Monti Maam Business Economics

Course: BBA
Semester: 1st
Paper: Business Economics
Paper Code: 10300
Submitted By
Monti Kalita.
Asst. Professor
Business Administration Dept.
NERIM Group of Institutions

INTRODUCTION
 Business Economics- Business economics is the study of financial issues and challenges
faced by corporations operating in a specified market place or economy. Business
economics deals with such as business organization, management, expansion of strategy.
Business Economics is also called as managerial economics.
• Nature of Business Economics – Traditional economic theory has developed along two
line i.e. normative and positive. Normative focuses on prescriptive statements and help to
establish rules aimed at attaining the specified goals of business. Positive, on the other
hand, focuses on description. It aims at describing the manner in which the economy
operates without staffing how they should operate.
• The emphasis in business economics is on normative theory. Business

economics seek to establish rules which help business farms to attain their goals, which
indeed is also the ascences of the word normative. However, if the firms are to establish
valid decission rules, they must thoroughly understand their environment. This requires
the study of positive or descriptive theory. Thus, business economics combines the
essentials of the normative and positive economic theory, the emphasis being more on the
former than the latter.
• Scope of Business Economics-
• Although no uniformity of use regarding the scope of business economics. Following

aspects are said to fall under business economics-
• Demand analysis and forecasting – It provide the essential basis for business planning
and occupies the strategic place in managerial economics. The main topics covered are
demand determinants, distinctions and demand forecasting.
• Cost and production analysis- A study of economic cost, combine with the data drawn
from the firm’s accounting records can yield significant cost estimates which are useful
for management decission.
• Production analysis is narrower in scope than cost analysis. Production analysis
frequently proceeds in physical terms, while cost in monetary terms. The main topics
covered under it are cost concepts and classification, cost-output relationships, economies
and diseconomies of scale, production function and cost control.
• Pricing decision, policies and practices - Pricing is an important area of business

economics. The important aspects deal with under pricing include price determination in
various market forms, pricing method, differential pricing, product line pricing and price
forecasting.
• Profit Management- Business firms are generally organized for the purpose of making
profits and in the long –run profits earned are taken as an important measure of the firm’s
success. The important aspects covered under the area are nature and measurement of
profit, profit policies and technique of profit planning like break-even analysis.
• Capital Management – Among the various types of business problems, the most complex
and troublesome for the business managers are those relating to a firm’s capital
investments. The main topic deal with are cost of capital, rate of return and selection of
projects.
• Significance of Business Economics
• Business economics is concerned with those aspects of traditional economics which are
relevant for business decission making in real life.
• It also incorporate useful ideas from other disciplines such as psychology, sociology etc,
if they are found relevant to make decission making.
• Business economics makes a manager more competent model builder.
• Business economics takes or organizes the inter-relation between the firm and society and
accomplishes the key role of an agent in achieving the social and economic welfare goals.
• Business economics help in reaching variety of business decissions in a complicated

environment.
• Conclusion:
• Thus from the above discussion it is clear that business economics is a vast concept and
the study of it help the managers as well as the corporation to work properly.
• Economic objectives of firms
• The main objectives of firms are:
• Profit maximisation
• Sales maximisation
• Increased market share/market dominance
• Social/environmental concerns
• Profit satisfiying
• Co-operatives
• 1. Profit Satisfying
• In many firms, there is a separation of ownership and control. Those who own the
company (shareholders) often do not get involved in the day to day running of the
company.
• This is a problem because although the owners may want to maximise profits, the
managers have much less incentive to maximise profits because they do not get the same
rewards, (share dividends)
• Therefore managers may create a minimum level of profit to keep the shareholders
happy, but then maximise other objectives, such as enjoying work, getting on with other
workers. (e.g. not sacking them) This is the problem of separation between owners and
managers.
• This ‘principal-agent‘ problem can be overcome, to some extent, by giving managers

share options and performance related pay although in some industries it is difficult to
measure performance.
• More on satisfying.
• 2. Sales maximisation
• Firms often seek to increase their market share – even if it means less profit. This could
occur for various reasons:
• Increased market share increases monopoly power and may enable the firm to put up
prices and make more profit in the long run.
• Managers prefer to work for bigger companies as it leads to greater prestige and higher
salaries.
• Increasing market share may force rivals out of business. E.g. the growth of supermarkets
have lead to the demise of many local shops. Some firms may actually engage in
predatory pricing which involves making a loss to force a rival out of business.
• 3. Growth maximisation
• This is similar to sales maximisation and may involve mergers and takeovers. With this
objective, the firm may be willing to make lower levels of profit in order to increase in
size and gain more market share. More market share increases their monopoly power and
ability to be a price setter.
• 4. Long run profit maximisation
• In some cases, firms may sacrifice profits in the short term to increase profits in the long
run. For example, by investing heavily in new capacity, firms may make a loss in the
short run but enable higher profits in the future.
• 5. Social/environmental concerns
• A firm may incur extra expense to choose products which don’t harm the environment or
products not tested on animals. Alternatively, firms may be concerned about local
community / charitable concerns.
• Some firms may adopt social/environmental concerns as part of its branding. This can
ultimately help profitability as the brand becomes more attractive to consumers.
• Some firms may adopt social/environmental concerns on principal alone – even if it does
little to improve sales/brand image.
• 6. Co-operatives
• Co-operatives may have completely different objectives to a typical PLC. A co-operative

is run to maximise the welfare of all stakeholders – especially workers. Any profit the co-
operative makes will be shared amongst all members.
•
Economics Can be divided in to two parts, Viz: Microeconomics and Macroeconomics.
• Microeconomics is the study of economic actions of individuals and small group of

individuals. In other words, in microeconomics the interrelationships of individual
households, individual firms and individual industries to each other are studied.
• Macroeconomics is the study of aggregates or averages covering the entire economy,

such as total employment, unemployment, national income, national output etc. In other
words, it is aggregative economics which examines the interrelationships among the
various aggregates, their determinations and causes of fluctuations in them.
• Microeconomics • Macroeconomics
• It is the study of individual economic • It is the study of the economy as a

unit of an economy. For eg-A whole.
consumer.
• It is also called price theory. • It is also called theory of income and

employment.
• The main tools of microeconomics • The main tools of macroeconomics

are demand and supply of a particular are the aggregate demand and
commodity or factors of production aggregate supply of the whole
economy.
•
Goods Services
Goods are physical objects which satisfy wants of Services are economic activities which satisfy
consumers. wants of consumers.
They are tangible in nature. They are intangible in nature.
Example- Table, chair,tape recorder etc. Example-Services of a doctor.
 Factors that lead to an economic problem-
• Unlimited Wants-Human wants are unlimited. When one want is satisfied, another want
appears. In other words, wants appear one after another causing economic problems.
• Limited Resource – Although wants are unlimited, the resources like land, capital etc are
limited. These limited resources are unable to satisfy all wants of people and raises
economic problems.
• Alternative Uses-Resources have alternative uses. Though resources are limited, but one
resource can be used for different purposes. For e.g.- Land can be used for cultivation or
to build a house or to build a shopping mall. But, here problem arises when choice has to
be made regarding the use of resources for one purpose i.e. a land choose for cultivation,
can not be used to build a house.
In this way these 3 factors leads to economic problems.
• Three basic/central(or allocation of resources) of an economy-
• What to produce and in what quantities-
Due to limited resources every economy has to decide what commodities are to be produced and in
what quantities. Choice has to be made by an economy in between consumer and capital goods, health
services and education etc.
• How to produce-
Every economy also have to decide how to produce choosen goods and services. Economy have to
choose a particular way for producing a specified amount of the good. This problem relates to the choice
of techniques of production. So, it is also known as the problem of choice of techniques of production.
• For whom to produce-
It refers to the problem of distribution of produced goods and services among the various individuals
or factors of production. Here,selection has to be made who will ultimately consume the goods. For eg-
whether to produce goods for rich or poor,whether basic education should be freely available in the
economy or not etc.
Thus, these three problems can be considered as the central problems of an economy.
Positive Economics Normative Economics
It deals with what is or how the economic problems It deals with what ought to be or how the economic
are actually solved. problems should be solved.
It aims to make real description of an economy. It aims to determine economic activity with ideals.
It is a pure science. It is not a pure or objective science.
If we study that prices in Indian economy are If we study that Indian economy should take steps
constantly rising, then it will be under positive to control rising prices, then this will be under
economics. normative economics.
Unit-2
THEORY OF CONSUMPTION
• Utility refers to the psychological satisfaction that a person derive from the consumption
of a particular commodity.
• Utility of a consumer represents actual or expected satisfaction, derived from the

consumption of a commodity by a consumer.
• Goods that have direct relationship with income are called normal goods. In other words,
the goods which demand rises with rise in income of the consumer and falls with fall in
income of the consumer are called normal goods. For eg.- milk, wheat, shoes, shirts etc.
• The goods for which demand and income of the consumer have opposite relationship are
known as inferior goods. In other words, the goods of which demand falls with rise in
income and demand rises with the fall in income of the consumer are called inferior
goods.
• Giffen Goods-
• Giffen goods are a special category of inferior goods whose demand increases with the
price of the commodity.
Substitute Goods Complementary Goods
Two or more goods are substitutes if any one can be Two or more goods are complementary if they are
used in place of other to satisfy a particular want. demanded together to satisfy a particular want.
If two goods are substitute, the increase in price of one If two goods are complementary goods, the increase in
good leads to increase in quantity demand of other good. price of one good leads to decrease in quantity demand
of the other good.
There is positive relationship between price and demand There is negative relationship between price and demand
here.For eg.-Tea and Coffee. here.For eg.-Car and Petrol.
• Total Utility(TU)-
Total utility is the sum total of the satisfaction that a consumer derives when certain number of
units of a particular commodity consumed. Symbolically,
TUX= F(NX)
Where, TUX=Total utility from the consumption of X commodity
F=Function
NX=Number of units consumed of X commodity
• Marginal Utility(MU)-
Marginal utility is the additional satisfaction derived from the consumption of additional unit
of the commodity.
Symbolically- TU
MU=
Or MU=Tun-Tun-1
Where, MU=Marginal Utility
TU=Change in total utility
Q=Change in quantity of consumption
• Law of diminishing Marginal Utility-
Law of diminishing Marginal utility is a fundamental law of consumption. According to this

law, as more and more units of a commodity are consumed, the extra utility that we derive from
it goes on declining.
Assumptions of the law-
• All the commodities consumed are homogeneous in quality
• The consumption process should be continuas
• There is no change in the price of the commodity and income, taste, habit or preferences
of the consumer
• The units of consumption are of reasonable or of standard size.
• Tabular Representation-
Number of oranges MU (Utils) TU (Utils)

1 10 10
2 8 18
3 6 24
4 4 28
5 2 30
6 0 30
7 -2 28
8 -4 24
• Here, in the above table it is observed that as the consumer consumes more and more
units of oranges, MU goes on increasing and becomes zero till it consumes 6 th units of
oranges, after that M.U. becomes negative. When MU is zero, it is observed that TU is
maximum .
• Diagrammatic Representation-
• In this figure, the number of oranges are measured on the horizontal ax-is and vertical ax-
is measures the marginal utility from oranges. Here, it is observed that MU curve is
falling downward from left to right which represents diminishing MU. The MU of the
commodity is zero at the point where TU is maximum. It is clled as point of satiety or the
point of full satisfaction. After that MU becomes negative and the curve crosses the x-
axis and the TU curve also becomes downward sloping.
• Consumer’s equilibrium in case of single commodity(cardinal utility analaysis)-
A rational consumer will consume the commodity up to the point where the marginal utility
(measured in terms of money) of the final unit of the commodity is equal to the price paid for it.
Symbolically, A consumer will be in equilibrium when MU of the commodity/ MU of Money

=Price
• This can be better explained with the help of a utility schedule- Suppose a consumer
wants to buy orange. Let us suppose that price of orange is rs.2 per orange and marginal
utility of money is 4 utils.
Utility Schedule
Units of oranges MU(Utils) MU in money( in

Rs.)
0 0 0
1 20 5
2 22 5.5
3 18 4.5
4 14 3.5
5 10 2.5
6 8 2.0
7 6 1.5
8 4 1.0
• From the above table it is clear that condition of consumer’s equilibrium is satisfied at 6 th
units of orange. Here, the condition of consumer’s equilibrium is satisfied as follows-
MU of the commodity/ MU of Money =Price
• 8/4 =Rs.2
Diagrammatic Representation-
• Here, in the diagram the consumer is in equilibrium at pint E, where MU in terms of
money is equal to price, that is the MU curve intersects the price line at point E. To the
left of point E,MU>P i.e. consumer’s gaining more than its cost. So the consumer will
increase the consumption up to the unit corresponding to point E. Again, to the right of E,
MU<P, where cost is more than gain. So, consumer will reduce his consumption up to the
unit where E is the equilibrium point.
• Consumer’s equilibrium in case of two commodities-
• In case of two goods, a consumer attains equilibrium when he spent his given income in
such a way that MU of both the goods are equal. Symbolically-
• MUX = MUY =Mum
• PX PY
• Here, MUX =Marginal Utility of commodity X
• MUY = Marginal Utility of commodity Y
• PX = Price of X
• PY = Price of Y
• Mum = Marginal Utility of Money.
• Let us suppose that Price of X= Rs.3
Price of Y=Rs. 4
MU of money=8
Money Income=Rs. 20
Marginal utility schedules for commodities X and Y-
Units MUX MUY MUX MUY
PX PY
1 33 36 11 9
2 30 32 10 8
3 27 28 9 7
4 24 24 8 6
5 21 20 7 5
6 18 16 6 4
• Here, we observe that when the consumer buys 4 units of X and 2 units of Y,the
consumer will be in equilibrium. Here, the consumer maximises his or her utility because
the condition of equilibrium is satisfied here-
MUX = MUY =Mum
PX PY
• 24 = 32 =8
3 4
8=8=8
Here, MU of money is constant at OE. When the consumer buys OA units of X-

commodity and OB units of Y-commodity, MUX and MUY are
PX PY
Equal to EO.
• Defects of cardinal utility analysis
• According to the cardinal utility analysis utility can be measured in utils or can be added
or subtracted. But, according to Hick, as utility is a psychological phenomena it is
subjective and can not be measured cardinally. In this analysis, utility is measured in
terms of money, but money is incorrect and imperfect measure of utility because the
value of money often changes.
• Critics of the utility analysis point out that this analysis assumes too much but it proves
too little.
• Utility analysis fails to explain study of inferior goods and giffen goods
• It also fails to explain the demand for indivisible goods
This cardinal utility analysis was propounded by Alfred Marshall. But due to its
inability to analyze utility properly professor Hicks propounded ordinal utility analysis.
• Indifference Curve-
It is a curve that represents all the combinations of goods that give the same satisfaction to the
consumer. Since all the combinations give the same amount of satisfaction, the consumer prefers
them equally. Hence the name Indifference Curve.
It can be better explained better with the help of following indifference schedule-
Combinations Commodity A Commodity B
A 1 12
B 2 6
C 3 4
D 4 3
• All these combinations in the above table give the consumer equal levels of satisfaction.
As the consumer moves from combination A to B,B to C, C to D and D to E, he/she give
up some quantity of Y in order to have one additional units of X.
•
• By plotting all the combinations of X and Y, the following Indifference Curve is
obtained. In the figure, units of good X and good Y are measured on X-axis and Y-axis
respectively. The line joining the points A,B,C and D is the indifference curve. The
indifference curve is downward sloping and convex to the origin is based on how much a
consumer prefers one good to another and on Marginal Rate of Substitution.
• Assumptions of Indifference Curve-
• Two Goods- It is assumed that consumer buys only two goods. This assumption is made
because a graph has only two axis.
• Rational Behaviour of the consumer-It is assumed that the consumer behaves rationally
which means that he/she tries to obtain the maximum satisfaction from his/her
expenditure on consumer goods under a price-income scenario and has full knowledge
about market condition.
• Concept of ordinal utility- The indifference curve analysis is based on the concept of
ordinal utility which implies that the consumer is in a position to rank the alternative
combinations available to him.
• Diminishing Marginal Rate of Substitution(MRS)- Another assumption behind

indifference curve analysis is that of MRS. This means, to obtain equal unit of
commodity (say X) the consumer sacrifices lesser and lesser amount of other commodity
(say Y).
• Properties of Indifference Curve(I.C.)-
• IC must slope downward from left to right - This properly indicates that IC must have
negative slope. It means that the consumer to be indifferent to all the combinations on the
IC must sacrifice some unit of one good.
• IC are convex to the origin- The IC are always convex to the origin. The convexity rule
implies that as the consumer sacrifices Y for X, the MRS (Marginal Rate of Substitution)
diminishes. It means that the amount of X is increased by one unit that of Y diminishes
by smaller units.
•
• In this figure, IC is convex to the origin. Here, the consumer is giving up less and less units of
good Y in order to have equal additional units of good X.
• IC do not intersect- IC can never meet or intersect.

•
• In this figure, point A and C lie on the same indifference curve IC2 and as such it represents
same level of satisfaction. Therefore,
• Combination A= Combination C-----I
• Similarly, point A and B lie on the same indifference curve IC1 showing equal satisfaction. Thus,
• Combination A= Combination B-----II
• Thus,
• Combination B= Combination C----From I and II
• But, this result is absurd. Since, point C lies on the higher indifference curve, IC2 and thus
represents higher level of satisfaction, while point B is located on the lower indifference curve,
IC1 showing lower satisfaction. In this way, B can never be equal to C, thus two IC can never be
intersect each other.
• An IC can not touch either axis-
• If the indifference curve,I1 touch X-axis at point M, as shown in the following figure. At
point M, the consumer will have OM quantity of good X and no amount of good Y.
Similarly, if I2 touches Y axis at point L, the consumer will have only OL of good Y and
no amount of good X, but this against the assumption of two goods. So, IC can not touch
either axis.
• Higher IC represents higher level of satisfaction- An IC that lies above and to the right
above another IC represents higher level of satisfaction.
• Here, in the above figure, point R and Q is on the higher IC, IC2 and point S is on the
lower IC, IC1. Hence, point R and Q represents higher level of satisfaction and point S
shows lower level of satisfaction.
• Law of Diminishing Marginal Rate of Substitution(MRS)-
The principle of diminishing MRS occupies a key place in the indifference curve
analysis. The term MRS of commodity X for commodity Y. MRSxy implies that a
consumer will be willing to give up some units of Y for obtaining an additional unit of X
without causing any change in the level of his total satisfaction. In other words, the term
MRSxy means the rate at which a unit of X is exchanged for another good Y. The
MRSxy can be better explained with the help of following indifference schedule-
Combinations Good X Good Y MRSXY= X
A 1 15 ------
B 2 10 5=5
C 3 6 4=4
D 4 3 3=3
E 5 1 2 =2
• In the above table, it is seen that by moving from combination A to B, the consumer has
added one extra unit of X, but has given up 5 units of Y to obtain the additional units of
X. Hence, MRSxy is 5. Likewise, when the consumer moves from B to C, C to D and D
to E in his IC schedule MRSxy becomes 4,3,2 and 1 respectively. Thus, MRSxy goes on
diminishing. In other words, when a consumer has more and more of good X, he will
prefer to give up less and less of good Y in exchange for his every additional unit of X.
•
• As the figure shows, IC is the indifference curve. The vertical sides ab, cd, ef represents
Y and the horizontal sides bc, de and fg signify X.
• At point C, MRSxy= Y = ab
X bc
• At point e, MRSxy= Y = cd
X de
• At point g, MRSxy= Y= ef
X fg
• This shows that as the consumer moves downward along the IC, he obtain equal
additional units of X and give up lesser and lesser units of Y. Here, the consumer is
giving up ab>ed>ef of good Y for obtaining bc=de=gf unit of good X.
• Indifference Map-
• The Indifference Map indicates the set of indifference curves which represents
different levels of satisfaction.
• In the figure given below, the bundles of figure buying on IC2 yield higher
satisfaction than IC1 and IC3 yield higher satisfaction than IC2.
•
• Rationality of a consumer indicates minimum satisfaction obtained by consumption of a

commodity.
• Diminishing Marginal Utility • Diminishing Marginal Rate of

Substitution
• The law of diminishing MU is a • Diminishing MRS is a basic concept of IC

fundamental law of utility analysis. analysis.
• According to this law, as a person • According to this concept, as more and
consumes more units of a good, MU goes more units of one good (say X) is
on diminishing. substituted, consumer is prepared to give
up less and less of the other good (say Y).
• Budget Line is a line that shows different possible combinations of the two goods that
can be purchased by a consumer, given his money income and market price of goods.
The equation of the budget line is-
• P1X1+P2X2=M
• X1,X2 = Units of goods X1 and X2.

• P1,P2= Price of goods X1 and X2.
• M= Money Income.
• Points below the budget line indicates that the bundle of goods cost less than his or her
money income i.e. under-spending. Points above the budget line indicates that the
bundles cost more than his or her money income i.e. over-spending.
• Combinations • Units of Good X • Units of Good
• (Rs. 2 per unit) • (Rs. 1 per unit
• A • 0 • 40
• B • 5 • 30
• C • 10 • 20
• D • 15 • 10
• E • 20 • 0
• Negative Slope: It slopes downward showing an inverse relationship between the buying
of the two goods.
• Straight Line: It is a straight line which denotes the constant market rate of exchange at
each combination.
• Real Income Line: It functions on the principle of income and the spending capacity of a
consumer.
• Tangent to Indifference Curve: The indifference curve touches the budget line at a
point, and this point is known as the consumer’s equilibrium.
• Money Income is Budget Constraint –
The consumer can not buy any bundles of goods that lie above the budget line because
of his limited money income. Hence, money income is a budget constraint.
• Budget Set –
All bundles on or below the budget line constitute the budget set.
• The slope of the budget line is downward sloping from left to right. Its slope is – Px
Py
• Changes in price-Income line –
• A change in the price of a good and the budget line -
If income is held constant, and the price of one of the goods changes then the slope of the
curve will change. If the price of one of the commodity increases, the budget line will
move inwards and vice-versa.
• Increase in price of one commodity(for commodity X)
If the price of one of the commodity increases, the budget line will move inwards.
• Decrease in price of one commodity(For Commodity B)with no change in A

If the price of one of the commodity decreases, the budget line will move outwards. In
the diagram below, as the price of good B falls, the original budget line will become
flatter, which implies that he can now buy more of good B than before with constant
price of good A and income.
Again, if the price of good B decreases the original budget line become steeper due
to the increase in price.
• Increase and Decrease in price of one commodity(For Commodity Y)with no change in
price of commodity X and constant income-
Here, with the increase in price of Y, the budget line will shift inward i.e. to left.
Again, with decrease in price of Y, the budget line shift outward or right.
• Change in Income and budget line-
• An increase in income causes the budget line to shift outward, parallel to the original line
(holding prices constant). Which means that a consumer can buy more of both goods with
more income.
• A decrease in income causes the budget line to shift inward, parallel to the original line
(holding prices constant) so a consumer can buy less of both goods with less income.
• Conditions of Consumer’s Equilibrium according to IC approach or Consumer’s
equilibrium when MRS must be equal to the ratio of the prices of the two goods or
consumer’s equilibrium when consumer buys only that combination of the two goods that
is shown at the point of tangency of the Budget Life with IC-
Consumer’s equilibrium shows a situation in which the consumer purchases such a
combination of the commodities which gives him maximum satisfaction from his given
income and with given prices of the commodities. In other words, consumer’s
equilibrium is a situation from which the consumer does not want to move either forward
or backward because the point of equilibrium is regarded by the consumer as the ideal
point.
• Assumptions-
• Price of the commodities are given to the consumer.
• Consumer’s income is also given.
• The are two commodities X and Y, which are homogeneous and divisible.
• There is no change in the taste, habits of the consumer.
• The consumer is rational.
• The budget line should be tangent to the IC
Consumer’s equilibrium point is a common point is a common point between the
budget line and one of the IC in the indifference map.
• The Budget Line should be tangent to the IC-

In the above diagram, PQ is the budget line which the consumer can have any
combinations A,F,K,E,L,G and H. Combination A or B are out of question because in
either case he would have only Y or only X. He would not take combination F or G on a
lower IC, because combination K or L are available to him on a higher IC, IC2. But, there
is another combination E, which is on higher IC, IC3 on the budget line AB. Since, all
other combinations lie on lower IC, they represents lower levels of satisfaction than
combination ‘E’, where B.L. is tangent to the IC, IC3.Thus, ‘E’ is the consumer’s
equilibrium point.
• At the point of equilibrium the slope of the IC and the slope of the Budget Line should be
the same
In the above figure, at point ‘E’, the slope of the IC shows the MRS of X for Y and
the slope of the Budget Line shows the ratio of price of X for the price of Y. Thus, the
equilibrium condition being satisfied at point ‘E’, where MRSxy= Price of X
Price of Y
• IC should be convex to the origin

The last condition is that at the point of equilibrium the IC must be convex to the
origin for equilibrium to be stable.
If IC is concave to the origin as shown in the figure below by Indifference
Curve, IC, at point E, the MRSxy will be increasing. Which is against the property of
indifference curve. Again, the consumer will be at minimum level of satisfaction at point
E. Hence, IC must be convex to the origin, as shown in the figure by IC, IC1. Here at
point E1,the consumer will get maximum levels of satisfaction.
• Demand
A commodity will have demand when the consumer have the willingness to spend as
well as the ability to purchase the commodity.
• Demand Function
Demand function shows the functional relationship between quantity demanded for a
particular commodity and the factors influencing it. It is represented as-
Dx= f (Px, PR, Y, T, P)
• Where, Dx= Demand for a commodity X
Px=Price of commodity X
PR= Price of related goods
Y =Consumer’s Income
T=Taste
P= Population
Here, except price of X (Px),the other factors influencing the demand for a commodity
is assumed to be constant.
• So,in general demand function will be D=f(P)

• Assumptions of law of demand-
• Price of related goods (complementary and substitute) do not change.
• There is no change in the income of the consumers.
• Taste and Preferences of the consumers remain unchanged.
• Consumers do not expect any change in the price of the commodity in near future.
• Demand Schedule –The table relating price and quantity demanded is known as demand
schedule.
• Individual Demand Schedule-When we represent quantity demanded by an individual for
a given commodity per unit of time against the commodity’s price in a tabular form, we
obtain individual demand schedule.
• Market Demand Schedule- When demand for a market represent in a tabular form, we get
the market demand schedule.
• Demand Curve- Demand Curve indicates the inverse relationship between price and
quantity demanded of a commodity. The demand curve is shown below-
• Law of Demand- The law of demand states that other things being unchanged or constant
(ceteris paribus) as the price of a commodity rises the demand for it falls and vice-versa.
Thus, the law of demand establishes inverse relationship between price and quantity
demanded. The expression other things remaining unchanged implies that price of related
goods, income of the consumer, his taste, population remains constant or unchanged.
• Demand Curve and its Types-
• A demand curve is the graphical representation of the relationship between the price and
quantity demanded of a commodity.
• Individual Demand Curve-It refers to the graphical representation of the indifference
demand schedule.
• Market Demand Curve- It refers to the graphical representation of the market demand
schedule.
• Individual demand schedule-

Price (Rs. Per kg.) Quntity Demand of commodity
X(Kg.)
3 6
6 5
9 4
12 3
15 2
Pri Quantit Quantit Market
ce y y Demand(A
Deman Deman +B)
d of A- d of B-
Consum Consum
er er
1 5 6 11
2 4 5 9
3 3 4 7
4 2 3 5
5 1 2 3
• Reasons for Downward sloping demand curve or why law of demand operate
• The law of diminishing M.U.- The law states that with successive increase in the units of
consumption of a commodity, every additional unit of the commodity gives lesser
satisfaction to the consumer. A consumer tries to maximise his satisfaction by equalizing
price of X (Px) and MUx. If Px falls then MUx>Px ,so he will consume more of that
good,which reduces MU. This process continues until Mux=Px. So,demand and price are
inversely related leading to downward sloping demand curve.
• Law of Equi Marginal Utility –Law of demand can be explained on the basis of this law.
With two commodities X and Y consumer will be in equilibrium when Mux = Muy .
Px Py
If Mux>Muy (due to fall in Px),the consumer will
Px Py
buy more of X and less of Y until the consumer reaches equilibrium. This also shows
negative relationship between price and demand.
• Income Effect- When the price of a commodity falls,the consumer will have greater
purchasing power, which encourages him to increase his demand for the commodity
because it is as if the consumer’s income has increased. Similarly, at a higher price, he
can purchase only smaller quantity due to fall in purchasing power of his money income.
The change in demand due to purchasing power is called income effect.
• Substitution Effect- When the price of a commodity falls, the relative price of its
substitutes automatically rises, the consumer will then substitute the commodity for other
substitute goods, which price has not changed. For eg.- A rise in the price of commodity
say coffee, also means that price of its substitute say tea, has fallen with respect to coffee
even though price of tea remain unchanged. As a result, people will buy less of coffee
because they now substitute tea to coffee. The change in demand due to change in
relative prices is called the substitution effect.
• Cross Price Effect-When demand for a particular product is affected by change in the
price of another product, it is called cross price effect. It originated from related goods
like substitute and complementary goods. (For eg. Price of coffee falls, then quantity
demanded of its substitute tea will fall because the consumer substitute coffee for tea).
This shows cross price effect , since change in price of one product (coffee) has affect
demand for other product (tea). Similarly, fall in price of a complementary good like
petrol increases demand for its complementary good car or bike.
• Shift in the demand curve and the situation when it changes-
• Rightward Shift of the demand curve- The rightward shift of the demand curve shown
below.
• Here, the original demand curve shifts right due to the increase in quantity demanded.
• The situation under which rightward shift of demand curve takes place-
• Increase in income of the consumers- Generally, an increase in income of the
consumers shifts demand curve to the right. Which implies that more will be demanded at
its possible price.
• Increase in the price of the substitute goods-
An increase in the price of the substitute goods causes an increase in the demand for the
product in question Suppose, we take two substitute goods, say tea and coffee. A rise in
the price of substitute good coffee will increase the demand of tea, which implies
rightward shift of demand curve.
• Fall in price of complementary goods-
An example can be taken to explain this. Suppose, there are 2 complementary goods say
tea and sugar. A fall in price of sugar is likely to increase the demand for tea. This fall in
price of a good caused shift of demand curve to the right.
• Favourable Changes in taste, habit and preferences of the consumer-
A rise in the taste, habit and preferences of the consumer for the product leads to
rightward shift of the demand curve.
• Leftward shift of the demand curve shown below in the diagram, where the original
demand curve shift left due to fall in demand.
• The situation under which leftward shift of demand curve takes place are given below-
• Fall in income of the consumers- Generally, fall in income of the consumers shift demand
curve to the left, which implies less will be demanded at its possible price.
• Fall in price of substitute goods- Fall in price of substitute goods causes a fall in demand
for the product in question. Suppose, we take two substitute goods say tea and coffee. A
fall in the price of a substitute good say coffee will decrease the demand of tea. Because,
people will start consuming coffee instead of tea which shift demand curve.
• Increase in price of consumer goods – This can be explained with the help of a suitable
example. Suppose, we take consumer goods say tea and sugar and increase in price of
sugar is likely to decrease demand for tea. Thus, rise in price of consumer goods leads to
leftward shift of demand curve.
• Unfavourable changes in taste, habit and preferences of the consumer-
If consumers started to dislike a product it will cause left ward shift of the demand
curve.
• Exceptions to the Law of Demand-
• War- If shortage is feared in anticipation of war, people may start buying fore building
stocks or for hoarding even when the price rises.
• Depression- During a depression, the prices of commodities are very low and the demand
for them is also less. is because of the lack of purchasing power with consumers.
• Giffen Paradox-If a commodity happens to be a necessity of life like wheat and its price
goes up, consumers are forced to curtail the consumption of more expensive foods like
meat and fish and wheat being still the cheapest food they will consume more of it. The
Marshallian example is applicable to developed economies. In the case of an
underdeveloped economy, with the fall in price of an inferior commodity like maize,
consumers will start consuming more of the superior commodity like wheat. As a result,
the demand for maize will fall. This is what Marshall called the Giffen Paradox which
makesthe demand curve to have a positive slope.
• Demonstration Effect- If consumers are affected by the principle of conspicuous
consumption or demonstration effect, they will like to buy more of those commodities
which confer distinction on the possessor, when their price rise. On the other hand, with
the fall in the prices of such articles, their demand falls, as in the case with diamonds.
• Ignorance Effect- Consumers buy more at a higher price under the influence of the
‘ignorance effect’, where a commodity may be mistaken for some other commodity, due
to deceptive packing, lebel etc.
• Speculation- Marshall mentions speculation as one of the important exceptions to the
downward sloping demand curve. According to him, the law of demand does not apply to
the demand in a campaign between groups of speculators. When a group unloads a great
quantity of a thing on to the market, the price falls and the other group begins buying it.
When it has raised the price of the thing, it arranges to sell a great deal quietly. Thus,
when prioce rises, demand also increases.
• Price Elasticity of Demand: Definition, Types -
Elasticity of demand refers to price elasticity of demand. It is the degree of
responsiveness of quantity demanded of a commodity due to change in price, other things
remaining the same.
• Mathematical Expression of Price Elasticity of Demand-
• The price elasticity of demand is defined as the percentage change in quantity demanded
due to certain percentage change in price.
•
• Where, EP= Price elasticity of demand

• q= Original quantity demanded
• ∆q = Change in quantity demanded
• p= Original price
• ∆p = Change in price
• Calculation of Price Elasticity of Demand
• Suppose that price of a commodity falls down from Rs.10 to Rs.9 per unit and due to this,
quantity demanded of the commodity increased from 100 units to 120 units. What is the
price elasticity of demand?
• Give that,
• p= initial price= Rs.10
• q= initial quantity demanded= 100 units
• ∆p=change in price=Rs. (10-9) = Rs.1
• ∆q=change in quantity demanded= (120-100) units = 20 units
• Now,
• Ep= q * p
p q
= 20/1*10/100=2
The quantity demanded increases by 2% due to fall in price by Rs.1.
• Relatively Elastic Demand (EP> 1)
The demand is said to be relatively elastic if the percentage change in demand is
greater than the percentage change in price i.e. if there is a greater change in demand
there is a small change in price. It is also called highly elastic demand or simply elastic
demand. For example:
• If the price falls by 5% and the demand rises by more than 5% (say 10%), then it is a case
of elastic demand. The demand for luxurious goods such as car, television, furniture, etc.
is considered to be elastic.
• In the given figure, price and quantity demanded are measured along the Y-axis and X-
axis respectively. The demand curve DD is more flat, which shows that the demand is
elastic. The small fall in price from OP to OP1 has led to greater increase in demand
from OM to OM1. Likewise, demand decrease more with small increase in price.
• Relatively Inelastic Demand (Ep< 1 )
• The demand is said to be relatively inelastic if the percentage change in quantity
demanded is less than the percentage change in price i.e. if there is a small change in
demand with a greater change in price. It is also called less elastic or simply inelastic
demand.For example: when the price falls by 10% and the demand rises by less than 10%
(say 5%), then it is the case of inelastic demand. The demand for goods of daily
consumption such as rice, salt, kerosene, etc. is said to be inelastic.
• In the given figure, price and quantity demanded are measured along the Y-axis and X-
axis respectively. The demand curve DD is steeper, which shows that the demand is less
elastic.The greater fall in price from OP to OP1 has led to small increase in demand
from OM to OM1. Likewise, greater increase in price leads to small fall in demand.
• Unitary Elastic Demand ( Ep = 1)
• The demand is said to be unitary elastic if the percentage change in quantity demanded is
equal to the percentage change in price. It is also called unitary elasticity. In such type of
demand, 1% change in price leads to exactly 1% change in quantity demanded. This type
of demand is an imaginary one as it is rarely applicable in our practical life.
• In the given figure, price and quantity demanded are measured along Y-axis and X-axis
respectively. The demand curve DD is a rectangular hyperbola, which shows that the
demand is unitary elastic. The fall in price from OP to OP1 has caused equal
proportionate increase in demand from OM to OM1. Likewise, when price increases, the
demand decreases in the same proportion.
• Perfectly Inelastic Demand (EP = 0)
• The demand is said to be perfectly inelastic if the demand remains constant whatever may
be the price (i.e. price may rise or fall). Thus it is also called zero elasticity. It also does
not have practical importance as it is rarely found in real life.
 In the given figure, price and quantity demanded are measured along the Y-axis and X-
axis respectively. The demand curve DD is a vertical straight line parallel to the X-axis. It
shows that the demand remains constant whatever may be the change in price. For
example: even after the increase in price from OP to OP2 and fall in price
from OP to OP1, the quantity demanded remains at OM.
 Perfectly Elastic Demand (EP = ∞)
 The demand is said to be perfectly elastic if the quantity demanded increases infinitely
(or by unlimited quantity) with a small fall in price or quantity demanded falls to zero
with a small rise in price. Thus, it is also known as infinite elasticity. It does not have
practical importance as it is rarely found in real life.
 In the given figure, price and quantity demanded are measured along the Y-axis and X-
axis respectively. The demand curve DD is a horizontal straight line parallel to the X-
axis. It shows that negligible change in price causes infinite fall or rise in quantity
demanded.
 Methods of measuring Price Elasticity of Demand-
 1. The Percentage Method:
 The price elasticity of demand is measured by its coefficient (E p). This coefficient (Ep)
measures the percentage change in the quantity of a commodity demanded resulting from
a given percentage change in its price.
 Thus
• Where q refers to quantity demanded, p to price and Δ to change. If E P>1, demand is
elastic. If EP< 1, demand is inelastic, and Ep= 1, demand is unitary elastic.
• With this formula, we can compute price elasticities of demand on the basis of a demand
schedule.
• Let us first take combinations B and D.
• Suppose the price of commodity X falls from Rs. 5 per kg. to Rs. 3 per kg. and its
quantity demanded increases from 10 kgs.to 30 kgs.
• Then
• This shows elastic demand or elasticity of demand greater than unitary.
• 2. The Point Method:
• Prof. Marshall devised a geometrical method for measuring elasticity at a point on the
demand curve. Let CD be a straight line demand curve in Figure.
• Elasticity of demand can be analyzed on the CD demand curve with the help of
following formula-
• Lower Segment of demand curve=Ep
Upper segment of demand curve
• The elasticity of demand is measured with the help of following diagram-

• We arrive at the conclusion that at the mid-point on the demand curve, the elasticity of
demand is unity. Moving up the demand curve from the mid-point, elasticity becomes
greater. When the demand curve touches the Y- axis, elasticity is infinity. Ipso facto, any
point below the mid-point towards the A’-axis will show elastic demand. Elasticity
becomes zero when the demand curve touches the X -axis.
• The Arc Method
• We have studied the measurement of elasticity at a point on a demand curve. But when
elasticity is measured between two points on the same demand curve, it is known as arc
elasticity. In the words of Prof. Baumol, “Arc elasticity is a measure of the average
responsiveness to price change exhibited by a demand curve over some finite stretch
of the curve.”
• Any two points on a demand curve make an arc. The area between P and M on the DD
curve in Figure. 4 is an arc which measures elasticity over a certain range of price and
quantities. On any two points of a demand curve, the elasticity coefficients are likely to
be different depending upon the method of computation. Consider the price-quantity
combinations P and Mas given in Table. 2.
If we move in the reverse direction from M to P, then

• Thus the point method of measuring elasticity at two points on a demand curve gives
different elasticity coefficients because we used a different base in computing the
percentage change in each case.
• To avoid this discrepancy, elasticity for the arc (PM in Figure 4) is calculated by taking
the average of the two prices [(p1 + p2 )½] and the average of the two quantities [(q,
+q2)½]. The formula for price elasticity of demand at the mid-point (C in Figure 4) of the
arc on the demand curve is
• On the basis of this formula, we can measure arc elasticity of demand when there is a
movement either from point P to M or from M to P.
• From P to M at point P, p1 =8, q1 = 10, and at point M, p2 = 6, q2 = 12.
• Applying these values, we get
• Thus whether we move from M to P or P to M on the arc PM of the DD curve, the

formula for arc elasticity of demand gives the same numerical value. The closer the two
points P and M are, the more accurate is the measure of elasticity on the basis of this
formula.
• If the two points which form the arc on the demand curve are so close that they almost
merge into each other, the numerical value of arc elasticity equals the numerical value of
point elasticity.
• 4. The Total Outlay Method:
• Marshall evolved the total outlay, or total revenue or total expenditure method as a
measure of elasticity. By comparing the total expenditure of a purchaser both before and
after the change in price, it can be known whether his demand for a good is elastic, unity
or less elastic.
• Total outlay is price multiplied by the quantity of a good purchased: Total Outlay = Price
x Quantity Demanded. This is explained with the help of the demand schedule in Table.3.
• Professor Marshall has introduced total outlay method. The types of elasticity of demand
according to this method is explained with the help of table given above.
• Elastic Demand- Demand is elastic when with fall in price the total expenditure increases
and with rise in price the total expenditure decreases. As table shows, as price decreases
from rs. 9 to rs. 8,the total expenditure increases from rs.180 to rs.240. Demand is elastic
(Ep>1) in this case.
• Unity elastic Demand- When with the fall or rise in price, the total expenditure remains
unchanged, the elasticity of demand is unity. Here, in the table fall in price from rs.6 to
rs. 5 or with rise in price fro rs. 4 to rs. 5, the total expenditure remains unchanged at rs.
300,i,.e.Ep=1.
• Less Elastic Demand-Demand is less elastic if with the fall in price, the total expenditure
falls and with rise in price,total expenditure rises. As the table shows when price fall from
rs. 3 to rs.2, total expenditure fall from rs. 3 to rs.2. This is the case of inelastic demand
Ep<1.
• Meaning of Supply-Supply is the willingness and ability of producers to create goods and
services to take them to market. Supply is positively related to price given that at higher
prices there is an incentive to supply more as higher prices may generate increased
revenue and profits.
• The law of supply – The law of supply is the law that states that, all other factors being
equal, as the price of a good or service increases, the quantity of goods or services that
suppliers offer will increase, and vice-versa.
It can be explained with the help of following schedule and diagram:

• The supply schedule shows the positive relationship between price and quantity supplied.
This is in accordance with the Law of Supply.
SS is the supply curve sloping upward. It shows a positive relationship between price and
quantity supplied of a commodity.
When price increases from Rs 10 to Rs 20, quantity supplied increases from 100 to 200
units.
• Factors Influencing Supply-
• Price of the commodity- The higher the price of a commodity, the larger will be the
quantity supplied and vice-versa.
• Price of other commodities – A change in the price of another commodity also affects the
supply of a commodity. For instance- if the price of good A rises, the producer of good B
may produce less of good B and switch over to the production of good A in order to sell
more of it.
• Prices of factors used in its production -If the price of any one factor of production (i.e.
labour or capital) used in the production of a commodity increases, its cost of production
and price will increase. As a result, its output will fall and the supply will be reduced. The
reverse will happen in the case of a fall in the price of a factor.
• Goals of producers-If a producer aims at maximizing profit, he will produce less of the
commodity which involves large risk. A produce who aims at maximizing his sales will
produce and sell more.
• State of technology - If new and improved methods of production are used, they tend to
increase the supply of commodities.
• Thus,
• Sq= f(Pq,Pa,Pb,………;F1,F2,……..;G;T)
• S=Supply of commodity q
• f=Function
• Pq=Price of commodity
• Pa,Pb= Price of other commodities
• F1,F2=Prices of factors of production
• G= Goals of producers
• T= State of technology
• The Law of Supply states that other things being equal, quantity supplied increases with
the increase in price and decreases with the decrease in price of a commodity.
It can be explained with the help of following schedule and diagram:
• The supply schedule shows the positive relationship between price and quantity supplied.
This is in accordance with the Law of Supply.
SS is the supply curve sloping upward. It shows a positive relationship between price and
quantity supplied of a commodity.
When price increases from Rs 10 to Rs 20, quantity supplied increases from 100 to 200
units.
• Exceptions to the law of supply-
• When prices are expected to fall much, sellers will sell more in order to clear their stocks.
This is so in the short-run.
• Over the long-run, the supply is influenced by changes in cost which are, in turn, affected
by changes in technology.
• Changes in habits, tastes, fashions, weather and national and international disturbances
also affect the supplies of commodities.
• A rise in the price of a good or service sometimes leads to a fall in its supply. This
happens particularly in labour-service. When wages rise to a level where the workers feel
satisfied, they will work less than before in order to have more leisure. They will also
have a tendency to educate their children rather than send them to work. The supply
curve in such a situation is backward sloping.
• Elasticity of Supply- Elasticity of supply measures the degree of responsiveness of
quantity supplied to a change in own price of the commodity. It is also defined as the
percentage change in quantity supplied divided by percentage change in price.
• It can be calculated by using the following formula:
• ES = % change in quantity supplied/% change in price
• Symbolically,
• ES = ∆Q/Q ÷ ∆P/P = ∆Q/∆P × P/Q
• Types of Elasticity of Supply:

• For all the commodities, the value of E s cannot be uniform. For some commodities, the
value may be greater than or less than one.
• Like elasticity of demand, there are five cases of ES:
• (a) Elastic Supply (ES>1):
• Supply is said to be elastic when a given percentage change in price leads to a larger
change in quantity supplied. Under this situation, the numerical value of E s will be greater
than one but less than infinity. SS1curve of Fig. 4.17 exhibits elastic supply. Here
quantity supplied changes by a larger magnitude than does price.
• Inelastic Supply(Ep<1) -Supply is said to be inelastic when a given percentage change in

price causes a smaller change in quantity supplied. Here the numerical value of elasticity
of supply is greater than zero but less than one. Fig. 4.18 depicts inelastic supply curve
where quantity supplied changes by a smaller percentage than does price.
• Unit Elasticity of Supply (ES = 1):
• If price and quantity supplied change by the same magnitude, then we have unit elasticity
of supply. Any straight line supply Curve passing through the origin, such as the one
shown in Fig. 4.19, has an elasticity of supply equal to 1. This can be verified in this way.
• Perfectly Elastic Supply (ES = ∞):
• The numerical value of elasticity of supply, in exceptional cases, may reach up to

infinity. The supply curve PS1 drawn in Fig. 4.20 has an elasticity of supply equal to
infinity. Here the supply curve has been drawn parallel to the horizontal axis. The
economic interpretation of this supply curve is that an unlimited quantity will be offered
for sale at the price OS. If price slightly drops down below OS, nothing will be supplied.
Perfectly Inelastic Supply (ES = 0):
• Another extreme is the completely or perfectly inelastic supply or zero elasticity.

SS1 curve drawn in Fig. 4.21 illustrates the case of zero elasticity. This curve describes
that whatever the price of the commodity, it may even be zero, quantity supplied remains
unchanged at OQ. This sort of supply curve is conceived when we consider the supply
curve of land from the viewpoint of a country, or the world as a whole.
• Measurement of Elasticity of Supply:
• The elasticity of supply is measured by the point method. Diagram for this purpose is
given below-
• The Elasticity of Supply at point P on the supply curve S1 can be measured with the help
of the following formula-
• Es = q * p, where q is the slope of the
p q p
Supply curve S1 which is OB and p =BP .
BP q OB
Thus, the elasticity of supply curve S1 at point P is OB* BP = 1 (unity).
BP OB
• Similarly, the elasticity of supply at point P on the supply curve S2 is
AB* BP =AB< 1 (less than unity).
BP OB OB
Also, the elasticity of supply at point P on the supply curve S2 is
A1B* BP =A1B> 1 (greater than unity).
BP OB OB
S2
S1
S3
A1 O A B
• Income Elasticity of Demand-
• The elasticity of demand measures how factors such as price and income affect the demand for a
product. The income elasticity of demand measures how the change in a consumer’s income
affects the demand for a specific product. You can express the income elasticity of demand
mathematically as follows:
• Income Elasticity of Demand = % change in quantity demanded / % change in income
• The higher the income elasticity of demand for a specific product, the more responsive it
becomes the change in consumers’ income.
• Where, EY = Elasticity of demand
• q = Original quantity demanded

• ∆q = Change in quantity demanded
• y = Original consumer’s income
• ∆y= Change in consumer’s income
• Suppose that the initial income of a person is Rs.2000 and quantity demanded for the
commodity by him is 20 units. When his income increases to Rs.3000, quantity
demanded by him also increases to 40 units. Find out the income elasticity of demand.
• Solution:
• Here, q = 100 units
• ∆q = (40-20) units = 20 units
• y = Rs.2000
• ∆y =Rs. (3000-2000) =Rs.1000
• Now,
• Hence, an increase of Rs.1000 in income i.e. 1% in income leads to a rise of 2% in
quantity demanded.
• Types of Income Elasticity of demand
• Positive income elasticity of demand (EY>0)
• If there is direct relationship between income of the consumer and demand for the
commodity, then income elasticity will be positive. That is, if the quantity demanded for
a commodity increases with the rise in income of the consumer and vice versa, it is said
to be positive income elasticity of demand. For example: as the income of consumer
increases, they consume more of superior (luxurious) goods. On the contrary, as the
income of consumer decreases, they consume less of luxurious goods.
• Income elasticity greater than unity (EY > 1)
• If the percentage change in quantity demanded for a commodity is greater than

percentage change in income of the consumer, it is said to be income greater than unity.
For example: When the consumer’s income rises by 3% and the demand rises by 7%, it is
the case of income elasticity greater than unity.
• In the given figure, quantity demanded and consumer’s income is measured along X-axis
and Y-axis respectively. The small rise in income from OY to OY1 has caused greater
rise in the quantity demanded from OQ to OQ1 and vice versa. Thus, the demand
curve DD shows income elasticity greater than unity.
• Income elasticity equal to unity (EY = 1)

• If the percentage change in quantity demanded for a commodity is equal to percentage
change in income of the consumer, it is said to be income elasticity equal to unity. For
example: When the consumer’s income rises by 5% and the demand rises by 5%, it is the
case of income elasticity equal to unity.
and Y-axis respectively. The small rise in income from OY to OY1 has caused equal rise
in the quantity demanded from OQ to OQ1 and vice versa. Thus, the demand
curve DD shows income elasticity equal to unity.
• Income elasticity less than unity (EY < 1)
• If the percentage change in quantity demanded for a commodity is less than percentage
change in income of the consumer, it is said to be income greater than unity. For
example: When the consumer’s income rises by 5% and the demand rises by 3%, it is the
case of income elasticity less than unity.
• In the given figure, quantity demanded and consumer’s income is measured along X-axis and Y-
axis respectively. The greater rise in income from OY to OY1 has caused small rise in the
quantity demanded from OQ to OQ1 and vice versa. Thus, the demand curve DD shows income
elasticity less than unity.
• Negative income elasticity of demand ( EY<0)
• If there is inverse relationship between income of the consumer and demand for the commodity,
then income elasticity will be negative. That is, if the quantity demanded for a commodity
decreases with the rise in income of the consumer and vice versa, it is said to be negative income
elasticity of demand. For example:
• As the income of consumer increases, they either stop or consume less of inferior goods.
and Y-axis respectively. When the consumer’s income rises from OY to OY1 the quantity
demanded of inferior goods falls from OQ to OQ1 and vice versa. Thus, the demand
curve DD shows negative income elasticity of demand.
• Zero income elasticity of demand ( EY=0)
• If the quantity demanded for a commodity remains constant with any rise or fall in
income of the consumer and, it is said to be zero income elasticity of demand. For
example: In case of basic necessary goods such as salt, kerosene, electricity, etc. there is
zero income elasticity of demand.
and Y-axis respectively. The consumer’s income may fall to OY1 or rise
to OY2 from OY, the quantity demanded remains the same at OQ. Thus, the demand
curve DD, which is vertical straight line parallel to Y-axis shows zero income elasticity
of demand.
• Cross Elasticity of Demand-
• It is the ratio of proportionate change in the quantity demanded of Y to a given

proportionate change in the price of the related commodity X.
• It is a measure of relative change in the quantity demanded of a commodity due to a

change in the price of its substitute/complement. It can be expressed as:
UNIT-3
THEORY OF PRODUCTION
• Factors of Production-
• The factors, of production are the resources that include land, labor, capital, and
enterprise.
• Land-In literary sense, land is regarded as soil. However, in economics, land, a factor of
production, has a much wider scope. Marshall has defined land as, “the materials and the
forces which nature gives freely for man’s aid, in land and water, in air and light and
heat.” Land refers to a natural resource that can be utilized to produce income. It is a
useful factor of production, but is available in limited quantity.
• Characteristics-
• It is a gift of nature to man.
• Change in price of land does not affect its supply. Land is fix.
• Regarded as a permanent input having certain inherent properties, which are original and
indestructible.
• Land is an immobile factor of production.
• Land differs in fertility. This leads to variation in the prices of land.
• Labour-Labor constitutes one of the important factors of production. Labour involves

human services and efforts for the production of goods or services. In economic terms, a
work, physical or mental, carried out for monetary purpose is called labour.
• Labour is defined as the perishable factor of production that has no reserve price.
• Change in the price of labour would affect the supply of labour. Supply of labour
decreases with an increase in prices (wages) and vice-versa.
• Capital -
Capital, the third agent or factor is the result of past labour and it is used to produce more
goods. It is a man-made resource. Capital is that part of wealth which is not used for the purpose
of consumption but is utilized in the process of production. Tools and machinery, bullocks and
ploughs, seeds and fertilizers, etc. are examples of capital.
• Capital is a manmade factor of production.
• It is mobile, it can be shifted from one place to another.
• It is a passive factor of production.

•
• Organization(Enterprize)-
• Organization, as a factor of production, refers to the task of bringing land, labour and
capital together. It involves the establishment of co-ordination and co-operation among
these factors. The person in charge of organization is known as an organizer or an
entrepreneur. So, the entrepreneur is the person who takes the charge of supervising the
organization of production and of framing the necessary policy regarding business.
• He has imagination.
• He has great administrative power.
• An entrepreneur must be a man of action.
• An entrepreneur must have the ability to organize.
• He should be a knowledgeable person.
• He must have a professional approach.
• production function -production function refers to the functional relationship between the
quantity of a good produced (output) and factors of production (inputs)
• It shows a purely a technical relation between factor inputs and output
• Mathematically, such a basic relationship between inputs and outputs may be expressed
as:
• Q = f( L, K )
• Where Q = Quantity of output
• L = Labour
• K = Capital
• Thus, the level of output (Q), depends on the quantities of different inputs (L, K)
available to the firm.
• Short-run production function- The short-run production function is that time period in
which at least one factor of production(Labour) is thought to be fixed in supply, i.e. it
cannot be increased or decreased, and the rest of the factors(capital) are variable in
nature. In the short run, the firm’s capital inputs are assumed as fixed and the production
level can be changed by changing the quantity of other inputs such as labour, raw
material, capital and so on. Therefore, it is quite difficult for the firm to change the
capital equipment, to increase the output produced, among all factors of production
• Long-run production function- Long-run production function indicates the time period,
over which the firm can change the quantities of all the inputs. All the factors are variable
because the firm can change and adjust all the factors of production and level of output
produced according to the business environment.
• Short-Run production function • Long-Run production function
• Short run production function implies that time • Long run production function denotes that time
period, in which at least one factor of period, in which all the factors of production
production is fixed are variable
• In short run, Law of variable proportion • In long run, Law of returns to scale operates
operates
• There is no change in the scale of production in • Here, the scale of production changes
the short run
• Total Product(TP)-
• Other factors being constant Total product of a factor is the amount of total output
produced by a given amount of the factor. As the amount of a factor increases, the total
output also increases.
•
• Average Product(AP)-
• Average product of a factor is the total output produced per unit of the factor
employed. Thus,
• Average Product = Total Product/Number of units of a factor employed
• Symbolically, AP = Q/L
• Where, Q= Total product
• L= number of a variable factor employed
• Marginal Product-
• Marginal product of a factor is the addition to the total production by the employment
of an extra unit of a factor.
• Symbolically, MPL = ∆Q/∆L or MPL = TPL- TPL-1
• Law of variable proportion
• Keeping other factors fixed, the law explains the production function with one factor
variable. In the short run when output of a commodity is sought to be increased, the law
of variable proportions comes into operation. According to this law, ‘An increase in
Some inputs relative to other fixed inputs with a given state of technology when
increased after a point, first the marginal and then the average product of that factor will
diminish’.
• The state of technology is assumed to be given and constant as an improvement in
technology the production function will move upward
• The units of variable factor are homogeneous. Each unit is identical in quality and
amount with every other unit
• The law operates in the short-run where one is variable factor and other remains fixed
• Price of the factors are fixed
• This law can be better explained with the help of a table. Suppose take the example of
agriculture, where land is a fix and labour is a variable factor.
Capital(K) Labour T M Stages

(Acres) (L) P P
4 1 2 2 Increasi
ng
4 2 5 3 Returns
to a
Factor
4 3 9 4
4 4 1 3 Decreas
2 ing
Returns
4 5 1 2 to a
4 Factor
4 6 1 0
4
4 7 1 -1 Negativ
3 e
Returns
4 8 1 -2 to a
1 Factor
• From the table it is clear that there are three stages of the law of variable proportion.
• In the first stage as more and more units of labour employed with fixed factors (land),
both TP and MP increases. However, the rate of increase of TP is more than that of MP.
• The second stage starts from where the first stage ends. In this stage, marginal product
start falling. Here, total product increases at a diminishing rate. It is also maximum at 14
units of labour where marginal product becomes zero.
• The third stage begins where second stage ends. This starts from 7th unit. Here, marginal
product is negative and total product falls.
• In the above figure, number of labourers is measured on OX axis and quantity of product
is shown on OY axis. TP is total product curve.
• Law of variable proportion is divided in to 3 stages-
• First Stage -
• First stage starts from point ‘O’ and ends up to point F. Up to point ‘E’, total product is
increasing at increasing rate. between ‘E’ and ‘F’ it increases at diminishing rate.
Similarly marginal product also increases initially and reaches its maximum at point ‘H’.
Later on, it begins to diminish. In this stage, marginal product exceeds average product
(MP > AP).
• Second Stage –
• It begins from the point F. In this stage, total product increases at diminishing rate and is
at its maximum at point ‘G’ correspondingly marginal product diminishes rapidly and
becomes ‘zero’ at point ‘C’. In this stage, marginal product is less than average product
(MP < AP).
• In the lower part of the figure MP is marginal product curve. Up to point ‘H’ marginal
product increases. At point ‘H’, it is maximum. After that, marginal product begins to
decrease. Marginal product becomes zero at point C and it turns negative.
• Third Stage-
• This stage begins beyond point ‘G’. Here total product starts diminishing. Average
product also declines. Marginal product turns negative. In this stage, no firm will produce
anything. This happens because marginal product of the labour becomes negative.
However, of the three stages, a firm will like to produce up to any given point in the
second stage only.
• Rational Decision:
• Stage II becomes the relevant and important stage of production. Production will not take
place in either of the other two stages. It means production will not take place in stage III
and stage I. Thus, a rational producer will operate in stage II.
• Suppose b were a free resource; i.e., it commanded no price. An entrepreneur would want
to achieve the greatest efficiency possible from the factor for which he is paying, i.e.,
from factor a. Thus, he would want to produce where AP is maximum or at the boundary
between stage I and II.
• If on the other hand, a were the free resource, then he would want to employ b to its most
efficient point; this is the boundary between stage II and III.
• Obviously, if both resources commanded a price, he would produce somewhere in stage

II. At what place in this stage production takes place would depend upon the relative
prices of a and b.
• Condition or Causes of Applicability of the law of variable proportions
• Under Utilization of Fixed Factor
• In initial stage of production, fixed factors of production like land or machine, is under-
utilized. More units of variable factor, like labour, are needed for its proper utilization. As
a result of employment of additional units of variable factors there is proper utilization of
fixed factor. In short, increasing returns to a factor begins to manifest itself in the first
stage.
• Fixed Factors of Production
• The foremost cause of the operation of this law is that some of the factors of
production are fixed during the short period. When the fixed factor is used with variable
factor, then its ratio compared to variable factor falls. Production is the result of the co-
operation of all factors. When an additional unit of a variable factor has to produce with
the help of relatively fixed factor, then the marginal return of variable factor begins to
decline.
• Optimum Production
• After making the optimum use of a fixed factor, then the marginal return of such variable
factor begins to diminish. The simple reason is that after the optimum use, the ratio of
fixed and variable factors become defective. Let us suppose a machine is a fixed factor of
production. It is put to optimum use when 4 labourers are employed on it. If 5 labourers
are put on it, then total production increases very little and the marginal product
diminishes.
• Imperfect Substitutes
• Mrs. Joan Robinson has put the argument that imperfect substitution of factors is mainly
responsible for the operation of the law of diminishing returns. One factor cannot be used
in place of the other factor. After optimum use of fixed factors, variable factors are
increased and the amount of fixed factor could be increased by its substitutes.
• Such a substitution would increase the production in the same proportion as earlier. But
in real practice factors are imperfect substitutes. However, after the optimum use of a
fixed factor, it cannot be substituted by another factor.
• Applicability of the Law of Variable Proportions-
• The law of variable proportions is universal as it applies to all fields of production. This
law applies to any field of production where some factors are fixed and others are
variable. That is why it is called the law of universal application.
• The main cause of application of this law is the fixity of any one factor. Land, mines,
fisheries, and house building etc. are not the only examples of fixed factors. Machines,
raw materials may also become fixed in the short period. Therefore, this law holds good
in all activities of production etc. agriculture, mining, manufacturing industries.
• Application to Agriculture-
• With a view of raising agricultural production, labour and capital can be increased to any
extent but not the land, being fixed factor. Thus when more and more units of variable
factors like labour and capital are applied to a fixed factor then their marginal product
starts to diminish and this law becomes operative.
• Application to Industries-
• In order to increase production of manufactured goods, factors of production has to be
increased. It can be increased as desired for a long period, being variable factors. Thus,
law of increasing returns operates in industries for a long period. But, this situation arises
when additional units of labour, capital and enterprise are of inferior quality or are
available at higher cost.
• As a result, after a point, marginal product increases less proportionately than increase in
the units of labour and capital. In this way, the law is equally valid in industries.
• Law of Returns to Scale-

• Law of returns to scale explains the long-run production function where there is no
fixed factor of production in the long run and all the factors are variable factors. The law
of returns to scale analysis the effects of scale on the level of output. Law of returns to
scale describes proportions of the output changes when there is proportionate change in
the quantities of all inputs. Thus, according to this theory it is possible to get three stages
of production i.e. Increasing Returns to scale, Constant Returns to Scale and Decreasing
Returns to Scale.
• Assumptions-
• It is applicable during long-run.
• All the factors here are variable factors.
• This law is explained with the help of a table and a diagram below-
Labour(L) Capital(K) TP MP Stages
1 1 2 2 Increasing
Returns to
2 2 5 3 Scale
3 3 9 4
4 4 13 4 Constant
Returns to
5 5 17 4 Scale
6 6 21 4
7 7 24 3 Decreasing
Returns to
8 8 26 2 Scale
• Increasing Returns to Scale -Increasing returns to scale refers to a situation when all
factors of production are increased, output increases at a higher rate. It means if all inputs
are doubled, output will also increase at the faster rate than double. Hence, it is said to be
increasing returns to scale. As the table shows labour and capital increases to 2 units from
1 unit output (TP) increases by 3 units. Again, when input increases by 1 unit, output
increases by 4 unit.
• Constant Returns to Scale -Constant returns to scale increases exactly in the same
proportion in which factors of production are increased. In simple terms, if factors of
production are doubled output will also be doubled. Here, in the table as input increases
from 4 to 5 and the to 6 unit, output is constant at 4 unit.
• Diminishing Returns to Scale -Diminishing returns to scale refer to that production
situation, where if all the factors of production are increased in a given proportion, output
increases in a smaller proportion. It means, if inputs are doubled, output will be less than
doubled. In the table, increase in input by 1 unit reduces output by 1 unit.
• Economies of Scale
When more units of a good or service can be produced on a larger scale with less input
cost on average, economies of scale are said to be achieved. The effect of economies of
scale is to reduce the average cost of production. Economies of scale have brought down
the unit cost of production and have fed through lower prices for consumers. Most firms
find that as in a production output increases they can achieve lower cost per unit. In other
words, economies of scale are the cost advantages that a business can exploit by
expanding their scale of production.
The economies of large scale production are classified in to two by professor
Alfred Marshall. They are-
• Internal Economies
External Economies
• Internal Economies of Scale-

These are those economies which are internal to the firm. These arise within the firm
as a result of increasing the scale of output of the firm. The main internal economies are
grouped under the following heads-
a. Technical Economies- When production is carried on a large scale a firm can afford
to install up to date and costly machinery and can have its own repairing arrangements.
As the cost of machinery will be spread over a very large volume of output, the cost of
production per unit therefore will be low. Again, large establishments can utilize its
byproducts, which enable the firm to lower the price per unit of the main product. Large
establishments also have immense scope for specialization of work, utilization of the
services of experience entrepreneurs and workers which a small firm can not afford.
b. Managerial Economies- A large establishment is in a better position to buy the raw-
materials at a cheaper rate because they can buy these commodities on a large scale.
Further, at the time of selling the produced goods, the firm can secure better rates by
effectively advertising in the newspapers, journals, radios etc.
c. Financial Economies- Large establishments can also raise loans at a lower rate of
interest then a small establishment which enjoy little reputation in the capital market.
d. Risk bearing economies- A big firm have the ability to bear risk. Large establishments
produces variety of goods in order to meet the needs of different people with different
taste. If the demand for certain types of commodities slackens, it is counter balanced by
the increasing demand of the other type of commodities.
Internal Dis-Economies-
Internal diseconomies implies to all those factors which raise the cost of
production of a particular firm when its output increases beyond the certain limit. These
factors may be of the following two types:
• Inefficient Management- The main cause of the internal diseconomies is the lack of
efficient or skilled management. When a firm expands beyond a certain limit, it becomes
difficult for the manager to manage it efficiently or to co-ordinate the process of
production. Moreover, it becomes very difficult to supervise the work spread all over,
which adversely affects the operational efficiency.
• Technical Difficulties-Another major reason for the onset of internal diseconomies is the
emergence of technical difficulties. In every firm, there is an optimum point of technical
economies. If a firm operates beyond these limits technical diseconomies will emerge
out. For instance, if an electricity generating plant has the optimum capacity of 1 million
Kilowatts of power; it will have lowest cost per unit when it produces 1 million
Kilowatts. Beyond, this optimum point, technical economies will stop and technical
diseconomies will result.
• Production Diseconomies-The diseconomies of production manifest themselves when the
expansion of a firm’s production leads to rise in the cost per unit of output. It may be due
to the use of inferior or less efficient factors as the efficient factors are in scarcity. It
happens when the size of the firm surpasses the optimum size.
• Marketing Diseconomies-After an optimum scale, the further rise in the scale of
production is accompanied by selling diseconomies. It is due to many reasons. Firstly, the
advertisement expenditure is bound to increase more than proportionately with scale.
Secondly, the overheads of marketing increase more than proportionately with the scale.
• Financial Diseconomies-If the scale of production increases beyond the optimum scale,
the cost of financial capital rises. It may be due to relatively more dependence on external
finances. To conclude, diseconomies emerge beyond an optimum scale. The internal
diseconomies lead to rise in the average cost of production in contrast to the internal
economies which lower the average cost of production.
• External economies of scale happen externally i.e. not inside the organization but in
within the industry. External economies reduce the average cost of the company. Since,
cost per unit totally depends on the size of the industry, average cost decreases as
industry size increases. The positive benefits to the firm are External economies of scale
and negative externalities are known as External diseconomies of scale.
• The main external economies are grouped under the following heads-
• Economies of Concentration-It is the advantage of a firm due to its concentration. Many
other factors such as skilled labour, better transport facilities etc. also help in the
economy of the organization. Easy arrangement for repair, maintenance, communication,
insurance, and special services is available to the firm.
• Economies of Information-A firm needs continuous information from the industry like
the cost of the inputs, products, policies, and other services are required by the
organization. When an industry provides the firms with this, it provides economies to the
firm.
• Economies of Specialization-The industry can have more than one firm in a particular
area. These firms can help each other in their fields of specialization. This not only
provides support but also reduces the cost of their operation. The benefit is shared by all
the firms.
• Research and Development-The industry can have an R&D department. Running such a
department reduces costs by developing more efficient methods and techniques.
• Taxation- The cost falls when the Government reduces the tax on industries.
• External Diseconomies-
• External diseconomies are not suffered by a single firm but by the firms operating in a
given industry. These diseconomies arise due to much concentration and localization of
industries beyond a certain stage. Localization leads to increased demand for transport
and, therefore, transport costs rise. Similarly, as the industry expands, there is
competition among firms for the factors of production and the raw-materials. This raises
the prices of raw-materials and other factors of production. As a result of all these factors,
external diseconomies become more powerful.
• Some of the external diseconomies are as under-
• Diseconomies of Pollution- The localization of an industry in a particular place or region
pollutes the environment. The polluted environment acts as health hazard for the
labourers. Thus, the social cost of production rises.
• Diseconomies of Strains on Infrastructure- The localization of an industry puts excessive
pressure on transportation facilities in the region. As a result of this, the transportation of
raw materials and finished goods gets delayed. The communication system in the region
is also overtaxed. As a result of the strains on infrastructure, monetary as well as the real
costs of production rise.
• Diseconomies of High Factor Prices-The excessive concentration of an industry in a
particular industrial area leads to keener competition among the firms for the factors of
production. As a result of this, the prices of the factors of production go up. Hence, the
expansion and growth of an industry would lead to rise in costs of production.
•
SMALL SCALE PRODUCTION

In small scale production, the firm produces more outputs with low cost or small sized plants where the
scale of production is small. The small scale production is also associated with low capital-output and
low capital-labour ratios. Hence small scale production is largely labour-intensive.
Economies of scale
Economies of scale refer to the cost advantages a firm gains with the increase in production. This
happens because production costs can be spread over a large number of goods. It can be grouped under
two categories i.e., Internal and External.
I. i. Internal Economies of scale : It implies all those factors which are internal to the firm.
These arise within the firm as a result of increasing the scale of output of the firm.
a) Labour economies :- Small scale production usually requires more labour since it
is mainly based on labour-intensive production. Labours are required since they
are able to produce more outputs with low costs.
b) Inventory economies:- Small Firms might be able to lower average costs by
buying the inputs required for the production process in bulk or from special
wholesalers. By negotiating with suppliers for volume discounts, the purchasing
firm takes advantage of economies of scale. Small scale production is surviving
due to the availability of raw materials in the local ares.
c) Production economies:- Small scale production gives importance to the tastes
and fashions of the consumers. The small scale producers will be able to grasp
the needs and preferences of the consumers and produce commodities
accordingly.
d) Managerial economies:- Small scale production is convenient for taking decisions
without any delay. As the size of capital, labourers and market are limited, the
entrepreneurs of these industries take decisions and solve problem without
wasting time.
ii. Internal Diseconomies of scale : It implies all those which raise the cost of
production of a particular firm when its output increases beyond the certain
limit.
a) Outdated technology: Small scale producers run their business with limited
capital. They do not have sufficient funds to invest in latest technology.
Technology used in many small scale enterprises is outdated. Up-to-date
technology can’t be adopted due to the small size of the units.
b) Financial diseconomies: A small scale entrepreneur faces great difficulty in
sourcing the required finance. Banks are reluctant to fund small enterprises
because of the high rates of default and failure. Investors may not be interested
to invest in small firms.
c) Growth diseconomies: Small scale enterprises are not able to grow beyond a
certain level. Limited resources and skills and lack of a strong brand hinder
further expansion or diversification.
d) Marketing difficulties: The ultimate objective of production is to place the
product in the hands of the consumer. Small scale units are not able to
effectively market their products. They do not have sufficient funds to spend on
sales promotion and advertising. Therefore it is difficult to build a strong brand
image and attract customers.
II. i. External Economies of scale: It refer to economies of scale originating from outside
the company, rather than by internal companies. It arises when the average cost for
each company goes down as the industry’s output rises.
a) Employment opportunities : Small scale production promotes employment
opportunities and solves the unemployment problem. This is due to the fact that
they require more manpower than machines for their working.
b) Economies of satisfaction : The number of customers is limited and the small
scale entrepreneur would be directly involved in the business. Personal contact
can be maintained with customers. Their needs and requirements can be
understood and satisfied. This results in satisfied customers leading to stable
demand.
c) Economies of customisation : Today customers prefer products tailored to their
specific needs. They demand unique products. In such cases where products
have to be customized to individual customer needs large scale production
would not be suitable. Small Scale Industries are better suited in case products
have to be customized.
d) Economies of pollution : In the case of large scale enterprises, society has to
incur high social costs in terms of air and water pollution and environmental
degradation. But in the case of small enterprises, such social costs are less since
small scale industries mostly includes labour-intensive.
ii. External Diseconomies of scale : It refer to diseconomies of scale originating from outside the
company. They are not suffered by a single firm but by the firm operating in a given industry .
a) Diseconomies of research and development: Economics of research and

experimentation are not possible by small scale production since they don’t have
enough funds or requirements for the actual research work.
b) Diseconomies of competition: Small scale units can’t withstand the competition from
large scale industries since they are unable to cope up with the production of large
production. Large scale units use the latest technology, employ skilled workers and
enjoy the advantages of specialization. These advantages are not available to small scale
units.
c) Diseconomies of By-products: It is not possible to utilize the by-products in the small
scale production as they do not have required equipments to make use of waste
materials.
d) Diseconomies of Higher factor price: The number of units produced is less. Fixed costs
are spread over a limited number of units. Therefore the overhead cost per unit is high
and hence, the expansion and growth of an industry would lead to rise in costs of
production.
UNIT 4
MARKET MECHANISM AND COMPETITION
• Equilibrium of demand and supply-The equilibrium price and equilibrium quantity occur
where the supply and demand curves cross. The equilibrium occurs where the quantity
demanded is equal to the quantity supplied. If the price is below the equilibrium level,
then the quantity demanded will exceed the quantity supplied. Excess demand or a
shortage will exist. If the price is above the equilibrium level, then the quantity supplied
will exceed the quantity demanded. Excess supply or a surplus will exist. In either case,
economic pressures will push the price toward the equilibrium level.
• TC stands for TOTAL COST-It is the total expenditure incurred by producer on the
variable actor as well as fixed factor. Short run total cost is divided in to two, Total fixed
cost, Total variable cost.
• Total Fixed Cost(TFC)- TFC refers to the cost of a firm incurs to employ fixed inputs or
factors(eg.plant and equipment building etc). Whatever the amount of output the firm
produces, this cost remain fixed for the firm.
• Total Variable Cost(TVC)- To produce any required level of output, the firm in the short-
run can adjust only variable inputs or factors(eg.labour, raw-materials etc). Variable
inputs can be varied in the short-run.
• Average Total Cost (ATC)-The average total cost is the sum of the average variable cost
and the average fixed costs. That is,
• ATC = AFC + AVC
• In other words, it is the total cost divided by the number of units produced.
• Average Fixed Cost (AFC)-The average fixed cost is the total fixed cost divided by the
number of units produced. Hence, if TFC is the total fixed cost and Q is the number of
units produced, then
• AFC=TFC/Q
• Therefore, AFC is the fixed cost per unit of output.
• Average Variable Cost (AVC)- The second aspect of short-run average costs is an
average variable cost. Average variable cost is the total variable cost divided by the
number of units produced. Hence, if TVC is the total variable cost and Q is the number of
units produced, then
• AVC =TVC/Q
• Therefore, AVC is the variable cost per unit of output.
• It is important to note that the behaviour of the ATC curve depends upon that of the AVC
and AFC curves. Observe that:
• In the beginning, both AVC and AFC curves fall. Hence, the ATC curve falls as well.
• Next, the AVC curve starts rising, but the AFC curve is still falling. Hence, the ATC
curve continues to fall. This is because, during this phase, the fall in the AFC curve is
greater than the rise in the AVC curve.
• As the output rises further, the AVC curve rises sharply. This offsets the fall in the AFC
curve. Hence, the ATC curve falls initially and then rises.
• MARGINAL COST(MC)-It is the change in total cost when one more unit is to be
produced.
• AVERAGE COST(AC)-It is the cost per unit of output produced. It is get by dividing
total cost by no of units.
• Relation between Average Cost and Marginal Cost
• Relation between average cost and marginal cost is explained through Table and Figure-
• When AC Falls, MC is Lower than AC-When average cost falls, marginal cost is less
than AC. In this case, marginal cost falls more rapidly than the average cost. That is why
when marginal cost (MC) curve is falling, it is below the average cost (AC) curve.
• When AC Rises, MC is Greater than AC-When average cost starts rising, marginal cost is
greater than average cost. In Figure, AC starts rising from point E. And, beyond E, MC is
higher than AC.
• When AC does not Change, MC is Equal to AC-When average cost does not change,
then MC = AC. It happens when falling AC reaches its lowest point. Thus, Figure shows
that MC curve is intersecting AC curve at its minimum point E.
• Relation between Total Cost and Marginal Cost
• Marginal cost is estimated as the difference between total costs of two successive units of
output. Thus,
• MCn = TCn – TCn-1
• When MC is diminishing, TC increases at a diminishing rate.
• When MC is rising, TC increases at an increasing rate.
• When MC reaches its lowest point Q , TC stops increasing at a decreasing rate point Q*.
• Long-run Total Cost(LRTC) -The time period during which even/thing (except factor
prices and the state of technology or art of production) is variable is called the long run
and the associated curve that shows the minimum cost of producing each level of output
is called the long- run total cost curve.
• Long-Run Average Cost(LRAC)- Long-run average cost is arrived at by dividing the
total cost of producing a particular output by the number of units produced:
• LRTC= LRTC/Q
• Long-run Marginal Cost(LRMC) -Long-run marginal cost is the extra total cost of
producing an additional unit of output when all inputs are optimally adjusted:
• LRTC= ∆ LRTC /∆Q
• It, therefore, measures the change in total cost per unit of output as the firm moves along
the long run total cost curve.
• Above figure illustrates typical long-run average and marginal cost curves. They have
essentially the same shape and relation to each other as in the short run. Long-run average
cost first declines, reaches a minimum, then increases. Long-run marginal cost first
declines, reaches minimum at a lower output than that associated with minimum average
cost Q1 in the figure and increases thereafter.
• The marginal cost intersects the average cost curve at its lowest point L in Figure as in
the short-run. The reason is also the same.
• When marginal cost is greater than average cost, each additional unit of the good
produced adds more than average cost to total cost; so average cost must be increasing
over this range of output. Thus marginal cost must be equal to average cost when average
cost is at its minimum.
• Average Cost in the Long Run: Smooth Envelope Case:
• We know that in the short-run the firm has a fixed plant and it has a short run U-shaped
cost curve SAC. If a new and larger plant is built, the new SAC will be drawn further to
the right.As output increases, the firm moves to a new SAC curve.
• In the long run, the firm can change the size of the plant. Starting from zero output level,
successively larger plants typically have lower and lower AC up to some output level and
then successively higher AC curves beyond. The three representative AC curves
associated with the three successively larger plants are shown in the Figure below-
• In the above figure, plant I is the best plant for output levels less than 900 units because
its AC curve is the lowest to the left of point a. Plant II is the best plant size for output
levels between 900 to 2,000 units, because its AC curve is the lowest between point a and
b. Plant III is the best plant size for output levels greater than 2,000 units, since its AC
curve is the lowest beyond point b.
• If these are only three possible plant sizes, the long run ATC curve will consist of the
segments of Plant I’s AC curve up to point a, the segment of plant II’s AC curve between
points a and b, and the segment of Plant Ill’s AC curve from point of b and so on. The
thick LAC is composed of the three lowest branches of SACs. This is why the LAC is
called the envelope curve.
• Above figure is the smooth envelope case. Since there is an infinite number of choices,
we get LAC as a smooth envelope. And, as in the short-run, we can derive LMC from
LAC, and LMC emerges from the minimum point of LAC with a smoother slope than the
SMC curve.
• Total Revenue-The income earned by a seller or producer after selling the output is called
the total revenue. In fact, total revenue is the multiple of price and output. The behavior
of total revenue depends on the market where the firm produces or sells. Total revenue is
the sum of all sales, receipts or income of a firm.
• Average Revenue-Average revenue refers to the revenue obtained by the seller by selling the
per unit commodity. It is obtained by dividing the total revenue by total output.
• Marginal Revenue-Marginal revenue is the net revenue obtained by selling an additional
unit of the commodity. “Marginal revenue is the change in total revenue which results
from the sale of one more or one less unit of output.” Ferguson. Thus, marginal revenue
is the addition made to the total revenue by selling one more unit of the good. In
algebraic terms, marginal revenue is the net addition to the total revenue by selling n
units of a commodity instead of n – 1.
• Profit becomes maximum irrespective of the market situation, when the difference
between total revenue (TR) and total cost (TC) becomes the greatest.
• Total cost- Total cost (TC) is the total economic cost of production and is made up
of variable cost, which varies according to the quantity of a good produced and includes
inputs such as labour and raw materials, plus fixed cost, which is independent of the
quantity of a good produced and includes inputs that cannot be varied in the short term.
• Total cost in the short-run is divided in to Total variable cost and Total fixed cost.
• Total fixed cost- TFC refers to the cost a firm incurs to employ fixed inputs or factors(eg.
Plant and equipment building etc.)
• In general, the word Market means a group of shops where the buyers and sellers can
engage in transactions of goods and services. It refers to a market place. But in
economics, it refers to the market for a commodity containing the buyers and sellers of
this commodity
• Main factors which determine the market structure in a capitalist economy-
• Number of buyers and sellers- When the number of seller is less, firm can influence the
price as it can produce a larger proportion total supply. Again, small number of buyers
exercise a large control on the market.
• Nature of the product- Products in the market may be homogenous or heterogeneous in
nature. Homogeneous product will sell at uniform price and heterogeneous at
differentiated price.
• Knowledge about the market- If buyers and sellers have full knowledge about the
market, there will be uniform price for the products. Ignorance of knowledge leads to
differences in price.
• Entry and exit of firms- depending on the nature of the markets, there is either free
entry and exit or restricted entry and exit of firms.
• Free Entry and Exit- Under the perfect competition, the firms are free to enter or exit
the industry. This implies, If a firm suffers from a huge loss due to the intense
competition in the industry, then it is free to leave that industry and begin its business
operations in any of the industry, it wants. If firms earn profit, then it will attract new
firms, which will increase output, price reduce and profit will again come to its original
position. Again, if the firms are suffering from loss, some firms will leave the industry,
which reduce output as well as price and normal profit can be attained. Thus, there is no
restriction on the mobility of sellers.
• Perfectly competitive market- The perfectly competitive market refers to a market

structure where a large number of firms produce and sell similar products and each
individual firm sells the product at a market determined given price to a large number of
buyers.
• Features-
• Large number of buyers and sellers- In perfect competition, the buyers and sellers are
large enough, that no individual can influence the price and the output of the industry.
An individual customer cannot influence the price of the product, as he is too small in
relation to the whole market. Similarly, a single seller cannot influence the levels of
output, who is too small in relation to the gamut of sellers operating in the market.
Here, both buyers and sellers are price taker and industry is price maker.
• Homogeneous Product- Each competing firm offers the homogeneous product, such
that no individual has a preference for a particular seller over the others. Products are
identical in all respects like quality, colour, size, design, weight etc. Salt, wheat, coal, etc.
are some of the homogeneous products for which customers are indifferent and buy
these from the one who charges a less price. Thus, an increase in the price would let the
customer go to some other supplier.
• Perfect knowledge of prices and technology -This implies, that both the buyers and
sellers have complete knowledge of the market conditions such as the prices of
products and the latest technology being used to produce it. Hence, they can buy or sell
the products anywhere and anytime they want.
• No transportation cost- There is an absence of transportation cost, i.e. incurred in

carrying the goods from one market to another. This is an essential condition of the
perfect competition since the homogeneous product should have the same price across
the market and if the transportation cost is added to it, then the prices may differ.
• Absence of Government and Artificial Restrictions- Under the perfect competition,

both the buyers and sellers are free to buy and sell the goods and services. This means
any customer can buy from any seller, and any seller can sell to any buyer. Thus, no
restriction is imposed on either party. Also, the prices are liable to change freely as per
the demand-supply conditions. In such a situation, no big producer and the government
can intervene and control the demand, supply or price of the goods and services.
• Thus, under the perfect competition, a seller is the price taker and cannot influence the
market price.
• Shape of the AR and MR curves - Under perfectly competitive market, as firms are price
taker, the average revenue (=price) is same for all the units of output sold. Marginal
revenue is constant and equal to the average revenue.
•
• In the first figure, price is determined at OP by industry through intersection of demand
and supply. Second figure shows adoption of price by the price taking firms who are free
to sell any quantity at this price. This makes AR curve parallel to x-axis. As per the AR-
MR relationship, when AR is constant, MR must be equal to AR. Thus, AR curve is also
the MR curve of the firm. Again, industry’s demand curve is negatively sloped while
firm’s demand curve is horizontal since under perfect competition each firm is able to
sell any quantity that it wishes to sell at the given market price. In other words, demand
curve is not a constraint here. Therefore, it does not need to compete with other firms
to obtain a market for its product. Thus, competitive behaviour is missing under
competitive market structure.
• Long-run equilibrium of a firm and industry under perfect competition -
• One of the significant characteristic of perfectly competitive market is that there is free
entry and free exit of firms. Due to this characteristic there is always normal profit in the
market.
• Under perfect competition, the firm could be in long-run if they can fulfill the following
conditions-
• Long-run Marginal Revenue(LMR)=Long-run Marginal Cost(LMC)
• LMC must cut LMR from below at equilibrium point.
• The slope of LMC must be greater than than the slope of LMR.
• The given figure shows the equilibrium of a firm and industry respectively under
perfectly competitive market. The industry demand curve DD1 and supply curve SS1
intersect each other at point E where the market price is P. At point E, industry determine
OP price for OQ quantity of product. In the next figure it is observed that at point
E,P=LAR=LMR=LAC=LMC respectively. OP price is determined for OQ1 level of
output and firm making only normal profit.
• Pure competition- Pure competition is a term that describes a market that has a broad
range of competitors who are selling the same products. It is often referred to as perfect
competition. Here are some characteristics that define pure competition:
• In an ideal purely competitive market, the products being sold would be identical, which
removes the option of one seller offering something different or better than another seller.
• Because there are so many competitors in the market offering the same product at the
same price, one competitor doesn't have an edge over the others. Essentially, all the
sellers are equal.
• New companies can easily enter the market.
• The price of products is determined solely by what consumers are willing to pay.
• Difference between pure competition and perfect competition-
• Pure competition is pretty practical whereas Perfect competition is utterly unrealistic.
• Pure competition has no element of monopoly enabling a producer to change more where
Perfect competition has same element of monopoly.
• Pure competition is less restrictive whereas Perfect competition is more restrictive.
• Pure competition is a variants of perfect competition whereas Perfect competition is a

additional version of pure competition.
• Pure competition has no absence of transportation and communication cost whereas

Perfect has absence of transportation and communication cost.
• Pure competition is less sufficient whereas Perfect competition is more sufficient.
• Monopoly Market- The word monopoly composed of two words ‘Mono’ which means
single and poly which means a seller. Thus, Monopoly refers to a market situation where
there is only one seller. There is no close substitute for the commodity sold by the only
seller. A pure monopoly is that where a single seller have full control over the supply of a
commodity which have no close substitutes.
• Features-
• Single seller and large number of buyers- Under monopoly, there is only one seller of a
commodity. Being the single seller, a monopoly firm face no competition with other
firms. Again, a monopoly firm produces an industry’s entire output, the difference
between firm and industry disappears.
• No close substitutes- Under monopoly market, the commodity or service sold by the
seller has no close substitute. A pure monopoly will exist only when there are no close
substitutes of the product sold by the single seller.
• The restrictions on the entry of new firms- Another important feature of monopoly is that
there are restrictions on the entry of new firms in to the monopoly market. The closed
entry may result from natural, legal or man-made restrictions. These restrictions may take
several forms, such as, patent rights, copy rights, government laws and economies.
• Firm is a price maker- In monopoly market, the firm is a price maker. In monopoly
market, the firm has full control over the supply as there is no competition in the market,
there are barriers to the entry of new firm and there are no close substitutes of the
product. So, the firm can make the price. However, the firm can not charge high price due
to demand of consumers.
• Price Discrimination- In monopoly market, there is possibility of discriminating prices

for different customers. Price discrimination refers to a situation when a producer sells
the same product produced under single control to different buyers at different prices.
Price Discrimination
Price discrimination exists within a market when the sales of identical goods or services are sold
at different prices by the same provider. The goal of price discrimination is for the seller to make
the most profit possible. Although the cost of producing the products is the same, the seller has
the ability to increase the price based on location, consumer financial status, product demand,
etc.
Types of Price Discrimination
There are three types of price discrimination that exist. The exact price discrimination method
that is used depends on the factors within the particular market.
 First degree price discrimination: the monopoly seller of a good or service must know
the absolute maximum price that every consumer is willing to pay and can charge each
customer that exact amount. This allows the seller to obtain the highest revenue possible.
 Second degree price discrimination: the price of a good or service varies according to
the quantity demanded. Larger quantities are available at a lower price (higher discounts
are given to consumers who buy a good in bulk quantities).
 Third degree price discrimination: the price varies according to consumer attributes
such as age, sex, location, and economic status.
The purpose of price discrimination is to capture the market’s consumer surplus. Price
discrimination allows the seller to generate the most revenue possible for a good or service.
Price discrimination is prevalent in varying degrees throughout most markets. Methods of price
discrimination include:
 Coupons: coupons are used to distinguish consumers by their reserve price. Companies
increase the price of a good and individuals who are not price sensitive will pay the higher
price. Coupons allow price sensitive consumers to receive a discount. At the same time the
seller is still making increased revenue.
 Age discounts: age discounts are a form of price discrimination where the price of a good
or admission to an event is based on age. Age discounts are usually broken down by child,
student, adult, and senior. In some cases, children under a certain age are given free
admission or eat for free. Examples of places where age discounts are given include
restaurants, movies, and other forms of entertainment.
 Occupational discounts: price discrimination is present when individuals receive certain
discounts based on their occupation. An example is when active military members receive
discounts.
 Retail incentives: this includes rebates, discount coupons, bulk and quantity pricing,
seasonal discounts, and frequent buyer discounts.
 Gender based prices: in certain markets prices are set based on gender. For example, a
Ladies Night at a bar is a form of price discrimination.
• The relationship of TR,AR and MR is shown here with the help of following table-
Quantity Price (Rs. Per unit) TR (Rs) AR (Rs) MR(Rs)

sold(units)
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
6 5 30 5 0
• The above figure shows that firm’s MR is less than AR or price at which it sells output.
Again, MR fall faster than AR. The table can be better understood with the help of
following diagram-
• The straight line shown in the figure above is the market demand curve for a particular
product. The monopolist firm selling the product faces a downward slope, as seen above.
This is because the firm will have to reduce the price of the product if it wants to sell
more. Since he charges a single price for all the units he sells, the average revenue per
unit is identical to the price. Therefore, the market demand curve = the average revenue
curve for the monopolist. Three thing are there to observe from the figure-
• AR and MR are both negative sloped (downward sloping) curves.
• MR curve lies half-way between the AR curve and the Y-axis. i.e. it cuts the horizontal
line between the Y-axis and AR into two equal parts.
• AR cannot be zero, but MR can be zero or even negative.
• Causes behind emergence of monopoly-

• Licensing- Sometimes the government gives license to only one company for producing a
product or service in a given locality or region. For example till 2002, Videsh Sanchar
Nigam(VSNL) had monopoly in India in providing international telephone service.
• Patent Rights- When a big private company introduces a new product or new technology,
the government may grant it patent rights. Under patent right no other firm can copy the
product of innovator, but patent right is valid only for a certain fixed time period which is
known as patent life. For example- Xerox company of America.
• Formation of a cartel- Sometimes individual firms while retaining their identities unite in
to a group and co-ordinate their outputs and pricing policy so as to act as monopoly. The
Organization of Petroleum Exporting Countries (OPEC) in the 1970s is an example of a
cartel.
• Natural Restrictions- Monopoly may exist as a natural phenomenon. An industry in

which economies of scale are so great that only a single firm can achieve minimum
efficient scale is called natural monopoly. Under natural monopoly, average cost of
production goes on over a wide range of output and reaches the minimum at an output
level that is large enough for a single firm to meet the entire market demand.
• Long-run equilibrium of a firm and industry under Monopoly-
• Single organization constitutes the whole industry in monopoly. Thus, there is no need
for separate analysis of equilibrium of organization and industry in case of monopoly.
The monopolist will go on producing additional units of output as long as MR is greater
than MC, to earn maximum profit.
• Equilibrium under monopoly can be shown with the help of the diagram given below-
• As the figure shows, if output is increased beyond OQ, MR will be less than MC. Thus, if
additional units are produced, the organization will incur loss. At equilibrium point, total
profits earned are equal to shaded area ABEC. E is the equilibrium point at which
MR=MC with quantity as OQ.
• Monopolistic Competition-
Monopolistic competition refers to a market situation wherein there is a large number of small
firms selling differentiated but closely related (substitutes) products. Under monopolistic
competition, a large number of firms produce differentiated products which belong to the same
class. The markets of products like biscuits, fans, shoes, toothpastes etc are some examples of
monopolistic competition.
Features-
• Large number of buyers and sellers(firms) – In this market, the number of buyers and
large, where the size of each firm is small. Firms under monopolistic competition are not
price-takers. They set their own prices. In this market, the number of buyers is also
large , so large that no individual buyer can influence the price of the product by
changing his demand.
• Product Differentiation- In this market, product of various firms are similar in nature but
are differentiated in terms of brand name, shape and size, colour, quality, type of service
etc. For example-different brands of toothpaste vary on the basis of colour, taste fluoride,
packaging etc. Product differentiation thus refer to the differentiated products which are
close substitutes of one another.
• Free entry and exit of firms -In this market, firms are free to enter or exit the industry. It
implies that all firms normal profit with no loss in the long run.
• Selling Cost- Selling cost is one of the important feature of monopolistic competition. As
products are differentiated the firm have to incur selling expenses (expenditure on
advertisement) to promote their sales. Selling cost are very high here. Selling cost are
either constructive or persuasive. Constructive advertising provides useful information
about the product in terms of product features, price availability, warranty etc. Persuasive
advertising attempts to lure customers from other brands to its product.
• Non price competition- Much of the competition under this market takes place in the
form of non price competition. Product variation and advertisement are the two main
forms of non-price competition. Product variation refers to change in the quality of the
product, change in design, gifts and schemes etc.
• Shape of AR and MR curves-

Under monopolistic competition, the relationship between AR and MR is the same as under
monopoly. Both AR and MR curves are downward sloping here implies that in order to sell
more the price of the price of the commodity have to be reduced. But there is an exception that
the AR curve is more elastic(flatter) than monopoly, as shown in Figure. This is because
products are close substitutes under monopolistic competition. The firm can increase its sales
by a reduction in its price.
Each firm under this market estimates its planned sales on the basis of the assumption
that other firms would not react to the changes in price done by it, then, planned sales curve is
called perceived demand curve of the firm.
• Long-run equilibrium of a firm and industry under Monopoly-

• Equilibrium in Short Run-The short-run equilibrium of a monopolistic competitive
organization is the same as that of an organization under monopoly. In the short run, an
organization under monopolistic competition attains its equilibrium where marginal
revenue equals marginal cost and sets its price according to its demand curve. This
implies that in the short run, profits are maximized when MR=MC.
• Equilibrium in the short-run is shown below with the help of a figure-
• AR is the average revenue curve, MR represents the marginal revenue curve, SAC curve
denotes the short run average cost curve, while SMC signifies the short run marginal cost.
it can be seen that MR intersects SMC at output OM where price is OP’ (which is equal
to MP). This is because P is the, point on AR curve, which is price.
• Thus, it can be interpreted from that the organization is earning supernormal profit.
Supernormal profit per unit of output is the difference between the average revenue and
average cost. Here, average revenue at equilibrium point is MP and average cost is MT.
Therefore, PT is the supernormal profit per unit of output. In the present case,
supernormal profit would be measured by the area of rectangle P’PTT’ (which is output
multiplied by supernormal profit per unit of output).
• On the other hand, when marginal cost is greater than marginal revenue, organizations
would incur losses, as shown in Figure below-
• Figure shows the condition of losses in the short run under monopolistic competition.
Here, OP’ is smaller than MT, which implies that average revenue is smaller than average
cost. TP is representing the loss that has incurred per unit of output. Therefore total loss is
depicted from rectangle T’TPP’.
• Equilibrium in Long Run:
• In the long run, the AR curve is more elastic than that of in the short run. This is because
of an increase in the number of substitute products in the long- run. The long-run
equilibrium of monopolistically competitive organizations is achieved when average
revenue is equal to average cost. In such a case, organizations receive normal profits. It is
shown below in the diagram-
• In here, P is the point at which AR curve touches the average cost curve (LAC) as a
tangent. P is regarded as the equilibrium point at which the price level is MP (which is
also equal to OF) and output is OM. In the present case average cost is equal to average
revenue that is MP. Therefore, in long run, the profit is normal. In the short run,
equilibrium is attained when marginal revenue is equal to marginal cost. However, in the
long run, both the conditions (MR=MC and AR=AC) must hold to attain equilibrium.
• Oligopoly Market-
Oligopoly is a market situation where few firms competing with each other. The products
produced under this market are either homogenous or heterogeneous in nature. Steel, copper,
tyres etc are some examples of oligopoly market.
• Duopoly- The simplest case of oligopoly is duopoly which prevails when there are only
two producers or sellers of a product.
• Features of oligopoly market-
• Few sellers- The number of sellers are very less in this market. It implies that every seller
influences the activities and price of other customers.
• Either homogenous or differentiated products – In oligopoly market, products sold are

either homogenous or differentiated products. Many industrial products like
steel,copper,aluminium, cement are homogenous in nature. Again, many consumer goods
industries like automobiles, tyres, household appliances, electronic equipments, breakfast
cereals, cigarettes etc. are differentiated oligopolies.
• Interdependence- The most important feature of oligopoly is the interdependence in

decision making of the few firms which comprise the industry . This is because when the
number of competitors is few, any change, any change in price, output etc will have a
direct effect on the fortune of its rivals. The rival firms will then react by changing their
own prices, output as the case may be.
• Importance of advertising and selling costs- As in this market, one firm’s decision reacts
the other, various firms have to incur huge costs on advertising and on other measures of
sales promotion.
• Entry barriers- There is barriers in the entry of firms in this type of market.
• Conflicting attitudes of firms- Under oligopoly, firms have conflicting attitudes. At one
time, the rival firms may realise the disadvantages of hostile competition and may have a
desire to unite, so as to maximize their total profits. After some time, the dissatisfaction
of one firm or the other may lead to conflict and cut throat competition, firms may cut
down to fight each other to death.
There are two types of oligopoly market-
• Collusive Oligopoly
• Non-collusive oligopoly
• Collusive oligopoly-
Collusive oligopoly is a form of market in which few firms form a mutual agreements to avoid
competition. They form a cartel and fix the output quotas and the market price. Leading firm in
the market is accepted by the cartel as a price leader. All the firms in the cartel accept the price
as fixed by the price leader.
• Non-collusive oligopoly-
Non-collusive oligopoly is a form of market in which each firm has its price and output policy
independent of the rival firms in the market. The entire firms enable to increase its market share
through competition in the market.
• AR or Demand curve under oligopoly market-

• From the figure, it is observed that
• The prevailing price level = P
• The firm produces and sells output = OM
• Also, the upper segment (dP) of the demand curve (dD) is elastic.
• The lower segment (PD) of the demand curve (dD) is relatively inelastic.
• This difference in elasticities is due to an assumption of the kinked demand curve

hypothesis.
• Assumption:
• Each firm in an oligopoly believes the following two things:

• If a firm lowers the price below the prevailing level, then the competitors will follow
him.
• If a firm increases the price above the prevailing level, then the competitors will not
follow him.
• There is logical reasoning behind this assumption. When an oligopolist lowers the price
of his product, the competitors feel that if they don’t follow the price cut, then their
customers will leave them and buy from the firm who is offering a lower price.
• Therefore, they lower their prices too in order to maintain their customers. Hence, the
lower portion of the curve is inelastic. It implies that if an oligopolist lowers the price, he
can obtain very little sales.
• On the other hand, when a firm increases the price of its product, it experiences a
substantial reduction in sales. The reason is that consumers will buy the same/similar
product from its competitors.
• This increases the competitors’ sales and they will have no motivation to match the price
rise. Therefore, the firm that raises the price suffers a loss and hence refrain from
increasing the price.
• This behavior of oligopolists can help us understand the elasticity of the upper portion of
the demand curve (dP). The figure shows that if a firm raises the price of a product, then
it experiences a large fall in sales.
• Hence, no firm in an oligopolistic market will try to increase the price and a kink is
formed at the prevailing price. This is how the kinked demand curve hypothesis explains
the rigid or sticky prices.
• In oligopoly under the kinked demand curve analysis changes in costs within a certain
range do not affect the prevailing price. Suppose the cost of production falls so that the
new MC curve is MC1, to the right, as in Figure 2. It cuts the MR curve in the gap AB so
that the profit maximising output is OR which can be sold at OP0 price.
• It should be noted that with any cost reduction the new MC curve will always cut the MR
curve in the gap because as costs fall the gap AB continues to widen due to two reasons:
• As costs fall, the upper portion KP of the demand curve becomes more elastic because of
the greater certainty that a price rise by one seller will not be followed by rivals and his
sales would be considerably reduced.
• With the reduction in costs the lower portion PD of the kinked demand curve becomes
more inelastic, because of the greater uncertainty that a price reduction by one seller will
be followed by other rivals.
• Bilateral monopoly-
• Bilateral monopoly refers to a market situation in which a single producer (monopolist)

of a product faces a single buyer (monopolist) of that product. We analyse below price,
output and profit determination under bilateral monopoly.
• Monopsony-
• Monopsony is a market condition in which there is only one buyer. Like a monopoly, a
monopsony also has imperfect market conditions. The difference between a monopoly
and monopsony is primarily in the difference between the controlling entities. A single
buyer dominates a monopsonized market while an individual seller controls a
monopolized market. In a monopsony, the controlling body is a buyer. This buyer may
use its size advantage to obtain low prices because many sellers vie for its business.
• Duopoly Market-The duopoly market is a special form of oligopoly market which has
only two sellers. they are selling differentiated products but these products are similar to
one another. They can either declare their independent output and prices, or they can also
collude with each other and form a monopoly. A commonly cited example of a duopoly
is that involving Visa and MasterCard, who between them control a large proportion of
the electronic payment processing market. In 2000 they were the defendants in a U.S.
Department of Justice antitrust lawsuit. An appeal was upheld in 2004
• Existence of only two sellers.
• Independence.
• Presence of monopoly elements: so long as products are differentiated, the firms enjoy
some monopoly power, as each product will have some loyal customers.
UNIT-5
MACROECONOMICS
• Trade Cycle-
Trade cycle or business cycle shows the fluctuations in activities of an economy. According to
Wesley C. Mitchell, Business cycles are species of fluctuations in the economic activities of
organized communities. Keynes consider trade cycle as a cycle which is composed of periods of
good trade characterized by rising prices and a low employment percentage, altering with periods
of bad trade characterized by falling prices and high unemployment percentage.
• Characteristics of Trade Cycle-
• Some characteristics of trade cycle are given as follows-
• Prices and production are generally rise or fall together.
• The total output and employment fluctuate by a larger percentage in durable and capital
goods industries than in non-durable and consumer goods industries.
• Large changes in total output and employment and the price level are normally
accompanied by large changes in currency, credit and velocity of circulation of money in
the same direction.
• The prices of manufacturers are comparatively rigid (being kept stable by producers)
which prices of agricultural goods are normally flexible.
• Profits fluctuate by a much larger percentage than other types of income.
• Industries are so inter-connected that fluctuations in one will be passed on top others also.
These cyclical fluctuations affect all industries.
• Cyclical fluctuation tends to be international in the sense that prosperity and depression
spread from one country to another through foreign trade.
• Phases of Trade Cycle-

Schumpeter divided the four phases of a cycle as follows-
• Prosperity Phase
• Recession Phase
• Depression Phase
• Revival Phase
• Prosperity Phase or Boom- In this period, there is all-round prosperity. The business
outlook is extremely optimistic. The economy operates at full capacity. The level of
employment is high, the volume of employment is large, speculative activities are at a
high pitch, interest tends to increase, investment spending is at a high level, the total
income of the country increases and credit expansion is at its height. In short, the
economic activity is at its top and the idle resources or unemployed workers are very few.
• Recession- As soon as the near full-employment level is reached, the equilibrium is

disturbed by shortage of investment funds leading to an increase in their prices, finally
resulting in increased cost and high prices. Consumer’s spending falls leading to a decline
in sales and hence revenues. With a view to liquidating their stocks, the firms start selling
their goods at a low price and hence most of the firms suffer losses. Investment and
spending decline and unemployment starts leading to a fall in the aggregate demand. A
wave of passimism sweeps the entire economy. The turning point from optimism to
passimism or the point where the period of boom ends is called the point of recession.
• Depression- The period of recession is rather short because depression sweeps the
economy very soon. It is just the opposite of Boom. Depression is a state of affairs in
which real economy consume or volume of production per head and the rate of
employment are falling or are sub-normal in the sense that they are idle resources and
unused capacity, specially unused labour . The entire economic activity becomes slack.
The level of unemployment rises, rates of interest and wages and profits tend to fall, the
national income, production, investment and price level all show a declining trend. The
level of aggregate demand reaches the lowest point.
• Recovery- But the forces causing depression reinforce the economic activity. The same
forces rejuvenate the economy. During depression, the businessman postpond
replacement of their equipment and consumers defer their spending on the purchase of
durable goods. When prices crash they start purchasing capital goods and hence the level
of the output increases, which increase the level of employment and hence the level of
aggregate demand. The process of recovery once started takes the economy to the peak of
prosperity and the cycle is completed, repeating itself at frequent intervals.
• Causes of trade cycle-
• Low employment levels or high high unemployment rates may cause fluctuations in
trade.
• The cycle may also be affected by full employment level which disturb equilibrium in a
market.
• The ratios between aggregate demand and aggregate supply may affect the trade cycle
due to their frequent change.
• If businessmen or entrepreneurs invest in various economic activities without any

planning that is not able to utilize various resources economically. As a result, the price
of the commodity may fluctuate and also result in wastage of expenditure of their trends.
• Wages increase in periods of high employment levels and tend to fall in low employment
scenerio, which also affects the trade cycle and the demand and supply ratios.
• Due to the disparity between input and output level, price of the commodity may be
fluctuated.
• Budget deficit(expenditure is more than revenue) is the another reason for trade cycle.
• Control or remedies of trade cycle-
Since cyclical fluctuations affect the smooth functioning of the economy, steps should be taken
to control it. There are 3 ways by which a trade cycle can be controlled. They are-1. Monetary
policy 2. Fiscal Policy 3. Direct Controls.
• Monetary Policy- Monetary factors can cause permanent cyclical fluctuations. An

increase in money supply lowers the rate of interest which in turn increases investments
and profits, Thus creates an optimistic outlook. This leads prosperity; on the contrary, a
decrease in money supply leads to pessimistic outlook and depression. Therefore, to
avoid cyclical fluctuations, suitable monetary policy should be adopted.
During period of prosperity to control expansion of money supply, bank rate should be
increased, open market sale of securities should be undertaken, and cash reserve ratio (CRR)
should be increased. An increase in money supply should be controlled by adequate cover
against note issue. A number of selective control measures like raising margin requirements and
regulating consumers credit also be adopted. Thus, central bank should adopt a dear money
policy.
To control recession or depression, these weapons should be used by reversing them to ensure
adequate expansion of credit by increasing the reserve of commercial banks.
• Fiscal Policy- Monetary policy alone can not check cyclical fluctuations. Therefore,
economies like Keynes suggested compensatory fiscal policy to stabilize business
activity. The three main instruments of fiscal policy are taxation, spending and
borrowing.
During a period of depression, the government should reduce the existing rates of taxes.
It should not levy new taxes, and it should increase spending to stimulate business activity. At
the time depression, it should undertake public works programmes like construction of roads,
canals and parks and hospitals etc. which provide employment to unemployed workers.
Government should follow deficit budgeting and deficit financing. It should also follow public
borrowing.
When the economy recovers it should follow opposite policy. The government should
raise the rates of taxes, levy new taxes, reduce spending on public works and follow surplus
budgeting.
• Direct Controls – The aim of direct controls is to ensure proper allocation of resources for
the purpose of price stability. They are meant to affect stratagic points of the economy.
They affect particularly consumers and producers. The are in the form of
rationing ,licensing, price and wage control, export duties, exchange controls, quotas,
monopoly control etc. They are more effective in overcoming bottlenecks and strategies
arising from inflationary pressures. Their success depends on the existence of an efficient
and honest administration. Otherwise they lead to black marketing, corruption,
speculation etc. Therefore, they should be resorted to only in emergencies like war, crop
failures and hyper inflation.
• Budget-
• The term Budget has been derived from the French word ‘Bougette’ which implies a
small leather bag or a wallet(money bag or purse). Budget can be defined as the detailed
financial statement containing minutes of income and expenditure of the government
over the fiscal year. In simple words, budget is a document which contains estimates of
the government revenue and expenditure for the coming year.
• Features of Budget-
• Government budget is a statement that shows estimated receipts and estimated

expenditure during a fiscal year.
• Budget shows the planned revenue and planned expenditure and not what the government
actually spends.
• Budget requires the approval by the government.
• Objectives or functions of government budget
• Government budget is a statement of expected receipts and expenditure of the

government during a fiscal year. Main objectives of government budget are:
• Redistribution of income and wealth: It is one of the most important objective of the
government budget. The government imposes heavy taxation on a high income groups
redistribute it among the people of weaker section in the society. The government can
provide subsidies and other amenities to people whose income levels are low. These
increase their disposable income and this reduces the inequalities.
• Reallocation of Resources: Reallocation of resources in the manner such that there is a

balance between the goals of profit maximization and social welfare. Government uses
budgetary policy to allocate resources. This is done by imposing higher rate of taxation
on goods whose production is to be discouraged and subsidies provided on goods whose
production is to be promoted.
There are some goods and services in which the private sector shows little interest
due to huge investment required and lower profits, like sanitation, roads, parks etc. Government
can under take the production of these goods and services. Alternatively, it can encourage private
sector by giving tax concession and subsidies.
• Economic Growth: Another purpose of the government budget today is to study the
generation of savings, investment, consumption and capital formation to assess the trend
of growth in the economy to improve the standard of living of the people.
• Managing Public Enterprises: In the budget government can make various provision to
manage public sector enterprises and also provides them financial help.
• Economic Stability: The government of the country is always committed to save the
economy from business cycles. Government budget is a tool to prevent economy from
inflation or deflation and to maintain economic stability. The overall level of employment
and prices in the economy depends upon the level of aggregate demand during the time
of deflation, deficit budgetary policy are used to maintain stability in economy.
• The budget has two broad components-
• Revenue Budget
• Capital Budget
• Revenue Budget is divided in to Revenue Receipts and Revenue Expenditure

• Capital Budget is divided in to Capital Receipts and Capital Expenditure
• The revenue account- The revenue budget shows the current receipts of the government
and the expenditure that can be met from these receipts.
• Revenue Receipts- Revenue receipts are those receipts of the government which neither
create a liability nor lead to reduction in assets. Revenue receipts are divided in to tax and
non-tax revenue.
• Tax Revenue- Tax revenues consist of the proceeds of taxes and other duties levied by
the government. Tax revenue comprise of direct and indirect tax. Direct tax which fall
directly on individuals (personal income tax) and firms (corporation tax). These are the
taxes which are paid by the same person on whom they have been imposed. Tax burden
can not be shifted on to others. Indirect tax fall indirectly like excise taxes (duties levied
on goods produced within the country), custom duties (taxes imposed on imported and
exported goods) and service tax. The tax burden of indirect tax can be shifted.
• Non-Tax Revenue- Non-tax revenue of the government includes receipts from sources
other than tax, which does not create a liability for the government. It includes receipts in
the form of commercial revenues eg. Revenue in the form of prices paid for government
supplied commodities, interest and dividends on government investment, administrative
revenues like fees-school/college fees, license fees, registration fees, fines and penalties.
• Revenue Expenditure- Revenue expenditure refers to all those expenditures of the

government which do not result in creation of physical or financial assets. Revenue
expenditure is classified in to plan and non-plan expenditure.
• Plan Expenditure- Plan expenditure relates to central plans and central assistance for state
and union territory plans.
• Non-Plan Expenditure- Non-plan expenditure covers a vast range of general, economic

and social services of the government. It is the estimated expenditure provided in the
budget for spending on routine functions of the government during the year. The main
items of non-plan expenditure are interest payments, defence services, subsidies, salaries
and pensions.
• The Capital Account- Capital budget is an account of the assets as well as liabilities. It
consists of capital receipts and capital expenditure.
• Capital Receipts- Capital receipts are defined as any receipt of the government which
creates a liability or leads to reduction in assets. In other words, when raises either by
incurring a liability or by disposing off its assets, it is called a capital receipt. Capital
receipts include three items- a. Recovery of loans b. Other receipts (mainly through
disinvestment) and c. Borrowings and other liabilities (eg. Funds raised from PPF, small
savings deposits in post offices). Borrowings increase liability of the government whereas
disinvestment reduce government assets.
Capital Expenditure- An expenditure which either creates an asset or reduces liability is called
capital expenditure. Capital expenditure consists mainly of expenditure on acquisition of assets
like land, buildings, machinery, equipment, investments in shares etc. and loans and advances
granted by the central government to state and union territory governments, government
companies, corporation and other parties. Capital expenditure like revenue expenditure relates to
central plan and central assistance for central and union territory plans. Non-plan capital
expenditure covers various general, social and economic services provided by the government.
• Developmental Expenditure
Developmental expenditure refers to the expenditure of the government which helps in

economic development by increasing production and real income of the country. Some people
call it productive expenditure because it helps in increasing production and productivity of the
economy.
Developmental expenditure on revenue is divided into developmental expenditure on

revenue account and developmental expenditure on capital account.
• Non-Developmental Expenditure
it refers, to those expenditure of the government which does not directly help in economic
development of the country. Cost of tax collection, cost of audit, printing of notes, internal law
and order, expenditure on defence etc. are treated as non-developmental expenditure. Pension to
retired govt. employees, non-developmental assistance to states are also included in this
category. Non-Developmental expenditure may be non-developmental revenue, expenditure and
non developmental capital expenditure.
Developmental Expenditure
Developmental Expenditure Non-Developmental Expenditure
1. It helps in economic development of the country 1.It does not directly help in the economic
directly. development of the country.
2.Social and community services, economic services 2.Defence expenditure, police, pension, loan
and developmental assistance to states are included repayments, cost of tax collection, non-
in it. development assistance to states etc. are included
in it.
3.Developmental expenditure has a definite
objective to achieve during the plan period. 3.It is not possible to fix the targets and achieve it
under non-developmental expenditure.
4.The share of developmental expenditure is
gradually decreasing. 4. The share of Non-Developmental expenditure is
gradually increasing
• Plan Expenditure-Any expenditure that is incurred on programmes which are detailed

under the current (Five Year) Plan of the centre or centre’s advances to state for their
plans is called plan expenditure. Provision of such expenditure in the budget is called
Plan Expenditure. In other words, plan expenditure is that public expenditure which
represents current development and investment outlays (expenditure) that arise due to
proposals in the current plan. Such expenditure is incurred on financing the Central plan
relating to different sectors of the economy.
• Non-Plan Expenditure: This refers to the estimated expenditure provided in the budget
for spending during the year on routine functioning of the government. Non- Plan
expenditure is all expenditure other than plan expenditure of the govt. Such expenditure
is a must for every country, planning or no planning. For instance, no government can
escape from its basic function of protecting the lives and properties of the people and
protecting the country from foreign invasions. For this, the government has to spend on
police, Judiciary, military, etc. Similarly, the government has to incur expenditure on
normal running of government departments and on providing economic and social
services.
• BALANCED BUDGET
A government budget is said to be a balanced budget if the estimated government
expenditure is equal to expected government receipts in a particular financial year.
Advocated by many classical economists, this type of budget is based on the principle of
“living within means.” They believed the government’s expenditure should not exceed
their revenue. Though an ideal approach to achieve a balanced economy and maintain
fiscal discipline, a balanced budget does not ensure financial stability at times of
economic depression or deflation. Theoretically, it’s easy to balance the estimated
expenditure and anticipated revenues but when it comes to practical implementation, such
balance is hard to achieve.
• MERITS OF A BALANCED BUDGET
Ensures economic stability, if implemented successfully.

Ensures that the government refrains from imprudent expenditures.
DEMERITS OF A BALANCED BUDGET

Unviable at times of recession and does not offer any solution to problems such as
unemployment. It does not promote economic growth.
• DEFICIT BUDGET
A government budget is said to be a deficit budget if the estimated government
expenditure exceeds the expected government revenue in a particular financial year. This
type of budget is best suited for developing economies, such as India. Especially helpful
at times of recession, a deficit budget helps generate additional demand and boost the rate
of economic growth. Here, the government incurs the excessive expenditure to improve
the employment rate. This results in an increase in demand for goods and services which
helps in reviving the economy. The government covers this amount through public
borrowings (by issuing government bonds) or by withdrawing from its accumulated
reserve surplus.
MERITS OF A DEFICIT BUDGET

Helps in addressing public concerns such as unemployment at times of economic
recession.
Enables the government to spend on public welfare.
DEMERITS OF A DEFICIT BUDGET

Can encourage imprudent expenditures by the government.
Increases burden on the government by accumulating debts.
• SURPLUS BUDGET
A government budget is said to be a surplus budget if the expected government revenues
exceed the estimated government expenditure in a particular financial year. This means
that the government’s earnings from taxes levied are greater than the amount the
government spends on public welfare. A surplus budget denotes the financial affluence of
a country. Such a budget can be implemented at times of inflation to reduce aggregate
demand.
• Government Deficit-A deficit is an amount by which the expenditures in a budget exceed

the income. A Government Deficit is the amount of money in the set budget by which the
government expenditure exceeds the government income amount. This deficit provides
an indication of the financial health of the economy. To reduce the deficit or the gap
between the expenditures and income, the government may cut back on certain
expenditures and also increase revenue-generating activities.
• Types of Government Deficit
• Revenue Deficit
• The shortfall between the total revenue received to the total revenue expenditure is
revenue deficit.
• Revenue deficit = Total revenue expenditure – Total revenue receipts
• This deficit only includes current income and current expenses. A high value of deficit
indicates that the government should cut down on its expenditures. The government may
increase its revenue receipts by increasing tax income. Disinvestment which means
selling off assets is another remedial measure to reduce revenue deficit.
• Fiscal Deficit
• A fiscal deficit is a gap by which government’s total expenditures exceed the

government’s total generated revenue. This, however, does not include the government
borrowings.
• Fiscal deficit = Total expenditure – Total receipts excluding borrowings
• Fiscal deficit indicates the amount of money that the government will need to borrow
during the financial year. A greater deficit implies more borrowing by the government
and the extent of the deficit indicates the amount of expense for which the money is
borrowed.
• A huge disadvantage or implication of fiscal deficit is it may lead to a debt trap. Also, it
may lead to unnecessary and wasteful expenditure by the government. Increased fiscal
deficit leads to uncontrolled inflation. Borrowing is one way to reduce fiscal deficit.
Another way is deficit financing.
• Deficit financing refers to the printing of new notes to increase cash flow in the system.
The fiscal deficit is a positive outcome if it leads to the creation of assets. It is detrimental
to the economic condition of the nation if it is used to simply cover revenue deficit.
• Primary Deficit
• A primary deficit is the amount of money that the government needs to borrow apart
from the interest payments on the previously borrowed loans.
• Primary deficit = Fiscal deficit – Interest payments on previous loans
• Measures to Reduce Government Deficit

• Increased emphasis on tax-based revenues and appropriate measures to reduce tax
evasion.
• Disinvestment should be done where assets are not being used effectively
• Reduction in subsidies by the government will also help reduce the deficit.
• Try and avoid unplanned expenditures.
• Borrowing from domestic sources.
• Borrowing from external sources.
• A broadened tax base may also help in reducing the government deficit.
• To summarize, a government deficit is a condition where the budget expenditure exceeds

the budget revenue receipts. This could be due to a sudden shift in budget requirements.
A controlled deficit situation causes an economy to grow.
• An uncontrolled government deficit may lead to deterioration in the financial health of

the economy. The agenda of the government should be to plan the revenues and
expenditures such that the economy moves towards a balanced budget situation.
• Unemployment
Unemployment is defined as a situation where someone of working age is not able to get a job
but would like to be in full-time employment. Usually measured by the unemployment rate,
which is dividing the number of unemployed people by the total number of people in the
workforce, unemployment serves as one of the indicators of an economy’s status.
Types of unemployment
• There are several types of unemployment, each one defined in terms of cause and
severity.
• Cyclical unemployment
• Cyclical unemployment exists when individuals lose their jobs as a result of a downturn
in aggregate demand (AD). If the decline in aggregate demand is persistent, and the
unemployment long-term, it is called either demand deficient, general,
or Keynesian unemployment.
• Demand deficient unemployment
• This is caused by a lack of aggregate demand, with insufficient demand to generate full
employment.
• Structural unemployment
• Structural unemployment occurs when certain industries decline because of long term
changes in market conditions. For example, over the last 20 years UK motor vehicle
production has declined while car production in the Far East has increased, creating
structurally unemployed car workers. Globalization is an increasingly significant cause of
structural unemployment in many countries.
• Regional unemployment
• When structural unemployment affects local areas of an economy, it is called ‘regional’

unemployment. For example, unemployed car workers in the Midlands and Essex add to
regional unemployment in these areas. In the UK, the further we move away from the
affluent South East the greater the unemployment rate. Geographical immobility makes
regional differences more extreme.
• Classical unemployment
• Classical unemployment is caused when wages are ‘too’ high. This explanation of
unemployment dominated economic theory before the 1930s, when workers themselves
were blamed for not accepting lower wages, or for asking for too high a wage. Classical
unemployment is also called real wage unemployment.
• Seasonal unemployment
• Seasonal unemployment exists because certain industries only produce or distribute their
products at certain times of the year. Industries where seasonal unemployment is
common include farming, tourism, and construction.
• Frictional unemployment
• Frictional unemployment, also called search unemployment, occurs when workers lose
their current job and are in the process of finding another one. There may be little that can
be done to reduce this type of unemployment, other than provide better information to
reduce the search time. This suggests that zero unemployment is impossible at any one
time because some workers will always be in the process of changing jobs.
• Voluntary unemployment
• Voluntary unemployment is defined as a situation when workers choose not to work at

the current equilibrium wage rate. For one reason or another, workers may elect not to
participate in the labour market. There are several reasons for the existence of voluntary
unemployment including excessively generous welfare benefits and high rates of income
tax. Voluntary unemployment is likely to occur when the equilibrium wage rate is below
the wage necessary to encourage individuals to supply their labour.
• Disguised Unemployment:
• It is a situation in which more people are doing work than actually required. Even if some
are withdrawn, production does not suffer. In other words it refers to a situation of
employment with surplus manpower in which some workers have zero marginal
productivity. So their removal will not affect the volume of total production.
Overcrowding in agriculture due to rapid growth of population and lack of alternative job
opportunities may be cited as the main reasons for disguised unemployment in India.
• Educated Unemployment:
• Among the educated people, apart from open unemployment, many are underemployed
because their qualification does not match the job. Faulty education system, mass output,
preference for white collar jobs, lack of employable skills and dwindling formal salaried
jobs are mainly responsible for unemployment among educated youths in India. Educated
unemployment may be either open or underemployment.
• Technological Unemployment:
• It is the result of certain changes in the techniques of production which may not warrant
much labour. Modern technology being capital intensive requires less labourers and
contributes to this kind of unemployment.
• Chronic Unemployment:
• If unemployment continues to be a long term feature of a country, it is called chronic

unemployment. Rapid growth of population and inadequate level of economic
development on account of vicious circle of poverty are the main causes for chronic
unemployment.
• Full Employment- Full employment is an economic situation in which all available
labour resources are being used in the most efficient way possible. Full employment
embodies the highest amount of skilled and unskilled labour that can be employed within
an economy at any given time. True full employment is an ideal, and probably
unachievable, benchmark where anyone who is willing and able to work can find a job
and unemployment is zero. It is a theoretical goal for economic policymakers to aim for
rather than an actually observed state of the economy. In practical terms, economists can
define various levels of full employment that are associated with low but non-zero rates
of unemployment.
• Classical theory of full employment-
The classical theory assumes over the long period the existence of full employment without
inflation. Given wage-price flexibility, there are automatic competitive forces in the economic
system that tend to maintain full employment, and make the economy produce output at that
level in the long-run. Thus, full employment is regarded as a normal situation and any deviation
from this level is something abnormal since competition automatically pushes the economy
toward full employment.
• The classical theory of income, output and employment is based on the following
assumptions:
• There is a normal situation of full employment without inflation.
• There is a laissez faire capitalist economy without foreign trade.
• There is perfect competition in labour, money and product markets.
• Labour is homogeneous.
• Total output of the economy is divided between consumption and investment

expenditures.
• The quantity of money is given. Money is only a medium of exchange.
• Wages and prices are flexible.

• Money wages and real wages are directly related and this relationship is proportional.
• Capital stock and technological knowledge are given in the short run.
• Propositions of Classical Theory of Employment:
• The main propositions of the classical theory of employment are given below:
• Full employment is a normal feature of a capitalist economy.
• Full employment means absence of involuntary unemployment. Even at full

employment, there may exist, voluntary unemployment, frictional unemployment,
seasonal unemployment, structural unemployment or technical unemployment.
• The economy attains equilibrium only at full employment.
• General unemployment or general overproduction is not possible.
• Under conditions of perfect completion, flexibility of wages tends to establish full

employment. Reduction in wages can increase employment.
• The government should not interfere in the automatic working of the economic system
and should follow the policy of laissez faire.
• People spend their entire income either on consumption or on investment.
• Interest rate flexibility establishes equality between saving and investment.
• The full employment situation under classical theory can be explained with the help
of the following diagram-
• In the classical model, equilibrium level of output is determined by the employment of

labour. The level of output and, hence, the level of employment is established in the
labour market by the demand for and supply of labour. Equilibrium real wage rate and the
equilibrium level of employment are determined at that point where the negative sloping
labour demand curve cuts the positive sloping labour supply curve. Once we know the
equilibrium level of employment from the aggregate production function we can derive
the equilibrium level of output. This is shown in Figure below-
In the lower panel, aggregate production function has been shown. The intersection
between DL and SL curves at point E in the upper part of the figure determines the equilibrium
level of employment (LF) at the equilibrium real wage rate (W/P) F. The equilibrium of the
classical labour market is one where everyone willing to work at the real wage (W/P) F is able to
find work. Incidentally, this is the full employment position, denoted by L E = LF. The
corresponding equilibrium level of output (at the equilibrium level of employment) is Y F. This
equilibrium output level is also called full employment output level.
In the classical system, full employment is achieved automatically due to wage-price

flexibility. For instance, at a real wage (W/P) 1 there exists a situation of unemployment. Now,
this excess supply of labour (AB) will reduce the real wage rate until labour supply is equal to
the labour demand. Ultimately, real wage rate will decline to (W/P) F where aggregate labour
demand is exactly matched by aggregate labour supply. It may be added here that the volume of
output and employment in the classical system are determined by only supply side of the market
for output. Since the classical model is a supply-determined one, it says that equiproportionate
increases (or decreases) in both money wage and the price level will not change labour supply. \
Keynes’ theory of employment
• Classical theory of employment is nullified by neo classical economist mainly Keynes.

Keynes’ theory of employment is based on the principle of effective demand. In other
words, level of employment in a capitalist economy depends on the level of effective
demand. Thus, unemployment is attributed to the deficiency of effective demand and to
cure it requires the increasing of the level of effective demand. By ‘effective’ demand,
Keynes meant the total demand for goods and services in an economy at various levels of
employment. In other words, the sum of consumption expenditures and investment
expenditures constitute effective demand in a two-sector economy. Thus, effective
demand is the sum total of all expenditures-
• C+I+G
• where C =consumption expenditure
I =Expenditure, and
G=Government expenditure
• Here we ignore government expenditure as a component of effective demand. According

to Keynes, the level of employment is determined by the effective demand which, in turn,
is determined by aggregate demand function or aggregate demand price and aggregate
supply function or aggregate supply price. In Keynes’ words; “The value of D (Aggregate
Demand) at the point of Aggregate Demand function, where it is intersected by the
Aggregate Supply function, will be called the effective demand.”
• Aggregate Supply (AS):

• Employers hire and purchase various inputs and raw materials to produce goods. Thus,
production involves cost. If sales revenue from the sale of output produced exceeds cost
of production at a given level of employment and output, the entrepreneur would be
induced to employ more labour and other inputs to produce more. At any given level of
employment of labour, aggregate supply price is the total amount of money that all
entrepreneurs in the economy expect to receive from the sale of output produced by given
number of labourers employed. For each particular level of employment, there is an
aggregate supply price. Here, by ‘price’ we mean the amount of money received from the
sale of output, i.e., sales proceeds. Thus, aggregate supply price refers to the proceeds
from the sale of output at each level of employment and there are different aggregate
supply prices for different levels of employment. If this information is expressed in a
tabular form, we obtain “aggregate supply price schedule” or aggregate supply function.
The aggregate supply function is a schedule of the minimum amounts of proceeds
required to induce varying quantities of employment. Simply, it shows various aggregate
supply prices at different levels of employment. Plotting this information graphically, we
obtain aggregate supply curve.
• According to Keynes, aggregate supply function is an increasing function of the level of

employment. Aggregate supply (AS) curve slopes upward from left to right because
volume of employment increases with the increase in sale proceeds. But there is a limit to
increase output level. This is called full employment level of output beyond which output
cannot be increased, it is because of full employment that AS curve becomes vertical or
perfectly inelastic. This means that the level of employment cannot exceed full employ-
ment (LF) level even by increasing aggregate supply price. This is shown in the figure
below
• Aggregate Demand (AD):
• Aggregate demand or aggregate demand price is the amount of money or price which all
entrepreneurs expect to receive from the sale of output produced by a given number of
men employed. Or it refers to the expected revenue from the sale of output at a particular
level of employment. Each level of employment is associated with a particular aggregate
supply price and there are different aggregate demand prices for different levels of
employment.
• Like the aggregate supply schedule, aggregate demand schedule shows the aggregate
demand price for each possible level of employment. Plotting the aggregate demand
schedule we obtain aggregate demand curve as there is a positive relation between the
level of employment and aggregate demand price, i.e., expected sales receipts. This is
shown in Fig. 3.4. It rises from left to right.
• Equilibrium Level of Employment— The Point of Effective Demand:
• Here a description is made that how equilibrium level of employment is determined in an

economy by using the concept of effective demand. The level of employment in an
economy is determined at that point where the aggregate supply price equals the
aggregate demand price. In other words, the intersection of the aggregate supply function
with the aggregate demand function determines the volume of income and employment in
an economy. It is, thus, clear that so long as expected sales receipts of the entrepreneur
(i.e., aggregate demand schedule) exceed costs (i.e., aggregate supply schedule), the level
of employment should be increasing and the process will continue until expected receipts
equal costs or aggregate demand curve intersects aggregate supply curve.
• Here, AS curve starts from the origin. If aggregate receipts (i.e., GNP) are zero,
entrepreneurs would not hire workers. Likewise, AD curve also starts from the origin.
The equilibrium level of employment is determined by the intersection of the AS and AD
curves. This is the point of effective demand— point E in Fig. 3.4. Corresponding to this
point, OLE workers are employed. At the OL1 level of employment, expected receipts
exceed necessary costs by the amount RC. Entrepreneurs will now go on hiring more
labour till OLE level of employment is reached.
• At this level of employment, entrepreneurs’ expectations of profits are maximised.

Employment beyond OLE is unprofitable because costs exceed revenue. Thus, actual
employment (OLE) falls short of full employment (OLF). Keynesian system shows two
kinds of equilibrium—actual employment equilibrium determined by AD and AS curves
and underemployment equilibrium.
• Keynes made little emphasis to the aggregate supply function since its determinants (such
as technology, supply or availability of raw materials, etc.,) do not change in the short
run. Keynes was examining the possibility of unemployment in a capitalistic economy
against the backdrop of Great Depression of the 1930s.
• Fig. 3.4 shows the situation of equilibrium at less than full employment level. Actual equilibrium,
OLE, is short of full employment equilibrium, OL E. Thus, the distance OLF – OLE measures
unemployment. This is called involuntary unemployment—a situation at which people are willing
to work but do not find jobs.
• This unemployment, according to Keynes, is due to the deficiency of aggregate demand. This
unemployment can be removed by stimulating aggregate demand. Aggregate demand is the sum
total of consumption and investment demand or expenditures in the economy. By raising
consumption expenditure, level of employment can be raised.
• But there is a limit to consumption expenditure. So what is needed is the raising of (private)
investment demand. Anyway, an increase in consumption demand and investment demand will
raise the level of employment in the economy. The point of effective demand has been changed
because of the shifting of AD curve from AD to AD 1New effective demand is now given by
E1 Corresponding to this point, equilibrium level of employment is OL F—the level of full
employment.
• Thus, in Keynes’ theory, unemployment is due to the deficiency of effective demand. Only by
stimulating effective demand can a higher level of employment be achieved. However, Keynes
goes on arguing that equilibrium level of employment will not necessarily be at full employment.
• A capitalist economy will always experience underemployment equilibrium—an equilibrium situ-

ation less than full employment. Full employment, according to Keynes, can never be achieved.
In Keynes’ scheme of things, both consumption and investment cannot be raised enough to
employ more work force. Therefore, he recommends government to come forward and take
appropriate action to cure unemployment problem.
• Revealed Preference Theory:
• Prof. Samuelson has invented an alternative approach to the theory of consumer

behaviour which, in principle, does not require the consumer to supply any information
about himself.
• If his tastes do not change, this theory, known as the Revealed Preference Theory (RPT),
permits us to find out all we need to know just by observing his market behaviour, by
seeing what he buys at different prices, assuming that his acquisitions and buying
experiences do not change his preference patterns or his purchase desires.
• Given enough such information, it is even theoretically possible to reconstruct the

consumer’s indifference map.
• Samuelson’s Revealed Preference Theory is based on a rather simple idea. A consumer

will decide to buy some particular combination of items either because he likes it more
than the other combinations that are available to him or because it happens to be cheap.
Let us suppose, we observe that of two collections of goods offered for sale, the
consumer chooses to buy A, but not B.
• We are then not in a position to conclude that he prefers A to B, for it is also possible that
he buys A, because A is the cheaper collection, and he actually would have been happier
if he got B. But price information may be able to remove this uncertainty. If their price
tags tell us that A is not cheaper than B (or, B is no-more expensive than A), then there is
only one plausible explanation of the consumer’s choice—he bought A because he liked
it better.
• If their price tags tell us that A is not cheaper than B (or, B is no-more expensive than A),
then there is only one plausible explanation of the consumer’s choice—he bought A
because he liked it better. More generally, if a consumer buys some collection of goods,
A, rather than any of the alternative collections B, C and D and if it turns out that none of
the latter collections is more expensive than A, then we say that A has been revealed
preferred to the combinations B, C and D or that B, C and D have been revealed inferior
to A.
• Therefore, if the consumer buys the combination E 1 (x1, y1)of the goods X and Y and
does not buy the combination E 2(x2, y2) at the prices (p1x, p1y,) of the goods, then we
would be able to say that he prefers combination E1 to combination E2, if we obtain
• The complete set of combinations of the goods X and Y to which a particular

combination is revealed preferred can be found with the aid of the consumer’s price line.
Let us suppose that the consumer’s budget line is L 1M1 in Fig. 6.104 and he is observed
to purchase the combination E1 (x1, y1) that lies on this line. Now, since the costs of all
the combinations that lie on the budget line are the same as that of E 1 and since the costs
of all the combinations that lie below and to the left of the budget line are lower than that
of E1 we may say that E1 is revealed preferred to all the combinations lying on or below
the consumer’s budget line.
• Again, since the costs of the combinations that lie above and to the right of the budget
line are higher than that of E 1 we cannot say that the consumer prefers E 1 to these
combinations when he is observed to buy E1, because here E1 is the cheaper combination.
• We have to note here the difference between “preference” and “revealed preference”.
Combination A is “preferred” to B implies that the consumer ranks A ahead of B.
• But A is “revealed preferred to B” means A is chosen when B is affordable (no-more-

expensive). In our model of consumer behaviour, we generally assume that people are
choosing the best combination they can afford that the choices they make are preferred to
the choices that they could have made. That is, if (x 1 y1) is directly revealed preferred to
(x2, y2), then (x1, y1) is, in fact, preferred to (x2, y2).

TYPES OF ECONOMIC SYSTEM
Capitalist economy :
 Capitalism or capitalist economy is referred to as the economic system where the factors of
production such as capital goods, labour, natural resources, and entrepreneurship are
controlled and regulated by private businesses.
 A capitalist economy is a economic system in which production and distribution of commodities

takes place through mechanism of free market.Hence it is also called Market Economy Or Free
Trade Economy.
 In a capitalist economy, the production of all the goods and services is dependent on the
demand and supply in the market that is also known as a market economy. It is different from
the central planning system that is also known as a command economy or a planned economy.
 The main characteristic of a capitalist economy is the motive of earning profit. The capitalist
economy is also characterised by the presence of free markets and lack of participation by the
government in regulating the business.
 Features of capitalist economy-
 Let us discuss the important features of capitalism or capitalist economy.
 1. Private property: This is one of the most important characteristics of capitalism where private
properties like factories, machines, and equipment can be owned by private individuals or
companies.
 2. Freedom of enterprise: Under this system, every individual has the right to make their own
economic decisions without any interference. This is applicable to both consumers and
producers.
 3. Profit motive: The motive of earning profit is one of the most important drivers of a capitalist
economy. In this system, all the companies are looking to produce and sell their products to
consumers to earn maximum profit.
 4. Price mechanism: Under this system, the demand and supply in the market will determine
the production level and correspondingly the price set for the products without any kind of
involvement from the government.
 5. Free trade: In this system, the low tariff barriers exist that promote international trade.
 6. Government interference: In a capitalist economy, there is no government interference in the

daily activities of the business. The customers and producers are free to make their own
decisions regarding any product or service.
 7. Flexibility in labour markets: In capitalism, there is a flexibility in hiring and firing of the
workforce.
 8. Freedom of ownership: In this system, an individual can accumulate any amount of property
and use it according to his will. After his death, the same property is passed on to the successors
by the right of inheritance.
 Examples of Capitalist Economies
 1. Hong Kong
 2. United Arab Emirates
 3. Singapore
 4. New Zealand
 5. Australia
 6. Canada
 7. Switzerland
 8. United Kingdom
 9. United States
Advantages of Capitalist Economy :
 1. Optimization of Resources- Since government intervention is kept at a limited level, several

issues that generally arise with government intervention including corruption and poor
circulation of information within the market are prevented, allowing individual incentives to
work as hard as possible to achieve as much as possible.
 2. Leads to increased individual wealth-
 As the capitalist economy is dependent on the push factor of individuals, there is no limit to the
level of wealth an individual can accumulate through progression within the economy.
 As company proficiency improves so does the ability for people to move through social class as
an increase in wealth is available. This pushes individuals to work harder in the interest of self-
preservation to achieve more. Profit increase within the economy and personal industry, allows
an expansion in wealth and company resources, resources that will be used so as to best benefit
the company and in turn the economy by promoting foreign investment.
 3. Increases consumer choices-

 Capitalism allows individuals to choose both in commodity purchase and employment
opportunities. It allows resources to be distributed according to consumer choice rearing the
market in a more productive consumer friendly range.
 Individuals possess a freedom of choice to purchase and engage in virtually any and all economic
activities with little restraint. Promoting trade among nations and individuals, mutually profits
individuals and the economy itself.
 4. More efficient production-
 Through capitalism, firms and companies are inclined to produce with greater efficiency, by
cutting cost and improving efficiency. This is done with an aim to prevent losses in an industry
where competition is high bettering the economy as a whole.
 In different industries, companies effectively respond to changes in consumer desires. In

attempts to ensure the highest possible level of productivity, financial incentives are provided to
employees by companies so as to better improve self interest in company proficiency. This is
beneficial on a global level as countries practicing capitalism generally become exemplary
innovative fronts for improvement in technology and implications of productive changes.
 5. Results in profit maximization-
 Profit maximization is a main priority within the capitalist’s state. This can be produced via
meeting consumer wants. This causes large suppliers of goods and services that are similar and
diversification in brands allow for customer distinction and individuality.
 There is competition among producers to capture a bigger chunk of the market size, so
capitalists are always on the look-out for ways to maximize the resources employed in
production so as to positively increase their profit margin and possibly beat the competition.
Disadvantages of Capitalist Economy :
 1. Unequal distribution of wealth - In a capitalist system where the means of production and
distribution of goods and services are owned by just a few members of the society, the wealth
of an entire nation could be controlled by just a few wealthy individuals and families. The rest
of the people, who depend on the largeness of the rich through jobs offered to them, live from
one pay cheque to the next. The wealth of the nation is not evenly distributed among the bulk
of the people.
 2. Could result in costs to the environment-
 Due to market being profit and demand driven, negative externalities such as pollution are
generally ignored until they become a serious issue within the economy. This leads to a
necessity to reduce the money supply in the economy to resolve these issues.
 The drive for profit in a capitalist system sometimes pushes the captains of industry to go to
the extremes, all for the sake of profits. The by-products of some business entities are harmful
to the environment but these by-products are not disposed of properly, therefore causing
harm to the environment.
 3. Propensity for industrial unrest-
 There is always a power play between the owners of industry who want to pay less in wages
and salaries to enhance their profit margin and the workers who believe their wages must be
increased in consonance with the efforts they put into the production of goods and services.
This power play results in industrial unrest that could affect the stability of the society.
 4. Labour could be under-valued and exploited-
 Socialists and communists are people who do not support capitalism. They say it hurts
workers, because businesses make more money by selling things than they pay the workers
who make the things. Business owners become rich while workers remain poor and exploited
(taken advantage of). They also argue society would be more efficient if people thought less
about competing against one another for their own interests and thought more of working
together for the overall good of society. Another argument is that each person has a right to
basic needs (such as food and shelter). Within capitalism, sometimes people might not get
everything they need to live.
 5. Capital could reside with a few people-
 One of the disadvantages of capitalism is that wealth and the control of the means of
production is concentrated in the hands of very few individuals. The rich families always
control the wealth of the society. In the United States of America, which is the bastion of
capitalism in the world, according to the New York Times, the richest 1% of the total
population of the country controls roughly 38% of all privately held wealth. On the other
hand, 73% of the debt owed in the U.S. is owed by 90% of the population.
Socialist economy:
 In the 1840s a new type of economic theory emerged in the literary circles known as “The
Communist Manifesto”. Written by Karl Marx with Fredric Engels it propounded a new and
unique concept of an economy of a country. This came to be known as a socialist economy.
 In a socialist economy, the setup is exactly opposite to that of a capitalist economy. In such an
economy the factors of production are all state-owned. So all the factories, machinery, plants,
capital, etc. is owned by a community in control of the state.
 All citizens get the benefits from the production of goods and services on the basis of equal
rights. Hence this type of economy is also known as the Command Economy.
 Features of Socialist Economy:
 The main features of this system are detailed below.
 (1) Public Ownership: A socialist economy is characterised by public ownership of the means
of production and distribution. There is collective ownership whereby all mines, farms,
factories, financial institutions, distributing agencies (internal and external trade, shops,
stores, etc.), means of transport and communications, etc. are owned, controlled, and
regulated by government departments and state corporations. A small private sector also
exists in the form of small business units which are carried on in the villages by local artisans
for local consumption.
 (2) Central Planning: A socialist economy is centrally planned which functions under the
direction of a central planning authority. It lays down the various objectives and targets to be
achieved during the plan period. Central economic planning means “the making of major
economic decisions—what and how much is to be produced, how, when and where it is to be
produced, and to whom it is to be allocated—by the conscious decision of a determinate
authority, on the basis of a comprehensive survey of the economic system as a whole.”
 And the central planning authority organises and utilises the economic resources by deliberate
direction and control of the economy for the purpose of achieving definite objectives and
targets laid down in the plan during a specified period of time.
 (3) Definite Objectives:
 A socialist economy operates within definite socio-economic objectives. These objectives

“may concern aggregate demand, full employment, satisfaction of communal demand,
allocation of factors of production, distribution of the national income, the amount of capital
accumulation, economic development…and so forth.” For achieving the various objectives laid
down in the plan, priorities and bold targets are fixed covering all aspects of the economy.
 (4) Freedom of Consumption: Under socialism, consumers’ sovereignty implies that

production in state- owned industries is generally governed by the preferences of consumers,
and the available commodities are distributed to the consumers at fixed prices through the
state-run department stores. Consumers’ sovereignty under socialism is confined to the
choice of socially useful commodities.
 (5) Equality of Income Distribution: In a socialist economy, there is great equality of income
distribution as compared with a free market economy. The elimination of private ownership
in the means of production, private capital accumulation, and profit motive under socialism
prevent the amassing of large wealth in the hands of a few rich persons. The unearned
incomes in the form of rent, interest and profit go to the state which utilises them in providing
free education, public health facilities, and social security to the masses. “As far as wages and
salaries are concerned, most modern socialists do not aim at complete and rigid equality.
 Example of socialist economy :
 Many of the countries follow the principles of combined economics. Some states are
capitalistic , but countries like Norway ,Sweden , Denmark , Iceland and Finland follow
socialism strictly .They are purely socialistic countries .
 Advantages of socialist Economy :

(i) No Labour Exploitation:
 There is only one class in a socialistic economy hence there is no question of exploitation.
 There are no concept of strikes and lock-outs. Everybody works in a well-knit family way.
 (ii) Proper Utilisation of Resources:
 Under this economy, all types of natural resources are utilized in a most organized manner. Its
main objective is to exploit these resources for the welfare of society.
 (iii) No Wasteful Advertisement:
 The government is virtually the owner of almost every sector. Hence, all the individual
producers are also more according to the plan targets. Therefore, the competition among the
producers is almost nil. Hence, very less money is spent on wasteful advertisement.
 (iv) Proper Planning:
 In order to solve various problems, which arise from time to time, there is proper economic
plan in this type of economy. Thus, with the help of economic plans socialist economy will
adopt the balanced development strategy.
 (v) Social Welfare:
 The aim of socialist economy is to maximize social welfare of the society. It provides equal
opportunities of employment to all individual according to their abilities.
 (vi) Most Suitable to Developing Countries:
This type of economic system is most suitable to the needs of developing countries as all
means of production are controlled by the government.
Disadvantages of socialist Economy :
 (i) Loss of Consumer Sovereignty:
 A consumer has no choice of his own, he acts as a mere slave under this system. Government
produces goods and services keeping in view the needs of the people.
 (ii) Less Democratic:
 Socialist economy is always less democratic as it possesses no element of freedom. It is also

like government dictatorship.
 (iii) No Automatic Functioning:
 Under this system, no automatic function in system exists at all. It is the Central Authority,
i.e., government, that governs the country according to its own interest.
 (iv) Evils of Bureaucracy
 In socialist economy, all economic activities are controlled by the government. Thus, they
develop all evils of bureaucracy like favouritism, delay, corruption and other sue evils,
 (v) Rigid Economy:
 Socialist economy is very rigid and not susceptible to change according to requirements.
Hence people work like a machine and never get any incentive to work.
 (vi) Expenditure on Planning:
 In fact, planning is a long process in a socialist economy. This expenditure is unnecessarily

wasteful and a burden on the national economy.
Mixed economy:
 A mixed economic system is a system that combines aspects of both capitalism and socialism.
A mixed economic system protects private property and allows a level of economic freedom in
the use of capital, but also allows for governments to interfere in economic activities in order
to achieve social aims.
 A mixed economy is an economic system that incorporate aspects of more than one
economic system. This usually means an economy that contains both private and state owned
enterprise or that combined element of the capitalism and socialism.
 Mixed economy has following main features:
 (i) Co-existence of Private and Public Sector:
 Under this system there is co-existence of public and private sectors. In public sector,
industries like defence, power, energy, basic industries etc., are set up. On the other hand, in
private sector all the consumer goods industries, agriculture, small-scale industries are
developed. The government encourages both the sectors to develop simultaneously
 (ii) Personal Freedom:

 Under mixed economy, there is full freedom of choice of occupation, although consumer does
not get complete liberty but at the same time government can regulate prices in public
interest through public distribution system.
 (iii) Private Property is allowed:
 In mixed economy, private property is allowed. However, here it must be remembered that
there must be equal distribution of wealth and income. It must be ensured that the profit and
property may not concentrate in a few pockets.
 (iv) Economic Planning:
 In a mixed economy, government always tries to promote economic development of the

country. For this purpose, economic planning is adopted. Thus, economic planning is very
essential under this system.

(v) Price Mechanism and Controlled Price:
 Under this system, price mechanism and regulated price operate simultaneously. In consumer
goods industries price mechanism is generally followed. However, at the time of big shortages
or during national emergencies prices are controlled and public distribution system has to be
made effective.
 (vi) Profit Motive and Social Welfare:
 In mixed economy system, there are both profit motive like capitalism and social welfare as in
socialist economy.
 (vii) Check on Economic Inequalities:
 In this system, government takes several measures to reduce the gap between rich and poor
through progressive taxation on income and wealth. The subsidies are given to the poor
people and also job opportunities are provided to them. Other steps like concessions, old age
pension, free medical facilities and free education are also taken to improve the standard of
poor people. Hence, all these help to reduce economic inequalities.
Examples of Mixed Economies:
 India ,USA ,Uk and Japan .
 Advantages of Mixed Economy :
 There are many benefits of a mixed economy that are helpful in maintaining economical
balance which is
 Both public and private sectors can survive: A mixed economy offers better options for not
only private business growth but also public sectors to manage the economy without loss.
They can work together. Public sectors like atomic energy, telecommunication, defence, and
many others are totally run by the government and the private sector run their businesses on
their own without any government interference but state government encourages the private
sector to provide better incentive and better facilities to make nations economy strong.
 Consumer supremacy is maintained: The consumer has the power to freely buy any goods or
product of their own choices and needs. These goods can be produced by only the private
sector according to consumers’ needs.
 Government control on ownership: Sometimes private business owner gain more profit
increases the prices of goods but does not supply the proper output which means they stock
the goods and make them available at a higher cost which is not in the favor of customers.
This kind of monopoly is controlled by the government to give the customers maximum
benefit.
 Provide facilities for the weaker section: Weaker section of society sometimes gets exploited
by the industrialist. The labourers and daily wages workers do not get facilities and also
proper income of their work and the government have to interfere and give proper facilities
and correct the injustice.
 Economic imbalance is reduced: The government takes necessary steps to balance the
economic inequality in the society weaker section gets job opportunities and good education
to balance the economic difference between a private business that grows better in a mixed
economy.
 Disadvantages of Mixed Economy :
 There are a few disadvantages of a mixed economy that are
 Unclear government control: The aim of the private sector is to get maximum profit out of
their business which is sometimes against the planning of the national planning system done
by the government. Under the National plan, any private has to follow their guideline to run
their business but they find it difficult. But most of the economy is likely to be in favour of the
private sector which helps them to gain more profit
 Fear of the private sector: Generally people fear private sectors moving to public sectors due
to the economical system structure of the national economy which tends to be in the favor of
the private sector.
 Difficulties of the public sector: The national economic structure for the public sector is
planned nicely but then it fails to fulfil the demands, and thus there creates a trust issue for
the long term.
Submitted By
1. Loknath Deka
2.Faruk Hussain
3.Kishan Thokchom
4.Nikash Sarangthem
. Economic assumptions – two definitions
• Below are two definitions of the term; one from a company’s and the other from an economist’s
point of view:
• Company’s viewpoint
• This definition, from BusinessEnglish.com, explains economic assumptions from a company’s

viewpoint:
• “The set of assumptions that a firm will make about the upcoming economic situation.”
• Economist’s viewpoint
• This definition, which Mike Moffatt writes in ThoughtCo.com, explains the meaning of the term
from an economist’s viewpoint:
• “A basic assumption of economics begins with the combination of unlimited wants and limited
resources.”
• “All of economics, including microeconomics and macroeconomics, comes back to this basic
assumption that we have limited resources to satisfy our preferences and unlimited wants.”
Five economic assumptions
• According to economists, there are five basic assumptions that we make regarding economics:
1. Scarcity. 2. Trade-offs. 3. Self-interest. 4. Cost and benefits. 5. Models and graphs.
• 1. Scarcity
• Scarcity or paucity refers to limitation . Raw materials, components, goods, and other supplies
are limited. However, we exist in an environment with unlimited human wants.
• This is one of economics’ fundamental problems, i.e., having limitless human wants in a market
where resources that are not limitless.
• 2. Trade-off
• If our wants are limitless but scarcity exists, we cannot satisfy all our wants. Therefore, we must
make choices. When we chose one thing, we are subsequently trading it for something else.
• In other words, every choice has a cost, i.e., a trade-off.
• When we chose something, we also wonder what we will have to give up. We call this
determining what the opportunity cost is.
• In other words, first, we ask ourselves: “If I choose this, what will I have to give up?” Then, we
can determine whether we are better off with our choice.
• Self-interest
• Our goal is to make a choice that maximizes our satisfaction. In other words, we all act in our
own self-interest.
• Costs and benefits
• We all make decisions by comparing the cost and benefits of things. Whenever we make a
choice, we compare the choice’s marginal costs against its marginal benefits.
• In other words, we perform a cost-benefit analysis or benefit-cost analysis. This analysis is a type
of economic analysis.
• Models and graphs
• Economists explain real-life situations through simplified graphs and models. They also use them
to analyze real-life situations.
• Submitted By
• 1. Loknath Deka
2.Nikash Sarangthem
Nature and Scope of Micro- economics and Macro-economics

• Microeconomics
• Microeconomics is a branch of economics that contemplates the attributes of decision makers

within the economy, such as households, individuals, and enterprises. It is derived from the
Greek word “Mikro” meaning small.
• To put it in other words, microeconomics refers to the social science that analyses the
associations of human action, particularly about how those choices influence the consumption
and allocation of scarce resources.
• The concept of microeconomics shows how and why different commodities have different
values, how individuals make more practical or efficient decisions, and how individuals organize
and cooperate with each other.
• Nature of Micro-economics
• Micro-economics represents the study of how members in a society use available resources to
make choices in the marketplace. Those choices refer to purchases of goods and services from
business providers. The role of the business provider is to promote products that are demanded
by a target market group within the population. In essence, the business providers want to
influence the choices of customers who have limited budgets to spend various products and
services. The following are the nature of micro-economics
1.Supply and Demand
• Supply and demand is one of the most critical concepts at the microeconomic level. This is the
comparison of the level of consumer demand for particular goods to the available supply in the
marketplace. In a highly competitive industry in which consumers possess many choices, supply
might exceed demand. Over time, this can cause some businesses to fail. In a more niche market
with few providers, the opportunity of the businesses to succeed in meeting demand may be
higher if they offer and promote a quality product with desired benefits.
• 2. Pricing
• Business pricing strategies correlate strongly with microeconomic factors. The ideal, or
equilibrium price point exists at the point at which quantity supplied in the market exactly
equals demand. The higher your prices, the lower the size of the population who will buy them.
However, if you offer lower prices than the market demand dictates, you leave money on the
table and you might also end up with shortages of your product or services. This can cause
customer alienation and negatively affect the business in the long term.
• 3. Research and Promotion
• Understanding microeconomics helps in effectively researching and promoting products.

Research is useful in investigating potential customer demand and in developing products that
best match desired benefits. This benefits you once you pay for advertising and use other
promotional techniques to promote your brand and its benefits. These marketing techniques
are critical in achieving competitive advantages over other companies trying to optimize
performance as customers make choices based on their needs and budgets.
• Scopes of Microeconomics
• The scope or the subject matter of microeconomics is concerned with:
• 1.Commodity pricing
• The price of an individual commodity is determined by the market forces of demand and supply.
Microeconomics is concerned with demand analysis i.e. individual consumer behavior, and
supply analysis i.e. individual producer behavior.
• 2.Factor pricing theory
• Microeconomics helps in determining the factor prices for land, labor, capital, and
entrepreneurship in the form of rent, wage, interest, and profit respectively. Land, labor, capital,
and entrepreneurship are the factors that contribute to the production process.
• 3. Theory of economic welfare
• Welfare economics in microeconomics is concerned with solving the problems in improvement

and attaining economic efficiency to maximize public welfare. It attempts to gain efficiency
production, consumption/distribution to attain overall efficiency and provides answers for 'What
to produce?', 'When to produce?', 'How to produce?', and 'For whom it is to be produced?’
• Macro-economics
• Macroeconomics is a branch of economics concerned with the behavior and performance of the
economy as a whole. It is derived from Greek work “Makro” which means large.
• It stands in contrast with microeconomics, which focuses on the impact at an individual, group,
or company level.
• Macroeconomics primarily studies large-scale economic phenomena like inflation, price levels,
rate of economic growth, national income, gross domestic product (or GDP), and changes in
unemployment.
• Nature of Macro-Economics
• Macroeconomics is the study of aggregates or averages covering the entire economy, such as
total employment, national income, national output, total investment, total consumption, total
savings, aggregate supply, aggregate demand, and general price level, wage level, and cost
structure.
• In other words, it is aggregative economics which examines the interrelations among the various
aggregates, their determination and causes of fluctuations in them. Thus in the words of
Professor Ackley, “Macroeconomics deals with economic affairs in the large, it concerns the
overall dimensions of economic life. It looks at the total size and shape and functioning of the
“elephant” of economic experience, rather than working of articulation or dimensions of the
individual parts. It studies the character of the forest, independently of the trees which compose
it.”
• Macroeconomics is also known as the theory of income and employment, or simply income
analysis. It is concerned with the problems of unemployment, economic fluctuations, inflation or
deflation, international trade and economic growth. It is the study of the causes of
unemployment, and the various determinants of employment.
• In the field of business cycles, it concerns itself with the effect of investment on total output,
total income, and aggregate employment. In the monetary sphere, it studies the effect of the
total quantity of money on the general price level.
• In international trade, the problems of balance of payments and foreign aid fall within the
purview of macroeconomic analysis. Above all, macroeconomic theory discusses the problems
of determination of the total income of a country and causes of its fluctuations. Finally, it studies
the factors that retard growth and those which bring the economy on the path of economic
development.
• The obverse of macroeconomics is microeconomics. Microeconomics is the study of the

economic actions of individuals and small groups of individuals. The “study of particular firms,
particular households, individual prices, wages, incomes, individual industries, particular
commodities.” But macroeconomics “deals with aggregates of these quantities; not with
individual incomes but with the national income, not with individual prices but with the price
levels, not with individual output but with the national output.”
• Microeconomics, according to Ackley, “deals with the division of total output among industries,
products, and firms, and the allocation of resources among competing uses. It considers
problems of income distribution. Its interest is in relative prices of particular goods and
services.”
• Macroeconomics, on the other hand, “concerns itself with such variables as the aggregate
volume of the output of an economy, with the extent to which its resources are employed, with
the size of the national income, with the ‘general price level’.”
• Scope of Macro-economics
It is understandable that the Government is the regulating body of a nation. It considers the various
critical aspects that directly impact the lives of the citizens. There are six theories under the scope of
macroeconomics:
1. Theory of Economic Growth and Development
The growth of an economy also comes under the study of macroeconomics. The resources and
capabilities of an economy are evaluated based on the scope of macroeconomics. It influences the
increase in national income and output at the environmental level. They have a direct impact on the
economic development of an economy.
2. Theory of Money
Macroeconomics assesses the impact of the reserve bank on the economy, the inflow and outflow of
capital, and its effects on job rates. The frequent change in the value of money caused due to inflation
and deflation has adverse effects on a nation’s economy. They can be cured by taking monetary and
fiscal policies and direct economic control measures.
3. Theory of National Income
It includes different topics related to measuring national income, including revenue, spending, and
budgeting. The macroeconomic study is vital for assessing the economy’s overall performance in terms
of national income. At the onset of the Great Depression of the 1930s, it was essential to investigate the
triggers of general overproduction and unemployment.
This led to the creation of data on national income. It helps forecast the level of economic activity and
income distribution among various citizens.
4. Theory of International Trade
It is an area of study focusing on exporting and importing products or services. In brief, it points out the
effect on the economy through cross-border commerce and customs duty.
5. Theory of Employment
This scope of macroeconomics assists in determining the level of unemployment. It also determines the
causes that lead to such conditions of unemployment. Hence, this affects the production, supply,
consumer demand, consumption, and expenditure behavior.
6. Theory of General Price Level
This refers to the study of commodity prices and how specific price rates fluctuate due to inflation or
deflation.
Sumitted By-
1. Loknath Deka
2.Faruk Hussain
3. Kh. Pankaj Singha
4. Dipanjan Das.
Difference between Cardinal Utility and Ordinal Utility

Basis Cardinal Utility Ordinal Utility
Meaning Cardinal utility is the utility wherein the Ordinal utility states that the
satisfaction derived by the consumers from the satisfaction which a consumer
consumption of good or service can be derives from the consumption of
expressed numerically. good or service cannot be expressed
numerical units.
Approach Quantitative Qualitative
Realistic Less More
Measurement Utils Ranks
Analysis Marginal Utility Analysis Indifference Curve Analysis
Promoted by Classical and Neo-classical Economists Modern Economists
Example Pizza gives Sam 60 utils of satisfaction, whereas Sam gets more satisfaction from a
burger gives him only 40 utils. pizza as compared to that of a
burger.
Used By This theory was applied by Prof. Marshall This theory was applied by Prof. J R
Hicks
Diagram
Demand curve showing cardinal utility
Submitted by
Farnaaz M. Ahmed
Utility
Utility can be defined as the satisfaction derived from the consumption of a

commodity or the power of a commodity to satisfy wants.
Ex- When we consume a chocolate, we get some satisfaction. The satisfaction we

get is called utility.
Utility can be measured in two approaches-
 Cardinal approach
 Ordinal Approach
Cardinal Approach
It explains that the satisfaction level after consuming a good or service can be
scaled in terms of countable numbers.
Ex- After consuming a chocolate if we express our satisfaction as 2 or 3 units, it is

called cardinal measurement of utility.
Ordinal Approach
It explains that the satisfaction after consuming a good or service cannot be scaled
in numbers, however these things can be arranged in the order of preference.
Ex- After consuming a chocolate if we say that chocolate gives us greater

satisfaction than the chips, it is called ordinal measurement of utility.
Cardinal Utility vs Ordinal Utility

 According to cardinal approach we can measure the utility.
According to ordinal approach we cannot measure utility but we can rank.
 Cardinal utility is quantitative.
Ordinal utility is qualitative.
 Cardinal utility is less realistic.
Ordinal utility is more realistic.
 Cardinal utility measures satisfaction in terms of utils.
Ordinal utility measures satisfaction in terms of ranks.
 In cardinal utility, it is assumed that consumers derive satisfaction through

consumption of one good at a time.
In ordinal utility, it is assumed that a consumer may derive satisfaction from

the consumption of a combination of goods and services which will then be
ranked according to preferences.
 Cardinal utility was promoted by Classical and Neo-classical economists.
Ordinal utility was promoted by Modern economists.
 Cardinal utility is based on marginal utility analysis.
Ordinal utility is based on indifference curve analysis.
 Cardinal utility was given by Alfred Marshall.
Ordinal utility was given by Hicks and Allen.

Firm and Industry
Introduction: Firms andIndustry are words that are very commonly used yet
misunderstood by many. People think they know what they mean when they use
these words yet there are people who make erroneous use of the two concepts. This
article attempts to clear all doubts to enable readers to have a better understanding
of the two terms used in economics.
Firm
A firm is more or less similar to the concept of a business establishment. The term
is mostly used in relation to companies providing judicial services to clients. These
are business establishments referred to as law firms. A firm can be a sole
proprietorship or a partnership, but the basic premise is that it is run for making
profits. In US alone, there are an equal number of firms and establishments. A firm
can operate inside an industry such as a firm that makes and supplies steel to other
companies requiring steel while all these companies exist under the steel industry.
Industry
In economics, the economy of a country is divided into an umbrella of industries
where an industry consists of all organized activities for production and processing
of products. However, industry is also described as retail and wholesale depending
upon the nature of transactions with the customers. There are also industries in
services sector such as the banking industry or the insurance industry. An industry
covers all economic activities that are organized and carried on by all individuals,
units, firms, businesses, and organizations existing and working inside it.
Difference between Firm and Industry

• Industry refers to a kind of business inside an economy while a firm is a business
establishment inside an industry.
• There can be many firms inside an industry.
• Industry is not an entity while a firm is a type of company.

• A firm is a type of business whereas an industry is a sub sector of an economy.
• Rules and regulations are made for an industry, and that typically apply to all
firms inside the industry.
Submitted by,
JyotirmoyBoro
Loknath Deka
Faruk Hussain

Monti Maam Business Economics

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Monti Maam Business Economics

Uploaded by

Copyright:

Available Formats

Course: BBA

Paper: Business Economics

Paper Code: 10300

Business Administration Dept.

NERIM Group of Institutions

• The emphasis in business economics is on normative theory. Business

• Scope of Business Economics-

• Although no uniformity of use regarding the scope of business economics. Following

• Pricing decision, policies and practices - Pricing is an important area of business

• Significance of Business Economics

• Business economics makes a manager more competent model builder.

• Business economics help in reaching variety of business decissions in a complicated

• The main objectives of firms are:

• Increased market share/market dominance

• This ‘principal-agent‘ problem can be overcome, to some extent, by giving managers

• 4. Long run profit maximisation

• Co-operatives may have completely different objectives to a typical PLC. A co-operative

• Microeconomics is the study of economic actions of individuals and small group of

• Macroeconomics is the study of aggregates or averages covering the entire economy,

• It is the study of individual economic • It is the study of the economy as a

• It is also called price theory. • It is also called theory of income and

• The main tools of microeconomics • The main tools of macroeconomics

They are tangible in nature. They are intangible in nature.

Example- Table, chair,tape recorder etc. Example-Services of a doctor.

 Factors that lead to an economic problem-

In this way these 3 factors leads to economic problems.

• Three basic/central(or allocation of resources) of an economy-

• What to produce and in what quantities-

• For whom to produce-

Positive Economics Normative Economics

It is a pure science. It is not a pure or objective science.

• Utility of a consumer represents actual or expected satisfaction, derived from the

Substitute Goods Complementary Goods

NX=Number of units consumed of X commodity

Where, MU=Marginal Utility

TU=Change in total utility

Q=Change in quantity of consumption

• Law of diminishing Marginal Utility-

Law of diminishing Marginal utility is a fundamental law of consumption. According to this

Assumptions of the law-

• All the commodities consumed are homogeneous in quality

• The consumption process should be continuas

• The units of consumption are of reasonable or of standard size.

Number of oranges MU (Utils) TU (Utils)

• Consumer’s equilibrium in case of single commodity(cardinal utility analaysis)-

Symbolically, A consumer will be in equilibrium when MU of the commodity/ MU of Money

Units of oranges MU(Utils) MU in money( in

MU of the commodity/ MU of Money =Price

• Consumer’s equilibrium in case of two commodities-

• Here, MUX =Marginal Utility of commodity X

• MUY = Marginal Utility of commodity Y

• Mum = Marginal Utility of Money.

• Let us suppose that Price of X= Rs.3

Marginal utility schedules for commodities X and Y-

Units MUX MUY MUX MUY

MUX = MUY =Mum

Here, MU of money is constant at OE. When the consumer buys OA units of X-

• Defects of cardinal utility analysis

• It also fails to explain the demand for indivisible goods

Combinations Commodity A Commodity B

• Assumptions of Indifference Curve-

• Diminishing Marginal Rate of Substitution(MRS)- Another assumption behind

• Properties of Indifference Curve(I.C.)-

• IC do not intersect- IC can never meet or intersect.