Price of good
6. When the income of an individual consumer increases, his de-
mand for a normal good will (given that everything else remains
unchanged):
a. Fall b. Rise
c. Remain the same d. First rise and then fall sharply

178 MICROECONOMICS
7. When the price of a normal good drops, more of it is purchased.

This effect is called
a. Income effect b. Substitution effect
c. Consumer demand d. Price effect
8. Indifference curve is always:
a. L shaped b. U shaped
c. Convex to the origin d. Concave to the origin
9. If an indifference curve is convex, then marginal rate of substitu-
tion of X to Y is:
a. Diminishing b. Increasing
c. Negligible d. Constant
S
10. The higher the indifference curve, the _______________ will be
the level of satisfaction.
a. lower b. higher
IM
c. same d. more relative

? 1. Explain the concept of utility as a basis of consumer demand.
2. Explain the difference between cardinal utility and ordinal
M
utility.
3. What is the difference between total and marginal utility? Ex-
plain through an example.
4. Write a note on the law of diminishing marginal utility.
N
5. Discuss how the law of equi-marginal utility explains the con-

sumer behaviour.
6. Write a note on the marginal rate of substitution.
7. Write short notes on the following:
a. Income effect
b. Substitution effect
c. Price effect

7.13
(HOTS) QUESTIONS
1. According to the ordinal utility approach, a consumer will always
try to reach:
a. Lower price consumption curve
b. Higher income consumption curve

c. Higher indifference curve

d. Increasing marginal rate of substitution
2. Consumer’s equilibrium is achieved when:
a. The slope of indifference curve is fixed
b. The slope of indifference curve is equal to that of the income
budget line
c. The indifference curve is parallel to the budget line
d. The budget line is tangent to the lower indifference curve
3. What is the slope of the budget line?
a. Utility level of both goods
b. Income level of the consumer
S
c. Price level of a country
d. Ratio of price of both goods
4. The income effect:
IM
a. Is always positive
b. Is always positive for normal goods
c. Is always negative for normal goods
d. Depends on the price effect
M
5. Total utility
a. Increases at a decreasing rate
b. Is the utility derived from the last unit
c. Diminishes with the increasing rate of consumption
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d. Is negative at saturation point
Topic Q. No. Answer

Utility as a Basis of Consum- 1. b. The want-satisfying power
er Demand of a commodity
2. d. The pleasure that you get
from consuming it
Concept of Cardinal Utility 3. b. Ordinal utility
4. d. Cardinal utility
Total and Marginal Utility 5. d. increases, decreases
6. c. maximum

180 MICROECONOMICS
Topic Q. No. Answer

Law of Diminishing Marginal 7. b. First rises and then falls
Utility after reaching maximum
value
8. c. Zero
Consumer Behaviour 9. b. Equal to 1
10. a. Maximum utility
Consumer Preferences 11. c. Ordinal utility approach
12. d. A consumer always pre-
fers a larger quantity of
goods.
Ordinal Utility Approach – 13. d. Marginal rate of substitu-
S
Indifference Curve Analysis tion
14. b. indifferent
15. c. Tangential to each other
IM
Consumer Equilibrium 16. a. PX/PY
Effects
17. b. Vijay will demand more
tea

M
Q. No. Answer
1. c. Jeremy Bentham
2. d. The utility derived from one more unit
3. d. Decreasing
N
4. a. 0
5. d. Marginal utility = Price of good
6. b. Rise
7. d. Price effect
8. c. Convex to the origin
9. a. Diminishing
10. b. higher

1. Demand is the willingness or ability of a consumer to pay for a
particular good. A consumer is willing to purchase a good as he/
she derives utility from the consumption of that good. Refer to
Section 7.2 Utility as a Basis of Consumer Demand
2. Jevons, Menger, and Walras introduced utility as the satisfaction
that an individual receives from consuming one commodity. Re-
fer to Section 7.3 Concept of Cardinal Utility

3. According to the cardinal utility approach, utility of a commodity

is expressed in quantitative terms through two measures: Total
utility and Marginal utility. Refer to Section 7.4 Total and Mar-
ginal Utility
4. The decrease in MU with an increase in the consumption of an
apple represents the law of diminishing marginal utility. Refer to
Section 7.5 Law of Diminishing Marginal Utility
5. An extension of the law of diminishing marginal utility is the
law of equi-marginal utility. Refer to Section 7.6 Consumer Be-
haviour
6. The quantity of one good that a consumer is willing to substitute
for an extra unit of another good on the same indifference curve
S
is called the marginal rate of substitution (MRS). Refer to Sec-
tion 7.8 Ordinal Utility Approach – Indifference Curve Analy-
sis
7. The analysis of the effect caused by changes in consumer’s in-
IM
come on his/her purchases while the prices of commodities re-
main unchanged is called as Income Effect. Price effect can be
called the effect of change in price on consumer equilibrium
when price of one good changes keeping all other factors such as
the income of a consumer, his taste, and price of the other good
fixed. Refer to Section 7.9 Consumer Equilibrium Effects
M

QUESTIONS
Q. No. Answer
N
1. c. Higher indifference curve

2. b. The slope of indifference curve is equal to that of
the income budget line
3. d. Ratio of price of both goods
4. b. Is always positive for normal goods
5. a. Increases at a decreasing rate
SUGGESTED READINGS
Mandal, R. (2007). Microeconomic theory. New Delhi: Atlantic.
Palgrave Macmillan. (2014). Contributions to Consumer Demand
and Econometrics.
Samuelson,P., & Nordhaus, W. (2010). Microeconomics. Boston:
McGraw-Hill Irwin.

182 MICROECONOMICS
E-REFERENCES
(2020).Retrieved 1 August 2020, from http://ebooks.lpude.in/com-
merce/mcom/term_1/DECO405_MANAGERIAL_ECONOMICS_
ENGLISH.pdf
(2020).Retrieved 1 August 2020, from https://global.oup.com/us/
companion.websites/9780195336108/pdf/Salvatore_Chapter_3.pdf
Consumer Choice and Utility | Microeconomics. (2020). Retrieved
1 August 2020, from https://courses.lumenlearning.com/wm-mi-
croeconomics/chapter/consumer-choice-and-utility/
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C H A
8 P T E R
PRODUCTION THEORY: SHORT RUN
S
CONTENTS
8.1 Introduction
8.2 Basic Concepts of Production
IM
8.2.1 Meaning of Production
8.2.2 Factors of Production
8.2.3 Short Run and Long Run
Activity
8.3 Short-Run Production Function: Law of Variable Proportions
M

Activity
8.4 Summary
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184 MICROECONOMICS
PRODUCTION DILEMMA IN RK DESIGNS
Ragini Khanna opened a small manufacturing unit, called RK

Case Objective Designs, to produce jackets. She took a building and equipment
on lease for a year. She hired two workers to design and manufac-
This caselet introduces
the concept of short-run
ture jackets. One day she got a customer from Dubai who liked
production her jackets and purchased five of them. Soon she received a call
from a large shop in Dubai to supply 25 jackets. Ragini hired one
more worker to manufacture jackets and fulfilled the order. The
response of her jackets was outstanding and more shops in Dubai
started asking her to supply jackets, at least 100 in a month. More-
over, she was getting orders from Indian retailers as well as from
European countries. Overwhelmed, Ragini refused large orders
S
because she simply could not expand her manufacturing unit at
least for the next year. Why did Ragini refuse orders? What limit-
ed her production capacity? What constraints did she face? In this
chapter, you will find these answers.
IM
M
N

PRODUCTION THEORY: SHORT RUN 185
LEARNING OBJECTIVES

>> Explain the concept of production
>> Identify the factors of production
>> Differentiate between short-run and long-run production
>> Describe the law of variable proportions
8.1 INTRODUCTION
In the previous chapter, you have studied about consumer demand Quick Revision
analysis and two approaches to the measurement of utility, namely
S
cardinal utility approach and ordinal utility approach. Production is
a process of transforming tangible and intangible inputs into goods
or services. Raw materials, land, labour and capital are the tangible
inputs, whereas ideas, information and knowledge are intangible in-
IM
puts. These inputs are also known as factors of production. For an
organisation, the four major factors of production are land, capital,
labour and enterprise. An organisation needs to make an optimum
utilisation of these factors to achieve maximum output. The techni-
cal relationship between the inputs and the output is expressed by
production function. It enables an organisation to achieve maximum
output with the given combinations of factors of production in a par-
M
ticular time period.
The production function can be of two types, namely short-run pro-

duction function and long-run production function. Short-run pro-
duction function refers to the time period in which at least one input
factor of production is fixed and other input factors are variable. For
N
example, in the short run, increase in production cannot be achieved

by installing new factory or by purchasing new land while it can be in-
creased by putting extra units of labour. In this way, labour inputs are
variable while land, buildings or factories are fixed in the short-run
production function. On the other hand, in the long run, production
function includes the time period in which all inputs of production are
variable and increase in production can be achieved by increasing all
input factors simultaneously. For example, in the long run, increase in
production can be achieved either by installing new plant, machinery,
buildings or the extra units of labour. The production laws studied
under these periods are law of diminishing returns and law of returns
to scale.
This chapter focuses on the short-run production decisions. It starts

by explaining the meaning of production and factors of production.
Next, you will learn the differences between short- and long-run pro-
duction. Finally, you will understand the law of variable proportions,
which is a function of short-run production.

186 MICROECONOMICS
8.2 BASIC CONCEPTS OF PRODUCTION

Production can be defined as a process of converting inputs into out-
puts. Inputs include land, labour and capital, whereas output includes
finished goods and services. In other words, production is an act of
creating value that satisfies the wants of individuals. Organisations
engage in production for earning maximum profit, which is the differ-
ence between the cost and revenue. Therefore, the production deci-
sions of organisations depend on the cost and revenue. The main aim
of production is to produce maximum output with given inputs. Let
us understand the concept of production with the help of an example.
Suppose a farmer decides to grow sugarcane. Then, sugarcane is

an output of the production process. To grow sugarcane, the farmer
will have to use different inputs (also called factors of production),
S
including:
Land: He will grow the sugarcane on land.
Labour: The sugarcane will be planted and harvested using
IM
labour.
Capital: The farmer will use tractors, spades, hoes, irrigation
ditches, sacks, fertilisers and pesticides.
Similarly, a sugarcane firm decides to produce sugar. The output will

be sugar and the inputs of production will be sugarcane, capital and
labour.
M
Production is not just about physical outputs such as cloth, rice and
mobile phones. It also includes services of doctors, teachers, nurses,
consultants, etc. For attaining the maximum output, inputs are com-
bined in more than one way. The most efficient combination is chosen
N
from different combinations. The decisions for choosing combinations

depend upon the purchase of inputs, distribution of budget among
inputs, allocation of inputs and combination of output.
Production is considered important by organisations because of the

following reasons:
Helps in creating value by applying labour on land and capital
Improves welfare as more commodities mean more utility
Generates employment and income, which develops the economy
Helps in understanding the relation between cost and output
8.2.1 MEANING OF PRODUCTION
The production function can be defined as a relationship between an

output and different levels and combinations of inputs. It is the pro-
cess of getting maximum output from the given inputs in a specific pe-
riod. It includes only technically sound combinations of inputs, which
minimises the cost of production.

The production function is generally expressed through the following

equation:
X = f (L, K, S)
Here,
X = Level of output
L = Labour (physical and mental efforts of workers)
K = Capital (factories, machines, equipment and other human manu-

factured aids to production)
S = Land (soil, raw materials, etc.)
S
For example, a dairy needs 50 cows and 1 labourer to produce 50 litres
of milk per day, then the production can be shown as:
50X = L + 50K
IM
Here, 50X is the number of litres of milk, L is the number of workers,
and K is the capital input (number of cows).
The production function assumes that the state of technology is fixed.

Any change in the state of technology will change the production func-
tion. For example, the artificial intelligence has enabled IT firms to
produce software with fewer engineers and less capital.
M
8.2.2 FACTORS OF PRODUCTION
Factors of production are the inputs that are used for producing the
final output with the main aim of earning an economic profit. Each
and every factor is important and plays a distinctive role in the organ-
N
isation. The factors of production can be:

Fixed: The inputs whose quantity cannot be changed during a spe-
cific period of production are called fixed factors of production.
Examples include land, equipment, machinery, factory, etc. The NOTE
supply of these inputs remains fixed during short-run production.
The difference between fixed
Variable: The inputs whose quantity can be changed during a spe- factors and variable factors
cific period of production are called variable factors of produc- disappears during the long-run
production, as the supply of all
tion. Examples include raw materials, labour, electricity, fuel, etc. factors is variable during the
The supply of these inputs remains variable during short-run or long-run production.
long-run production.
8.2.3 SHORT RUN AND LONG RUN
Economists usually refer to periods of production as either short run

or long run. Short run is defined as a period in which some factors of
production (such as land and capital) are in fixed supply, while other
factors such as labour are in variable supply. Long run, on the other

188 MICROECONOMICS
hand, is defined as a period in which all factors of production are in

variable supply.
For example, RK Designs might want to expand its production. For

this, it can get its weavers and tailors to work longer hours through
overtime or shifts. The shop can also purchase more raw materials.
Thus, the supply of labour and raw materials is variable. However,
the shop has only a fixed amount of space in a building and a fixed
number of machines on which its workers can work. This fixed capital
places a constraint on RK Designs on how many jackets it can pro-
duce. This is a case of short-run production.
In the long-run production, Ragini can move her production unit into
a larger factory and purchase more machines, as well as employ more
labour and use more raw materials. Doing so will increase the produc-
S
tion capacity of her manufacturing unit, provided the technology does
not change.
In the very long-run production, the state of technology can change.

IM
For example, Ragini might be able to work with robots and increase
her production capacity tremendously at lower costs. There is no stan-
dard length of time for short-run or long-run production. Usually, in
the garment industry, a short-run production period can be from 1-3
years. A food stall owner in a market who hires everything from the
stall to cooking stove and keeps no stock, the short-run production
may be of 1 day, when he needs to hire equipment and sell his stock.
M
1. All of the following are factors of production, except:

a. Land b. Output
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c. Entrepreneur d. Capital
2. In a short-run production, __________ factors of production
are in _____________ supply.
a. all, variable b. all, fixed
c. some, infinite d. some, fixed
3. Which expression below defines the production function?
(X – level of output, L – labour, K – capital, S – land, T – state
of technology)
a. X = f (L,K,S) b. X = f(T/L+K+S)
c. S = f (X, T, K) d. f(X, T) = f (L,K,S)
ACTIVITY
Visit any organisation and learn about its production function in

detail.

SHORT-RUN PRODUCTION FUNCTION:

8.3
LAW OF VARIABLE PROPORTIONS
The short run refers to a time period in which the supply of inputs,
such as plant and machinery is fixed. Only the variable inputs such
as labour and raw materials can be used to increase the production of
goods. Suppose a firm, such as RK Designs, uses only two factors of
production:
Land (S) – Fixed
Labour (L) – Variable
The short-run production function of the firm can be expressed as:
S
X = f (S, L)
The law of production studied under short-run production is called

the law of variable proportions or the law of diminishing marginal re-
turns.
IM
What will be the output of the firm as it continues to employ more and
more labour? To know the answer, let us first understand the concepts
of Total Product (TP), Average Product (AP) and Marginal Product
(MP).
Total Product (TP): This is the total quantity of output produced
M
by a firm during a specific period. It is expressed in physical terms

and not in money terms. For example, the total product of 1000
weavers in the garment industry over a year might be 30,000 jack-
ets. It is also known as total physical product.
N
Average Product (AP): It refers to the ratio of the total product

to the variable input used for obtaining the total product. It is the
product produced per unit of variable input employed when fixed
inputs are held constant. The average product is calculated as:
Average Product = Total Product/Variable inputs employed
It determines how much output each labour produces on an aver-
age. For example, the output per worker would be 30 jackets per
year. AP can be expressed as:
Total Product TPL
=APL =
Labour Input L
Marginal Product (MP): Marginal product refers to the product

obtained by increasing one unit of input. In terms of labour, the
change in total quantity of product produced by including one
more worker is termed as marginal product of labour. This is the
change in TP produced by an extra unit of a variable factor (la-
bour). For example, if the addition of an extra weaver increases

190 MICROECONOMICS
the output to 30,004, then the MP would be 4 jackets. MP can be

expressed as:
Change in Total Product ∆TPL
MPL = =
Change in Labour Input ∆L
The following formula can be used to calculate:

MPL f or nth unit: TPn–TP(n-1)
Here, n = Number of labour units
Now, consider Table 8.1. In this example, land is fixed at 1 unit, while
labour input is in variable supply:
Table 8.1: TP, AP, MP in Short Run
S
Land Labour Total Product of Average Product Marginal Product
Labour (TPL) of Labour (APL) of Labour (MPL)
1 0 0 0 -
IM
1 1 4 4 4
1 2 10 5 6
1 3 18 6 8
1 4 24 6 6
1 5 28 5.6 4
M
1 6 30 5 2
1 7 30 4.3 0
1 8 28 3.5 -2
1 9 25 2.7 -3
N
The above table indicates that:

If no workers are employed, the total output will be zero.
The first worker produces 4 units of output. So the marginal prod-
uct of the first worker is 4 units.
The second worker produces an extra 6 units of output. So the
marginal product of the second worker is 6 units. The total output
of two workers is 4 + 6 = 10 units. The average output is 10/2 or 5
units per worker.
The third worker produces an extra 8 units of output. Thus, the to-
tal output with three workers is 4 + 6 + 8 = 18 units. The average
output is 18/3 = 6 units per worker.
The marginal product (MPL) initially rises but the fourth worker
produces less than the third. The diminishing marginal returns,
therefore, set in between the third and fourth workers.
The average product (APL) also rises at first and then decreases, but
the turning point is the fifth worker instead of the fourth worker

(later than for the marginal product). Therefore, the diminishing

average returns set in between the fourth and fifth workers.
Now, let us plot the values of TPL, APL and MPL on the graph, as shown
in Figure 8.1:
TPL
TPL
Maximum
A B
TPL
Inflextion
Point
S
C IM
O QL(land)
APL
MPL
Power of diminishing
C’
marginal returns
Power of diminishing
average returns
M
A’
APL
B’ MPL= 0
N
O QL(land)
APL MPL
Figure 8.1: Total, Average and Marginal Product

(Source: Principles of Economics: Deepashree)
As Figure 8.1 shows, the TPL curve starts from the origin, increases
at an increasing rate, then increases at a diminishing rate, reaches a
maximum, and then starts to fall. This means that as more and more
labour units are employed, TPL increases but at a diminishing rate.
APL and MPL curves are derived in the lower panel of Figure 8.1.
Relationship between TPL and APL curves
APL at any point on the TPL curve is the slope of the straight line from
the origin to that point on the TPL curve. It is positive as long as TPL is
positive. The APL curve is in the shape of inverted U. It initially rises,
reaches a maximum, and then falls.

192 MICROECONOMICS
Relationship between TPL and MPL curves
MPL at any point on the TPLcurve is the slope of the TPL curve at that
point. MPL between two points on the TPLcurve is the slope of the line
connecting the two points on the TPL curve. The slope increases till
point C and then decreases. At maximum TPL the slope is zero and
then it is negative.
The MPL curve initially rises, reaches a maximum when the slope of
the tangent is highest, and then falls. When TPL is maximum, MPL is
zero (point B to B’). When TPL declines, MPL is negative. This means
that an extra worker results in fall of output (or slows down the pro-
duction process). Thus, the MP of that worker is negative.
The area under the MPL curve is TPL. MPL is positive as long as is TPL
S
positive, but it becomes negative when TPL starts to decrease.
Relationship between APLand MPL curves

IM
Both APL and MPL curves rise initially; the MPL curve increases at a
faster rate than the APL curve. This is because for the average prod-
uct to increase, the marginal product must be more than the previous
average product. Both the curves rise till the fixed factor land is fully
utilised. Post that, both curves start to fall. The MPL curve declines at
a faster rate than the APL curve.
From point C’ to A’, the APL curve is rising even though the MPL curve
M
is falling. At point A’, the APL curve neither rises nor falls. At this point,
MPL = APL.
Mathematically, the relationship between the two curves is as follows:

N
TPL=APL.L
∂TPL ∂( APL .L)
MPL = = = APL + L(slope of APL curve)
∂L ∂L
Thus, when the slope of curve is:

Equal to 0 → MPL = APL
More than 0 → MPL > APL
Less than 0 → MPL < APL
This law is a short-run phenomenon that operates when the total out-
put or production is increased by increasing units of a variable factor.
Another name of this law is the Law of Diminishing Marginal Re-
turns. The law of diminishing returns is an important concept of the
economic theory. The law of diminishing returns is a short run con-
cept where some factors are fixed and some are variable.
It explains that when more and more units of a variable input are em-
ployed at a given quantity of fixed inputs, the total output may initially

increase at an increasing rate and then at diminishing rates. It implies

that the total output initially increases with an increase in variable
input at a given quantity of fixed inputs, but it starts decreasing after
a point of time.
Statement: When the total output or production of a good increases

by using more of a variable factor (while keeping other factors con-
stant), then after some point the increase in total production becomes
smaller and smaller.
This law is based on the following assumptions:

The state of technology remains unchanged.
All units of variable factor (labour) are of the same quality.
S
There must always be some fixed factor and diminishing returns
must result from limitations on the use of this factor.
The law of variable proportions can be split into three specific stages
of production in the short-run:
IM
1. Stage of increasing returns
2. Stage of diminishing returns
3. Stage of negative returns
Let us consider Figure 8.2 to understand these three stages:

M
Product
N
Stage I TPL
Stage II
Stage III
APL
O b d
MPL
Figure 8.2: Stages of Short-Run Production

(Source: Principles of Economics: Deepashree)
1. Stage of increasing returns: It refers to the stage of production

in which the total output increases initially with an increase in

194 MICROECONOMICS
the number of labour. This stage of production is from the origin

to the point b, where APL is maximum. In this stage:
a. The TPL curve starts from the origin and increases at an in-
creasing rate. Then, from the point of inflexion C, it starts
increasing at a decreasing rate.
b. The APL curve starts from the origin and increases through-
out in this stage.
c. The MPL curve increases initially, reaches a maximum, and
then starts to fall.
The APL and MPL curves increase because the fixed factor of land
is not fully utilised. These increasing returns are due to following
reasons:
S
Underutilisation of a fixed factor: The fixed factor (land) is
underutilised in relation to the labour employed on it. This
helps in better use of land, which, in turn, will increase the
TPL curve at an increasing rate.
IM
Indivisibility of factors: The factors employed in the pro-
duction process cannot be divided further into smaller units.
Therefore, when more units of variable factor (i.e., labour)
are mixed with the fixed factor (i.e., land), the returns will
keep on increasing.
Specialisation and division of variable factor: As the units
M
of the variable factor (labour) are increased, their specialisa-

tion and division will give increasing returns.
A rational producer will not operate in this stage because
he always has an incentive to expand through labour in this
stage.
N
2. Stage of diminishing returns: It refers to the stage of production

in which the total output increases, but marginal product starts
declining with an increase in the number of workers. This stage
of production is from the point b (where APL is maximum) to
point d (where is MPL zero). It refers to the stage of production
in which the total output increases, but marginal product starts
declining with the increase in the number of workers. In this
stage:
a. The TPL curve increases at a decreasing rate till it reaches the
maximum point.
b. The APL curve falls continuously.
c. The MPL curve falls continuously till it is equal to zero.
The diminishing returns are due to the following reasons:
Utilisation of the fixed factor at an optimal capacity: When
the quantity of the fixed factor (land) is efficiently utilised

in relation to the quantity of the variable factor (labour

employed on it), the returns will start increasing at a decreas-
ing rate.
Perfect substitution between factors: All factors of produc-
tion will be in scarce supply. When one factor can be perfectly
replaced with another factor, then returns start increasing at
a diminishing rate.
A rational producer will always operate at this stage to get
maximum efficiency or profits for his firm.
3. Stage of negative returns: It refers to the stage of production in
which the total product starts declining with an increase in the
number of workers. This stage of production is from the point d
onward (where MPL is negative). In this stage:
S
a. The TPL curve falls.
b. The APL curve falls continuously.
c. The MPL curve is negative.
IM
It is a non-economic and inefficient stage. Since a producer can
increase his output by using less labour, he will not have any
incentive to operate in this stage.
Therefore, if we consider Table 8.2 again in relation to these three

stages, then:
M
TABLE 8.2: TP, AP, MP IN SHORT-RUN

Land Labour Total Average Marginal Stage of
Product Product Product Production
N
of Labour of Labour of Labour

(TPL) (APL) (MPL)
1 0 0 0 - Stage I of
Increasing
1 1 4 4 4 Returns
1 2 10 5 6
1 3 18 6 8
1 4 24 6 6 Stage II of
Diminishing
1 5 28 5.6 4 Returns
1 6 30 5 2
1 7 30 4.3 0
1 8 28 3.5 -2 Stage III of
Negative Re-
1 9 25 2.7 -3 turns

196 MICROECONOMICS
4. In which of the following stages of production, the total product

starts declining with an increase in the number of workers?
a. Stage of increasing returns
b. Stage of diminishing returns
c. Stage of negative returns
d. Stage of constant returns
5. In the short-run production, the slope is zero at ___________.
a. maximum TPL
b. minimum TPL
S
c. maximum MPL
d. minimum MPL
IM
ACTIVITY
Search on the Internet and find out the significance of law of dimin-
ishing returns.
S 8.4 SUMMARY
M
Production can be defined as the process of converting the inputs

into outputs. Inputs include land, labour and capital, whereas out-
put includes finished goods and services.
The production function can be defined as a relationship between
an output and different levels and combinations of inputs. It is the
N
process of getting maximum output from the given inputs in a spe-

cific period. It includes only technically sound combinations of in-
puts, which minimise the cost of production.
Factors of production are the inputs used by a firm in the pro-
duction process. These can be fixed (land, equipment) or variable
(labour, electricity) during short-run production.
Short run is defined as a period in which some factors of produc-
tion (such as land and capital) are in fixed supply, while others
such as labour are in variable supply. Long run, on the other hand,
is defined as a period in which all factors of production are in vari-
able supply.
Total Product (TP) is the total quantity of output produced by a
firm during a specific period. It is expressed in physical terms and
not money terms.
Average Product (AP) is the quantity of output per unit of labour
input. It determines how much output each labour produces on an
average.

Marginal Product (MP) is the change in TP produced by an extra

unit of a variable factor (labour).
According to the law of variable proportions, when the total output
or production of a good increases by using more of a variable fac-
tor (while keeping other factors constant), then after some point
the increase in total production becomes smaller and smaller.
The law of variable proportions can be split into three specific
stages of production in the short-run: stage of increasing returns,
stage of diminishing returns, and stage of negative returns.
KEY WORDS
Long run: A planning period during which producers can con-

sider all factors of production as variable
S
Fixed factor of production: A factor of production whose quan-
tity remains constant during a specific period
Variable factor of production: A factor of production whose
IM
quantity can be modified during a particular period
Production: The process of conversion of inputs into outputs
Production function: The relationship between factors of pro-
duction and output

M
MCQ
1. Addition of utility should be regarded as ___________, which
brings about an addition in the value of goods.
a. Production
N
b. Consumption
c. Marginalisation
d. Profiteering
2. Total product divided by the amount of variable factor is:
a. Marginal product
b. Total product per unit of labour
c. Average product
d. Aggregate product
3. The technological relationship between physical inputs and the
maximum producible output is:
a. Total product
b. Marginal product
c. Production function
d. Law of variable proportions

198 MICROECONOMICS
4. The period of time during which a firm can change only some
factors of production (such as labour) is called:
a. Short run
b. Long run
c. Production run
d. Maximum run
5. In which production has all factors of production variable?
a. Total production
b. Marginal production
c. Short-run production
S
d. Long-run production
6. When total product increases at a diminishing rate, the marginal
product will:
IM
a. Increase continuously
b. Increase, reach a maximum, and then fall
c. Remain fixed
d. Decrease
7. Total physical product is derived by ________ the marginal
M
physical product.
a. Summing up
b. Subtracting
c. Multiplying
N
d. Dividing by the quantity of variable factor

8. When the total product is falling, the marginal product will:
a. Increase
b. Decrease
c. Be negative
d. Be zero
9. The total product will be __________ when the marginal product
is zero.
a. maximum
b. minimum
c. zero
d. negative

10. In which stage of the law of variable proportions, the total

product, average product and marginal product curves decline?
a. First
b. Second
c. Third
d. Second and third

?
1. Explain the basic concepts of production. Define the production
function mathematically.
2. What are the factors of production? Differentiate between fixed
S
and variable factors with examples.
3. What is the difference between short-run and long-run
production?
IM
4. Define total product, average product and marginal product.
Use an example to plot their curves and explain the relationships
between:
a. TP and AP curves
b. TP and MP curves
c. AP and MP curves
M
5. Explain the law of variable proportions. What are its assumptions?

6. With the help of a graph, write a note on the following:
a. Stage of increasing returns
b. Stage of diminishing returns
N
c. Stage of negative returns

8.7
(HOTS) QUESTIONS
1. In the first stage of the law of variable proportions, the total
product curve is:
a. Convex
b. Concave
c. U-shaped
d. Downward sloping
2. In the second stage of the law of variable proportions, the total
product curve is:
a. Convex
b. Concave

200 MICROECONOMICS
c. U-shaped
d. Downward sloping
3. In the third stage of the law of variable proportions, the total
product curve is:
a. L-shaped
b. Inverse U
c. U-shaped
d. Downward sloping
4. The shape of the marginal product and the average product
curves is:
a. U-shaped
S
b. Inverse U-shaped
c. Downward sloping
IM d. Convex
5. Which stage of the law of variable proportions is relevant for
a rational producer who wants to get maximum efficiency or
profits for his firm?
a. First
b. Second
M
c. Third
d. Both first and second

N
Topic Q. No. Answer

Basic Concepts of Production 1. b. Output
2. d. some, fixed
3. a. X = f (L,K,S)
Short-Run Production 4. c. Stage of negative returns
Function: Law of Variable
Proportions
5. a. maximum TPL
Q. No. Answer
1. a. Production
2. c. Average product

Q. No. Answer
3. c. Production function
4. a. Short run
5. d. Long-run production
6. c. Decrease
7. a. Summing up
8. c. Be negative
9. a. maximum
10. c. Third

1. Production is conversion of inputs into outputs. Suppose a
S
farmer decides to grow sugarcane. Then, sugarcane is an output
of the production process. Refer to Section 8.2 Basic Concepts of
Production
IM
2. Factors of production are the inputs that are used for producing
the final output with the main aim of earning an economic profit.
Refer to Section 8.2 Basic Concepts of Production
3. Economists usually refer to periods of production as either
short-run or long-run. Refer to Section 8.2 Basic Concepts of
Production
M
4. Total Product (TP) is the total quantity of output produced by a

firm during a specific period. It is expressed in physical terms and
not money terms. Refer to Section 8.3 Short-Run Production
Function: Law of Variable Proportions
5. When the total output or production of a good increases by using
N
more of a variable factor (while keeping other factors constant),

then after some point an increase in total production becomes
smaller and smaller. Refer to Section 8.3 Short-Run Production
Function: Law of Variable Proportions
6. The law of variable proportions can be split into three specific
stages of production in the short-run: stage of increasing returns,
stage of diminishing returns, and stage of negative returns. Refer
to Section 8.3 Short-Run Production Function: Law of Variable
Proportions

QUESTIONS
Q. No. Answer
1. a. Convex
2. b. Concave
3. d. Downward sloping

202 MICROECONOMICS
Q. No. Answer
4. b. Inverse U-shaped
5. b. Second
SUGGESTED READINGS
Forsund, F. (2016). Topics in Production Theory. London: Palgrave
Macmillan Limited.
Frank, C. (2016). Production theory and indivisible commodities.
(psme-3). [Place of publication not identified]: Princeton Univer-
sity Pres.
S
Katz, M., & Rosen, H. (2005). Microeconomics. Boston, Mass.: Mc-
Graw-Hill.
IM
E-REFERENCES
Microeconomics: Theory and Applications, 5th Edition. (2020). Re-
trieved 5 August 2020, from https://global.oup.com/us/companion.
websites/9780195336108/
Theory of Production - Tutorialspoint. (2020). Retrieved 5 August
2020, from https://www.tutorialspoint.com/managerial_economics/
M
theory_of_production.htm
Microeconomics: Production Theory. (2020). Retrieved 5 August
2020, from https://www.slideshare.net/salasvelasco/microeconom-
ics-production-theory
N

C H A
9 P T E R
PRODUCTION THEORY: LONG RUN
S
CONTENTS
9.1 Introduction
9.2 Long-Run Production Function: Isoquant Analysis
IM
9.2.1 Isoquant Curve
9.2.2 Iso-Cost Curves
9.2.3 Producer’s Equilibrium
Activity
9.3 Long-Run Production Function: Law of Returns to Scale
M
9.3.1 Increasing Returns to Scale

9.3.2 Constant Returns to Scale
9.3.3 Diminishing Returns to Scale
Activity
N
9.4 Summary

204 MICROECONOMICS
LONG-RUN PRODUCTION IN RK DESIGNS
Ragini Khanna opened a small manufacturing unit, called RK

Case Objective Designs, to produce jackets. Initially, the firm operated out of a
This caselet introduces the shop, where only one worker did stitching and embroidery work
concept of long-run produc- on jackets. The shop had just enough business for one tailor and
tion. one sewing and embroidery machine to keep busy for a day. The
tailor completed five jackets a day.
One day, RK Designs received a rush order from a customer for

10 jackets, which were to be delivered the next day. Ideally, Ragini
would have liked to use two tailors and two machines to produce
twice their normal output of five jackets. However, in the short
run, her firm had fixed capital, i.e., only one machine. Consider
S
Table 9.1 that shows the short-run production function for RK De-
signs:
IM Table 9.1: Short-Run Production Function for
Jacket Manufacturing
Labour (# Tailors) 1 2 3 4 5 6
Total product (Jack- 5 7 8 8 8 8
ets/hour) For K = 1 Machine
Marginal product 5 2 1 0 0 0
M
In the short run, the only variable factor was labour. Therefore,
the only way RK Designs could produce more jackets was by hir-
ing additional tailors.
From the given table, note that RK Designs initially had one tailor
(labour) and one sewing machine. Now, in the short-run, the num-
N
ber of tailors is varying at RK Designs while the number of sewing

machines is kept constant.
When RK Designs had 1 tailor, it was able to produce 5 jackets in

a day. When 2 tailors were employed, 7 jackets were produced. It
means that addition of 1 labour resulted in an increase of 2 jack-
ets. This is called marginal product (=2). When 3 tailors were
employed, 8 jackets were produced. It means that addition of 1
labour resulted in an increase of 1 jacket which means that mar-
ginal product is 1. Now, when RK Designs employed 4 tailors, 8
jackets were produced. It means that addition of 1 labour does not
result in an increase in productivity. Here, the marginal product
is 0.
When the data related to the number of tailors employed and the
total number of jackets produced is analysed, it is revealed that
adding any number of tailors beyond 3, i.e. (4, 5, 6, tailors) has no
impact on productivity.

PRODUCTION THEORY: LONG RUN 205
In case of RK Designs, the marginal productivity started to de-

cline after the second tailor. This was because capital was fixed
at one machine. The production process for jackets worked best
when each tailor was combined with one machine. If the firm add-
ed more than one tailor to a machine, the marginal productivity
would decline.
Suppose the firm’s demand increased to 15 jackets per day. What

could RK Designs do to operate more efficiently? If demand had
tripled, the firm could acquire two more machines, which would
give a new short-run production function, as shown in Table 9.2:
Table 9.2: Short-Run Production Function for

Jacket Manufacturing
S
Labour (Tailors) 1 2 3 4 5 6
Total product 5 7 8 8 8 8
(Jackets/hour) For K = 1 Machine
Marginal product 5 2 1
IM
0 0 0
Total product 5 10 15 17 18 18
(Jackets/hour) For K = 3 Machines
Marginal product 5 5 5 2 1 0
With more capital, RK Designs hired three tailors before dimin-

ishing productivity started to apply. Since all factors of production
M
were variable, the long-run production function showed the most

efficient way of producing any level of output. In this chapter, you
will study about the concept of such long-run production.
N

206 MICROECONOMICS
LEARNING OBJECTIVES

>> Explain the concept of isoquant analysis in the long-run pro-
duction function
>> Define iso-cost curves
>> Describe the producer’s equilibrium in the long run
>> Explain the laws of returns to scale in the long-run produc-
tion function
9.1 INTRODUCTION
S
Quick Revision In the previous chapter, you have studied about the production theo-
ry in the short run. Short-run production function refers to the time
period in which one input factor of production is variable and oth-
er input factors are fixed and increase in production can be brought
IM
by increasing only one factor of production, while keeping the other
factors constant. On the other hand, in the long run, the production
function includes the time period in which all inputs of production
are variable and increase in production can be achieved by increas-
ing all the input factors simultaneously. For example, in the long run
increase in production can be achieved either by installing new plant,
machinery, buildings or the extra units of labour.
M
The long-run production function can be illustrated graphically

through Isoquant curves or Iso-cost curves. A technical relation that
shows how inputs are converted into output is depicted by an isoquant
curve. It shows the optimum combinations of quantities of factor in-
puts that are used to produce the same output. Isoquant curves are
N
also called as equal product curves or production indifference curves.
In this chapter, you will study about these curves and the producer’s
equilibrium. The chapter also explains the law of returns to scale. In
this chapter, you will study about the concepts of production in long
run.
LONG-RUN PRODUCTION FUNCTION:

9.2
ISOQUANT ANALYSIS
Long run is the period in which the supply of labour and capital is
elastic. It implies that labour and capital are variable inputs. In the
long-run production function, all factors of production are variable.
Suppose a firm has two factors of production: labour and capital. Both
of these factors are variable. Then, the long-run production function
can be expressed through the following equation:
X = f ( L, K )


Here,
X = Level of output
L = Labour (physical and mental efforts of workers)
K = Capital (factories, machines, equipment and other human manu-
factured aids to production)
In the long run, the relation between input-output is studied by the

laws of returns to scale (long-run laws of production). The laws of re-
turns to scale can be explained with the help of an isoquant curve.
9.2.1 ISOQUANT CURVE
An isoquant is the graphical representation of a long-run production
S
function. The word ‘iso’ means constant and the word ‘quant’ means
quantity. An isoquant is defined as a line that shows the various com-
binations of factors of production (labour and capital) which yield a
given quantity of output. According to Cohen and Cyert, an isoquant
IM
is a curve “along which the maximum achievable production is con-
stant.” It represents the flexibility of a firm when it makes production
decisions. Consider Table 9.3 that shows the Labour and Capital data
for different levels of output.
TABLE 9.3: LABOUR AND CAPITAL DATA FOR DIFFERENT

LEVELS OF OUTPUT
Combination Labour Capital Output
M
A 5 10 100
B 10 6 100
C 20 3 100
D 7 12 200
N
E 12 8 200
F 22 5 200
G 9 15 300
H 15 11 300
I 25 8 300
Using the data from Table 9.3, isoquant curves are drawn as shown in
Figure 9.1:
Figure 9.1: Production Isoquants

208 MICROECONOMICS
In Figure 9.1, suppose isoquant I1 shows that a firm can produce 100
kg of output using 10 units of capital and 5 units of labour (combina-
tion A), 3 units of capital and 20 units of labour (combination B) or
any other combination which lies on isoquant I1. Note, however, that
you cannot determine which combination the firm actually uses to
produce the output, it only shows the technically possible combina-
tions of factor inputs which can produce 100 kg of output. Combina-
tion A, which requires more units of labour but less units of capital, is
a capital intensive method of production. On the other hand, combi-
nation B, which requires less units of capital but more units of labour,
is a labour intensive method of production. Figure 9.1 shows three
isoquants:
Isoquant I1: Suppose it shows 100 kg of output. This output can
S
be produced by using either combination A or combination B or
any other combination on this isoquant. The firm or the producer
is indifferent between any of these combinations that lay on the
isoquant I1.
IM
Isoquant I2: This isoquant shows a higher quantity of output, say
150 kg.
Isoquant I3: This isoquant represents even higher quantity of out-
put, say 200 kg.
Therefore, a movement along an isoquant curve represents the con-

stant level of output and different ratios of inputs (capital to labour).
M
On the other hand, a movement from one isoquant to another means

that the level of output changes. An isoquant closer to the point of or-
igin will indicate a lower level of output (such as Isoquant I1), where-
as a higher isoquant will represent a higher level of output (such as
Isoquant I3). There are four main characteristics or properties of an
N
isoquant curve:
An isoquant slopes downward from left to right in the relevant
range: Isoquants are downward sloping as shown in Figure 9.1.
This means that if a firm wants to use more units of labour, it must
use less units of capital to produce the same units of output in or-
der to remain on the same isoquant curve. Such behaviour can
only be satisfied through a downward sloping isoquant because it
only shows the substitution of one factor with the other. Therefore,
the slope of the isoquant curve is negative.
An isoquant is convex to the origin: It implies that factor inputs
are not perfect substitutes. This property shows the substitution
of inputs and diminishing marginal rate of technical substitution
of isoquant. The marginal significance of one input (capital) in
terms of another input (labour) diminishes along with the iso-
quant curve.
A higher isoquant depicts a higher level of output: The great-
er the distance of an isoquant curve from the point of origin,

the higher output it represents. As Figure 9.2 shows, combina-

tion B on isoquant Q2 represents more of both input factors,
OK2 + OL2 as compared to point A on isoquant Q1 , which rep-
resents OK1 + OL1 . Since the marginal factor productivities across
the isoquant remains positive, the point B indicates a higher level
of output than point B:
Units K2 B
of
K1 A
Capital Q2
S
Q1
X
O L1 L2
IM
Units of Labour
Figure 9.2: Isoquant Curves

Source: https://www.microeconomicsnotes.com/production-function/isoquant/isoquant-
concept-characteristics-and-type-production-function-economics/15331
Two isoquants never intersect each other: Two isoquants, which

represent different levels of output cannot intersect. For example,
M
consider Figure 9.3. Suppose isoquant Q1 (= 100 units) and iso-

quant Q2 (= 200 units) intersect each other at point A:
Y
N
Units
of
Capital
A Q2 (=200)
K
Q1 (=100)
O L X
Units of Labour
Figure 9.3: Intersecting Isoquants

Source: https://www.microeconomicsnotes.com/production-function/isoquant/isoquant-con-
cept-characteristics-and-type-production-function-economics/15331
According to Figure 9.3, at point A, the combination of factors OK +

OL can produce both 100 units as well as 200 units of output. This is
an illogical situation. Therefore, two isoquants cannot intersect each
other.

210 MICROECONOMICS
9.2.2 ISO-COST CURVES
An iso-cost curve is the locus of points of all different combinations of

labour and capital that an organisation can employ, given the price of
these inputs. Iso-cost line represents the price of factors along with
the amount of money an organisation is willing to spend on factors.
In other words, it shows different combinations of factors that can be
purchased at a certain amount of money. The slope of the iso-cost line
depends upon the ratio of price of labour to the price of capital. The
Algebraic equation of linear iso-cost line is as follows:
C = PL × L + PK × K
Where,
S
PL = Price of labour (i.e., wages – w)
PK = Price of capital (i.e., interest – r)
Therefore, C = w × L + r × K
IM
For example, a producer has a total budget of `120, which he wants to
spend on the factors of production, namely X and Y. The price of X in
the market is `15 per unit and the price of Y is `10 per unit. Table 9.4
depicts the combinations:
TABLE 9.4 COMBINATION OF X AND Y

M
Combinations Unit of X Unit of Y Total Expenditure

A 8 0 120
B 6 3 120
C 4 6 120
N
D 2 9 120
E 0 12 120
The iso-cost line is shown in Figure 9.4:
X
10
8 T
1
Iso-cost Line
2
H
Y
0 2 4 6 8 10 12
Figure 9.4: Iso-cost Line
As shown in Figure 9.4, if the producer spends the whole amount of

money to purchase X, then he/she can purchase 8 units of X. On the

other hand, if the producer purchases Y with the whole amount, then
he/she would be able to get 12 units. If points H and L are joined on
X and Y axes, respectively, then a straight line is obtained, which is
called iso-cost line. All the combinations of X and Y that lie on this
line, would have the same amount of cost that is `120. Similarly, other
iso-cost lines can be plotted by taking cost more than `120, in case the
producer is willing to spend more amount of money on the production
factors.
With the help of isoquant and iso-cost lines, a producer can determine
the point at which inputs yield maximum profit by incurring mini-
mum cost. Such a point is termed as producer’s equilibrium.
9.2.3 PRODUCER’S EQUILIBRIUM
S
In an earlier chapter, you studied about consumer’s equilibrium. In
this section, you will study about producer’s equilibrium. Producer’s
equilibrium implies a situation in which a producer maximises his/her
profits.
IM
In the long run, the producers can vary all the factors of production.
The producers or the firms usually aim at maximising their profits by
selecting the least cost combination of factors to produce a given level
of output. The combination of factors of production using which an
organisation can produce a given quantity of goods at the lowest cost
or at which the total cost of producing a given output is minimum is
M
known as least cost combination or the optimum factor combination.

The producers always strive to maximise their profit at least cost by
choosing an optimum combination of inputs. If it is assumed that an
organisation is using two factors of production namely capital and la-
bour to produce a certain level of output; then, the optimum combina-
N
tion of factors of production can be explained by two methods which

are:
i. Marginal Product approach; and
ii. Isoquant/Iso-cost approach
Here, we will discuss the producer’s equilibrium using isoquant ap-

proach.
A given level of output can be produced by various combinations of

factors. For maximising profit, the producer must choose a combina-
tion of factors which produce the given level of output at least cost/
outlay. For any level of output, such a least cost combination of factors
occurs where the isoquant curve is tangent to an iso-cost curve. Pro-
ducer’s equilibrium using iso-quant approach is based on the follow-
ing assumptions:
Only two factors of production namely X and Y are considered.
All the units of factors of production are homogenous.

212 MICROECONOMICS
Price of factors of production are stated and are constant.

Total cost is also given and is constant.
Perfect completion exists.
When all these assumptions are true; then, a producer is said to be in

equilibrium when the following two conditions are fulfilled:
The isoquant must be convex to the origin.
The slope of the isoquant equals the slope of iso-cost line.
Producer’s equilibrium using isoquant approach is shown in

Figure 9.5:
S
IM
M
Figure 9.5: Producer’s Equilibrium Using Isoquant Approach

(Source: https://economicsconcepts.com/optimum_factor_combination.htm)
In Figure 9.5, note that the isoquant curve (for product quantity = 400
N
units) is tangent to iso-cost line CD. Here, the cost outlay is Q units.
At point Q, the two conditions required for producer’s equilibrium are
satisfied as follows:
Isoquant curve is convex the origin.
At Q, the slope of the isoquant (= ΔY/ΔX) is equal to the slope of the

iso-cost line (=Px/Py).
1. The line that shows various combinations of factors which

yield a given output is called:
a. Demand curve
b. Budget line
c. Isoquant curve
d. Iso-cost line

2. The following equation represents which expression?

C = PL × L + PK × K
a. Consumer’s equilibrium
b. Isoquant curve
c. Producer’s equilibrium
d. Iso-cost line
3. For the producer’s equilibrium, isoquants must be _________
to the origin.
a. convex
b. concave
S
c. parallel
d. independent
ACTIVITY
IM
Consider any manufacturing company of your choice. Note down
its factors of production and the units of output for the last 5 years.
Draw the isoquant curve of the company.
LONG-RUN PRODUCTION FUNCTION:

9.3
M
LAW OF RETURNS TO SCALE

Returns to scale implies the behaviour of output when all factor inputs
are changed in the same proportion given the same technology. In oth- NOTE
er words, the law of returns to scale explains a proportional change
N
Return to scale is a long-run

in output with respect to a proportional change in inputs. In the long- phenomenon, whereas the law
run production, the output can be increased by increasing the scale of diminishing returns is a short-
of operations. The scale of operations in turn can be increased by in- run phenomenon.
creasing all factors of production at the same time and by the same
proportion. For example, a firm can increase its scale of operations in
the long run by doubling the factors of capital and labour. The scale of
operations is governed by a law called the Law of Returns to Scale.
This law always refers to long-run production, where all factors of pro-
duction are in variable supply.
Statement: When all factors of production are increased in the same

proportion and at the same time, the output will increase. However, an
increase may be at an increasing rate or constant rate or decreasing
rate. Thus, there are three stages of returns to scale:
Increasing returns to scale
Constant returns to scale
Diminishing returns to scale
Let us discuss each stage in detail.

214 MICROECONOMICS
9.3.1 INCREASING RETURNS TO SCALE
It is a situation in which output increases by a greater proportion

than increase in factor inputs. 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 return 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 organisation
enjoys high economies of scale.
During this stage, the output increases more than proportionately to

the increase in factors of production. For example, capital (K) and la-
bour (L) are the only two factors of production in a firm. To produce
100 Q units of output, the firm needs 3 units of K and 3 units of L. If
both these factors are doubled from 3 to 6 units, then 300 Q is pro-
S
duced, which is more than double of 100 Q. This more than double
output is represented by point B in Figure 9.6, which lies on a higher
isoquant than point A:
IM K
B
6
Q 300 Q
A
3
M
100 Q
L
0 3 6
Figure 9.6: Increasing Returns to Scale

N
Source: http://ebooks.lpude.in/commerce/mcom/term_1/DECO405_MANAGERIAL_ECONOM-
ICS_ENGLISH.pdf
Increasing returns to scale happen because when a firm increases its

scale of operations, there will be:
Greater division of labour and specialisation
Use of more specialising and productive machinery
Increasing returns to scale are because of technical and/or managerial

indivisibilities. As the scale of production increases, mass production
methods (such as assembly lines) are used to produce large levels of
outputs. Instead of multitasking, each worker specialises in perform-
ing a simple, repetitive task. This will increase the labour productivity.
Moreover, the firm will use more productive specialised machinery to
increase its scale of operations.
9.3.2 CONSTANT RETURNS TO SCALE
A constant return to scale implies the situation in which an increase

in output is equal to the increase in factor inputs. For example, in the

case of constant returns to scale, when the inputs are doubled, the
output is also doubled. During this stage, the output increases by the
same proportion as the increase in factors of production. For example,
consider Figure 9.7. To produce 100 Q units of output (point A), 3 units
each of K and L are used. If 6 units of K and 6 units of L are used,
then the output produced is 200 Q (point B), which is double the initial
output. Similarly, if the factors of production are trebled, then treble
output will be produced, and so on.
B
6
S
200 Q
A
3
100 Q
0
IM L
3 6
Figure 9.7: Constant Returns to Scale

(Source: http://ebooks.lpude.in/commerce/mcom/term_1/DECO405_MANAGERIAL_ECO-
NOMICS_ENGLISH.pdf)
9.3.3 DIMINISHING RETURNS TO SCALE

M
Diminishing returns to scale refers to a situation in which output in-

creases in lesser proportion than increase in factor inputs. For exam-
ple, when capital and labour are doubled, but the output generated
is less than double, the returns to scale would be termed as dimin-
N
ishing returns to scale. During this stage, the output increases by less
proportion than the increase in factors of production. For example, in
Figure 9.8, both capital and labour are doubled from 3 units to 6 units,
but the output rises by less than double—from 100 Q to 150 Q.
B
6
150 Q
A
3
100 Q
L
0 3 6
Figure 9.8: Decreasing Returns to Scale

Source: http://ebooks.lpude.in/commerce/mcom/term_1/DECO405_MANAGERIAL_ECONOM-
ICS_ENGLISH.pdf

216 MICROECONOMICS
Decreasing returns to scale mainly arises due to a difficulty in manag-

ing a firm as its scale of operations increases. As the scale of operations
increases, the management diseconomies also increase. The manage-
ment of the firm become overburdened and their efficiency in deci-
sion making and coordination activities suffers. Difficulties in commu-
nication also make it harder for them to run a business effectively. The
decreasing returns to scale may also arise due to exhaustible natural
resources. If the capacity of a mining plant or an oil extraction field is
doubled, then it will not lead to double output, as natural resources
have limited supply.
In reality, the forces of increasing or decreasing returns to scale usu-

ally operate side-by-side. At small levels of output, the increasing re-
turns to scale plays a dominant role, whereas the decreasing returns
to scale plays a significant role at very large levels of output.
S
4. Which law exclusively applies to the long-run production?

IM
a. Law of marginal rate of production
b. Law of diminishing returns
c. Law of demand
d. Law of returns to scale
5. If L units of labour and K units of capital are utilised to produce
M
X units of output then the inputs are tripled, the output will
increase by _____________ under decreasing returns to scale.
a. 2X b. 3X
c. 4X d. 5X
N
ACTIVITY
Take an example of any organisation in your area and learn

how it achieves producer’s equilibrium.
S 9.4 SUMMARY
An isoquant is defined as a line that shows various combinations of
the factors of production (labour and capital) which yield a given
quantity of output.
An isoquant curve is downward sloping in the relevant range and
convex to the origin.
The iso-cost or the equal-cost line shows various combinations of
labour and capital that a firm can hire or rent within the given
total cost.

To maximise output for a given cost constraint (or to minimise

production costs), the extra output or marginal product spent on
labour must be equal to the marginal product per unit spent on
capital.
A producer can attain equilibrium by applying the least cost com-
bination of factors of production to attain maximum profit. There-
fore, he/she needs to decide an appropriate combination among
different combinations of factors of production to get the maxi-
mum profit at the least cost.
Law of returns can be classified into three categories, namely, in-
creasing returns to scale, constant returns to scale and diminish-
ing returns to scale.
According to the law of returns to scale, when all factors of produc-
S
tion are increased in the same proportion and at the same time,
the output will increase. However, the increase may be at an in-
creasing rate or constant rate or decreasing rate.
IM
KEY WORDS
Isoquant: A curve that displays different combinations of fac-

tors of production (labour and capital) with which a firm can
produce a given quantity of output
Production function: The functional relationship between in-
puts and outputs of production
M
Iso-cost line: A line that displays different combinations of la-

bour and capital, which a firm can buy, given total cost and pric-
es of other factors
N

1. The higher the isoquant curve, the _______________ the quantity MCQ
of output.
a. higher b. lower
c. fixed d. consistent
2. An isoquant is __________________.
a. downward sloping b. upward sloping
c. parallel to x-axis d. parallel to y-axis
3. Asha Electricals produces 500 units of an output by using needs
30 units of capital and 20 units of labour. When the firms uses 60
units of capital and 40 units of labour, output produced is 1300
units. This is a case of ________ .
a. Increasing returns to scale
b. Decreasing returns to scale

218 MICROECONOMICS
c. Constant returns to scale

d. Either a. or b.
4. Technical indivisibilities cause _________________ returns to
scale.
a. increasing b. constant
c. decreasing d. no
5. In the long run, output can be ___________ by increasing the
scale of operations.
a. decreased b. increased
c. made constant d. standardised
6. Returns to scale means an increase in the output by increasing
S
_________ factor(s) of production in a fixed proportion.
a. no b. only one
c. some d. all
IM
7. What is the slope of an isoquant?
a. Marginal product
b. Ratio of input prices
c. Marginal rate of technical substitution
d. Average product
M
8. The slope of an isoquant is equal to:

a. The ratio of marginal products
b. Total product
N
c. The increasing returns to scale

d. Ratio of quantity and price
9. If all inputs used in the production of a mobile phone are
increased by 20% and the quantity of mobile phones produced
increases by 20%, then there must be:
a. Increasing returns to scale
b. Diseconomies of scale
c. Increasing average total costs
d. Constant returns to scale
10. An isoquant is ________ to the origin.
a. convex
b. concave
c. converging
d. diverging

9.6 DESCRIPTIVE QUESTIONS ?

1. Explain the concept of isoquant analysis in a long-run production.
2. Write a brief note on isoquants and their uses.
3. What is an iso-cost curve? Give an example.
4. What do you mean by returns to scale? Discuss the law with the
help of everyday examples.
5. Write a short note on constant returns to scale.

9.7
(HOTS) QUESTIONS
S
1. Varun Beverages doubles its inputs and finds that its output has
increased by 25%. This is:
a. Constant returns to scale
b. Increasing returns to scale
IM
c. Decreasing returns to scale
d. Diminishing rate of marginal product
2. The overall output generated at a given level of input is shown
by:
a. An isoquant curve
M
b. The budget line

c. An iso-cost line
d. The production function
N
3. An isoquant is _______________ to an iso-cost line at the

equilibrium point.
a. parallel
b. perpendicular
c. convex
d. tangent
4. If a firm doubles in size but needs less than twice as many
workers, then the firm experiences:
a. Increasing costs
b. Increasing returns to scale
c. Constant returns to scale
d. Decreasing returns to scale

220 MICROECONOMICS
Topic Q. No. Answer

Long-Run Production Func- 1. c. Isoquant curve
tion: Isoquant Analysis
2. d. Iso-cost line
3. a. convex
Long-Run Production Func- 4. d. Law of returns to scale
tion: Laws of Returns to Scale
S
5. a. 2X

IM
Q. No. Answer
1. a. higher
2. a. downward sloping
3. a. Increasing returns to scale
4. a. increasing
M
5. b. increased
6. d. all
7. c. Marginal rate of technical substitution
N
8. a. The ratio of marginal products

9. d. Constant returns to scale
10. a. convex

1. In a long-run production, a firm can produce the same level of
output X by using different combinations of factor inputs L and
K (assuming that both factors can be substituted for each other).
Refer to Section 9.2 Long-Run Production Function: Isoquant
Analysis
2. An isoquant is defined as a line that shows various combinations
of the factors of production (labour and capital) which yield
a given quantity of output. Refer to Section 9.2 Long-Run
Production Function: Isoquant Analysis
3. Iso-cost curve is the locus of points of all different combinations
of labour and capital that an organisation can employ, given the

price of these inputs. Iso-cost line represents the price of factors

along with the amount of money an organisation is willing to
spend on factors. Refer to Section 9.2 Long-Run Production
Function: Isoquant Analysis
4. Returns to scale implies the behaviour of output when all the
factor inputs are changed in the same proportion given the same
technology. In other words, the law of returns to scale explains
the proportional change in output with respect to proportional
change in inputs. Refer to Section 9.3 Long-Run Production
Function: Law of Returns to Scale
5. A constant return to scale implies the situation in which an
increase in output is equal to the increase in factor inputs. For
example, in the case of constant returns to scale, when the inputs
S
are doubled, the output is also doubled. Refer to Section 9.3
Long-Run Production Function: Law of Returns to Scale

IM
QUESTIONS
Q. No. Answer
1. b. Increasing returns to scale
2. d. The production function
M
3. d. tangent
4. b. Increasing returns to scale

N
SUGGESTED READINGS
Richardson, G. (2013). Economic Theory. Hoboken: Taylor and
Francis.
Salvatore, D. (2003). Microeconomics. New York: Oxford University
Press.
Taylor, J., & Weerapana, A. (2012). Microeconomics. [Mason, Ohio?]:
E-REFERENCES
(2020).
Retrieved 7 August 2020, from http://ebooks.lpude.in/com-
merce/mcom/term_1/DECO405_MANAGERIAL_ECONOMICS_
ENGLISH.pdf
Isoquant: Concept, Characteristics and Type | Production Func-
tion | Economics. (2020). Retrieved 7 August 2020, from https://
www.microeconomicsnotes.com/production-function/isoquant/

222 MICROECONOMICS
isoquant-concept-characteristics-and-type-production-func-
tion-economics/15331
Production in the Long Run | Microeconomics. (2020). Retrieved 7
August 2020, from https://courses.lumenlearning.com/wm-micro-
economics/chapter/production-in-the-long-run/
S
IM
M
N

CASE STUDIES
7 TO 9
CONTENTS
Case Study 7 Why is Water Cheaper than Diamonds?

Case Study 8 How do Near-Empty Restaurants Operate?
Case Study 9 Microsoft’s Experience with Increasing and Diminishing Returns
S
IM
M
N

224 MICROECONOMICS
CASE STUDY 7
WHY IS WATER CHEAPER THAN DIAMONDS?
Water is essential to life, while diamonds are just trinkets. Yet,

Case Objective
water is cheaper than diamonds. This case study explores why.
This case study explains why
diamonds are much more BACKGROUND
expensive than water which
is extremely essential for
If you purchase a 1-carat diamond, you need to shell out $10,000.
survival, whereas people can
easily live without diamonds. With this money, you could purchase approximately 10,000 bot-
tles of water or about 4 million gallons of municipal water (which
is usually priced at about 25 cents per 100 gallons). To cut a long
story short, for the price of a 1-carat diamond, you could purchase
water to last a lifetime. Then, how is it that the price of something
S
as essential to life as water be so much cheaper than that of a bau-
ble? This case study explores the reasons.
IM
ANALYSIS
The diamonds-water paradox was first explored by the “Father

of Economics” Adam Smith in 1776. He said that the total utility
derived from water is significantly higher than the total utility de-
rived from diamonds. However, the market value of a good is not
based on the total utility of that good, but on what consumers are
willing and able to pay for an extra unit of that good. This is called
M
the marginal utility of that good.
Water is abundantly present in nature. Most people do not have

to make an effort to get water. Just open the faucet, and there it
is! If there are concerns about water purity, then get a Reverse
N
Osmosis (RO) machine installed and consume water from there.

We consume water to the point where the marginal utility of the
last litre purchased is relatively low.
On the other hand, diamonds are not lying around everywhere.

They are relatively scarce as compared to water. Therefore, the
marginal utility of the last diamond bought is relatively high. This
is the reason for the more expensive price tag for diamonds in
comparison to water. Just as Ben Franklin once said, “We will
only know the worth of water when the well is dry.”
RESULTS
The marginal utility of water is the reason that bottled water sales
grew exponentially in the US and the rest of the world during the
last 20 years. In 2019, the per capita consumption of bottled water

Case study 7: WHY IS WATER CHEAPER THAN DIAMONDS? 225
CASE STUDY 7
was approximately 43.7 gallons in the US, whereas it was just 16.2
gallons in 1999 as shown in Figure A:
50
45 43.7
42.3
40.6
40 38.5
Per capita consumption in gallons
35.9
33.6
35
31.6
30.4
29 28.1 28.7
30 27.6 27.8
27.0
25.4
25 23.2
21.6
S
20.1
20 18.2
16.2 16.7
15
99
00
01
02
03
04
05
06
07
08
09
10
13
14
15
16
17
18
19
11
12
19
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
IM
Figure A: Per Capita Consumption of Bottled Water in US
(1999 – 2019)
(Source: https://www.statista.com/statistics/183377/per-capita-consumption-of-bottled-
water-in-the-us-since-1999/)
The per capita consumption of bottled water has also grown in the
rest of the world. In 2018, Mexico and Thailand were the leading
M
countries in bottled water consumption at 72.4 gallons per person

as shown in Figure B:
Mexico 72.4
N
Thailand 72.4
Italy 50.3
United States 42.3
France 38.3
Germany 38.1
Spain 37.6
Belgium-Luxembourg 35.4
United Arab Emirates 35
Indonesia 32.5
0 10 20 30 40 50 60 70 80
Per capita consumption in gallons
Figure B: Per Capita Consumption of Bottled Water Worldwide

2018
(Source: https://www.statista.com/statistics/183388/per-capita-consumption-of-bot-
tled-water-worldwide-in-2009/)

226 MICROECONOMICS
CASE STUDY 7
The bottled water segment earned revenue of $61076 million in

2020, and the market is expected to grow annually by 9.6%. The
US is the world’s largest market for bottled water. Water from
countries such as Italy, France, Sweden, Wales and even Fiji is im-
ported to the US and packaged in bottles to be sold to customers
at a premium price. There are ‘water bars’ in Boston, New York
and Los Angeles, where bottled water is the main attraction.
Now, the question is why would anyone pay a premium price for
water in a bottle when they can drink it for free from a tap? Eco-
nomics provides the following answers for this:
1. For most people, bottled water is a healthy alternative to
tap water. In a Gallup Poll, 50% respondents said that they
S
would not drink water straight from the tap. Therefore, bot-
tled water and tap water are not good substitutes of each
other.
2. Even those people who drink tap water consider bottled
IM
water a convenient option when they are away from home.
According to the theory of utility maximisation, consumers
who purchase bottled water actually feel that the extra ben-
efit offsets the extra cost.
CONCLUSION
M
Today, the sales of bottled water are threatening the gigantic soft
drinks industry. Consumers consider bottled water to be a healthy
alternative to soft drinks. Therefore, bottled water is on the menu
in fast food restaurants. However, soft drink companies might
have had the last laugh after all. If you cannot beat them, join
N
them. Coke and Pepsi have launched their own brands of bottled
water, Dasani and Aquafina, respectively. Their business model is
hugely profitable.
(Source: https://sangu.ge/images/Economics1.pdf)
QUESTIONS
1. How does utility analysis relate to the high demand for

Bisleri and Kinley bottled water, which are sold at a pre-
mium price?
(Hint: Theory of utility maximisation, bottled water and
normal water being not good substitutes)
2. Which country/countries had an approximate per capita
bottled water consumption of 38 in 2018?
(Hint: France, Germany)

CASE STUDY 8
HOW DO NEAR-EMPTY RESTAURANTS OPERATE?
BACKGROUND
Case Objective
The Darbar Restaurant is a Mughlai restaurant in New Delhi. If
This case study analyses
you were to walk to the restaurant during lunch time on a week- when to open the restaurant
day, you will find it almost empty. The restaurant has a seating and when to close it so
capacity of around 50 people. It is luxuriously decorated as any that the restaurant remains
Mughal durbar of a bygone era. There are also classical instru- profitable, using the short-run
mental musicians playing live music at one side of the restaurant. production theory.
On the other side, buffet tables are laid out, with an assortment
of continental and Indian food. As you pick up a delicious spoon-
ful of gravy on your plate, you wonder why the restaurant even
S
bothers to stay open when there are only a couple of customers
(including yourself). It would seem that the revenue from these
couple of customers cannot possibly cover the cost of running the
restaurant.
IM
ANALYSIS
The Darbar restaurant gets a fair crowd during the evenings.

The weekend evenings are particularly busy. However, when the
restaurant owner makes the decision whether to open the restau-
rant for lunch, he must consider the difference between fixed and
variable costs. Most costs of the restaurant are fixed, which in-
M
clude:
Rent
Kitchen equipment
N
Tables and chairs

Plates and cutlery
If the restaurant is closed during lunch times, these costs would

not be reduced. This means that these fixed costs are sunk in the
short run. When deciding to open the restaurant for serving lunch,
the owner must only consider variable costs, including:
Price of additional food
Wage of extra waiters and servers
RESULT
The owner will decide to close the restaurant at lunchtime only if

the revenue from the few customers during that time fails to cover
the variable costs of the restaurant.

228 MICROECONOMICS
CASE STUDY 8
CONCLUSION
In the short run production, the supply curve of the restaurant is

its marginal cost curve (MC) above average variable cost (AVC). If
the restaurant has to be profitable, then its revenue must be more
than its variable costs. As shown in Figure A, it must supply food
in the quantity at which MC is equal to the price of the food. If the
price is less than the AVC, then it would be better to shut down
the restaurant and not serve any food.
Costs
MC
Firm’s short-run
supply curve
S
ATC
AVC
IM Firm
shuts
down if
P < AVC
0 Quantity
Figure A: Short-Run Supply Curve of a Competitive Firm

(Source: Economics by N. Gregory Mankiw, Mark P. Taylor)
M
QUESTIONS
1. Suppose you operate a miniature golf course in a hill sta-

tion. You decide to open the golf course for business only
during the busy summer season and keep it closed during
N
the off-season. What is the reason for this decision when

you have invested so much in the golf course?
(Hint: Since revenue varies from season to season, you
must decide when to keep the golf course open and when
to close it. The golf course should ideally be kept open
only during those times when its revenue exceeds its vari-
able costs.)
2. What are fixed and variable costs associated with the
miniature golf course? Which costs are sunk during the
short run?
(Hint: Fixed costs include the costs of purchasing the
land and building the golf course.)

CASE STUDY 9
MICROSOFT’S EXPERIENCE WITH INCREASING

AND DIMINISHING RETURNS
It has been seen that in some industries, it is not easy for people to
adopt an industry standard that is beneficial to their own product Case Objective
in an easy way. It invariably involves a lot of marketing efforts,
This case study highlights
which helps to grow more productive, which makes the product the different instances where
market share grow bigger. Microsoft experienced
increasing and diminishing
A good example of this is Microsoft’s Windows. It is observed that returns.
when more customers adopt Windows, then there are more appli-
cations which are introduced by independent software develop-
ers in the market, and the more interesting applications that are
introduced which have a better chance of being accepted by the
S
users. It is seen that with other products, the market can show re-
sults in diminishing returns towards the expenditure for promo-
tions, since it becomes saturated. But due to the latest standards
of technology and accepting these new industry standards, the
IM
law for increasing returns can continue. Taking advantage of this,
Microsoft is willing to spend big expenditures on promotion and
marketing to dominate the industry. Many would claim that this is
a limited practice, which can be justified by the recent anti-trust
suit filed against the company.
In December 1999, Microsoft introduced a new program Office

M
2000 included Word, Excel, PowerPoint and Access for its custom-
ers. It had certain advance features over the previous package of
Office 97. The new features allow more interaction with the In-
ternet. It is also beneficial for the firms since it also allows easier
collaborative work for them using an intranet. Therefore, many
N
larger firms are willing to buy and pay for it.
There are limitations in terms of scope for the users to take ad-
vantage of these beneficial features. Office 97 contained a num-
ber of features that most customers cannot finish using them, and
exhaust all its prospects. It was expected that with Word 97 even
skilled users were not likely to use more than a quarter of all its
benefits. Keeping these aspects in mind Microsoft is a victim of
the law of diminishing returns.
The small business and end-users from home may not be im-
pressed with the advanced features and further capabilities of Of-
fice 2000. Since there are large expenditures and costs involved
for upgrading and developing to the package, the next question is
where Microsoft moves from here. It is expected that the next ver-
sion of Office 2003, may bring in a speech-recognition program,
which would eventually make the keyboard and mouse useless.
But these kinds of programs need a good amount of investment

230 MICROECONOMICS
CASE STUDY 9
in terms of time and energies for the user to train the computer
to understand and interpret their commands correctly. It is also
a huge investment for the software producer for developing the
package.
(Source: http://marketworksasia.com/yahoo_site_admin/assets/docs/Excerpts_Ch5_Manage-
rial_Economics)
QUESTIONS
1. Is it possible for a firm to experience both the increasing

and the diminishing returns at the same time?
(Hint: Advance features, extra benefits, expenses)
2. Explain the nature of the fixed factor that is responsible
S
for the law of diminishing returns in Microsoft’s case?
(Hint: Using the benefits of features and costs in terms of
variable and fixed factors)
IM
M
N

C H
10 A P T E R
COST ANALYSIS
S
CONTENTS
10.1 Introduction
10.2 Basic Cost Concepts
IM
10.2.1 Actual and Opportunity Costs
10.2.2 Implicit and Explicit Costs
10.2.3 Fixed and Variable Costs
10.2.4 Accounting and Economic Costs
10.2.5 Private and Social Costs
10.2.6 Short-Run and Long-Run Costs
M

Activity
10.3 Cost Function
10.3.1 Short-Run Cost Function
10.3.2 Long-Run Cost Function
N

Activity
10.4 Economies and Diseconomies of Scale
Activity
10.5 Summary

232 MICROECONOMICS
COST ALLOCATION BY INCREASING REVENUE
Cost refers to expenses incurred in the process of production.

Case Objective From the viewpoint of a business, overall cost is categorised into
two subcategories namely fixed cost and variable cost. Fixed cost
This caselet highlights the
allocation of cost by making is that portion of total cost which remains constant even if the
changes in product prices. quantity of production is varied. For example, rent, salaries of
executives, depreciation, etc. On the other hand, variable cost is
that portion of total cost which varies with the quantity of produc-
tion. For example, labour wages, raw material cost, etc. The total
amount of money that a producer receives after selling goods is
called revenue. Revenue can be calculated by multiplying price
S
per unit with the total number of units sold.
The present case is about a sporting products manufacturer

named XYZ Sports Ltd. XYZ recently started producing a new
IM
range of athletic shoes. This range is specially focused on teen-
ager boys. These shoes are quite similar to the firm’s main prod-
uct, women’s athletic shoe. The only difference between these two
categories is colour. Due to this, the company does not have to
install any new machinery for the production of new range. Be-
fore launching the product, the company was working below its
full capacity and producing only 2000 units per week. However,
M
the company has a capacity to produce 3500 units per week. The
launch of new product range will enable to utilise its full capacity.
The total fixed overhead cost of the company was `1,00,000 per
week. This fixed overhead cost includes shared factory space,
N
machines, electricity, depreciation on machinery, etc. The compa-

ny’s policy is to allocate the shared fixed costs in proportion to the
numbers of pairs of each line of shoes. This makes the product rel-
atively cheaper because per unit fixed cost decreases. Now, XYZ
is working on its full capacity and all the resources are perfectly
utilised.
The company has a new brand in boys’ shoe market because of

this it launched the shoe at lower price. The company charges av-
erage price of `1600 per pair for boys’ shoe and `2000 for women’s
shoe. However, the total revenue generated at that price fails to
cover the total direct costs of raw material and labour. The com-
pany’s management was in dilemma whether to increase price or
not. Then the company’s business analyst suggested to the man-
agement that the product is already getting good response from
market and there is condition of overfull demand (when demand

COST ANALYSIS 233
for a product is more than the company’s manufacturing capacity)

in some areas. He also suggests that it will be better to increase
price level around `1800 per pair. The management agreed with
all these facts and decided to increase price level from `1600 per
pair to `1780 per pair. As a result, within a few weeks of price in-
crease, the company was able to cover up all the direct costs with
increased revenues.
S
IM
M
N

234 MICROECONOMICS
LEARNING OBJECTIVES

>> Discuss the basic cost concepts used in economics
>> Describe the short-run and long-run cost functions
>> Outline the basic concept behind economies of scale and dis-
economies of scale
10.1 INTRODUCTION
Quick Revision In the previous chapter, you studied about the long-run production
function, isoquant curves, iso-cost curve and the producer’s equilib-
S
rium. The chapter also discussed about the laws of returns to scale.
Various costs are involved in running a business. These costs include

production costs, cost of delivering goods or services to the final con-
IM
sumer, etc. A business must consider these costs individually as well
as collectively to conduct cost analysis. Cost analysis helps in deter-
mining whether or the costs are within control and whether the costs
are limiting the profit margins of the business. Cost analysis is essen-
tial for any business to sustain in the market. Continuous alterations
are required to keep costs under control to ensure profit generation.
Cost functions are the mathematical expressions that show the rela-
tionship between input cost and production quantity. The cost func-
M
tion helps in understanding the cost behaviour in the short-run and

long-run. Cost analysis is important in organisational decision making
and resource allocation. For example, decisions regarding capital in-
vestments, such as purchase or replacement of machinery.
N
In this chapter, you will study about the basic cost concepts used in
economics, the cost function and the economies and diseconomies of
scale.
10.2 BASIC COST CONCEPTS

In economics, cost analysis involves measuring the cost-output rela-
tion. In other words, cost analysis involves determining the costs in-
curred for inputs and how they affect the output or productivity of a
company. Cost analysis also involves breaking down a total cost into its
different constituents and studying each cost component. Cost anal-
ysis also involves the comparison of costs for making improvements
in future. For example, comparing the standard cost with actual cost.
Certain cost concepts are used by accountants while some are used
by economists. The cost concepts used by economists are basically to
analyse the cost of production for the year which has to be budgeted.
The economists are more focussed on rearranging the input cost and

COST ANALYSIS 235
output cost to increase the profitability of the business. Various costs

involved in the cost of production include actual and opportunity
costs, implicit and explicit costs, fixed and variable costs, accounting
and economic costs, private and social costs and short-run and long-
run costs.
Let us now study about these costs in detail in the next sections.
10.2.1 ACTUAL AND OPPORTUNITY COSTS
Actual costs are the costs incurred on producing a certain quantity of

goods or providing a certain service. The costs incurred by a business
for manufacturing a product or providing a service are actual costs
which include costs incurred on purchasing raw materials and selling
the final products to customers. In case of services, operations cost is
S
the actual cost. These costs are recorded in the books of accounts and
are used for financial analysis. Let us understand the concept of actu-
al cost with the help of an example.
IM
Maya purchases raw materials for ` 5,000 and incurs transportation
costs of ` 500. The labour and machine costs are ` 5,000 for one week.
The goods are ready for sale and are transported to retail shops at a
cost of ` 500. Therefore, the total cost incurred on the production of
goods are:
S. NO. PARTICULARS OF EXPENSES AMOUNT (`)

M
1. Purchases 5000
2. Transportation (500 + 500) 1000
3. Labour and Machine cost 5000
Total Cost 11000
N
Opportunity cost refers to the costs that a business could have in- NOTE
curred on producing other goods or services which the business did Opportunity cost is also known
not produce as it chose to produce some other goods. Opportunity cost as alternative cost.
is the cost of next best alternative which was available but the busi-
ness let it go.
Business owners always aim to maximise their profits by using the

scarce resources efficiently. In this process, they choose one option
over the other. The other option which they forego is the opportuni-
ty cost as it could have become the alternative source of income. For
example, Ben has ` 50,000 which he can use to buy a press machine
or a drill machine. If he buys a press machine, he expects to earn a
business of ` 5,000 per month and from drill machine he could earn a
business of ` 7,000 per month. Ben decides to buy a drill machine and
earn ` 7,000 per month. Thus, now he cannot buy the press machine
and cannot make ` 5,000 per month. Hence the second-best alterna-
tive income is foregone by Ben.

236 MICROECONOMICS
10.2.2 IMPLICIT AND EXPLICIT COSTS
Implicit costs, as the name suggests, are implied costs. This means an
implied cost is not an actual expense or cost incurred but a reduction
in revenue. This reduction in revenue is a loss incurred due to the
event or an action. However, as there is no actual money spent, it does
not get recorded in the books of accounts.
For example, due to the COVID-19 pandemic, many employees were

asked to work from home, which reduced the revenue of organisa-
tions. There was no actual money spent but the revenue decreased
due to employees working from home. Implicit cost can also be called
opportunity cost. For example, if a fixed deposit of ` 5,00000 is kept for
5 years, it will fetch ` 50,000 interest. But if the deposit is withdrawn
before the required period for investing in a project, it would yield
S
` 10,000 per month. In this case, the interest of ` 50,000 is lost which is
the opportunity cost or the implicit cost.
Stock clearance sale is another example of implicit costs where to cre-

IM
ate space in the warehouse the goods are sold at a lower price. This is
a loss of revenue.
Explicit costs are the actual expenses or costs incurred and these are
recorded in the books of accounts. They are also called actual costs.
For example, costs incurred on purchase of raw materials, paying
wages and salaries to workers, paying rent, etc.
M
In other words, explicit costs are measurable expenses of a business

which are recorded in its books of accounts. For example, if a business
hires 10 new workers, it has to pay salaries to these 10 new workers
which will increase the expenses on salaries in the profit and loss ac-
count. However, if new employees are given training by the existing
N
workers, the training expenses of these 10 workers will be included as

implicit cost and will not be recorded in the books of accounts. How-
ever, if an external training and development consultant is hired for
providing training, the costs would be explicit costs.
10.2.3 FIXED AND VARIABLE COSTS
The total expenses incurred by businesses are classified into two main
categories, i.e., fixed costs and variable costs.
Fixed costs are expenses that are fixed in nature. It means that fixed
costs do not fluctuate according to production and are incurred by the
business even if it is not producing anything. For instance, rent of the
building is a fixed cost.
For example, Dayashankar starts a poultry farm on 1st May 2019. The
rent for the poultry farm is ` 10,000 per month. Workers salary is
` 10,000 per month. These two are fixed costs. Also, electricity bill
is approximate ` 2,000 per month. Food for the hens and chicken is

COST ANALYSIS 237
approximately ` 5,000 per month. Other miscellaneous various costs

vary each month. Therefore, the total fixed cost is ` 27,000. In May
and June, there was no revenue as the hens did not lay any eggs. But
Dayashankar had to bear the fixed costs for months of May and June.
In July, he was in a position to sell around 50 chickens and 100 dozen
eggs and make a revenue of ` 25, 000. Table 10.1 shows the fixed cost
and revenue of Dayashankar from May 2019 to April 2020:
TABLE 10.1: FIXED COST, REVENUE AND PROFIT/LOSS

OF DAYASHANKAR
Month Fixed Cost Revenue Profit/Loss
May 2019 20000 0 –20000
June 2019 20000 0 –20000
S
July 2019 20000 25000 5000
August 2019 20000 30000 10000
September 2019 20000 35000 15000
October 2019 20000
IM 40000 20000
November 2019 20000 41000 21000
December 2019 20000 50000 30000
January 2020 20000 50000 30000
February 2020 20000 45000 25000
March 2020 20000 42000 22000
M
April 2020 20000 41000 21000

Total 240000 399000 159000
Note that the fixed cost remains the same over the months and is not
N
affected by the amount of production. Therefore, the total fixed cost

curve plotted is a parallel line to the horizontal axis which is the level
of output. This is because the fixed cost will remain the same even if
the output is changed.
Variable costs are the costs that vary with the amount of production
or output. These costs can include raw materials, water, labour, etc.
It depends on the usage. For example, a construction site requires
more workers while constructing the building. But once the structure
has been built, only interiors need to be done which requires half the
number of workers. Therefore, wages salaries to workers on a site are
variable costs for a construction company as they vary every month.
On the contrary, the salary of office staff of the construction company,
such as engineers, accountants, site supervisor, office boy, salesper-
sons, is fixed cost.
Every business incurs both fixed and variable costs. Some of the costs
of the business are fixed in nature and some vary according to the
nature of the business.

238 MICROECONOMICS
Similarly, if a business gets a new project, it would hire more workers

or existing workers will have to work overtime. Also, more electricity
will be used. Hence the costs would vary accordingly till the project is
completed and again it will come back to normal while the rent will
remain the same.
Let us extend example of Dayashankar and his poultry. Table

10.2 shows fixed cost, variable cost, revenue and profit/loss of
Dayashankar from May 2019 to April 2020. Note that the total and vari-
able costs change with the demand for more chickens in the month of
December 2019 and January 2020.
TABLE 10.2: FIXED COST, VARIABLE COST, REVENUE AND

PROFIT/LOSS OF DAYASHANKAR
S
Month Fixed Cost Variable Cost Revenue Profit/Loss
May 20000 9000 0 -29000
June 20000 9500 0 -29500
IM
July 20000 9600 25000 -4600
August 20000 9000 30000 1000
September 20000 9400 35000 5600
October 20000 9600 40000 10400
November 20000 8000 41000 13000
December 20000 10000 50000 20000
M
January 20000 10200 50000 19800

February 20000 10100 45000 14900
March 20000 9000 42000 13000
April 20000 8200 41000 12800
N
Total 240000 111600 399000 47400
Variable costs vary according to the level of output. When the level
of output is zero, the variable cost is also zero. Therefore, if we plot
NOTE variable costs on a graph, the variable cost curve will emerge from the
origin.
The Total Variable Cost (TVC)
curve is in the form of an As the output increases, variable costs also increase. This results in
inverted S.
marginal costs. Therefore, in the beginning, the curve is concave and
when the value starts diminishing, it becomes convex in shape thus
forming an S shape.
10.2.4 ACCOUNTING AND ECONOMIC COSTS
Cost analysis done by an accountant and an economist differs as

they work on different fundamentals of costing. An accountant is fo-
cused on making the books of accounts and recording expenses and

COST ANALYSIS 239
revenues to draw up a financial statement to attract investors and give

a good picture of the business. He/she needs to continuously compare
the past performance of the business with the current year’s perfor-
mance. Economists are not concerned with the books of accounts and
preparation of financial statements. They are more focussed on mak-
ing best utilisation of resources to reduce costs and increase profits.
Accounting costs include all actual expenses, depreciation expenses

and all regulatory expenses as per law. Economic costs include oppor-
tunity costs, implicit costs in addition to the actual and explicit costs.
In case the office space is owned by the business, the accounting cost
would show zero rent for the space used. But economic cost will show
the rent of the office space as opportunity cost foregone as the space
used by the business and has not earned rent if it would have let it out.
S
The business owner works full time for the business but does not take
a salary. The accounting cost will show zero as business owner’s sal-
ary. However, economic cost will show the implicit cost of the salary
that should be paid to the business owner for the skills and time he
IM
uses for the business.
Accounting cost applies tax rules to ascertain the amount of deprecia-

tion and accordingly values assets. On the other hand, with respect to
the economic cost view, the actual market value of the asset is taken
and only that amount of depreciation according to the actual wear and
tear of the asset is considered.
M
10.2.5 PRIVATE AND SOCIAL COSTS
No business functions in isolation. It works in a social environment.

It uses its own resources as well as social resources. For example, a
N
business uses its own capital, building, machine, employees and ve-
hicles for production of its goods and services. The cost of employing
all these resources is its private cost. These costs are incurred by the
business but are passed on to consumers when it sells its goods or ser-
vices. Therefore, the society has to bear these private costs ultimately.
There are certain external costs that are created by a business but are
borne by the society or the government. For example, infrastructure
(such as roads), sewage disposal, etc. The entire society pays taxes
MARK IT!
for paying the expenses of all such infrastructure development. You
will find more business units in urban and metro areas than in rural Social costs are private costs
areas because there is a convenient infrastructure available in metros. plus external costs.
Therefore, the society as a whole has to bear private costs as well as
the external costs.
Therefore, social costs are private costs plus external costs. For main-
taining a good social environment, social costs have to be borne by
the society. Every business is treated as a separate legal entity from

240 MICROECONOMICS
its owner and thus should behave as a socially responsible unit of the
society. A society can progress only if every member of the society acts
responsibly and takes care of social costs created by them. Therefore,
every consumer and producer should review the decision of consump-
tion and production taking into consideration the external cost creat-
ed by this decision.
10.2.6 SHORT-RUN AND LONG-RUN COSTS
Short-run and long-run costs are costs involved in different time pe-
riods in an economy. In short-run, one factor of production is fixed.
Short-run is usually considered for up to one year. For example, if the
capital employed (factor of production) is fixed, then, for increasing
production in short-run, the business cannot increase its capital but
S
it will have to increase the number of workers or machinery, etc. It is
also possible that the business would rent a machinery instead of pur-
chasing a machinery. Thus, in short-run, the business would observe a
rise in marginal costs resulting in diminishing marginal returns. This
IM
will affect the price of the product or cost of labour. For example, due
to the COVID-19 pandemic, the cost of all essentials went up because
there was an increase in demand but supply could not be increased in
the short run.
In the long-run, none of the factors of production is fixed, they are all
variable. Time period for long-run is usually more than a year. Here
the business has to consider the long-run impact and plan accordingly.
M
For example, during 2020, all educational institutes had to be closed.

These schools and colleges thought the first lockdown period will be
able to eradicate the COVID-19 pandemic and they will be able to re-
open in the next academic year. However, they did not consider the
long-term impact of the pandemic and plan accordingly for the long
N
run.
Variable costs related to creating virtual classrooms, preparing online

study materials and student support systems had to be borne. Also,
fees had to be varied or deferred. Thus, the price elasticity of demand
varied as the students and the parents have to get used to the new way
of learning and ready to pay for the fees associated with it.
1. ___________ is also called the cost of second best alternative.

a. Actual cost
b. Opportunity cost
c. Explicit cost
d. Fixed cost

COST ANALYSIS 241
2. Which of the following costs are not recorded in the books of

accounts?
a. Implicit cost b. Explicit cost
c. Fixed cost d. Variable cost
3. Social costs include ___________ costs and _________ costs.
a. implicit, explicit b. actual, opportunity
c. private, external d. short run, long run
ACTIVITY
S
Prepare a short note on the meaning and types of social and private
costs.
10.3 COST FUNCTION

IM
A cost function is a mathematical function that shows how produc-
tion costs change at different output levels. It represents the relation
between inputs and outputs. The cost function calculates the value of
output given certain inputs. Businesses use the cost function to mini-
mise cost and maximise production efficiency.
M
10.3.1 SHORT-RUN COST FUNCTION
In the short-run, only one cost is fixed and the cost of production var-
ies with the output produced. The short-run cost function is mathe-
matically written as:
N
C = f (X)
The cost of production is denoted as C and the level of output is denot-

ed as X. The fixed cost curve is a straight line parallel to the horizontal
axis for the cost of output and the variable cost is an S-shaped curve.
Every business incurs fixed cost as well as variable cost which results
in total cost.
Total Cost (TC) = Total Fixed Cost (TFC) + Total Variable Cost
(TVC)
In the long-run cost, no factor of production is fixed. Hence, all factors

of production have variable costs. Therefore, here fixed costs are zero
and total costs equal to the total of variable costs.
TC = TVC
The total cost curve will be the summation of total fixed cost curve and
total variable cost curve.

242 MICROECONOMICS
Figure 10.1 shows the graphical presentation of total fixed cost curve,
total variable cost curve and total cost curve:
Y
TC
TVS
TVS
TFC
TC
S
TFC
X
IM Output
Figure 10.1: Total Fixed Cost Curve, Total Variable Cost Curve
and Total Cost Curve
From Figure 10.1, observe that:

M
The TFC curve is parallel to the X-axis. TFC shows the cost of out-
put is fixed even if the output is zero.
The TVC curve is an S-shaped curve. Initially, the increase in cost
gives increase value of output but after a point with every increase
of variable cost, the marginal cost diminishes giving the curve an
N
S shape. The TVC curve starts from the origin as when the output
is zero, the variable cost is also zero.
The TC is the sum of TFC and TVC. The shape of the TC curve is
similar to the shape of the TVC curve but it does not start from the
origin instead it starts at the point of the fixed cost curve.
Let us now learn about the short-run average and marginal costs.
SHORT-RUN AVERAGE COST
Average Fixed Cost (AFC) is calculated by dividing the Total Fixed

Cost (TFC) by the output quantity (Q).
AFC = TFC/Q
You are already aware that the TFC does not change with the output,
it remains constant. Therefore, the AFC decreases if the output in-
creases and the AFC increases if the output decreases.

COST ANALYSIS 243
The short-run average cost curves and marginal cost curve are shown
in Figure 10.2:
MC
ATC
AVC
Cost
S
AFC
Q1 Q2 Q3
IM
Quantity of Output
Figure 10.2: Graphical Representation of Short-Run Average

Cost Curves and Marginal Cost Curve
In Figure 10.2, observe that the AFC falls till zero as the output in-
creases and takes a shape of a rectangular hyperbola.
M
Average Variable Cost (AVC) is calculated by dividing the Total Vari-

able Cost (TVC) by output.
AVC = TVC/Q
N
In Figure 10.2, observe that the AVC becomes minimum at quantity

output Q2 and then again it increases.
Average Total Cost (ATC) is calculated by dividing the total cost by the
output quantity.
ATC = TC/Q
It is known that the total cost is the sum of total fixed cost and total
variable cost. Therefore,
ATC = (TFC + TVC )/Q
It is also known that TFC/Q is AFC and TVC/Q is AVC. So, this formu-
la can be further modified as:
ATC = AFC + AVC
This formula also explains why the ATC curve is U-shaped like the
AVC curve in Figure 10.2. From Figure 10.2, observe that the ATC
curves keep falling as the AFC and AVC curve keep falling and the

244 MICROECONOMICS
ATC continues even when the AVC curve picks up after point Q2. AFC
decreases till it reaches the minimum output of Q3 and then it starts
rising up with the AFC and AVC.
SHORT RUN AVERAGE COST
In the short run, the cost of producing a small amount of additional

units of a good or service is called Short-Run Marginal Cost (SMC).
The short-run marginal cost is obtained by dividing the Short-Run
Total Cost (STC) by output.
SMC = STC/Q
And, STC = TFC + TVC
S
Therefore, we can write the above formula as:
SMC = (TFC + TVC)/Q
SMC = (TFC/Q) + (TVC/Q)
IM
And when we reach the marginal cost, the TFC is at 0 output. There-
fore,
SMC = 0 + (TVC/Q)
SMC = TVC / Q
Thus, it proves that the short-run marginal cost is the change in cost
M
that occurs from the change in the output quantity due to change in
the variable factor.
From Figure 10.2, observe that the marginal cost declines to the min-
imum output at Q1 and then starts rising up. This minimum output
is less than that of AVC and ATC. You can also see the intersection of
N
the marginal curve with the AVC and ATC at their minimum output
levels.
It can be said that for each additional unit of output, more cost is add-
ed to the average variable cost than to the total cost. Therefore, the
marginal cost curve is below the average variable cost curve.
However, when the marginal cost curve is above the average variable
cost curve, it means that for each additional unit of output, more cost
is added to the total cost than to the average variable cost.
Average Variable Cost is falling when MC < AVC
Average Variable Cost rises when MC > AVC
Therefore, MC = AVC at the minimum output of AVC.
The same logic applies between MC and ATC

COST ANALYSIS 245
10.3.2 LONG-RUN COST FUNCTION
In the long-run, fixed costs are zero and all the costs are variable. It
means that there would be minimum cost of production for a given
level of output. Therefore, it is observed that long-run costs are never
more than short-run costs but will always be lower or equal to short-
run average costs.
If we try to depict this graphically, you will find that the minimum
points of all short-run total cost curves at different levels when joined,
this gives us the long-run total cost curve. The long-run average cost
curve is the average cost per unit of production in the long-run. Math-
ematically, it is calculated by dividing the long-run total cost by the
output level. This is shown in Figure 10.3:
S
Y
E2 SAC SAC2
1
IM SAC3
E1
E
E3 LAC
Cost
R
M
O M2 M4 M1 M3 X
Output
N
Figure 10.3: Envelope Curve
In Figure 10.3, each short-run average cost curve belongs to a particu-

lar machinery capacity. The capacity of the machinery is fixed but the
input can vary in the short-run. However, in the long-run, the business
has the opportunity to minimise its cost for the output it wants to pro-
duce in the year.
Therefore, OM1 is the level of output when the machinery capacity

is SAC2. In the long-run, if the business tries to operate at a cost of
SAC2 to produce OM2 output, the costs will increase. In the long-run,
the business can have an output planned at a capacity of the machin-
ery which will minimise the costs. Figure 10.3 shows the minimum
points of all SAC curves. When all these minimum points are joined,
LAC curve is obtained. The LAC is also known as the envelope curve.
The business owner thus decides the scale of operation or the size of
the firm. To make this decision, the owner needs to know the cost of
production for a certain level of output.

246 MICROECONOMICS
DERIVATION OF LONG RUN TOTAL COST FUNCTION FROM LONG

RUN PRODUCTION FUNCTION
For calculating cost schedules from long-run cost function, the follow-
ing assumptions are made:
The input level does not affect the input prices.
The business owner has measured the production function for the
level of output required and decides to expand the output.
The firm uses only two variable factors, i.e., capital and skilled
workers.
Example 1: Assume that the firm uses two variable factors, i.e., capi-
tal and workers which are available at ` 2 and ` 5 per unit of output,
respectively. In the below table, we will see the unique features of a
S
derived expansion path.
1 2 3 4 5 6
Output Skilled Least Cost Total cost at ` Average Marginal Cost
IM
(Units) Workers Usage of 2/- per Unit ` Cost (per Unit)
(Units) Capital of 5/- per Unit of Col 4 / Diff of Col 4 /
Workers Capital (col 2 × Col 1 Diff of Col 1
`2) + (col 3 × `5)
25 5 3 25 1.00 =(25-0)/(25-0)
= 1.00
50 7 5 39 0.78 =(39-25)/(50-25)
= 0.56
M
75 10 7 55 0.73 =(55-39)/(75-50)
= 0.44
100 12 9 69 0.69 =(69-55)/(100-75)
= 0.56
125 15 11 85 0.68 =(85-69)/(125-
N
100) = 0.64
150 20 13 105 0.70 =(105-85)/(150-
125) = 0.80
175 25 15 125 0.71 =(125-105)/(175-
150) = 0.80
200 30 20 160 0.80 =(160-125)/(200-
175) = 1.4
Column 1: Eight output levels
Column 2 and Column 3: Skilled workers and capital employed to get

the output.
Column 4: Total cost of production for each level of output. For example,
for producing 75 units of output, the business has employed 10 skilled
workers and 7 units of capital. The cost thus comes to ` 55. Therefore,
column 4 gives the minimum cost for the given levels of output.
Column 5: Gives average cost by dividing total cost given in column 4

by the corresponding output level. For example, when total cost is 55
divided by the corresponding output 75 gives us 0.73. This shows that

COST ANALYSIS 247
the long-run average cost first decreases to the minimum then starts
rising similar to the case in short-run.
Column 6: This column calculates the long-run marginal cost by di-

viding the change in total cost given in column 4 by the change in
output given in column 1. For example, when out-put increases from
`25 to `50, the total cost increases from `25 to `39. The total increase
in cost (`14) divided by total increase in output (25) is calculated as `
0.56. This shows that similar to the case of short-run, the marginal cost
decreases first and then increases. The expansion path can be repre-
sented graphically as shown in Figure 10.4:
I4
S
I3 IM
I2
Capital Employed
Expansion Path
S’
R’
I1
B’ Q4
M
Q3
K1 P’
Q2
Q1
N
L1 I1 I2 I3 I4
Skilled Workers
Figure 10.4: Long-Run Cost and Expansion Path
In Figure 10.4, we see two inputs K and L on the two axes. Observe the
iso-cost lines, I1I’1, I2I’2 and so on represent the fixed factor price ratio.
The isoquant maps Q1, Q2, and so on are derived from the production
function.
In the long-run production function, all input costs are variable costs.
Therefore, the business owner makes the best choice of producing a
certain level of output for minimum cost.
Thus, at a given factor price ratio and production function, the expan-
sion path is derived which depicts the levels of input that will allow
the business to produce the level of output at minimum possible cost.
There is a major difference between long-run average cost curve and

marginal cost curve. The long-run average cost curve is derived by

248 MICROECONOMICS
dividing the total cost of producing an output by the level of output.

In the long-run marginal cost curve, additional cost is incurred with
increase in every unit with maximum utilisation of input.
The long-run average cost curve and the marginal cost curves are
shown in Figure 10.5:
LRMC
LRAC
Cost
L
S
IM O Q1 Q2
Quantity
Figure 10.5: Long-Run Average Cost Curve and

Marginal Cost Curve
In Figure 10.5, observe the following:

M
The long-run average cost curve and marginal cost curve have the
same shape as in the short-run.
LRAC decreases and goes down to the minimum possible cost at
Q2 and then starts to increase.
N
LRMC also decreases till it touches the lowest output at Q1 and

then starts increasing.
Both the curves intersect each other at their lowest point L as it
did in the short-run because marginal cost is less than the aver-
age cost and for each additional unit produced, the cost added to
average cost is less than the total cost. Therefore, average cost de-
creases. Similarly, when the marginal cost is more than the aver-
age cost, for every additional unit of output, the cost added to total
cost is less than the average cost and the average cost increases.
Therefore, marginal cost should always be equal to average cost to
maintain the average cost at its lowest.
4. In ___________ cost, there is only one fixed cost factor and

others are all variable cost.
a. short-run b. long run
c. very short run d. very long run

COST ANALYSIS 249
5. Which of the following options is true with respect to the

graphical representation of the Total Fixed Cost (TFC) curve?
a. It intersects the short run average cost.
b. It intersects the total variable cost.
c. It is parallel to the horizontal axis.
d. It is parallel to the vertical axis.
6. In ________cost, there is no fixed cost and all the costs are
variable.
a. short run
b. long run
S
c. very short run
d. very long run
7. In ________, additional cost is incurred with increase of every
IM
unit with maximum utilisation of input.
a. short-run cost
b. long-run cost
c. long-run average cost curve
d. long-run marginal cost curve
M
ACTIVITY
Graphically represent the long-run average cost curve and the long-
run marginal cost curve and fill in the following blanks.
N
1. Long-run average cost curve and marginal cost curve have

the ______ shape.
2. Long-run average cost curve first ______till the ______ cost
and then ______.
3. Long-run marginal cost curve first ______till the ______ cost
and then ______.
4. Both the curves ______each other at their ______ point.
ECONOMIES AND DISECONOMIES OF

10.4
SCALE
In the preceding sections, you have seen that the output can be in-
creased in the long-run and cost can also be minimised. There are
some disadvantages of the large-scale production as well. These ad-
vantages and disadvantages of large-scale production are known as
economies and diseconomies of scale.

250 MICROECONOMICS
ECONOMIES OF SCALE
Economies of scale is an advantage that results due to large-scale pro-

duction. When costs are saved due to an increased level of production,
it is a case of economies of scale. Economies of scale is caused by the
following factors:
Specialisation: When a business operates at higher scale, it has
greater opportunities to specialise in that field irrespective of the
job performed by men or machine. At large scale, the business can
afford to divide the work and allot specialised tasks to different
groups of people. Specialisation ensures good finesse to goods or
services.
Inputs at reduced costs: Businesses require raw materials in
large quantities due to which suppliers provide materials at large
S
discounts resulting in a favourable purchase price.
By-products: Usually, large-scale businesses create by-products in
the process of production of the main product. These by-products
IM can be reutilised or recycled or sold which results in an effective
and efficient use of resources. A small-scale business may not be
able to take an advantage of by-products due to limited capaci-
ty. For example, in sugar factories, sugar is produced as the main
product whereas molasses and bagasse are produced as by-prod-
ucts.
M
DISECONOMIES OF SCALE
After a point, cost cannot be reduced. After reaching the minimum

cost, costs start to increase and economies of scale cannot be achieved.
From that point, diseconomies of scale crop-up and starts affecting the
N
cost curve of the business.
The main reasons for diseconomies of scale is planning and decision

making. In large-scale businesses, communication channels increase.
Also, the hierarchy levels increase and top management personnel en-
joy greater authority. Therefore, it takes more time to take appropri-
ate decisions and implement them. Slow decision making and plan-
ning leads to a loss of opportunity.
8. Which of the following factors does not result in the economies

of scale?
a. Specialisation
b. By-products
c. Large inputs
d. Diminishing managerial expertise

COST ANALYSIS 251
9. Which of the following causes the diseconomies of scale?

a. Maximum utilisation of resources
b. Competitive resources
c. Creating business opportunities for others
d. Reduced input costs
ACTIVITY
Draw the LAC curve for the two stages of economies of scale.
10.5 SUMMARY S
S
Cost analysis involves determining the costs incurred for inputs
and how they affect the output or productivity of a company.
Actual
IM
costs are costs incurred on producing a certain quantity of
goods or for providing certain service.
Opportunity cost is the cost of next best alternative which was
available but the business let it go.
Implicit costs, as the name suggests, are implied costs. This means
implied cost is not an actual expense or cost incurred but a reduc-
tion in revenue. They are also called opportunity cost.
M
Explicitcosts are the actual expenses or costs incurred and these

are recorded in the books of accounts. They are also called actual
costs.
Fixed Costs are expenses that are fixed in nature. It means that
N
fixed costs do not fluctuate according to production.

Variable costs are the costs that vary with the amount of produc-
tion or output.
Cost analysis done by an accountant and an economist differs as
they work on different fundamentals of costing.
Private cost are costs are incurred by the business but are passed
on to the consumers when it sells its goods or services. There are
certain external costs that are created by the business but are
borne by the society or the government.
In short-run, one factor of production is fixed. Short-run is usually
considered for up to one year. In the long-run, none of the factors
of production is fixed, they are all variable. Time period for long-
run is usually more than a year. Total cost is obtained by adding
total fixed cost and total variable cost.
Average fixed cost is the total fixed cost divided by the output
quantity.

252 MICROECONOMICS
AVC is calculated by dividing total variable cost by output quantity.
Average cost is the result of total cost divided by output quantity.

ATC curve is U-shaped similar to the AVC curve.
In the short run, the cost of producing a small amount of additional
units of a good or service is called Short-Run Marginal Cost (SMC).
LRTC has a positive slope when costs and output are directly pro-
portional.
LRTC starts from the origin as all factors are variable and no fixed
cost is involved.
First cost increases at a decreasing rate and then increases at an
increasing rate.
S
Long run average curve is total cost of producing a output divided
by the level of output.
In the long-run marginal cost curve, additional cost is incurred
IM with increase in every unit with maximum utilisation of input.
Economies of scale is an advantage that results due to large-scale
production. When costs are saved due to increased level of produc-
tion, it is a case of economies of scale. After a point, cost cannot be
reduced. After reaching the minimum cost, costs start to increase
and economies of scale cannot be achieved.
M
KEY WORDS
Fixed cost: The cost that remains constant even for zero output
quantity
Marginal cost: The additional cost incurred as a result of pro-
ducing one additional unit of a product or service
N
Marginal revenue: The additional revenue generated by pro-

ducing one additional unit of a product or service
Opportunity cost: The cost associated with the loss of other al-
ternatives when one alternative is chosen
Variable cost: The cost that varies with the production quantity

MCQ 1. Which of the following is an implicit cost for a business?
a. Wages and salaries of workers
b. Building lease
c. Raw material cost
d. Salary of the owner

COST ANALYSIS 253
2. If a business shows only opportunity costs as its revenues, it

means that ___________.
a. there is zero profit
b. the total revenue and implicit costs are same
c. the total revenue and explicit costs are same
d. None of the these
3. A business produces 2000 units in a year and sells them at ` 5,000
each. The explicit cost of production is ` 50 lakhs and the implicit
cost is ` 3 lakhs. The business earns accounting profit of ________
and economic profit of ____________.
a. 50 lakhs, 47 lakhs b. 40 lakhs, 47 lakhs
S
c. 47 lakhs, 50 lakhs d. 50 lakhs, 50 lakhs
4. Which of the following is not an example of fixed cost?
a. Rent of ` 5,000 payable in the contract of lease
IM
b. Lawyer’s fees ` 2,000
c. Insurance premium of ` 20,000
d. Wages to worker ` 3,000
5. To have an output level of 10 units, a business has to incur an
average fixed cost of `20 and average variable cost of `100. What
is the total cost for the given output level?
M
a. 120 b. 110
c. 1200 d. 900
6. A business has fixed costs of ` 40,000; average total costs of
N
`300 and average variable cost of `250. Its output level would be
_____________.
a. 100 units b. 200 units
c. 800 units d. 400 units
7. A business employs upgraded technology for production. Which
of the following options would be right for the MC curve?
a. It will shift down. b. It will shift up.
c. It will shift right. d. It will shift left.
8. A business’s short run marginal cost curve will start increasing
when the _____________.
a. total fixed cost starts increasing
b. average fixed cost starts decreasing
c. marginal output starts increasing
d. marginal output starts decreasing

254 MICROECONOMICS
9. A business can earn the economies of scale if the ___________.

a. long-run average cost curve is increasing
b. long-run average cost curve is decreasing
c. long-run average cost curve is constant
d. long-run average cost curve first increases then decreases
10. A business orders for twice the inputs and discovers that
the output produced is twice. This means the business has
___________.
a. diseconomies of scale b. constant returns of scale
c. economies of scale d. extended economies of scale
S
? 1. Explain the LAC curve.
2. Explain the meaning of private and social costs?
IM3. Describe the economies and diseconomies of scale.

10.8
(HOTS) QUESTIONS
1. Average variable cost falls when
A. MC < AVC B. MC > AVC
M
C. MC = AVC D. AFC > AVC

2. Short run marginal curve and average cost curve decrease
to minimum at a certain output level. Which of the following
ascending order is correct?
N
A. Marginal Cost, Average Variable Cost, Average Total Cost

B. Average Variable Cost, Average Total Cost, Marginal Cost
C. Average Variable Cost, Marginal Cost, Average Total Cost
D. Average Total Cost, Average Variable Cost, Marginal Cost
3. Which of the following is an incorrect representation of the SMC
formula?
a. SMC = STC/Q b. SMC = (TFC + TVC)/Q
c. SMC = TVC/Q d. SMC = TFC/Q
Topic Q. No. Answer

Basic Cost Concepts 1. b. Opportunity cost

COST ANALYSIS 255
Topic Q. No. Answer

2. a. Implicit cost
3. c. private, external
Cost Function 4. a. short run
5. c. It is parallel to the horizontal axis
6. b. long run
7. d. long-run marginal cost curve
Economies and 8. d. Diminishing managerial expertise
Diseconomies of Scale
9. b. Competitive resources
S
Q. No. Answer
1. d. Salary of the owner
IM
2. d. None of the above
3. a. 50 lakhs, 47 lakhs
4. d. Wages to worker `3000
5. c. 1200
6. c. 800 units
M
7. a. It will shift down.

8. d. marginal output starts decreasing
9. b. long-run average cost curve is decreasing
10. c. economies of Scale
N

1. In the long-run, the business can have an output planned at a
capacity of the machinery which will minimise the costs. When
the minimum points of all SAC curves are joined, LAC curve is
obtained. The LAC is also known as the envelope curve. Refer to
Section 10.3 Cost Function
2. No business functions in isolation. It works in a social
environment. It uses its own resources as well as the social
resources. The cost of employing all these resources is its private
cost. Social costs are private costs plus external costs. Refer to
Section 10.2 Basic Cost Concepts
3. Economies of scale is an advantage that results due to large-
scale production. When costs are saved due to increased level
of production, it is a case of economies of scale. Refer to Section
10.4 Economies and Diseconomies of Scale

256 MICROECONOMICS

QUESTIONS
Q. No. Answer
1. a. MC < AVC
2. a.
Marginal Cost, Average Variable Cost, Average Total
Cost
3. d. SMC = TFC/Q
SUGGESTED READINGS &

10.10
REFERENCES
SUGGESTED READINGS
S
Richardson, G. (2013). Economic Theory. Hoboken: Taylor and
Francis.
Salvatore, D. (2003). Microeconomics. New York: Oxford University
IM
Press.
Taylor, J., & Weerapana, A. (2012). Microeconomics. [Mason, Ohio?]:
E-REFERENCES
Variable Cost & Fixed Cost - Economics. (2020). Retrieved 10 Au-
M
gust 2020, from http://economics.fundamentalfinance.com/micro_

costs.php
Difference between Economic Cost and Accounting Cost. (2020).
Retrieved 10 August 2020, from https://www.economicsdiscussion.
N
net/production/cost-of-production/difference-between-econom-
ic-cost-and-accounting-cost/16344

C H
11 A P T E R
REVENUE ANALYSIS
S
CONTENTS
11.1 Introduction
11.2 Concept of Revenue
IM
11.2.1 Total Revenue (TR)
11.2.2 Average Revenue (AR)
11.2.3 Marginal Revenue (MR)
11.2.4 Relationship Between TR and MR
11.2.5 Relationship Between AR and MR
M
Activity
11.3 Summary
N


258 MICROECONOMICS
SURESH’S BICYCLE MART
Suresh Mittal owns a bicycle mart. He has fixed the sale price for
Case Objective his bicycles, whereas other bicycle traders in the market give dis-
This caselet highlights how counts to their customers. Due to this, the sale of his bicycles is
Suresh, a bicycle mart owner, limited. He too is thinking of giving discounts on his bicycle and
learns about the need to in- proposes the below options:
crease revenue by increasing
sales and offering discounts. 1. The price will be fixed up to the sale of 10 bicycles, then, a
discount of 5% will be given. In the last week of the month, the
discount will be increased to 10%. Later, it was realised that
the customers who bought in the first week were extremely
disappointed to know this.
S
2. A discount of 2% will be given on all bicycles sold throughout
the month.
3. A discount will be given based on Suresh’s personal relation
with the customer and the cost of the bicycle purchased.
IM
Suresh is worried about possible losses in the bargain. Suresh
doesn’t know how he will be able to decide after what point he
must not give discounts or the price below which he should not
sell the bicycles.
Suresh is paying a rent of ` 5,000 to stock his goods in a godown.

In this case, it is better to sell goods as early as possible and he
M
should try to sell more bicycles by offering discounts than stock-

ing it and paying rent for them. With low sales, there is also a risk
that goods would become outdated.
A business owner must think of all possibilities and have a good

N
understanding of the market to make quick decisions related to

pricing and revenues. Here, in the current situation, an analysis
of revenue can help Suresh decide the price and discount rates for
his product. He can determine when and how much discounts to
give. Or, at which price he should sell rather than making a com-
plete loss.
Suresh observed a new regulation on the production of two-wheel-

ers to bring it at par with the best practices in the world. All show-
rooms were offering two wheelers at reduced prices as they would
become outdated and there will be zero demand for them. Show-
rooms will not be able to sell them after the stipulated date given
by the government. At the same time, Suresh who was not plan-
ning to buy a two-wheeler in the near future rose up to this occa-
sion and grabbed the opportunity.

REVENUE ANALYSIS 259
LEARNING OBJECTIVES

>> Explain the meaning of revenue
>> Outline the concept and formulae of Total Revenue (TR), Av-
erage Revenue (AR) and Marginal Revenue (MR)
>> Examine the relationship between TR and MR
>> Describe the relationship between AR and MR
11.1 INTRODUCTION
In the previous chapter, you studied about the basic cost concepts Quick Revision
S
such as the meaning of actual cost, opportunity cost, private cost, so-
cial cost, accounting cost and economic costs. You also studied about
short-run and long-run cost functions. The later sections also shed
light on the economies and diseconomies of scale.
IM
The most important objective of businesses is to earn revenue by sell-
ing goods or services. For instance, a chocolate company produces dif-
ferent types of chocolates and sells them at ` 50,000 in December 2019.
In this case, the revenue earned by the business is ` 50,000. Revenue is
different from profit. Therefore, one must not confuse between these
two economic terms. Revenue is the amount generated from sales or
the total income of the business. In contrast, profit is the margin or
M
difference between the expenditure borne and the revenue received.

If the revenue is more than the expenditure, there will be a profit and
if expenditure is more than the revenue, there will be a loss.
In this chapter, you will study about the basic concepts of revenue
N
such as the meaning of Total Revenue (TR), Average Revenue (AR)

and Marginal Revenue (MR). The later sections will also discuss the
relationship between TR and MR and also between AR and MR.
11.2 CONCEPT OF REVENUE

In economics, revenue refers to the amount of money generated by an
organisation by selling its products and services. Revenue generation
is the single most important reason for the existence of a business.
The business meets its expenses and various costs by generating rev-
enues. Revenue is directly affected by the sales of the organisation.
When sales increases, there is an increase in revenue and vice versa.
For instance, for producing 50 carpets, an organisation incurs a cost of
`50,000 and by selling these carpets, it earns `3,00,000. In this case, the
revenue is `3,00,000. When an organisation has complete details about
its costs and revenues, it can conveniently carry out financial analysis
to calculate various ratios and uncover various trends.
Revenue generation is the lifeline of any business and an important

factor for its continuity. Therefore, a constant monitoring of revenue is

260 MICROECONOMICS
very essential. This monitoring is known as revenue analysis. The three

revenue concepts that are used frequently in economics include Total
Revenue (TR), Average Revenue (AR) and Marginal Revenue (MR).
11.2.1 TOTAL REVENUE (TR)
Total revenue is the total amount of money made by a business by

selling a certain number of products. It is calculated by multiplying
the total quantity of product sold by the price per unit at which the
product is sold. Mathematically, total revenue is calculated as:
Total Revenue (TR) = Quantity of product sold (Q) × Price per unit (P)
For example, a business sells instant soup packets at the rate of `50
per packet and sells 1000 packets in June 2019. The total revenue of
S
the business for June 2019 will be ` 50,000 (1000 packets × `50 per
packet). Figure 11.1 shows the TR curve:
IM 50
TR
40
Total Revenue
30
20
10
M
0 1 2 3 4 5 6 7 8 9 10
Quantity
Figure 11.1: Total Revenue Curve

N
It can be observed from Figure 11.1 that when the quantity of prod-
ucts sold (sales) increases, the total revenue also increases. Therefore,
the TR curve is a positive and upward rising curve.
11.2.2 AVERAGE REVENUE (AR)
The products sold by a business in a certain period may not be sold

at a uniform fixed price. Usually, there are variations due to trade dis-
counts, cash discounts, long-term association discounts, etc., given by
the business to its customers. Therefore, every batch of products may
be sold at different selling prices. Since, the selling price is not uni-
form throughout a particular period, therefore, the average revenue
generated for a period must be calculated. Average Revenue is calcu-
lated by dividing the total revenue by the quantity of products sold. In
this way, the average price at which a product is sold can be derived.
However, if there is no discount given, AR will be the same as the price

per unit of product sold.

Mathematically, AR is calculated as:
AR = TR/Q
Where, TR is Total Revenue, and
Q is total quantity sold
If we substitute the formula for TR in the preceding formula, we get,
AR = (Q × P)/Q
AR = P
Figure 11.2 shows the AR curve when the price is constant:
S
11
10
9
8
Average Revenue
7
IM
6
5 AR
4
3
2
1
0 1 2 3 4 5 6 7 8 9 10
M
Quantity
Figure 11.2: Average Revenue Curve at Constant Price
From Figure 11.2, it can be observed that when price is constant and
the quantity of sales is increasing, it has no effect on AR. The AR re-
N
mains constant at a constant price and is represented as a horizontal

line parallel to the X-axis.
Figure 11.3 shows the AR curve when the price is decreasing:
11
10
9
8
Average Revenue
7
6
5
4 AR
3
2
1
0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity
Figure 11.3: Average Revenue Curve when the Price is Decreasing

262 MICROECONOMICS
From Figure 11.3, it can be observed that the quantity of products sold
increases at decreased prices, therefore, the average revenue made
per unit also decreases. In this case, the AR has a negative slope.
11.2.3 MARGINAL REVENUE (MR)
The additional revenue generated as a result of sale of one more unit

of the product is called the Marginal Revenue. This sale of one more
unit changes the TR as revenue from selling one more unit is added
in the TR.
For example, a business sells 10 laptops at a price of `40,000 each. The

total revenue would be ` 4,00,000 (10 × 40,000). The business sells one
more laptop on the last day of the month. This sale of one more laptop
increases the TR to ` 4,40,000.
S
Therefore, MR would be New TR – Old TR.
Marginal Revenue = ` 40,000 (` 4,40,000 – ` 4,00,000). This change

IM
happens by the sale of one additional unit.
Mathematically, MR is calculated as:
MRn = TRn – TRn–1
Where, MRn is MR on the sale of the nth unit.

M
TRn is the total revenue which is earned from the sale of the nth unit.
TRn–1 is the total revenue earned from n–1 units.
Figure 11.4 shows the MR curve when price is constant:

N
11
10
9
Marginal Revenue
8
7
6
5
4 MR
3
2
1
0 1 2 3 4 5 6 7 8 9 10
Quantity
Figure 11.4: Marginal Revenue Curve at Constant Price
In Figure 11.4, it is observed that the price has remained constant

throughout and the revenue has increased along with increased sales.
Therefore, MR has remained constant and is represented as a hori-
zontal line parallel to the X-axis.

Let us now continue with the preceding example. If on the last day,
five more laptops were sold and the total revenue now is ` 5,25,000;
then in this case MR would be calculated as:
MR = Change in TR / Change in Total Quantity of Units Sold
MR = ΔTR /ΔQ
TR for 15 Laptops = `5,25,000
ΔTR = 5,25,000 – 400000 = `1,25,000
ΔQ = 15–10 = 5
MR = 1,25,000/5 = 25,000
S
Figure 11.5 shows the MR curve when the price is decreasing:
IM
Price
M
ar
gin
al
Re
ve
nu
e
Quantity
M
Figure 11.5: Marginal Revenue Curve at Decreasing Price
From Figure 11.5, it can be observed that the Marginal Revenue (MR)
N
curve is decreasing and has a negative slope which decreases rapid-

ly with every additional unit sold at a lesser price. The MR goes on
decreasing till zero and cuts the X-axis. At this point, the TR is the
maximum. The TR cannot increase beyond this point. If the MR con-
tinues to slope down and become negative, then the total revenue of
the business starts decreasing.
11.2.4 RELATIONSHIP BETWEEN TR AND MR
In the examples given in the preceding section, with the addition of

one unit of sale, the TR and MR change. However, if we observe more
closely, we see that:
when TR increases, MR decreases
when the sale price per unit remains constant, the MR will also
remain constant even if the TR increases
Business organisations usually extend various kinds of offers and dis-

counts to increase their sales. Offers such as buy one, get one free are

264 MICROECONOMICS
very common. This means that the quantity of the units sold increases
but the TR does not increase. Also, the marginal rate will decrease
with every unit sold.
For example, Dough Bakers sell their Cakes at `300 per piece. From
1st March till 14th March, they sold 75 cakes. They had 20 cakes in their
shop on the 15th of March and the government declared lockdown
from 16th March to 31st March. These 20 cakes cannot be preserved till
that time so instead of facing a complete loss, Dough Bakers decide
to clear the stock on the 15th March itself by offering cakes at half the
price i.e. `150 and are able to sell all of them. Table 11.1 shows the TR
and MR of Dough Bakers:
TABLE 11.1: TR AND MR OF DOUGH BAKERS
S
Date Cakes Rate Daily Total Total Marginal
Revenue Revenue Quantity Revenue
1 3 300 900 900 3 300
2 4 300 1200 2100 7 300
IM
3 5 300 1500 3600 12 300
4 5 300 1500 5100 17 300
5 5 300 1500 6600 22 300
6 6 300 1800 8400 28 300
7 7 300 2100 10500 35 300
8 4 300 1200 11700 39 300
M
9 5 300 1500 13200 44 300

10 8 300 2400 15600 52 300
11 4 300 1200 16800 56 300
12 7 300 2100 18900 63 300
N
13 7 300 2100 21000 70 300

14 5 300 1500 22500 75 300
15 20 150 3000 25500 95 150
95 25500
Figure 11.6 shows the TR and MR of Dough Bakers:
30000
25000
20000
15000
10000
5000
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Quantity TR MR
Figure 11.6: TR and MR of Dough Bakers

Now, consider Figure 11.7 showing the TR and MR:
TR MR
350
300
250
200
150
100
50
0
–50 100 200 300 400 500
S
–100
Figure 11.7: TR and MR

IM
In Figure 11.7, it is observed that the TR starts from the origin and
keeps rising while MR never starts at zero. MR remains constant and
is represented as a horizontal line parallel to the X-axis until the price
drops. When the quantity of sale increases, the TR does not increase
at the same rate so the MR deceases. Thus, with every sale, the TR
curve will rise with a decreasing rate of revenue and MR will keep
decreasing till it touches the X-axis.
M
When the MR curve touches the X-axis, the TR curve would have
reached the maximum height. Beyond this point, revenue cannot be
increased. Now, if the MR curve moves below the X axis, the TR curve
will start to move downwards. This is the time when the sale is hap-
N
pening at zero price. Therefore, it can be observed that the MR chang-

es only when TR changes with every additional unit sold.
It is important to note the following observations:

When TR increases due to increased sales quantity with the same
price per unit, then the MR remains constant.
When TR increases due to an increased sale of quantity with a de-
creased price, then the MR starts decreasing.
When MR is zero, TR is the maximum.
When MR is negative, TR starts to decrease.
11.2.5 RELATIONSHIP BETWEEN AR AND MR
Average revenue is obtained by dividing the TR by the total quantity

of units sold. You have already seen that if the TR increases, MR de-
creases at this time. But what happens to the AR? Let us understand
with help of an example.

266 MICROECONOMICS
Let us continue with our previous example of Dough Bakers. The TR

of Dough Bakers till 14th March is ` 22,500 for 75 cakes sold and on 15th
March, the TR is `25500 for 95 cakes sold.
AR on 14th March is `300 (` 22,500/75).
And, MR on 14th March is `300 (` 22,500/75)
AR and MR as on 14th March are shown in Figure 11.8:
Revenue
S
D D’
AR=MR
X
O
IM Output
Figure 11.8: AR and MR as on 14th March
Let us calculate AR and MR as on 15th March.
AR on 15th march is `268 (`25500/95).
MR on 15th March is ΔTR/ Q = 3000/20 = `150

M
Observe that when AR decreases from `300 to `268, MR decreases

steeply from `300 to `150.
TQ, AR and MR for Dough Bakers from 1st to 14th March are shown in
N
Figure 11.9:
350
300
250
200
150
100
50
0
300 300 300 300 300 300 300 300 300 275 270 265 260 250 150
Total Quantity Marginal Revenue Average Revenue
Figure 11.9: TR, AR and MR for Dough Bakers from 1 st to 14 th March

Observe that as AR is calculated on the sale of all the units of the

business, a small increase or decrease in AR causes a big increase or
decrease in the MR.
It is important to note the following points:

When AR increases, MR increases
When AR decreases, MR decreases
The increase in MR is much greater than the increase in AR
The decrease in MR is much greater than the decrease in AR
1. Total revenue is obtained by _________.
S
a. Total quantity × Price per unit
b. Total profit of the business
c. Total income of the business
IM
d. Deducting expenditure from total income
2. ΔTR/ΔQ is the formula to obtain ____________.
a. total revenue b. average revenue
c. marginal revenue d. total quantity
3. The AR curve is a parallel line to X-axis when the:
M
a. price per unit is increasing

b. price per unit is decreasing
c. price remains constant
N
d. quantity remains constant

4. Consider the given figure and chose the correct option?
Price
M
ar
gin
al
Re
ve
nu
e
Quantity
a. Price per unit is decreasing

b. Price is zero where marginal cuts the X-axis
c. Marginal curve is a negative slope
d. All of the these

268 MICROECONOMICS
ACTIVITY
Calculate and draw the TR, MR and AR curve for Zen Ltd. with the
table shown below:
Quantity Price
50 200
60 150
70 100
80 50
90 10
S
100 0
10 -5
IM
S 11.3 SUMMARY
Total revenue is the total amount of money made by the business
by selling a certain number of products. Total revenue is calculat-
ed by multiplying the total quantity of product sold by the price
per unit at which the product is sold.
TR curve is a positive and upward rising curve. AR is obtained by
M
dividing the total revenue by the number of units sold. The formu-
la is written as TR/Q.
The AR, i.e., average price per unit can differ from the selling price
of the unit. In this case, the AR will decrease and will show a neg-
N
ative slope.
The additional revenue generated as a result of sale of one more
unit of the product is called the MR. This sale of one more unit
changes the TR as revenue from selling one more unit is added in
the TR.
If the price remains constant, the MR will also remain constant
and AR and MR will be the same curve that runs parallel to the
X-axis.
If the price is decreasing, the MR is a negative slope which falls
more rapidly and becomes zero when it cuts the X-axis. Here, the
total revenue is the maximum. After this point, it starts falling.
When MR becomes negative, TR starts falling.
When TR increases, MR decreases. But if the price remains con-
stant, even if TR increases, MR will remain constant.
If price decreases, MR will decrease at a greater rate, the increase
in TR and will become zero when TR is maximum.

When MR becomes negative, TR starts decreasing.

When the price remains constant, AR and MR are equal and rep-
resented as a horizontal line parallel to the X-axis.
When price is decreasing and sales increases, AR and MR curves
both have negative slopes. AR decreases causing MR to decrease.
The rate of decrease or increase of MR is greater than the rate of
decrease or increase of AR.
KEY WORDS
Average Revenue (AR): The revenue earned per unit of prod-

uct
Marginal Revenue (MR): The revenue earned by selling an ad-
S
ditional unit of revenue
Revenue analysis: An analysis of the amount of money generat-
ed by selling products
IM
Revenue: The income generated from the operations of a busi-
ness
Total Revenue (TR): The revenue that a business earns by sell-
ing goods in a given period

M
MCQ
1. If the price is kept constant which of the following options is
correct?
a. TR is constant
N
b. MR is constant
c. AR is constant
d. Both MR and AR are constant
2. For calculating which of the following quantities, total quantity is
not required?
a. TR
b. AR
c. MR
3. For calculating ________, one requires price per unit.
a. TR
b. AR
c. MR
d. All of the these

270 MICROECONOMICS
4. Harish is a fruit vendor and he sold 10 Kg apples at a price of

` 250/kg (each kg). The total revenue earned was ` 2,500 (10 ×
250). He sold 5 kilograms more of apples on the last day of the
month. He earned a total revenue of ` 3,500; in this case MR will
be
a. `200
b. `250
c. `225
d. `275
5. When MR cuts the X-axis, TR is the _________.
a. maximum
S
b. minimum
c. zero
d. negative
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6. When TR increases with a decrease in price per unit, the AR
________.
a. increases
b. decreases
c. becomes zero
M
d. becomes negative
7. When AR increases, ___________.
a. MR decreases
b. MR increases at the same rate
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c. MR increases at a greater rate than AR

8. TR starts sloping down when ___________.
a. MR is negative
b. AR is negative
c. MR is zero
d. AR is zero
9. When the TR increases with a decrease in price, AR and MR
show __________.
a. negative slope
b. positive slope
c. constant curve

10. The TR of T Ltd. is ` 30,000 for 100 units sold on 30th March. On
31st March, the TR is ` 35,000 for 120 units sold. Then, MR will be
__________.
a. `200
b. `250
c. `300
d. `350

?
1. Describe the concept and formulae for total revenue, average
revenue and marginal revenue.
S
2. Explain the relationship between the MR and AR curves.
3. Explain the relationship between the TR and MR curves.

IM
11.6
(HOTS) QUESTIONS
1. The total quantity sold at Z Ltd. is 5000 units at a price of `100
for the first 1000 units, `90 for the second 2000 units, `80 for the
remaining 2000 units. Select the correct value of TR.
a. `88
M
b. ` 4,40,000
c. ` 44,000
d. ` 4,50,000
N
2. The TR is ` 55,500 with a total quantity sold of 40,000 units. There

was an additional sale of 500 units increasing the revenue to
` 56,000. Choose the correct values of AR and MR.
a. AR and MR are 1
b. AR is 1.38 and MR is 1
c. MR is 1.38 and AR is 1
d. AR and MR are 1.38
Topic Q. No. Answer

Concept of Reve- 1. a. Total Quantity × Price per unit
nue

272 MICROECONOMICS
Topic Q. No. Answer

2. c. Marginal Revenue
3. c. Price remains constant
4. d. All of the these
Q. No. Answer
1. d. Both MR and AR are constant
2. d. None of the these
S
3. a. TR
4. a. `200
(Hint: MR = Change in TR / Change in Total Quantity of
Units Sold
IM
MR = ΔTR /ΔQ
TR for 15 Kg Apples = `3,500
ΔTR = 3,500 – 2,500 = `1,000
ΔQ = 15–10 = 5
MR = 1,000/5 = `200)
5. a. maximum
M
6. b. decreases
7. c. Marginal Revenue increases at a greater rate than the
Average Revenue
8. a. Marginal Revenue is negative
N
9. a. negative slope
10. b. `250
(Hint: MR = Change in TR / Change in Total Quantity of
Units Sold
MR = ΔTR /ΔQ
TR for 120 units = `35,000
ΔTR = 35,000 – 30,000 = `5,000
ΔQ = 120–100 = 20
MR = 5,000/20 = `250)

1. Total revenue is the total amount of money made by a business
by selling a certain number of products. The AR is the average
price per unit of a product. The additional revenue generated
as a result of sale of one more unit of the product is called as the
MR. Refer to Section 11.2 Concept of Revenue

2. When AR increases, MR increases. And, when AR decreases,

MR decreases. Refer to Section 11.2 Concept of Revenue
3. When TR increases due to an increased sales quantity with
the same price per unit, the MR remains constant. When TR
increases due to an increased sale of quantity with decreased
price, then the MR starts decreasing. Refer to Section 11.2
Concept of Revenue

QUESTIONS
Q. No. Answer
1. b. ` 4,40,000
S
(Hint: Total Revenue (TR) = Quantity of product sold (Q)
× Price per unit (P)
= (1000 X 100) + (2000 X 90) + (2000 X 80)
= 1,00,000 + 1,80,000 + 1,60,000
IM
= 4,40,000)
2. b. AR is 1.38 and MR is 1
(Hint: ΔTR = 56,000 – 55,500 = `500
ΔQ = 500
MR = ΔTR /ΔQ = 500/500 =1
AR = 56,000/40,500 = 1.38)
M
SUGGESTED READINGS
N
Chauhan. (2017). Microeconomics. [S.l.]: PHI Learning.

Atmanand. (2009). Managerial Economics. New Delhi: Excel Books.
E-REFERENCES
(2020).
[Ebook]. Retrieved from http://edudel.nic.in/welcome_fold-
er/SupportMaterial2019_20/XI/English%20Medium/11_sm_eco-
nomics_eng_2019_20.pdf
Total Revenue, Average Revenue and Marginal Revenue. (2020).
Retrieved 13 August 2020, from https://www.economicsdiscussion.
net/revenue/total-revenue-average-revenue-and-marginal-reve-
nue/6890

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M
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S
C H
12 A P T E R
MARKET STRUCTURE
S
CONTENTS
12.1 Introduction
12.2 Perfect Competition
IM
12.2.1 Features of Perfect Competition
12.2.2 Equilibrium of the Firm and Industry Under Perfect Competition
12.2.3 Profit Maximisation and Perfect Competition
Activity
12.3 Monopoly
M
12.3.1 Characteristics of Monopoly

12.3.2 Price Discrimination Under Monopoly
Activity
12.4 Monopolistic Competition
N
12.4.1 Characteristics of Monopolistic Competition

Activity
12.5 Oligopoly
12.5.1 Features of Oligopoly
Activity
12.6 Summary

276 MICROECONOMICS
PERFECT COMPETITION IN DRY FRUITS MARKET
Jain Foods is a well-known dealer of dry fruits and has 15 outlets

Case Objective in India. He also exports dry fruits to countries such as Canada
and Australia. There are multiple dry fruits dealers in the mar-
This caselet highlights why ket. Jain Foods is operating in a nearly perfect market. During the
Jain Foods participates in
year 2020, due to COVID-19 pandemic and the lockdown imposed
perfect competition and how
all businesses in the same by the government, all the outlets of Jain Foods were operating for
market were affected by the very less hours and there was a substantial decrease in the sales.
COVID-19 epidemic.
Jain Foods need to pay the rent for all its outlets. For Jain Foods,
this means high costs and no revenue. Jain Foods analyses the
situation and presumes that this situation will last long and they
decide to close down some of their outlets and only keep those
S
outlets which generate high sales and returns. Due to stoppage
of international flights and cargo, exports were also affected. Jain
Foods needed to sell its products fast and to stock unsold products
IM
in a safe place.
Jain Foods wanted to know what its competitors are doing in the
given situation and at what prices they are selling their goods,
whether they are offering discounts or are increasing their price.
Jain Food analysis that dry fruits are a non-essential does not
come under essentials. Jain Foods sees that the demand for dry
fruits is almost low and the supply is also low. They can sell only
M
what is available in the stock. Jain Foods now wants to engage

in online selling. They estimate the costs that they might have to
incur and the expected revenues. Managing costs and revenues is
essential for their business as it will decide whether they are able
to sustain or not in the market.
N

MARKET STRUCTURE 277
LEARNING OBJECTIVES

>> Explain the meaning and features of perfect competition
>> Discuss the equilibrium of the firm and industry under
perfect competition
>> Describe the meaning and characteristics of monopoly
>> Analyse the short-run and long-run equilibrium under
monopoly
>> Explain the meaning of price discrimination under monopoly
>> Discuss the characteristics of monopolistic competition
>>
S
Describe the meaning and characteristics of oligopoly
12.1 INTRODUCTION
IM
In the previous chapter, you studied about major concepts of revenue. Quick Revision
You studied about the Total Revenue (TR), Marginal Revenue (MR)
and the Average Revenue (AR). You also studied about the relation-
ship that exists between TR and MR and between AR and MR.
A market refers to any physical or virtual place where buyers and sell-
ers meet. In a market, the price of a product is fixed by the demand
M
for the product and the supply of the product. Virtual markets refer
to online marketplaces. For instance, after the spread of COVID-19
pandemic, many people purchase their daily essential requirements
through virtual markets or shops.
N
Presence of online marketplaces increases the scope of operations

and they can operate at local or global levels under perfect conditions
or imperfect conditions. Today, there exist a large and integrated net-
work of markets. Different markets have different market structures
and offer a variety of products and services. Understanding the mar-
ket structures is quite essential in order to determine product prices
and to maximise profits. Market structures are categorised majorly on
the basis of the nature of market and levels of competition existing in
the market.
In this chapter, you will study about four basic types of market struc-
tures, namely perfect competition, monopoly, monopolistic competi-
tion and oligopoly. The chapter will start by explaining about perfect
competition, its features and the equilibrium conditions. Thereafter,
you will study about the monopoly market structure, its characteris-
tics and the equilibrium conditions. The later sections of the chapter
will shed light on the meaning and features of the monopolistic com-
petition and oligopoly market structures, respectively.

278 MICROECONOMICS
12.2 PERFECT COMPETITION

Perfect competition is a theoretical model of a market structure where
all the firms sell homogenous or identical products and the firms are
price takers. Perfect competition represents an ideal situation of how
a market must operate. But, a lot of factors affect the market at all
times which makes it difficult for creation of perfect competition mar-
ket to exist.
12.2.1 FEATURES OF PERFECT COMPETITION
As already stated, perfect competition is an idealistic model. It is based

on certain key assumptions or features, which are as follows:
S
Large number of buyers and sellers: Under this market structure,
the number of buyers and sellers is large enough. This implies that
their position in the market is as a drop in the ocean, hence, they
are unable to influence the market price of the product. In this
IM
market structure, firms deemed to be the price takers.
Homogeneous products: Under perfect competition, the products
offered in the market are close substitutes or homogeneous in na-
ture. This means that high competition prevails in the market and
no competitor enjoys a competitive advantage over the rival firms.
Freedom of entry and exit: There are no financial, technological
M
and legal restrictions prevalent in the market for the entry and exit
of the firms under this market structure.
Perfect mobility of factors of production: Under perfect compe-
tition, the factors of production are free to move in or out of any
N
firm or industry. However, this is a purely theoretical assumption.

Perfect knowledge: The buyers and sellers have perfect knowl-
edge about the product’s nature, availability and market price un-
der perfect competition. This implies that the buyer has a clear
idea about what can be bought at what price and seller has the
idea of what can be sold at what price.
Absence of artificial constraints: Collusions between the sellers
or the buyers do not take place under this market structure. Both
the buyers and the sellers act independently and take decisions on
their own.
No government interventions: The working of the market system
is not controlled by the government under perfect competition.
This implies that there is no licencing system that controls the en-
try of the firms, no control over the market prices, no control over
the supply of the product, etc.

12.2.2 EQUILIBRIUM OF THE FIRM AND INDUSTRY UNDER

PERFECT COMPETITION
Under perfect competition, the price is determined at the point where

the demand and supply curves meet. Therefore, each firm in the in-
dustry offers products at the same price. Figure 12.1 shows the perfect
competition in the industry:
P S
E
P1
S
D
O
IM
Qe Q
Figure 12.1: Perfect Competition in an Industry

NOTE
An industry is made of firms that
In Figure 12.1, it is observed that the market price is the point where deal in business of same nature.
For example, Tata Steel Ltd.,
the demand and supply curves intersect each other. This is called the
JSW Steel Ltd., Steel Authority
M
market equilibrium price E. Figure 12.2 shows the perfect competition of India Ltd., Essar Steel Ltd.,
in the case of a firm: etc., are a part of the Indian steel
industry.
MC
N
AC
P1 D
D=AR=MR
Q1
Figure 12.2: Perfect Competition in a Firm
In Figure 12.2, it is observed that the demand curve is perfectly elastic,

represented as a line running parallel to the X-axis. It means that the
demand for the product is increasing at the same price.
Also note that the firm makes maximum profits at Q1, the point where
the marginal cost curve and marginal revenue curve intersect each
other. Marginal revenue is the demand curve.

280 MICROECONOMICS
This is the normal profit for the firm as the average revenue meets the
average cost also in the same point. However, if the AC curve is below
the AR curve, the point at which the MC and AC meet would be the
price where the firm makes normal profits.
SHORT-RUN EQUILIBRIUM
In short run, with an increase in demand, the price also increases,

which leads to an increase in profit of the firms and the industry as a
whole. In short run, it is not possible to increase the supply, therefore,
the supply remains constant. Figure 12.3 shows the industry price in
short run under perfect competition:
S
IM S
D2
D1
Q1 Q2 Q
M
Figure 12.3: Industry Price in Short Run under

Perfect Competition
In Figure 12.3, it is observed that the industry demand increases from

N
D1 to D2 when there is an increase in price from P1 to P2. Also, D2 inter-

sects the supply curve at Q2.
Profit is the difference between the revenues and the costs of a compa-
ny. Profits may be broadly categorised as normal profits, supernormal
profits and negative profits (losses). If a company earns less than nor-
mal profits in the long run, it usually leaves the industry.
Let us study about the short-run equilibrium of a firm when it makes:

i. Supernormal profits
ii. Normal profits
iii. Losses
When the AR of a firm is greater than its ATC, it earns supernormal

profits.

Figure 12.4 shows the firm price in the short run under perfect com-
petition when it earns supernormal profits:
Supernormal MC
Profit
AC
P2
P1 D = AR = MR
S
Q1 Q2
Figure 12.4: Firm Price in Short Run under

Perfect Competition: Supernormal Profits
IM
In Figure 12.4, it is observed that the firm’s marginal curve is also the
firm’s supply curve. As the price increases from P1 to P2, the quantity
increases from Q1 to Q2. The firm makes supernormal profits when
MC intersects the new AR curve.
When the AR of a firm is equal to its ATC, it earns normal profits. Fig-
ure 12.5 shows the firm price in short run under perfect competition
M
when it earns normal profits:
Y MC
N
ATC
Price
E
AR = MR
P
O X
Q Output
Figure 12.5: Firm Price in Short Run under Perfect Competition:

Normal Profits
In Figure 12.5, MC = MR at point E. Equilibrium output is EQ. Also,

AR = ATC.
A firm can be in equilibrium and still make losses. When the AR of a

firm is less than its ATC, it experiences losses.

282 MICROECONOMICS
Figure 12.6 shows the firm price in short run under perfect competi-
tion when it is making losses:
Y
ATC
MC
Price
A R
Losses
P E AR = MR
O Q Output X
S
Figure 12.6: Firm Price in Short Run under
Perfect Competition: Losses
IM
In Figure 12.6, MC > MR. Equilibrium output is EQ. Also, ATC > AR.
No firm can continue to make losses in the long run; ultimately, it will
be forced to leave the industry if losses persist for long time.
LONG-RUN EQUILIBRIUM
Long run refers to a period more than a year. In the long run, new
M
sellers can enter the market, thus, increasing the supply of the prod-
uct. Therefore, in the long run, both change in demand and change in
supply determine the price. Figure 12.7 shows the industry price in
long run under perfect competition:
N
S
S2
P2
P1
D2
D1
Q
Q1 Q2 Q3
Figure 12.7: Industry Price in Long Run under Perfect Competition
In Figure 12.7, it is observed that with an increase in demand, both

price and supply increase. Therefore, when the price is P1 (where D1
and S1 intersect), the profit is Q1 but when demand increases and D2

intersects S1 at price P2, the profit increases to Q2. Then new sellers
enter the market and the supply increases to S2 and now D2 intersects
S2 to get the prices at P1 and the profits increase to Q3. Therefore, the
price is controlled by the movement of demand and supply in the long
run, but the profit in the overall industry increases.
There would be an opposite effect when the demand falls. When de-
mand falls, the price will come down and some firms will make losses.
Small firms that cannot withstand the losses will exit the market. This
will bring down the supply. Thus, instead of the supply curve moving
upwards, it will shift down to the left. As the supply decreases, the
price will increase bringing it back to the previous level to give normal
profits.
Figure 12.8 shows the firm price in the long run under perfect compe-
S
tition:
MC
IM
AC
P2
D2 D = AR = MR
P1
D1
M
Q1 Q2
Figure 12.8: Firm Price in Long Run under Perfect Competition

N
In Figure 12.8, the firm makes normal profit Q1 at price P1 in the long
run. With an increase in demand, the price goes up to P2 and firm
makes supernormal profits at Q2. These supernormal profits attract
more firms in the market and due to the contribution of these new NOTE
firms, the supply increases from S1 to S2. As the supply increases, the In the long run, the firms make
price decreases and again comes back to P1. This brings the profit only normal profits.
back to Q1.
In the long run, all the factors of production are variable. Also, there is
free entry and exit in the industry.
When, in an industry, firms are making abnormal profits, new firms

are attracted and they enter into the market. Due to an increased
number of firms, the industry supply will increase which will lead to a
decrease in industry price. The firms will keep entering the industry
till all existing firms are making zero economic profit.
Also, the firms that are making losses will leave the industry. This
will lead to a decrease in industry supply and increase in the industry

284 MICROECONOMICS
price. This will continue till the remaining firms in the industry are
making normal profits.
Therefore, all the firms in perfect competition will make only normal
profits in the long run.
12.2.3 PROFIT MAXIMISATION AND PERFECT

COMPETITION
A firm always seeks to maximise its profits. Profit is earned when the
total revenue is more than the total costs incurred. Therefore, to maxi-
mise profits, the firm needs to increase its revenue and minimise costs.
A firm can maximise its profits when it produces a quantity where
marginal revenue is equal to marginal cost. Figure 12.9 shows profit
maximisation of a firm under perfect competition:
S
8 Profit MC
Maximisation
7
IM 6
5
4
3
2
MR
M
1 2 3 4 5 6 7 8 Q
Figure 12.9: Profit Maximisation of a Firm under

Perfect Competition
In Figure 12.9, it is observed that at price 4.5 and output 5, maximum

N
profit is achieved. We see that the combination of price 4.5 and output
5 is derived when MC and MR intersect each other. Beyond this point,
if output 6 is produced, the MC increases and marginal revenue with
that one output produced falls. At output 4, marginal cost will be lower
than marginal revenue which means that production is not done at
full capacity and that there is scope for increasing production. Figure
12.10 shows that the firm can achieve maximum profit at quantity 5:
Total Profit
Profit increasing Profit decreasing

MR>MC MR<MC
1 2 3 4 5 6 7 8 Q
Figure 12.10: Profit Maximisation at Output 5

1. Which of the following is not a recognised market structure?

a. Perfect competition
b. Monopoly
c. Monopolistic competition
d. Imperfect competition
2. Which of the following is not a feature of perfect competition?
a. No market barriers
b. Large number of buyers and sellers
c. Unidentical products
S
d. Market information is available to everybody
3. The market equilibrium price is obtained when ________.
a. demand is a line parallel to the x-axis
IM
b. MC = MR
c. supply and demand curve intersect
d. supply and demand curve are parallel to each other
4. In a perfectly competitive market, _________ remains constant
in the short run.
M
a. supply b. demand
c. MR d. MC
ACTIVITY
N
Describe the disadvantages of perfectly competitive markets.
12.3 MONOPOLY
In perfect competition, there are many buyers and sellers. But, in the
monopoly market structure, there is either one seller or only one buy-
er. Since, there is only one seller, he can influence the entire market
and is usually in a strong position to dictate the terms and market
prices. In case, there is only one buyer and many sellers, the buyer is
usually in a strong position and dictates the market prices.
12.3.1 CHARACTERISTICS OF MONOPOLY
The unique characteristics of monopoly market structure are as fol-

lows:
A monopoly always maximises profits for itself as there is no com-
petition in the market.

286 MICROECONOMICS
A monopoly firm can dictate the prices and maximise its revenues.
A monopoly also decides how much to sell at what price to maxi-

mise profits.
A monopoly restricts entry of other sellers.
The industry is comprised of only one firm.
For example, Google and Microsoft are the best examples of monopo-
ly. There is no competitor close enough to these two IT giants in terms
of the product range and the services they provide. Therefore, the
prices are determined and dictated by these firms. Other examples of
monopoly include Facebook, WhatsApp, Twitter, Indian Railways, etc.
Since, the Indian Railways do not have any competition, the railway
tickets pricing and the number of trains to be allotted is decided by
S
the Indian Railways. There is also an entry barrier for other players.
12.3.2 PRICE DISCRIMINATION UNDER MONOPOLY

IM
Price discrimination is when the monopoly decides or offers different
prices to different customers or a group of customers which do not de-
pend on the cost of production or product/service variation. For exam-
ple, if you book Ola Cabs, the prices are different during peak hours
and during general hours for the same destination. Similarly, Cinema
Ticket prices vary for same movie run at different times. Similarly,
special discounts are offered for loyal customers by beauticians and
M
hair dressers. A price discrimination can be done by a monopoly for

various reasons:
To retain loyal customers
To create barriers for new entrants
N
To improve its revenue

To improve its cash flow
To clear its stock through sale
Price discrimination depends on trade use. For instance, electricity

used for domestic consumption is charged at different price than elec-
tricity used for commercial use. Various conditions for price discrimi-
nation are as follows:
Different price elasticity of demand for different consumers or
group of consumers: When there is a different price elasticity of
demand for each consumer or group of consumers, only the mo-
nopoly firm is able to charge different prices. It will charge high
prices to consumers where there is price inelastic demand and less
prices to consumers where there is price elastic demand. In this
way, the monopoly firm is able to increase its revenues and profits.
Thus, the monopoly firm identifies the segments of markets with
price inelastic demand and price elastic demand to set prices that
will give it overall marginal revenue equal to the marginal cost.

Encouraging consumer loyalty: The monopoly prevents consum-

ers from choosing other market players over itself by offering su-
perior services or unique services or giving free consulting or ac-
cessories with the product. For instance, people prefer to use the
services of same beauticians or doctors as they trust them for the
unique and personalised service provided by them. The monopoly
can also set a new price at certain times. For instance, during peak
travel seasons, flight tickets are quite expensive, whereas during
off-seasons, the tickets are sold at cheap rates. Educational insti-
tutes also charge different fees from different categories of stu-
dents such as General, SC, ST and OBC students demonstrating
scholarly performance.
Customised product: When the goods are tailor-made as per the
requirements of the customer and there is no similar product
S
available in market, the monopoly sells at its discretionary prices.
There are three major types of price discrimination as follows:

1. Geographical price discrimination: Geographical price dis-
IM
crimination means that for the same product, the monopoly pro-
ducer charges different prices in different locations or markets.
For example, if there is a single supermarket in one area, the
superstore owner may charge higher prices in comparison to his
superstore that is located in an area that has competing super-
stores.
M
2. Personal price discrimination: Personal price discrimination

means that a monopolist charges different price from differ-
ent customers for the same product or service. For example,
Ramesh, a mason charges `200 per square feet from Mahesh, a
businessman whereas the Ramesh charges `150 per square feet
N
from Suresh, a Clerk and neighbour of Ramesh.

3. Utility based price discrimination: Price discrimination on
basis of utility or use means that a monopolist charges different
prices for same product for different uses of the same product.
For example, electricity used in residential areas is charged at
lower rates than electricity used in commercial areas.
EXHIBIT
Three Degrees of Price Discrimination

1. First-degree discrimination (perfect price discrimination):
The monopoly segments the market with each type of con-
sumer and charges them according to the capacity and will-
ingness of the consumer to pay for the product or service.
Based on its analytical skills, it can make normal to supernor-
mal profits by using this technique. The only difficulty in this
process is to obtain the correct information of the consumer
at what price he would be willing to buy and is he capable of

288 MICROECONOMICS
paying it. Here, the average revenue curve and marginal rev-
enue curve are the same. The firm will sell till the marginal
revenue is more than the marginal cost. However, most firms
in the actual market have fixed price lists and discounts in
place and prefer to stick to it rather than negotiate such as
street vendors.
2. Second-degree price discrimination: The monopoly firm
sells at lower price for clearing its stock to create capacity.
This type of price discrimination occurs when a firm charges
different prices for different quantities of the same product.
Two-part tariffs and volume discounts are the examples of
second-degree price discrimination.
S
3. Third-degree price discrimination: Early bird discounts and
various other discounts are given based on some eligibility
criteria. Air tickets when booked six months before are avail-
able at cheaper rates than last minute bookings. Various edu-
IM cational institutions offer early bird discounts and charge late
fees penalties for late admissions.
5. In a monopoly market, there is/are __________ seller(s).

a. One b. Two
M
c. Many d. None of the above

6. Which of the following is not a characteristic of a monopoly?
a. Monopoly dictates the price of the product
N
b. Output is decided by the Monopoly

c. Free entry and exit for other sellers
d. Industry is made up of only one firm
7. When a monopoly decides to supply output at different prices
to different consumers or group of consumers, it is called
___________.
a. product discrimination b. service discrimination
c. unique pricing d. price discrimination
ACTIVITY
Find out five monopolies in the market and list down products or
services they offer. Find out how they price their products or ser-
vices.

12.4 MONOPOLISTIC COMPETITION

In a monopolistic competition market structure, there are many sell-
ers in the market but every seller’s product is unique or distinct. Many
small and medium businesses represent monopolistic competition, as
they try to attract the same group of customers. For example, in any
market, there are multiple beauticians, hairdressers, garment sellers,
electronic goods shops, mobile phones of different companies, etc.
However, the products and services offered by each market player
vary.
12.4.1 CHARACTERISTICS OF MONOPOLISTIC
COMPETITION
S
The name monopolistic competition is derived from the two market
structures namely monopoly and perfect competition. A monopolisti-
cally competitive market structure exhibits the following characteris-
tics:
IM
Presence of many buyers and sellers
No entry and exit barriers
Presence of similar but differentiated products
Demand curve is downward sloping
The key feature of a monopolistic competition market structure is the

M
presence of differentiated products. Differentiation is of four major

types:
1. Physical product differentiation: This differentiation exists
where the products look different. For example, different models
N
of mobile phones, motor bikes, cars, etc. Product differentiation

may also occur in shape, size, colour, design and performance.
2. Marketing differentiation: Differentiation in products can also
be done in terms of the promotional techniques and packaging
used. For example, Maggi Noodles, Amul Butter, Tide, etc., all
have unique packaging and the marketing techniques.
3. Human capital differentiation: At times, there are certain prod-
ucts and services where employee skills matter. For example,
the level of skills of employee of banks, insurance companies,
e-learning software, etc., have a lot of influence on customers’
satisfaction.
4. Distribution differentiation: When different firms use differ-
ent logistics and operations, distribution differentiation occurs.
Firms can create high level of consumer satisfaction using distri-
bution differentiation. For example, Flipkart, Amazon, etc., use
different distribution practices.

290 MICROECONOMICS
8. Which of the following is not a characteristic of a monopolistic

competition market structure?
a. There are many buyers and sellers
b. Demand curve has a downward slope
c. Every product is identical
d. Information is available to all the participants of the mar-
ket
ACTIVITY
S
Complete the following table.
No. Product Differentiation Examples
1 Physical appearance
IM 2 Distribution
3 Packaging
4 Employees
12.5 OLIGOPOLY
M
You studied that, in monopoly, there is only one firm in the industry.
In oligopoly, there are a few firms in the industry. Although there are
not many sellers, the number is more than one. For example, airlines
such as Indigo, Spice Jet, Air India and Vistara are a part of oligopoly.
Similarly, LPG gas providers such as Bharat Gas and HP are part of
N
oligopoly.
Oligopoly markets are highly concentrated markets and the concen-

tration ratios can be calculated by using the H-H Index.
THE HERFINDAHL-HIRSCHMAN INDEX (H-H INDEX)

TURN TO THE
WEB
The Herfindahl-Hirschman Index is calculated by adding together the
Study about the H-H index and
find out the examples of oligop- squared values of the percentage market shares of each firm operat-
oly markets which are highly ing in the Oligopoly market. For example, if there are three firms in
concentrated, concentrated and the Oligopoly market A, B and C and the percentages of their market
not concentrated. shares are a, b and c, then,
Herfindahl-Hirschman (H-H) Index = a2 + b2 + c2
The market is highly concentrated if the index is above 2000, concen-

trated if above 1000 and below 2000 and not concentrated if it is below
1000.

12.5.1 FEATURES OF OLIGOPOLY
An oligopoly is a market structure that is dominated by a few large

firms. Some of the major features of an oligopoly are as follows: NOTE
Few sellers: The entire market industry is dominated by the ex- A market structure with two
istence of a few sellers. The few sellers affect the prices of each major sellers is called a duopoly.
other. Also, there are a large number of buyers in the oligopoly
market structure.
Entry and exit barriers: Oligopoly market structure restricts the
entry of new firms into the industry with various legal, techno-
logical and social barriers. These entry barriers distinguish the
oligopoly market from the monopolistic competition. The existing
organisations hold full control over the market. Neither the entry
S
nor the exit is easy in oligopoly market.
Mutual interdependence: It is one of the most important char-
acteristics of the oligopoly market structure. Interdependencies
among the sellers influence various important decisions related
IM
to price, supply and output. In other types of market structures,
such as perfect market or monopoly, organisations do not get af-
fected by the pricing of others so they do not take the reactions and
decisions of the rival organisations into consideration. However,
in case of oligopoly market, firms are not able to make indepen-
dent decisions since a small number of sellers are competing with
each other. Hence, the sales and prices of one organisation depend
M
upon the moves of the competitors. This is the distinctive feature

that makes oligopoly a different market structure altogether.
Lack of uniformity: Organisations in oligopoly market structure
are of different sizes, i.e., some are very large in size, while others
N
are very small. There is no uniformity in the size of the organisa-

tions. For example, in the small car segment, Cielo and Tata have
very less market share in comparison to Maruti Udyog which has
86% market share.
Price rigidity: Generally, in oligopoly market, firms do not prefer
to change product prices because it would not be beneficial. In
case, if a firm decreases its price, the competitors will also reduce
its prices accordingly. It would affect the profits of both organi-
sations. Also, in case the firm increases its price, it would lose its
buyers.
Differentiated or identical product: Firms in oligopoly are re-
quired to produce either differentiated products or identical prod-
ucts which is similar in the case of perfect competition. In case, the
organisation produces identical products such as bricks, concrete
and cement, then it is known as a perfect or pure oligopoly. Where-
as differentiated products, such as automobile, are categorised un-
der imperfect or differentiated oligopoly.

292 MICROECONOMICS
Apart from these, some other features of an oligopoly are as follows:

Complete information may not be available.
Oligopoly firms may compete or collude with each other.
Oligopoly firms generally do not engage in price wars as all of them
would experience reduction in revenues.
Oligopoly firms generally follow the cost-plus pricing method for
calculating product prices.
COST-PLUS PRICING
In cost-plus pricing, the firm adds a certain mark-up price to the aver-
age production cost to get the desired profit. Cost-plus pricing can be
calculated in two ways:
S
Full-cost pricing: It takes place when all costs (fixed plus vari-
able) are added to a profit mark-up price to determine the price of
a product.
IM
Contribution pricing: It takes place when only variable costs are
calculated with accuracy. Under contribution pricing, selling price
is set at a rate higher than variable costs so as to cover some fixed
costs.

M
9. In the oligopoly market structure, there are/is __________.

a. only one firm b. few firms
c. more firms d. many firms
N
ACTIVITY
Calculate the H-H index for four telecom firms, Firm I, Firm V, Firm
A, Firm J, having market shares of 23%, 47%, 34% and 56%.
S 12.6 SUMMARY
Market structures are categorised majorly on the basis of the na-
ture of market and levels of competition existing in the market.
There are four basic types of market structure: perfect competi-
tion, monopoly, monopolistic competition and oligopoly.
In perfect competition, there are a large number of buyers and
sellers.
In perfect competition, the demand curve is perfectly elastic, rep-
resented as a line running parallel to the X-axis. The firm makes
normal profits when average revenue meets average cost.

In the short run, it is not possible to increase the supply, there-

fore, the supply remains constant. When demand increases price
increases, thus increasing the profit of the industry. Firms make
supernormal profits in short run if the demand increases.
Long run refers to a period more than a year. In the long run, new
sellers can enter the market, thus, increasing the supply of the
product. Therefore, in the long run, both changes in demand and
changes in supply determine the price.
Profit is earned when the total revenue is more than the total costs
incurred. In the monopoly market structure, there is either one
seller or only one buyer.
A monopoly can do price discrimination, i.e., offer the same goods
or services at different prices to different groups of consumers.
S
In a monopolistic competition market structure, there are many
sellers in the market but every seller’s product is unique or dis-
tinct.
IM
In oligopoly, there are a few firms in the industry. Therefore, they
are concentrated markets and concentration ratios are calculated
by the Herfindahl-Hirschman (H-H) index.
The H-H Index is calculated by adding together the squared val-
ues of the percentage market shares of each firm operating in the
oligopoly market.
M
KEY WORDS
Entry barrier: An obstacle that prevents new firms from enter-

ing into a market
N
Price fixing: The practice of setting the price of a product or

service
Price war: A competitive situation where rival firms keep de-
creasing their prices in order to capture more market and to
drive out the rival firms
Supernormal profits: The amount of profit over and above the
normal profit
Virtual marketplace: A online marketplace where buyers and
sellers transact using the Internet

1. _____________ represents a market structure where there are
MCQ
many buyers and sellers and goods or services are identical.
a. Monopoly
b. Perfect competition

294 MICROECONOMICS
c. Monopolistic competition
d. Oligopoly
2. Which of the following phenomenon occurs when the firms are
making abnormal profits in an industry?
a. New firms enter into the market
b. Industry supply increases
c. Industry price decreases
d. All of these
3. Under what conditions would a company leave the industry in
the long run?
S
a. Company is earning less than normal profits
b. Company is earning less than supernormal profits
c. Company earning negative profit for five years
IM
d. Both a. and c.
4. Lokesh is a gym trainer and has opened his new gym recently.
Madan and Sudan both took admission in Lokesh’s gym but
Lokesh charged `2,000 per month from Madan whereas he
charged `2,600 per month from Sudan. What kind of price dis-
crimination was done by Lokesh?
M
a. Geographical
b. Personal
c. Utility-based
N
d. None of these
5. Which of the following is not a type of product differentiation
under the monopolistic competition market structure?
a. Physical variation
b. Price variation
c. Human resource variation
d. Distribution variation
6. Which of the following represents the correct formula for calcu-
lating the H-H Index?
a. The percentage values of the squared market shares of each
firm in the monopoly monopolistic competition market are
added together
b. The squared values of the percentage market shares of each
firm operating in the oligopoly market are added together

c. The values of the percentage market shares of each firm op-

erating in the oligopoly market are added together
d. The squared values of the percentage market shares of each
firm operating in the perfect competition market are added
together
7. The monopolistic competition market structure for firm forms a
____________ demand curve.
a. elastic b. perfectly elastic
c. inelastic d. perfectly inelastic
8. Consider the given figure and select the option which represents
the type of pricing shown in the given figure.
S
ATC plus
25%
IM
ATC
Price
Cost
M
Quantity

a. Full cost pricing b. Contribution pricing
c. Difference pricing d. Equilibrium pricing
N
9. In a monopoly market structure, the firm identifies the market

segments and fixes the price of the product. Which type of price
discrimination is this?
a. First Degree – Price discrimination
b. Second Degree – Product discrimination
c. Third Degree – Discount discrimination
10. A monopoly does not engage in price discrimination in order
to ______________.
a. retain loyal customers
b. create barriers for new entrants
c. create barriers for customers
d. improve its cash flow

296 MICROECONOMICS
? 12.8 DESCRIPTIVE QUESTIONS

1. Write a short note on perfect competition and its features.
2. Explain the meaning and characteristics of a monopoly.
3. What do you understand by monopolistic competition? Explain
its major characteristics.
4. What is oligopoly? Discuss its characteristics.

12.9
(HOTS) QUESTIONS
1. Which of the following is/are (an) example(s) of a perfect compe-
tition market structure?
S
a. Agricultural produce b. Share market
c. Oil and petrol d. All of the above
2. State which of the following comes under the monopolistic com-
IM
petition.
a. Electricity board
b. Iron and steel industry
c. Automobile manufacturing industry
d. Automobile servicing industry
M

N
Topic Q. No. Answer

Perfect Competition 1. d. Imperfect competition
2. c. Unidentical products
3. c. supply and demand curve inter-
sect
4. a. supply
Monopoly 5. a. One
6. c. Free entry and exit for other
sellers
7. d. price discrimination
Monopolistic Competi- 8. c. Every product is identical
tion
Oligopoly 9. b. few firms

Q. No. Answer
1. b. Perfect Competition
2. d. All of these
3. a. Company is earning less than normal profits
4. b. Personal
5. b. Price variation
6. b. The squared values of the percentage market shares of
each firm operating in the oligopoly market is added
together
S
7. a. elastic
8. a. Full cost pricing
9. a. First Degree – Price discrimination
IM
10. c. create barriers for customers

1. Perfect competition is a theoretical concept or an ideal situation
of how a market must operate. Some of the important features of
perfect competition include: presence of a large number of buy-
M
ers and sellers, no price fixing, etc. Refer to Section 12.2 Perfect
Competition
2. In monopoly, there is either one seller or only one buyer. Since,
there is only one seller, he can influence the entire market and
N
is usually in a strong position to dictate the terms and market

prices. Refer to Section 12.3 Monopoly
3. In monopolistic competition, there are many sellers in the mar-
ket but every seller’s product is unique or distinct. There are no
entry and exit barriers. Refer to Section 12.4 Monopolistic Com-
petition
4. In oligopoly, there are a few but interdependent firms in the
industry. Although, there are not many sellers, the number is
more than one. Refer to Section 12.5 Oligopoly

QUESTIONS
Q. No. Answer
1. d. All of the above
2. d. Automobile servicing industry

298 MICROECONOMICS
SUGGESTED READINGS &

12.11
REFERENCES
SUGGESTED READINGS
Chauhan. (2017). Microeconomics. [S.l.]: PHI Learning.
Atmanand. (2009). Managerial economics. New Delhi: Excel Books.
E-REFERENCES
(2020). Retrieved 20 August 2020, from https://www.georgebrown.
ca/sites/default/files/uploadedfiles/tlc/_documents/market_struc-
tures.pdf
S
ECON101: Principles of Microeconomics, Topic: Unit 6: Market
Structure: Competitive and Non-Competitive Markets | Saylor
Academy. (2020). Retrieved 20 August 2020, from https://learn.say-
lor.org/course/view.php?id=8&sectionid=62
IM
M
N

CASE STUDIES
10 TO 12
CONTENTS
Case Study 10 Economies and Diseconomies of Scale in a Movie Theatre

Case Study 11 Oil Crash Explained – Negative Marginal Revenue
Case Study 12 Perfect Competition in Credit Card Industry
S
IM
M
N

300 MICROECONOMICS
CASE STUDY 10
ECONOMIES AND DISECONOMIES OF SCALE IN A MOVIE

THEATRE
In the long-run production, an organisation can modify the re-

Case Objective sources within its control. However, some resources are beyond
This case study describes
the organisation’s control. The inability to modify such resources
the factors which lead to may contribute to diseconomies of scale. This case study analyses
economies and diseconomies the economies and the diseconomies of scale at movie theatres.
of scale in case of multiplex
movie theatres.
BACKGROUND
In India, the multiplexes first emerged in the 90s and since then,
they have enjoyed a fantastic run. The number of multiplexes in
S
India grew faster than the number of single-screens, eventually
wiping them out almost. The same growth pattern can be seen
elsewhere in the world—US, Europe, China, Middle-East and
South-East Asia.
IM
In 2018, there were 2950 multiplexes in India. If not for COVID-19,
the multiplex market was expected to grow by more than 7% to
cross 4500 screens by 2024. The primary multiplex owners in In-
dia are cinema chains such as PVR, INOX and Big Cinemas. On
an average, a multiplex runs about 5-6 screens per theatre. What
is the reason for multiplex operators to add more screens to a
M
theatre? And why stop at 6 or 10 screens per theatre? The larg-

est multiplex in India, Mayajaal in Chennai, operates 16 screens.
Therefore, why not add 20 – 30 screens to a theatre? This case
study analyses all these questions.
N
ANALYSIS
Consider a one-screen movie theatre. It needs someone to sell

tickets, someone to sell snacks and beverages (such as popcorn
and soft drinks) and someone to operate the projector. Now, if
the theatre owner adds one more screen to the same location, the
same staff can perform these tasks for both screens. Thus, the
ticket-seller becomes more productive by selling tickets of both
movies, the concession stand seller becomes more productive by
selling snacks and beverages for movie-goers to both movies, and
the projector operator is able to operate the projector for both
movies.
Moreover, construction costs per screen are reduced because

only one lobby and one set of rest rooms are required to serve for
movie-goers for both movies. Now, the two-screen theatre can run
bigger and more visible advertisements in media (TV, radio, social
media, print, etc.) to spread the cost over more movies. Therefore,

Case study 10: ECONOMIES AND DISECONOMIES OF SCALE IN A MOVIE THEATRE 301
CASE STUDY 10
by operating more screens at the same location, the owners of

multiplexes take advantage of the economies of scale.
In India, a multiplex runs an average of 5-6 screens per theatre.

This screen count lags far beyond the average screen count in
multiplex theatres in the US and China, which run about 10 to 20
screens per theatre. Why do Indian multiplex operators not add
more screens, considering that most cities are highly populated
and there is enough demand among the general public to watch
movies?
One problem with adding on the number of screens in India is

high congestion of the public roads leading to a multiplex theatre.
The public roads are the resources, which the multiplex operators
S
cannot control. As the number of screens to a multiplex will grow,
so will the congestion around the multiplex. In addition, popu-
lar films may not be released quickly enough to fill up so many
screens.
IM
Finally, a multiplex operator cannot control time, which is also
a resource. Only some specific hours and days are popular with
moviegoers. Addition of more screens will make scheduling of
movies highly complicated for the manager. This is because he/
she may need to space out starting and ending times of each mov-
M
ie to avoid the congestion that would inevitably occur when too

many customers come and go at the same time. It would be diffi-
cult for them to create a “prime time” slot for movies. These fac-
tors contribute to the diseconomies of scale.
N
RESULT
As multiplexes add more and more screens to a theatre, they be-

come more profitable due to economies of scale. The factors con-
tributing to the economies of scale are:
Increased productivity of the same staff
Reduced construction costs
However, if the multiplex operators keep on adding more and

more screens (i.e., more than 10 screens to a theatre in India on
average), they cannot control the following inputs:
Public roads
Supply of movies
Amount of “prime time” in the day
All of these factors contribute to the diseconomies of scale.

302 MICROECONOMICS
CASE STUDY 10
CONCLUSION
The long-run average cost curve of a multiplex is U-shaped (just

as its short-run average cost curve).
Long-run
average cost
Cost per unit
S
O A B Output per period
Economies Constant Diseconomies

IM
of scale average cost of scale
Figure A: Long-Run Average Cost Curve of a Firm
As a multiplex adds more and more screens, its output expands.

This will reduce the average cost of the multiplex. In Figure A, A
M
is the minimum efficient scale, it is the lowest rate of output (max-

imum screens added) at which the multiplex takes full advantage
of economies of scales.
Eventually, the average cost stops falling and then becomes con-
N
stant over some range (A to B).
If the multiplex continues to add more screens (beyond the point

B), it will experience diseconomies of scale, as the cost of coordi-
nating resources increases.
Economies and diseconomies of scale can occur both at the level

of a single multiplex (firm level) or at the level of a chain of multi-
plexes (plant level).
(Source: https://sangu.ge/images/Economics1.pdf )
QUESTIONS
1. What are the major factors behind diseconomies of scale

in case of multiplexes?
(Hint: Public roads, supply of movies, etc.)

Case study 10: ECONOMIES AND DISECONOMIES OF SCALE IN A MOVIE THEATRE 303
CASE STUDY 10
2. Compare and contrast the average number of screens per

theatre in India and abroad along with reasons for the
difference.
(Hint: In India, a multiplex runs an average of 5-6 screens
per theatre. Multiplex theatres in the US and China run
about 10 to 20 screens per theatre.)
S
IM
M
N

304 MICROECONOMICS
CASE STUDY 11
OIL CRASH EXPLAINED – NEGATIVE MARGINAL REVENUE
Due to the lockdown which has forced the factories to remain

Case Objective close and stop people from travelling, the world’s demand for oil
This case study discusses has significantly reduced by 29 million barrels a day.
why the price of oil futures fell
below zero due to COVID-19 With the cost of production, transportation and storage now being
pandemic in 2020. higher than the production cost a question arises, how oil-pro-
ducing giants such as Russia and Saudi Arabia will survive in the
coming years?
Because of COVID-19 situation which has prompted a lockdown,

closing of factories and stopped people to travelling it is hard to
believe that the price of a commodity such as oil is getting into
S
negative territory and contracting the global economy.
This pandemic has reduced the world’s oil demand by 29 million

barrels a day from 100 years ago. The OPEC and other oil pro-
IM
ducers have decided to lower the production rate by 9.7 million
barrels per day which is much less than a decrease in the demand,
leaving a huge quantity of oil with no customer.
Filling the oil capacity on the land quickly, several oil-importing

companies have accumulated large quantities of oil, taking advan-
tage of cheap prices which might not last long. Few oil producers
M
are expecting to maintain their market share by storing their ex-

cess oil at sea by leasing tankers at a high price, while some are
thinking to pay over $100,000 per day for each tanker.
WILL OIL PRICES COME BACK UP?

N
Therefore, what was the reason for Alberta oil prices and future
prices from West Texas Intermediate (WTI) shift into the negative
marginal revenue? It began with the future’s contract for WTI
where it needs to deliver oil in a few months at the present price.
With time several rigs will stop working and a new balance be-
tween supply and demand will be set up at a cost that beats the
total average cost. But this does not bode well for either Alberta
or the United States.
COLLATERAL DAMAGE
Alberta is now facing collateral damage due to the oil war be-
tween Saudi Arabia and Russia and the COVID-19 situation creat-
ing an extra hit. On the other hand, these two factors have caused
trouble for Alberta’s oil production, but the global pandemic and
Russia-Saudi conflict have proven to be disastrous for Canada
and can have same outcomes for the U.S Energy Industry. Both

Case study 11: OIL CRASH EXPLAINED – NEGATIVE MARGINAL REVENUE 305
CASE STUDY 11
Saudi Arabia and Russia depends greatly on their oil revenues to

uphold their economies and certainly, Saudi Arabia’s economy is
less diversified than the Russian Economy. Nevertheless, oil rev-
enues provide a huge share of their GDPs budget and exports.
To maintain the government’s budget, Russia requires a price of
$60 per barrel more price to maintain its current account which
means subtracting exports of goods and services from imports
and adding the short-term capital transfer.
SAUDI ARABIA NEEDS MUCH HIGHER OIL PRICES
The lowest cost producer of the world Saudi Arabia can make a
significant amount of money when the price of oil per barrel gets
above $20 and Russia when the price gets above $40. However, get-
S
ting a profit when prices are higher than the costs is not enough.
Saudi Arabia requires a price of $80 per barrel to maintain its
budget, understand its plan to broaden its economy and sustain
IM
a heavily subsidized economy. To be determined is the steadiness
of both the Russian and Saudi Arabian political frameworks and
current systems.
The more drawn out the COVID-19 pandemic keeps going, the
more prominent the harm oil makers will persevere. It is diffi-
cult to tell now how high oil costs will rise once the pandemic
dies down. They will probably go higher as peripheral makers are
M
wiped out, however not for long. Utilising oil and other non-re-
newable energy sources is not, at this point reliable with evading
the normal fiascos of environmental change. Oil is progressively
turning into an abandoned resource.
(Source: https://www.weforum.org/agenda/2020/04/negative-oil-prices-covid19/ )
N
QUESTIONS
1. What do you understand by negative marginal revenue?

(Hint: Diminishing returns)
2. How did COVID-19 negatively impact the marginal reve-
nue of oil?
(Hint: Demand for oil decreased)

306 MICROECONOMICS
CASE STUDY 12
PERFECT COMPETITION IN CREDIT CARD INDUSTRY
Credit cards are the medium of money exchange that allows the
Case Objective
customers to charge purchases rather than making them pay cash
This case study discusses at the time of transaction. In case of credit cards, no interest is
the various characteristics charged if payment is made within 30 days.
of the credit card market
which makes it a perfectly These cards are the source of credit through which people can de-
competitive market.
fer payment for a purchase for an extended time period by paying
an interest rate. As per the number of banking players offering
credit card services, it is a perfect competition industry where-
in the competition should decrease the rate of interest drawn on
credit cards. The majority of customers prefer Visa, Mastercard
S
and American Express which are offered by a large number of
banks and credit unions. Credit cards are homogenous products
and mostly similar in appearances and used for the same purpos-
es. Entry and exit from the credit card industry are easy which is
IM
the reason why there are so many institutions offering this ser-
vice. However, a new firm may find it challenging to enter into
the market but a financially stable bank or even a modest size
banks or credit unions can obtain the right to issue Visa card or
Mastercard from the parent companies with little difficulties. In
case of exit, banks can exit the field by selling their accounts to
other suppliers of credit cards. Therefore, the credit card industry
M
holds most of the characteristics of perfectly competitive market.

(Source: http://bkmiba.blogspot.com/2015/08/case-study-perfect-competition-in.html)
QUESTIONS
1. Which characteristics make the credit card industry a

N
perfectly competitive market?

(Hint: Large number of players, high competition, avail-
ability of substitute, etc.)
2. What is the reason behind the decreasing interest rate on
credit cards?
(Hint: High competition, large number of buyers, etc.)

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MICROECONOMICS

Chief Academic Officer

Content Reviewer TOC Reviewer

Author : Ms. Ritika Israney

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CHAPTER NO. CHAPTER NAME PAGE NO.

2 Working of Economy and its Basic Problems 19

6 Elasticity of Supply 121

Case Studies 4 to 6 137

7 Consumer Demand Analysis 147

8 Production Theory: Short Run 183

9 Production Theory: Long Run 203

Case Studies 7 to 9 223

10 Cost Analysis 231

11 Revenue Analysis 257

12 Market Structure 275

Case Studies 10 to 12 299

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Introduction to Economics: An Overview of Economics; Nature of Economics; Branches of

Demand Analysis: Meaning of Demand; Types of Demand; Determinants of Demand; Law of

Elasticity of Demand: Concept of Elasticity of Demand; Price Elasticity of Demand; Income

Elasticity of Supply: Types of Elasticity of Supply; Factors Determining Elasticity of Supply;

Measurement of Elasticity of Supply.

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NMIMS Global Access - School for Continuing Education

Self Assessment Questions

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INFLUENCE OF MICROECONOMICS IN DAILY LIFE

Vinod Gawre, an investment banker, wants to rent an apartment

At the other end of the spectrum, we have Maithri Rawat. She is

and demand. Supply means the total number of apartments avail-

If the demand for a 2-BHK apartment in Versova is very high and

In conclusion, both Vinod and Maithri will make decisions to get

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After studying this chapter, you will be able to:

decisions that individual consumers, households, businesses and gov-

1.2 AN OVERVIEW OF ECONOMICS

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making choices arises due to the following three fundamental eco-

a factory will give more earnings or income than when used as a

efit of alternative options while making their decisions.

In conclusion, economics is a social science because it deals with hu-

1.2.1 NATURE OF ECONOMICS

There are several schools of thought to understand the nature of eco-

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of wealth’. A drawback of the classical view is that economics is de-

and cannot be objectively decided which activities promote it and

words, economics is a human science. It involves maximising sat-

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relation to numerous ends. Although this viewpoint is popular, it

dynamics, which is a substantial improvement over Robbins’

1.2.2 BRANCHES OF ECONOMICS

The scope of economics as a subject continues to grow and expand.

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 Macroeconomics: Macroeconomics is the branch of economics

1.2.3 APPLICATIONS OF MICROECONOMICS AND

Microeconomics is the study of the behaviour of individuals and busi-

Microeconomics uses a bottom-up approach to analyse the economy.

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aggregate economy. It studies the effects of government policies on the

SELF ASSESSMENT QUESTIONS

1. Economics is a _________ science.

List the three microeconomics decisions that you make on a day-

Consider the following two statements:

Macroeconomics: Macroeconomics is the branch of economics

1.2.3 APPLICATIONS OF MICROECONOMICS AND

The two main branches of economics are microeconomics and

Capital:The human-made tools used in the economy, such as

Theory and Applications of Economics - Table of Contents. (2020).