BBA 102 - Business Economics

BUSINESS ECONOMICS
Under Graduate Commerce Programmes
(Distance Mode)
Centre for Distance and Open Learning

JAMIA MILLIA ISLAMIA
New Delhi – 110025
EXPERT COMMITTEE
Prof. Talat Ahmad Prof. M. Mujtaba Khan

Patron Officer on Special Duty, CDOL
Vice-Chancellor,
Jamia Millia Islamia
Prof. Mohammad Miyan Mr. Prashant Negi

Hony. Chief Advisor, CDOL, Hony. Jt. Director, CDOL
Founder Director, CDOL
Prof. Y.P. Singh Dr. Arvind Kumar

Department of Commerce, Hony. Jt. Director, CDOL
University of Delhi
Prof. K.V. Bhanu Murthy Dr. Ritu Sapra

Department of Commerce, Department of Commerce,
University of Delhi University of Delhi
Prof. Madhu Tyagi Dr. Sunayana

School of Management, Centre for Management Studies,
IGNOU Jamia Millia Islamia
Prof. Attam Prakash

Indian Institute of Foreign Trade
PROGRAMME COORDINATOR
A. Mannan Farooqui / Juned Khan, CDOL, Jamia Millia Islamia
COURSE WRITERS
Dr. Rajeev Johri, Professor, Technia Institute of Advance Studies, Pritampura, Rohini, Delhi
Block: 1 to 2: (Block 1: Fundamental Problems of Economic System and Basic Concept, Block- 02: Consumer Behaviour and
the Demand Theory)
Unit : 1 to 7: (Unit 1: Fundamental Problems of Economic System, Unit 2: Basic Concepts of Business Economics, Unit 3: Economic
System, Unit 4: Law of Diminishing Marginal Utility and Equal Marginal Utility, Unit: 5: Indifference Curve Analysis
Unit: 6: Consumer Demand and Unit: 7: Elasticity of Demand)
Mr. Yogesh Sharma, Assistant Professor, Manav Rachana International University, Faridabad, Haryana.
Block: 3: Theory of Production
Unit : 8 to 11: (Unit 8: Production Function- I, Unit 9: Production Function - II, and Unit 10: Law of Supply and Elasticity of Supply and
Unit 11: Theory of Costs and Cost Curves)
Dr. Prashant Sarangi, Assistant Professor, APJIT, Noida, Uttar Pradesh,

Block : 4 to 5: (Block 4: Theory of Price, and Block 5: Distribution of Income)
Unit : 12 to 20: (Unit 12: Equilibrium Concept and Conditions, Unit 13: Prefect Competition, Unit 14: Monopoly,
Unit 15: Monopolistic Competition, Unit 16 : Oligopoly, Unit 17: Theory of Distribution, Unit 18: Distribution of
Income – I: Wage and Interest, Unit – 19: Distribution of Income – II: Rent & Profit and Unit 20: Inequality of Income)
All rights reserved. Printed and published on behalf of the CDOL by Maktaba Jamia Ltd., Jamia Nagar, New Delhi-110025
August, 2018
ISBN: 978-93-82997-76-4
All rights reserved. No part of this book may be reproduced in any form or by any means, electronic or mechanical, including
photocopying, recording or by any information storage or retrieval system, without permission in writing from the CDOL,
Jamia Millia Islamia, New Delhi.
Cover Credits: Anupma Kumari, Faculty of Fine Arts, Jamia Millia Islamia
EXPERT COMMITTEE
Prof. Talat Ahmad Prof. M. Mujtaba Khan

Patron Officer on Special Duty, CDOL
Vice-Chancellor,
Jamia Millia Islamia
Prof. Mohammad Miyan Mr. Prashant Negi

Hony. Chief Advisor, CDOL, Hony. Jt. Director, CDOL
Founder Director, CDOL
Prof. Y.P. Singh Dr. Arvind Kumar

Department of Commerce, Hony. Jt. Director, CDOL
University of Delhi
Prof. K.V. Bhanu Murthy Dr. Ritu Sapra

Department of Commerce, Department of Commerce,
University of Delhi University of Delhi
Prof. Madhu Tyagi Dr. Sunayana

School of Management, Centre for Management Studies,
IGNOU Jamia Millia Islamia
Prof. Attam Prakash

Indian Institute of Foreign Trade
PROGRAMME COORDINATOR
A. Mannan Farooqui, CDOL, Jamia Millia Islamia
COURSE WRITERS
Dr. Rajeev Johri, Professor, Technia Institute of Advance Studies, Pritampura, Rohini, Delhi
Block: 1 to 2: (Block 1: Fundamental Problems of Economic System and Basic Concept, Block- 02: Consumer Behaviour and
the Demand Theory)
Unit : 1 to 7: (Unit 1: Fundamental Problems of Economic System, Unit 2: Basic Concepts of Business Economics, Unit 3: Economic
System, Unit 4: Law of Diminishing Marginal Utility and Equal Marginal Utility, Unit: 5: Indifference Curve Analysis
Unit: 6: Consumer Demand and Unit: 7: Elasticity of Demand)
Mr. Yogesh Sharma, Assistant Professor, Manav Rachana International University, Faridabad, Haryana.
Block: 3: Theory of Production
Unit : 8 to 11: (Unit 8: Production Function- I, Unit 9: Production Function - II, and Unit 10: Law of Supply and Elasticity of Supply and
Unit 11: Theory of Costs and Cost Curves)
Dr. Prashant Sarangi, Assistant Professor, APJIT, Noida, Uttar Pradesh,

Block : 4 to 5: (Block 4: Theory of Price, and Block 5: Distribution of Income)
Unit : 12 to 20: (Unit 12: Equilibrium Concept and Conditions, Unit 13: Prefect Competition, Unit 14: Monopoly,
Unit 15: Monopolistic Competition, Unit 16 : Oligopoly, Unit 17: Theory of Distribution, Unit 18: Distribution of
Income – I: Wage and Interest, Unit – 19: Distribution of Income – II: Rent & Profit and Unit 20: Inequality of Income)
All rights reserved. Printed and published on behalf of the CDOL by Maktaba Jamia Ltd., Jamia Nagar, New Delhi-110025
August, 2017
ISBN: 978-93-82997-76-4
All rights reserved. No part of this book may be reproduced in any form or by any means, electronic or mechanical, including
photocopying, recording or by any information storage or retrieval system, without permission in writing from the CDOL,
Jamia Millia Islamia, New Delhi.
Cover Credits: Anupma Kumari, Faculty of Fine Arts, Jamia Millia Islamia
Contents
Block: 1 Fundamental Problems of Economic Systems and Basic Concepts

Unit 1: Fundamental Problems of Economic Systems 5
Unit 2: Basic Concept of Business Economics 23
Unit 3: Economic Systems 42
Block: 2 Consumer Behavior and the Demand Theory

Unit 4: Law of Diminishing Marginal Utility Equi-Marginal Utility 58
Unit 5: Indifference Curve Analysis 73
Unit 6: Consumer Demand 92
Unit 7: Electricity of Demand 109
Block: 3 Theory of Production

Unit 8: Production Function - I 126
Unit 9: Production Function - II 136
Unit 10: Law of Supply and Elasticity of Supply 145
Unit 11: Theory of Cost and Cost Curves 154
Block: 4 Theory of Price

Unit 12: Equilibrium Concepts and Conditions 168
Unit 13: Perfect Competition 183
Unit 14: Monopoly 203
Unit 15: Monopolistic Competition 221
Unit 16: Oligopoly 238
Block: 5 Distribution of Income

Unit 17: Theory of Distribution 254
Unit 18: Distribution of Income-I: Wages and Interest 267
Unit 19: Distribution of Income-II: Rent and Profits 283
Unit 20: Inequality of Income 297
NOTE
184
BLOCK - 1
Fundamental Problems of Economic Systems and Basic Concepts

Fundamental Problems
of Economic Systems
UNIT - 1 FUNDAMENTAL PROBLEMS OF ECONOMIC SYSTEMS
Structure
1.0 Introduction
1.1 Objectives
1.2 Concept of Economic System and Business Economics
1.3 Economy – an overview
1.3.1 An economy- a system that ensures living to the people
1.3.2 An economy – a cooperation of producers
1.3.3 An economy – a system of mutual transaction
Activity 1
1.4 Processes of an Economy
1.4.1 Production
1.4.2 Consumption
1.4.3 Investment or Capital Creation
Activity 2
1.5 Fundamental problems of an Economy
1.5.1 What to Produce?
1.5.2 How to Produce?
1.5.3 For whom to produce?
Activity 3
1.6. Price Mechanism
1.6.1 Price Mechanism and Determining Techniques
1.6.2 Price Mechanism and Process of Distribution
1.6.2 Effectiveness of Price Mechanism
Activity 4
1.7 Production Possibility Curve
Activity 5
1.8 Let us Sum Up
1.9 Key Words
1.10 Terminal Exercises
1.10.1 Objective Questions
1.10.2 Descriptive Questions
1.11 Suggested Readings
1.0 INTRODUCTION
An economy in common understanding may refer to any system that leads to some value-
monetary or non monetary with the objective of providing living to the people. And
economics is that the branch of study which is based on the concept of economy.
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Business Economics
Economics is a general term applied to the social science of how choices are made when
resources available are in limited quantity. It is a study of how societies employ restricted
resources to produce useful goods to be distributed among people. A producer faces the
dilemma of what to produce, for whom to produce and how to produce. A consumer in
turn has to decide which goods to spend upon as his income is limited. Economy at the
level of a nation refers to the organization of the economic activities of a country and
relates to the mode of production of goods and services and distribution of income
between its people.
1.1 OBJECTIVES
After reading this unit, you should be able to

 Understand the concept of economy and economic system.
 Describe the processes inherent to the functioning of economy
 Realize the fundamental problems pertaining to economy
 Have clarity related to price mechanism and process of distribution
 Understand the significance of the production possibility curve
1.2 CONCEPT OF ECONOMIC SYSTEM AND BUSINESS ECONOMICS
An economy is an organization that provides living to the people. Towards this it makes
use of the available resources to produce goods and services needed by people. As the
availability of resources in an economy is limited, all types of goods and services cannot
be produced. A decision needs to be to be hence made between the alternative uses of
resources. Copper is used in electrical appliances, wires, vessels, decorative items that is
it has alternative uses. This choice is of varied nature that takes the shape of problems
like what to produce, how to produce and for whom to produce. To solve these complex
problems, different alternative mechanisms are made use of, depending upon the type of
economic system. A centrally command economy relies exclusively on economic
planning as an investment of resource allocation. A market economy is guided by the
price signals. The centrally command economies have failed and have given way to
market economies. All the market economies are not capitalistic economies in absolute
sense; in fact all of them are mixed economies, in which the governments play an
important role.
An economic system is a system in which a central agency makes all decisions about the
production and allocation of goods and services. The term is used most often to refer to a
centrally planned economy or command economy, in which the state or government
controls the factors of production and makes all decisions about their use and about the
distribution of income. In a centrally planned economy, the planners decide what should
be produced and direct enterprises to produce those goods. A planned economy may
either consist of state owned enterprises, private enterprises who are directed by the state,
or a combination of both. Planned economies are usually contrasted with market
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of Economic Systems
economies where production, distribution, and pricing decisions are made by the private
owners of other factors of production and influenced by market forces. However, it is not
necessary for an economy to be either just market based or centrally planned; other
systems are also followed. At one extreme there are countries where the government
plays a minor role in the economic sphere; at the other extreme, there are countries where
the government controls and directs all aspects of economic activity. Between these two
extremes, there are countries, which openly prefer an economic system, now commonly
called the mixed system. Many European countries and also the United States of America
are predominantly capitalist economies. The U.S.S.R, China and East European countries
are socialist economies. India has chosen the middle path, and it is known as mixed
economy.
Individuals or entrepreneurs almost each day experience situations on which they need to
take economic decisions. Most of these decisions are directly or indirectly related to
economic variables of demand, supply, stock, price, input, output, finances etc. Business
economics is a tool used in decision making by business firms on issues like least cost,
production techniques, output level, price, investment etc. Baumol has pointed out three
main contributions of economic theory to business economics.
1. „One of the most important things which the economic theories can contribute to
the management science‟ is building analytical models, which help to recognize the
structure of managerial problems, eliminate the minor details that might obstruct decision
making, and help to concentrate on the main issue.
2. Economic theory contributes to the business analysis „a set of analytical
methods‟, which may not be applied directly to specific business problems, but they do
enhance the analytical capabilities of the business analyst.
3. Economic theories offer clarity to the various concepts used in business analysis,
which enables the managers to avoid conceptual pitfalls.
1.3 ECONOMY- AN OVERVIEW
In this section we discuss the various dimensions or approaches from which the concept
of economy can be understood.
1.3.1 An economy- A system that ensures living to the people

Every day in our lives we chance upon a number of busy people, these people each day
reach their places of work and perform their duties. Among these people, there are
government servants who work in respective government departments, school and
college teachers, advocates in courts, doctors who attend to their patients in clinics or
hospitals, free lance workers, small shop keepers and big businessmen who transact the
exchange of goods, ordinary unskilled workers who work in some construction activity,
etc. the nature of peoples employment and occupations is too varied to be put together
completely. People engage in these different occupations with the objective of earning
their living. The occupations are indeed different and varied, but one fact that remains
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Business Economics
common to all the ways and means of earning one‟s living is indulging in labor be it
physical, be it mental and getting paid for it. Man engages himself in either of these
occupations, he works for somebody else and gets paid for his services; income earned by
him is the source of his livelihood. In this way, people earn their living and satisfy some
or more of their wants. People may be employed in retail establishments, huge or small
firms, factories, mines, shops, banks, transport, schools, cinemas, hospitals, etc. These
institutions taken together constitute what is known as an economic system which
provides the people with the goods and services.
An economy, as A.J. Brown defines it, “is a system by which people get their living.”
1.3.2 An Economy – As a Cooperation of Producers

Economy can be viewed also as “an immense cooperation of workers or producers to
make things and do things which consumes want.” Various goods and services are
produced by millions of producers each working independently of the other. The work or
contribution of many workers if left to themselves, would be absolutely rendered useless,
which on the other hand becomes very useful when combined with the efforts and work
outcome of the other people. We can illustrate this by taking the example of a
consumable item like biscuit. The company that produced the biscuit procures its
essential ingredient flour from flour mills, butter used in making from the dairy, the sugar
from sugar factory. The dairy and mills must have in turn procured them from crop
farmers and dairy farmers who in turn must have availed the services of manure,
pesticide suppliers, irrigation providers etc. and so on. Besides the ingredient aspect there
were machineries or equipments involved in the manufacturing process. The equipment
industry would have taken the service of steel, copper and iron industry. Now where were
iron and copper procured from-mines. The list of contributors for any item we consume
direct or indirect is clearly long.
Therefore, in the production activity, it is necessary that there should be somebody to

organize it. This type of work is done by the entrepreneur. An entrepreneur is an
important factor in the process of production who is paid for his services out of the
revenue earned from the sale of goods produced in the economy. Thus it can be said that
an economy is the organization of producers and workers to satisfy the wants of
consumers. Let us also understand that producers and consumers are not different people.
To a large extent, they are just the same people, the same people are workers and
producers in one capacity and consumers in another.
1.3.3 An economy – A system of mutual transaction

We can explain economy in another way- as a system of mutual exchanges or
transactions. Taken from this dimension, it is however not necessary that a worker should
spend his income only on the products he has helped to produce. In other words a worker
will earn income while working in a particular occupation or a specific job. He will spend
his income on a number of products which have been produced by other workers like
him.
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of Economic Systems
The system of exchange originated in the simple, traditional economies. These economies
are often described as subsistence economies, the economic unit in this type of economy
was usually the village. A traditional village economy used to be self sufficient in nature:
producers within the village would produce all those commodities required by the
inhabitants. In other words the manufacturers and consumers both belonged to the same
physical boundary. There was hardly any intercourse with outside world. Within the
village economy, there used to be division of labor. Through the system of exchange the
varied needs of individuals were fulfilled. The underlying principle of working of this
exchange system, as described by Hicks is “you do this for me, and I will do that for
you”. In the modern economies too the Hicks principle seems to be fully operative.
However the modern exchange system differs from the traditional system in the
following respects:
1. Use of money- The traditional system was based on the principles of barter, cloth
was exchanged for rice, wheat for milk and so on. In the modern economies, all exchange
transactions take place through the medium of money. The use of money has promoted
division of labor and specialization.
2. Division of Labor and Specialization- In traditional economy, natural division

of labor formed the basis of production activity. Natural division of labor implied that
different jobs were assigned to different persons on the basis of their sex and age. In the
modern economy, the introduction of money coupled with the introduction of fast
transportation, has made it possible to fine tune division of labor and specialization. The
various processes of production have been divided and subdivided in parts, making all the
contributing workers interdependent. A biscuit manufacturer as described above has to
depend upon a host of other producers to enable him to produce the final product. In
order to satisfy an individual‟s want for this biscuit, the whole economy gets together to
produce it. The same principle applies to every other product. Division of labor promotes
specialization. Specialization brings many advantages:
 Specialization offers an individual an opportunity to engage in a job for which he
has better abilities. This is also known as the principle of comparative advantage.
 People‟s abilities enhance as they specialize. A person who concentrates on one
activity becomes better skilled at it.
3. Globalization- A traditional economy produced for its own self; it produced for
a limited market. The modern economies are globalised. Both manufacturing and
marketing have become global. The global economy is being driven by multinational
corporations. Globalization has been made possible, by and large, due to the following
factors:
 The cost of moving products around the world has fallen greatly in recent
decades owing to containerization and the increasing size of ships.
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Business Economics
 The revolution in information and communication technology has made it

possible to coordinate economic transactions around the world in ways that were difficult
and impossible earlier.
Activity 1
(i) Describe the term economy, economics and business economics.
(ii) Elaborate upon the approaches of understanding economy
(iii) What are the differences between traditional and modern exchange system
1.4 PROCESS OF AN ECONOMY
Every economy has its vital processes viz. production, consumption and investment. All
economies perform these three basic functions though they differ with regard to the
volume of production and consumption and the rate of growth.
1.4.1 Production
Production can be either of goods or services. The necessary condition is that such an
endeavor in order to qualify as production should serve a purpose or create utility. If a
service that has been rendered does not command any reward in return, it will not be
considered production. According to economists, production is not complete unless the
product is taken to the hands of consumer, and accordingly, production necessitates trade.
The process of production continues till the product reaches the consumer. Production
becomes complete only when commodities and services reach the final consumers and
are paid for, such an act must intrinsically involve the process of exchange.
1.4.2 Consumption
Production of goods and services has no meaning unless it is used to satisfy human
wants. Hence consumption, the act of satisfying one‟s wants, is the second vital process
of the economy. Consumption implies the using up of material goods and of immaterial
services. Consumption may be of different types. There are many goods, which are used
up or destroyed when they are consumed. A good example is food. There are some goods
and services which are produced and consumed simultaneously, as for example, the
services of electricians, plumbers, doctors, waiters etc. In many cases, there are a number
of stages between production and consumption. In the case of many finished
manufactured articles, a silk saree for instance, a number of intermediate manufacturing
processes may be involved, like the raw material stage, semi finished stage, the wholesale
stage and lastly retail stages. The goods which are in the intermediate stages are known as
investment goods. There are some goods, which are not consumed right away, but
continue to provide services for long periods as long as they are available and functional.
These are durable consumer goods-“long lasting goods”- such as vehicles, refrigerators,
furniture, clothing, etc. it is difficult to estimate how much services a person secures from
the consumption of durable goods in any period, say, a month. Economists, therefore,
10
of Economic Systems
include these goods under the category of consumption the moment they are brought by
the consumers.
1.4.3 Investment
By investment, we mean adding to wealth or „capital formation‟. It arises to the extent
that commodities produced in given period are not consumed in that period. These remain
available for future consumption, or for use in the production of other goods and services
for future consumption. Thus, if an economy can save something out of its present
production, this will be available for investment.
The three vital processes of an economy- production, consumption and investment- are
interrelated. The three taken together constitute what has come to be known as the
process of production, or the productive process.
Activity 2
(1) What do you mean by the term production
(2) What constitutes the process of consumption and what are its types.
(3) Explain the concept of investment
1.5 FUNDAMENTAL PROBLEMS OF AN ECONOMY
All economies face three fundamental or basic problems. These three problems are made
well known by Prof. Samuelson‟s phrase “what, how and for whom”
a) What goods and what varieties should be produced, and in what quantities should
be produced?
b) How should they be produced?
c) For whom are these goods and services produced or who will consume them?
1.5.1 What goods to produce?

Prof. Robbins demonstrated that human wants are unlimited but the resources available to
satisfy them are limited. If an economy has unlimited wants and equally unlimited
resources to satisfy them, then there will be no economic problem. For, whatever the
economy needs be it food, clothing, shelter can be met fully. This, however, is not the
case. Economic resources or means of production are not only limited but have
alternative uses. The economy is hence forced to decide what goods and services should
be produced, and in what quantities they should be produced. In a full employment
economy, in which all factor services are employed in somewhere or the other,
production of additional quantities of any commodity can only be at the expense of some
other commodity. For instance, the production of more sugar is possible only at the
expense of rice or wheat. If more men are required in textile industry because of greater
demand for textiles, workers will have to be diverted from some other industry or
industries thus limiting production of other commodities.
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Business Economics
1.5.2 How to produce the goods

Let us presume that an economy has decided to produce certain goods and services. The
economy has then to decide how these goods and services will be produced. This is the
problem of production and it depends upon three factors, viz,
i) The extent of resources available to the economy in terms of nature resources,
labor and capital.
ii) The quality of efficiency of these factors of production and
iii) The nature of technology available to the economy.
At any particular time, these three conditions may be assumed to be constant. By this
logic the total amount of production of any commodity will be fixed. To illustrate
supposing additional land has been brought under cultivation; labor supply may increase
through an increase in population and capital supply can be changed through increased
manufacture of tools and machinery. At the same time, the efficiency of factors of
production can also be improved and the state of technology can be raised through
innovations and inventions. At any given time, every economy must decide (i) how its
resources- viz, labor, land and capital- can be used to achieve maximum production and
(ii) how these resources themselves can be increased so as to produce more for the future.
The economy must decide about the number and kind of labor to be used, the quantity of
capital to be utilized, the amount of land to be combined with other factors, and so on.
The objective of an economy is to produce the maximum quantity of goods of the best
quality and at the minimum cost possible. Every economy has thus to choose between
different goods and services, as resources at its disposal are limited and do not permit the
production of all goods. How goods and services are produced will depend upon the state
of technology in the country, quantity and quality of factors and the manner in which the
factors of production are combined and organized.
1.5.3 For whom to produce the goods?

Obviously goods and services are produced for the people, and more specifically, for
those who have the necessary means to pay for them. One cannot have everything one
requires. If that were possible, there will be no economic problem. In every society, the
production and supply of goods is always smaller than the demand for them. Hence, the
economy should evolve some method by which it can distribute the goods produced
among the people. What will be the share of labor, land rent, capital interest, and
enterprise profit? When these shares of various factors are decided, it gets simple for the
economy to decide for whom it is producing.
Every economy follows its own style to resolves these three core problems. In a pure
capitalist enterprise economy, goods and services are distributed among those who can
pay for them.
Activity 3
(1) Explain the fundamental problems of economy.
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of Economic Systems
(2) Distinguish between what, how and for whom in relation to production.
1.6 PRICE MECHANISM
Every commodity has its own price determined by its demand and supply in a free
market. There are as many prices as there are goods and factors of production. All the
prices are collectively called the price mechanism or the price system. The price
mechanism requires the existence of free market forces of demand and supply. The price
mechanism, also known as the market mechanism, helps to solve the central problems in
capitalist economy.
1.6.1 Price Mechanism and Determining Techniques

The issue of how goods are produced is addressed by the producers with the help of price
mechanism. Every producer aims at minimizing his cost, so that he can maximize his
profits. Under competitive conditions, only those producers who can adopt the most
efficient method of combining factors and keep the cost of production to the minimum
can gain high profits. In order to reduce cost, cheaper factors of production must be used.
If labor is cheaper than capital goods, production of commodity will and should include
more labor. The price system, therefore, indicates to the producers which factors of
production must be chosen to make production cheapest. Every producer attempts to
produce the maximum quantity of a commodity at the minimum cost. This means that a
worker who can work for 8 hours a day will not be allowed to work for less than 8 hours.
A machine that can work 24 hours a day will not be given any break In other words,
i) No factor unit will be wasted in production
ii) Every factor unit will be put to that use in which its productivity will be the
highest.
iii) Every factor will be employed up to the point at which the revenue from the last
unit employed is equal to the cost on that unit. If hiring an additional worker contributes a
significant amount to production in a day and if his cost to company by way of wages is
much lesser, it would be beneficial to employ this extra worker. A firm will continue to
employ more and more workers till the productivity of the last worker and the wage paid
to him are equal.
If factor units are underutilized or wastefully used, total production will not be maximum,
cost per unit will rise and profit decline. On all these counts, producers are guided by the
price system that is prices of the factors they engage and also the prices of the product
they help to produce.
1.6.2 Price Mechanism and Distribution

In general goods and services are produced for people or consumers who can afford to
purchase them. In a free economy goods and services are produced for people who have
effective demand that is people having adequate income and who are willing to pay the
price of the goods. An income on which effective demand is based is nothing other than
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Business Economics
price of factor service. There are numerous ways in which people can ensure their
earnings or income- salary, interest, profit or rent. Salary or wages is the price of labor
rendered, interest is the price for use of capital, profit is the price of initial investment and
rent is the price for usage of the property. Hence effective demand depends on money
income that constitutes part of the price mechanism. Thus the distribution of goods and
services or the dilemma of for whom to produce is met on the basis of effective demand
which depends on the price mechanism.
There exists no obvious authority in a free economy to control the economic system. The
three economic problems are resolved through price mechanism. The capitalist system of
production and distribution which is based on market forces of demand and supply is
regarded as the most efficient of all. It is believed to most effectively allocate resources
within the physical boundary of a nation. Only those goods and services are produced
which consumers demand and they are produced only in as amounts as required. Also
production, a joint work of n number of independent producers is maximized while the
cost of production is minimized. This mechanism ensures minimal or no wastage of
economic resources. Then comes the distribution of goods and services based on
effective demand. Price mechanism thus ensures best allocation of economic resources
and brings about efficiency in production and distribution process. In a free enterprise
economy each economic move is controlled, directed and determined by price
mechanism. Prices of all goods and services are determined at the same point of time in
ways that ensure best coordination among production, distribution and consumption
activity. In event of any overproduction or underproduction, price mechanism in the
course of time does the balancing act. More production will bring about fall in prices and
production curb on the part of producers. However against this explanation we do need to
test the efficacy of the price system which theoretically seems to be effective.
1.6.3 How effective is the price mechanism

We need to reflect upon the question that is price mechanism a real representation of the
demands of the people. The response to this question can be yes only under the condition
when income is almost equal for all people such that they make a free demand of goods
and services. However in reality this is not the case. Effective demand remains for people
possessing adequate income and will to spend and not for people with need but
insufficient income. People with adequate income create demand for luxuries which
demand is tapped by manufacturers while the inadequate income lot survives even
without the basic amenities. The credibility of price mechanism in bringing about equal
and fair distribution of goods and services based on needs thus remains a question mark.
Demand and supply in free market determine wages, prices and profits. Markets though
are never free and competition is never perfect. Prices are usually formulated and affected
by the powerful few monopolistic producers. These producers do not produce as per the
demand of consumers and keep the prices high. Market prices due to this do not represent
supply and demand. Trends and interests too change with time which may lead to
overproduction in some sectors and underproduction in others. Usually by the time
14
of Economic Systems
requisite changes are made in supply the demands may have changed. Price mechanism
hence does not guarantee efficient allocation of resources. Monopoly and time to time
business depression are preventive factors involved. The ideal condition of maximum
output out of minimum input remains far from reachable through price mechanism.
Consumers too are responsible for faulty allocation of resources to a lesser or great
extent. They may compromise on utility value of goods over prestige value. Producers
take recourse to advertisements in order to influence choices of consumers and may
succeed in promoting products that may actually be harmful for the consumers.
Promotions play a major role in miss selling of products in a free enterprise economy. It
is thus argued by experts that price mechanism may maximize output and contribute to
national income but high figures of national income may not correlate with high welfare
index of people. Price mechanism can be successful only under stable monetary system.
Instability in value of money be it inflation, be it deflation has an effect on the
functioning of economy as they create imbalances in production as well as distribution.
Price mechanism can be effective only in event of certain conditions. If there is free
enterprise, perfect competition and absence of disturbance of the market forces of
demand and supply either through producers or consumers or the state. Diminishing of
income inequalities will also go a long way in ensuring success of price mechanism. In
this ideal set up production of goods will reflect the needs of consumers and distribution
of goods and services will not be based on income but need of consumers. But in reality
this set up does not exist and hence price mechanism remains ineffective in efficient
production of goods and equitable distribution of goods. In a socialist economy central
planning and direction of resources is practiced and this mechanisms appears to be of
better use against price mechanism.
Activity 4
(1) Define price mechanism.
(2) How can you relate price mechanism with distribution?
(3) Write a note on how effective is price mechanism.
1.7 PRODUCTION POSSIBILITY CURVE
Production possibility curve or PPC is a graphical representation of all the possible

combinations of maximum amounts of two goods that can be produced with the available
resources. The different alternatives possible are referred to as production possibilities.
As the total productive resources at any economy‟s disposal remains limited and as the
resources have alternative uses, the economy has to choose between different goods. A
production possibility curve or frontier depicts the maximum amount of any two products
that can be produced from a limited amount of available resources. A rise in production
of one good will lead to fall in production of other goods since productive resources must
15
Business Economics
have been consumed for the production of commodity with increased production. The
PPC is based on following assumptions:
(i) There are numerous number of goods produced in any economy but for an easy
analysis production of only two goods have been assumed
(ii) Resources available to an economy are restricted but they can always be shifted
from production of one good to another.
(iii) Every available resource is fully made use of that is resources are neither wasted
nor underemployed. The economy is assumed to function at full employment achieving
full production.
(iv) It is assumed that technology level does not progress. It remains at the same
level.
(v) Efficiency of production of the resources is regarded in physical terms only. The
effect of prices is overlooked.
(vi) Various units of productive resources are not perfect substitutes for each other.
Some units are more efficient in production of one good and other units are more
effective for other goods.
Once the above assumptions are made we arrive at different combinations of goods that
an economy will be able to produce. Suppose the economy decides to use its entire
resources in the production of electronic items, it is natural that it will not be left with
resources to produce say food products. The opposite of this would imply that if all
resources are consumed for production of food items it would not be possible to produce
electronic items. The economy though has the possibility of directing part of its resources
towards production of consumables like food and part towards non consumable like
electronics. A similar logic can be extended to choice between production of war goods
like ammunition and civilian goods as upholstery or choice between production of
consumer goods like vehicles and capital goods like power looms. In case the economy
concentrates its production on infrastructure development which is a public utility service
it will have to compromise on production of private goods like real estate, apparel etc.
Decisions on resource allocation influence the productive capacity of the economy for a
good period of time.
For our explanation let us go by the example of choice between consumable and non
consumables that is electronics vs. food to illustrate the production possibilities available
with the economy. The alternative production possibilities are represented by different
combinations of amounts of electronics and food products that can be produced with the
help of the resources available with the economy. At one extreme we have a situation
where all resources are consumed for production of electronics and we are left with
nothing for producing food items. At the other extreme we have the opposite. Between
these two extremes we have many possible production combinations available with us.
These combinations are illustrated in the following table
16
of Economic Systems
Table 1 Alternative Production Possibilities

________________________________________________________________________
Alternative Possibilities electronics in lakhs food in million tonnes
A 10 0
B 8 21
C 6 48
D 4 69
E 2 85
F 0 99
The above table clearly shows that if the economy produces more and more amounts of
one good, it will produce less and less of the other. Because of the fact that resources
have been fully employed it is impossible to increase the production of both goods at the
same time. Increased production of one has to be done at the expense of the other.
Substitution is the rule in full employment economy.
We can plot the various points represented in Fig.1. Point A represents the first
possibility in which only electronics are produced. Point F represents the other extreme
when only food is produced. In between the points B, C, D, E represent other possibilities
in which both goods are produced in different combinations. If the points A, B, C, D, E, F
are joined we get the PPC.
production possibility curve
120
food in million tonnes
100
80
60
40
20
0
0 5 10 15
electronics in lakhs
A PPC is an economy‟s range of available options. If an economy chooses to produce any

combination of two goods as shown in the curve it can be said that it is using its resources
efficiently. The PPC is also called the transformation curve for the simple reason that in
moving from one possibility to another D to E for instance we are transforming
electronics to food that is allocating more resources for production of food than
electronics.
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Business Economics
As mentioned above PPC is based on the assumption that all resources are fully used. In
case some of the resources are not utilized that is if there is underemployment or
unemployment of some resources, output combinations of the two commodities will lie
below the production possibility curve as shown in Fig.2. Any point exactly on the curve
represents best utilization of resources, while any point on the inside of the PPC implies
that either some of the resources are lying unused which further means that production of
both food and electronics can be increased if the economy moves on to touch upon the
curve. Also any point on the outside of the curve remains unreachable or unachievable
for the economy as long as resources and technology remain the same.
The PPC throws light on the three central problems of economy. The first problem relates
to allocation of resources between goods to be produced that is which goods to be
produced and in what amounts. If we refer to the curve in Fig.1 it is clear that when the
economy is operating at point “C”, 6 lakhs electronic items and 48 million tonnes of food
can be produced. But when the economy is operating at point “B” 4 lakhs electronic
items and 69 million tonnes of food can be produced. The economy will have to sacrifice
two lakh electronics to increase production of food products by 21 million tones. In terms
of economics opportunity cost of producing 21 million tones is two lakh electronics.
Different points of the PPC thus represent different allocation of resources between two
goods to be produced. The particular point at which economy will operate depends upon
the demand of the consumer for various goods. The second problem relates to techniques
to be used in production. If the best possible technology is employed, the economy would
be operating at a point lying exactly on the curve. But if the economy is operating at a
point inside the curve, it implies that resources are not being used efficiently. Resources
ought to be used efficiently so that standard of living and welfare of people are best
ensured.
As regard to the third problem, an indication on distribution of national product can be

made from the PPC to some extent. Let us form a curve with luxuries on y axis and basic
consumer goods on x axis.
18
of Economic Systems
Basic consumer goods

By knowing the point on the curve at which economy is operating, we will be able to
assess the quantity of production of either luxury or basic good. This way equality or
inequality of income in economy can be fairly assessed. More production of luxury items
would denote gross inequality and vice versa.
Activity 5
1. Explain the production possibility curve
2. What are the assumptions on which it is based?
3. How does PPC explain the central problems of an economy?
1.8 LET US SUM UP
Wants of human beings are unlimited and at the same time resources available for us is
limited too. Economic problems stem from this fact. Had our wants been limited and
resources unlimited there would have been no economic problems. Any activity or
occupation physical or mental if performed for monetary benefit constitutes economic
activity. Economics is that branch of social science concerning economic activities and
institutions involved in allocation of scarce resources among unlimited uses in order to
produce goods and services towards satisfaction of man‟s unlimited wants. Every
economy faces the challenge of making the most and best of available limited resources
with it.
Man works and gets paid for his/her services. By earning their living they satisfy some or
more of their wants. People may be employed in retail establishments, firms, factories,
mines, banks, teaching institutions, hospitals, entertainment business etc. These and other
institutions taken together constitute an economic system which provides people with the
goods and services by way of earning. Economy can be viewed also as a cooperation of
workers or producers to make things and do things which consumes want. An economy is
a cooperation of producers and workers to produce those goods which directly or
indirectly satisfy the wants of the consumers. Economy can also be described as a system
of exchanges, in which through extensive cooperation, a large number of producers
coordinate with the purpose of satisfying the wants of consumers. Modern and traditional
exchange systems differ on points of money usage, division of labor, specialization and
globalization.
There are three vital processes of an economy- production, consumption and investment-
and these are interrelated. The three taken together constitute the process of production.
The act of production becomes complete only when commodities and services produced
reach the final consumers and are paid for. Consumption is the act of satisfying one‟s
wants. If an economy can save something out of its present production for future, this
will provide for investment.
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Business Economics
The three central problems facing any economy are what to produce, how to produce and
for whom to produce. Economic resources or means of production are not only limited
but have alternative uses. The economy thus has to decide what goods and services
should be produced and in what quantities.
At any given time, every economy must decide (i) how its resources- viz, labor, land and
capital- can be used to achieve maximum production and (ii) how these resources
themselves can be increased so as to produce more for the future. The third problem here
relates to the distribution of goods for consumption among consumers.
Every commodity has its own price determined by its demand and supply in a free
market. There are as many prices as there are goods and factors of production. All the
prices are collectively called the price mechanism. Under competitive conditions, only
those producers who can adopt the most efficient method of combining factors and keep
the cost of production to the minimum can gain high profits. In a free economy goods and
services are produced for people who have effective demand that is people having
adequate income and who are willing to pay the price of the goods. The distribution of
goods and services or the dilemma of for whom to produce is met on the basis of
effective demand which depends on the price mechanism. Price mechanism does not
guarantee efficient allocation of resources. Monopoly and time to time business
depression are preventive factors involved.
Production possibility curve or PPC is a graphical representation of all the possible

combinations of maximum amounts of two goods that can be produced with the available
resources. The PPC depicts the three central problems of economy. The first problem
relates to allocation of resources between goods to be produced that is which goods to be
produced and in what amounts. The second problem relates to techniques to be used in
production. An indication on distribution of national product too can be made from the
PPC which is the third problem.
1.9 KEY WORDS
 Economics- It is a study of how societies employ restricted resources to produce

useful goods to be distributed among people.
 Business Economics- It is an analytical tool used in decision making by business
firms on issues like least cost, production techniques, output level, price, investment etc.
 Production- making of something for people which has utility value.
 Consumption- the act of satisfying one‟s wants
 Investment- adding to wealth or creation of capital.
 Price Mechanism- Every commodity has its own price determined by its demand
and supply in a free market. There are as many prices as goods and factors of production.
All the prices are collectively called the price mechanism
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of Economic Systems
1.10 TERMINAL EXERCISES

1. Economics is a science because of -
a) Systematized study b) Scientific laws
c) Own methodology d) All the above Answer D
2. The central problem relating to allocation of resources are-

a) What to produce? b) How to produce?
c) For whom to produce? d) All the above.
Answer-A
3. A mixed economy to solve its central problems relies on –
a) Economic planning b) Price mechanism
c) Price fixing d) Both „a‟ and „b‟ Answer –A
4. Wastes of competition are found in

a) Capitalist economy b) Socialist economy
c)Mixed economy d)None of these Answer A
5. Price mechanism is an important feature of

i) Market economy ii) Regulated economy iii) Mixed economy iv) Capitalist economy
a) i and ii only b) iii and iv only
c) i and iii only d) i and iv only Answer D

1. What do you mean by an economy and how does it relate with business
economics?
2. What are the fundamental problems of an economy?
3. How is business economics different from Economics? which is more useful in the
choice of better decisions?
4. Explain the meaning of Production, Consumption and Investment.
5. What are the fundamental concepts one should study under business economics?
6. “Business economics is economics applied in decision making”. Discuss.
7. Examine the central problems with the help of price mechanism.
8. Explain the role of Production Possibility Curve in understanding the central problems
of an economy.
21
Business Economics

1. Principles of Micro Economics, Mishra and Puri, Himalaya
2. Micro Economics, Jain and Ohri, B.K Publishers
3. Business Economics, Gupta C.B., S.Chand
4. Managerial Economics, Geetika, T Mc Hill
5. Micro Economics and Applications, D.N Dwivedi, Vikas
6. Introduction of Micro Economics, Dutt and Sharma, Himalaya
22
Basic Concept of
Business Economics
UNIT - 2 BASIC CONCEPTS OF BUSINESS ECONOMICS
Structure
2.0 Introduction
2.1 Objectives
2.2 Nature of Economic Analysis
2.2.1 Deduction and Induction Method
2.2.2 Positive and Normative Economics
2.2.3 Micro Economics and Macro Economics
2.2.4 Equilibrium, Statics and Dynamics
Activity 1
2.3 Nature of Business Economics
2.3.1 Concept of Business Economics?
2.3.2 What is business all about?
2.3.3 Types of Business
2.3.4 Difference between Business Economics and Economics
2.3.5 Basic Techniques under Business Economics
2.3.6 Responsibilities of business economics
Activity 2
2.4 Basic Tools and Techniques
2.4.1 Functions
2.4.2 Total, Average and Marginal Functions
2.4.3 Slope
2.4.4 The Incremental Concept
2.4.5 Elasticity
2.4.6 Position and Shifts
2.4.7 Economic Models
2.4.8 The case method
2.4.9 Opportunity cost
2.4.10 Nominal and real variables
2.4.11 Business Efficiency
Activity 3
2.5 Let us Sum Up
2.6 Key Words
2.8 Answers to Exercises
23
Business Economics
2.0 INTRODUCTION
Economics is a science of making choices between different alternative uses of the

available scarce resources. A firm takes decisions about the best possible uses of
available resources in consonance with its goals. The final goal of any business firm is
attaining maximum profits. A household takes decisions on best possible use of the
income at its disposal with the ultimate goal of attaining maximum satisfaction.
Economics is a science of scarcity.
2.1 OBJECTIVES
After reading this unit you should be able to

 Understand the nature of economic analysis and business economics
 Differentiate between economics and business economics
 Understand the basic concepts of economics
 Understand the basic tools and techniques of economics
2.2 NATURE OF ECONOMIC ANALYSIS
Economics is a social science totally revolving around scarcity. This science strives at
analyzing the behavior of various economic entities driven by the goal of best allocation
of resources. Economics has evolved itself as a branch of study along two lines of
thought- one as a positive science two as a normative science. It studies the behavior of
individual units like families, small firms. At the same time it studies the behavior of
larger community like the entire nation. As a scientific discipline it has resorted to
scientific investigation methods like models and theories.
2.2.1 Deduction and Induction Method

Economics has adopted scientific methods of investigation- deduction and induction.
Deductive method is also called as abstract, hypothetical method. Accepting some
universal truths it tries to deduce inferences about the particular events through logical
reasoning. Deductive method moves from general to particular. Inductive method is also
called as historical method, concrete method, analytical method or realistic method. This
method investigates on the basis of particular facts, historical events and tries to draw
generalizations for the whole economy. After formulating general laws it conducts
experiments to test their validity.
2.2.2 Positive and Normative Economics

A positive science deals with things as they are. It aims at analyzing causes and effects. A
positive scientist restrains from issuing any moral judgment. Positive economics offers
objective or scientific explanations of the working of the economy. It aims at explaining
the decisions made by society regarding consumption, production and exchange of goods.
24
Basic Concept of
Business Economics
This knowledge serves two purpose- to provide answers on why the economy functions
the way it functions. Second purpose is to elicit some base for predicting how the
economy will respond in event of circumstantial changes. Some illustrations of positive
statements could be- a rise in price of a good leads to fall in the demand of its quantity,
domestic inflation causes currency depreciation. Economists who proposed that
economics be treated as a pure and positive science came to be known as purists. Purists
insist that economics should be neutral about ends. It should analyze things the way they
are and refrain from being judgmental. A normative approach to economics involves
judgments. It focuses on how things ought to be. It attempts to delineate how far the
economic action is right or wrong, desirable or undesirable. Normative economics
provides recommendations based on value judgments hence it is not neutral with respect
to ends. A few normative statements could be- government ought to concentrate on
infrastructure, inflation affects lower income groups the most. There are some statements
however which can neither be categorized as positive or normative. These statements fall
under the classification of analytical statements whose truthfulness or falsehood is based
on logical rules. Economists have taken different positions but in practice the science has
developed along both positive and normative lines.
2.2.3 Micro Economics and Macro Economics

Microeconomics studies in detail the operation of individual units like individual
household, pricing of a firm, worker wages, profits of an entrepreneur etc. It provides
analytical tools for the study of the behavior of market mechanism. Some subject matter
for microeconomics could be
 What determines the price of household electrical appliances?
 What determines the output of IT industry?
 What determines the wages of workers?
 What determines the interest rates on home loans?
 How do government policies on minimum wages, price controls, tariffs and
excise affect the price and output levels of individual markets?
Microeconomics has its own sets of limitations- it focuses on various aspects of

individual units but at the same time is unable to explain the working of entire economy.
What holds for individual entities may or may not hold for whole economy.
Macroeconomics focuses on the whole economy as one single entity. It deals with larger
aggregates and averages of the economic system overlooking the individual units. These
aggregates are then subject to purposeful examinations. There are certain forces which
influence the economy as a whole. Analysis of individual markets or units may serve no
purpose towards understanding of these forces. Macroeconomics offers the necessary
framework against which broader national economic policies are planned. Some subject
matter for macroeconomics could be
 How are price level and rate of inflation determined?
 How are production levels and national income determined?
25
Business Economics
 How are national employment levels determined?

 How do government monetary and budgetary policies influence price level,
income, production and unemployment levels?
 What measures can the government adopt to counter inflation and recession?
2.2.4 Equilibrium, Statics and Dynamics

Equilibrium refers to a condition in which there is no further tendency to change. A
situation where both buyers and sellers are happy with the price of a particular
commodity, there would not arise any tendency for price to change resulting in price
equilibrium. Economic analysis focusing its attention on equilibrium positions is called
statics. An analysis which differentiates equilibrium positions arising in two or more
different circumstances is called comparative statics. Study relating to time path of
economic relationship is economic dynamics. Microeconomics relies heavily on
comparative static analysis which is only interested in knowing the beginning and final
equilibrium points and not the dynamic path.
Activity 1
1. Distinguish between inductive and deductive method?
2. What do you understand by normative and positive economics?
3. Give some examples of micro and macroeconomic problems
4. Explain equilibrium, statics and dynamics
2.3 NATURE OF BUSINESS ECONOMICS
Economic policies of a business unit are based on microeconomic principles. Though no

business unit can ignore the national and global economic policies based on
macroeconomic principles. Similarly government and economy too consider the impact
of economic policies of business firms. Business economics is basically micro, though
often references to macroeconomics are made. Business firms operate within the broad
framework of economic environment or macroeconomic conditions which cannot be
controlled. Firms adjust themselves for survival to changes in national income, business
cycles, international trade, government policies, tax, exchange rates etc.
2.3.1 Concept of Business Economics

We make a number of decisions in our lives each day as individuals or entrepreneurs.
These decisions directly or indirectly relate to economic variables of demand, supply,
stock, price, input, output, profit etc. In traditional economics the problem of optimal
decision fell under the scope of microeconomics. But today these are covered under the
domain of business economics. It provides an analytical tool box and a technique of
thinking for business firms to address the decision making problems relating to least cost
input mix, product mix, production technique, output level, price, investment decision,
advertizing costs etc. It involves the application of economic concepts, precepts, tools,
26
Basic Concept of
Business Economics
techniques, principles and theories by business firms towards decision making and
planning for future. It estimates the relationship like demand and demand elasticity, input
output, cost output and the like for forecasting so as to plan for future. It does not restrict
itself to explanation of behavior but moves beyond linking abstract theory and business
practice by locating the problem and evaluating all possible alternatives to arrive at the
best. It makes use of quantitative techniques to measure the impact of different factors
and policies. Business economics is both mathematical as well s conceptual. The major
source of analytical tools for business economics is microeconomic theory as the unit of
study is the firm.
2.3.2 What is business all about

A business is an economic activity that begets outputs from inputs in such manner that
value of output generated exceeds the value of inputs applied. Mobilization, utilization
and generation of profit are the essence of business activity. The efficiency and adequacy
of inputs of man (labor), material (land), machine (capital) and management
(entrepreneur) will determine output flow.
2.3.3 Types of Business

Organizations may be classified on the basis of
(a) level of activity-this classification comprises of primary business including
agriculture, mining, animal husbandry, construction using land as basic input. Secondary
business includes manufacture of food, clothing, electronics, automobiles, machines,
tools using capital and technology as basic inputs. Tertiary business includes services like
banking, insurance, transport, communication, health education etc.
(b) sector- sector based classification comprises private sector like TELCO with
ownership in private hands, public sector including railways, SAIL, BHEL etc which are
managed and controlled by government. Joint sector cover voluntary organizations which
are owned and managed by private and public sector and cooperative sector.
(c) legal structure- these comprise of two groups unincorporated eg. Sole proprietorship,
partnership with limited liability and no separate legal identity. The second group
incorporated includes joint stock companies like private limited and public limited with
limited liability and independent legal identity.
(d) trade destination- this group comprises of domestic business that carries operation
with national frontiers and international business which involves operations cross
national frontiers.
2.3.4 Difference between Business Economics and Economics-

Business economics deviates from standard economic theory because all decision taken
up by firms is surrounded by risk and uncertainty. Standard economic decisions are based
on certainty and risk free atmospheres whereas in practice uncertainty prevails. So every
business decision comes with its share of inherent risks. Distinct criteria based
differences are summed up in the table below:
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Business Economics
Criteria Business Economics Economics

Nature deals with application of economic deals with the body of
principles to problems of business principles only
firms
Nature of deals with application of normative deals with both micro and
Economic microeconomic principles and macro economic principles-
Principles involves value judgments or is normative and positive
prescriptive
Scope Though it is macro it deals with Microeconomics branch of
problems of business firms economics deals with economic
problems of business firms and
also individual’s economic
problems, economics has wider
scope
Focus of Main focus is profit theory Distribution theories like rent,
Study wages, interests etc. are dealt
along with theory of profit
Approach It adopts, modifies or reformulates Economic theory makes
already existing economic models to assumptions, hypothesizes
suit the specific conditions and serve economic relationships and
the particular problem of the firm generates economic models
Methodology Business economics is pragmatic, it Economic theory ignores many
introduces some realistic aspects about complexities and makes
the firm like its objectives, resources, simplified assumptions as a
legal and behavioral constraints, solution to complicated
environmental and technological theoretical issues
factors and attempts to sort real life
business problems using other related
branches of study
2.3.5 Basic Techniques under Business Economics

The subject matter of business economics originates mainly from microeconomic
theories, however other disciples like quantitative techniques, operational research,
management and accounting principles play vital roles in business and management
decisions.
28
Basic Concept of
Business Economics
Chart 2.1 Disciplines of Business Economics
Decision
Problems of
Firms under
Risk and
Uncertainty
Discipline of
Discipline of
Management
and Economic
Accounting Theories
Principles
BUSINESS
ECONOMICS
Discipline of Discipline of
Operational Quantitative
Research Techniques
Optimal
Solutions to
Business
Problems
2.3.6 Responsibilities of business economics- the basic driving force for any business
unit is maximizing of profits. Chart 2.2 depicts the role of these aspects in profit analysis
of a business firm.
Chart 2.2 Scope of Business Economics
1. Demand
Analysis and
Forecasting
(Demand
Decisions)
5. Risk and
2. Cost and
Uncertainty
Product
Analysis
Analysis
(Economic
PROFIT (Input- Output
Forecasting ANALYSIS Decisions)
and Planning) (PROFIT
MAXIMIZATION
AND
ALTERNATIVE
THEORIES)
4. Investment 3. Market
Analysis Structure and
(Project Pricing
Appraisal and Policies (Price-
Investment Output
Decisions) Decisions)
29
Business Economics
Demand analysis gives the relation between quantity demanded and the factors
affecting it. Quantity demanded is a function of price of the good or service in
question, price of other related goods or services, income, tastes and preferences. To
analyze demand, demand function is estimated by finding the current values for the
coefficients of all the factors affecting the demand function. Demand forecasting is
the process of finding the values for demand in future. Production is the process
whereby inputs are transformed into outputs. Efficient production means to produce
at a least cost way as degree of efficiency in production translates into a level of costs
per unit of output. Cost is the monetary value of production. A production function is
the relation which elicits the technically efficient way of producing the output, with
the applied inputs. Given the production function we can arrive at cost estimation and
forecasting. The two sides of market are supply and demand. Market is a dynamic
concept striving to attain equilibrium. Equilibrium is a situation where supply is
equal to demand. Continuous changes keep taking place to achieve equilibrium. The
mechanism which can bring about this equilibrium is the price of the good by
clearing a situation of excess supply when price will fall and excess demand when
price will rise. Investment analysis involves planning and control of capital
expenditure. The decision to invest or not invest funds in the purchase of assets or
other resources in an attempt to make profit and making choice among competing use
of funds fall under the purview of investment analysis. Decision environment of
business firms involves changes which are either known or unknown. While definite
outcome associated with known changes results in certainty, the risks involved are
calculable and can be insured. But for unknown changes outcome is indefinite and
the inherent risk is incalculable. Non calculable risk is called as uncertainty.
Activity 2
1. What do you understand by the term business economics?
2. Describe the types of business.
3. Differentiate between economics and business economics
4. Which disciplines play a role in business economics?
5. What are the responsibilities of business economics?
2.3 BASIC TOOLS AND TECHNIQUES
Economics as a science applies own tools and techniques like
2.4.1 Functions
Economics is always concerned about the relation between two different quantities. For
instance net revenue obtained by a firm from the cars it sells is related to the number of
cars it sells. Total revenue here is variable quantity or a variable number or just a
variable. By the same logic the number of cars is a variable number or variable. The
30
Basic Concept of
Business Economics
relation between variables is called as function. The concept of a function is not restricted
to the relation between two variables. A function may involve the relation between one or
more independent variables and a dependent variable. Here the total revenue TR is a
function of quantity sold Q. The functional relationship between two variables can be
expressed in three ways
 Algebraic expression- TR= f (Q). The exact relation between Q and TR
is to be found out or assumed. If we assume that the following equation
expresses the relation TR= Q (20-2Q). now if Q has a value 4, TR would
have the value
TR=4(20-2(4)) =48
 Tabular expression- given that TR=Q(20-2Q), we can find the values of
TR corresponding to different values of Q as shown in the table
Table 2.1 Total Revenue Schedule

TR=Q (20-2Q)
Q 0 1 2 3 4 5 6 7 8 9 10
TR 0 18 32 42 48 50 48 42 32 18 0
 Graphic expression- in graphic form the relations between two variables

are described by means of points and curves. The values of Q and TR in
Table 2.1 can be plotted as in fig. 2.1
Figure 2.1 TR curve
60
50
40
30
20
10
0
1 2 3 4 5 6 7 8 9 10 11
Quantity
2.4.2 Total, Average and Marginal Functions

Ssince average revenue function is total revenue divide by quantity (TR/Q) , the average
revenue function is
AR= Q (20-2Q) =20-2Q
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Business Economics
Q
Since marginal revenue for a given level of sales Q n, is the difference between
total revenue at the level Qn and total revenue at the next lower level Q n-1, the
marginal revenue function is the function showing the increments or decrements
to the total revenue associated with small increases in units sold. This is
represented as
MR=∆ (TR)/ ∆Q
for our example it becomes ∆Q (20-2Q)
∆Q
Or MR= 20-4Q
2.4.3 Slope
The slope of a curve is the change in the value of the variable on the Y axis divided by
the change in the value of the variable on the X axis represented by ∆Y/∆X. a straight
line or linear relationship has a constant slope. A curved line has a varying slope
1. Slope at a point- this can be calculated by drawing the straight line tangent to
the curve at that point and then calculating the slope of the line.
2. Slope of an arc- this can be calculated by drawing a straight line across the
two points on the curve and then calculating the slope of the line.
60
50
40
30
20
10
0
0 1 2 3 4 5
Fig.2.2
Slopes of curves are important. Whether the slope is positive or negative is more relevant
than the actual value of the slope. Change in variable measured on the vertical axis is
referred to as rise. Change in variable measured on the horizontal axis is referred to as
run. The formula ∆Y/∆X popularly called rise over run makes it convenient to decide if
the slope is positive or negative. If the rise is a drop then the slop is negative and if the
rise is an increase then the slop is positive.
2.4.4 The Incremental Concep

The incremental concept involves estimating the impact of a business decision on costs
and revenues emphasizing the changes in total cost and total revenue arising out of
changes in prices, products, procedures, investments etc. Two basic concepts in this
analysis are incremental cost and incremental revenue. Incremental cost may be defined
32
Basic Concept of
Business Economics
as the change in total cost resulting from a decision. Incremental revenue may be defined
as the change in total revenue resulting from a decision. A decision can be profitable
when
1. It increases revenues more than costs.
2. It decreases some costs more than it increase others.
3. It increases some revenues more than it decreases others.
4. It reduces costs more than revenues.
2.4.5 Elasticity
Elasticity is the name given to the ratio of relative changes in the values of two
functionally related variables. The relative changes are often expressed in percentages.
Supposing the variable x increases by 1 percent and the variable y by 2 percent, the
elasticity of y with respect to x will be +2, that is 2/100: 1/100=2. If the y variable had
decreased with an increase in the x variable or vice versa a minus sign would be assigned
to the elasticity value. We can have an algebraic expression of elasticity as
EYX = ∆Y ÷ ∆X
Y X
Where EYX is the elasticity of variable y with respect to variable x, ∆Y/Y is the relative
change in the y variable from any given value of y variable and ∆X/X is the relative
change in the x variable from the corresponding x value.
2.4.6 Position and Shifts

The position of a curve means its location in the coordinate system, quite apart from the
question of its shape. This position is given algebraically by the constants that are the real
numbers in the function. Curves representing economic phenomenon or their relations do
not maintain same positions and keep shifting with time. Shifts are of two kinds-positive
and negative. A positive shift means a rightward movement of an entire curve or in the
case of a curve horizontal to the x axis, an upward movement. A negative shift means a
leftward movement of an entire curve, or in the case of a curve horizontal to the x axis, a
downward movement.
2.4.7 Economic Models

Scientists use theory to abstract from the complex descriptive facts of the real world and
focus only on those elements that are essential for understanding. These essential
elements are presented in the form of a model. A model is a highly simplified version of
the real world. A.N Phillips, engineer turned economist constructed a working model of
the determination of national income. Model building in economics is explained by the
chart below.
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Business Economics
Chart 2.3
Real
Economic
economic
model
world
Deduction
Abstraction
will lead to
will lead to
Theoretical
conclusions
Will be tested
against
The first step is to abstract from the complex real world. The model builder must select
the variables and relationships among them that are most relevant to the problem. The
resultant economic model contains a set of assumptions regarding the relevant variables
and the relationships among them. The second step is to apply logical deductions to the
model and strives for theoretical conclusions. Lastly the conclusions are tested against the
real world. If the conclusions do not support the empirical information, another model is
built. A model used in business can be depicted through a breakeven chart as shown in
fig. 2.3
140
120
100
80
60
40
20
Output/Sales
The TR curve shows the total receipts of a firm at each of the levels of output. As
the TR curve is a straight line, it reflects that the price per unit sold is constant.
The second curve is the total cost curve. The TC curve begins at C on the Y axis.
34
Basic Concept of
Business Economics
OC represents the total fixed costs which need to be incurred irrespective of the
level of output. The fact that TC curve is a straight line shows that variable costs
per unit of output are constant, whatever be the output level. The intersecting
point of the curves means that total revenue is just equal to total cost. The firm is
breaking even. The breakeven output is OQ.
2.4.8 The Case method- The case method requires the development of an orderly
analysis of the given situation. It involves the evaluation of facts, organization of
these facts into meaningful patterns, weighing of important facts against
unnecessary information, formulation of alternative courses of action, evaluation
of those alternatives in terms of the facts and the goals of the undertaking and the
final choice of solution.
2.4.9 Opportunity Cost- Opportunity cost of a decision means the sacrifice of

alternatives required by that decision. To illustrate the opportunity cost of
employing a machine to produce one product is the sacrifice of earnings that
could be obtained from other products. The opportunity cost of funds invested in
one’s business is the interest that could be earned on those funds in other
business. The opportunity cost of the time one invests in one’s business is the
salary that could be earned through other occupations.
2.4.10 Nominal and Real Variables- Nominal variables re measured in the prices
ruling at the time of measurement. Real values adjust nominal values for changes
in the price level. The distinction between nominal and real variables applies to
all variables whose unit of measurement is in terms of money and not physical
quantities. To illustrate irrespective of inflation rate 100 motorbikes will remain
100 motorbikes but in terms of money the value of 100 Rs. will never be the
same ten years apart. The nominal price of bikes seen significant changes from
say twenty years back. Index of real price can be calculated by dividing an index
of nominal bike prices by the retail price index and multiplying by 100. Real
prices are an indicator of economic scarcity. They show if the price of one
commodity is increasing faster than price of others. Hence they are known as
relative prices.
2.4.11 Business Efficiency- In economics operational efficiency is measured in terms of

productivity concepts like output per unit of labor, output per unit of capital,
output per unit of man- hours or machine hours, output per unit of outlay spent
etc.
Activity 3
1. What are the basic tools and techniques used in economics?
2. Write note on the basic tools and techniques used in economics
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Business Economics
2.5 LET US SUM UP
Economics is a social science based on scarcity. This science strives at analyzing the
behavior of various economic entities driven by the goal of best allocation of resources.
Economics has evolved itself as a branch of study along two lines of thought- one as a
positive science two as a normative science. Economics has adopted scientific methods of
investigation- deduction and induction. Economics has adopted scientific methods of
investigation- deduction and induction. Deductive method moves from general to
particular. Inductive method investigates on the basis of particular facts, historical events
and tries to draw generalizations for the whole economy.
A positive science deals with things as they are. It aims at analyzing causes and effects.
Normative economics provides recommendations based on value judgments, hence is not
neutral with respect to ends.
Microeconomics studies in detail the operation of individual units like individual

household, pricing of a firm, worker wages, profits of an entrepreneur etc. it provides
analytical tools for the study of the behavior of market mechanism. Microeconomics has
its own sets of limitations- it focuses on various aspects of individual units but at the
same time is unable to explain the working of entire economy. What holds for individual
entities may or may not hold for whole economy. Macroeconomics focuses on the whole
economy as one single entity. It deals with larger aggregates and averages of the
economic system overlooking the individual units. These aggregates are then subject to
purposeful examinations.
Equilibrium refers to a condition in which there is no further tendency to change.

Economic analysis focusing its attention on equilibrium positions is called statics. An
analysis which differentiates equilibrium positions arising in two or more different
circumstances is called comparative statics. Study relating to time path of economic
relationship is economic dynamics.
Business economics is basically micro, though often references to macroeconomics are

made. Business economics provides an analytical tool box and a technique of thinking for
business firms to address the decision making problems relating to least cost input mix,
product mix, production technique, output level, price, investment decision, advertizing
costs etc. organizations may be classified on the basis of (a) level of activity (b) sector (c)
legal structure (d) trade destination.
Business economics deviates from standard economic theory because all decision taken
up by firms is surrounded by risk and uncertainty. Standard economic decisions are based
on certainty and risk free atmospheres whereas in practice uncertainty prevails. Disciples
like quantitative techniques, operational research, and management and accounting
principles play vital roles in business and management decisions.
36
Basic Concept of
Business Economics
Responsibilities of business economics include demand analysis and forecasting. After

determining its best level of output, the firm decides on input output by choosing the least
cost input mix and technology. A correct pricing policy under different market structures
leads to firm’s success. Then come investment analysis and finally analysis of uncertainty
and risk.
The basic tools and techniques in economics are Functions, Total, Average and Marginal
Functions, Slope, The Incremental Concept, Elasticity, Position and Shifts, Economic
Models, The case method, Opportunity cost, Nominal and real variables, Business
Efficiency
2.6 KEY WORDS

 Positive economics- Positive economics offers objective or scientific
explanations of the working of the economy. It aims at explaining the decisions
made by society regarding consumption, production and exchange of goods.
 Normative economics- Normative economics focuses on how things ought to
be. It attempts to delineate how far the economic action is right or wrong,
desirable or undesirable.
 Microeconomics- Microeconomics studies in detail the operation of individual
units like individual household, pricing of a firm, worker wages, profits of an
entrepreneur etc.
 Macroeconomics- Macroeconomics focuses on the whole economy as one
single entity. It deals with larger aggregates and averages of the economic
system overlooking the individual units.
 Equilibrium- Equilibrium refers to a condition in which there is no further
tendency to change.
 Statics- Economic analysis focusing its attention on equilibrium positions is
called statics.
 Dynamics- Study relating to time path of economic relationship is economic
dynamics.
 Variable- The relation between variables is called as function.
 Function- The relation between variables is called as function.
 Demand analysis- it gives the relation between quantity demanded and the
factors affecting it. To analyze demand, demand function is estimated by
finding the current values for the coefficients of all the factors affecting the
demand function.
 Demand forecasting – it is the process of finding the values for demand in
future.
 Production function- it is the relation which elicits the technically efficient way
of producing the output, with the applied inputs.
 Incremental cost- it is the change in total cost resulting from a decision.
 Incremental revenue- it is the change in total revenue resulting from a decision.
37
Business Economics
1. Normative statements concern about things

(a) what they were (b) what they will be
(c) what is normal (d) what they ought to be
Answer d
2. Microeconomics deals with
(a) economic behavior of individual unit (b) problem of poverty in
country
(c) inflation in country (d) per capita income
Answer c
3. The objective of macroeconomics is to study
(a) problems, principles policies relating to full employment of available
resources
(b) problems, principles policies relating to optimum allocation of resources
© growth of resources (d) both a and c
Answer d
4. The statement deductive and inductive methods are competitive to each other
is
(a) absolutely correct (b) absolutely incorrect
© partially incorrect (d) none of these
Answer b
5. Microeconomics does not cover
(a) consumer behavior (b) factor pricing
© general price level (d) product pricing
Answer c
1. Differentiate between microeconomics and macroeconomics and explain
how they are interdependent.
2. Write a note on the concept of business economics.
3. Describe the basic tools and techniques used in economics
Activity 1
Answer 1- Deductive method after accepting some universal truths tries to deduce
inferences about the particular events through logical reasoning. Deductive method
moves from general to particular. Inductive method investigates on the basis of particular
facts, historical events and tries to draw generalizations for the whole economy. After
formulating general laws it conducts experiments to test their validity.
38
Basic Concept of
Business Economics
Answer 2. A positive scientist restrains from issuing any moral judgment. Positive
economics offers objective or scientific explanations of the working of the economy. It
aims at explaining the decisions made by society regarding consumption, production and
exchange of goods. This knowledge serves two purpose- to provide answers on why the
economy functions the way it functions. Second purpose is to elicit some base for
predicting how the economy will respond in event of circumstantial changes. A
normative approach to economics involves judgments. It focuses on how things ought to
be. It attempts to delineate how far the economic action is right or wrong, desirable or
undesirable.
Answer 3- Some macroeconomics problems could be

 How are price level and rate of inflation determined?
 How are production levels and national income determined?
 How are national employment levels determined?
 How do government monetary and budgetary policies influence price
level, income, production and unemployment levels?
 What measures can the government adopt to counter inflation and
recession?
Some microeconomics problems could be
 What determines the price of household electrical appliances?
 What determines the output of IT industry?
 What determines the wages of workers?
 What determines the interest rates on home loans?
 How do government policies on minimum wages, price controls, tariffs
and excise affect the price and output levels of individual markets?
Answer 4- Equilibrium refers to a condition in which there is no further tendency to

change. A situation where both buyers and sellers are happy with the price of a particular
commodity, there would not arise any tendency for price to change resulting in price
equilibrium. Economic analysis focusing its attention on equilibrium positions is called
statics. An analysis which differentiates equilibrium positions arising in two or more
different circumstances is called comparative statics. Study relating to time path of
economic relationship is economic dynamics.
Activity 2
Answer 1- Business Economics involves the application of economic concepts, precepts,
tools, techniques, principles and theories by business firms towards decision making and
planning for future. It estimates the relationship like demand and demand elasticity, input
output, cost output and the like for forecasting so as to plan for future. It does not restrict
itself to explanation of behavior but moves beyond linking abstract theory and business
practice by locating the problem and evaluating all possible alternatives to arrive at the
39
Business Economics
best. It makes use of quantitative techniques to measure the impact of different factors
and policies.
Answer 2- organizations may be classified on the basis of
(a) level of activity-this classification comprises of primary business including
occupations like agriculture, mining, animal husbandry, construction using land as basic
input. Secondary business includes manufacture of food, clothing, electronics,
automobiles, machines, tools using capital and technology as basic inputs. Tertiary
business includes services like banking, insurance, transport, communication, health
education etc.
(b) sector- sector based classification comprises private sector like TELCO with
ownership in private hands, public sector including railways, SAIL, BHEL etc which are
managed and controlled by government. Joint sector cover voluntary organizations which
are owned and managed by private and public sector and cooperative sector.
(c) legal structure- these comprise of two groups unincorporated eg. Sole proprietorship,
partnership with limited liability and no separate legal identity. The second group
incorporated includes joint stock companies like private limited company and public
limited company with limited liability and independent legal identity.
(d) trade destination- this group comprises of domestic business that carries operation
with national frontiers and international business which involves operations cross
national frontiers.
Answer 3- See section 2.3.4
Answer 4- Business economics originates mainly from microeconomic theories; however

other disciples like quantitative techniques, operational research, management and
accounting principles play vital roles in business and management decisions.
Answer 5- Demand analysis and forecasting help the firm in demand decision by
choosing the product and in planning its output levels. After determining its best level of
output, the firm decides on input output by choosing the least cost input mix and
technology. A correct pricing policy under different market structures leads to firm’s
success. Product competition like advertizing, product design enables survival and
growth of the firm. Under investment analysis, the firm must evaluate its investment
decisions alongside its price and costs. Lastly comes analysis of uncertainty and risk.
Activity 3
Answer 1- The basic tools and techniques in economics are Functions, Total, Average
and Marginal Functions, Slope, The Incremental Concept, Elasticity, Position and Shifts,
Economic Models, The case method, Opportunity cost, Nominal and real variables,
Business Efficiency
Answer 2- refer section 2.4.1 to 2.4.11
40
Basic Concept of
Business Economics
2.9 SUGGESTED READINGS

1. Principles of Micro Economics, Mishra and Puri, Himalaya Publication
2. Micro Economics, Abha Mittal, Taxman Publishers
4. Managerial Economics, P.L Mehta, Sultan Chand & Sons
5. Managerial Economics and Applications, D.N Dwivedi, Vikas Publications
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Business Economics
UNIT - 3 ECONOMIC SYSTEMS
Structure
3.0 Introduction
3.1 Objectives
3.2 Kinds of Economic Systems
3.2.1 Traditional Systems or Primitive Community
3.2.2 Command Systems or Socialism
3.2.3 Market Economies or Capitalism
3.2.4 Mixed systems or Mixed Economy
Activity 1
3.3 Scarcity and Problem of choice
3.3.1 Sources limited, wants unlimited
3.3.2 Choice problem
3.3.3 Scarcity- root cause of problems
Activity 2
3.4 Let us Sum Up
3.5 Key Words
3.0 INTRODUCTION
Depending upon ownership of resources four different types of economic systems can be
demarcated viz. primitive community, socialism, capitalism and mixed economy. In the
traditional or primitive system of economic organization, means of production were the
common property of the entire community. As this system could not find grounds in
modern times, the modern times gave way to evolved economic organizations like
socialism, capitalism and mixed systems. Resources for humans have been scarce since
time immemorial. At the same time his wants are many which kept on rising with his
own evolution on a social ladder. The whole study of economics and economic systems is
based on these two conflicting facts. It is all about adapting to the equation between these
two conflicts with the goal of deriving maximum benefits for human beings in such a
manner that least disturbs the balance between wants and resources.
3.1 OBJECTIVES
42
Economic Systems

 comprehend the different types of economic systems
 understand the characteristics and limitations of socialism
 understand the problem of scarcity and problem of choice
 understand the role of scarcity in giving birth to economic problems
3.2 KINDS OF ECONOMIC SYSTEMS
Economic systems can be categorized into four types on the basis of ownership of
resources- traditional systems, command systems, market systems, mixed systems. In the
following paragraphs each system has been dealt with in detail as regards to their
features, merits and demerits.
3.2.1 Traditional Systems or Primitive Community

In the traditional system of economic organization, land and other means of production
were the common property of the entire community. The primitive economic system was
subsistence economy organized on a tribal or family scale, with no exchange of goods
and services either between them or with the external community. In this type of
production, productive forces were undeveloped. Basic tools like bow, arrow, axe, saw
were used by human beings to procure food. They hunted in groups and jointly consumed
their prey. Food in primitive system was scarce and there were no stocks. Cooperation
was the rule. Each individual rendered the same amount of labor and as a group could
achieve tasks which could have otherwise not been achieved if performed singly.
Later development in instruments of labor led to natural division of labor based on age and
gender. Women remained in homes and men went to hunt. Later the occupation of animal
and crop farming evolved. The primitive community can be related to primitive communism
in which there was no class based division of society and property was common.
3.2.2 Command Systems or Socialism

Socialism is defined by H.D Dickinson in his study Economics of Socialism as
“socialism is an economic organization of society in which material means of production
are owned by the whole community according to a general economic plan, all members
being entitled to benefit from the results of such socialized planned production on the
basis of equal rights”. The government will own and manage all industries, distributors,
transport and communication as well as finance. Loucks defines socialism as a movement
which aims to vest in society as a whole rather than in individuals, the ownership and
management of all nature made and manmade producer’s goods used in large scale
production, to the end that an increased national income may be equally distributed
without materially disturbing the individuals economic motivation or his freedom of
occupational and consumption choices. The predominant characteristics of a socialist
economy are as follows:
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Business Economics
(1) Collective Ownership- this means that all property belongs to the society as a
whole. Social ownership of the means of production implies that profit
motive and self interest do not drive the economy. This however does not
rule out the plying of private sector in socialist economy. There may a
private sector of small units in the form of small business units which may by
and large not play a significant role. These industries will depend on public
sector institutions and not the government. The government in a socialist
economy is the authority on the material means of production and sources of
distribution and exchange. It owns and operates all the means of production.
All the industries are controlled by the government. The government may
permit the operation of small business units especially agriculture based.
These are however directly or indirectly under the government’s control
because of the fact that they take the services of banks, transport,
communication and other production and distribution agencies owned by the
government.
(2) Clarity of Social and Economic Objectives aimed at social welfare- a
socialist economy is known to have clear community defined objectives
which are realized as per plan. Goals may be varied like industrialization,
computerization, minority economic upliftment, mainstreaming of
marginalized groups etc. Since all enterprises are state owned, the question of
individual or private profit does not arise.
(3) Central Economic Planning- a socialist economy is a centrally planned
economy. In this kind of economy, profit motive and the automatic pricing
process are diminished. The controlling authority owns and allocates all
material and human resources as per plan directed at achieving the
socioeconomic goals. ,
(4) Absence of Competition- as the state has the monopoly of production and
investment in socialism; it inhibits any type of competition amongst the
production units.
(5) Relative Equality of Incomes- absolute equality of income being an
impossible proposition socialist economy ensures much less inequality as
compared to capitalist economy. There is no such thing as private property
and private motive in a socialist economy which two are the major factors in
propagating inequality. As wage differences are much low, large
accumulation of capital is not simple. Abolition of private property and all
other sources of income which is not earned brings about equality of
opportunities and ensures equal pay for equal work.
(6) Absence of Exploitation- as there are no class distinctions because of the fact
that no property is privately owned, the situation where workers are exploited
by employers does not gain ground.
(7) Production for Exchange- production for sale holds relevance for socialism
making pricing system and money its important features. A socialist
44
Economic Systems
economy provides for free choice of consumption and free choice of work.
Free choice of consumption entails that the goods are available to consumers
in unrestricted manner and production is based on consumer choice. Free
choice of occupation in a socialist economy means that people have the
freedom to shift occupations and regions.
Socialist economies had their own set of limitations like-

(1) Loss of efficiency and productivity- socialism entails management of
industries by public or state officials who are not as efficient as private
entrepreneurs. The pressure of competition ensures best productivity for the
private entrepreneurs. As there is no job insecurity involved for state
employee’s lack of initiative, decision making ability and corruption are
negative features of workers in socialism.
(2) Administrative complexities- administration proves cumbersome in socialist
economy since every issue big or small is to be addressed by a central
authority. In a fixed plan amendment of errors observed at advanced stages
does not come easy and may prove expensive too.
(3) Loss of consumer’s sovereignty- socialism only theoretically ensures
freedom of choice to consumers. In practice consumers sovereignty is
permitted only to the extent that is admissible within the plan outline.
(4) Loss of incentives- abolition of private property and free enterprise affects
motivation to work which may in turn lead to decline in production.
(5) Concentration of political and economic powers- state ownership of the
material means of production and control of economic activities increases the
power of the state over the individual. The remuneration of labor does not
depend on the productivity but on the total product and the method of
distribution adopted by the state.
Though socialist economy promotes economic growth, equality and stability, it is

governed by rigid controls. The first socialist nation was established by Russia previously
Soviet Union. Inspired by remarkable growth of the Soviet Union other countries too
adopted socialism like- Romania, Bulgaria, Yugoslavia, Czechoslovakia, Poland, East
Germany, Vietnam, China, Cuba etc. The centralized planning and control due to
socialism enabled to create a strong base of capital goods industries in these countries,
but people suffered at times as they were forced to abstain from basic needs too
sometimes. Socialism could not keep its pace with rapid technological changes of the
70’s and 80’s. By the turn of 1980’s, socialist economies disintegrated. Almost all of
them gave away with central control and chose free markets embracing multinational
corporations which trend accelerated in the 1990’s.
3.2.3 Market Economies or Capitalism
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Business Economics
Capitalism refers to an economic order where all means of production are privately
owned. Production occurs at behest of private individual entrepreneurs who are in turn
driven by private profit motives. Role of government is negligible in order to ensure
growth and stability. Capitalism is also called as free market economy since it is based on
private enterprise. It is characterized by the following features
(i) The right to private property- private property implies that rights of the
property are with the owner of the property who has full control over it. But
this right cannot be considered as absolute. Many prohibitory and restrictive
legislation lie above these rights. This right to acquire private property and
have right over the property which is an integral part of capitalism offers the
following functions:
(a) It places the power to decide upon the uses to which productive agents will
be put.
(b) It provides for accumulation of wealth and encourages individual and
corporate savings which are a source of capital formation.
(c) It motivates towards wealth conservation and protecting it from dwindling
away.
(d) Accumulation aids in developing systematic patterns of estimates of
depreciation in calculations of production costs.
(ii) Right of inheritance- this implies owning of fathers property by his heirs as a
matter of legal right. This right serves as a motivation to accumulate wealth
and capital so that one can leave it for one’s children on death.
(iii) Right of free enterprise- this means that people have right to take decision on
economic issues. A consumer is free to spend whatever he she wants to
spend his/her income on. Consumer is at the centre of capitalist economy.
The consumer choice influences the types of goods and services produced. A
producer may make his living the way he/she desires. He may indulge in
production individually or jointly as in partnership with other people or with
organizations. This feature is relevant as:
(a) The agents of production are channelized so that their best is made use of.
Each factor of production chooses for itself the line of work which
provides for most attractive compensation. If society is not happy with that
choice, the market adopts measures like endorsement by way of higher
rewards for the factor services that motivate people to transfer to another
occupation, where they may have better use according to society’s
perspective.
(b) Entrepreneurial function is to assimilate and coordinate the required
amounts and optimum quality of the productive agents for the turning out
of specific commodities and services. Entrepreneurs must be free to
delineate advantageous possibilities and to acquire and use the agents of
production to achieve such beneficial goals.
46
Economic Systems
(c) The society attempts to make full use of the existing resources. If some
units of any factor of production are unemployed, the entrepreneurs will try
to make use of the services of such a factor, as it will be available at lesser
price. Such endeavors can boost employment.
(d) It encourages inventions and uses of new kinds of machinery and new
technological advancements, new types of business organizations.
(iv) Perfect competition- competition implies rivalry between the participants
both buyers and sellers in the market. Free markets or perfectly competitive
markets perform the following functions:
(a) It is through competition fair or normal prices are worked out for both
consumer goods and factor services.
(b) Competition creates and preserves efficiency in the production of goods.
It means the turning out of goods and services at least costs.
(c) Competition among workers for jobs ensures efficiency on the part of the
worker as every worker would strive to prove himself/ herself most
efficient against others.
(v) Profit motive- the motive to earn profit is the guiding principle in capitalism.
It has the following functions to perform-
(a) It acts as a central controlling mechanism as a capitalist system cannot
work if there is a single head or agency for directing its manifold
activities.
(b) It acts as a coordinating force. Entrepreneurs resort to least cost
combinations while agents of production look for most productive uses.
(c) It causes entrepreneurs to march ahead with risks and assurances
essential for maintaining the regularity of the productive process.
(vi) Self interest or economic motivation- a capitalist economy is individualistic
meaning that each individual pursues his/her self interest for economic gain.
This motivation for gain serves to coordinate the activities of millions of
individuals.
(vii) Price mechanism- the price system determines how the natural resources,
capital or labor will be made use of. Prices determine what to produce and
play a major role in distribution of the product. Prices provide for economic
maintenance and growth.
(viii) The role of government- though private entrepreneurship is central to
capitalism it does not negate the role of government. Some areas of
government intervention can be demarcated-
(a) The field of collective wants which cannot be addressed by private
entrepreneurs.
(b) When the technical aspects of production process are not supportive.
47
Business Economics
(c) When the risks accrued to monopolistic exploitation assume bigger

magnitude.
(d) When the use of large and widely ramifying plant is necessitated.
When it comes to practice free markets suffer from various limitations which constitute
market failure some of these are-
1. Impossibility of perfect competition- a perfect competitive markets never
exists due to the following reasons-
(a) Economies of large scale operation- this factor leads to death of small
units with time due to their inability to withstand competition offered by
large low cost rival units.
(b) Incentives to differentiate- to the extent a seller succeeds in making
buyers have more faith in him as against other sellers in terms of distinct
nature of his goods he has an edge over other sellers.
(c) Frequent entry into markets is not easy- either on account of natural
barriers like economies of scale or artificial barriers like need for a
license, tying up of technical know-how via patent or closely guarded
trade secret or advertizing etc.
(d) Information is expensive- this may have many implications- new
competitors may not force their entry into a market for the simple reason
of their ignorance on the markets profitability; consumers may be
exploited on account of ignorance about the goods they are purchasing.
2. Externalities- the thinking that competition begets efficiency is based on the
assumption of lack of difference between private and social valuations. But
in reality, the two costs are not the same. Industries avoid spending on
environment friendly waste disposal and discharge their harmful effluents
conveniently in water bodies. The society in turn ends up paying the price for
this.
3. Public goods- a public good known as social or collective good is non
marketable in absolute sense due to its inherent characteristics of
indivisibility and non excludability. These goods cannot be provided by the
market.
4. Merit goods- merit goods are those goods that the society considers its
people to be consuming or receiving irrespective of their earnings. But the
market fails to value the need for goods like housing and food for lower
income groups and the like.
5. Other goods- besides achieving economic efficiency a society also seeks
better distribution of income and wealth. These goals can again not be met by
the market.
48
Economic Systems
Thus we find several flaws of free markets in a free competitive market. In the interests
of all, market needs to be guided and controlled so as to serve its own social, political and
economic goals. These goals can be achieved through the involvement of the government
which can regulate and control the market as per the needs of society paving way for
what has come to be known as mixed economy. .
3.2.4 Mixed Systems or Mixed Economy- these are characterized by:

1. Coexisting of public and private sectors- both public and private sectors exist
in this system with clearly outlined roles. The private sector is expected to
supplement the initiatives of the public sector and derive benefits from
opportunities brought by the public sector. The role of the public sector is as
follows-
(a) To create industrial climate by providing required infrastructure.
(b) To control and facilitate the growth of industries requiring big capital
investments.
(c) Promoting growth of long gestation projects.
(d) Promoting industries in those areas which may not provide for proper
inducements to private entrepreneurs.
2. Categorization of industrial undertakings- the industrial economic system can
be classified into-
(a) Those fields of production over which public sector holds exclusive
monopoly.
(b) Those areas which are exclusively entrusted to the private sector.
(c) Few fields could be available for both public and private units of
production.
(d) Those areas in which government may disallow new units but may
permit the already functioning private units to carry on with production.
(e) Those collaboration sector projects in which the state may work with
private entrepreneurs.
3. Objective of economic welfare- this is the most important success criteria for
a mixed economy. Public sector seek to avoid regional inequalities, provides
maximum employment opportunities and its price policy is usually driven by
economic welfare objective and not profit motive.
4. Economic planning- the government is in full charge of economic planning
the public sector enterprises work as per this plan in order to achieved the set
objectives. The same is applicable to private sector. Programs of both the
sectors are planned such that growth in one complements growth in the other.
Activity 1
1. Describe primitive economic system
49
Business Economics
2. What are the characteristics of a socialist economy?

3. What are the limitations of socialism and why did socialism fail?
4. Describe the characteristics of capitalism
5. What are the limitations of free market?
6. What do you understand by mixed economy?
3.3 SCARCITY AND PROBLEM OF CHOICE
The two fundamental facts that applies to man is that his wants are unlimited and at the
same time resources viz. land, labor, machinery and other productive resources required
to satisfy these wants are limited. If a person is hungry he can have a sandwich to satisfy
his want of food. If a person is feeling bored he can ask his friend to drop in home and
have his want of killing boredom satisfied. But there is never an end to human wants. If
one want is satisfied another want arises. Wants keep recurring within us. Many a times
there are more than one wants operating simultaneously like you want to purchase a split
AC and an LED television at the same time. At the time of exams you may both want to
study hard as well as entertain yourself by visiting a theatre simultaneously. However all
these wants differ on parameters of intensity. Our simultaneously occurring wants can be
arranged in order of preference or urgency providing us the possibility of choice amongst
different wants. An individual will satisfy his want of hunger before satisfying his other
want of cleaning up his dirty body or room. During examinations a person will satisfy his
want of studying first then satisfy a simultaneously occurring want of socializing or
entertainment. This goes to show that a lesser intense want will be satisfied only after an
intense want has been satisfied.
3.3.1 Sources limited, wants unlimited-

The resources required to satisfy human wants are limited whether they be natural or
artificial though different resources could be put to alternative uses. With the available
amount of money a person possess he could either purchase an LED or an AC. A person
could use the land he owns either for construction of a house or crop cultivation. If a
student spends his time studying more of one subject he is left with less time to study
another. If you work laboriously cleaning up your house you are left with little stamina
for say cooking for your family. In other words whether the resources are in terms of
money, time, labor the fact remains that it is impossible to satisfy both similar nature
wants simultaneously and up to same proportions with the fixed amount of resources at
one’s disposal.
3.3.2 Choice problem

It is clear that a person has to choose between alternative uses of available resources. As
wants differ in intensity or urgency we make efforts to go for that particular use which
would provide us maximum satisfaction. This is the problem of choice or economizing
problem. What holds for a member of society holds for the entire society or economy as
well. Every economy has to choose between different alternative uses of available
50
Economic Systems
resources and has to give up one of the two alternatives. The alternative given up is
regarded as the opportunity cost of the alternative selected. This problem of choice is the
real economic problem. Every economy has to decide if it needs to produce more biscuits
or more electronics. It has to decide whether to use more labor or more capital by way of
technology in production activity. It has to decide whether its production should focus
more on present consumption or future consumption. These problems translate into the
expression what to produce, how to produce and for whom to produce which are the three
central problems of an economy as discussed in unit 1.
3.3.3 Scarcity- root cause of problems

The problem of choice which gives rise to various central problems of an economy is also
defined as the problem of economizing resources. This problem has its origins in the
concept of scarcity. Scarcity implies the non availability of necessary resource in
necessary amounts. Scarcity is a relative concept. A resource is considered scarce if its
demand is more than supply. Even if there are few people whose wants for a particular
commodity remains unsatisfied the resource would be called scarce even if large amounts
of it is available in the market. On the same lines if there is a commodity for which the
demand is negligible even a small quantity of the resource would not imply that this
resource is scarce. Only when demand and supply are pitted against each other the
labeling of scarcity can be made.
Scarcity and poverty are not one and same. Poverty refers to a basic level of need either
in absolute or relative terms. If there is no poverty it would imply that the basic level of
living has been attained. And if there is no scarcity it would indicate attainment of not
just some basic level but production of all goods in quantities as desired. Poverty can be
eradicated but scarcity can hardly be eradicated. Even in rich societies scarcity does and
will exist.
Activity 2
1. Write a note on the concept of scarcity
2. Describe sources limited, wants unlimited
3. How is scarcity the root cause of economic problems?
4. Explain the problem of choice
3.4 LET US SUM UP
Based on ownership of resources four different types of economic systems can be

identified viz. primitive community, socialism, capitalism and mixed economy. The
primitive economic system was subsistence economy organized on a tribal or family
scale, with no exchange of goods and services either between them or with the external
community. The primitive community can be related to primitive communism in which
there was no class based division of society and property was common.
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Business Economics
Socialism can be defined as a movement which aims to vest in society as a whole rather
than in individuals, the ownership and management of all nature made and manmade
producers goods used in large scale production, to the end that an increased national
income may be equally distributed without materially disturbing the individuals
economic motivation or his freedom of occupational and consumption choices. It is
characterized by collective ownership, clarity of social and economic objectives aimed at
social welfare, central economic planning, absence of competition, relative equality of
incomes, absence of exploitation as there are no class distinctions, production for
exchange. Limitations of socialism include loss of efficiency and productivity,
administrative complexities, loss of consumer’s sovereignty, concentration of political
and economic powers. Socialism could not keep its pace with rapid technological
changes of the 70’s and 80’s and by the turn of 1980’s, socialist economies across the
globe disintegrated.
Capitalism refers to an economic system where all means of production are privately
owned. Production occurs through private individual entrepreneurs who are in turn driven
by private profit motives. Role of government is negligible in order to ensure growth and
stability. Capitalism is also called as free market economy since it is based on private
enterprise. It is characterized by the following features-the right to private property, right
of free enterprise, right of inheritance, profit motive, perfect competition, self interest,
price mechanism. There are several flaws in a free competitive market. In the interests of
all, market needs to be guided and controlled so as to serve its own social, political and
economic goals. These goals can be achieved through the involvement of the government
which can regulate and control the market as per the needs of society paving way for
what has come to be known as mixed economy which are characterized by coexisting of
public and private sectors, categorization of industrial undertakings, objective of
economic welfare, economic planning on the part of the government.
The two fundamental facts that apply to man are that his wants are unlimited and at the
same time resources required to satisfy these wants are limited. Our simultaneously
occurring wants can be arranged in order of preference or urgency providing us the
possibility of choice amongst different wants. The resources required to satisfy human
wants are limited whether they be natural or artificial though different resources could be
put to alternative uses. As wants differ in intensity or urgency we make efforts to go for
that particular use which would provide us maximum satisfaction. This is the problem of
choice or economizing problem. Every economy has to choose between different
alternative uses of available resources and has to give up one of the two alternatives. The
problem of choice which gives rise to various central problems of an economy is also
defined as the problem of economizing resources. This problem has its origins in the
concept of scarcity. Scarcity implies the non availability of necessary resource in
necessary amounts. Poverty can be eradicated but scarcity can hardly be eradicated.
3.5 KEY WORDS
52
Economic Systems
 Primitive economy- in traditional economic organization, land and other means

of production were the common property of the entire community. It was
subsistence economy organized on a tribal or family scale, with no exchange of
goods and services either between them or with the external community.
 Socialism- socialism is an economic organization of society in which material
means of production are owned by the whole community according to a general
economic plan, all members being entitled to benefit from the results of such
socialized planned production on the basis of equal rights.
 Capitalism- Capitalism refers to an economic order where all means of
production are privately owned and production is undertaken by private
individual entrepreneurs who are driven by private profit motives.
 Free markets- are perfectly competitive markets.
 Scarcity- it implies the non availability of a required resource in necessary
amounts.

1. A mixed economy to solve its central problems mainly relies on
(a) Economic planning (b) price mechanism
(c) Price fixing (d) both a and b
Answer: a
2. In a socialist economy, the basic force of economic activity is profit. This

statement is
(a) Right (b) wrong
(c) Partially right (d) none of these
Answer: b
3. Government intervention is very limited in

(a) Socialism (b) capitalism
(c) Mixed system (d) none of the above
Answer: b
4. In a competitive economy which of the below is supreme

(a) Government (b) producer
(c) Consumer (d) seller
Answer: c
5. Wastes of competition are found in

(a) Capitalism (b) socialism
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Business Economics
(c) mixed system (d) all of these

Answer: a
6. A dual system of pricing exists in

(a) Capitalism (b) socialism
(c) mixed economy (d) none of these
Answer: c
7. One of the important features of capitalism is

(a) Economic planning (b) price mechanism
(c) Economic equality (d) welfare of the masses
Answer: b

1. Describe in detail the different types of economic system
2. What are the features of socialism and what are its limitations?
3. Write a note on the state of socialism across the world describing its history and
present.
4. What are the characteristics of capitalist economy?
5. What are the limitations of free markets?
6. Describe scarcity as the root cause of problems
7. Describe the problem of choice between alternative uses of resources.
3.7 ANSWERS TO CHECK YOUR PROGRESS/ EXERCISES
Activity 1
Answer 1- In the traditional system of economic organization, land and other means
of production were the common property of the entire community. The primitive
economic system was subsistence economy organized on a tribal or family scale,
with no exchange of goods and services either between them or with the external
community
Answer 2- Socialist economy is characterized by collective ownership, clarity of

social and economic objectives aimed at social welfare, central economic planning,
absence of competition, relative equality of incomes, absence of exploitation as
there are no class distinctions, production for exchange.
Answer 3- Limitations of socialism include loss of efficiency and productivity,

administrative complexities, loss of consumer’s sovereignty, concentration of
political and economic powers. Socialism could not keep its pace with rapid
technological changes of the 70’s and 80’s and by the turn of 1980’s, socialist
economies across the globe disintegrated.
54
Economic Systems
Answer 4- Capitalism is characterized by the following features-the right to private

property, right of free enterprise, right of inheritance, profit motive, perfect
competition, self interest, price mechanism.
Answer 5- There are several limitations of free markets like impossibility of perfect
competition. The second limitation relates to the thinking that competition begets
efficiency which is based on the assumption of lack of difference between private
and social valuations. But in reality, the two costs are not the same. The third relates
to non marketability of social good. These goods cannot be provided by the market.
The fourth relates to merit goods which are those goods that the society considers
its people to be consuming or receiving irrespective of their earnings. But the
market fails to value the need for goods like housing and food for lower income
groups and the like. Besides achieving economic efficiency a society also seeks
better distribution of income and wealth. These goals can again not be met by the
market.
Answer 6-Mixed economy is an economic system characterized by coexisting of

public and private sectors, categorization of industrial undertakings, objective of
economic welfare and economic planning on the part of the government.
Activity 2
Answer 1- Scarcity implies the non availability of necessary resource in necessary
amounts. Scarcity is a relative concept. A resource is considered scarce if its
demand is more than supply. Even if there are few people whose wants for a
particular commodity remains unsatisfied the resource would be called scarce even
if large amounts of it is available in the market. On the same lines if there is a
commodity for which the demand is negligible even a small quantity of the resource
would not imply that this resource is scarce.
Answer 2- The resources required to satisfy human wants are limited whether they
be natural or artificial though different resources could be put to alternative uses.
Whether the resources are in terms of money, time, labor it is impossible to satisfy
both similar nature wants simultaneously and up to same proportions with the fixed
amount of resources at one’s disposal.
Answer 3- The problem of choice which gives rise to various central problems of an
economy is also defined as the problem of economizing resources. This problem has
its origins in the concept of scarcity. Only when demand and supply are pitted
against each other the labeling of scarcity can be made.
Answer 4- An individual has to choose between alternative uses of available

resources. As wants differ in intensity or urgency we make efforts to go for that
particular use which would provide us maximum satisfaction. This is the problem of
55
Business Economics
choice or economizing problem. What holds for a member of society holds for the
entire society or economy as well. Every economy has to choose between different
alternative uses of available resources and has to give up one of the two alternatives.

4. Managerial Economics, Varshney and Maheshwari, Sultan Chand & Sons
5. Micro Economics and Applications, D.N Dwivedi, Vikas Publications
56
BLOCK - 2
Consumer Behavior and the Demand Theory

Business Economics
UNIT – 4 LAW OF DIMINISHING MARGINAL UTILITY AND EQUI-

MARGINAL UTILITY
Structure
4.0 Introduction
4.1 Objectives
4.2 Utility
4.2.1 Meaning and Characteristics
4.2.2 Utility Function
4.2.3 Cardinal Measurement of Utility
4.2.3.1 Marginal Utility
4.2.3.2 Total Utility
4.2.3.3 Average Utility
4.2.3.4 Relationship between MU,TU and AU
4.2.4 Assumptions of Utility Analysis
Activity 1
4.3 Law of Diminishing Marginal Utility
4.3.1 Statement of the Law
4.3.2 Consumer’s Equilibrium (case of a single Commodity)
4.3.3 Assumptions of the Law
4.3.4 Exceptions of the Law
Activity 2
4.4 Law of Equi-Marginal Utility
4.4.2 Consumer’s Equilibrium (case of many commodities)
4.4.3 Limitations of the Law
4.4.4 Importance of the Law
Activity 3
4.5 Let us Sum Up
4.6 Key Words
4.0 INTRODUCTION
The demand theory attempts to analyze the behavior of utility maximizing households.
Every household is faced with the common problem of expenditure of its limited income
so that maximum satisfaction is attained. Consumer’s equilibrium is a situation when a
58
Law of Diminishing
Marginal Unity…..
household has allocated its resources among the various uses in such a way that it has no
incentive for change. Economists have proposed two alternative explanations on how this
stage is arrived at- utility analysis or cardinal utility approach and indifference curve
analysis or ordinal utility approach.
4.1 OBJECTIVES

 Understand the concept of utility
 Understand the relationship between marginal utility, total utility and average
utility
 Understand the Law of Diminishing Marginal Utility
 Understand the Law of Equi-Marginal Utility
4.2 UTILITY
Lipsey and Chrystal define utility as the satisfaction a consumer receives from consuming
of a product. Utility is the want satisfying power of the commodity. Though it is different
from satisfaction in that utility is expected satisfaction and satisfaction is realized utility.
Utility can exist without consumption but satisfaction arises only after actual
consumption. But since for most of the goods expected satisfaction is more or less the
same as realized satisfaction, the two terms of utility and satisfaction are used
synonymously in the theory of consumer behavior. A commodity is said to have utility
even though it may not be useful. Heroin is useless but for a drug consumer it has utility.
Keeping a gun may be illegal but for a goon it has utility.
4.2.1 Meaning and Characteristics

Some characteristics of utility include
 It depends on the intensity of want.
 It is subjective, cannot be quantified. For a Chinese person insects may have
utility in terms of food not for an Indian.
 Has no legal, social or ethical implication as illustrated in the drug and goon
example.
 It is relative. It changes from individual to individual, and for the same individual
it differs from place to place, time to time.
4.2.2 Utility Function

Utility function explains the relationship between the utility of a commodity and the units
of the commodity consumed expressed as
Ux=f (qx≥0)
Where Ux is the total utility from the consumption of commodity x, and q x is the quantity
of commodity x consumed.
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Business Economics
Utility function states that the total utility from the consumption of commodity
depends upon the quantity consumed. If there are more than one good, the utility
function can be expressed as
U=F (x1x2x3……..xn)
where U is the total utility if there are n commodities with quantities x 1x2x3……..xn
4.2.3 Cardinal Measurement of Utility-

Utility is measured in units called utils. It can be measured in terms of total utility and
marginal utility.
4.2.3.1 Marginal Utility

Marginal utility is the utility obtained from the additional unit of a commodity consumed.
Lipsey and Chrystal define marginal utility as the change in satisfaction resulting from
consuming one unit more or one unit less of a product.
MUn=TUn- TUn-1
Where MUn is the marginal utility of the nth unit.
TUn is the total utility of the nth unit and
TUn-1 is the total utility of the (n-1) th unit.
Or MUx=dTUx
dQx
Marginal utility of commodity x is the first derivative of total utility of x with respect to
quantity of x.
4.2.3.2 Total Utility

Total utility (TU) is the sum of all the utilities derived from the total number of units
consumed. It is the sum of marginal utilities associated with the consumption of
successive units.
Let us suppose that from the consumption of one banana a consumer gets 10 utils. We
represent the different utils obtained from different units of consumption
Table 4.1 Utility Schedule
Units of banana Total utility in utils Marginal utility in utils

1 10 10
2 16 16-10=6
3 20 20-16=4
4 20 20-20=0
5 18 18-20=-2
If we know the total utility derived from the n units of a commodity and n-1 units of a
commodity, we can calculate the marginal utility for the nth unit as
MUn = TUn-TUn-1
60
Law of Diminishing
Marginal Unity…..
And total utility can be obtained by summing up of marginal utilities of various

commodities as
TUn= MU1+ MU2 ……….+MUn
4.2.3.3 Average Utility

Average utility (AU) is derived by dividing total utility by the number of units of the
commodity. In general change in AU is smaller than or at the most equal to the change in
MU as addition to TU brought by MU tends to spread over all the units of the
commodity.
4.2.3.4 Relationship between MU,TU and AU

The relationship can be understood after careful observation of Table 4.2 and Fig.4.1
Table 4.2
Relationship among total utility, marginal utility and average utility in rupees
Number of units Total utility Marginal utility Average utility

1 10 10 10
2 18 8 9
3 24 6 8
4 28 4 7
5 30 2 6
6 30 0 5
7 28 -2 4
8 24 -4 3
Fig.4.1
Relation among MU, AU and TU
35
30
25
20
total utility
15
marginal utility
10
average utilty
5
0
-5
-10
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Business Economics
Number of units
Both the table and figure show that initially the total utility curve slopes upwards to the
right indicating that total utility will rise with consumption of additional units of the
commodity. But the increase in total utility is not constant and falls slowly. This is to say
that the total utility curve rises at a falling rate. This is shown by corresponding
downward or negative slope of the marginal utility curve. When the total utility reaches
its maximum value, marginal utility becomes zero. This is called the point of satiety. The
total utility stops increasing after this point. When consumption is increased beyond the
point of satiety, the total utility starts decreasing as marginal utility turns negative. Unlike
marginal utility, average utility is always positive, as it is the ratio of two positive values.
When average utility attains maximum value it is equal to the marginal utility. Like
marginal utility curve average utility curve too is downward sloping but it remains above
the x axis.
4.2.4 Assumptions of Utility Analysis

Utility analysis is based on the following assumptions:
1. Rationality- the consumer is rational. The consumer aims at the
maximization of his utility subject to the constraint imposed by his given
income.
2. Cardinal utility- the utility of each commodity is measurable. The most
convenient measure is money.
3. Constant marginal utility of money- this assumption is relevant if utility is
measured in monetary terms. The essential feature of a standard unit of
measurement is that it be constant. If the marginal utility of money changes
as income increases, money is rendered inappropriate for measurement.
4. Diminishing marginal utility- the utility gained from successive units of a
commodity tends to diminish. As the consumer procures larger quantities of
a commodity its marginal utility diminishes.
5. Total utility depends on quantities of individual commodities- the total utility
of goods depends on quantities of the individual commodities. If there are n
commodities in the bundle with quantities x1, x2, …….xn, the total utility is
U=f (x1, x2, …….xn)
Activity 1
1. Write a note on meaning and characteristics of utility
2. What is average utility?
3. What is marginal utility?
4. What are the Assumptions of Utility Analysis?
62
Law of Diminishing
Marginal Unity…..
4.3 LAW OF DIMINISHING MARGINAL UTILITY
This law is used to explain consumer behavior and demand analysis. It is human behavior
to value something that is scarce and not care about something in plenty. Let us suppose
that price of onions have temporarily increased five folds in one particular state of India
due to whatever reason. It is obvious that cooks of this particular state will use less of
onions in cooking. This is nothing but the law of diminishing marginal utility.

Alfred Marshal states that the additional benefit a person derives from a given increase of
his stock of a thing diminishes with every increase in the stock that he already has. With
successive increase in consumption of a commodity, the marginal utility may initially
increase with increase in level of consumption. Total utility will continue to increase till
the point of consumption when marginal utility becomes zero. Consumption of a sweet
say gulabjamun up to a certain number will be pleasurable and have utility, but soon a
point is reached where the person would achieve satiety. Every increase in consumption
beyond this point brings about disutility, marginal utility turns negative.
4.3.2 Consumer’s Equilibrium (case of a single Commodity)

The law of diminishing marginal utility helps a consumer to reach equilibrium position.
Consumer equilibrium is a situation denoting maximum satisfaction to the consumer out
of the money spent on a commodity. At equilibrium position total utility is at its
maximum. Consumer’s equilibrium is attained when the marginal utility gained from the
units consumed of a commodity equals the utility sacrificed in terms of per unit price
paid for that commodity.
It can be expressed as MUx= Px
where MUx is the marginal utility gained from commodity x
Px is the per unit price paid for commodity x or utility sacrificed
Consumer’s equilibrium can be explained with the help of following schedule:
Table 4.3 Utility Schedule of Banana
Units of Marginal utility Price of banana or Difference between utility

bananas Or utility gained Utility sacrificed Gained and utility
(MU) in Rs. (p) in Rs. sacrificed
1 6 3 3
2 5 3 2
3 4 3 1
4 3 3 0
5 2 3 -1
6 1 3 -2
7 0 3 -3
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Business Economics
It is clear from the table that as the consumer consumes successive units of bananas, the
marginal utility goes on diminishing. In order to reach equilibrium, he eats 4 units of
bananas such that marginal utility gained equals the price or utility sacrificed in terms of
money. Let us assume that the consumer consumes fewer units or 3 units. Here the price
paid for bananas Rs. 3 is less than the marginal utility obtained which is Rs.4. The
consumer will gain more utility than sacrifice of utility. He should so increase his
consumption to a level where equilibrium between marginal utility and price is restored.
On the same lines if the consumer consumes 5 units of bananas, the marginal utility
obtained i.e. Rs. 2 is less than the price paid. His utility gains are less than the sacrifice of
utility or price; hence he should reduce his consumption to restore equilibrium.
4.3.1 Assumptions of the Law-

The law makes the following assumptions-
 Consumption of a commodity should be in proper units.
 Quality of the commodity should remain the same. All the bananas
consumed should be of equal size, sweetness, freshness etc.
 Consumption should not proceed after time gaps and be continuous.
 The consumer should be rational.
 The price of the substitute goods should remain the same.
4.3.2 Exceptions of the Law

Some of the exceptions to the law are-
 Drunkards, drug addicts, and misers are exceptions to this law. Their desire for
wealth, narcotics and alcohol may increase with every successive increase in
consumption.
 A collector of rare artifacts, stamps, coins, paintings etc. may not fall under its
purview.
 The law may not apply to entertainment like a music recital or natural scenic
landscapes.
Activity 2
1. What is the law of diminishing marginal utility?
2. Explain consumer equilibrium
3. What are the assumptions of the law of diminishing marginal utility?
4.4 LAW OF EQUI-MARGINAL UTILITY
This law helps us to explain the question of how a consumer achieves maximum
satisfaction out of his limited resources. The dilemma of how a consumer allocates his
limited resources among different uses such that maximum total utility is obtained from
the consumption is addressed by this law. At a stage where total utility is maximum, the
consumer is said to have reached equilibrium. .
64
Law of Diminishing
Marginal Unity…..

The law of equimarginl utility states that a consumer will reach the stage of equilibrium
when the marginal utilities of the various commodities that he consumes are equal. As a
consumer purchases goods of food, clothing etc. the more he gets of one good the less he
will buy and avail of other goods because of the limited money available with him. The
marginal utilities of goods will fall with increased purchases. At the same time marginal
utilities of goods on which he is spending less amounts will remain high. The consumer
would thus gain by substituting among goods with higher marginal utility for goods with
lower marginal utility. This process of substitution would go on till the time he attains
optimum combination that results in maximum total utility. We can illustrate this through
an example. Let us suppose that a consumer with Rs.100 at his disposal has to spend on
three commodities a, b, c. Utility schedule is laid down in Table 4.4.
Table 4.4 Utility Schedule
Units M.U of a M.U of b M.U of c

1 100 140 180
2 80 120 150
3 70 100 120
4 40 80 80
5 20 60 50
6 0 40 30
It is assumed that each of the commodities costs Rs. 100 each. For reaching equilibrium
the consumer should purchase that combination of the three commodities where the
marginal utility of all of them is equal, i.e. MUa=MUb=MUc. This situation can be
reached when the consumer buys the combination- 2a+4b+4c, on which he would have
spent Rs.100 and obtained total utility equal to
(100+80)+(140+120+100+80)+(180+150+120+80)==1150 utils. This is the maximum
total utility that the consumer could have derived, with his available money and the utility
schedule.
4.4.2 Consumer’s Equilibrium (case of many commodities)

This law is explained by Marshall as “if a person has a thing which he can put to several
uses, he will distribute it among these uses in such a way that it has the same marginal
utility in all. For if it had a greater marginal utility in one use than in another, he would
gain by taking away some of it from the second use and applying it to the first”. The
equilibrium condition on the basis of the law of equimarginal utility can be stated in two
different ways:
(a) A consumer is in equilibrium, when the quantities of various commodities
are brought in such a way that the ratios of marginal utilities of various
commodities to their respective prices are same and are equal to the marginal
utility of money. That is when
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Business Economics
MUa = MUb = MUm

Pa Pb
Where MUa is the marginal utility of commodity a, P a is the price of commodity a
and so on
(b) A consumer is in equilibrium, when the ratios of marginal utilities of two
goods and their respective prices are the same. This condition is satisfied by
all the pairs of goods. That is
MUa = Pa and MUb = Pb and so on.
MUb Pb MUc Pc
When a consumer is faced with equal price of all the commodities that he
plans to consume, the equilibrium condition is reduced to MUa = MUb = MUc
………..= MUm as illustrated above.
4.4.3 Limitations of the Law

There are many situations in practical life when the law of equimarginal utility cannot be
applied because of its limitations like-
 It is assumed that the consumer spends very less amount of money on
different commodities. But when it comes to expensive commodities this
does not apply because of these goods being indivisible. Smart phones,
LED’s, smart refrigerators are commodities which cannot be purchased
in parts. Their purchases are bulky and do not permit minor variations. In
these cases it becomes difficult to equate marginal utilities.
 Consumers most of the times are ignorant about the different alternatives
which are most useful. They are not smart to assess and compare
variations in marginal utilities of various commodities.
 The law assumes that utility is measurable. However this is subjective in
nature and subjectivity cannot be measured on a cardinal scale.
 Constancy of marginal utility of money always remains a question. As a
consumer spends money on the commodity, he is left with less money to
spend on other commodities. In the process, marginal utility of money
with the consumer goes up which may influence his purchasing
decisions.
 The law assumes that tastes, trends, preferences, habits, customs and
income of people remains constant which is not the reality. Consumers
do spend irrationally on commodities which are less useful or yield low
utilities.
 Durable goods are consumed over long span of time. Expenditure on
such goods is increased during one period, but utility obtained from the
good spreads over a larger time span. It becomes difficult for a consumer
to equate the marginal utility of services of durable commodities in each
period.
66
Law of Diminishing
Marginal Unity…..
 In practical life the consumer rarely compares the marginal utilities of

different commodities, when the expenditure involved is too small as a
result of which he often buys less useful commodities.
 The law cannot be applied to complementary goods which cannot be
substituted for each other.
4.4.4 Importance of the Law-

This law can be applied to almost every field of economic enquiry.
 In consumption- the law explains the essential basis of the consumer’s
equilibrium to maximize his satisfaction.
 In production- every producer aims to adopt a least cost combination of the
factors of production. Every producer substitutes a factor with lesser marginal
productivity by a factor with higher marginal productivity. The producer reaches
equilibrium when the marginal productivity of the various units of factors of
production employed is equal. The law hence enables the producer to maximize
output and minimize costs.
 In exchange- exchange is the substitution of a commodity with less utility by a
commodity with higher utility. It is useful to the extent that marginal utilities of
the exchangeable goods are equal.
 In distribution- the problem of distribution of national income as between
different factors of production is answered by the principle of substitution. Every
factor of production is paid in proportion to its marginal productivity. Optimum
distribution is obtained when all the factors get their reward in proportion to their
productivity.
 In public finance- the structure of public finance theory is based on the law of
maximum social advantage. Maximum social advantage out of a given public
expenditure can be ensured when the nation substitutes socially less
advantageous projects by more socially advantageous projects. The optimum
point will be reached when the marginal advantages of the various projects are
equal.
Activity 3
1. What is the law of equimarginal utility?
2. Explain consumer’s equilibrium
3. What are the limitations of the law of equimarginal utility”
4. What is the practical importance of the law of equimarginal utility?
4.5 LET US SUM UP
Utility is the want satisfying power of the commodity. Utility function explains the
relationship between the utility of a commodity and the units of the commodity consumed.
Utility is measured in units called utils. It can be measured in terms of total utility and
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Business Economics
marginal utility. Marginal utility is the utility obtained from the additional unit of a
commodity consumed. Total utility (TU) is the sum of all the utilities derived from the total
number of units consumed. Average utility (AU) is derived by dividing total utility by the
number of units of the commodity. Utility analysis is based on the assumptions of
rationality, cardinal utility, constant marginal utility of money, diminishing marginal utility
and dependence of total utility on quantities of individual commodities.
The law of diminishing marginal utility states that the additional benefit a person derives
from a given increase of his stock of a thing diminishes with every increase in the stock
that he already has. With successive increase in consumption of a commodity, the
marginal utility may initially increase with increase in level of consumption. Total utility
will continue to increase till the point of consumption when marginal utility becomes
zero. The law of diminishing marginal utility helps a consumer to reach equilibrium
position. At equilibrium position total utility is at its maximum. Consumer’s equilibrium
is attained when the marginal utility gained from the units consumed of a commodity
equals the utility sacrificed in terms of per unit price paid for that commodity.
The law of equimarginl utility states that a consumer will reach the stage of equilibrium
when the marginal utilities of the various commodities that he consumes are equal. The
marginal utilities of goods will fall with increased purchases. At the same time marginal
utilities of goods on which he is spending less amounts will remain high. The consumer
would thus gain by substituting among goods with higher marginal utility for goods with
lower marginal utility. This process of substitution would go on till the time he attains
optimum combination that results in maximum total utility.
A consumer is in equilibrium, when the quantities of various commodities are brought in

such a way that the ratios of marginal utilities of various commodities to their respective
prices are same and are equal to the marginal utility of money. The law of equmarginal
utility has its own set of limitations. Nevertheless its importance cannot be overlooked as
this law can be applied to almost every field of economic enquiry like consumption,
production, public finance, exchange and distribution.
4.6 KEY WORDS

 Utility- utility is the satisfaction a consumer receives from consuming of a product.
 Utils- it is an imaginary measure of utility.
 Cardinal Approach- It is an approach which assumes that utility is measurable
quantitatively.
 Utility Function- utility function explains the relationship between the utility of a
commodity and the units of the commodity consumed
 Marginal Utility- marginal utility is the utility obtained from the additional unit
of a commodity consumed
68
Law of Diminishing
Marginal Unity…..
 Total Utility- total utility (TU) is the sum of all the utilities derived from the total
number of units consumed.
 Average Utility- average utility (AU) is derived by dividing total utility by the
number of units of the commodity.
 Consumer’s Equilibrium- it is that level of consumption where a consumer
maximizes his satisfaction.

1. a curve which first moves upwards then downwards is
(a) marginal utility curve (b) average utility curve
© total utility curve (d) demand curve
Answer c
2. the utility of a commodity is
(a) its accepted social value (b) extent of its practical use
© its relative scarcity (d) want satisfying power
Answer d
3. marginal utility can be expressed as
(a) MUn=TUn+ TUn-1 (b) MUn=TUn-1+ TUn
© MUn=TUn- TUn-1 (d) none of these
Answer c
4. marginal utility curve of a given consumer is also his
(a) indifference curve (b) total utility curve
© supply curve (d) demand curve
Answer d

1. Explain the relationship between marginal utility, total utility and average utility
with the help of a schedule and a diagram.
2. Explain how law of diminishing marginal utility leads to consumer equilibrium.
3. Describe the law of equimarginal utility.
4.8 ANSWERS TO EXERCISES
Activity 1
Answer 1 - utility is the satisfaction a consumer receives from consuming of a product.
Some characteristics of utility include
 It depends on the intensity of want.
 It is subjective, cannot be quantified.
 Has no legal, social or ethical implication
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Business Economics
 It is relative. It changes from individual to individual, and for the same

individual it differs from place to place, time to time.
Answer 2- average utility (AU) is derived by dividing total utility by the number of units
of the commodity. In general change in AU is smaller than or at the most equal to the
change in Marginal Utility as addition to Total Utility brought by MU tends to spread
over all the units of the commodity.
Answer 3 - marginal utility is the utility obtained from the additional unit of a commodity
consumed. Lipsey and Chrystal define marginal utility as the change in satisfaction
resulting from consuming one unit more or one unit less of a product.
MUn=TUn- TUn-1
Where MUn is the marginal utility of the nth unit.
TUn is the total utility of the nth unit and
TUn-1 is the total utility of the (n-1) th unit.
Or MUx=dTUx
dQx
Marginal utility of commodity x is the first derivative of total utility of x with respect to
quantity of x.
Answer 4- utility analysis is based on the following assumptions:

1. Rationality- the consumer is rational.
2. Cardinal utility- the utility of each commodity is measurable.
3. Constant marginal utility of money- this assumption is relevant if utility is
measured in monetary terms. The essential feature of a standard unit of
measurement is that it be constant. If the marginal utility of money changes
as income increase, money is rendered inappropriate for measurement.
4. Diminishing marginal utility- the utility gained from successive units of a
commodity tends to diminish.
5. Total utility depends on quantities of individual commodities.
Activity 2
Answer 1- the law of diminishing marginal utility states that the additional benefit a
person derives from a given increase of his stock of a thing diminishes with every
increase in the stock that he already has. With successive increase in consumption of a
commodity, the marginal utility may initially increase with increase in level of
consumption. Total utility will continue to increase till the point of consumption when
marginal utility becomes zero.
Answer 2- the law of diminishing marginal utility helps a consumer to reach equilibrium
position. Consumer equilibrium is a situation denoting maximum satisfaction to the
consumer out of the money spent on a commodity. At equilibrium position total utility is
at its maximum. Consumer’s equilibrium is attained when the marginal utility gained
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Law of Diminishing
Marginal Unity…..
from the units consumed of a commodity equals the utility sacrificed in terms of per unit
price paid for that commodity.
Answer 3- the law of diminishing marginal utility makes the following assumptions-
 Consumption of a commodity should be in proper units.
 Quality of the commodity should remain the same.
 Consumption should not proceed after time gaps and be continuous.
 The consumer should be rational.
 The price of the substitute goods should remain the same.
Activity 3
Answer 1- The law of equimarginl utility states that a consumer will reach the stage of
equilibrium when the marginal utilities of the various commodities that he consumes are
equal. The marginal utilities of goods will fall with increased purchases. At the same time
marginal utilities of goods on which he is spending less amounts will remain high. The
consumer would thus gain by substituting among goods with higher marginal utility for
goods with lower marginal utility. This process of substitution would go on till the time
he attains optimum combination that results in maximum total utility.
Answer 2 - A consumer is in equilibrium, when the quantities of various commodities are

brought in such a way that the ratios of marginal utilities of various commodities to their
respective prices are same and are equal to the marginal utility of money. A consumer is
in equilibrium, when the ratios of marginal utilities of two goods and their respective
prices are the same.
Answer 3- there are many situations in practical life when the law of equimarginal utility
cannot be applied because of its limitations like-
 It is assumed that the consumer spends very less amount of money on different
commodities. But when it comes to expensive commodities this does not apply
because of these goods being indivisible. In these cases it becomes difficult to
equate marginal utilities.
 Consumers most of the times are ignorant about the different alternatives which
are most useful.
 The law assumes that utility is measurable. However this is subjective in nature
and subjectivity cannot be measured on a cardinal scale.
 Constancy of marginal utility of money always remains a question. As a
consumer spends money on the commodity, he is left with less money to spend
on other commodities. In the process, marginal utility of money with the
consumer goes up which may influence his purchasing decisions.
 The law assumes that tastes, trends, preferences, habits, customs and income of
people remains constant which is not the reality. Consumers do spend irrationally
on commodities which are less useful or yield low utilities.
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Business Economics
 Durable goods are consumed over long span of time. Expenditure on such goods
is increased during one period, but utility obtained from the good spreads over a
larger time span. It becomes difficult for a consumer to equate the marginal
utility of services of durable commodities in each period.
 In practical life the consumer rarely compares the marginal utilities of different
commodities, when the expenditure involved is too small as a result of which he
often buys less useful commodities.
 The law cannot be applied to complementary goods which cannot be substituted
for each other.
Answer 4- this law is practically important for

 consumption- the law explains the essential basis of the consumer’s equilibrium
to maximize his satisfaction.
 production- every producer substitutes a factor with lesser marginal productivity
by a factor with higher marginal productivity. The producer reaches equilibrium
when the marginal productivity of the various units of factors of production
employed is equal. The law hence enables the producer to maximize output and
minimize costs.
 exchange- exchange is the substitution of a commodity with less utility by a
commodity with higher utility. It is useful to the extent that marginal utilities of
the exchangeable goods are equal.
 distribution- the problem of distribution of national income as between different
factors of production is answered by the principle of substitution. Every factor of
production is paid in proportion to its marginal productivity. Optimum
distribution is obtained when all the factors get their reward in proportion to their
productivity.
 public finance- the structure of public finance theory is based on the law of
maximum social advantage. Maximum social advantage out of a given public
expenditure can be ensured when the nation substitutes socially less advantageous
projects by more socially advantageous projects. The optimum point will be
reached when the marginal advantages of the various projects are equal.

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Indifference Cure
Analysis
UNIT 5 INDIFFERENCE CURVE ANALYSIS
Structure
5.0 Introduction
5.1 Objectives
5.2 Ordinal Approach
5.2.1 concept of indifference curve
5.2.2 indifference curve with money income
5.2.3 indifference map
5.2.4 marginal rate of substitution
5.2.5 law of diminishing marginal rate of substitution
5.2.6 properties of indifference curves
5.2.7 exceptional shapes of indifference curves
Activity 1
5.3 budget line
5.3.1 shift in budget line
5.3.2 effect of income change
5.3.3 effect of price change
5.3.4 effect of real life income change and money income change
5.3.5 kinked budget line
5.3.6 consumer equilibrium
Activity 2
5.4 Effect of price and income changes
5.4.1 Price effect
5.4.2 Income effect
5.4.3 Equivalent and compensating variations
5.4.4 Derivation of Engel’s curve or income demand curve
5.4.5 Inferior goods and income effect
5.4.6 Shapes of income consumption curve
5.4.7 Substitution effect
Activity 3
5.5 Let us Sum Up
5.6 Key Words
5.0 INTRODUCTION
A thorough understanding of the previous unit throws light on the limitations of the
cardinal approach mainly its subjective nature and not so realistic assumptions. Due to
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Business Economics
these limitations a more logical approach to explain consumer behavior was proposed
which is known as the indifference curve approach. In this ordinal approach utility is not
measured but emphasis is made on comparing different levels of satisfaction so that the
consumer achieves maximum satisfaction.
5.1 OBJECTIVES

 Differentiate between indifference curve analysis and utility analysis
 Understand the concept of marginal rate of substitution and law of diminishing
marginal rate of substitution
 Understand budget line and consumer equilibrium
 Have a clear understanding of income consumption curve, price consumption
curve and Engel’s curve
5.2 ORDINAL APPROACH
Edgeworth proposed that measuring subjective utility on a cardinal scale is neither

required nor is possible, every consumer behavior can be analyzed in terms of preference
or rankings. The consumer is able to rank various combinations of goods and services in
order of his preference for them. A collection comprising a given quantity of each good is
called a bundle of goods for instance bundle A comprising of 4 bananas and 2 cake slices,
bundle B comprising of 2 banana and 4 cake slices. The consumer can decide whether he
prefers one commodity bundle to another. The consumer can conveniently arrange the
various combinations of two or more goods available to him in order of preference. This
is the terminology of scale of preference. In case he is indifferent to both bundles it
shows he has equal preference to both bundles and so he can accord same numerical
value to both. This theory that evolved due to dissatisfaction of Marshall’s theory was
given the name of preference approach of consumer behavior or indifference approach.
The indifference curve analysis does not make use of cardinal numbers i.e. 1, 2, 3 etc. but
it makes use of ordinal positions like 1st, 2nd, 3rd etc.
5.2.1 Concept of indifference curve

An indifference curve shows the various alternative combinations of the goods, which
provide same satisfaction level to the consumer. It is a graphical representation of an
indifference schedule that shows all combinations of goods offering same satisfaction
levels. The indifference approach provides for a consumer to arrange various commodity
bundles in order of preference but does not allow him to measure the satisfaction. Let us
illustrate the concept of indifference curve though an example of a consumer who plans
to purchase two goods x and y. He can do so in various combinations as depicted in the
indifference schedule in table 5.1. These combinations have been plotted to obtain the
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Indifference Cure
Analysis
indifference curve. If the consumer wishes to have more units of x he will have to
compromise on the number of units of y and vice-versa as his money income is fixed.
Combinations Units of good y Units of good x

A 46 2
B 31 4
C 22 6
D 15 8
E 9 10
fig.5.1
50
units of commodity y
40
30
20
10
0
2 4 6 8 10
units of commodity x
The schedule shows that the consumer is indifferent for five combinations of goods x and
y meaning that 2 units of x and 46 units of y provides him same satisfaction as 4x and
31y or 6x and 22y or 8x and 15y or10x and 9y. We interpret that the five combinations of
x and y offer equal satisfaction to the consumer. His preference for all the combinations
is same and he can choose any combination. An indifference curve is also called iso
utility curve, as every point on the curve stands for same utility level and provides same
satisfaction to consumer.
5.2.2 Indifference curve with money income-

if we replace the commodity y with money income and plot money income on y axis
along with commodity x on x axis we arrive at a curve that can measure the units of
money income that a consumer is willing to spend for a given unit of commodity x as
shown in fig. 5.2. The different combinations of A and B will provide equal satisfaction
to the consumer. Combination A measures a1 units of commodity x along with am1 units
of money income. This means that the consumer is willing to spend mm1 units of money
income so that he can have a1 units of commodity x. am is the total money income
available with him.
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Business Economics
fig.5.2
money income
good x
5.2.3 Indifference map-

It is a set of indifference curves. Handerson and Quandt define it as “an indifference map
is a collection of indifference curves corresponding to different levels of satisfaction”. It
is shown in fig. 5.3
Fig.5.3 indifference map
quntities of commodity y
IC1
IC2
IC3
IC4
quantities of commodity x
Higher the curve it means higher units of both commodities and consequently higher
levels of satisfaction. While a lower curve will measure lesser amounts of both
commodities implying lesser satisfaction levels. As the consumer passes along the line 5
his satisfaction levels keep rising as he moves from IC1 to IC2 to IC3 to IC4. It is now
clear that a consumer’s preferences are shown by not just one indifference curve but a
group or set of indifference curves which when put together constitute the indifference
map.
5.2.4 Marginal rate of substitution-

As explained above the total utility at different points on any indifference curve be it IC1,
IC2, IC3,IC$ remains constant. The consumer can substitute some units of one
commodity for others but without an addition in the total utility as shown below in fig.
5.4. At point A the consumer has a1 unit of commodity x and aa unit of commodity y. Let
us suppose that he moves to position B. In this position he has a new combination i.e. a2
unit of commodity x and ab unit of commodity y. This point B features a substitution of
a2-a1 of commodity x for aa-ab of commodity y. The loss in utility on the part of
consumer due to reduction in consumption of commodity y is neutralized by the gain in
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Indifference Cure
Analysis
increase in quantity of commodity x. This step or change in positions is such that the
level of satisfaction for the consumer remains unaltered.
fig.5.4
good y B
good x
Marginal rate of substitution is the rate at which a consumer can exchange a small
amount of one commodity for a small amount of another commodity without affecting
his total utility. According to Lipsey & Chrystal marginal rate of substitution tells us how
much more of one product we need to compensate for successive lost units of the other.
5.2.5 Law of diminishing marginal rate of substitution

The principle of diminishing marginal rate of substitution is an extended version of
principle of diminishing marginal utility. This principle states that with every increase in
the quantity of commodity x, the consumer shall be willing to forgo only lesser quantity
of commodity y. This means that the marginal significance of commodity y will increase
with decrease in quantity of commodity y while the same for commodity x will decrease.
Hence the quantity of commodity y that the consumer is willing to give up for every
successive increase in the quantity of commodity x will go on decreasing. Let us illustrate
Combinations Cake slices or commodity y Milk cups or commodity x MRSx,y
A 11 1
B 7 2 4:1
C 4 3 3:1
D 2 4 2:1
E 1 5 1:1
the law of diminishing marginal rate of substitution in the indifference schedule below in
table 5.2
This table is depicted graphically in fig. 5.5 below. The fig. 5.5 shows that for every
successive unit increase in commodity x, as shown by dark horizontal lines, the quantity
that the consumer is willing to give up as shown by dark vertical lines tends to decline.
As every successive entry on x axis increases by the same number
ox1=x1x2=x2x3=x3x4=x4x5. As we increase the quantity of commodity x by an equal unit,
we observe that the corresponding decrease that goes on with commodity y takes place at
a declining rate or y1y2 › y2y3 › y3y4 › y4y5 .
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Business Economics
fig.5.5
12
10
8
6
4
2
0
1 2 3 4 5
In the above schedule increase in quantity is constant with respect to every successive
increase in commodity on x axis. On the same line if the change with every successive
increase is constant on y axis and not x axis we will yield an opposite expression like
oy1=y1y2=y2y3=y3y4=y4y5 and x1x2 › x2x3 › x3x4 › x4x5 as depicted in fig.5.6.
fig.5.6
The principle of diminishing marginal rate of substitution explains the convex nature of
indifference curves. The curve is convex towards its origin point. As the curve moves
down towards the right, its slope tends to get flatter meaning that the rate at which
additional unit on the x axis is compensated by units of commodity on y axis goes on
diminishing.
5.2.6 Properties of indifference curves-

Properties of indifference curves are based on the assumptions of the indifference curve
approach.
1. Slope of indifference curve is downwards from left to right- the indifference curve has
a negative slope. This property reflects that any increase in the quantities of one good
leads to a decrease in quantity of the other good. This property rests on the assumption
that marginal utilities of both the goods are positive. Addition to total utility due to
increase in one commodity needs to be offset with equivalent decrease in total utility by a
reduction in the amounts f the other commodity. In any case the total utility or
satisfaction will remain unchanged.
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Indifference Cure
Analysis
2. Indifference curves are convex towards the origin- they are convex to the point of
origin of the two axes. The curve is relatively steep in its left portion and tends to flatten
as it moves towards the right. As we move along the curve from left to right the absolute
slope decreases. This property is based on the law of diminishing marginal rate of
substitution. As the consumer decreases his consumption of commodity y and increases
that of x, his desire for more units of commodity x tends to decline on a continuous basis.
3. Indifference curves can never intersect each other- this assumption is based on the
reasoning that each indifference curve represents a different level of satisfaction and each
point on one single curve gives an equal satisfaction level. If the curves intersect it would
mean that indifference curves representing different levels of satisfaction are showing the
same satisfaction level at the point of intersection which is a contradiction to the very
idea of indifference curve.
4. Higher the indifference curve higher is the level of satisfaction- if the indifference
curve is closer to the point of origin it would imply that we have lesser combination of
both the commodities. An indifference curve farther from the point of origin would depict
larger combinations of commodities. Larger combinations would naturally provide
greater satisfaction to any consumer. By this logic the higher the indifference curve,
higher will it stand in the consumer’s preferential order. If we refer to indifference map in
figure 5.3, curve IC4 will indicate highest level of satisfaction followed by IC3 then IC2
and IC1 will offer least level of satisfaction.
5.2.7 Exceptional shapes of indifference curves

Based on empirical premise of diminishing marginal rate of substitution indifference
curves are convex to the origin. There are exceptional situations where the shape of
indifference curve may be different as in the condition when two commodities are perfect
substitutes of each other. Two goods are considered perfect substitutes of each other if
they can be used in place of one another with equal ease to satisfy consumer want. The
consumer is willing to forgo the same quantity of one good for each additional unit of the
other good. In this case the marginal ate of substitution between the two goods would be
constant and hence the indifference graph would not be a curve but a line as in fig. 5.7. In
this figure x1x2=x2x3=x3x4=x4x5 and y1y2=y2y3=y3y4=y4y5. The consumer is willing to give
up equal amounts of y to obtain each additional unit of x and vice versa. In practical life
two goods are not and cannot be perfect substitutes of each other
fig. 5.7 perfect substituion
commodity y
commodity x
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Business Economics
The second condition of exceptional shape of indifference curve could be when two
goods are perfectly complementary to each other and are consumed in fixed proportions.
MRS between such commodities would be zero. A consumer would want fixed amounts
of both goods to give him satisfaction. An increase in demand on one would imply an
increase of similar quantum in another. For example if a caterer purchases ten gas stoves
for ten of his kitchen outlets he needs to purchase ten gas cylinders as well. He cannot
manage with 15 gas stoves and 5 gas cylinders or 12 gas cylinders and 8 gas stoves. This
shows that the satisfaction level cannot be maintained by the addition of some units of x
at the cost of some units of y. The rate of substitution in this case would be infinite. The
indifference curve for perfect complements would be L shaped as shown in fig. 5.8
Y
Commodity x
Perfect complements Fig.5.8
A third condition would be for a commodity that offers zero utility to a consumer. For a
teetotaler alcohol has zero utility, he will hence not sacrifice even a small amount of one
good say fruit juice for alcohol. Indifference curves for commodities with zero utility are
parallel to that commodity’s axis as shown in fig. 5.9
fig. 5.9 zero utility
fruit juice
IC1
IC2
alcohol
A fourth condition could be when one of the goods involved is an absolute necessity. For
every human being water is an absolute necessity. If a human being is made to consume
less quantity of water larger amounts of other commodities would be needed to offset the
loss of water. A fifth condition of exceptionality could be when a good provides negative
utility after a certain level of consumption. If a consumer goes on consuming more and
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Analysis
more units of a commodity like a mango, tea etc. the marginal utility from successive
units goes on diminishing. But a saturation point may be reached when consumption
beyond it may yield negative utility.
Activity 1
1. What is indifference map?
2. What is the law of diminishing marginal rate of substitution
3. What are the properties of indifference curve?
4. What are the different exceptions to the indifference curve?
5.3 BUDGET LINE
The indifference curve studied so far does not throw light on which combination of goods
will offer the consumer the best bargain for his money. For predicting consumer behavior
two categories of information is significant for the consumer apart from his well defined
preference pattern. One is the income and the other is the price of commodity. A budget
line shows all the combinations of the two commodities which the consumer can buy by
spending his entire income for the given prices of the two commodities. Let us suppose a
consumer has Rs.100 to be spent on two commodities x and y. supposing the price of x is
Rs. 10 per unit while that of y is Rs.5 per unit. With his available Rs. 100 he can either
buy 10 units of commodity x or either 20 units of commodity y and he will be left with
zero Rs. the budget line has been drawn in fig. 5.10. The consumer can choose any
combination on the budget line when he spends some amount on one good and remaining
on the other. That is he could either purchase 5 units of commodity x for Rs. 50 and 10
units of commodity y for Rs.50. the budget line indicates that the consumer cannot chose
any combination of commodities beyond this line. Any point below the line would mean
that his available money income has not been spent fully. The budget line is also called
the consumption possibility line as it represents the different possibilities of the two
goods that can be purchased.
fig.5.10 budget line
25
20
commodity y
15
10
5
0
commodity x
5.3.1 Shift in budget line-

When the price of commodity x changes and the income and price of other commodity
are constant in that case the budget line will shift at its end touching the x axis as shown
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Business Economics
in fig.5.11. If the price of x decreases the consumer will be in a position to purchase more
of x in which case the budget line shifts outward at B1. In case the price of x rises the
budget line will move inwards at B2.
Fig. 5.11 budget line shifts
commodity y
B2
B1
commodity x
5.3.2 Effect of income change

If the income of the consumer changes the new budget line formed would be parallel to
the original budget line because change in income will not affect the price ratio of the two
commodities. The slope of the budget line would not change. The new budget line would
be either to the left or right of the original depending on whether the income has
increased or decreased. It is obvious that budget line for raised income would be towards
right of original while that with reduced income would be towards left of original budget
line. Farther away the line is from the point of origin it would indicate greater capacities
to purchase both of commodity x and commodity y.
5.3.3 Effect of price change

If the price of the commodity changes while the income remains constant, the budget line
will change due to the fact that price change would affect the price ratio and consequently
the slope of the budget line. If the price of commodity x falls, the price ratio between x
and y will change. The intercept to the new budget line on y axis will remain unchanged,
while on the x axis it will shift to the right as there will be different slopes corresponding
to respective price changes. A reduction in price of x would mean that the consumer
would purchase more of x. Similarly if the price of y reduces while the price of x and
income remains constant, the intercept of the budget line on the x axis would remain the
same, while the slope of the line will change to cut y axis at different points. This is
shown in fig. 5.12
fig. 5.12 effect of fall in price of y
B3
commodity y
B2
B1
commodity x
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Indifference Cure
Analysis
If the prices of both the commodities change in similar proportion with no change in
income, the effect will be the same as rise and fall in money income. If the prices of both
goods are doubled, the consumer will be in a position to purchase exactly half of what he
would have got previously. Consequently the budget line will shift inwards and have the
same slope as the original budget line. In case the price of both gods is halved the new
budget line will shift outwards or towards the right of the original. In the situation of
doubling of money income as well as doubling of prices of both goods there will be no
change in budget line as the equal positive aspect of income would be neutralized by
equal negative aspect of the prices
5.3.4 Effect of real life income change and money income change
Money income represents a consumer’s income in terms of monetary unit or currency
while real income represents the purchasing power of a consumer’s money income. A
rise in income by 30% along with rise in 30% prices keeps a consumer’s purchasing
power or real income constant. The budget line will also remain the same.
5.3.5 Kinked budget line

In some situations a budget line may not be a straight line but may take a kinked shape as
in the case when a part of consumption of commodity takes place at one price while the
remaining part is consumed at a different price. Let us illustrate this with an example. We
often come across sale techniques when the seller sells a particular set unit or a slab of a
commodity at a fixed price per unit, any consumption beyond this fixed unit is priced at a
lesser price or greater price as in our electricity bills. The money income remaining the
same whether the part of consumption is priced at higher or lower side, the budget line
derived in these cases turn out to be kinked and not straight.
Fig.5.13 kinked budget line
250
200
commodity y
150
100
50
0
commodity x
5.3.6 Consumer equilibrium

The indifference map and budget line are independent of each other as long as the
consumer does not begin purchases. Both these tools are though relevant in determining
consumer equilibrium or in predicting what the consumer will purchase actually so as to
meet his needs and interests to the maximum level. The consumer who wants to get the
most of his income would choose as high a curve as his purchasing power permits. For
obtaining consumer’s equilibrium the budget line is superimposed upon the indifference
map. The consumer is considered to be in equilibrium when he maximizes his satisfaction
subject to his income constraint. Consumer equilibrium is illustrated in fig.5.15.
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Business Economics
Fig.5.14 consumer equilibrium
IC1
commodity y
IC2
IC3
IC4
budget line
commodity x
AB is the budget line. The consumer is free to choose any combination of x and y. all
combinations of commodities beyond the budget line are not within the capacity of the
consumer. That is the curves IC3 and IC4 are beyond the reach of consumer. The
consumer will not choose any combination below the budget line as it will not provide
him maximum satisfaction. The consumer equilibrium must therefore lie on the budget
line. Points c and d lie on the budget line but they will not provide maximum satisfaction
since these points also lie on a lower indifference curve IC2 as compared to curve IC3.
IC3 is the highest curve that the consumer can reach with his budget constraints. The
budget line touches this curve at point e. This point e is thus the point of consumer
equilibrium. All other points on the budget line to left of point e lie on lower curves and
show lower levels of satisfaction. Thus with the budget constraints, the consumer
maximizes his satisfaction at that point where the budget line forms a tangent to the
indifference curve. It is clear that budget line can be tangential to only one indifference
curve of all the curves in an indifference map. Consumer’s equilibrium essentially
involves two conditions-
1. First order condition- at the equilibrium position, budget line is tangent to the
indifference curve. Hence the slope of the budget line should be equal to the
slope of the indifference curve and both slopes are negative. That is Px = MRSxy
Py
which means that the ratio of prices between two goods is equal to the marginal rate of
substitution of commodity x for commodity y. This implies that at equilibrium the rate at
which a consumer can exchange y for x should be equal to the rate at which he is willing
to substitutes y for x.
As MRSxy = MUx/ MUy the equation can be written as Px = MUx
Py MUy
This shows that at equilibrium the marginal utilities of the two commodities are
proportional to their respective prices. This further means that a rational consumer can
maximize his utility by allocating his income between the two commodities in such a way
that the marginal utility per unit spent on commodity x equals the marginal utility per unit
spent on commodity y.
2. Second order condition- at the point of consumer equilibrium the indifference

curve is convex to the origin which shows the MRS to be diminishing. If the
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Indifference Cure
Analysis
indifference curve is not convex but concave to the origin at the point where the
budget line is tangent o the curve, the consumer equilibrium cannot be stable.
Fig.5.15
commodity y
IC2
IC3
budget line
commodity x
At point p the indifference curve is concave which means that he MRS is increasing
which is a contradiction to obtaining equilibrium. The consumer would be increasing his
satisfaction level if he moves to any point on the budget line and also reach a higher
curve at the same time. The point p hence does not stand for a stable equilibrium position
for the consumer.
Activity 2
1. What do you understand by budget line and shift in budget line?
2. What is the effect of income change and price change on budget line?
3. Illustrate a condition when we could get a kinked budget line
5.4 EFFECT OF PRICE AND INCOME CHANGES
As discussed in the previous section a change in price and income may bring about
increase or decrease in a consumer’s level of satisfaction. These have been listed below
under three heads price effect, income effect, substitution effect.
5.4.1 Price effect

This effect assumes a. Money income of the consumer remains unchanged. b. Absolute
price of the commodity y remains unchanged. c. Absolute price of commodity x changes.
In fig. 5.16 P1 is the equilibrium point of the consumer, where the budget line B1 is
tangent to IC1. The consumer consumes OY1 units of y and OX1 units of x. Assuming that
price of y is constant, if the price of x falls, the consumer’s budget line would shift
outwards to B2 and his new equilibrium is obtained at P2. With successive decreases in the
price of x the consumer’s budget line keeps shifting further outwards. This can lead to
two results-
(a) Commodity x has become cheaper in absolute terms or the consumer’s real
income in terms of x has increased.
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Business Economics
(b) Commodity y has become expensive in relative terms and so the consumer will
purchase less of y.
Fig. 5.16 price consumption curve
commodity y
B2
B3
B4
commodity x
The consumer will purchase less and less of y i.e. he will move from OY 1 to OY2 to OY3
and purchase more and more of x i.e. from OX 1 to OX2 to OX3. However a point will be
soon reached when the consumer would prefer to spend that part of his income that was
saved due to fall in x on commodity y. This is due to the fact that with diminishing units
of y, the marginal significance of y may rise, while increased quantity of purchased x
commodity will result in lesser want of x. this shows that after a point-
(i) the consumer prefers to have more of commodity x
(ii) and more of commodity y also.
In the fig. 5.16 we find that on the budget line B4 the combination chosen is OX4 and
OY4. Quantities of both the commodities in the combination marked as P4 is more in
comparison to the combinations marked on the points P 2 and P3. By joining the
equilibrium points P1 P2 P3 P4 we obtain the price consumption curve, PCC or price
consumption line. A price consumption curve for x shows how changes in the price of x
affect the quantity of x purchased, when the price of y and money income are constant.
5.4.2 Income effect

A consumer’s equilibrium point is affected by the change in the level of money income
which will also affect his budget line. Income effect assumes a. price of both x and y are
constant. b. both x and y are equally preferred i.e. both are superior or normal goods. In
fig. 5.17, below the consumer’s equilibrium point is P 1 here the budget line B1 is tangent
to IC1. The consumer consumes OX1 of x and OY1 of y. if the money income increases his
budget line shifts outwards to B2. The new budget line is tangent to IC2 and equilibrium
shifts to P2. With successive income increase thus the consumer is able to have both x and
y in equal increased amounts. Also the level of satisfaction keeps rising with income rise.
When we join the various equilibrium points we obtain the income consumption curve or
income consumption line.
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Indifference Cure
Analysis
Fig.5.17 income consumption curve
commodity y
B3
B2
B1
commodity x
5.4.3 Equivalent and compensating variations

Income effect of a price change may be explained in terms equivalent variation and
compensating variation.
Fig. 5.18
B
commodity y
B1
IC2
IC1
commodity x
Equivalent variation refers to a change in income that leaves the consumer with just as
much money as with some change in price of any commodity. It answers the problem on
how much extra money should be provided to a consumer so that he may feel just as rich
as a fall in price of a good. Fig. 5.18 shows that if the price does not fall, the consumer
should be given extra money so that his budget line shifts to B2 and he is able to obtain
equilibrium on higher IC that is IC2.
Compensating variation refers to variation in income which leaves the consumer neither
better off nor worse off. The consumer’s income here is withdrawn such that he
maintains the same level of satisfaction as before.
Fig. 5.19
B
commodity y
B1
IC2
IC1
commodity x
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Business Economics
If the price of x falls as shown in fig. 5.19 the budget line shifts outwards to B1. The new
equilibrium is on IC2. To maintain consumer’s wellness in terms of money, his income
should be withdrawn so that the new budget line B2 touches the original curve IC1
5.4.4 Derivation of Engel’s curve or income demand curve

An Engel’s curve expresses the relation between the income of a consumer and the
quantity demanded of a commodity. Let us refer to the ICC in fig. 5.17. Corresponding to
three different levels of income say 100, 150 and 200 respectively, the price of x would
be 100/4, 150/6, 200/8 respectively i.e. constant at Rs. 25 while price of y would be
100/10, 150/15 and 200/20 i.e. Rs.10 each. If we draw three perpendiculars on y axis
corresponding to the three levels of income. By joining the points at the three origins we
derive the Engel’s curve shown in Fig. 5.20. If in a combination of goods, both are
equally preferred Engel’s curve will have a positive slope otherwise its slope is negative.
Fig. 5.20 Engel’s Curve
5.4.5 Inferior goods and income effect

By inferior good we mean a commodity of which a lesser quantity is purchased when the
level of money income goes up. If either of the commodities is inferior, the effect of the
rise in income would be (a) the consumer will prefer less of the inferior good and shall
substitute more of the superior good for inferior. (b) with the substitution of the superior
good for the inferior, the consumer shall reach higher level of satisfaction.
This type of effect is called as negative income effect.
5.4.6 Shapes of income consumption curve

An ICC originates from the point of origin and moves upwards up to a point, indicating
that at very low levels of income, income effect is always positive, irrespective of the fact
that both commodities are equally preferred or not. Only at higher levels of income ICC
may bend backwards or downwards, if one of the commodities is an inferior commodity
to show the negative income effect.
5.4.7 Substitution effect-

There may arise a condition when the consumer’s money income may reduce but this
reduction is compensated by an increase in the consumer’s real income due to fall in the
price of any of the commodities. These variables change in such a way that the
consumer’s equilibrium is remains on the same IC.
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Indifference Cure
Analysis
Activity 3
1. What is an income consumption curve?
2. What is a price consumption curve
3. What are equivalent and compensating variations?
4. How is Engel’s curve derived?
5. What is substitution effect?
5.5 LET US SUM UP
In ordinal approach utility is not measured but emphasis is made on comparing different
levels of satisfaction so that the consumer achieves maximum satisfaction. An
indifference curve shows the various alternative combinations of the goods, which
provide same satisfaction level to the consumer. It is a graphical representation of an
indifference schedule that shows all combinations of goods offering same satisfaction
levels. Indifference map is a collection of indifference curves corresponding to different
levels of satisfaction. Higher the curve it means higher units of both commodities and
consequently higher levels of satisfaction.
Marginal rate of substitution is the rate at which a consumer can exchange a small
amount of one commodity for a small amount of another commodity without affecting
his total utility. The principle of diminishing marginal utility states that with every
increase in the quantity of commodity x, the consumer shall be willing to forgo only
lesser quantity of commodity y. The principle of diminishing marginal rate of substitution
explains the convex nature of indifference curves. The curve is convex towards its origin
point. As the curve moves down towards the right, its slope tends to get flatter meaning
that the rate at which additional unit on the x axis is compensated by units of commodity
on y axis goes on diminishing. There are exceptional situations where the shape of
indifference curve may be different as in the condition when two commodities are perfect
substitutes or perfect complements of each other. A third condition would be for a
commodity that offers zero utility to a consumer. A fourth condition could be when one
of the goods involved is an absolute necessity. A fifth condition of exceptionality could
be when a good provides negative utility after a certain level of consumption.
A budget line shows all combinations of two commodities which the consumer can buy
by spending his entire income for the given prices of the two commodities. When the
price of commodity x changes and income and price of other commodity are constant in
that case the budget line will shift at its end touching the x axis. If the income of the
consumer changes the new budget line formed would be parallel to the original budget
line because change in income will not affect the price ratio of the two commodities.
Farther away the line is from the point of origin it would indicate greater capacities to
purchase both of commodity x and commodity y. If the price of the commodity changes
while the income remains constant, the budget line will change due to the fact that price
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Business Economics
change would affect the price ratio and consequently the slope of the budget line. If the
prices of both the commodities change in similar proportion with no change in income,
the effect will be the same as rise and fall in money income. In some situations a budget
line may not be a straight line but may take a kinked shape as in the case when a part of
consumption of commodity takes place at one price while the remaining part is consumed
at a different price. For obtaining consumer’s equilibrium the budget line is superimposed
upon the indifference map. The consumer is considered to be in equilibrium when he
maximizes his satisfaction subject to his income constraint. Budget line can be tangential
to only one indifference curve of all the curves in an indifference map.
Price effect assumes money income of the consumer remains unchanged, absolute price
of the commodity y remains unchanged, absolute price of commodity x changes. Income
effect assumes price of both x and y are constant, both x and y are equally preferred.
Equivalent variation refers to a change in income that leaves the consumer with just as
much money as with some change in price of any commodity. An Engel’s curve
expresses the relation between the income of a consumer and the quantity demanded of a
commodity.
5.6 KEY WORDS
 Ordinal approach- ordinal approach implies that utility is not measured but
emphasis is made on comparing different levels of satisfaction so that the
consumer achieves maximum satisfaction.
 Indifference curve- It is a graphical representation of an indifference schedule
that shows all combinations of goods offering same satisfaction levels.
 Marginal rate of substitution – it is the rate at which a consumer can exchange a
small amount of one commodity for a small amount of another commodity
without affecting his total utility.
 Budget line- it represents the purchasing power or opportunities open to the
consumer in the market, with his available income and given price of
commodities.
 Equivalent variation – it refers to a change in income that leaves the consumer
with just as much money as with some change in price of any commodity.

1. a consumer is in equilibrium at the point of tangency of his indifference curve
and price line because
(a) he cannot go below it (b) he cannot go beyond it
© he cannot go along it (d) none of the above
answer b
2. a fall in price of a commodity leads to
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Indifference Cure
Analysis
(a) a shift in demand (b) a rise in real income

© a fall in demand (d) none of the above
answer b
3. on an indifference curve MRS falls while
(a) moving upwards (b) moving downwards
© in the centre (d) none of the above
answer b
4. if a fall in price of y results in fall in sale of x, the two goods are
(a) substitute goods (b) complementary goods
© inferior goods (d) superior goods
answer a

1. Explain diagrammatically the concept of indifference curve through a schedule.
2. Describe consumer equilibrium with indifference curve and budget line.
3. Describe effect of price and income changes.

5. Micro Economics and Applications, D.N Dwivedi, Vikas Publications
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Business Economics
UNIT 6 CONSUMER DEMAND
Structure
6.0 Introduction
6.1 Objectives
6.2 The statement of consumer demand
6.2.1 Individuals and motives
6.2.2 Meaning of consumer demand
6.2.3 Determinants of Demand
6.2.3.1 Price of the commodity
6.2.3.2 Prices of other related goods
6.2.3.3 Income of the consumer
6.2.3.4 Tastes and preference of the consumer
6.2.3.5 Other factors of consumer demand
6.2.4 Demand function
Activity 1
6.3 Law of consumer demand
6.3.1 Demand schedule
6.3.2 Demand curve
6.3.3 Downward slope of demand curve from left to right
6.3.4 Exceptions to the law of demand
Activity 2
6.4 Change in demand versus change in quantity demanded
6.4.1 Change in quantity demanded
6.4.2 Change in demand or shift in demand curve
6.4.2.1 Increase in demand
6.4.2.2 Decrease in demand
6.4.2.3 Difference between increase and expansion in demand
6.4.2.4 Difference between decrease and contraction in demand
Activity 3
6.5 Let us Sum Up
6.6 Key Words
Terminal Exercises
6.0 INTRODUCTION
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Consumer Demand
Consumer‟s demand goods since they have utility. As long as the good is satisfying the
want of an individual it will be demanded. An alcoholic will demand alcohol but not a
teetotaler as he has no want for it. In economics however every want of a consumer may
not be expressed as demand. Demand does not necessarily mean just desire for a good.
An individual stingy in terms of money may hold desire to not pay for his utility bills but
these desires are not demand. A slum dweller may desire to own a bungalow, but this
desire of his will not affect the market price of the bungalow for the simple reason that
the slum dweller lacks purchasing power to purchase the bungalow. Any desire which is
not supported by the required purchasing power will remain a desire only and never
become demand. It follows that to become demand a desire must be supported by
necessary purchasing power to spend on the good and the consumer‟s willingness to
spend on the good. A demand is thus effective desire and a demand that cannot be met
due to limitedness of capacity is known as insatiable demand.
6.1 OBJECTIVES

 Understand consumer demand and determinants of demand
 Understand law of consumer demand
 Understand the nature of slope of demand curve
 Understand change in demand versus change in quantity demanded
6.2 THE STATEMENT OF CONSUMER DEMAND
Consumer demand is defined with reference to price and time period otherwise it stands
meaningless. A statement like demand for milk is 200 liters has no meaning unless the
price at which it is demanded is mentioned as with price change quantity demanded may
change. As for the time aspect, at Rs. 48 per liter the demand for milk may be different at
different times during a particular period. Consumer demand for a good may be defined
as the quantity of a commodity that a consumer will purchase at a particular price and
during a given time period.
6.2.1 Individuals and motives

the demand for goods and services is made by individuals who earn and spend that
income on goods and services. Every individual consumer seeks to maximize his
satisfaction or utility with a given level of income. Based on preference of goods the
consumer decides on how much money to spend on what such that his satisfaction is at
maximum.
6.2.2 Meaning of consumer demand

Consumer demand for a commodity means the number of units of a particular commodity
or service that the consumer is willing and is able to purchase at a specific point of time.
Quantity demanded is not the same as demand. It implies the amount of a commodity that
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Business Economics
a consumer is willing to purchase per period of time at a given price. And demand
describes the behavior of consumers at every conceivable price. Two aspects are involved
in this understanding- (a) quantity demanded is the desired quantity that a consumer
wishes to purchase and not the quantity actually bought. (b) Quantity demanded is a flow
meaning that it is a stream of purchases per period of time and not purchases at one point
of time. To illustrate it is not sufficient to state that a consumer wishes to purchase four
kgs of cooking oil. He ought to state whether he wishes to purchase four kgs of cooking
oil per week, per month or per year. A flow variable involves time dimension- how much
per unit of time. A stock variable is independent of time. It is how much of something at
one point of time and not per unit of time. Also quantity demanded is expressed with
reference to a given price. Quantity demanded of a commodity is the amount of the
commodity a consumer is willing to purchase per unit of time at a given price.
6.2.3 Determinants of demand-

There are various factors which determine the demand for a commodity. These are
6.2.3.1 Price of the commodity

Other things remaining the same; demand for a commodity depends on its own price.
This relationship is studied under the head law of demand. Price and quantity demanded
are inversely proportional to each other. This is known as price demand.
6.2.3.2 Prices of other related goods

Other things remaining the same, demand for a commodity is dependent on the price of
other related commodities. There are two kinds of related commodities complementary
goods and competitive or substitute goods. Complementary goods are those goods which
are used jointly with each other. Change in the price of holders will affect the price of
LED bulbs. LPG and gas stoves, toothbrush and toothpastes, diesel and trucks, inverter
battery and inverter are sets of complementary goods. This type of relationship is called
inverse relationship and is represented by a downward sloping demand curve depicted in
fig. 6.1
fig. 6.1 complementary goods
price of inverter batteries
quantity of inverters
Competitive goods are those goods that can be substituted for each other as these goods
can satisfy the same need. Change in the price of a commodity affects the demand for the
related commodity. If the price of soya milk falls consumers may substitute soya milk for
cow milk. Demand for cow milk consequently will fall even though its price has not
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Consumer Demand
changed. This type of relationship is known as direct relationship and is shown in fig. 6.2
as an upward sloping demand curve. Relationship between demand for a commodity and
price of the related commodity is also called cross demand.
fig. 6.2 substitute goods
quantity of cow milk
price of soya milk
6.2.3.3 Income of the consumer

Other things being equal demand for a commodity depends upon the level of household‟s
income. An increase in income usually leads to increase in demand of goods though this
may not always hold true. Goods can be classified as necessaries, comforts and inferior
goods. Necessaries are essential for human existence. They hold a priority position in any
consumer‟s order of preference. Even at lower level of income, a major portion of income
s spent on necessaries. With increase in income it is possible that a consumer‟s demand
for necessaries may increase but this increase has a finite end to it. In other words beyond
a level of income the consumers demand for necessaries assume income elasticity
meaning they are not affected by increase in income any more as in fig. 6.3
Quantity is measured along x axis and income along y axis the curve O represents the
relationship between level of income and quantity demanded for necessaries of life.
Beyond the income level the curve becomes a vertical straight line showing that any more
increase in income has no affect on demand of quantity. Demand for comfort and
luxuries have a positive relation with income. It increases with rise in income level. It is
shown by curve in fig. 6.3. Quantity demanded increases with income increase and hence
the curve foes upwards towards the right. Demand for inferior commodities is inversely
related to level of income. Increase in level of income means that the consumer will
consume expensive and better quality or branded commodities and avoid cheap ones. If
we start with zero income level, it is possible that with rise in income the consumer‟s
demand for inferior goods may rise but this will happen only up to a point further income
increase beyond which will lead to fall in inferior goods quantity demanded as shown in
the curve. The relationship between demand for a commodity and household‟s level of
income is called income demand.
6.2.3.4 Tastes and preference of the consumer

Other things being the same demand for a commodity depends upon consumer‟s tastes
and preferences which includes all nonmonetary determinants of demand like occupation,
age, family composition, community size, rationality. These factors remain by and large
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Business Economics
stable for a larger community of consumers and hence are clubbed together. Any change
in tastes will directly affect the demand for affected commodities.
6.2.3.5 Other factors of consumer demand
Other things remaining same the demand for a commodity is also determined by size of
population, composition of population, distribution of income and environmental factors.
Larger population would mean more demand for goods. If the population has more of
children as compared to adults there will be naturally more demand for children related
products. If there is equal distribution of income across the various segments of the
population, all segments will be able to demand goods. Environmental factors include
season and exogenous factors like droughts, floods etc. AC‟s are in demand in summer
season and geysers are in demand in winter.
6.2.4 Demand function

The above text makes it clear that there are various factors which determine demand for a
commodity. These determinants can be summarized or put together in the equation for
demand function as follows- Dn= f (Pn, Pr, Y, T, S),
Where Dn is the quantity demanded for good n, Pn is the price of related goods, y is the
money income of consumer, t is the tastes of consumer, and s is the individual specific or
environmental factors. The demand function explains the relationship between variables
involved in influencing demand. Left side variable is the quantity demanded and is a
dependent variable. Variables on right side are independent variables. The effect of all the
variables cannot be considered simultaneously while determining demand. Only one
variable is considered at one time keeping all other variables constant. The constancy of all
other factors is labeled “ceteris paribus” which in English means „other things being equal‟.
Activity 1
1. What do you understand by consumer demand?
2. What are the determinants of demand?
3. What is demand function?
6.3 LAW OF CONSUMER DEMAND
Law of consumer demand expresses the functional relationship between the price of a
commodity and its quantity demanded. A fall in the price of a good either makes a
consumer to purchase that good or purchase more of that good if it has already been
purchased. Price and demand share an inverse relationship. Similarly when the price rises
quantity demanded falls. If demands fall due to price rise, prices are usually brought
down by manufacturers to induce demand. The law of demand states that, other things
being equal, at a higher price, consumers will purchase less of a commodity while at a
lower rice consumers will purchase more of it.
6.3.1 Demand schedule
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Consumer Demand
A demand schedule is a table that expresses the different quantities of a commodity that
would be demanded at different prices. There are two kinds of demand schedule-
individual demand schedule and market demand schedule.
1. Individual demand schedule- it is a numerical table that shows the quantity that will
be demanded at selected prices. Supposing a family consumes 5 kgs of cheese at
Rs.500/- per month. If the price of cheese goes up to Rs.700, the family may not
afford more than 3 kgs. More the rise in price, lesser and lesser will be the
consumption quantity of the family. We may tabulate this demand behavior of the
family as shown in table 6.1
Table 6.1 Individual Demand Schedule
Price of cheese in Rs. Quantity demanded in kgs.
500 5
600 4
700 3.25
800 3
2. Market demand schedule- this states the quantities of a commodity that not one consumer
but all the consumers in the market will buy at different prices. Market demand schedule
is derived from the individual demand schedule. Two methods can be applied to obtain
the market demand schedule- additive method and multiplicative method.
Table 6.2 Market Demand Schedule
Price of cheese Quantity demanded by individual Total quantity
households in kgs demanded
st nd
Rs. 1 2 3rd 4th
500 5 4 6 7 22
600 4 3.25 5 5.5 17.75
700 3.25 2.75 4.25 5 15.25
800 3 2.5 3.5 4.25 13.25
As per the additive method market demand schedule is a sum total of individual demand
schedules. A basic limitation of this addition method is its cumbersomeness and practical
complexity.
In multiplicative method individual demand schedules for a particular commodity are not
determined. An average consumer demand schedule is estimated for a commodity and then
quantities being demanded by the consumer are multiplied at different prices by the estimated
number of total consumers of this commodity. This method is illustrated in table 6.3
Average consumer’s Market demand (b) (Q x no.

demand (a) of consumers)
Price in Rs. Quantity in kgs Price in Rs. Quantity in kgs
500 5 500 25000000
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600 4 600 30000000

700 3.25 700 35000000
800 3 800 40000000
Let us suppose that for an average consumer demand schedule of cheese is as shown in
part a of table 6.3 and there are 50,000 consumers of cheese in a particular market. The
total demand for cheese will then be as shown in part b of the table. It can be seen in the
market schedule that an increase in the price of a commodity leads to reduction in
demand as in the case of individual demand schedule.
6.3.2 Demand curve

a demand curve is nothing but a graphical representation of a demand schedule. As it
shows the inverse relationship between price and quantity demanded it slopes downwards
towards the right. In other words it has negative slope. Any single point n the curve
represents a single price quantity value. The curve is shown in fig. 6.4 and it as a whole
expresses the total relationship between quantity demanded and price.
fig. 6.4
price per kg
demand
curve
quantity in kgs
Market demand curve is the horizontal sum total of the demand curves of all the
consumers in market as shown in fig. 6.5. Let us take two individual households and
draw curves for them. The two curves have been put together to form a third curve which
is the market demand curve.
6.3.3 Downward slope of demand curve from left to right-

Downward slope of the demand curve shows that the relationship between price and
quantity demanded is inverse. Demand of a commodity is more at a lower price and less
at a higher price. This consumer behavior has been explained in traditional theory of
demand and modern theory of demand. As per the Marshallian utility analysis, the factors
responsible for the downward slope are.
(a) law of diminishing marginal utility- the law of demand is based on the law of
diminishing marginal utility states that with successive increases in the units of
consumption of a commodity, every individual unit of that commodity provides lesser
satisfaction to the consumer. The aim of a consumer is to maximize his satisfaction which
is done by equalizing marginal utility of the commodity with its price. This equality will
be attained sooner at a higher price than a lower price. Let us illustrate this by taking the
following household schedule as in table 6.4
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Consumer Demand
Units of bananas Marginal utility in Rs.
1 6
2 5
3 4
4 3
5 2
6 1
7 0
In table 6.4 when the price of bananas is Rs. 2 each, the household will purchase 5
bananas. If the price increases to Rs.5 in order to equate the new price with the marginal
utility, the household will purchase 2 bananas. It shows that lesser units will be demanded
at higher price. Demand curve can also be obtained graphically from the marginal utility
curve as shown in fig. 6.6
fig. 6.6
marginal utility and price
MU
quantity
(b) change in the number of consumers- a fall in the commodity price increases the
number of households which demand it in the market and vice-versa.
© diverse use of commodity- there are some commodities which can be used for diverse
purposes like electricity is used for many purposes. At a lower price the commodity will
be demanded for variety of uses. At a higher price the commodity will be used for only
the essential or unavoidable purposes.
According to the modern theory of demand price effect is treated as the sum of the
income effect and the substitution effect. Any change in the price of a commodity affects
the purchasing power or real income of the household. A fall in price brings about an
increase in real income and vice-versa. A rise in real income leads to increased
consumption and greater demand or the commodity. As for substitution effect, when the
price of a commodity increases the relative price of its substitute diminishes
automatically i.e. its substitutes become cheaper. The household will purchase more of a
commodity that has become cheaper.
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Business Economics
6.3.4 Exceptions to the law of demand

The demand curve normally slopes downwards from left to right stating that demand
rises as price falls. There may however be instances when the opposite occurs. These
situations constitute the exceptions to the law of demand. More is purchased at higher
price and less at lower. The demand curve here has an upward slope from left to right.
Some of these exceptions could be:
(a) giffen goods- this name is attributed to Sir Robert Giffen to denote a type of goods
whose demand rises with price rises. Demand for an inferior good falls with a fall in its
price and rises with price rise. Price change leads to a change in the real income of the
consumer. When the real income of the consumer rises due to a fall in price, he
substitutes an inferior commodity by the superior commodity and when his real income
falls due to price rise, he tends to consume more of the inferior commodity. The resultant
demand curve moves upwards.
(b) conspicuous necessities- constant use of such commodities which have fashion or
prestige value attached become necessities of life. Price of LED‟s, smart refrigerators,
smart phones, AC‟s are too high and keep rising with time, but their demand never seems
to fall.
© goods for conspicuous consumption- more of commodities like diamonds; gems are
demanded when their prices go up by the richer sections of society. The law of demand
will not hold true in these cases.
(d) future changes in prices- when the prices keep rising consumers tend to purchase
larger quantities of the commodity due to the fear of further rise. And when prices are
expected to fall further consumers may hold on to purchasing any more units of the
commodity.
(e) emergencies- situations like floods, wars, drought etc. do not permit the operation of
law of demand. Households induce further price rises by making increased purchases
even at higher prices during these times.
(f) change in fashion- a change in fashion and tastes influence the market for a good. A
commodity in fashion will be demanded even at higher price as compared to a previous
version of the commodity priced low.
(g) ignorance- an ignorant consumer too tends to purchase more of a commodity at a

higher price for the simple reason that consumers perceive expensive goods to be better
quality wise.
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Consumer Demand
(h) share market- when the price of a particular share keeps falling, investors demand for
such a share falls. Increase in price of a share also brings an increase in its demand.
Activity 2
1. What is the law of consumer demand?
2. Explain downward slope of the demand curve.
3. List some exceptions where law of demand does not operate.
6.4 CHANGES IN DEMAND VERSUS CHANGE IN QUANTITY DEMANDED
A distinction needs to be made between change in demand and change in quantity

demanded. Change in quantity demanded is the rise and fall in the quantity demanded for
a change in the price of commodity. Change in quantity demanded relates to the law of
demand. Change in demand is related to factors other than price of a commodity or other
determinants of demand. When the quantity demanded of a commodity increases or
decreases because of factors like change in household income, family size, prices of
related goods, weather conditions etc. it is change of demand.
6.4.1 Change in quantity demanded

Change in demand can occur in two directions. When larger quantity of a good is
demanded at a lower price, it is referred to as expansion of demand or extension of
demand. Decrease in the quantity demanded of a commodity due to increase in its price is
contraction of demand. Both in expansion and contraction of demand, neither the demand
schedule nor the demand curve undergo any change. Expansion and contraction of
demand can be explained with the help of schedule below in table 6.5
Table 6.5 Original Demand Schedule
Price in Rs. Quantity (units) Reference point

100 50 A
Table 6.6 Revised Demand Schedule
Expansion Contraction
Price Quantity Reference point Price Quantity Reference point
75 65 B 125 40 C
Expansion and contraction of demand curve can be shown graphically which is called
movement along a demand curve.
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fig. 6.7
140
120
100
price in Rs.
80
60
40
20
0
quantity
6.4.2 Change in demand or shift in demand curve-

The demand schedule and the demand curve are drawn on the assumption of ceteris
paribus. But when other things undergo a change, the effect of factors other than the price
cannot be explained through the same demand schedule and demand curve. Due to
change in factors other than price, the demand may either increase or decrease.
6.4.2.1 Increase in demand-

An increase in demand is an increase in quantity demanded at each price which means
larger quantity of a commodity is demanded at the same price. Let us suppose that a
consumer is purchasing different quantities of good x at different prices with his fixed
monthly income. If his monthly income rises by 25%, he will naturally be able to
purchase larger quantity of good x at the same price. This is illustrated in table 6.6
Reference Price of x Quantity of x at Quantity of x at New reference

Combination Per unit Original level of New level of Combination
income income
A 25 60 65 A1
B 45 50 55 B1
C 65 40 45 C1
D 85 30 35 D1
E 105 20 25 E1
Increase in demand would make the demand curve shift to the right as shown in fig. 6.8
fig. 6.8 increase in demand

price in Rs.
DC
DC1
quantity
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Consumer Demand
6.4.2.2 Decrease in demand-

A decrease in demand is a fall in the quantity demanded at each price.
Table 6.8 decrease in demand
Reference Price of x Quantity of x at Quantity of x at New

combination Per unit original family new family size reference
size combination
A 40 35 27 A1
B 50 27 23 B1
C 60 23 21 C1
D 70 20 17 D1
Let us suppose that there are four members in a family. The monthly consumption of
good x at different prices is listed in table 6.7. The eldest child of the family relocates to a
new city for employment. With reduction in family members from 4 to 3 the demand
schedule that would change is again listed in the same table. The table shows that a fall in
number of family members leads to fall in quantity demanded at each price. Decrease in
demand would make the whole demand curve shift to the left as shown in fig. 6.9.
fig. 6.9 decrease in demand
price in Rs.
DC
DC1
quantity
1.4.2.3 Difference between increase and expansion in demand
Table 6.9:
Increase in Demand Expansion in Demand

It is caused due to increase in income, fall in It is caused due to fall in price of a
price of complementary goods, favorable weather good.
conditions, Increase in family size, favorable
taste changes.
It denotes rightward shift in demand curve. It denotes downward movement
along the same Demand curve.
It denotes rise in demand at same price. It denotes rise in demand due to price
fall.
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Business Economics
6.4.2.3 Difference between decrease and contraction in demand-
This difference is in table 6.10
Decrease in Demand Contraction of Demand

It is caused due to fall in income, fall in It is caused due to increase in price of a
price of substitute goods, unfavorable commodity
weather conditions, ceasing to be in
fashion, fall in family size
It denotes leftward shift in demand curve It denotes upward movement along the same
demand curve.
It denotes fall in demand at the same price It refers to fall in demand at a higher price
Activity 3
1. Distinguish between change in demand and change in quantity demanded.
2. Distinguish between increase and expansion in demand.
3. Distinguish between decrease and contraction in demand.
6.5 LET US SUM UP
Consumer demand for a commodity means the number of units of a particular commodity
or service that the consumer is willing and is able to purchase at a specific point of time.
Quantity demanded is not the same as demand. It implies the amount of a commodity that
a consumer is willing to purchase per period of time at a given price. And demand
describes the behavior of consumers at every conceivable price. Two aspects are involved
in this understanding- (a) quantity demanded is the desired quantity that a consumer
wishes to purchase and not the quantity actually bought. (b) quantity demanded is a flow
meaning that it is a stream of purchases per period of time and not purchases at one point
of time. Various factors which determine the demand for a commodity are price of the
commodity, price of related goods, income of the consumer, tastes and preference of the
consumer, size of population, composition of population, distribution of income and
environmental factors.
Law of consumer demand expresses the functional relationship between the price of a
commodity and its quantity demanded. A fall in the price of a good either makes a
consumer to purchase that good or purchase more of that good if it has already been
purchased. A demand schedule is a table that expresses the different quantities of a
commodity that would be demanded at different prices. A demand curve is a graphical
representation of a demand schedule. As it shows the inverse relationship between price
and quantity demanded it slopes downwards towards the right. Market demand curve is
the horizontal sum total of the demand curves of all the consumers in market. Demand of
a commodity is more at a lower price and less at a higher price. This consumer behavior
has been explained in traditional theory of demand and modern theory of demand. There
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Consumer Demand
are certain exceptions to the law of demand. The demand curve here has an upward slope
from left to right. Some of these exceptions could be giffen goods, conspicuous
necessities, conspicuous consumption, future price changes, emergencies, fashion,
ignorance, share market.
Change in quantity demanded is the rise and fall in the quantity demanded for a change in
the price of commodity. Change in quantity demanded relates to the law of demand.
Change in demand is related to factors other than price of a commodity or other
determinants of demand. When the quantity demanded of a commodity increases or
6.6 KEY WORDS

 Insatiable demand - A demand is thus effective desire and a demand that cannot
be met due to limitedness of capacity.
 Competitive goods- these are those goods that can be substituted for each other
as these goods can satisfy the same need.
 Cross demand- it is the relationship between demand for a commodity and price
of the related commodity.
 demand schedule - a demand schedule is a table that expresses the different
quantities of a commodity that would be demanded at different prices
 giffen goods- this name is attributed to Sir Robert Giffen to denote a type of
goods whose demand rises with price rises.
Terminal Exercises

1. a rightward shift in the demand of cheese could be predicted from
(a) fall in number of cheese consumers (b) a change in tastes
© a fall in the price of cheese (d) a rise in the price of butter
answer d
2. when we draw a market demand curve
(a) do not consider tastes, incomes and all other prices
(b) assume that tastes, income and all other prices are irrelevant
(c) assume that tastes, incomes and all other prices change in the same way
prices change
(d) assume that tastes, incomes and all other prices remain the same
answer d
3. all but one of the following are assumed to remain the same while drawing
individual‟s demand curve for a commodity. It is
a) individual‟s preference (b) income
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Business Economics
b) © price of commodity (d) price of related goods

answer c
4. The sentence demand for a commodity is elastic means
(a) The demand curve slopes downwards to the right
(b) More is sold at lower price
(c) A rise in price will increase total revenue
(d) Change in quantity sold is proportionately greater than the change in
price.
Answer d

1. Describe in detail the determinants of demand.
2. Describe through illustrations individual demand schedule and market
demand schedule.
3. Explain in detail shift in demand curve.
Activity 1
Answer 1- consumer demand is defined with reference to price and time period otherwise
it stands meaningless. Consumer demand for a good may be defined as the quantity of a
commodity that a consumer will purchase at a particular price and during a given time
period. - consumer demand for a commodity means the number of units of a particular
commodity or service that the consumer is willing and is able to purchase at a specific
point of time. Quantity demanded is not the same as demand. It implies the amount of a
commodity that a consumer is willing to purchase per period of time at a given price.
Answer 2- determinants of demand are price of goods, income of consumer, price of
other related goods, size of population, composition of population, distribution of income
and environmental factors.
Answer 3- that there are various factors which determine demand for a commodity. These
determinants can be summarized or put together in the equation for demand function as
follows- Dn= f (Pn, Pr, Y, T, S), Where Dn is the quantity demanded for good n, Pn is the
price of related goods, y is the money income of consumer, t is the tastes of consumer, s
is the individual specific or environmental factors. The demand function explains the
relationship between variables involved in influencing demand. Left side variable is the
quantity demanded and is a dependent variable. Variables on right side are independent
variables. The effect of all the variables cannot be considered simultaneously while
determining demand. Only one variable is considered at one time keeping all other
variables constant.
Activity 2
Answer 1- law of consumer demand expresses the functional relationship between the
price of a commodity and its quantity demanded. A fall in the price of a good either
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Consumer Demand
makes a consumer to purchase that good or purchase more of that good if it has already
been purchased. Price and demand share an inverse relationship. Similarly when the price
rises quantity demanded falls. If demands fall due to price rise, prices are usually brought
down by manufacturers to induce demand. The law of demand states that, other things
being equal, at a higher price, consumers will purchase less of a commodity while at a
lower rice consumers will purchase more of it.
Answer 2- downward slope of the demand curve shows that the relationship between
price and quantity demanded is inverse. Demand of a commodity is more at a lower price
and less at a higher price. This consumer behavior has been explained in traditional
theory of demand and modern theory of demand. As per the Marshallian utility analysis,
the factors responsible for the downward slope are. (a) law of diminishing marginal
utility (b) (b) change in the number of consumers (c) diverse use of commodity.
According to the modern theory of demand price effect is treated as the sum of the
income effect and the substitution effect. Any change in the price of a commodity affects
the purchasing power or real income of the household.
Answer 3- the demand curve normally slopes downwards from left to right stating that
demand rises as price falls. There may however be instances when the opposite occurs.
These situations constitute the exceptions to the law of demand. More is purchased at
higher price and less at lower. The demand curve here has an upward slope from left to
right. Some of these exceptions could be: (a) giffen goods (b) conspicuous necessities ©
goods for conspicuous consumption (d) future changes in prices (e) emergencies- situations
like floods, wars, drought etc. (f) change in fashion (g) ignorance (h) share market.
Activity 3
Answer 1- Change in the quantity demanded is the rise and fall in the quantity demanded
for a change in the price of commodity. Change in quantity demanded relates to the law
of demand. Change in demand is related to factors other than price of a commodity or
other determinants of demand. When the quantity demanded of a commodity increases or
Answer 2-
Increase in demand Expansion in demand

It is caused due to increase in income, fall in price of It is caused due to fall in
complementary goods, favorable weather conditions, price of a good.
increase in family size, favorable taste changes.
It denotes rightward shift in demand curve. It denotes downward
movement along the same
demand curve.
It denotes rise in demand at same price. It denotes rise in demand
due to price fall.
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Answer 3
Decrease in Demand Contraction of Demand

It is caused due to fall in income, fall in It is caused due to increase in price of a
price of substitute goods, unfavorable commodity
weather conditions, ceasing to be in
fashion, fall in family size
It denotes leftward shift in demand curve It denotes upward movement along the same
demand curve.
It denotes fall in demand at the same price It refers to fall in demand at a higher price

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Consumer Demand
UNIT 7 ELASTICITY OF DEMAND
Structure
7.0 Introduction
7.1 Objectives
7.2 Meaning of elasticity of demand
7.2.1 Price elasticity of demand
7.2.2 Average elasticity of demand
7.2.3 Elasticity of demand curve and slope of demand curve
7.2.4 Measurement of price elasticity of demand
7.2.4.1 Total expenditure method
7.2.4.2 Point method
7.2.4.3 Arc method
Activity 1
7.3 Factors influencing elasticity of demand
7.3.1 Determinants of price elasticity of demand
Activity 2
7.4 Income elasticity of demand
7.4.1 Income elasticity of demand and propensity to consume
7.4.2 Determinants of income elasticity of demand
7.5 Cross elasticity of demand
7.6 Importance of elasticity of demand
Activity 3
7.7 Let us Sum Up
7.8 Key Words
7.0 INTRODUCTION
Analysis of demand explains the direction of change in prices and quantities due to shifts
in demand. In practice however it is so that a firm may not accurately predict that sales of
its product will increase in response to price decrease. Likewise it is not always that
consumers tend to buy more income increases. The manner in which demand behaves in
response to changes in determinants can be measured in terms of elasticity’s of demand.
7.1 OBJECTIVES
After going through this unit you will be able to understand:

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Business Economics
 Measurement of responsiveness of demand to price change.

 Factors determining price elasticity of demand.
 Measurement of elasticity in terms of point and range.
 Response of demand to income change and its variation with goods.
 Relation of goods on the basis of elasticities.
7.2 MEANING OF ELASTICITY OF DEMAND
Dem and function throws light on the nature of relationship between demand for a good
and its determinants. It provides information on direction of change but not magnitude of
change. Magnitude of change in demand may differ in case of different goods. If there is
rise in price, demand for laptops may fall significantly, demand for talcum powders may
show comparably less fall while demand for flour may show no change. This degree of
responsiveness of demand to a change in any of its determinants is elasticity of demand.
As there are three measurable determinants of demand viz. price of commodity, price of
related commodities and level of income, there are three types of elasticities of demand-
price elasticity, cross elasticity and income elasticity.
7.2.1 Price elasticity of demand

Price elasticity of demand is the degree of responsiveness of the demand for a commodity
to any change in price. According to its proponent Alfred Mashall the elasticity or
responsiveness of demand in a market is great or small depending on the fact that the
amount demanded increases much or little for a given fall in price and diminishes much
or little for a given rise in price. It is the ratio of the percentage of change in the quantity
demanded to a change in price. It is shown as elasticity coefficient and is expressed as
Ed= percentage change in quantity demanded
Percentage change in price
Percentage change in quantity demanded will be q1-qo x 100
qo
where q1 is quantity demanded after price change and qo is quantity demanded at original
price.
Percentage change in price will be p1-po x 100
po
where p1 is the changed price and po is the original price.
Thus Ed = ∆q x100
q
∆p x100
P
Or Ed = ∆q. p
q ∆p
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Consumer Demand
The value of elasticity coefficient ranges from zero to infinity. The possible values have
been listed in table 7.1
Table 7.1 Value of Elasticity Coefficients and their Meaning
Value of Type of Implication

Elasticity Elasticity
Coefficient
Ed=0 Perfectly quantity demanded does not respond to price change at
Inelastic all
Ed< 1 Inelastic or less change in demand percentage is less than percentage
than unit elastic change in price
Ed=1 Unit elastic change in demand percentage is equal to percentage
change in price
Ed>1 Elastic or more change in percentage of demand is more than
than unit elastic percentage change in price
Ed=∞ Perfectly elastic consumers will purchase all they can at some ceiling
price but will purchase none of it at an even slight price
rise.
7.2.2 Average elasticity of demand

The formula ∆q. p
q ∆p works for the price decreases;
however it does not give the same elasticity coefficient for price increases over the same
range. Let us consider that price falls from Rs.50 to Rs.45 and the quantity increases from
5 to 6. The elasticity coefficient will be 1/5 x 50/5 =2. If the price increases from 45 to 55
and quantity decreases from 5 to 4 we get the elasticity coefficient as 1/ 5 x 45/10= 0.9
which is much lesser than 2. There arises a problem of direction in the calculation of
elasticity as the same formula applied for upward and downward movement yields
significantly different results. A solution to this problem is application of the concept of
average elasticity of demand which is calculated by using the smaller of the two
quantities and the smaller of the two prices as denominators in the respective price
quantity ratio so we get the coefficient against the equation ∆q. po
qo ∆p
as 1/4x 45/10 = 1.125 which lies in between the earlier coefficients 2 and 0.9.
7.2.3 Elasticity of demand and slope of demand curve

Ed is the product of reciprocal of slope of the demand curve (slope of demand curve is ∆p
/ ∆q) and p/q value of which is determined by a point on the demand curve. Slope of
demand curve is dependent on the scale used. Let us make use of the following demand
schedule. This schedule is represented in four different ways in Fig. 7.1 by taking
different scales on different axis. The four graphs show that as we take larger or smaller
units on x axis or y axis, the slope will differ accordingly. But the elasticity of demand
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Business Economics
remains the same for all the graphs. Hence while interpreting elasticity of demand;
attention is required on the scale we use.
Table 7.2
Price in Rs. Quantity in units

10 12
20 10
30 8
40 6
50 4
60 2
DD
price
quantity
XY (Scattet) 1
price
DD
quantity
XY (Scattet) 1
price
North
quantity
Fig.7.1
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Consumer Demand
price
quantity
Fig. 7.1
7.2.4 Measurement of price elasticity of demand
Price elasticity of demand can be measured through different methods like total outlay
method, point method, arc method
7.2.4.1 Total expenditure method

Total outlay is the product of price of a commodity and the number of units purchased of
this commodity. TQ=pq, where TQ is total outlay or total expenditure, p is price and q is
quantity. This method leads to different measures of elasticity of demand like less than
unit elastic, unit elastic, more than unit elastic. To illustrate let us assume three
household commodities with different demand schedules as in Table 7.4
Table 7.4 Household’s Demand Schedule for three Commodities

Salt Salt Salt Hand towel Hand towel Hand Milk Milk Milk
towel
p Q TQ P Q T p q TQ
21 10 210 21 10 210 21 10 210
15 11 165 15 14 210 15 15 225

10 13 130 10 21 210 10 24 240
Less than unit elastic- Demand is considered less than unit elastic or inelastic if with
price decrease there is fall in total outlay or with rise in price there is rise in total outlay.
In the above table demand for salt is inelastic implying that demand does not change
much to price change.
Unit elastic- demand is labeled as unit elastic if total outlay does not change with price
variation. The price gets high but households continue their expenditure in same quantity
as earlier on the item. Rise in price leads to contraction in demand but the total outlay
remains the same. Demand for hand towel is unit elastic.
More than unit elastic- demand is called more than unit elastic if total outlay increases
with fall in price or with an increase in price the total outlay declines. Demand for milk
falls in this category.
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Business Economics
7.2.4.2 Point method

The total outlay method features terms like less than unit elastic or more than unit elastic
applicable to the total demand for a commodity. However this can hold true only for
some purposes as the demand for a commodity may be elastic in one price range and
inelastic in another. But price range is not a precise expression in itself. For precision,
elasticity of demand must be measured at a point on demand curve which comes to be
known as point elasticity of demand.
7.2.4.3 Arc method

Point method does not guarantee satisfactory results especially while measuring elasticity
on unit elasticity curve. Let us consider an equation for demand curve like p=100/q. if we
cross multiply the value of p.q will always be Rs.100/-. Or elasticity will be equal to
unity. When there are definite changes in price and quantity demanded such that it relates
to a stretch over the demand curve, then the formula needs to be modified and arc
elasticity is used. Arc elasticity is the price elasticity of demand between two points (arc)
on a demand curve. Let us suppose we have the following combinations of price and
quantity demanded as in table 7.4
Reference points as in fig. 7.2 Price in Rs. Quantity in units

A 55 11
B 45 21
Elasticity from point A to B would be ∆q . p = 10/10x 55/11= 5

q ∆p
while elasticity from point B to A would be 10/21x 45/10 = 2.14. This shows that the
same combinations of price and quantity demanded yield different elasticity values. The
value of elasticity is dependent on the direction of change. To avoid inaccuracy problem
because of this the average of price and quantity values are worked at and elasticity at the
mid-point is found. Arc elasticity (shown in fig. 7.2) thus offers a value lying in between
two values estimated by point method.
fig. 7.2 arc elasticity
price
DD
quantity
Activity 1
1. What is elasticity of demand?
2. What are the different values of elasticity coefficients and what do they mean?
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Consumer Demand
3. What is price elasticity of demand?

4. Describe the different methods of measurement of price elasticity of demand
7.3 FACTORS INFLUENCING ELASTICITY OF DEMAND
Demand for some commodities is much more elastic than others. This is dependent on a
number of determinants like:
7.3.1 Determinants of price elasticity of demand-

These are
1. Availability of substitutes- a commodity will have elastic demand when good
substitutes are available for it. Any small rise will incline the consumers towards the
substitutes. Also a reduction in price would wean away consumers from substitute goods.
When substitutes do not exist the demand for the commodity will be inelastic.
2. Nature of commodity- an essential commodity like food that has no substitutes will
have inelastic demand. Consumers will purchase a fixed amount per unit of time,
irrespective of price change. Demand for luxuries will be elastic in nature.
3. Share in total expenditure- the elasticity of demand will depend on the proportion of
income spent on the good. Items on which consumers spend very little proportion of their
incomes will have inelastic demand. Rise in price of these commodities may not disturb
the consumer’s budget to the extent that he reduces their consumption.
4. Possibility of delaying consumption- consumption of food, medicines or other essential

commodities cannot be delayed hence their demand is inelastic. Consumption of
consumer durable goods like smart TV’s, smart phones, split Ac’s, expensive four
wheelers can be postponed implying that these goods have elastic demand.
5. Inexpensive commodities like combs, matchbox, and safety pins have inelastic
demand. Lowering of price and raising of price both conditions will not have much
impact on consumers in terms of buying these goods.
6. Varied uses of commodity- a commodity that can be put to several uses is elastic in
demand. For every individual use demand may be inelastic, so that when the price of the
good reduces only a little more is purchased for every use, but when these single uses are
cumulated in terms of percentage they may lead to a huge rise in the total amount
demanded. A small fall in electricity charges may lead to its greater usage in cooking,
lighting or other activities resulting in greater cumulative usage as compared to earlier
higher electricity charges.
7. price level- when the ruling price of a good is toward the upper end of the demand
curve, demand tends to be more elastic than the condition when price was at the lower end.
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Business Economics
8. adjustment time- the demand for a good tends to be more elastic if it involves longer
period of adjustment as consumers take time to acquaint themselves of new prices and
products. The price elasticity of demand is likely to be greater if the time gap in adjusting
is greater. A short run demand curve depicts the behavior of quantity demanded to a
change in price, against the existing amounts of durable commodities and existing stock
of substitutes. A separate short run demand curve will be there for each structure of
durable goods and substitute commodities. A long run demand curve indicates the
response of quantity demanded to a change in price after as much time is passed so as to
allow adjustments.
9. consumer behavior- most important determinant is the taste and preferences of

consumer. There are consumers who stick to a particular brand of any commodity even if
its price rises. Demand here as a consequence becomes inelastic.
Activity 2
1. List the factors influencing elasticity of demand.
2. Explain adjustment time as a determinant of price elasticity of demand.
7.4 INCOME ELASTICITY OF DEMAND
income elasticity of demand is the responsiveness of demand to income change. Ey=

proportionate change in quantity demanded
Proportionate change in income
Ey= q1-q x y = ∆q . y or ∆q . y
q y1-y q ∆y ∆y q
where q and y are quantity demanded and income. Demand for most goods increases with
rise in household’s level of income. Demand for inferior commodities has negative
relation with income changes. There are five different types of income elasticity of
demand shown in table 7.5
Table 7.5 Types of Income Elasticity of Demand
Numerical value of Implication

income elasticity
Negative Demand for commodity falls with income increase
Zero Demand for commodity does not change with income change
Greater than zero Demand for commodity rises less in proportion to income rise
but less than one
Unity Demand for commodity rises in same proportion as income rise
Greater than unity Demand for commodity rises more in proportion to income rise
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Consumer Demand
7.4.1 Income elasticity of demand and propensity to consume

Income elasticity of demand may be defined in terms of the average and marginal
propensity to consume. Average propensity to consume APC is the ratio of aggregate
consumption to aggregate income. APC=c/y. Marginal propensity to consume is the ratio
of change in consumption to income change or MPC= ∆c/∆y. Income elasticity of
demand is the ratio of proportionate change in consumption to proportionate income
change ey= ∆c/∆÷ c/y or ey= MPC/APC. In other words income elasticity of demand is
the ratio of marginal propensity to consume to average propensity to consume.
7.4.2 Determinants of income elasticity of demand

Determinants of income elasticity of demand are as follows-
1. The nature of the need that the commodity addresses, the percentage of expenditure on
food reduces with income rises. This is Engel’s law.
2. The initial income level in a nation
3. Time period as consumption patterns adjust to income change as time passes by.
7.5 CROSS ELASTICITY OF DEMAND
The responsiveness of demand to changes in prices of related commodities is cross

elasticity of demand. Cross elasticity of demand is the rate of change in quantity
associated with a price change of related good. Cross elasticity of demand is the
responsiveness of demand for commodity x to price change in commodity y.
Ec= proportionate change in the quantity demanded of commodity x
Proportionate change in the price of commodity y
The relationship between x and y can be substitutive as in case of cow milk and soya
milk or complementary as in the case of light bulb and holder. Measures of cross
elasticity have been put together in table 7.6
Table 7.6 Measures of Cross Elasticity of Demand
Numerical measure Implication

Infinity Commodity x is almost a perfect substitute for y
Greater than zero but less than Commodity x is a substitute for y
infinity
Zero Commodities x and commodity y are unrelated
Negative Commodities x and commodity y are
complementary
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Business Economics
7.6 IMPORTANCE OF ELASTICITY OF DEMAND-
Elasticity of demand is of great significance for a variety of situations like
1. Monopolist- A monopolist needs to consider the nature of demand while fixing price
of products. If it is elastic for some commodities, it will pay him to charge a high price
and sell a slightly lesser amount. While if the demand is elastic for some other goods, he
will reduce the price, boost demand and hence his monopoly net revenue will be
maximum.
2. Government- Elasticity of demand influences the policies pertaining to government

tax. The government may impose higher taxes and gain higher revenue if the demand for
a good on which tax is to be imposed is inelastic. While for commodities with elastic
demand, high rates of axes may not bring about the required revenue for the government.
State takeover of public utility services can be understood in terms of elasticity of
demand. Demand for electricity, water supply, posts and telegraphs, public transport is
inelastic. If these public services are handed over to private parties there are chances of
consumers being exploited and hence these services are run by the government.
3. Determination of Factor Pricing- Share of each factor of production is determined in

proportion to its demand in production activity. A factor with inelastic demand can
always be highly priced in comparison to a factor with elastic demand.
4. International Trade- Elasticity of demand at the level of nation plays a vital part in
exports, imports, in the effect of tariffs and in balance of payments. Inelastic demand of
imports will have negative effect on the balance of payments, while inelastic demand of
exports will boost exports.
5. Explanation of Poverty in the Backdrop of Abundance- Condition of a bumper crop

instead of leading to prosperity may lead to adverse condition if demand for the
commodity is inelastic especially in case of perishable commodities. In case of goods that
can be stored demand is less inelastic. A reduction in rice may cause increased buying
and stocking.
Activity 3
1. What is income elasticity of demand and what are the different types of income
elasticity of demand?
2. Explain income elasticity of demand in terms of propensity to consume
3. What are the determinants of income elasticity of demand?
4. What is cross elasticity of demand and describe its different measures.
5. What is the importance of elasticity of demand?

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Consumer Demand
7.7 LET US SUM UP
Degree of responsiveness of demand to a change in any of its determinants is elasticity of

demand. As there are three quantifiable determinants of demand viz. price of commodity,
price of related commodities and level of income, there are three types of elasticities of
demand- price elasticity, cross elasticity and income elasticity of demand. The elasticity
or responsiveness of demand in a market is great or small according as the amount
demanded increases much or little for a given fall in price and diminishes much or little
for a given rise in price. It is the ratio of the percentage of change in the quantity
demanded to a change in price. Elasticity of demand curve and slope of demand curve or
Ed is the product of reciprocal of slope of the demand curve and p/q value of which is
determined by a point on the demand curve. Slope of demand curve is dependent on the
scale used. Price elasticity of demand can be measured through different methods like
total outlay method, point method, arc method. Total expenditure method- total outlay is
the product of price of a commodity and the number of units purchased of this
commodity. For precision, elasticity of demand must be measured at a point on demand
curve which is known as point elasticity of demand. Point method does not always
provide satisfactory results especially when we are measuring elasticity on unit elasticity
curve. When there are finite changes in price and quantity demanded such that it relates
to a stretch over the demand curve, then the formula is modified and arc elasticity is used.
Arc elasticity is the price elasticity of demand between two points on a demand curve.
Determinants of price elasticity of demand are 1. availability of substitute goods. 2.
nature of commodity 3. share in total expenditure 4. possibility of postponing
consumption 5. inexpensive commodities 6. different uses of commodity 7. price level 8.
adjustment time 9. consumer behavior.
Income elasticity of demand is the responsiveness of demand to change in income.

Demand for most goods increases with rise in household’s level of income. Demand for
inferior commodities shows a negative relation with income changes. There are five
different types of income elasticity of demand. Income elasticity of demand may be
defined in terms of the average and marginal propensity to consume. Average propensity
to consume APC is the ratio of aggregate consumption to aggregate income.
Determinants of income elasticity of demand are 1. the nature of the need that the
commodity addresses 2. the initial level of income in a nation.3. time period as
consumption patterns adjust to income change as time passes by. The responsiveness of
demand to changes in prices of related commodities is cross elasticity of demand. Cross
elasticity of demand is the rate of change in quantity associated with a change in the price
of related good.
Elasticity of demand is of considerable significance for a monopolist, for government

taxation policy, for determining of factor pricing, for international trade and for
explanation of poverty when there is abundance of the commodity.
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Business Economics
7.8 KEY WORDS

 Elasticity of demand- degree of responsiveness of demand to a change in any of
its determinants is called elasticity of demand.
 Total expenditure method- total outlay is the product of price of a commodity
and the number of units purchased of this commodity.
 Arc elasticity – it is the price elasticity of demand between two points (arc) on a
demand curve.
 Income elasticity of demand – it s the ratio of marginal propensity to consume to
average propensity to consume.
 Cross elasticity of demand- the responsiveness of demand to changes in prices of
related commodities is cross elasticity of demand.

1. a demand curve is perfectly inelastic if
a. a rise in price brings a fall in quantity demanded
b. a rise in price leads to a rise in seller’s total receipts.
c. the commodity in question is perishable.
d. a change in price does not affect the quantity demanded.
answer d
2. if 10% rise in price of commodity causes the demand to fall by 20%

a. demand is inelastic b. demand is infinitely elastic
c. demand is elastic d. none of the above

answer c
3. To measure price elasticity over large changes in price the following is used
a. Point elasticity method b. arc elasticity method
c.income elasticity method d. none of the above

answer b
4. Price elasticity of demand for a good tends to be high when

a. The commodity is a necessity b. closer substitutes are available
c.commodity is not a necessity d. the price is less

answer b
5. inferior commodities have

a. zero income elasticity of demand b. negative cross elasticity of demand
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Consumer Demand
c. unit elasticity of demand d. negative income elasticity of demand

answer d
6. Orange and lime have
a. Same income elasticity of demand b. very low price elasticity of demand
c.negative cross elasticity of demand d. positive cross elasticity for each other
answer d
7. sugar and coffee have
a. the same income elasticity of demand b. very low income elasticity of demand
c. negative cross elasticity of demand d. positive cross elasticity of demand
answer c
8. if the demand for a good is elastic, an increase in its price will cause the total
expenditure of consumers to
a. remain the same b. increase
c. decrease d. none of these

answer c
9. the factor which keeps the price elasticity of demand for a good low is
a. variety of uses for that good b. its low price
c.close substitutes for that good d. high proportion of income spending on it

answer b

1. describe average elasticity of demand with illustrations.
2. explain elasticity of demand curve and slope of demand curve with illustrations and
graphs.
Activity 1
Answer 1- Magnitude of change in demand may differ in case of different goods. If there
is rise in price, demand for laptops may fall significantly, demand for talcum powders
may show comparably less fall while demand for flour may show no change. This degree
of responsiveness of demand to a change in any of its determinants is elasticity of
demand. As there are three quantifiable determinants of demand viz. price of commodity,
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Business Economics
price of related commodities and level of income, there are three types of elasticities of
demand- price elasticity, cross elasticity and income elasticity of demand.
Answer 2- refer to table 7.1

Answer 3- price elasticity of demand is the degree of responsiveness of the demand for a
commodity to any change in price. The elasticity or responsiveness of demand in a
market is great or small according as the amount demanded increases much or little for a
given fall in price and diminishes much or little for a given rise in price. It is the ratio of
the percentage of change in the quantity demanded to a change in price. It is shown as
elasticity coefficient and expressed as Ed= percentage change in quantity demanded
Percentage change in price
Answer 4- price elasticity of demand can be measured through different methods like
total outlay method, point method, arc method. Total outlay is the product of price of a
commodity and the number of units purchased of this commodity. TQ=pq, where TQ is
total outlay or total expenditure, p is price and q is quantity. This method provides
different measures of elasticity of demand like less than unit elastic, unit elastic, more
than unit elastic. In the total outlay method, the terms less than unit elastic or more than
unit elastic have been used to the whole demand for a commodity. However this can hold
true only for some purposes as the demand for a commodity may be elastic in one price
range and inelastic in another. But price range is not a precise expression in itself. For
precision, elasticity of demand must be measured at a point on demand curve which
comes to be known as point elasticity of demand. Point method does not always provide
satisfactory results especially when we are measuring elasticity on unit elasticity curve.
When there are finite changes in price and quantity demanded such that it relates to a
stretch over the demand curve, then the formula needs to be modified and arc elasticity is
used. Arc elasticity is the price elasticity of demand between two points (arc) on a
demand curve.
Activity 2
Answer 1- these determinants of elasticity of demand are
1. availability of substitute goods- a commodity will have elastic demand when good
substitutes are available for it. Any small rise will incline the consumers towards the
substitutes. Also a reduction in price would wean away consumers from substitute goods.
If no substitutes are available the demand for the commodity will be inelastic.
2. nature of commodity- an essential commodity like food that has no substitutes will
have inelastic demand. Consumers will purchase a fixed amount per unit of time,
irrespective of price change. Demand for luxuries will be elastic in nature.
3. share in total expenditure- the elasticity of demand will depend on the proportion of
income spent on the good. Items on which consumers spend very little proportion of their
incomes will have inelastic demand. Rise in price of these commodities may not disturb
the consumer’s budget to the extent that he reduces their consumption.
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Consumer Demand
4. Possibility of postponing consumption- consumption of food, medicines or other

essential commodities cannot be postponed hence their demand is inelastic. Consumption
of consumer durable goods like smart TV’s, smart phones, split Ac’s, expensive four
wheelers can be postponed implying that these goods have elastic demand.
5. Inexpensive commodities like combs, matchbox, and tongue cleaners have inelastic
demand. Lowering of price and raising of price both conditions will not have much
impact on consumers in terms of buying these goods.
6. Different uses of commodity- a commodity that can be put to several uses is elastic in
demand. For each single use demand may be inelastic, so that when the price of the good
reduces only a little more is purchased for every use, but when these uses are cumulated
in terms of percentage they may lead to a huge rise in the total amount demanded.
7. Price level- if the ruling price of the commodity is toward the upper end of the demand
curve, demand tends to be more elastic than if it were at the lower end.
8. Adjustment time- the demand for a good tends to be more elastic if it involves longer
period of adjustment as consumers take time to acquaint themselves of new prices and
products.
9. Consumer behavior- most important determinant is the taste and preferences of
consumer. There are consumers who stick to a particular brand of any commodity even if
its price rises. Demand here as a consequence becomes inelastic.
Answer 2- the demand for a good tends to be more elastic if it involves longer period of
adjustment as consumers take time to acquaint themselves of new prices and products. The
price elasticity of demand is likely to be greater if the time gap in adjusting is greater. A
short run demand curve shows the response of quantity demanded to a change in price,
given the existing amounts of durable commodities and existing stock of substitutes. A
separate short run demand curve will be there for each structure of durable goods and
substitute commodities. A long run demand curve shows the response of quantity
demanded to a change in price after as much time is passed so as to allow adjustments.
Activity 3
Answer 1- income elasticity of demand is the responsiveness of demand to change in
income.
Ey= proportionate change in quantity demanded
Proportionate change in income
There are five different types of income elasticity of demand refer to table 7.5
Answer 2- income elasticity of demand may be defined in terms of the average and
marginal propensity to consume. Average propensity to consume APC is the ratio of
aggregate consumption to aggregate income. APC=c/y. Marginal propensity to consume
is the ratio of change in consumption to change in income or MPC= ∆c/∆y. Income
elasticity of demand is the ratio of proportionate change in consumption to proportionate
change in income.
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Business Economics
Answer 3- determinants of income elasticity of demand are 1. the nature of the need that
the commodity addresses. 2. the initial level of income in a nation. 3. time period as
consumption patterns adjust to income change as time passes by.
Answer 4- the responsiveness of demand to changes in prices of related commodities is
cross elasticity of demand. Cross elasticity of demand is the rate of change in quantity
associated with a change in the price of related good. Cross elasticity of demand is the
responsiveness of demand for commodity x to change in price of commodity y. Ec=
proportionate change in the quantity demanded of commodity x
Proportionate change in the price of commodity y
The relationship between x and y commodities may be substitutive as in case of cow milk
and soya milk or complementary as in the case of light bulb and holder.
For main measures of cross elasticity refer to table 7.6
Answer 5- elasticity of demand is important for
1. monopolist- a monopolist needs to consider the nature of demand while fixing price of
products. If it is elastic for some commodities, it will pay him to charge a high price and
sell a slightly lesser amount. While if the demand is elastic for some other goods, he will
reduce the price, stimulate demand and hence maximize his monopoly net revenue.
2. government- elasticity of demand influences the policies pertaining to government tax.
The government may impose higher taxes and gain higher revenue if the demand for a
good on which tax is to be imposed is inelastic. While for commodities with elastic
demand, high rates of axes may not bring about the required revenue for the government.
3. Determination of factor pricing- share of each factor of production is determined in
proportion to its demand in production activity. A factor with inelastic demand can
always be highly priced in comparison to a factor with elastic demand.
4. International trade- elasticity of demand plays an important part in exports, imports, in
the effect of tariffs and in balance of payments of a country. Inelastic demand of imports
will have adverse effect on the balance of payments, while inelastic demand of exports
will stimulate exports.
5. explanation of poverty in the backdrop of abundance- a bumper crop instead of leading
to prosperity may lead to adverse condition if demand for the commodity is inelastic
especially in case of perishable commodities. In case of goods that can be stored demand
is less inelastic. A reduction in rice may cause increased purchasing and storing.

5. Micro Economics and Applications, D.N Dwivedi, Vikas Publication
124
BLOCK - 3
Theory of Production
Business Economics
UNIT 8 PRODUCTION FUNCTION - I
Objectives

 Understand the concept of Production function.
 Explain the types of production function.
 Differentiate among Total Product, Average Product and Marginal Product.
 Describe the law of Variable Proportion.
 Explain the law of returns to scale.
 Enlist the reasons behind application of law of Variable Proportion and returns to
scale.
 Define Economies and diseconomies of scale.
Structure
8.1 Introduction
8.2 Production Decision
8.3 Technology of production
8.4 The Production Function
8.5 Short Run Vs Long Run
8.6 Total Production, Average production, Marginal Production
8.7 Relationship between Total Product, Average product, Marginal Product
8.8 Law of variable proportion
8.9 Returns to scale
8.10 Difference between Returns to factor & Returns to scale
8.11 Economies of scale.
8.12 Self Assessment Questions.
8.1 INTRODUCTION
In the present unit we will study the supply side and examine the behaviour of producers.
We will by to understand how firms can produce goods and services efficiently and in
what manner their costs of production changes with change in both input process and the
level of output.
8.2 THE PRODUCTION DECISION
The Production decisions are just similar to the buying decisions of consumers and
accordingly it includes following three stages.
1. Production Technology : It refers to the technique of converting raw material into
outputs.
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Production
Function - I
2. Cost Constraints : Cost here refers to cost of factors of production i.e. prices of
labour, capital, land and entrepreneurship.
3. Input choices : Given the technology and cost constraints of firm also have to
decide how mucho f each input to use in producing output.
We will begin this chapter by showing how the firm’s technology can be presented in the
form of a production function, the we will use the production function to show how the
firm’s output changes when just one of its factor i.e. labour is changed holding the other
factors fixed. Next we will study the case in which a firm can change all of its factors of
production and we show how the firm chooses a cost minimized combinations of inputs
to produce its outputs. Moreover we will also study the scales of production and
economies and diseconomies of scale of production.
8.3 TECHNOLOGY OF PRODUCTION
During production process a firm converts inputs into outputs, here inputs refers to all
factors of production which are : Land, labour capital and entrepreneurship can divide
them into two broad categories of labour and capital. Labour includes skilled and
unskilled labours as well as entrepreneurial efforts of the firm’s managers. Capital
includes land, building and other equipments along with stocks.
8.4 THE PRODUCTION FUNCTION
A production function explains the technological relationship between inputs and output.
It can be written as
Q = ⨍ ( L, K)
Where,
Q = Physical quantity produced per period of time.
L = Labour
K = Capital
8.4.1 Forms of Production Function

Production function is having various forms but here we’ll discuss only two major forms:
(a) When only one input is variable and all other inputs are assumed to be constant.
Here we study the effect of the changes in the units of one input on the total output,
assuming all other inputs as constant. This is known as production function with one
variable input. The classical thinkers have named it as ‘Laws of returns’ and the modern
thinkers call it as law of variable proportions.
(b) A situation when all the inputs are assumed to be variable.
When all the inputs are changed, the capacity or scale of Production also changes
and this change is known as returns to scale.
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Business Economics
8.5 SHORT RUN VS LONG RUN
Short Run refers to a period of time in which the quantities of one or more factors of
production cannot be changed. In other words in the short run at least one factor of
Production is fixed.
Long Run refers to a period where all the factors of production are variable.
8.6 TOTAL PRODUCTION, AVERAGE PRODUCTION AND MARGINAL

PRODUCTION
8.6.1 Total Production (TP)

It refers to the total quantity produced using different units of variable and fixed factors.
8.6.2 Average Production (AP)

It refers to output per unit of variable factor (Labour). It can be obtained by dividing total
output by the total units of variable factor employed.
AP = Where TP = Total Production (Units)

L = Total Units of Variable Factors
8.6.3 Marginal Product

It refers to the change in total Production due to employment of an additional unit of
variable factor.
We can understand these three concepts using following Numerical example.
Land Labour (Units) TP AP MP

1 1 10 10 10
1 2 24 12 14
1 3 39 13 15
1 4 52 13 13
1 5 60 12 8
1 6 60 10 0
1 7 56 8 -4
8.7 RELATIONSHIP BETWEEN TOTAL PRODUCTION, AVERAGE

PRODUCTION AND MARGINAL PRODUCTION.
We can understand the relationship between TP, AP and MP with the help of following
diagramme.
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Production
Function - I
Y
c TP
b
TP a
(Units)
O X
Y Labour (Units)
AP, MP b1
(Units) AP
O L L1 L2 X
Labour
(Units)
Explanation of Diagramme
It is clear from the above diagramme that
(a) TP (Total Product Curve) increases at an increasing rate till point a, the same
time MP is increasing and reaches at its maximum point and AP is increasing.
(b) TP is increasing at diminishing Rate i.e. between point a and c, at the same time
MP has started decreasing and reaches at Zero, AP on the other hand after reaching its
maximum starts declining. (Note that TP is maximum when MP = 0).
(c) TP starts diminishing after reaching its maximum point i.e. ‘C’ and during same
period AP is decreasing and MP becomes negative.
8.8 LAW OF VARIABLE PROPORTION
This law is also known as ‘Law of non-proportional returns or the ‘law of diminishing
marginal returns. The law of variable proportion explains the relation between ratio of
fixed and variable factors of production and the output. When a firm increased its output
by employing more units of a variable factor. It changes the proportion between the fixed
and variable factors. As per law of variable proportion there are three stages of
production. Let us explain all the three stages using a Numerical example and a suitable
diagramme.
Output Schedule
Fixed No. of TP (Total AP (Average MP Stages
input labour production) Production) (Marginal
Production)
1 0 0 0 -
1 1 6 6 6 I
1 2 16 8 10
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Business Economics
1 3 24 8 8
1 4 30 7.5 6
1 5 34 6.8 4 II
1 6 34 5.66 0
1 7 32 4.57 -2
III
1 8 24 3 -8
We can explain all the three stages as follows using above schedule and diagramme.
Stage – I
It starts from the origin to the point where the average output is maximum. In this stage
the MP increases and reaches its maximum point and starts falling and AP is also
increases and reaches its maximum point out TP is also increasing. It would b e seen
from the above table that the AP is maximum when 2 units of the variable factor are
employed; it remains constant at the maximum when even 3 units are employed. The first
stage of production operates till this point. Similarly, in fig. 18.4 we see that the average
output curve AQ goes upwards till it reaches T. The MP curve, on the other hand, begins
to fall from the point J onwards. Thus the first stage is characterized by the operation of
the increasing returns.
Stage – II
The second stage starts from the point where the (AP) average output is maximum to the
point where the MP is zero. After having attained the optimum combination of the fixed
inputs and the variable input, if the firm increases still further the quality of the variable
input. The total output rises but only at a diminishing rate. In table given above the
second stage of law of variable proportion operates between the stage when 4 units and
the 6 units of labour are employed. In the above figure the second stage continues till the
point S is reached.
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Production
Function - I
Stage – III
The third stage covers the range over which the MP is negative. In the above table, this
stage occurs when 7 or more units of labour are employed along with the given quantity
of fixed factors. In the figure the third stage operates beyond point S. In this stage the
total production (TP), after reaching its maximum point M at the beginning of this stage,
begins to fall.
No Producer will operate in this stage, even if he can procure the variable input at no
price.
8.9 RETURNS TO SCALE
In the law of variable proportions we have studied as to have a variable factor when it
works with fixed factors raises the TP at increasing rate in the beginning and at a
diminishing rate afterwards. During the short period some factors of production are
relatively scarce, therefore, the proportion of the factors may be changed but not their
scale. But in the long run, all factors are variable, therefore the scale of production can be
changed in the long run.
Returns to scale explain the behaviour of output when the quantities of all factors of
production are raised simultaneously in given proportion. It is important here to note that
increase in scale can only be done when all factors of production (fixed as well as
variable) changed.
There are three stages of law of returns to scale which are as follows:
1. Increasing returns to scale
2. Constant returns to scale
3. Diminishing returns to scale
Returns to scale have been illustrated in the following Table :
Returns to Scale
Units of Units of TP (Total Product) Addition to Total Nature of Returns to

Labour Land (Units) Product (Units) Scale
2 1 15 15
4 2 45 30 Increasing
8 4 125 80
16 8 250 125
Constant
32 16 500 250
64 32 900 400
Diminishing
128 64 1500 600
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Business Economics
Above table shows that 2 units of labour and one unit of land produces 15 units of total
product. By doubling the units of labour and land the total product gets more than
doubled. Similarly, four times increase in the labour and land causes more than four times
increase in total Product. This tendency to increase more than proportionately to a given
rise in two inputs is called law of increasing returns to scale.
It can be observed in the above table that 16 units of labour and 8 units of land give a
total product of 250 units and it gets doubled after using 32 units of labour and 16 units
of land. This stage of increase in scale of production is called the ‘Law of Constant
returns to Scale’. Finally, a further increase in the scale of production results into a less
than proportionate increase in output. This stage of increase in scale of production is
called ‘Law of Diminishing Returns to Scale’.
8.10 DIFFERENCE BETWEEN RETURNS TO A FACTOR AND RETURNS

TO SCALE.
Sl. Point of Returns to a Factor Returns to Scale

No. Difference
1. Time Period It is a short term phenomenon. It operates in Long Run.
2. Change of Under this, we study the effect Under this, we study effect f
Input of change in one factor of change in all factors of
Production, keeping others as production.
constant.
3. Technology Technology is assumed to be Under this, it is possible to

constant. introduce technological
changes.
8.11 ECONOMIES OF SCALE
Meaning
Economies of scale refers to reduction in per unit cost of production or benefit derived by
increasing the scale of business. When a firm raises its scale of production it finds itself
using in optimum way some of the resources that were previously under utilized.
Similarly, with the growth of an industry, an individual firm shall enjoy certain
advantages that shall lead to reduction in its per unit cost of production. The former are
known as internal economies (arising because of interval functioning of a firm) and latter
are known as external economies (arising because of external factor such as govt. policy,
deflation etc.). Let us explain each of these economies in detail.
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Production
Function - I
8.11.1 Internal Economies

Internal economies are earned by individual firms using the best practice in utilizing its
resources. Such economies are particular to the individual firms. They do not reach to the
whole industry. Following are various types of Internal Economies.
8.11.2 Types of Internal Economies

(1) Technical Economies – Such economies arise from the use of better plant,
machinery, equipment and techniques of production. A large size firm can obtain
technical economies in following terms.
(i) Economies of superior techniques.
(ii) Economies of linked processes e.g. using own sources of raw material, transport
and distribution system.
(iii) Economies of the use of by-products
(iv) Economies of division of labour and specializations.
(v) Economies of bulk purchases.
(2) Managerial Economies: A large firm can hire business executives of high skill
and qualifications to increase the productive efficiency of the firm.
(3) Financial Economies: A large firm gets the advantage of financial economies
while raising capital. The firm can raise capital by issuing shares, debentures and public
deposits. The cost of raising funds through public issue is very low and this lead to
economies of scale.
(4) Marketing Economies: A large firm may also reap economies of bulk purchase of
raw material and large sales. It can also have marketing economies by hiring best
professionals in the field and thus capturing large market for its product.
(5) Risk and Survival Economies: A large firm is better placed or compared to its
counterpart small producer to face the uncertainties and risk of business. A large firm
produces variety of goods. Even if there is loss in the production of one good, it can be
set off from the surplus in other units.
8.11.3 Causes of Internal Economies

There are two major causes of Internal Economies which are (i) Indivisibilities and (ii)
Specializations.
(i) Indivisibilities : There are certain actors of production that cannot be used in
parts. Larger scale of production makes it possible to make better use of such factors of
production. e.g. Rent of whole factory is to be paid even if one is using one fourth part of
same.
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Business Economics
(ii) Specialization : Large scale of production makes it possible to introduce better

division of labour. Through division of labour and resultant specialization it is possible
for a firm to have more units of output at a lesser cost per unit.
8.11.4 External Economies

External Economies are common to all the firms in an industry or all firms in an area.
Whenever an area is developed, transport facilities are provided; roads, railways etc. are
built; commercial services of all kinds – banking, warehousing, accounting, insurance
etc. become available. All these advantages are jointly showed by each of the firms in an
industry or all the industries in a group of industries. They fund their cost per unit going
down. These economies are monopolies by any single firm. They are showed by all the
firms in the Industry
8.11.5 Causes of External Economies

Major causes of external economies are :
(i) Localization of Industries
(ii) Specialization
(i) Localization of Industries : It means the concentration of a number of firms
belonging to a particular industry at a particular place. This concentration gives rise to
reap the benefits of the market as a whole by all the firms and not by any single firm.
(ii) Specialization : It take the form of division of labour among the different firms
belonging to the same area and to the same industry e.g. if an industrial area develops, it
makes possible the growth of all firms in the Industrial area not to a single firm.
8.11.6 Diseconomies of Scale

For all the firms and Industry there is always a point of ‘Optimum Capacity’. The Scale
of production in these firms and industries cannot be expanded infinitely. If any
individual firm grows beyond the point of optimum capacity, the firm attracts
diseconomies of scale.
The diseconomies of scale again can be of two types
(i) Internal diseconomies and
(ii) External diseconomies.
(i) Internal diseconomies : These diseconomies are arises because of malfunctioning
of Internal structure of firms. e.g. inefficient managers, frequent blackouts, irregular
supply of raw material etc.
(ii) External diseconomies : Such diseconomies are arises because of reasons like
heavy concentration in an area, frequent traffic Jams, market obstacles, financial
obstacles etc.
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Production
Function - I
8.12 SELF ASSESSMENT QUESTIONS

1. What are the basic decisions taken by the producers during the production
process?
2. Explain the relationship between Total Product, Average Product and Marginal
Product using a labelled diagramme and production schedule.
3. Using a well prepared diagramme and production schedule explain he law of
variable proportion.
4. Describe the law of returns to scale.
5. Differentiate between returns to factor and returns to scale.
6. Explain with examples the economies and diseconomies of scale in detail.
7. Differentiate between short0-0run and long run with suitable examples.
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Business Economics
UNIT 9 PRODUCTION FUNCTION – II
Objectives

 Understand the concept of ISO-Quant curves.
 Describe the features of ISO-Quant Curves
 Appreciate the use of ISO-Quant Curves in the analysis of theory of production
 Describe the producer equilibrium using ISO-Quant curves and ISO-Cost line
 Explain the stages of production using ISO-Quant Curves
 Draw the ISO-Quant for various firms in real life situations by taking relevant
assumptions.
Structure
9.1 Introduction
9.2 Meaning of ISO-Quant curves
9.3 ISO-Quant map
9.4 Properties of ISO-Quant Curves
9.5 Optimum Combination of Factors of Production.
9.6 Expansion Path
9.7 ISO-Quant and Returns to scale
9.1 INTRODUCTION
In the last chapter we have discussed the theory of production with one variable input. In
production, however, a producer at times has to employ two variable inputs
simultaneously. Every firm seeks to find such a combination of two variable inputs which
may provide it maximum output at minimum cost. We can say that a firm makes rigorous
efforts to attain the optimum combination of factors or least cost combination of factors.
In the present chapter we will study a tool known as ISO-Quant Curve which has been
introduced to determine the optimum combination of factors of production.
Just as Indifference curve analysis helps a consumer to pick up that combination of two
goods which provide him maximum satisfaction, the ISO-Quant curve analysis helps a
producer to find such an optimum combination of two factor inputs which gives him
maximum output at minimum cost.
9.2 MEANING OF ISO-QUANT CURVE
The word ISO-Quant is made up two words „ISO‟ which means equal and „Quant‟ which
means quantity of production. Hence one can draw out the meaning of ISO-Quant curve
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Production
Function - II
or the „Curve which represents equal level of production using different combination of
factor inputs‟. According to Keirstead
“ISO-Quant Curve represents all possible combinations of two factors that will give the
same total product.”
e.g. Suppose that a firm is provided with the variable inputs, labour and capital. The firm
can produce 100 units of a commodity by employing varying combinations of these
inputs. The alternative factors combinations are given below in table – 9.1
Combination Capital Labour (Units) Total Product

(Units) (Units)
1st 10 + 5 100
2nd 6 + 10 100
3rd 4 + 15 100
4th 3 + 20 100
Table 9.1 shows different combinations of labour and capital inputs which jointly
produce 100 units of output. e.g. 10 units of capital and 5 units of labour provide the
same total produce as 3 Units of capital and 20 units of labour input. The firm is free to
choose any of these combinations to get 100 units of output. All these combinations are
shown through a diagramme which provide us the ISO-Quant Curve.
Y
Fig. 9.1
12 IQ
IQ
10 A
8
6 B
Capital
4
Input
C
2
D 100 Units
0
5 10 15 20 25 X
Labour Input
The above figure shows equal product curve i.e. ISO-Quant Curve which represent 100
units of output. The various combinations of factor inputs have been represented by
points A,B,C and D on the ISO-Quant curve.
9.3 ISO-QUANT MAP
A family of or a Group of equal product curves called an ISO-Quant Map. A firm is

provided not only with one ISO-Quant curve but by a number of ISO-Quant Curves
which represent different levels of Total product.
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Business Economics
Fig. 9.2
Y
IQ
IQ 3
IQ 2
1
Capital
Input
300
200
100
O Labour Input X
In the above figure IQ1 represents 100 unit of output while the IQ2 and IQ3 are
representing 200 and 300 units of total product, respectively. Hence when equal product
curves representing different levels of output are shown on same diagramme, it is known
as ISO-Product map or ISO-Quant Map.
9.4 PROPERTIES OF ISO-QUANT CURVES
It has already stated that the ISO-Quant Curve analysis is based on indifference Curve
analysis, therefore properties of Indifference curves are also to be found in the ISO-Quant
Curves. There are three main properties of ISO-Quant Curves which are :
9.4.1 An ISO-Quant Curve slopes downward to the right.

It means that an ISO-Quant curve has negative slope. The implication of such slope is
that if a firm wants to employ more of one factor input it shall have to employ less of
another factor input in order to attain the same level of Production.
9.4.2 ISO-Quant Curve are convex to the origin Point.

The Convexity of ISO-Quant indicate that it is relatively steep along Y axis and relatively
flat along the X axis. The convexity of IQ curve depends upon diminishing marginal rate
of technical substitution (MRTSLK). If we denote labour by „L‟ and Capital by „K‟, then
MRTS between L and K is defined as the quantity of K which can be given up in
exchange for an additional unit of L Mathematically,
MRTSLK =
Where = Change in Capital
And = Change in labour
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Production
Function - II
The ability to use one factor in place of another is measured by the marginal rate of
technical substitution. If we look back to table 9.1, we find that for successive units of
labour input lesser units of capital inputs are sacrificed.
9.4.3 ISO-Quant Curves never intersects each other

ISO-Quant representing different levels of output never cut each other. If they cut then
there would be logical contradiction. It will mean that ISO-Quant can show same level of
production at any point.
9.5 OPTIMUM COMBINATION OF FACTORS OF PRODUCTION
Due to scarcity f resources each firm would like to employ these resources in such a way
as to obtain maximum output by using these resources. Therefore every firm has to face
problem of choosing optimum combination of factors of production.
9.5.1 ISO-Cost Line

In order to find out optimum combination, a firm is supposed to have knowledge about
two things: (i) Its total expenditure, and (ii) per unit price of factor inputs.
Suppose that the total Finance available with firm are worth Rs. 10,000. Labour and
capital are the two factors which the firm can employ to produce a certain amount of
output. Per unit price of labour is Rs. 100, while per unit price of capital is Rs. 1000.
Three alternatives available to the firm are :
(i) The firm can spend all the money on capital. In such case the firm would be able
to get 10 units of capital; or
(ii) The firm can spend all its finance on labour which enables it to get 100 units of
labour; or
(iii) The firm can spend the available finance partly on capital and partly on labour.
All these alternatives are shown in the following diagramme 9.3.
Fig. 9.3
Y
10
Units of Capital
8
ISO-Cost line
6
4
2
B
O 20 40 60 80 X
100
Units of labour
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Business Economics
In the above figure all the combinations of labour and capital that a firm can purchase
using given amount of money are shown. When we join all these combinations we get a
line which is known as ISO-COST LINE.
ISO-Cost line is a counter part of Budget Line or the price line. If a firm spend all the
money on capital it would get OA amount of capital input and similarly if it spends all
the money on labour it would get OB amount of labour input. By joining these two points
we get ISO-Cost line or factor cost Line. The slope of ISO-Cost line is given as
9.5.2 Determination of optimal combination :
Fig. 9.4
Y
IQ IQ IQ
1 2 3
A
Equilibrium Point (MRTS=

)
Capital
(Units)
K E
150
100
Q 50
O L B X
Labour (Units)
In figure 9.4 ISO-Quant IQ1, IQ2 and IQ3 represents the total output of 50 units, 100 units
and 150 units respectively. AB is the ISO cot line. Firm attains equilibrium at point „E‟,
where the ISO-Cot line AB is tangent to ISO quant IQ2. At the equilibrium point the
producer is able to produce 100 units of output by employing K Units of capital and L
units of labour. Firm could get more output, i.e. 150 units if it would have established its
equilibrium at point P located at the ISO-quant IQ3. But due to limited money the firm
would be unable to do this.
Similarly if the firm sets its equilibrium at point Q it would be attainable by the firm but
the firm would be in loss as at this point the firm would be producing on lower ISO-
Quant IQ1 at which it can produce only 50 units of output.
Hence there will be only one point of equilibrium where
MRTSLK = = (i.e. Slope of IQ = Slope of ISO-Cost line)

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Production
Function - II
9.6 EXPANSION PATH
So far we have assumed that financial resources of the firm do not change. Suppose the
firm goes financially well off naturally it worked like to raise the level of output. Let us
explain this phenomenon using a diagramme.
Fig. 9.5
Y
A₂ IQ3
Capital (Units)
IQ2
A₁
IQ1 (Expansion
A E₂ Path)
E₁ 300
E 200
100
O B B₁ B₂ L
Labour (Units)
In Figure 9.5, AB is the original ISO-Cost lien of the firm which is tangent to IQ at E
Point, therefore point E is the original equilibrium point of the firm. Now, suppose the
factor prices remain unchanged while the financial resources of the firm increase. The
firm would be in a position to purchase more units of factor inputs with the help of
additional finances.
As a result of this, the ISO cost line will shift from AB to A1B1. THE New ISO cost line
A1B1 is tangent to a higher IQ 2 at point E1 representing higher level of output, similarly
if the finance of the firm further increase the new ISO-cost line would be A2B2 which is
tangent to IQ3 at point E2 representing still higher level of output.
By joining the equilibrium points E, E1 and E2 we get a curve known as expansion path. It
is also known as the scale line.
9.7 ISO-QUANTS AND RETURNS TO SCALE
Returns to scale is a very important concept that we have studied in previous chapter
using total product and total input concepts. The same concept can also be explained with
the help of ISO-Quant curves. Let us study their concept using ISO-Quant curves.
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Business Economics
9.7.1 Increasing Returns to scale

Increasing returns to scale refers to a situation in which increase in total output is more
than proportionate increase inputs. When the increasing returns to scale operate, the firm
will be required to increased the factor proportion at a diminishing rate to obtain same
level of output again as shown in the Figure 9.6.
Fig. 9.6
Y
IQ4
IQ3
P
IQ2
IQ1
Capital Input
K4 E3
K3 E₂ 400
K2
E₁ 300
K1
E 200
100
X
O L₁ L2 L3 L4 B4
Labour Input
In the Fig. 9.6, IQ, IQ2, IQ3 and IQ4 are the ISO-Quant which represent the output of 100
Units, 200 Units, 300 Units and 400 Units respectively. OP is expansion path which
indicates how different quantities of output could be produced at minimum cost. The
increasing returns to scale are indicated by the gradual decrease in the distance between
the ISO-Quants along the expansion path.
e.g. EE1 > E1E2 > E2E3
9.7.2 Constant Returns to Scale

Constant returns to scale occurs when the increase in the total output is proportional to
the increase in the quantities of inputs. This situation has been depicted in Fig. 9.7
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Production
Function - II
Fig. 9.7
Y
IQ3
IQ2
Capital (Units)
P
K3
IQ1 E₂
K2 E₁
K1 E 200
100 300
X
O L₁ L2 L3
Labour (Units)
In Fig. 9.7 IQ1, IQ2 and IQ3 are the ISO-Quants which represents the total output of 100
Units, 200 units and 300 units respectively. OP is the expansion path representing
different levels of output presented by various ISO-Quants. The constant returns to scale
one indicated by equal distances between various ISO-Quants. In order to raise the output
from 100 units to 200 units the factor proportion has also doubled e.g. EE 1 = E1E2.
9.7.3 Diminishing returns to Scale –

It implies that for a given increase in output, a larger increase in the quantities of factors
of production is required. In other words the proportionate increase in factor inputs will
be more than the proportionate increase in output. This has been shown in fig. 9.8.
Fig. 9.8
Y
IQ3
Capital (Units)
IQ2 P
K3
IQ1 E₂
K2 E₁ 300
K1 E 200
100
X
O L₁ L2 L3
Labour (Units)
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Business Economics
In figure 9.8 IQ1, IQ2 and IQ3 are the ISO-Quants representing output of 100 units, 200
units and 300 units respectively. OP is the expansion path representing proportionate
increase in output as a result of an increase in inputs. It is clear from the fig. 9.8 that for
getting another double units of output a firm had to employ units of labour and capital
more than double and this progressively increasing input as compare to output shows
diminishing returns to scale.
9.8 SELF ASSESSMENT QUESTIONS

1. What is ISO-Quant map? Explain with the help of a suitable diagramme.
2. Define ISO-Quant curve. Explain the properties of ISO-Quant curve.
3. What are the essential conditions for an optimal combination of factors. Illustrate
your answer with the help of ISO-product curves.
4. Explain the concept of returns to scale using ISO-Quant curves.
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Law of Supply &
Elasticity of Supply
UNIT 10 LAW OF SUPPLY & ELASTICITY OF SUPPLY
Objectives
 Understand the Concept of Supply.
 Describe the various factors affecting supply.
 Explain the law of supply with the help of appropriate examples.
 Distinguish between change in supply and change in quantity supplied.
 Understand the meaning of term elasticity and elasticity of supply.
 Identify various factors influencing supply.
Structure
10.1 Introduction
10.2 Meaning of Supply
10.3 Factors affecting Supply
10.4 Law of Supply
10.5 Shifts in Supply
10.6 Elasticity of Supply
10.7 Factors Affecting elasticity of supply
10.8 Summary
10.9 Key words
10.10 Self Assessment Questions.
10.1 INTRODUCTION
Like the term ‘demand’ the term supply is also after misused in the ordinary language.
Supply of a commodity is often confused with the ‘Stock’ of that commodity available
with the Producers.
Stock of a commodity, more or less, will equal the total quantity produced during a
period less the quantity already sold out. But we know that producers do not offer whole
of their stocks for sale in the market. Hence the amount offered for sale may be less than
the stocks of the commodity. The term supply shows a relationship between quantity and
price.
10.2 MEANING OF SUPPLY
Supply refers to various quantities of a commodity which producer will offer for sale at a
particular time at various corresponding prices.
In Simple words supply (like demand) means the quantity of a commodity offered for
sale at some price during a given period of time.
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Business Economics
10.3 FACTORS AFFECTING SUPPLY
The important determinants of supply can be grouped together in a supply function as

follows:
Sx = ⨍ (Px, Pr, F, T, G)
Where, Sx = Supply of Commodity ∝
⨍ = Function
Px = Price of Commodity ∝
Pr = Price of related Commodity
F = Prices of factors of production
T = Technology
G = Goals or general objectives of the producer.
Let us study how these factors affect supply of an commodity.
(1) Price of Commodity – If other things remains same, as the price of the
commodity increases, its supply also increases and as the price of any commodity
decreases. Its means that there exist positive and direct relationship between price and
supply of any commodity.
(2) Price of related goods : Related goods includes substitute goods and
complementary goods. If the price of substitute good goes up, producers would be
tempted to divert their available resources to the production of that substitute. e.g. If
prices of pulses rises relatively to the price of wheat, land shall be used in the cultivation
of pulses only, and supply of what will fall.
(3) Prices of factors of production : Prices of factors of production also affect the
supply of the commodity to be produced. A rise in the prices of factors of production will
cause of consequent increase in the cost of producing those commodities which lead to
reduction in the supply of that commodity.
(4) Technology: The supply of a commodity depends upon the state of technology
also overtime technical know law changes. Discoveries and innovations help raise the
productivity of the factors and thus contribute to the raising supply upwards.
(5) Goals of firms : Goals of firms also affect the supply of any commodity.
Sometimes the firms supply more of the commodity only because the goal of the firm is
not only the profit maximization, rather to enhance the status and prestige of the firm.
10.4 LAW OF SUPPLY
Law of supply explains the relationship between price of a commodity and its quantity
supplied. Price and supply are directly related. A rise in price induces producers to supply
more quantity of the commodity and fall in price makes them reduce the supply.
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Law of Supply &
10.4.1 Supply Schedule and Supply Curve

Law of supply can be illustrated with the help of a schedule and a supply curve. A supply
schedule is a tabular statement that gives a full account of supply of any given
commodity in a given market at a given time. Supply schedule is of two types :
(i) Individual supply schedule and
(ii) Market Supply Schedule.
(i) Individual Supply Schedule states the quantities of a commodity that a producer
would offer for sale at various prices. e.g. following is an individual supply schedule.
Price Qty. (Units)

1 20
2 23
3 29
4 32
5 34
(ii) Market Supply Schedule – It is the sum of individual supply schedules for all
those firms which are engaged in the production of a given commodity during a given
period.
Individual Supply Curve : It conveys the same information as a supply schedule but it
shows the information graphically. In other words when we plot the details given under
individual supply schedule whatever curve. Let us draw individual supply curve using
previous individual supply schedule.
Y SS1
6
5
Price (Rs.) 4
3
2
3
1
2O V 2 2 2 2 2 3 3 3 X
0 2 4 6 8 0 2 4
Quantity
In the above figure, curve SS1 shows individual supply curve showing various levels of
supply of a commodity by a producer at different prices.
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Business Economics
Similarly market supply curve can be obtained by summing up the individual supply
curve or by platting the market supply schedule graphically.
10.5 SHIFTS IN SUPPLY
In this heading basically we wanted to study change in supply that can occur either
because of price factor or because of factors other than price. The change in supply
because of price factor is known as change in quantity supplied. On the other hand
fluctuation in supply because of any other factor (e.g. price of related goods, technology,
prices of factors of production etc.) is known of change in supply.
10.5.1 Change in Quantity Supplied

The fluctuations in the supply because of price is known as change in quantity supplied.
This causes movement along the supply curve either upward or downward. The upward
movement along the supply curve is known as contraction of supply and downward
movement along the supply curve denotes the extension of supply. Let us illustrate this
concept with the help of a diagramme as follows:
It is clear from the above diagramme that SS 1 is Supply Curve. Initially when price was
OP quantity supplied was OQ. Suppose price of the commodity increases from OP to OP1
as a result quantity supplied also increases from OQ to OQ1 and this increase in quantity
supplied is known as extension of supply.
On the other hand if price of the commodity decreases from OP to OP 0 quantity supplied
of the commodity also decreased from OQ to OQ 0 and this reduction in quantity supplied
is known as contraction of supply.
10.5.2 Change in Supply

The fluctuations in the supply of any commodity because of factors other than price (e.g.
price of related goods, technology en) is known as change in supply. This leads to shift in
supply curve either rightward or leftward. The rightward shift in supply curve denotes
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Law of Supply &
increase in supply and leftward shift in supply curve expresses decrease in supply. Let us
illustrate the concept with the help of following diagramme.
Y SII
S SI
Price P
SII
(Rs.) S SI
Q0 Q Q1
Decrease in Increase in
Supply Supply X
O
Quantity
In the above figure SS is the initial supply curve at which the producer is producing OQ
units at price OP. Now suppose there is enhancement in the technology it will lead to
increase in supply from OQ to OQ1 and the new supply curve will be SISI. On the other
hand if Prices of the factors of production increased. It will lead to increase in overall
cost and this in turn will result in the decrease in supply from OQ to OQ 0 and the supply
curve will shift leftward from SS to S IISII. Such enhancement and reduction in supply due
to factors other than price is known as increase and decrease in supply respectively.
10.6 ELASTICITY OF SUPPLY
Before studying the concept of elasticity of supply one should know about elasticity. The
term elasticity refers to the flexibility of anything. Any object is said to be elastic if it can
be changed easily and it is said to be inelastic if it can’t be changed easily. Elasticity of
supply refers to the responsiveness of quantity supplied as a result of change in price of
the commodity. In other words, elasticity of supply measured as a percentage change in
price of the commodity. In short
Where, P = Initial Price

Q = Initial Quantity Supplied
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Business Economics
ΔP = Change in Price
ΔQ = Change in Quantity Supplied
ES = Elasticity of Supply
Illustration
Suppose of Producer is willing to supply 200 quintals of wheat at the price of Rs. 220.00
per quintal. If the price increases to Rs. 240.00 per quintal. He is willing to supply 250
quintals of wheat. Calculate the elasticity of supply of wheat.
Sol. Elasticity of supply of wheat will be calculated as follows :

Quintal Price
200 220
250 240
Here, Q = 200 P = 220
ΔQ = 50 ΔP = 40
We know that
ES = 1.375
ES = 1.375 means that if the price of wheat goes up by one percent supply of wheat will
increase by 1.375 percent.
The value of elasticity of supply varies from zero to infinity. The major categories of
elasticity of supply are as follows :
1. Perfectly inelastic supply : (ES =O)

It refers to a situation in which there will be no change in the elasticity of supply in spite
of the change in price of the commodity. The graphical presentation of such a case would
be like as follows :
In the above figure SS is perfectly inelastic supply cure. In spite of change in price from
OP to OP0 and OP1 there is no change in quantity supplied.
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Law of Supply &
2. Less than elastic (es<1) :

It refers to a situation in which quantity supplied changes by a smaller percentage than
the percentage change in price of the commodity. We can show such elasticity with the
help of following figure :
It is clear from the above figure that percentage change in quantity supplied is (QQ 1) is
less than percentage in price of commodity and as a result the elasticity of supply is less
than one in above diagramme.
3. Unitary elastic (es = 1)

It refers to a situation in which the percentage change in quantity supplied is equal to the
percentage change in price of the commodity. We can show the situation with the help of
following diagramme.
It is clear from the above diagramme that percentage change in quantity supplied (QQ 1) is
equal to the percentage change in price (PP 1). It shows unitary elastic supply curve (SS).
4. More than Unitary Elastic (es>1)

It refers to a situation in which percentage change in quantity supplied is more than the
percentage change in price of the commodity. We can show this with the help of
following diagramme.
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Business Economics
In the above figure SS is Supply curve showing more than Unitary elastic supply as
percentage change in quantity supplied is more than percentage change in price (PP1).
5. Perfectly elastic Supply Curve (es = ∞)

It is a situation in which there is continuous changes in supply. The change in places are
zero still the quantity supplied keep an increasing. We can experts this situation an
following
(es = ∞)
It is clear from the above diagramme that quantity supplied is increasing in spite of no
change in the price of commodity.
10.7 FACTORS AFFECTING ELASTICITY OF SUPPLY.
(i) Nature of Commodity:

The most important determinant of the elasticity of supply is the nature of commodity.
The commodity can be (i) Perishable and (ii) Non-Perishable (Durable). Perishable
products cannot be stored hence their supply is inelastic or their supply can’t increase or
decrease as and when needed. Non-Perishable goods on the other hand can be stored and
hence their supply is flexible in nature and elastic also.
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Law of Supply &
(ii) Time required for production:

Production of any commodity always involves a lime-bag which may vary from a few
days to a few years. The commodities which required less time in production are having
elastic supply on the other hand the commodities when required more time in the
production process are having will be having less elastic supply.
(iii) Techniques of Production:

Techniques of Production also affects the elasticity of supply as simpler the technique.
The more ease in producing goods which in turn lead to more elastic supply as the
production of goods can be enhanced as and when required very easily. On the other hand
the commodities having complex production process will be having less elastic supply.
(iv) Future Expectations:

Expectations about price changes may also affect the elasticity of supply. If the producers
expect the prices to rise in future, they may hold on to the stocks of goods and may not
make the products available for sale in market. Supply in such situation would be
inelastic in nature. On the other hand the supply would be elastic if the prices are
expected to fall in future.
(v) Nature of Inputs:

There can be two kinds of inputs : Specialized inputs and non-specialized inputs. If
production of a commodity involves the use of specialized inputs its supply tends to be
inelastic, on the other hand supply of commodity will be elastic whose production
requires the use of non-specialized inputs.
(vi) Nature of Cost :

Supply of commodity having increasing cost will be inelastic; whereas supply of a
commodity involving low cost will be elastic.
Self Assessment Questions

1. Explain various factors affecting supply curve.
2. Define ‘Supply’ and Market Supply.
3. Define ‘Law of Supply’. Illustrate the concept using appropriate examples and
diagramme.
4. Illustrate the concept of elasticity of supply with an appropriate examples.
5. What are various factors affecting elasticity of supply? Explain.
6. A producer is selling 100 units of a commodity at price Rs. 5.00. How many
units of the commodity would he sell if the price of the commodity falls to Rs.
4.00 per unit? Assume Price elasticity of Supply is 1.
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Business Economics
UNIT 11 THEORY OF COST & COST CURVES
Objectives
 Understand the concept of cost and various components of cost.
 Explain cost function and its types
 Describe various types of cost.
 Draw various cost curves neatly.
 Explain the traditional and modern aspects of Long-Run Cost Curves.
 Appreciate the relevance of cost theory.
Structure
11.1 Introduction
11.2 Meaning of cost
11.3 Components of Costs
11.4 Cost function
11.5 Short Run cost function
11.6 Nature of Long run cost Curves
11.7 Long-Run cost curves – Modern version
11.1 INTRODUCTION
The concept of cost generally explained in the context of production. A producer has to
use all the factors of production which are land, labour capital and entrepreneurship. The
producer has to capital and entrepreneurship. The producer has to pay for these factors of
production for their services. The expenses incurred on these factors of production are
known as the cost of production or in short, the cost. The concept of cost is o great
significance in the price theory as these are cost and revenue that determine the
production decision f an entrepreneur whose sole aim is to earn maximum profits.
11.2 MEANING OF COST
In simple words ‘the term’ cost of production refers to the money expenses incurred in
the production of a commodity. It would be wrong to say that money expenses alone
constitute the cost of production of commodity. Money expense constitutes only a part of
the cost. The real nature of cost could be understood only after understanding the
following components of cost.
(i) Money cost (ii) Real cost (iii Opportunity cost (iv) Incremental and sunk cost and (v)
Private, External and social costs.
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Theory of Cost &
Cost Curves
11.3 COMPONENTS OF COSTS
(i) Money cost : Money cost includes the following :

(a) Explicit and implicit costs : Money cost incurred can the resources used in the
production of a commodity are known as explicit cost of a commodity. These includes
wages paid to the labour force, rent paid in.
Implicit costs of production are those costs of self owned. Self employed resources that
frequently overlooked in computing the expenses of a firm.
(b) Normal Profits : Normal profits are an additional amount over the cost that must
be earned by a producer in order to induce him to stay in the industry.
(ii) Real cost : Real cost refers to those payments which are made to factors of
production to compensate for the efforts put in by them. Real cost is computed in terms
of pain and discomfort involved for labour when it is engaged in production. This
concept, however, does not carry any importance in the cost of production because it is a
subjective term and it lacks precision.
(iii) Opportunity cost : The concept of opportunity cost shows the problem of choice.
It is the cost of next best alternative available with the producer. In the more simpler
terms opportunity lost. For example if a person choose for a job of salary amounting to
Rs. 50,000/- and for that he has to leave the job offers of Rs. 40,000 and Rs. 30,000. In
that case the person’s opportunity cost of doing the job is Rs. 40,000.00 (cost of
next best alternative).
(iv) Incremental cost and sunk cost incremental cost is the additional cost to a change
in the level or nature of business activity. It can be defined as the change in total cost
resulting from a decision. Symbolically,
ICn = TCn – TCn-1 = TC

Where, ICn = Incremental cost of nth unit.
TCn = Total Cost of nth unit.
TCn-1 = Total Cost of (n-1) unit.
The incremental cost differs from the marginal cost in the sense that whereas the
marginal cost measures change in total cost per unit of output, the incremental cost
measures change in total cost as a result of change in total output.
Sunk cost is one which is not affected by change in nature of business activity. It is the
cost already incurred in past. e.g. of sunk cost is - Depreciation.
(v) Private, External, and social costs. A cost that is not borne by the firm but is
incurred by others in society is called an external cost. The true costs to the society must
include all costs regardless of who bears them. Thus social cost is the sum of private and
external cost.
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Business Economics
Hence,
Social Cost = External cost + Private cost
Private Cost = Social cost – External Cost
11.4 COST FUNCTION
Cost function expresses the relationship between cost and its determinants. Cost function
is expressed in terms of functional relationship as follows :
C = ⨍ (S, O, P, T,…)
Where, C = Cost
S = Size of Plant
O = Level of output
P = Prices of inputs
Cost function can be formulated for the short run and the long run depending upon the
requirements of the firm. However, the short run and the long run functions are interrelated.
11.5 SHORT RUN COST FUNCTION
We have defined ‘cost’ to include expenses (explicit and implicit) incurred on factors of
production used in the production of a commodity. These factors can be classified in two
groups, viz., (a) Fixed Factors and (b) Variable factors.
11.5.1 Total cost of production

Total cost of production refers to the aggregates of expenses on fixed and variable
factors. We can divide total cost into two parts.
(i) Total Fixed Cost and
(ii) Total variable costs
11.5.1 (i) Total Fixed Cost (TFC)

Total fixed cost refers to the sum of all the expenses on the fixed factors like land
insurance, top management salary etc. Total fixed costs remains same in short run and are
independent of output. Graphically, total fixed cost will be represented as a straight line
parallel to the horizontal axis as shown below :
Y
Cost (Rs.’
000) 1 TFC
156 O 3 X
1 2
Output(‘000)
Theory of Cost &
Cost Curves
The curve TFC shows that the total fixed cost remain constant at different levels.
11.5.1 (ii) Total Variable Costs (TVC)

Total variable costs represent the cost of all variable resources such as labour or raw
materials. These costs rise as the firm’s output increases.
Graphically TVC can be presented as follows :
Y
TV
C
Cost (Rs.’
000)
Output(‘000)
O X
In the above figure TVC is total variable cost showing positive relationship between total
variable cost and output.
11.5.1 (iii) Total Costs

Total costs of a firm are the sum total of total fixed cost and total variable costs. We can
diagrammatically express total costs as follows :
TC (TVC +
Y TFC)
TV
C
Cost (Rs.’
000) TF
C C
Quantity
(‘000)
O X
In the above figure TC is Total Cost which is arrived at by summing up TVC and TFC.
11.5.2 Average Cost (AC)

Average cost is the per unit cost of production. Like Total Cost it is also the sum of
Average Fixed Cost (AFC) and Average Variable Costs (AVC).
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Business Economics
11.5.2.(i) Average Fixed Cost (AFC)

AFC is the per unit cost of the fixed factors of production. Average fixed cost is obtained
by dividing total fixed cost by total units of output.
Symbolically
Where, TFC = Total Fixed Cost

TQ = Total Quantity Produced
Since TFC remain constant and total quantity keep on increasing hence the value of AFC
keep on decreasing. The Graphical presentation of AFC would be like as follows :
Y
Cost (Rs.’
000)
TFC (Total Fixed Cost

Quantity Curve)
(‘000)
O X
It is clear from the above diagramme that TFC curve is declining continuously.
11.5.2 (ii) Average Variable Cost (AVC)

Average variable cost is the per unit cost of variable factors of production.
Symbolically
Where, TQ = Total Quantity

TVC = Total Variable Cost
AVC = Average Variable Cost
Graphically we can show AVC as follows :

Y
AV
C
Cost (Rs.’
000)
Q
158 Quantity O X
(‘000)
Theory of Cost &
Cost Curves
In the above figure AVC Curve is shown as a ‘U’ shaped curve which is depicting
tendency to fall initially and rises after the point of normal capacity has been reached.
11.5.2 (iii) Average Cost (AC)

Average cost is per unit cost of fixed and variable factors of production. The Average
cost is arrived at by dividing total cost by total output.
Symbolically
Since, TC = TFC + TVC, AC can also be written as
AC = AFC + AVC
Shape of AVC and AC is looked move or less similar to each other but if we draw both
figures on a single diagramme. We can differentiate between them. Let us have a look on
AC curve as the summation of AFC and AVC curves.
Y MC
AC
Cost (Rs.’ AV
000) C
AF
C
O Q0 Q1 X
Quantity
Graphically, AC curve is obtained by adding AFC and AVC curve as in the above figure.
At each level of output, AC curve lies above AVC curve at a distance equal to the
corresponding height of curve AFC. Hence, there are two major things to be noted about
Nature of AC curve.
(i) AC curve tends to come closer to AVC curve (as amount of AFC keep an
decreasing) but it never touches to AVC.
(ii) The minimum point of AVC (i.e. OQ0) comes before the minimum point of AC
(i.e. OQ1).
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Business Economics
Another important observation about the shape of short run AC curve is that it is a U
shaped curve.
Why AC behind U shape of AC curve are ?

(i) AC curve is the sum of AFC and AVC curve.
(ii) Average Fixed Cost is obtained by dividing Total Fixed Cost by total output.
Since total fixed cost remains constant at different levels of output. It follows that
average fixed cost falls s the level of output is increased.
(iii) Average variable cost is influenced by the law of variable proportions. AVC
curve is a saucer shaped curve, which shows that average variable cost begins to rise
beyond the point of normal capacity.
(iv) Hence, as long as average variable cost falls, Average total cost also falls.
Beyond this point for sometime though the Average variable cost may be rising, the
falling Average fixed cost overbears it, resulting in declining average total cost. But
ultimately average total cost must rise. This gives us the U-shape of the average cost
curve.
11.5.3 Marginal Cost (MC)

Marginal cost is the addition to the total cost as a result of a unit increase in the output. It
is calculated by measuring change in total cost resulting from a unit increase in output.
Symbolically
MCn = TCn – TCn-1
Where, MCn = Marginal Cost of nth unit.
TCn = Total Cost of nth unit.
TCn-1 = Total cost of (n-1)th unit.
Like Average Variable Cost, initially marginal cost also falls with an increase in the level
of output. Ultimately it also increases. Graphically it can be shown as follows :
Y
MC AV
C
Cost (Rs.’
000)
Q
O X
Quantity
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Theory of Cost &
Cost Curves
11.5.4 Relationship between Average cost and Marginal cost.

The major points of relationship0 of AC and MC and as follows :
(i) Both Average Cost (AC) and marginal costs are derived from Total Costs. as
MC = TCn – TCn-1 and
(ii) When average cost falls with an increase in output, marginal cost is less than the
Average Cost. It can be shown with the help of following diagramme.
Y
MC AV
C
Cost (Rs.’
000) M (Minimum point of
AC)
Q Q
O o X
Quantity
It is clear from the above figure that marginal cost curve is less than the Average Cost
Curve till point M upto which the Average Cost is falling.
(iii) Marginal Cost (MC) begins to rise at a lesser level of output than AC. It is also
clear from above diagramme that minimum point of MC (OQ O) comes before the
minimum point of AC (OQ), therefore MC begins to rise at lesser output level than AC.
(iv) The MC curve cuts AC curve at its minimum point. In the above figure M is a
point Where MC curve is cutting AC curve and M is the minimum point of AC curve.
(v) With increase in average cost, marginal cost rises at a faster ate. This can be seen
in the figure above that beyond OQ level of output MC curve is above AC curve.
11.6 NATURE OF LONG-RUN COST CURVES
In the Long run, all factors are variable and hence there is no difference between fixed
and variable costs. All costs and variable costs. Hence we will study only Long-Run
Average Cost curve (LAC) and Long Run Marginal cost curve (LMC).
11.6.1 Long-Run Average Cost Curve (LAC)

The Long run average cots curve is derived from short-run cost curves, which is tangent
to the LAC at the point. Let us see with the help of following diagramme. How the LAC
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Business Economics
is derived from the SAC curves. Let us assume is derived from the SAC curves. Let us
assume that the available technology to the firm at the particular point of time includes
three methods of production. Each with different plant size, a small plant, medium plant
and large plant. The small plant operates with costs denoted by the curves SAC, the
medium-size plant operates with the cost on SAC 2, and the large size plant gives rise to
costs shown on SAC3.
Y
C1 SAC
C2 1 SAC
2
SAC
Cos C3 3
t
O q1 Q Q1 q2 Q3 q3 X
Output
It is clear from the diagramme that if the firm wants to produce oq1. It will choose small
plant, if it wants to produce oq2 it will choose medium plant, and if it plans to produce
oq3 it will go in for large plant. If the firm starts with the small plant and its demand
increases, it will produce at lower cost upto level OQ. Beyond that point its costs starts
rising. If its demand reaches the level OQ1, the firm can either (i) continue to produce
with the small plant, or (ii) it can install medium size plant. The decision at this point
depends not on costs but on the firm’s expectations about its future demand.
If the firm expects that the demand will expand further than OQ 1 it will install the
medium plant because with this plant output larger than OQ1 could be produced at a
lower cost.
Similar considerations hold for the decision of the firm when it has to shift from the
medium-size plant to large plant.
Now, if we assume that there is a large number of plants available each suitable to a
different size, we obtain a continuous curve which is the planning LAC curve of the firm.
Each point on this curve.
Shows the minimum cost for producing the corresponding level of output. The LAC
curve is the locus of points denoting the least cost of producing the corresponding output.
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Theory of Cost &
Cost Curves
The traditional LAC curve is U shaped and it is after called, the ‘envelope curve’,
because it envelopes SAC curves as shown in following figure.
Y SAC
SAC 6 LAC
1
SAC
SAC 5
2 SAC
Cost SAC
3 4
O X
Q
Output
An implicit assumption of the U shaped LAC curve is that each plant size is designed to
produce optimally a single level of output. Any deviation from that point leads to
increased cost. The plant is completely inflexible, there is no reserve capacity. As a result
LAC curve, envelopes the SAC curves. The point of tangency occurs to the falling part of
the SAC curves for points lying to the left of the minimum point, M of the LAC. The
point of tangency for outputs larger than OQ occurs to the rising part of SAC curves.
Thus at the falling part of the LAC the plants are not worked to full capacity; to the rising
part of the LAC the plants are overworked; only at the minimum point M is the plant
optimally employed.
The ‘U’ shape of LAC curve is due to the economies and diseconomies of scale. Initially,
when the firm increases its scale of production it reaps economies of scale. However,
beyond a point in the short-run further expansion in the scale of production results in
diseconomies of scale and the long run average cost curve begins to rise.
11.6.2 Long Run Marginal Cost Curve (LMC)

Long Run Marginal Cost Curve (LMC) bears the same relationship to the long run
average cost curve (LAC) that any given short run marginal cost bears to short run
average cost. LMC curve cuts LAC at its lowest point as shown in the following figure.
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Business Economics
Y
SAC LAC
SAC 2
SM 1
SMC
LMC
C1 SAC 3
2
SAC
Cost SMC2 1 SAC
1
O X
Output
R
LMC curve cuts LAC at is lowest point R. LMC curve is flatter than the SAC curve.
11.7 LONG RUN COST CURVES – MODERN VERSION
Modern economists divide long run total cost into two parts, (1) production costs and (2)
Managerial costs.
11.7.1 Production Costs

Production costs fall continuously with increase in output. These costs fall steeply to
begin with and then gradually as the scale of production increases. This behaviour of
production costs is explained by the technical economies of large scale production.
Initially, these economies are substantial, but after a certain level of output is reached all
or most of these economies are attained and the firm is said to have reached the minimum
optimum scale, given the technology of the industry. If new techniques are invested for
larger scales of output, they must be cheaper to operate. But even with the existing
known techniques some economies can always be achieved at larger output :
a) Economies from further decentralisation and improvement in skills;
b) Lower repair costs may be attained if the firm reaches a certain size; and
c) The firm, especially if it is multiproduct, may well undertake itself the production
of some of the materials or equipment which it needs instead of buying them from other
firms.
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Theory of Cost &
Cost Curves
11.7.2 Managerial cost

In the modern management science for each plant size there is a corresponding
organizational administrative set up appropriate for the smooth working of that plant.
There are various levels of management, each with its appropriate kind of management
technique. Each management technique is applicable to a range of output. The costs of
different techniques of management fall upto a certain plant size. At very large scales of
output managerial costs may rise, but very slowly.
11.7.3 Derivation of Long Run Average Cost curve.

The result of slowly falling production costs and very slowly rising managerial costs at
very large scales of output may be that the LAC curve would fall smoothly or remain
constant.
We may draw the LAC curve implied by the modern theory of costs as follows :
SAC SA
Y 1
SAC SAC
C2 3
4
Cost
LA
2/3
C
2/3
2/3
Output 2/3 X
O
For each short-run period we obtain the SAC. Assume that we have a technology with
four plant sizes with costs falling as size increases. In business practice it is customary to
consider that a plant is used normally when it operates between two-thirds and three
quarters of capacity. We may draw the LAC curve by joining the points on SAC curves
corresponding to the two-thirds of the fall capacity of each plant size, as shown in the
figure above.
The characteristics of the LAC curve shown in the above figure is that
(a) it does not turn up at very large scale of output;
(b) It is not the envelope of the SAC curves rather it intersects them.
11.7.4 Derivation of Long-Run Marginal Cost Curves.

If the LAC falls continuously, the LMC will lie below the LAC at all scales, as shown in
following figure.
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Business Economics
Y LA
Y C
Minimum
LM Optional
Cos Cos C Scale
t LA t
C
LM
CX X
O O Output Q
Output
O O
If there is a minimum optimal scale of a plant e.g. OQ in the above figure at which all
possible scale economies are reaped, beyond that scale the LAC remains constant. In this
case the LMC lies below the LAC until the minimum optimal scale is reached, and
coincides with the LAC beyond that level of output.
The above shapes of costs are more realistic than the U-Shaped of the LAC. Many studies
have shown that Long run average cost curve is ‘L’ shape curve.
Self Assessment questions

1. What is the relationship between average cost and marginal cost? Can the
average cost curve fall when the marginal cost curve is rising? Use a
diagramme.
2. How is Long-run average cost curve derived with the help of short run average
cost curves.
3. Consider the two statements given below. Which of these are true and which
false? Explain your answer briefly :
(a) If the MC Curve is rising, it must be above AC Curve.
(b) If the AC curve is falling, MC Curve should be below it.
4. Why is the AC curve U-Shaped?
5. The output and total cost data of a firm are given below :
Output (Units) : 0 1 2 3 4 5
Total Cost (Rs.): 30 50 66 72 94 130
Computer TFC, AFC, TVC, AVC and MC.
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BLOCK - 4
THEORY OF PRICE
Business Economics
UNIT 12 EQUILIBRIUM CONCEPTS AND CONDITIONS
Objectives
After reading this unit, you should be able to understand:
 Difference between a firm and an industry in economics
 Deriving equilibrium of both firm and industry
 Use of the TR, TC, MR and MC approaches in deriving equilibrium
 How equilibrium can be derived in both short-run and long-run
Structure
12.1 Introduction
12.2 Approaches of firm’s equilibrium
12.2.1 TR and TC approaches
12.2.2 MR and MC approaches
12.3 Equilibrium of Firm and Industry
12.3.1 Short-run firm and industry equilibrium
12.3.2 Long-run firm and industry equilibrium
12.4 Let us sum up
12.5 Key terms
12.6 Suggested readings
12.7 Check your progress
12.1 INTRODUCTION
A firm is the smallest unit of production, in the production process. It uses the same
amount of different factors of production to produce a product. Therefore, number of
firms producing the same product in the market is called as an ‘industry’. For example,
let the product be the toothpaste. Colgate toothpaste produced by Colaget-Pamolive is a
firm. Hinduatan Unilever which produces Close-up is a firm and so on. In such a way,
combining several firms for the same product takes the shape of an industry and in this
case it is the toothpaste industry. Further, all shoe producing firms like Bata, Liberty,
Reebok, etc., are individual firms and combine together to form the shoe industry. Each
firm in the industry determines its output individually, of course, given the industry
determined price for the product. Such type of industry may be called as perfectly
competitive industry. But in monopoly, the firm itself is an industry. Hence, it has the
option to choose either the price of the product or the quantity of output it will produce
and sell but cannot determine both at a time. The overall objective of firms is to earn
maximum profit. In other words, the ultimate target of each firm is to produce that
quantity of output from which they can maximize their profit level. This much of
production of output level is called as equilibrium output.
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Equilibrium Concepts
and Conditions
The term ‘equilibrium’ when used to measure the behaviour of a firm and/or industry
implies that stage of production process where it has no inclination to either expand or
contract its produced quantity of output. This is the most liked stage in the production
process for any firm or industry. Such a stage is reached when the firm maximizes its
profits. Thus a firm is in equilibrium at that point where it enjoys maximum profits. For
this, the determination of the point of profit maximization is, therefore, the determination
of the point of equilibrium of the firm or industry.
Profit depends on two forces, viz.,

a. The revenue structure of the firm or industry
b. The cost structure of the firm or industry
Both revenue structure and cost structure are considered simultaneously in order to
determine the extent of profit. Total profit can be derived either by using the total revenue
with total cost or marginal revenue with marginal cost or average revenue with average
cost, as the difference between total revenue and total cost incurred in production
determines total profit.
a. Total Profit (TP)=Total Revenue (TR)- Total Cost (TC)
b. Average Profit= Average Revenue (AR) – Average Cost (AC).
c. Total profit can be derived by multiplying average profit by the units of
output sold, i.e., Total Profit = Average profit (AP) per unit × Output (Q)
d. Marginal Profit (MP) = Marginal Revenue (MR) – Marginal Cost (MC).
Again Total profit = the aggregate of marginal profits, i.e., Total profit = Σ MP.
12.2 APPROACHES TO FIRM’S EQUILIBRIUM
All business firms have some objective to pursue, which is in relation to the mission and
vision of the firm. Conventional economic theory of firm and industry behaviour assumes
profit maximization as the single objective of any business organization. Profit
maximization means the largest absolute amount of profits in terms of money under
given demand and supply conditions. Profit maximization analysis helps not only in
predicting the behaviour of business firms but also the price-output behaviour of the same
firm under different market conditions. No other analysis can explain and forecast the
behaviour of firms better than profit-maximization analysis.
Under perfect competition individual firms have to maximize their profits at the price
determined by the industry. Whereas under imperfect market competition firms search for
their profit maximizing price-output as they are price makers.
In general, a firm’s equilibrium condition can be explained with the help of two
important approaches. It is the nature of the market condition that determines the choice
among the two approaches. They are:
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Business Economics
12.2.1 Total Revenue (TR) and Total Cost (TC) approach and
12.2.2 Marginal Revenue (MR) and Marginal Cost (MC) approach.
Both the approaches are discussed as under.
12.2.1 Total Revenue and Total Cost Approach:

A firm to earn maximum profit has to produce that quantity of output at which the
difference between the TR and TC reaches a maximum. Total Cost (TC) is the sum total
of money expenditure incurred by the firm to produce a particular quantity of output. It is
the sum of Total Fixed Cost (TFC) and Total Variable Cost (TVC) in the short-run. TFC
remains constant in the short-run whereas TVC increases with the increase in quantity of
output. It, thus, indicates that TC of a firm increases with the increase in output but per
unit of TC will come down and total income will increase. On the other hand, TR is the
sum of total income received by the firm after selling a particular quantity of output. It is
determined by multiplying total output with the selling price of the product. Hence, given
the price of the product, TR depends on the total output produced for selling. It indicates
that TR, like TC, also increases with the increase in output but not in direct proportion.
The correlation is TVC per unit is constant and TFC decreases with the increase in
quantity of production.. Hence, both TR curve and TC curve are increasing functions of
output. Considering both TC and TR curve, the firm’s equilibrium condition is derived in
the figure as below.
Y
Total Rev., Cost & Total Profit
TC
TR
N
P S
D
O X
L M N
F
Output TP
Figure No-12.1
From figure-12.1, it can be seen that the total cost (TC) curve slopes upward from the
point P on the OY-axis. It shows that OP is the TFC of production. TR is the total
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and Conditions
revenue curve which starts from the origin O. The shape of TR curve is upward sloping
to right and is concave to the origin. The first interaction point between TR and TC
curves is at point S, producing OL quantity of output. At this point S, the TR curve
remains below the TC curve (i.e., TC > TR), which indicates that the cost is greater than
the revenue earnings i.e., the expenditure is greater than the income. Thus, the firm does
not earn any profit at this quantity of output OL. From this it is clear that production of
any quantity of output less than or equal to OL quantity is not an equilibrium output.
Furthermore, with increase in output by the firm beyond the OL quantity of output, the
firm will earn profit. From the figure it can be seen that, beyond OL quantity, the gap
between total cost and total revenue increases with every increase in output. The
difference remains highest at OM level of output. Two tangents drawn at point E on TR
curve and at point N on TC curve are parallel to each other, logically suggesting the
highest gap between the two curves. Production of any output beyond OM quantity will
cause reduction of profit to the firm. If still the firm continues to produce more, at OH
quantity of output again TC and TR will be the same. But any output beyond OH quantity
leads the firm to bear loss as the TC will be greater than TR. Hence, OM is the
equilibrium quantity of output for the firm. At this quantity the firm earns SNE amount of
total profit.
Thus, from the above derivation, it is quite reasonable to state that a firm to maximize
profit, has to produce an output at which the difference between TR and TC will be the
greatest. But locating the highest difference at the figures with the tangents is the greatest
drawback of this approach. An analyst has to draw a numbers of tangents on both the
curves to find the parallel pair of tangents. Further, this approach only explains the
equilibrium quantity of output and the amount of profit at that level of output only, but it
fails to explain the equilibrium price at which the product will be sold in the market. It is,
however, the marginal cost and marginal revenue approach of expressing firm’s
equilibrium that avoids the demerits as mentioned above.
12.2.2 Marginal Revenue and Marginal Cost Approach:

This concept of marginal cost and marginal revenue can be used as a better tool for
analyzing the firm’s equilibrium. Marginal Cost (MC) refers to the additional amount of
cost that a firm has to bear to produce an additional quantity of output. The marginal cost
curve shows the cost to be incurred for an additional unit at different quantities of output.
Whereas Marginal Revenue (MR) is the addition to total revenue due to the sell of an
additional quantity of output. At this point of equilibrium, the marginal cost of production
must be equal to the marginal revenue of the product. When MC > MR, it will not be
wise on the part of any producer to produce any additional unit of the product. On the
other hand, if MR > MC, the total profit of the firm will not be maximum and a rational
producer will not stop producing additional product. Alternatively, the firm will keep on
increasing its profit as long as MR > MC. Ultimately, the firm will continue producing
output until it reaches at a point where MC = MR. It is, therefore, the point where
marginal cost reaches a level where it is equal to marginal revenue at the point of
equilibrium.
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Business Economics
The above condition of equilibrium can also extracted from the Total Cost and Total
Revenue approach as discussed in the previous section. It is already discussed that a firm
will be in equilibrium at a point where the tangents drawn to both TR and TC curves are
parallel to each other. Geometrically, tangent at a point on the curve denotes slope of the
curve at that point. It implies that slopes of both the curves must be equal. The slope at a
point on the total cost curve is the marginal cost and the slope at a point on the total
revenue is the marginal revenue. Further, as the tangents drawn on both the curves are
parallel, hence, the slope drawn at TC curve and the slope of the TR curve are equal at
the point of equilibrium. It ultimately proves that marginal revenue is equal to marginal
cost at the point of equilibrium. Since MR and MC are equal, it is the stage of
equilibrium. The MC and MR approaches of the firm’s equilibrium can be determined
with the help of following figures.
It can be seen from figure-12.2 that the marginal cost curve is U-shaped. The U-shaped
MC curve implies that in the beginning stage of the production process, marginal cost
decreases with each additional increase in output and beyond a point it starts increasing
with each additional increase in output. Where as it can be seen that the marginal revenue
curve is a decreasing function of output. This implies that marginal revenue falls with
each additional increase in output.
Y
Y
MC MC
MC, MR & AC
MC & MR
R
A
C P1
E
F P
B
D E
AC
MR
MR
X O X
O L M H M
Output Output
Figure No.-12.2
In figure-12.2, the marginal revenue curve intersects the marginal cost curve at point E,
producing OM quantity of output. Since, at point E, MC=MR, this point can be treated as
the point of equilibrium. Analyzing further, at any unit of output below OM quantity, MR
> MC. This indicates that the firm can acquire more profit with each unit increase in
production of output at this point. Thus, any rational producer will not stop production as
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and Conditions
he is adding profits with each addition of output. However, a rational producer will not
continue production beyond OM quantity of output. It can be seen from the figure that,
beyond OM quantity, for each output of quantity, MC > MR. This implies that the firm
has to bear more cost than revenue for each additional unit of production, which any
rational producer never follows. This proves that the firm must be in equilibrium if it has
to earn maximum profit, is necessary that MC must be equal to MR. This condition of
determination of firm’s equilibrium is called first-order condition.There exists another
condition to explain the firm’s equilibrium position along with the above derived first-
order condition and that is the second order condition.
Another condition of deriving firm’s equilibrium is that its marginal cost curve (MC)
must intersect its marginal revenue curve (MR) from below. In other words, before
reaching the equilibrium point, marginal cost of the firm must be less than the marginal
revenue. This condition can be well explained with the help of figure-12.3.
MC
P E
MR
MC & MR
X
O N Output M
Figure No.-12.3
It can be seen from figure-12.3, that the marginal revenue curve of the firm is a parallel
straight line to OX-axis. This implies that the firm has assumed that it is working under
the condition of perfect competition. The U-shaped marginal cost curve intersects the
marginal revenue curve twice at points P and E. It indicates that the firm is in equilibrium
at both the points. At point P, the MC=MR curve of the firm and the firm is producing
ON amount of output. It can be closely observed from the figure that any further
production of output beyond ON quantity indicates reduction of marginal cost. The
marginal cost curve is falling gradually with each additional increase in output beyond
the equilibrium point P. Since the marginal cost is falling with each additional unit of
production, no rational producer tries to stop production at point P rather will wish to
expand beyond. Thus an increase in output beyond ON quantity of output yield profit to
the firm. It, hence, can be concluded that point P cannot be the point of equilibrium as the
firm has a tendency to increase the output beyond ON quantity of output to increase
profit.
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Business Economics
Further, the point E satisfies both the conditions of equilibrium that is at this point
MR=MC and the MC curve is intersecting the MR curve from below. The amount of
profit will be the maximum once the firm reaches at point E. Thus, it is right to say that
point E is the real point of equilibrium. Any further production by the firm beyond point
E leads to increase in MC than the MR and it indicates that it is not ideal for any firm to
produce an output beyond OM quantity. The second order condition can be strongly
validated with two cases that are given below.
E
MC & MR
MR
MC
X
Out put
Figure No-12.4
In the figure-12.4 above, E is the point of equilibrium as it satisfies the first order
equilibrium condition. But it can be seen form the figure that, the MC curve is
intersecting the MR curve from above. It indicates that MC curve is a decreasing function
of each additional unit of output produced beyond point E. Since MC is less than MR
beyond the equilibrium point, hence, each firm will have a definite tendency to go on
increasing output throughout the MC curve. This possibility practically looks vague.
Thus it is clear that point E in this case is not a point of equilibrium.
Where as, in the figure-12.5, it can be observed that both MC and MR curves are
decreasing function of output. The firm’s MC curve is intersecting its MR curve from
below. It implies that before the point of equilibrium E, MC is less than MR where as
after the equilibrium MR is less than MC. Any rational firm will stop producing its output
at point E as further expansion of output may lead to loss. It is thus, concluded that E is
the stable equilibrium point.
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and Conditions
MR & MC E
MC
MR
X
Out put
Figure No.-12.5
Thus, from the above derivation of firm and industry equilibrium the following two
conditions emerge.
The point of equilibrium must satisfy two conditions as derived below:

a. The marginal cost (MC) = marginal revenue (MR)
b. Marginal cost curve (MC) must intersect the marginal revenue (MR) curve from
below.
Activity-1:
Consider the case of a firm near by your region. Collect the data on total revenue and
total cost for some level of output. Plot the total revenue curve.
________________________________________________________________________
________________________________________________________________________
___________________________________________________________________
Activity-2:
Do you think that the firm is producing maximizing profit level of output? What advice
will you give as an economist to the producer?
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
____________________________________________________________________
12.3 INDUSTRY AND FIRM EQUILIBRIUM
Previous sections of the analysis determine the equilibrium condition of the firm. Perfect
competition is a form of market condition in which there are large numbers of buyers and
sellers, single price, no government interference, homogeneous product, free entry and
free exit of the buyers and sellers, consumers having perfect knowledge about the
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Business Economics
product, profit maximization and absence of transport cost. In such a market structure
there are large numbers of firms producing the same commodity. In other words, there
are producers of the same product in the market and the products are easily available to
consumers at their desired competitive price. Thus, the industry consists of the firms
producing similar commodity.
Price of the product is determined by the two forces of the market i.e., demand for and
supply of the commodity. An industry will be in equilibrium at that point where the
quantity demanded for the product will be equal to the quantity supplied. Each individual
firm producing the similar product in the industry has to accept that price which is
determined by the interaction of demand for and supply of the product in the market. The
quantities of output each individual firm produces are so small in the market that it
cannot affect the total supply and also price of the product in the industry. Thus, a firm
under the condition of perfect competition to be in equilibrium has to determine a suitable
quantity of output. The output which a firm produces in the short-run may or may not
yield normal profit. There is possibility that in the short-run at the point of industry
equilibrium a firm may get supernormal profit or normal profit or incur losses. This
happens because short-run is a period of time in which, a firm to change the quantity of
output has options to change only the quantities of variable factors of production only.
12.3.1 Short-run equilibrium of the industry and firm:

The determination of equilibrium of firm and industry under the condition of perfect
condition in short-run is explained with two cost situations given below:
a. Short-run equilibrium of firm and industry under identical cost conditions
b. Short-run equilibrium of firm and industry under differential cost conditions
(a) Short-run equilibrium of firm and industry under identical cost conditions
In order to analyse the equilibrium conditions of firm and industry, it is necessary to
assume the condition of uniformity. This assumption of uniformity states that the size of
all the firms that exists in the industry is uniform or same. The nature of the industry is
such that all firms are identical. That is why the total output produced in the industry is
shared equally by all the existing firms in the industry. Moreover, the price in the
industry is also determined by the point of equilibrium between the demand for and
supply of the product. In the short run, the existing firms can only make adjustments in
their output while the number of firms remains constant. Thus, the industries as well as
all the firms that exist in the industry get their equilibrium where the short-run demand
and supply curves of the product are equal.
The equilibrium of the firms with the industry equilibrium does not mean that all the
firms are getting supernormal profit. The possibility is also that some may be incurring
losses. The status of individual firm depends upon their own demand curve for the
product. The equilibrium condition of firm and industry are shown with the help of
figure-.12.6.
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and Conditions
Panel-A (Industry) Panel-B (Firm)
SMC SAC
D
Cost & Revenue

S
Price
E K T
P AR=MR
S R
S D
O X O X
Q M
Quantity Out put
Figure No.-12.6
The figure-12.6 is divided in two connected panels. Panel-A of the figure shows industry
equilibrium whereas panel-B shows firm equilibrium condition. In panel-A, the X-axis
represents quantity demanded and supplied and Y-axis represents the price of the
product. The industry demand curve DD intersects the industry supply curve SS at point
E determining OP price for the product. This implies that the OQ is the quantity of
output, where the industry demand and supply equal each other. Thus, each firm has to
trade their product at determined price OP in the industry. This implies that firm’s have to
adjust their quantity of output at the industry given price OP in order to maximize profit.
Whereas the panel-B of the diagram shows the supernormal profit condition of a firm.
The OX-axis represents firm’s output and OY-axis represents the amount of cost that the
firm is incurring to produce the output and the amount of profit it determined out of sale
of the product at the industry determined price. It can be seen that the short-run marginal
cost curve (SMC) intersects the marginal revenue curve (MR) at point T, determining the
supply of output as OM quantity. At this level of output the average revenue (AR) that
the firm is incurring is greater than the average cost (SAC) that it is bearing (i.e.,
AR>AC). Hence, it implies that the firm is incurring supernormal profit of an amount
KSRT.
Further, it is also possible that the firm may also have supernormal losses at the industry
determined price OP. A condition of firm who is incurring supernormal loss in the
industry is derived with the help of figure-12.7.
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Business Economics
Y
Y
Cost & Revenue

SMC
SAC
Price
D
S
K
EA R
P MR=AR
S T
S
D
O Quantity
XO X
M Output M
Figure No.-12.7
The descriptions that are represented in both the axis of both parts of the figure-12.7 are
same as that of figure-12.6. In panel-A, the industry gets its equilibrium at point E
determining the OP price of the product. The firm has to accept this industry determined
price. At this price OP, in panel-B, the firm is producing OM quantity of output as the
SMC intersects the marginal revenue curve at point T. Here, MR = MC = AR. So, with
OM quantity of output the firm is in equilibrium. Further it can be seen that to produce
OM quantity of output the firm is bearing the cost of an amount KM and earning total
revenue of an amount TM. This shows that the firm’s expenditure is more than the
income for which it is un-necessarily bearing a loss of an amount RSTK. This may
happen because of the unfavorable demand conditions of the industry’s product.
This implies the following few points on the determination of short-run firm and industry
equilibrium:
a. At the point of equilibrium, the short-run demand for and supply of the product in
the industry must be equal.
b. This equilibrium point determines the price of the product at which each firm has
to sell.
c. Each firm is in equilibrium where SMC = MR for each of them.
d. At the industry determined price, there is possibility that few firms may attain
profit or few may attain losses.
(b) Short-run equilibrium of firm and industry under differential cost conditions
It is not necessarily argued that all firms in the industry are producing in identical cost
conditions. The nature of the cost conditions for each firm may surely differ. In such a
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and Conditions
case, each firm is producing the same product at different scale. Let us consider three
different sizes of firm in an industry as derived in the figure-12.8.
Industry Firm-A Firm-B Firm-C

Supernormal profit Normal profit Supernormal loss
Y Y
Y Y
SAC
S SMC
Price
SAC
SMC
E C SMC
SAC
T
K
o K T E
P s S R MR=AR
t S R
D
X X X X
O Q O M O N O
L Quantity Output Output Output
Figure No-12.8
The figure-12.8 consists of two parts. The interaction between demand and supply curves
of the industry in part-A of the figure determines the equilibrium output and price. OP is
the price where quantity demanded is equal to quantity supply of the industry. In part-B
of the diagram, three different sizes of firms are considered. At OP price, firm-A
produces OM quantity of output and equalizes short-run marginal cost with the
determined price. Firm-A earns supernormal profit at the industry determined price OP,
where as, firm-B produces ON quantity of output and earns normal profit with the
industry determined price OP. On the other hand, firm-C bears a loss by producing OL
quantity of output at the equilibrium price. The industry output or supply OQ is
determined by adding the individual output produced by the firms in the industry. Hence,
in the derived figure-12.8, the industry output OQ = OM + ON + OL.
12.3.2 Long-run equilibrium of the industry and firm:

Long-run is a period of time in which both firm and industry are in equilibrium. Long-run
equilibrium of the industry is a condition in which the demand for and the supply of the
product are equal. Therefore, the industry and its members are in equilibrium when the
industry supply of the product equals to the industry demand for the product. A firm will
be in equilibrium when its marginal cost (MC) equals to its marginal revenue (MR). The
long-run is such a period where all the firms in the industry earn normal profit. Since all
firms are earning normal profit in the long-run, a new firm does not enter nor does an
existing firm exit from the industry. The long-run equilibrium determination of industry
and firm is well explained with the figure-12.9.
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Business Economics
Y Y
D S LMC
LAC
Cost & Revenue

Price
E Q
P LMR=LAR
S D
X X
O M O N
Quantity Output
Figure No-12.9
In the figure-12.9, DD is the long-run demand curve and SS is the long run supply curve
of the industry. The SS intersects the DD curve at point E. At point E, the industry
produces the equilibrium quantity i.e., OM at equilibrium price OP. At price OP,
assuming all firms are in identical cost condition, each firm is producing ON quantity of
output. At this quantity of output, the long-run marginal cost equals to long-run marginal
revenue and average revenue (i.e., LMC = LAR = LMR = LAC). Since at the price OP,
the long-run average cost equals to the long-run average revenue, hence, all the firms are
earning normal profit. Moreover, as all the firms are earning normal profit, no new firms
have the tendency to enter into the industry. Hence, all the producers are producing at
minimum cost in the long-run i.e., long-run marginal cost equals long-run average cost.
Activity-3
Confirm from the producers of at least two firms that whether they apply the theoretical
considerations for determining the point of maximum profits.
Activity-4
List out all the firms that are operating in a mobile handset manufacturing industry in
India. Collect their total cost figures and total revenue figures. Comment, who had the
highest turn over in the last year.
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and Conditions
12.4 LET US SUM UP
 At the point of equilibrium, the short-run demand for and supply of the product
in the industry must be equal.
 This equilibrium point determined the price of the product at which each firm has
to sell.
 Each firm is in equilibrium where their SMC = MR.
 At the industry determine price, there is possibility that few firms may attend
profit or few may attend losses.
 No existing firm has the tendency to quit the industry
 The long-run supply and demand for the product should be equal
 All firms in the industry are in equilibrium
 Entrepreneurs don’t just want profit, they want to maximize profit.
 No new firm shows its tendency to enter into the industry in the long-run.
 Total revenue is the price of a good multiplied by the number of units sold.
Average revenue and price are identical
 Marginal revenue is the change in total revenue generated by the change in the
level of output.
 Firms maximize profits by producing at that output where MC = MR. Production
at any other quantity of output may generate profits, but not the maximum profit.
 The principle of MC = MR is also applicable when a firm is incurring losses.
12.5 KEY TERMS
 Firm  Industry
 Equilibrium  Short-run
 Long-run  Profit
 Marginal cost  Marginal revenue
 Average cost  Average revenue
 MC=MR and slope  Normal profits
 Super normal profits  Supernormal losses

1. Lipsey, R.G. and Chrystal, K.A. (1995), An Introduction to Positive Economics,
(8th Edition), Oxford University Press.
2. Lyos, I.L. and Zymelman, M. (1966), Economic Analysis of the Firm, Pitman,
New York Press.
3. Pindyck, R.S. and Rubinfeld, D.L. (2001), Microeconomics, Pearson Education.
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Business Economics
.
12.7 CHECK YOUR PROGRESS
1. Critically evaluate the profit maximizing hypothesis of a firm.
2. Derive the condition of profit maximization based on:
a. TR and TC approach
b. MR and MC approach
3. Show that a firm is in equilibrium at the point where MR=MC.
4. MR =MC is not the only condition to attain equilibrium. Explain
5. Define marginal cost and marginal revenue with suitable diagrams.
6. Visit a few firms that are operating around your place. Ask them the most
common objective of their operation. Comment all the objectives which are
observed by you as top priority.
7. ‘At the point of equilibrium, the short-run demand for and supply of the product
in the industry must be equal’. Enumerate the statement in detail.
8. What do you mean by short-run in economics? Explain the conditions of short-
run equilibrium of a firm and industry in identical cost conditions.
9. Show with proper figures the conditions of short-run firm and industry
equilibrium under differential cost conditions.
10. What does long-run in economics imply?. Explain the condition of equilibrium
of firm and industry in long run.
11. Explain, why in long-run all firms operating in an industry acquire normal profit
only.
12. Consider the case of a shoe manufacturing industry. Make a list of firm
operating in this industry. Collect their total cost and total revenue figures over
the last few years.
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Perfect Competition
UNIT 13 PERFECT COMPETITION
Objectives
After completing this chapter, you will be able to understand
 What is market in economic sense?
 Difference between product market and factor market
 Types of market that exist in an economic environment
 Characteristics of perfect competitive market structure
 Determination of price and output under perfect competition
 Determination of profit under perfect competition
Structure:
13.1 Introduction
13.2 Classification of markets
13.2.1 Product market
13.2.2 Factor market
13.3 Structure of market
13.3.1 Classification based on geographical area
13.3.2 Classification based on time
13.3.3 Classification based on nature of competition
13.4 Perfect Competition market condition
13.4.1 Characteristic of perfect competitive market
13.4.2 Difference between pure and perfect competition
13.5 Price determination under perfect competition
13.6 Effect of shift in demand and supply on price level
13.7 Marshallian time period analysis
13.7.1 Market period price determination
13.7.2 Short-period price determination
13.7.3 Long-period price determination
13.8 Let us sum up
13.9 Key terms
13.1 INTRODUCTION
A market is a place where commodities are bought and sold at retail or wholesale prices.
In economics, however, the term market does not refer to a particular place as such but it
refers to a market for a commodity or commodities. Thus, the market is an arrangement
whereby buyers and sellers come in close contact with each other directly or indirectly to
sell and buy goods is termed as market. Hence, the term market is used in economics in a
typical and a specialized sense. They are:
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Business Economics
i. It does not refer only to a fixed location. It refers to the whole area of operation
of demand and supply.
ii. It refers to the conditions in which transactions between buyers and sellers take
place.
iii. A group of potential sellers and potential buyers are required at different places
for creating market for a commodity.
iv. Markets may be physically identifiable, e.g., Corral Bag in Delhi, Liuhing road in
Mumbai etc.
v. Existence of different prices for a specific commodity means existence of
different markets.
13.2 CLASSIFICATION OF MARKETS
Markets may be classified into two categories, like:

13.2.1 Product market and
13.2.2 Factor market.
13.2.1 Product market

A ‘product market’ or ‘commodity market’ refers to an arrangement for effective buying
and selling of commodities. In fact, each commodity has its market. Thus, we speak of
the cotton market, the wheat market, the rice market, etc. Markets for precious metals
such as gold and silver are called as the bullion exchanges or bullion markets. Markets
for capital change such as government securities, bonds, shares, etc., are the capital or
financial markets and are traded through stock exchanges..
13.2.2 Factor market

Factor markets are markets in which factors of production such as land, labour and
capital are transacted. There are, markets called labour market, land market, and capital
market. The households or the consumers are the buyers in the product markets. Their
demand is the direct demand for the consumption of goods.
The firms or the producers are the buyers in the factor markets. Their demand for
productive resources or factors of production is a derived demand. In the product market,
the commodity price of a specific commodity is determined individually by the
interaction of society. Factor prices such as rent of land, wages of labour and interest for
capital are determined in the factor markets. The price of each factor is determined by the
interaction between its demand and supply in its respective market. Thus, factor markets
facilitate distribution of income in the form of rents, wages, interest and profits.
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Perfect Competition
13.3 STRUCTURES OF MARKETS
The market is a set of conditions in which buyers and sellers come in contact for the
purpose of exchange of goods and services. The market situations vary in their structure.
Different market structures affect the behaviour of buyers and sellers directly. Further,
different prices and trade volumes are influenced by different market structures. Again,
all kinds of markets are not equally efficient in the exploitation of resources, and
consumers’ welfare also varies accordingly. Hence, the different aspects of the pricing
process should be analysed in relation to the different types of market.
Markets may be divided on the basis of different criteria. They are:
13.3.1 Classification based on geographical area,
13.3.2 Classification based on time element and
13.3.3 Classification based on nature of competition.
13.3.1 Classification based on geographical area:

Markets based on geographical area may be classified as:
a. local markets,
b. regional markets,
c. national markets, and
d. world markets,
(a) Local markets: Markets pertaining to local areas are called local markets. When
commodities are bought and sold at one place or in one locality only, then it is known as
local market.
(b) Regional markets: Goods are sold within a particular region, is known as regional
market. For example, most of the films produced in regional languages in India have their
regional markets only.
(c) National markets: Goods in a national market are demanded and sold on a nationwide
scale. A large number of items such as TV sets, cars, scooters, fans, vanaspati ghee,
cosmetic products, etc., produced by big companies have national markets. A good
network of transport, communication and banking facilities are required in promoting
national markets.
(d) World markets: In world markets goods are traded internationally. In international
markets, goods are exchanged between buyers and sellers from different countries and we
use the term exports and imports of goods. In this context the important fact is that those
countries which have competitive advantages will be able to produce cheaper goods in
that area and others will have to buy from them.
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Business Economics
13.3.2 Classification based on time element:

Time element refers to the functional or operational time period pertaining to market
forces at work. The time element may be classified as:
a. very short period market,
b. short period market,
c. long period market, and
d. very long period market.
(a) Very short period market: On functional basis, the market period is regarded as a very
short time period during which it is physically impossible to change the stock of a
commodity even by a single unit. The basic characteristic of a very short period market is
that in this market it is not possible to make any adjustments in the supply to the
changing demand conditions.
(b) Short period market: The market of a commodity during short period is referred to as
the short period market. During this period, it is possible for a firm to expand output of a
commodity to some extent by changing the variable inputs such as labour, raw materials,
etc., under its fixed plant size. Thus, the firm is in a position to make some adjustment in
the supply on the basis of changing demand conditions. Besides, the equilibrium price is
established by the intersection of short period demand and short period supply curves.
(c) Long period market: The market for a commodity in the long period is referred to as
the long period market. Here, long period is sufficient to permit changes in the scale of
production of a firm by changing its plant size. Further, the firm is in a position to make
better period market; the equilibrium price of a commodity is established by the
interaction of long period demand and long period supply curve.
(d) Very long period market: The market for a commodity in the secular time period is
referred to as the very long period market. This period runs over a series of decades.
During this period, dynamic changes take place in demand and supply conditions. There
can be perfect adjustment between demand and supply in the secular period.
13.3.3 Classification based on nature of competition:

Traditionally the nature of competition is adopted as the fundamental criterion for
distinguishing different types of market structure. The degree of competition may vary
among the sellers as well as among the buyers in different market situations. Usually, the
market structures are classified in accordance with the nature of competition among the
sellers. The nature of competition among the sellers is viewed on the basis of two major
aspects: (1) the number of firms in the market; and (2) the characteristics of the products,
such as homogeneous or differentiated. The main types of markets are:
a. Perfect competition,
b. Monopoly and discriminating monopoly
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Perfect Competition
c. Monopolistic competition
d. Oligopoly and duopoly
The equilibrium price-output determination in case of perfect competition is derived in

this section. The conditions of equilibrium price-output determination in case of other
market conditions are derived in subsequent chapters.
Activity-1:
Take the case of a pickle product available near by your market. Analyse its various
stages of development from the very starting of the company to find out whether it is a
local or regional or national product.
13.4 PERFECT COMPETITION MARKET STRUCTURE
In the perfectly competitive market, a single market price prevails for the commodity,
and it is determined by the forces of demand and supply in the market. Under perfect
competition, every participant (whether a seller or a buyer) is a price taker, and no one is
in a position to influence it.
13.4.1 Characteristics of perfect competition:

Before determining the price of the product under perfect competition, it is necessary to
analyse the basic characteristic of a perfect competition. The various characteristics of
identifying a perfect competitive market is underlined as below:
(a) Large number of buyers and sellers:

A perfectly competitive market is basically formed by a large number of actual and
potential buyers and sellers. Their number is sufficiently large and the size of each seller
and buyer is relatively small in terms of market. So, the individual seller, buyer, supply
and demand reactions are negligible in terms of market supply and demand. Hence,
individual seller and buyer do not have a control over supply and demand of the market.
(b) Homogeneous product:

The commodity supplied by each firm in a perfectly competitive market is homogeneous.
This means that the product of each seller is virtually standardized. Since each firm
produces an identical product, their products can be readily substituted for each other.
Hence, the buyer has no specific preference to buy from a particular seller and his
purchase from any particular seller is a matter of chance and not of choice.
(c) Free entry and exit of firms:

New firms are not having any legal, technological, economic, and financial or any other
barrier to their entry in the industry. Similarly, existing firms are free to quit the market.
Thus, the mobility of firms ensures that whenever there is scope in the business, new
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Business Economics
entry will take place and competition will remain always stiff. Due to the natural stiffness
of competition, inefficient firms would have to eventually quit the industry.
(d) Perfect knowledge of market conditions:

Perfect competition requires that all the buyers and sellers must possess perfect
knowledge about the existing market conditions such as market price, quantities and
sources of supply and demand. The perfect knowledge ensures transactions in a perfectly
competitive market at a uniform price.
(e) Non-intervention of the government:

A perfect competition also implies that there is no government intervention in the
working of market economy. This means that there are no tariffs, subsidies, rationing of
goods, control on supply of raw materials and licensing policy. Government non-
intervention is essential to permit free entry of firms and for automatic adjustment of
demand and supply through the market mechanism and self decided price.
(f) Absence of transport costs:

It is essential that competitive position of no firm is adversely affected by the transportion
cost differences. Hence, it is assumed that there is absence of transport cost as all firms
are closer to the market.
Activity-2
Take for example a music system producing company. Visit two to three electronic stores
you have in your market. Select a particular model. Now based on the above
characteristics of perfect competition, examine the nature of the music system industry.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
_______________________________________________________________________
13.4.2 Difference between pure competition and perfect competition:

Economists like Chamberlin and few others often make a distinction between pure and
perfect competition. The term pure competition is often used in a narrow sense. It is other
wise pronounced as atomistic competition by the economists. A competition is said to be
pure when there exists large numbers of buyers and sellers, homogeneity of the product
and freedom of exit and entry of new and existing firm from the industry. It is, implied
that pure competition requires fulfillment of only three conditions among the numbers of
conditions that are derived for identification of a perfect competition. Thus, the
conditions of pure competition together mean that no individual firm can exert any
influence in the operation of the industry as a whole.
Moreover, perfect competition is used in a wider sense than pure competition. It includes
all the characteristics of perfect competition. Hence among all the characteristics including
the additional characteristics like possession of perfect knowledge about the product and
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Perfect Competition
market by both buyers and sellers, perfect mobility of the factors of production and absence
of transportation cost etc., along with the three characteristics of pure competition. This
means that perfect competition requires that there should not be any imperfections in the
market. Imperfections in the market basically exist because of lack of proper knowledge
about the product or may be due to immobility of the factors of production. Thus, pure
competition is almost treated as a part and parcel of perfect competition.
13.5 PRICE DETERMINATION UNDER PERFECT COMPETITION
Price under perfect competition is determined by the interaction of demand for and
supply of the product. This interaction point is called as the point of equilibrium. At this
point of equilibrium the quantity demanded for the product is equal to the quantity
supplied of the product. The output that the firm produces at this point is called as
equilibrium output.
Price under perfect competition is determined by the intersection of demand and supply
curve of the product. It is the two forces- demand for and supply of the product that
determines the price under the perfect competition. Prof. Marshall has compared the
process of price determination with the cutting of cloth with a pair of scissors. As two
blades are required to cut the cloth, similarly, the two blades- demand for and supply of
the product in the market scissor- are required to determine the price in the market. This
does not lead that one force may be more active or effective than the other. Both forces
are required to be present in the market. Thus, the analysis of price determination under
perfect competition is the analysis of the demand and supply conditions of the product in
the market industry.
Demand side:
Demand side analysis shows buyers reactions at different prices of the product. Demand
curve states the various quantities that the buyers are willing to purchase at different
prices of the product. The market demand curve slopes downward to the right subject to
the law of demand. It indicates that the quantity demand of the product falls with the rise
in price and the quantity demand rises with the fall in price. This shows that there exists
inverse relationship between the price and quantity demand of the product. This inverse
relationship between the price and quantity demanded is due to the income and
substitution effect of the price change.
With the fall in price the commodity becomes cheaper. This encourages the consumer to
purchase more and more of the same commodity. Again, fall in price of the commodity
causes the real income of the consumer to increase. Increase in real income results
increase in consumption of the commodity. Hence, the quantity purchased of a
commodity increases with the fall in price of the commodity and vice versa. This inverse
relationship between price and quantity demanded can also be derived from the law of
diminishing marginal utility. A consumer will be in equilibrium when marginal utility
that he is deriving out of the consumption of the commodity equals to its price. When
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Business Economics
price of the commodity falls marginal utility becomes greater than marginal revenue. To
restore himself on the equilibrium, a consumer, according to the law of diminishing
marginal utility has to consume more quantities of the same commodity. For which the
quantity demanded of the commodity increases with the fall in price of the commodity.
The inverse relationship between the quantity demanded and price of the product can be
derived with the help of a demand schedule and a demand curve. In the demand schedule
derived below, when the price of the commodity is Rs. 1/-, the market demand for the
commodity equals to 20 units. An increase in price of the commodity from Rs. 1/- to Rs.
2/- causes the demand to reduce from 20 units to 15 units. The corresponding quantities
to prices Rs. 3/-, 4/-, 5/- and 6/- are 12 units, 10 units, 8 units and 6 units respectively.
Thus the hypothetical statement of the quantities demanded at various prices of the
commodity shows the quantities that a seller would be able to sell at different prices of
the quantities. A demand curve drawn on the basis of above demand schedule will slope
down ward to the right, as shown in the figure-13.1 derived below. In the figure OX- axis
measures quantity demanded of the product and OY- axis measures prices of the product.
DD is the demand curve of the product at various prices.
Table No-13.1: Demand Schedule
No of Units Price per Unit No. of Units

1 Rs. 1/- 20
2 Rs. 2/- 15
3 Rs. 3/- 12
4 Rs. 4/- 10
5 Rs. 5/- 8
6 Rs. 6/- 6
D
Price
O X
Demand
Figure No.-13.1
Supply side:
The other force which plays an important role in determination of price in perfect
competition is the industry supply of the product. The industry supply of the product is
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Perfect Competition
the sum total of the products produced by each individual firm. Supply is the quantity of
a particular commodity offered for sale at a particular price of the product. The firms in
the industry under the perfect competition are the price takers. A firm at a given price of
the commodity equalizes marginal revenue that it is acquiring; to the marginal cost it is
bearing to produce an additional quantity of output. At the point of equilibrium the
marginal cost that it bears to produce each additional unit must be equal to the marginal
revenue that it is deriving out of the sale of the product. Otherwise, a firm will not earn
maximum profit till MR>MC or MC<MR. The marginal cost curve under the conditions
of perfect competition is nothing but the supply curve of the firm. Hence, the quantities
offered for sale at a given industry price of the product can be derived from the marginal
cost curve of the firm. Any increase in the price of the product causes the firm to increase
the supply of the product and vice versa. Increase in supply leads to increase in cost of
the product. The reverse will happen when the price of the commodity reduces. Hence,
marginal cost of the firm is the supply curve of the firm. In the figure-13.2 derived below,
OX- axis measures output and OY-axis measures price.
Table No-13.2: Supply Schedule

No of Units Price per Unit No. of Units
1 Rs. 1/- 05
2 Rs. 2/- 10
3 Rs. 3/- 12
4 Rs. 4/- 20
5 Rs. 5/- 25
6 Rs. 6/- 30
Y
S
Price
S
X
O
Supply
Figure No.-13.2
The total supply of the product in the industry is the sum total of supply of the individual
firms. As it is explained earlier, any firm produces more quantities of output with the
increase in the price of the commodity and vice versa. The supply of the industry
increases with the rise in the price and decreases with the fall in price. The supply curve
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Business Economics
of the industry is the lateral summation of the supply curves or marginal cost curves of
the firms. The nature of the industry supply curve is so that it normally slopes upward to
the right. The upward slopping nature of industry supply curve is derived with the help of
a supply schedule-13.2 and supply curve-13.2.
The supply schedule is a hypothetical statement of the various quantities that an industry
supplies at different prices of the product. It can be seen from the schedule that at price of
Rs. 1/- the industry supplies 5 units of output. An increase in price of the commodity
from Rs. 1/- to Rs. 2/-, quantity supply of the product increases from 5 units to 10 units.
Similarly, quantity supply of the product increases from 12 units, 20 units, 25 units and
30 units as price increases to RS. 3/-, Rs. 4/-, Rs. 5/- and Rs. 6/- respectively. When the
supply schedule is drawn on a graph it represents the supply curve. In the figure-13.2, SS
is the industry supply curve. It can be seen that SS slopes upward from left to right.
Interaction of demand and supply curve:

We know from the above analysis that the demand schedule and the demand curve show
the various quantities that the buyers are willing to purchase at different prices of the
product. On the other hand, the supply schedule and supply curve state the quantities that
the sellers offer for sale at different prices of the product. All the prices available for the
product are not the equilibrium price. Similarly, all the quantities offered for sale and
demanded by the consumers are not equilibrium quantities. The price at which the
quantity demanded for the product is equal to the quantity supplied of the product is the
equilibrium price. Similarly, the quantity at which the sellers are offering for sale and
buyers are willing to purchase is the equilibrium quantity in the industry.
In the above derived demand and supply schedules, when price is Rs. 3/- per unit, the
quantity demanded for the product (20 units) is equal to the quantity supplied of the
product (20 units). Thus, price at Rs. 3/- is the equilibrium price of the industry under
perfect competition. Where as, at all prices less than Rs. 3/- per unit, the quantity
demanded will be more than the quantities supplied. This happens because, since the
price is less, the consumers are demanding more of the commodity but he producers are
not willing to offer more at less prices. Because of lack of supply in the market, the price
will increase and will reach at Rs. 3/- per unit. On the other hand, at any prices more than
Rs. 3/- per unit, the quantity demanded is less than the quantity supplied. As because of
the higher prices, consumers do not offer to purchase but producers are supplying more
of the product. The result is over production in the industry. Over production in the
industry forces the producers to reduce the price of the product. This reduction in price
leads to fall in price again to equilibrium price i.e., at Rs. 3/- per unit. Thus, Rs. 3/- per
unit is the equilibrium price of the product. The derivation of equilibrium condition is
derived with the help of a figure-13.3.
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Perfect Competition
D S
M1 M2
P1
Price
P E
P2
M3 M4
S D
X
O M
Demand & Supply
Figure No.-13.3
In the derived figure-13.3, OX-axis measures quantity demanded and supplied of the
product and OY-axis measures price of the product. DD is the demand curve and SS is
the supply curve of the product. It can be seen that, the DD demand curve is intersecting
the SS supply curve at point E. At point E, OM is the output that the consumers are
demanding and the producers are supplying. Suppose a price higher than OP, say, at price
OP1, the quantity demanded is OM1 but the quantity supplied is OM2. M1M2 quantity is
due to excess of supply of the product. Since demand for the product is less there will be
a tendency among the sellers to reduce the price further to increase demand and will
reach at price OP. On the other hand, suppose a price less than OP, say at price OP 2, the
quantity demanded of the product will be more than the quantity supplied of the product.
The excess demand will be amounting to M3M4. This excess demand in the market causes
scarcity of supply. Scarcity of supplies leads to increase in price of the product. The price
will increase till it reaches at the equilibrium price OP. Thus, given the demand and
supply curves of the product, OP is the equilibrium price of the product and OM is
equilibrium quantity demanded and supplied.
13.6 EFFECTS OF SHIFT IN DEMAND AND SUPPLY ON THE PRICE LEVEL
The effects of shift in the price on the equilibrium price determination are analyzed as
follows:
(a) Why and when does the price of a product rise? Economists have answered this
question by analyzing two conditions, viz., when (i) the demand for the product increases
and (ii) the supply of the product decreases.
(b) Why and when does the price of a product fall? The answer of this question is
when (iii) the demand for the product decreases and (iv) the supply of the product
increases.
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Business Economics
(i) The case of increase in demand

When demand increases because of a number of factors in the economy, it leads to the
right shift in the demand curve from its original position. A shift in demand curve
disturbs the original equilibrium point but the supply curve remains the same. The new
point of equilibrium is derived at that point where the existing supply curve intersects the
new demand curve. This can be more clearly understood with the help of figure-13.4.
Y
D1
D S
P1 E1
Price
P E
D1
S D
X
O M M1
Demand & Supply
Figure No.-13.4
In figure-13.4 derived, OX-axis measures quantity demand and supply of the product and
OY-axis measures price of the product. The DD demand curve intersects the SS supply
curve at point E deriving OP as the equilibrium price and OM as the equilibrium quantity
demanded and supplied. Let us suppose that because of certain factors the demand for the
product increases. Now with the increase in demand, the demand curve shifts to the right
and new demand curve is D1D1. This new demand curve D1D1 intersects the supply curve
SS at point E1. This interaction determines a new equilibrium price OP 1. It can be seen
that this new equilibrium price is higher than the original price, which indicates a rise in
price of the product when the demand (PP1) for the product increases at constant supply.
(ii) The case of decrease in supply

When supply decreases with constant demand, then the supply curve shifts to the left.
This indicates that there is a scarcity of supply in the market. It is obvious that since
supply is scarce, it is definite that the price of the product will increase. This case is
explained with the help of the following derived figure-13.5.
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Perfect Competition
S1
D S
P1
E1
Price
P E
S1
S D
X
O M1 M
Demand & Supply
Figure No.-13.5
In figure-13.5, OX-axis measures quantity demanded and supplied and OY-axis measures
price of the product. The demand curve for the product DD intersects the industry supply
curve SS at point E, the equilibrium prices OP. Suppose that the supply decreases, the
supply curve shifts to the left from its original position and the new supply curve is S 1S1.
The new supply curve of the product intersects the demand curve DD at a new point of
equilibrium E1. At this new point of equilibrium, the new price that is determined is OP 1.
It can be clearly seen form the figure that the new price OP 1 is higher than the original
price OP by PP1 amount. This case confirms that when the supply of the product
decreases keeping the demand for the product as usual, the price of the product will rise.
(iii) The case of decrease in demand

Because of a number of factors there is a possibility that the demand for a commodity
may decrease in the market. When the demand for the commodity decreases with the no
change in supply curve, this leads to the demand curve to shift left. This shows logically
because with the reduction in demand for the product there will be excess of supply of the
product. Excess supply of the product forces the producers to reduce the price of the
product in order to attract the buyers. This case of fall in demand can be well visualized
with the help of figure-13.6.
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Business Economics
Y
D
D1 S
P E
Price
P1 E1
D
S D1
X
O M1 M
Demand & Supply
Figure No.-13.6
In the figure-13.6, OX-axis represents quantity demanded and supplied of the product and
OY-axis represents price of the product. In the figure, the DD demand curve intersects
the SS supply curve at point E determining the equilibrium price OP. Now, when the
demand for the product decreases the demand curve shifts to left. D 1D1 is the new
demand curve which intersects the SS supply curve at point E 1. Thus, the new
equilibrium price that is derived is OP1. It can be observed from the figure that OP1 price
is lower than the original price OP. Thus, when demand for the product decreases, the
price of the product fall.
(iv) The case of increase in supply

The supply curve shifts to the right when the supply of the product increases. In the
figure-13.7 given below, OX-axis measures quantity demanded and supplied for the
product and OY-axis measures the price of the product. The DD demand curve is
intersecting the SS supply curve at point E that determines the OP as the equilibrium
price. Now, suppose that because of certain factors, the supply of the product increases.
With the increase in supply the new supply curve will shifts to right. The new supply
curve S1S1 is intersecting the demand curve DD at a new equilibrium point E 1. At this
new equilibrium point the new price of the product is OP 1. It can be seen from the figure
that the new price OP1 is less than the original price OP by an amount PP 1. This happens
because of the excess in supply of the product in the market than the desired demand.
Thus, the price will decrease when supply increases.
196
Perfect Competition
S
D S1
P
E
Price
P1 E1
S
S1 D
X
O M M1
Demand & Supply
Figure No.-13.7
All the above derived four cases indicate that shift in demand and supply curve influences
the equilibrium price of the product.
Numerical calculation of a perfect competition equilibrium condition:

Let us assume that the total cost curve of a perfectly competitive firm is given by:
TC=600+40Q+Q2
Then find out:
(a) What will be the profit of the firm when the equilibrium price is P=120?
(b) Determine whether the firm is operating in short-run or long-run?
Solution:
A firm operating under perfect competition will be in equilibrium when it satisfies two
conditions, that is, MC=MR (first order condition) and slope of MR should be less than
slope of MC at the point of equilibrium (second order condition).
Given that
TC=600+40Q+Q2
TC 600  40Q  Q 2 600 40Q Q 2
MC=      40  2Q
Q Q Q Q Q
Further, we require to determine MR. However, we are aware that under perfect
competition Price=MR=AR. Since, equilibrium price of the product is given as Rs. 120.
This implies that MR=Rs. 120.
Now, the first order condition for equilibrium is MC=MR, hence, we have:
40+2Q=120 or 2Q=120-40 or 2Q=80 or Q=80/2=40 Thus, Q=40
Now the second order condition is to be satisfied, thus, slope of MC and slope of MR
needs to be estimated. Hence,
MC  40  2Q MR 120
slope of MC    2 and slope of MR    0. Thus
Q Q Q Q
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Business Economics
we have MC=2 and MR=0.

Since, slope of MR (i.e., 0) is smaller than slope of MC (i.e., 2), hence, the second order
condition satisfies.
Now total profit will be,
TR=P×Q=120 × 40=4800
TC=600+40Q+Q2=600+40(40)+(40)2= 600+1600+1600=4800
Thus, total profit=TR-TC=4800-4800=0, hence, the firm is not incurring any profit.
(b) Since the firm is neither incurring profit nor loss, hence, it is in the long-run
equilibrium condition.
Activity-3
Assume that a perfectly competitive firm’s total cost curve is given as, TC=200+10Q+Q 2.
Calculate: (a) profit of the firm when equilibrium price is at Rs. 40/- and (b) determine
whether it is operating in short-run or long-run?
13.7 MARSHALLIAN TIME PERIOD ANALYSIS:
Prof. A. Marshall has pointed out that both demand and supply are the two forces that
determine the equilibrium price under the perfect competition. But the relative strength of
demand and supply in different time periods are different. In other words, in equilibrium
price determination, some time it is observed that demand becomes more active than
supply. In some other cases the reverse is also observed where supply actively influences
demand. This analysis of relative importance of demand and supply in different time
periods is known as the Marshallian time period analysis.
Prof. A. Mashall in order to explain the relative importance of demand and supply has
analyzed price determination under perfect competition in three different conditions such
as (i) market period price determination, (ii) short-period price determination and (iii)
long-normal-period price determination. All the three above periods are discussed in
detail below
13.7.1 Market Period Price determination:

Market period is a period of time in which the seller can vary his quantity of supply
within the existing stock. Stock of a product is not really the supply of that product. The
quantity supplied is that quantity which the seller is willing to offer for sale at a particular
price. This period is such a period of time in which the seller cannot increase the
production, hence, the existing stock. The expectation of the seller is to sell the product at
a higher price. On the other hand, there is minimum expected price of the product. At any
price equal to or less than the minimum expected price, the quantity to be supplied will
be zero. However, between the minimum and the highest expected price of the product
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Perfect Competition
the quantity of supply increases with the increase in price. Within the range of the prices,
the supply curve of the product slopes upward to the right.
Further, the nature of supply curve of perishable goods is slightly different from the
supply curve of the durable goods as discussed above. In case of perishable goods (like
milk, fish, red meat etc.), the seller has to sell the existing quantity of the entire stock.
Since these goods cannot be kept for a long time, hence, the seller has to accept the
existing price without any expectation of a higher price. This is the reason why the supply
remains inelastic in the entire market period.
13.7.2 Short-period price determination:

Short-period as it mean in economics refers to a period of time in which the producers
can increase or decrease the quantity of production by changing the quantity of variable
factors of production only. As such supply remains more or less elastic during the short
period. According to the law of variable proportion, a firm operates in the phase of
diminishing marginal returns, marginal cost of production increases with the increase in
quantity of output. Therefore, a short-run industry supply curve of a product which is the
lateral summation of the short-run supply curves of the firms, slopes upward to the right.
In the short-run, AR = MR = MC under perfect competition but AC may or may not be
equal to AR. Hence, a firm may earn supernormal profit or may bear losses in the short-
run. It implies that supply cannot be adjusted fully with the change in demand in the
short-run. Determination of price in short-run can be explained with the help of a figure-
13.8 given below.
Y
D1
D
D2 S
P1 E1
P E
Price
P2 E2
D1
D
S D2
X
O M2 M M1
Demand & Supply
Figure No.-13.8
In the figure-13.8, OX-axis measures quantity demanded and supplied and OY-axis
measures price. The short-run industry supply curve SS intersects the demand curve DD
at point E determining the equilibrium price as OP. Suppose demand increase, as a result
of which the DD demand curve shifts to D 1D1, the higher price of the product is obtained
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Business Economics
at OP1. At this new price OP1, both demand and supply are increasing but the rate of
increase in demand is not matched with the rate of increase in supply. This happens
because of lack of supply in the market to cope with the increased demand. Here, the
price of the product is increasing in the short-run. The reverse in price will be observed
when the demand for the product falls.
13.7.3 Long-period price determination:

Long-period is a period of time in which the seller has the freedom to change all the
factors of production to meet the required quantity of output. Long-period supply curve
of an industry depends upon the nature of the industry. An industry may operate in the
increasing cost or diminishing returns to scale. In such case, the cost of production
increases with each additional increase in scale. Thus, a particular commodity can be
supplied more with the higher price of the product. As a result the supply curve slopes
upward to the right. Equilibrium price of the product is subject to increase in cost. In case
of an industry operation for constant returns to scale, the average cost of production
remains same at all the units of production. This implies that the average cost of
production remains constant throughout the level of production, irrespective of increase
or decrease in scale. The long-run supply curve, here, is parallel to OX-axis. It implies
that a seller can supply any quantity of product at the same price. There will be no
tendency of change in price of the product in the long-run.
In case of increasing returns to scale or decreasing cost industries, the average cost of
production decreases with each additional increase in output in the long-run. Cost per unit
of product decreases if the scale of production increases. For this reason, the long-run
supply curve slopes downward to the right. It implies that, the seller in this case will have
to supply more of the product with the fall in the price of the product in the long-run
which is in relation to lower price and greater demand.
13.8 LET US SUM UP

 Perfect competition is defined as a market structure mainly characterized by
presence of large numbers of buyers and sellers, free entry and exit of firms,
perfect homogeneity of the product and perfect knowledge.
 Theory of perfect competition aims to determine equilibrium quantity of output
that a firm should produce for maximizing profit.
 The market share of each individual firm is very small in the industry.
 Industry determines price of the product where the industry demand for the
product is equal to the industry supply of the product.
 Marginal and average cost curve of the firm are U-shaped.
 Average revenue (demand) curve is equal to the marginal revenue curve and are
parallel to X-axis.
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Perfect Competition
 Profit maximizing output level is obtained by fulfilling two conditions like

MC=MR and slope of MR < slope of MC.
 A firm under perfect competition in short-run may incur normal profit or super
normal profit or super normal loss depending upon the cost structure.
 Long-run is a situation where each firm incurs normal profit only.
 A firm continues business activities till price of the product exceeds average
variable cost. In reverse situation, it closes down into operation.
13.9 KEY TERMS
 Perfect competition  Entry barrier

 Homogeneous product  First order condition
 Price-out put determination  Normal profit
 Supernormal loss  Super normal profit
 Equilibrium  Demand and supply
 Firm  Industry
 Average and marginal revenue  Average and marginal cost
 Second order condition  Short-run and Long-run

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McGraw Hill Publishing Company Limited.
 Thomson, Christopher and Maurice, S.C. (2006), Managerial Economics, Eighth
edition, The McGraw Hill Publishing Company Limited.

1. Explain why can’t a perfectly competitive firm influence the industry price?
2. Examine the role of time element in equilibrium price determination.
3. What is a market? How can a market be classified?
4. How can a perfect competitive market scenario be identified?
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5. Why is price=average revenue=marginal revenue under perfect competition?

6. ’Perfect competition is a myth’. Discuss.
7. State and illustrate the conditions of a firm’s equilibrium under perfect
competition.
8. Why is a firm under perfect competition called as a price taker and not a price
maker?
9. Examine a firm’s price-output equilibrium condition under perfect competition
in short-run.
10. Differentiate between pure competition and perfect competition.
11. What do you mean by perfect mobility of a factor?
12. Which firm would you like to specify for perfect competition in the Indian
scenario? Support your answer with relevant reasons.
13. It has been said that the operations of stock exchange market is a bright
example of perfect competition. To examine the reality, pick the stock of any
one IT firm registered under BSE and examine the claim.
14. What do you mean by perfect competition? Discuss how the price is
determined under perfect competition?
15. Under what condition should a firm continue to produce in the short-run if it
incurs losses at the best level of output.
16. What is the best level of output of perfectly competitive firm in the long-run?
17. The total cost curve of a firm that is operating under perfect competition is
given by the equation as TC= 300+20Q+Q2. Estimate the level of profit when
the equilibrium price is assumed to be Rs. 40/-.
18. Write short note on:
(a) Perfect competition
(b) Marshallian time period analysis in short-run
(c) Homogeneous product under perfect competition
(d) Free entry and exit of firms under perfect competition
(e) Effect on equilibrium point due to change in demand condition
(f) Effect on equilibrium point due to change in supply condition
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UNIT 14 MONOPOLY
Objectives
The basic objectives of this unit are to make the following concepts familiar to the
students:
 To identify a monopoly market
 To know why monopoly exists and what are its consequences
 How price is determined under different periods in monopoly
 To know the concept of price discrimination
 When does a monopolist discriminate price
 How equilibrium is determined under price discrimination and dumping
Structure
14.1 Introduction
14.2 Characteristics of monopoly
14.3 Why monopoly?
14.4 Consequences of monopoly
14.5 Elasticity of demand and the concept of equilibrium
14.6 Price determination under monopoly
14.6.1 Short-run price determination
14.6.2 Long-run price determination
14.7 Comparison between perfect competition and monopoly
14.8 Discriminating monopoly or price discrimination
14.9 Types of price discrimination
14.10 Degrees of price discrimination
14.10.1 Price discrimination of first degree
14.10.2 Price discrimination of second degree
14.10.3 Price discrimination of third degree
14.10.4 Conditions for price discrimination
14.11 Derivation of equilibrium under price discrimination
14.12 Equilibrium price determination under dumping
14.13 Let us sum up
14.14 Key terms
14.1 INTRODUCTION
Monopoly is a market situation where there is a single producer (trader) of a particular

product which has anticipated being having no close substitutes. It has no direct
competitors or rivals. Perfect competition provides the economist with a very useful
analytical concept, even though the exacting conditions of the concept never exist in the
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real world. The same statement almost applies to the concept of monopoly. The
conditions of the model are exacting, and it is very difficult practically, if not impossible,
to pin point a monopolist in real-world markets. On the other hand, many markets closely
approximate monopoly organization, and monopoly analysis often explains observed
business behaviour quite well. Thus, from the sales or revenue side, monopoly and
perfect competition are polar opposites. The perfectly competitive firm has so many
rivals in the market that competition becomes impersonal. Personal rivalry does not exist
in case of a monopoly market condition.
14.2 CHARACTERISTICS OF MONOPOLY
Following are few features of a monopoly market:

1. Large numbers of buyers:
The number of buyers is large. Buyers react in the market through the demand curve. In
other words, it is the demand curve for the product that determines buyer’s reaction. In
case of monopoly, the average revenue curve is the demand curve of the buyers.
2. Single seller of the product:

There is a sole producer of the product. The firm in monopoly is an industry. It may be an
individual firm or may be a company or may be a single unit.
3. Complete absence of close substitutes:

There is no close substitute available to the product in the market. Since there are no
substitutes, hence, there is no competition between the industries or firms for sale of the
similar product. It is therefore, cross elasticity of demand for the product is very small.
4. Independent in price decision:

A monopolist is also known as a price maker not the price taker as that of a firm
operating under perfect competition. Since he is the sole decision maker of the industry,
hence, it is his liberty to take decision on price of the product. A monopolist can
discriminate price differently to different customers.
5. Strong barriers to entry:

It becomes very difficult to a new firm or industry to enter into the market. Otherwise,
entries of new firms are strictly prohibited under monopoly. There are numbers of
economic factors that restrict the new firms to enter into the industry.
14.3 WHY MONOPOLY?
Since the business of entrepreneurs is earning profits, one might wonder why a monopoly
even arises, that is, why other firms do not enter in the industry in an attempt to capture a
part of the monopoly profit. Many different factors may lead to the formation of a
monopoly or near monopoly. Few important among them are outlined below:
(i) Lack of government control:
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Monopoly
The role of the government sector in an economy is to control the operations in the
economy by controlling the existing sectors like business sector, household sector,
banking sector and foreign sector. Any discrepancy in the government control unbalances
that operation. Some times either knowingly or unknowingly the government grants
license to any particular person or persons which should not be done. Basically, it is seen
that for operating public utilities like a gas company or an electricity undertaking, etc.,
government grants license unnecessarily.
(ii) Monopoly of factors of production:

A producer may possess certain scarce raw materials, patent rights, secret methods of
production, or specialized skill which might give him monopoly power. For example,
private transportation providers in many places in India hold a monopoly for providing
transportation facilities to travel to a particular place. In such places the transportation
union is so strong that they do not allow other parties to run their vehicles. For providing
these services they charge blindly without any logic.
(iii) Hording of large resources:

The necessity of having large resources, as is the case where the minimum efficient scale
of operations is very large, may often create monopoly. For example, it has been said that
the onion and sugar had been horded by the middle men to sell these essential items at a
higher price during 2013-14 in India. For this the onion price per k.g., reached at even
more than Rs. 100/- in some places of India.
(iv) Ignorance of the buyers:

Ignorance, laziness and prejudice of the buyers may create monopoly in favor of a
particular producer.
14.4 CONSEQUENCES OF MONOPOLY
Few main costs of existing monopoly are:

i. When a monopolist exercises the market power by restricting supplies, he charges
the price as per his convenience. It is ultimately the consumers who bear the stroke
of the monopolist.
ii. Since the monopolist is the sole producer, hence, consumer choice is restricted. The
consumer has to compromise forcefully with the quality, quantity and price of the
product.
iii. The exercise of monopoly power causes resources to be misallocated from
society’s point of view. As the monopolist restricts output, his output is too small.
He employs too little of society’s resources. As a result, too much of these
resources may go into the production of goods with low consumer preferences.
Thus resources are misallocated.
iv. A firm enjoying monopoly position in a strategic sector may provide too big a risk
for the economy. For example, it has been pointed out by the experts that putting
all the power engineering facilities to BHEL may be full of risks. This may be
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because any natural or man-made ill effect may hamper the production of the
company which ultimately may act as a setback to the economy.
14.5 ELASTICITY OF DEMAND AND THE CONCEPT OF EQUILIBRIUM
The concept of elasticity of demand has an important bearing on monopoly equilibrium.

A monopolist cannot be in equilibrium where elasticity of demand is less than one. It is,
hence, a monopolist will be in equilibrium at the point where he can maximize his profit.
The relationship between the elasticity of demand and monopolist’s equilibrium
condition is derived with the help of simple derivations as derived below:
AR
ed 
AR  MR
or ed ( AR  MR)  AR
or (ed ). AR  (ed ).MR  AR
It is known to us that or (ed ). AR  AR  (ed ).MR
or AR (ed  1)  (ed ).MR
AR (ed  1)
MR 
ed
Where ‘ed’ stands for elasticity of demand, MR is the marginal revenue and AR is the
average revenue of the monopolist. It is therefore, for different values of elasticity of
demand:
When ed>1, it implies that MR is positive
When ed=1, it implies that MR is zero and
When ed<1, it implies MR is negative
When the marginal revenue of the monopolist will be negative, the monopolist cannot
attend maximum profit. Further, If profit will not be maximum then the monopolist
cannot attend equilibrium. It implies that a monopolist cannot be in equilibrium where
elasticity of demand is less than one.
14.6 PRICE DETERMINATION UNDER MONOPOLY
A monopolist like a firm under perfect competition has the objective of profit
maximization. But the condition that a monopolist faces is quite different from perfect
competition. Under perfect competition the demand curve faced by a firm is a horizontal
straight line. But a monopolist’s demand curve is its average revenue curve. The
monopolist’s average revenue curve (AR) slopes downward to the right. As such the
marginal revenue (MR) curve lies below the average revenue (AR) curve. A downward
slopping AR curve or demand curve of the monopolist implies that the monopolist can
either determine price at which he will sell the product or the quantities of the product
that can be sold in the market but cannot determine both. Thus, the monopolist has the
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Monopoly
option to choose a price and quantity combination which will provide him maximum
possible profit. On the other hand, a firm under perfect competition is only a quantity
adjuster. Therefore, the situation of monopolist’s price determination is quite different
from the firm under perfect competition.
At the point of equilibrium, a monopolist will be equalizing marginal cost (MC) to

marginal revenue (MR). It goes on producing more quantities of output so long as
AR>MC, as this situation helps the monopolist in acquiring more profit with each
additional unit of output. His total profit will be maximum when MC=MR. This
condition of equilibrium can be shown with the help of a figure-14.1 as below.
AR=TM
Cost & Revenue
MC AC=SM
AC
H T Thus
AR>AC=
P S
Profit
Area=
AR HTSP
E
MR
X
O M
Quantity
Figure No.-14.1
In the figure-14.1, OX-axis measures quantity and OY-axis measures cost and revenue.
AR and MR are the average and marginal revenue curves and MC and AC are the
marginal and average cost curves of the monopolist respectively. In the figure, MC
intersects MR at point E where the monopolist is producing OM quantity of output. It can
be seen that, any further production of output beyond OM quantity will reduce the profit
of the monopolist. Thus, the monopolist will be in equilibrium at OM quantity of output.
With this output, the monopolist is getting total profit of the area HTSP.
Another thing to be noted from the above analysis is that marginal cost (MC) curve is not
the supply curve for the monopolist. Whereas in perfect competition MC curve of the
firm represents the supply curve of the firm because price of the product equals MC.
Since monopolist does not equals MC with price and also price in this case is higher than
MC, hence, MC does not represents the price and quantity relationship for the
monopolist. Thus, MC curve under monopoly cannot function as a supply curve.
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Further more, a monopolist is always in equilibrium at a point where the elasticity of

demand on the average revenue curve is equal to or greater than one. Thus, price of the
product or the average revenue curve is somewhere at which elasticity of demand is
greater than one (ed >1). Marginal revenue is also zero when ed =1. An elasticity of
demand less than one (ed<1), implies negative marginal returns. At any output where
marginal revenue is negative, marginal cost must also be negative. But, as it is known to
us that MC cannot be negative, therefore, no rational monopolist will produce an output
where elasticity of demand is less than one or marginal revenue is negative. It clears that
monopolists equilibrium price is the price corresponding to the point where MC = MR.
14.6.1 Short-run equilibrium of the monopolist:

Short-run in economics is a period of time in which producers have to adjust their
quantities of output by changing the quantities of variable factors of production. The
short-run equilibrium of the monopolist is the level of output at which the short-run
marginal cost curve intersects the marginal revenue curve of the monopolist. The
condition of equilibrium under monopoly can be well illustrated with the help of a figure
as derived below.
Y
Cost & Revenue
SMC
SAC
H T
S P
AVC
E AR
MR
X
O M
Output
Figure No.-14.2
The OX-axis in the above figure-14.2 represents output and OY-axis measures cost and
revenue of the monopolist. The curve SMC is the short-run marginal cost curve. SAC and
AVC are the short-run average cost and average variable cost of the monopolist
respectively. MR and AR are the marginal and average revenue curve respectively. It can
be seen from the figure that the marginal cost curve (SMC) of the monopolist intersects
the marginal revenue curve (MR) at point E. This determines OM as the equilibrium
output and OH as the equilibrium price. The monopolist is earning a profit equal to the
area HTPC.
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Monopoly
But it is a wrong perception among us that a monopolist is always earning profit in the
short-run. Rather the truth is that monopolist position is not always a guaranteed position
to earn profit. In certain conditions the demand for a product may drastically fall. Again,
since the monopolist is operating in short-run, hence, it cannot reduce the size of its plant.
It is therefore, the possibility that a monopolist may even bear losses. In such a situation,
a monopolist, to remain in the market, has to accept that price which is higher than its
average variable cost. The short-run loss making condition of the monopolist is explained
with the help of figure-14.3 as below.
Y
SMC
SAC
H P
Cost & Revenue
AVC
G Q
E
AR
MR
X
O S
Output
Figure No.-14.3
In the figure-14.3, OX-axis represents output and OY-axis represents cost and revenue
structure of the monopolist. It can be seen from the figure that the AR curve is below the
AC curve throughout the length. MC = MR at point E producing OS quantity of output.
At OS quantity of output, the monopolist is incurring net losses of the amount GQ and
the total loss is equal to the area HPQG. In this situation, the firm is making loss in the
short-run. In such a loss making scenario, if the monopolist decides to close down its
business, still it has to bear the fixed cost of the firm. It can be seen from the figure that
the monopolist is both covering the fixed cost along with a part of variable cost. Thus, it
proves that a monopolist can reach equilibrium with loss in the short-run.
14.6.2 Long-run equilibrium under monopoly:

In the long-run, monopolist gets enough time to make adjustments in the size of plant. For
this reason, he has enough time to choose the appropriate firm size that could cope with the
existing demand. The monopolist derives equilibrium at the point where the marginal cost is
equal to marginal revenue. Since long-run is a period where the monopolist gets enough time
to adjust, for any chance to increase the level of profit. Fixing the output level at which the
MR is equal to MC, the size of the plant needs to be adjusted. That plant size has to be chosen
which will be most optimal for the emerging demand of the product. The long-run
equilibrium condition of the monopolist is drawn as below.
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LMC
Cost & Revenue SMC SAC LAC
P Q
H
T
AR
E
MR
X
O L
Output
Figure No.-14.4
It can be seen from the figure-14.4 that OX-axis measures output and OY-axis measures
cost and revenue. The monopolist is in equilibrium at point E where the long-run
marginal cost curve is intersecting the marginal revenue curve. At point E, the
monopolist is producing OL quantity of output. At this point of equilibrium, the
monopolist is choosing a short-run plant. In the figure, at OQ level of output the
monopolist is choosing SAC at point H in the LAC curve. This has been done by
choosing a plant size whose short-run average cost and marginal cost curve (SAC and
SMC) cope up with the existing market demand. In this case the monopolist is charging
price equal to LQ or OP and is making profit equal to the area THQP. It is therefore,
follows from the above derivation that for a monopolist to maximize profit in the long-
run, the following highlighted conditions must be fulfilled:
MR = LMC = SMC
LAC = SAC
Price is greater than or equal to long-run average cost i.e., P ≥ LAC.
Activity-1
Pick up the product ‘Amul-butter’ available in your market. Examine, whether it is still
experiencing monopoly in production of butter in India?
Activity-2
It is a general impression in India that aluminum is produced with monopoly power.
What is your observation in this regard? Explain clearly.
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Monopoly
14.7 COMPARISON BETWEEN PERFECT COMPETITION AND MONOPOLY
Determination of price and output under both monopoly and perfect competition market
differs in their derivations. The differences in conditions of equilibrium are given below:
1. A significant difference between the two is that under perfect competition price
equals to marginal cost at the equilibrium level of output. Where as, the monopolist’s
price is higher than the marginal cost. Under perfect competition average revenue curve
is the horizontal straight line. This is why the marginal revenue curve coincides with the
average revenue curve at the point of equilibrium. Thus, AR = MR at all quantities of
output in the perfect competition. On the other hand, the monopolist’s average revenue
curve slopes downward to the right. For this the monopolist’s marginal revenue curve lies
below the average revenue curve.
2. The second important difference between the two is that under perfect
competition, equilibrium is possible when marginal cost (MC) is rising at the point of
equilibrium but in monopoly, equilibrium condition can be attained irrespective of the
condition of MC curve i.e., it may be rising or falling or remaining constant at the
equilibrium quantity of output.
3. Another significant difference between the two is that, in the long-run the firm
under perfect competition earns normal profit at the point of equilibrium. Whereas, the
monopolist may earn normal profit or super normal profit in the long run. In perfect
competition, at the point of equilibrium the marginal cost curve of a firm intersects the
average cost curve at its minimum point. This is due to the free entry and exit of the firm.
On the other hand, a monopolist generally attends equilibrium at a level of output where
average cost curve is still falling. There remains no scope for the monopolist to expand
output beyond the point of equilibrium even though average cost still continues to fall.
4. The fourth important difference between the two is that the monopolist’s price is
relatively higher and output is smaller in comparison to perfect competition. Under
perfect competition with the identical cost conditions a firm continues to expand its
quantity of output till AC = AR. Whereas the monopolist does not have any option to do
so.
5. The last but not the least difference between the two is that a monopolist can
discriminate price of his product. It implies that it has the flexibility to charge different
price differently to different customers. But a firm under perfect competition cannot do
so. It has to sell the product at the same price that has been determined by the industry
irrespective of the level of demand.
In conclusion, it can be said that no one can be a pure monopolist in reality. But it is true
that even though monopolist can produce at low cost, but he fixes a higher price by
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restricting supply. However, by higher price does not imply that too high price. In other
words, there are also numbers of restrictions that are imposed on the monopolist to
restrict him not to charge higher prices in the economy. The government, in many states
keeps close watch on the price of the products. Hence, any violation may impose legal
procedures. Again, the modern consumers are conscious. There is possibility that the
consumers may boycotts the purchase of that product. For example, there was a rise in
the onion price during the last part of 2013 and beginning of 2014 in India. During the
time, most of the consumers either boycotted the use of onion or reduced the quantity of
use of the product.
Activity-3
Which features of monopoly, among the discussed features, seem to be illogical.
Enumerate the causes.
Activity-4
Do you think that Indian Railways is imposing a clear cut monopoly power on the long
distance travelers? Explain your answer by assuming a place where air traffic is not
available.
14.8 DISCRIMINATING MONOPOLY OR PRICE DISCRIMINATION
Price discrimination, also known as differential pricing, may be defined as the practice by
a seller of charging different prices from the same buyer or from different buyers for an
individual product. In other words, it is that form of imperfect market condition where a
seller disposes his product at different prices to different buyers at the same place. This
situation will be in operation when it looks profitable and practicable to the monopolist.
But in real practice, it is very difficult to charge different prices for the same product to
different customers. Rather one can easily charge different prices for even a slightly
differentiated product. Professor Strigler defines a situation of price discrimination as ‘the
sale of technologically similar products at prices which are not proportional to marginal
cost (MC)’.
For example, a book publisher normally releases two types of books in the same title.
One type is student’s edition whose prices are as per the market price. The price of
deluxe edition is generally kept higher than that of the student’s edition. Whereas the
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Monopoly
subject matter and contents of both the editions are same. Suppose the cost of production
of a students edition is Rs. 50/- and Rs. 60 /- for deluxe edition. Now, let that the seller is
selling the students edition at Rs. 60/- per book and deluxe edition at Rs. 80/- per book.
This higher price of deluxe edition is not in proportion to the student’s edition. Thus this
causes price discrimination in the sale of book. For the same content, one group of
customers are paying less price where as the other group is paying higher price. The basic
assumption of the analysis of the concept of price discrimination is that the seller is
selling the same product at different prices.
14.9 TYPES OF PRICE DISCRIMINATION
a. Personal price discrimination: Any price discrimination is said to be personal when a

seller charges different prices for the same product from different persons. Basically,
while doing this, the seller analyses the level of tastes, preferences, brand image etc., with
each customer and charges prices accordingly. Since the personal characteristics of the
customers are considered by the seller, thus, such type of price discrimination is called as
personal price discrimination.
b. Local price discrimination: Any price discrimination is said to be local when a seller
charges different prices for people residing in different locality. The elasticity of demand
of one locality for the same product differs from the elasticity of demand of the other
locality. Based on the elasticity of demand, the seller charges prices. For example,
difference in price of same product between two countries.
c. Discrimination based on use: Some times a seller charges different prices for the same
product for different use. For example, the electric suppliers are charging lower prices for
agricultural and domestic consumption and higher prices for the industrial consumption.
Further, the mango seller charges lower price during normal business day and higher
price during festive season.
14.10 DEGREES OF PRICE DISCRIMINATION
Professor A.C. Pigou has suggested three categories of price discrimination. They are;
14.10.1 Price discrimination of first degree
14.10.2 Price discrimination of second degree and
14.10.3 Price discrimination of third degree.
14.10.1 Price discrimination of first degree:

This type of discrimination is said to occur when a monopolist is able to trade each
separate unit of output at different prices. This type of price discrimination is also called
as perfect price discrimination. In this case, the seller is so strong in his position that he
charges that price which each buyer is willing to pay. Thus, the seller is able to deal
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individually with the buyers. The condition of first degree price discrimination can be
explained with the help of a figure as drawn below.
10
9
8
7
6
Price
5
4
3
2
1
0
0 2 4 6 8 10
Quantity dem and
Figure No-14.5
In the figure-14.5, OX-axis measures quantity and OY-axis measures price of the
product. It can be seen from the figure that, the monopolist has charged ten different
prices for ten units of same product. As already discussed, a monopolist’s price is
determined at a point where MC=MR and the buyer is allowed to purchase at this price.
For example, let the determined price of the product be Rs. 7/- per unit. Given the
demand curve for the product DD, a buyer can purchase four units with a total
expenditure of Rs. 28/-. This purchase is leading the consumer to attain a consumer
surplus of Rs. 6/-. Where as, when the price discrimination of first degree is in operation,
now the consumer has to pay Rs. 34/- for purchasing the same four units of goods. So, the
consumer is not getting any surplus out of the purchase.
14.10.2 Price discrimination of second degree:

The seller segregates buyers according to income, geographic location, individual tastes,
kinds of uses for the product and charges different prices to each group or market despite
equivalent costs in serving them. As long as the demand elasticity among different buyers
are unequal, it will be profitable for the seller to group the buyers into separates classes
according to elasticity, and charge each class a separate price. In such scenario, each
individual buyer faces a perfectly inelastic demand situation for the goods below and
above a certain price.
14.10.3 Price discrimination of third degree:

Here the trader divides the entire markets into sub-markets on the basis of elasticity of
demand for the product. The price to be charged in a sub-market is determined according
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Monopoly
to the demand condition and the quantity sold in the market. This type of price
discrimination is very common in real practice.
14.10.4 Conditions for Price Discrimination:

The main conditions of price discriminations are:
(i) Multiple demand elasticity: There must be difference in demand elasticity among
buyers due to differences in income, location, available alternatives, tastes or other
factors.
(ii) Market segmentation: The seller must be able to partition (segment) the total
market by segregating buyers into groups according to demand elasticity.
(iii) Market sealing: The seller must be able to prevent, or natural circumstances must
exist which will prevent any significant resale of goods from the lower to the
higher price sub-market.
14.11 DERIVATION OF EQUILIBRIUM UNDER PRICE DISCRIMINATION
Price discrimination is not possible and profitable under all the situations. It is possible
when there prevails strong barriers either on the transportation of goods from one place to
other or movement of buyers from one place to other. Such barriers may occur due to legal
provisions, nature of the commodity, large distance, prejudice of the buyers, ignorance and
laziness of the buyers etc. In all above conditions, each monopolist is able to discriminate
the price. A monopolist to be in equilibrium has to determine (a) the total output available
with him and (b) the quantity it has to trade with a price in the market. For the simplicity of
our analysis, let us assume that there exist only two sub-markets for the product.
Monopolist to practice price discrimination has to equalize the marginal revenue with the
marginal cost of the product. The aggregate marginal revenue curve of the monopolist is
the lateral submission of the individual marginal revenue curves of both the sub-markets
(two sub-markets are considered here). The equilibrium price-output determination can
be illustrated with the help of a figure as given below.
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The above drawn figure-14.6, has three panels. Panel-A represents the sub-market-A,
panel-B represents the sub-market B and panel-C derives the aggregate demand curve for
the product. MRa and MRb are the marginal revenue curves of sub-market-A and sub-
market-B respectively. Da and Db are the demand curve or the average revenue curves for
both the sub-markets respectively. AMR is the aggregate marginal revenue curve and AD
is the aggregate market demand curve for the product. The AMR curve depicts the
marginal revenue received at each unit of trade. MC in panel-C is the marginal cost curve
of the product. In the figure, in panel-C, it can be seen that the MC curve intersects the
AMR curve at point E. At this equilibrium point the entrepreneur is producing OM
quantity of the commodity. Thus, the total availability of quantity of product in the
market to trade is OM. This OM quantity of output will be distributed in two sub-
markets. The product needs to be so equally distributed between the two sub-markets that
the levels of marginal revenue in both the markets are equal. Equality of marginal
revenue in both the sub-markets yields maximum profit to the monopolist.
The marginal revenues in both the sub-markets are not only equal to each other but are
also equal to the marginal cost of the whole output produced. MC is the marginal cost for
producing OM quantity of output. When the seller is trading OM 1 quantity in sub-market-
A, OM2 quantity of output in sub-market-B, then the MRa = MRb = MC. The monopolist
is trading OM 1 quantity of output at price OP1 in sub-market-A and OM2 quantity of
output at price OP2 in sub-market-B. It can be seen from the figure that the prices that the
monopolist is charging in both the sub-markets are higher than the equilibrium price OP.
Thus, the monopolist is getting profit by trading OM1 of commodity in sub-market-A at
OP1 price and OM2 quantity of output at price OP 2 (OM1 + OM2 = OM). The price level
will remain high in that market where elasticity of demand is less and vice versa.
Activity-4
Observe a vegetable seller for at least two days. Note down the way he is trading with
different customers. Share your experience in details by mentioning the different prices
he is charging from different customers in the same day.
14.12 EQUILIBRIUM PRICE DETERMINATION UNDER DUMPING
Dumping is a form of market situation in which a monopolist trades a product at a lower

price in the international market than the price it is charging in the domestic market. The
demand curve that the monopolist is facing in a domestic market slopes widely. But the
international demand curve is more narrow i.e., the demand condition is perfectly elastic.
The determination of equilibrium price in a dumping scenario is discussed with the help
of a figure derived below.
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Monopoly
In the figure-14.7 derived, OX-axis measures output and OY-axis measures price and
cost of the product. ARH and MRH is the average revenue or demand curve and marginal
revenue curve of the monopolist in domestic market respectively. The monopolist faces
the situation of perfect competition while trading in the international market. Since
perfect competition exists in the market, thus the demand curve or average revenue curve
for the entrepreneur will be ARW and marginal revenue curve will be MRW. It can be seen
that both average and marginal revenue curves are same. From the figure, BFED is the
aggregate marginal revenue curve of the entrepreneur. This is derived by the lateral
summation of MRH and MRW. The marginal cost curve (MC) is intersecting the aggregate
marginal revenue curve BFED at point E. This derives the equilibrium output as OM.
Now, this total quantity of output is so distributed in both the domestic and international
market that the marginal revenue curve in both the markets is equal.
In the figure, OR quantity of the product is traded in domestic market with RF marginal
revenue. OPH is the price of the product at domestic market. Now the remaining quantity
of output RM (OM-OR=RM) will be traded at OPW price at international market. DEFB
is the total area which represents the total profit earned by the producer. Hence, dumping
as a special case of price discrimination generates profit for the monopolist.
K1 MC
PH
Price and cost
F E
PW D=ARW=MRW
C ARH
MRH
X
O R M
Output
Figure No.-14.7
14.13 LET US SUM UP

 Monopoly is a particular type of market structure which is characterized by
presence of only one firm in that product category.
 The product is so unique in quality that it has no close substitutes in the market.
Existence of entry barriers is also one of the important features of monopoly.
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Business Economics
 There are several reasons for a monopoly to exist. The factors like exclusive
control over the raw materials, economies of scale, high capital requirements,
etc., cause the existence of monopoly.
 The demand curve that the monopolist is facing is a downward sloping curve.
When the demand curve is negatively sloped, the marginal revenue curve is also
negatively sloped.
 A monopolist maximizes profit by producing and marketing that output for
which marginal cost equals marginal revenue. Whether a profit or loss is made
depends upon the relation between price and average total cost.
 A monopolist maximizes profit in the long-run by producing and marketing that
quantity of output for which long-run marginal cost curve equals long-run
marginal revenue.
 If the aggregate market for a monopolist’s product can be divided into
submarkets with different price elasticities, the monopolist can profitably practice
price discrimination.
 Total output under discriminating monopoly is determined by equating marginal
cost with aggregate monopoly marginal revenue.
 The output is allocated among the submarkets so as to equate marginal revenue
in each sub-market with aggregate marginal revenue at the MR=MC point.
 Price in each submarket is determined directly from the submarket demand
curve, given the submarket allocation of sales.
14.14 KEY TERMS
 Monopoly  Discriminating monopoly

 Negative sloping demand curve  Supernormal profit
 Degrees of price discrimination  Monopoly power
 Machiup, Fritz (1952), The Political Economy of Monopoly, Johns Hopkins

University Press.
 Robinson, Joan (1933), The Economics of Imperfect Competition, Macmillan
publishing.
 Hirchey, M. (2003), Managerial Economics, Thomson South-western.
 Thomas, C.R. and Murice, S.C. (2005), Managerial Economics: Concepts and
Applications, Tata McGraw Hill publishing Private Limited.
 Gould, J.P. and Edward, P.L. (2003), Microeconomic Theory, Richard D. Irwin
Inc. Publishing.
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Monopoly
 Koutsoyiannis, A. (2007), Modern Microeconomics, Second edition, Macmillan

Press Ltd.
1. Define monopoly. Explain the factors causing monopoly to exit.

2. Draw average revenue, marginal revenue, average cost and marginal cost curves
for a monopolist.
3. Derive an equilibrium profit maximizing price-output condition in short-run
under monopoly.
4. Derive the condition of equilibrium under monopoly.
5. ‘Under monopoly, price is higher and output is restricted’. Discuss.
6. ‘A monopolist cannot be in equilibrium where elasticity of demand is less than
one’. Enumerate the statement.
7. Distinguish between price, output and profit conditions under perfect competition
and monopoly.
8. ‘Is monopoly necessarily an evil’. Give sufficient reasons for your answer.
9. What do you mean by price discrimination? Give at least one examples of
personal, regional and trade price discrimination.
10. When price discrimination is possible?
11. Let us suppose that a seller sells the same product in two markets like in market-
M and market-P and enjoys monopoly. How does he determine the output and
price of his product in these two market?.
12. Show with the help of suitable diagrams that the discriminating-monopolist
maximizes his profits where combined marginal revenue equals marginal cost for
the total output produced.
13. Explain that ‘differences in elasticity of demand in different markets are the
necessary condition for price discrimination’.
14. State that ‘the discriminating monopolist so distributes his output between
different markets that MR from all markets must be the same’.
15. If a producer is a monopolist in the home market and faces perfect competition in
the world market, explain:
(i) How he derives profit?
(ii) Distinguish between the quantity he will sell in home market and domestic
market
(iii) Show with diagram the price he will charge at home market and domestic
market
16. What is dumping? Explain the equilibrium price and output determination in case
of dumping.
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Business Economics
17. Select a product and two countries from your interest. Examine if there is any
case of dumping? Justify your answer.
18. Explain with diagram, the actual price of the product, price charged in the home
market and price charged at the international market in dumping.
19. Can we describe the supply curve of the monopolist from its marginal cost curve
in the same manner that it was derived for a perfectly competitive firm? Why?
20. Can a monopolist incur losses in the short-run? Why?
21. A monopolist who is earning short-run profits will also continue earning in the
long-run? Why?
22. Why do monopolists exist? What are the factors responsible for their existence?
Discuss few consequences of monopoly.
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Competition
UNIT 15 MONOPOLISTIC COMPETITION
Objectives
After reading this unit, students will have a clear understanding on the following
concepts:
 To understand a monopolistic competitive market
 To derive the equilibrium price and output under different scenarios when the firm
is operating under monopolistic competition
 To study the relevance of product variation under monopolistic competition
 To understand the use of selling cost in a monopolistic competitive market
Structure:
15.1 Introduction
15.2 Characteristics of monopolistic competition
15.3 Price determination under monopolistic competition
15.4 Derivation of equilibrium under monopolistic competition
15.4.1 Individual equilibrium
15.4.2 Group equilibrium
15.5 Why the output is smaller and the price is higher in case of monopolistic
competition
15.6 Product equilibrium under monopolistic competition
15.6.1 Individual equilibrium and product variation
15.6.2 Group equilibrium and product variation
15.7 Relevance of selling cost in monopolistic competition
15.8 Let us sum up
15.9 Key terms
15.1 INTRODUCTION
In the real world neither perfect competition nor monopoly exists. Rather, almost every
market seems to exhibit characteristic of both perfect competition and monopoly and it is
mix of both the market forms. A Cambridge economist, Piero Sraffa, was among the first
to point out the limitations of perfect Competition and monopoly. In the late 1920s and
1930s economists began turning their attention to the middle ground between monopoly
and perfect competition. Two of the most notable achievements were attributable to an
English economist, John Robinson and an American economist, Edward Chamberlin. It is
Prof. Edward Chamberlin who credited for the development of the concept of
monopolistic competition for the first time in the economics literature.
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Business Economics
Monopolistic competition is a market situation in which there are elements of both

perfect competition and monopoly. The nature of the products is such that they are not
purely homogeneous but are very close substitutes. Otherwise the products are so close
that they differ slightly from each other. Since close substitutes are available in the
market, as such, there is steep competition among the producers to attract the customers.
On the other hand, there is an element of monopoly in respect of product differentiation.
Moreover, products are close substitutes with each other but are not similar in feature.
This characteristic of product differentiation differentiates one firm to other. That is why,
each producer enjoys the monopoly over own product but faces close competition
because of availability of close substitutes in the market. Since both the elements exist in
the market for which this type of market scenario is called as monopolistic competition.
For example, the brands of tooth paste like colgate, pepsodent, dabur lal dant manjan,
close-up etc., constitute the tooth paste industry in Indian market. The brand colgate is
having its monopoly of producing colgate. No other existing brand can produce a tooth
paste in the name of colgate. But colgate product faces close competition with other
existing brands in the tooth paste market. Therefore, colgate pamolive, the producer of
the brand colgate cannot alone determine the price of its brand rather has to consider the
price level and output quantity of other brands in the industry by using the process of
inter-firm comparison.
15.2 CHARACTERISTICS OF MONOPOLISTIC COMPETITION

Following are the basic features of monopolistic competition:
1. Differentiated products but close substitutes:

As discussed above, the nature of the products that are produced under monopolistic
competition is that the products between two manufactures differ from each other but the
features are such that they are very close substitutes. It implies that the products of
different firms are differentiated. Each brand in an industry may vary on quality, packing,
design etc. There is steep competition between the existing players in the industry. This
happens due to adoption of brand loyalty created by the firms in the mindset of
customers.
2. Large numbers of sellers:

There exists large numbers of sellers in the market to sell a particular brand. But the
numbers of seller are not as large as that exists in perfect competition nor are as small as
of monopoly. Each seller sells the brand independently without any fear from the rivals.
3. Free entry and exist:

New firms are freely allowed to enter into the industry and existing firms are free to leave
the industry as per their convenience. However, entry or exit to or from the industry is not
so easy in reality as it looks theoretically. In reality, however, numbers of forces are there
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Monopolistic
Competition
which restricts the new firm to enter into the industry and existing firm to leave the
industry.
4. Imperfection in the market:

Acquiring complete market knowledge both from the buyers and sellers is quite difficult
in the monopolistic competition. This is because the market becomes so vast that things
change frequently. Buyers some time remain ignorant about the price and availability of
brands in the market. Likewise sellers also lack in complete information on the price and
availability of brands in the market. Thus, monopolistic competition is characterized by
imperfections in the market which may arise due to ignorance, negligence, consumer’s
irrational attitude, cost of transportation etc.
5. Degree of competition:
As discussed earlier producers of each brand under monopolistic competition do face
steep competition to attract consumers towards their product. Even though each producer
produces the products independently, still other’s actions are under strict review while
taking any decision for their brands.
Activity-1:
Compare the above characteristics with the characteristics of perfect competition and
monopoly as discussed in previous units.
Activity-2
Examine, which of the following is a close approximation of a monopolistic competitor
in the Indian market?
(i) Whirlpool as a refrigerator manufacture
(ii) Indian railway
(iii) Asian paints
(iv) A local stationary shop and
(v) Coco Cola
15.3 PRICE DETERMINATION UNDER MONOPOLISTIC COMPETITION
Analysis of equilibrium price and output under the condition of monopolistic competition
involves fulfillment of three different strategies viz., (i) product differentiation, (ii) price
and output variation and (iii) selling cost adjustment. The price and output can be
determined in two different ways viz., (a) individual equilibrium and (b) group
equilibrium. Under the conditions of perfect competition, a seller can sell any quantity at
the industry derived price of the product. But under monopolistic competition individual
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Business Economics
firm’s market is isolated in certain degree from those of its rivals. Hence a firm operating
under monopolistic competition generally faces more complicated issues than a firm who
is operating under perfect competition.
Strategies for price determination:
There are the three strategies which are important for the price determination under the
condition of monopolistic competition as outlined below.
(i) Product variation:

The monopolistic competitive firm enjoys certain degree of monopoly power because
some consumers have strong attachments for its products (brand loyalty). In such a
situation, any rise in price of the product raises the fear of losing few customers but not
all the existing customers. On the other hand, if the company takes a decision to reduce
the existing price of the product, then the possibility lies that it may attract few
competitors’ customers but not all the customers. Alternatively, the quantity demanded
for the product may increase with the fall in price but not infinitely and the quantity
demanded for the product may fall with the rise in price but it will not be zero. It is,
therefore, the demand curve of firm which is operating under this market condition slopes
down ward from left to right. What the firms do is that they have to choose a suitable
price and output combination in order to maximize profit.
(ii) Product differentiation:

A firm operating under monopolistic competition has the liberty of product
differentiation. Differentiation in a product can be done in two ways. One way is real
product differentiation and the other way is based on the condition of sale. The
differentiation may be in the form of trade name, packages, quality of the product, design,
colour, style. Another way of differentiating a product is based on the services rendered
in the process of selling of the product by different sellers. It may be due to the location
factors, the general reputation of the company, goodwill of the product, ways of dealing
with the customers etc. Under modern management concept it is termed as customer
satisfaction and value addition and is being used globally. Some times product
differentiation involves increase in the cost of production. Hence, profit maximization
principle applies to the choice of the nature of the product as to its price. Given the prices
of the product, a firm has to choose that product among the alternatives which will result
into maximum profit.
(iii) Adjustment of selling cost:

Generally, the sellers who are operating under the condition of monopolistic competition
realize too much on selling costs to increase the sale of their product. Advertisement cost
among various elements is one of the prominent elements of selling cost. Each rival firm
under this market condition competes with each other based on selling cost. Hence,
advertisement expenditure has the power to influence the cost and demand condition of a
firm. Thus derivation of equilibrium of the firm ultimately involves equilibrium in regard
to the amount of selling outlays.
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Monopolistic
Competition
Analysis of equilibrium price and output determination under the condition of

monopolistic competition involves a complicated process. Following is the derivation of
the equilibrium of a monopolistic competitive firm.
15.4 DERIVATION OF EQUILIBRIUM UNDER MONOPOLISTIC

COMPETITION
The equilibrium price and output can be determined in two different conditions viz.,
15.4.1 Individual equilibrium and
15.4.2 Group equilibrium.
Both the conditions are outlined as under:
15.4.1 Individual equilibrium or short-run equilibrium:

Equilibrium price under monopolistic competition can be determined by the interaction
of demand and cost conditions of the firm. Moreover, individual equilibrium refers to the
determination of price and output of the product. Since there are many firms operating in
the industry who are producing close substitutes of each other, the shape of the elasticity
of demand curve for the product of any of the firm depends upon the availability of
substitutes and prices. Therefore, individual equilibrium cannot be analysed in isolation
to the general equilibrium. In such a situation, it is to be assumed that the price and
quantity of output of the substitutes are constant. The immediate implication of this
assumption is that the demand curve faced by the individual firm will be fairly elastic.
Otherwise, given the prices of the rivals, any increase in the price of the product may
shift few customers to the rivals and vice versa.
Further, it also needs to be assumed that the quantity to be produced by an individual firm
is to be held constant. It is, hence, can be noticed that the only variable that is left with
the producer to vary is the price of the product. That is, why, the individual equilibrium
under this market condition is nothing but only an adjustment of price and quantity of
sale. Based on the above assumptions, the derivation of individual equilibrium of a
monopolistic competitive firm is well derived in the figure-15.1.
In the figure15.1 derived above, OX-axis measures output and OY-axis measures cost
and revenue. AR is the average revenue curve or the demand curve of the firm and MR is
the marginal revenue curve of the firm. Where as MC and AC are the marginal and
average cost curves of the firm. The derivation of theory of value is based on the
principle of profit maximization. The firm earns maximum profit when its MC = MR. In
the derived figure, MC = MR at point E where the firm is producing OM quantities of
output. Q is the point on AR corresponding to the point E on MR. This determines price
of the product as OP and the area RSQP is the total profit that the firm will earn.
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Business Economics
Cost & Revenue

MC
AC
P Q
R S
AR
E
or D
MR
X
O M
Output
Figure No.-15.1
It is not always certain that a firm under the monopolistic competition only earn
supernormal profit in the short-run. There is possibility of getting supernormal loss also.
The graphical derivation of individual firm’s condition of supernormal loss is derived
with the help of a figure-15.2.
In the short-run, a firm under monopolistic competition can earn either super normal
profit or even can incur super normal loss. The OX-axis in the figure represents output
and OY-axis represents cost and revenue. It can be seen that, the firm attends equilibrium
at point E by producing ON quantity of output at OT equilibrium price. It can be seen that
the company bears an average cost OG which is more than the price OT. Otherwise, it
can be seen that the price on which the company is selling less in comparison to the cost
that the company is bearing to produce an additional unit of output. Thus it implies that
the company is running in loss. The total amount of loss that the company is bearing in
the figure is the area of TKHG.
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Monopolistic
Competition
Y
MC
AC
G H
Cost & Revenue T K
E
AR
MR
X
O N
Output
Figure No.-15.2
Again, there is every chance that the company can also earn normal profit. A
monopolistic competitive firm can also run in a situation of no-profit-no-loss. When the
price of the product will be equal to the average cost of production, at the point of
equilibrium, the company can start earning normal profit. The condition of derivation of
normal profit is derived at the figure-15.2. In the figure, the marginal revenue curve (MR)
is tangent to the marginal cost curve (MC) at point E, which is the point of equilibrium. It
can be seen that the average cost of production MK is equal to the price of the product
OP at OM (equilibrium) quantity of output.
D MC
AC
Cost & Revenue
P K
E
AR/D
MR
X
O M
Output
Figure No.-15.3
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Business Economics
In all the above derived cases it can be noted that once the equilibrium price is
determined there does not remain any tendency of the firm to change the amount of price
further. If price increases, the loss due to fall in quantity demanded would be more than
the gain due to rise in price. Furthermore, if the seller cut the price of the product than the
gain due to the increase in quantity demanded is less than the loss due to the lower price.
15.4.2 Group equilibrium or long-run equilibrium:

Long-run is a period of time where all the firms get plenty of time to make efforts to
attract the customers of its rivals. Publicity and advertisement, salesmanship are the usual
devices used by each firm to attract the customers of the rival firms. There will be an
intense competition among rival firms. It is always possible that any one firm has
introduced some innovative design for its commodity. With this technique each firm
always looks at each others customers in the market.
In order to simplify the derivation of group equilibrium under the conditions of
monopolistic competition, Prof. E. Chamberlin has taken two heroic assumptions. Both
the assumptions are as detailed below:
(a) Uniformity assumption:

Prof. Chamberlin states that, under the conditions of monopolistic competition, the firms
producing substitutes are assumed to be uniform in both demand and cost curves.
Otherwise, both demand and cost conditions of the product for all the firms remain
uniform throughout the process of production of output. According to him, such an
assumption does not ignore the difference in the production.
(b) Symmetric assumption:

Further to explain his theory of equilibrium, Chamberlin has assumed the symmetric
assumption. This implies that any adjustment in price and output by a firm has negligible
effect upon price and output adjustment of rivals. Since there are large numbers of firms
operating in the monopolistic competition, change in price of any individual seller does
not affect the entire rivals. For instance, suppose a firm-A reduces the price of its product.
As a result of this price cut, the demand for its product will increase. This increase in
demand implies that few customers of competitive firms have adopted to purchase the
product of firm-A. But Chamberlin opines that the reductions in the numbers of
customers of the rivals are negligible.
Given the above two assumptions the group equilibrium condition of monopolistic
competition is derived with the help of a figure-15.4. OX-axis in the figure measures
output and OY-axis measures cost and revenue. DD is the demand curve; MC and MR
are the marginal cost and marginal revenue curve of the monopolist respectively. It can
be seen from the figure that at the equilibrium output (OM), the price that is determined
is OP. At this price the firm is enjoying supernormal profit. Since the firms are enjoying
supernormal profit, hence, new firms are attracted to expand their business. But the
condition of entry for the new firms under monopolistic competition is that they have to
produce identical products as that of the competitors.
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Monopolistic
Competition
Cost & Revenue

MC
AC
P Q
S R
E AR / D
MR
X
O M
Output
Figure No.-15.4
Now due to the entry of new firms into the industry divides the existing customers among
them selves. This distribution of customers causes reduction in demand for individual
firm. As a result of the decrease in demand, the existing demand curve shifts backward.
This shift in demand curve will continue till the average revenue curve becomes tangent
to the average cost curve. As a result of this shift in demand curve the condition of
acquiring supernormal profit is wipe out. All firms will enjoy normal profit in due course
of time in the industry. This condition of equilibrium derivation is well explained using
the figure-15.5.
D MC
AC
Cost & Revenue
K T
E
AR/D
MR
X
O L B
Output
Figure No.-15.5
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Business Economics
In the figure-15.5, OX-axis measures output and OY-axis measures cost and revenue of
the firm. AR, MR, AC and MC are the average revenue, marginal revenue, average cost
and marginal cost curves respectively. In the figure, the AR curve is tangent to AC curve
at the point T, corresponding to the point of interaction between the MC and MR curve.
This determines the long-run price of the product as LT or OK for producing OL quantity
of output. It can be marked that the firm is acquiring normal profit. As it has been
assumed that all the firms that are operating the industry are alike in respect of cost and
demand condition, hence, each firm in the group is earning normal profit. Since, at this
stage in the industry i.e., in long-run, all firms are acquiring normal profit, as such, no
new firm has a liking to enter into the industry. Thus it is clear that the possibility of
entry of new firms into the industry is very rare in long-run.
15.5 WHY THE OUTPUT ARE SMALL AND PRICE IS HIGHER IN CASE OF
MONOPOLISTIC COMPETITION?
It is one of the important point to note down from the equilibrium price and output
determination is that in long-run, a firm operating under both perfect competition and
monopolistic competition earns normal profit, but the price that has been charged by the
monopolistic competition is marginally higher than the price charged by the perfect
competitive firm. Again, the output that is produced by the firm at the determined price
under monopolistic competition is quite less as compared to the case of perfect
competition. In other words, a firm operating under perfect competition charges lesser
price and produces more quantity of output. A firm under monopolistic competition in the
long-run charges monopoly price without enjoying monopoly profits. The existence of
monopoly power under monopolistic competition necessitates the demand curve to slope
downward. Each firm balances both the monopoly and perfect competition forces under
the monopolistic competition. The derivation of normal profit in the long-run by a firm
does not imply that the firm is operating under perfect competition.
15.6 PRODUCT EQUILIBRIUM UNDER MONOPOLISTIC COMPETITION
Product equilibrium under monopolistic competition can be derived in two different

scenarios as under:
15.6.2 Group equilibrium and product variation

Under monopolistic competition an entrepreneur faces the challenge of not only
determining the price-output of the product but also the quantity of product to be
produced. Thus getting equilibrium in respect to variation of quantity of product is an
important requirement under monopolistic competition. To derive equilibrium of a
product, it is essential to assume that the price of the product is remaining constant. Price
being constant, it can be decided that which product-mix the firm should choose.
Generally, firms accept that price which is already prevailing in the market or the price
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Monopolistic
Competition
fixed as granted by tradition and because of trade practices or may continue the price
which the customers are willing to pay.
Further, the quality of a product depends upon the location of firm’s operations, trade
mark (brand name) under which the product is marketed, technological qualities that the
product possesses like the packaging, brand building and presentation and so on. It is
known that any changes in the above factors make a change in the quality of the product
and, hence, cost of the product. An increase in quality of product increases cost of
production and also demands for the product. Thus, it always acts as a challenge for the
entrepreneur to bridge between the demand for the product to that of cost of production
so as to earn maximum profit. With the help of following figure-15.6, the qualitative
changes are highlighted.
In the figure-15.6 derived, OX- axis measures quantity produced and OY-axis measures
price and cost. The two cost curves AA1 and BB1 are drawn in the figure. The AA1 is the
average cost curve for variety-A product and BB1 is the average cost curve for variety-B
product. Since price of the product is assumed to be given, let, OP be the price of the
product. At this price, the entrepreneur is producing OM quantity of variety-A product.
The total cost that he is bearing is equal to the area OMRS and the total profit that he is
generating is equal to the area SRQP and are when he produces ON quantity of output of
variety-B, the total profit is the area GFEP.
One thing has to be noted that the price line, PE is not perfectly demand curve. For each
variety of the product, the quantity demanded is limited. The quantity demanded of a
product depends upon products own price and also the nature of its substitutes. Therefore,
it is not possible to move along the cost curve AA1. Thus from the figure it can be seen
that at ON quantity of production of variety-B product, the entrepreneur is getting
maximum profit rather than producing OM quantity of variety-A product. Hence, among
the two possibilities of the products available, a rational entrepreneur will choose to
produce variety-B of the product.
Any change in cost and demand conditions in the industry will cause a change in the
demand of the product. In such scenarios, a firm needs to be adjusted as per the change in
the situation. For example, let us assume that the costs of production for variety-A
product of the substitute entrepreneurs have increased. This increases the price of the
product-A. Increase in price reduces the demand for the product-A. In the figure, LL1 is
the new demand of variety-A product due to the fall in demand. At this quantity of sale
the entrepreneur can earn normal profit. If the amount demanded will be less than OL, it
does not cover the average cost of production at the price of the product OP. Therefore,
the firm will closedown producing variety-A of the product. This leads to increase in
profit. Thus the individual product equilibrium derives maximum profit.
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Business Economics
B
B1
Price & cost

A
L1 Q E A1
P
G
F
S R
O X
L M N Quantity
Figure No.-15.6
15.6.2 Group equilibrium and product variation:
Group equilibrium or product variation is such a situation under monopolistic
competition in which all firms are earning normal profit. For explaining the conditions of
product equilibrium it is needed to assume that the demand curve faced by all the firms
are alike. Again, it also needed to assume that the product variation remains uniform for
all the competitors. The group equilibrium condition can be explained with the figure-
15.7.
Y D
C
Price & cost
L Q S D1
P E
H
G C1
O X
T M N
Quantity
Figure No.-15.7
In the figure-15.7, OX-axis measures quantity and OY-axis measures cost and price of
the product. Price of the product is OP and PE is the price line. CC 1 is the cost curve of
product variety-C and DD1 is the cost curve for product variety-D. At variety-C, yields
profit equal to the area GHQP. But the group to be in equilibrium, the supernormal profit
is to be eliminated.
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Monopolistic
Competition
Elimination of supernormal profit may be either by price cutting or by product

adjustment or by the entry of new competitors. But since price is assumed to remain
constant and given, hence, the change of price cutting is ruled out. Thus the only
alternative remained is either by entry of new firms or by product adjustments. Now entry
of new firms can continue till the price of the product equals the cost of production viz.,
till OT quantity of variety-C produced by each firm. If further entry of new firms beyond
this quantity continues, then the possibility is that all firms operating in the industry may
incur loss or profit will be reduced.
Another way of eliminating supernormal profit is by improving quality of product.

Improve in product quality will shift the cost curve upward. Increase in cost will continue
till the cost curve of an improved variety will tangent to the price line PE. The cost curves
cannot be higher than DD1. In case, it will be higher than DD 1, the firm will incur loss.
But the fact is that it will remain lower than DD1 because PE is not the perfectly elastic
demand curve. The derivation of group equilibrium in case of product variation depends
upon following important conditions.
a. the average cost must be equal to the price at the point of equilibrium
b. it is not possible for any individual firm to increase its profits by making further
improvement in its own product
c. all firms in the long-run are in equilibrium.
Activity-3
Advertisement war between two competitors is a common phenomenon in India.
Examine the recent wars between:
(a) PepsiCo and Coco cola
(b) Colagete and Pepsodent
(c) Horlicks and Complan
Activity-4
Point out some new advertisement wars beside the above mentioned brands. Are you
finding any war between Nirma and Surf soap bars? Explain.
15.7 RELEVANCE OF SELLING COST IN MONOPOLISTIC COMPETITION
According to Prof. E. Chamberlin, selling costs are costs incurred by the firms in order to
alter the position or shape of demand curve for a product. These are those costs which are
incurred to create demand and push up the sales of the product. Such costs are like
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Business Economics
advertising cost, publicity expenses and so on. Through selling costs a firm can attract
new customers and induce old ones to buy more and increases the demand for its
commodity. Since, there is product differentiation in imperfect competition, vigorous
efforts are needed for selling. Hence, it is through selling efforts that a firm positions its
product in the mind of the consumers. Different economists opine differently on the
usefulness of selling cost for a firm. A group of economists argue that selling efforts are
essential for a monopolistic firm. Where as the other group argue that selling efforts are
wasteful expenses. Few important arguments of both the group are outlined below.
Argument in favour of selling cost:
i. Selling efforts make the consumers aware about the entry of new firm, new
product or any modification that has been done in the product. Thus selling efforts need
not to be avoided.
ii. The selling efforts create extra employment in the economy. Because of this
there are huge vacancies in sales personnel, advertising agencies, media engagement.
iii. The basic purpose of selling effort is to increase demand. Increase in demand
increases supply. Increase in production gradually reduces average cost due to which
price of the product also falls.
Argument against selling costs:

i. Some argue that selling efforts mislead the consumers. It so influences the
consumers that the consumers could not accurately judge the real quality of the product.
ii. Selling efforts are the items of cost. It increases the cost of product. Increase of
the cost of product definitely is transferred to the consumers. Ultimately price of the
product increases.
iii. The tendency of selling effort increases the advertisement war in the market.
When one firm starts advertising, the other will definitely start. This creates an
advertising war like phenomena in the market.
The relationship between selling cost and output is one of the important areas of
discussion under the equilibrium price-output determination in monopolistic competition.
It is known that firm incurs high selling costs to sell more output. With the increase in
selling cost, total cost of the firm increases.
For example, consider a firm that is offering one free baby lotion with every pack of baby
wipes. With this offer the total cost of the firm will definitely increase as of the cost of
baby lotion which will be equal to the number of packets of baby wipes packets
produced. For this, with the every increase in output the average as well as the marginal
cost per unit of output of the company will be higher. These conditions will prevail when
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Monopolistic
Competition
the selling costs are variable. But once the selling costs are assumed to be fixed, this free
offer does not affect to the company’s marginal cost rather the average cost of production
will go on diminishing as the total output increases. That output which yields the firm
maximum net returns will be the equilibrium output. Net return can be calculated by
using a simple procedure as:
Net Return= (price × output)-(cost of production +selling costs incurred)

= Total Revenue- total cost incurred by the firm including the selling
cost
Y
Cost and Revenue
MC
P
P AC1
AC
AR
MR
X
O M Amount
Figure No-15.8
The equilibrium condition of a firm with fixed selling cost can be well explained with the
help of the figure derived. In the figure-15.8, OX- axis measures quantities of output
produced and OY-axis measures cost and revenue. AR and MR is the average and
marginal revenue curve respectively. From the figure it can be seen that AS is the average
cost before the allocation of selling cost. Now, with the introduction of the selling cost,
the average cost curve of the firm moves upward and AS 1 becomes the new average cost
curve of the firm. It can be seen that the cost and revenue increases, hence, PQRS area of
the figure accounts to the net profit to the organization.
15.8 LET US SUM UP

 Monopolist competition is in the mid way between the perfect competition and
monopoly. Two characteristics of monopolistic competition have been borrowed
from perfect competition.
 Each firms operating under monopolistic competition sells differentiated
products, and hence, the demand curve facing a monopolist is negatively sloped.
But under perfect competition, product that all the firms are selling is
homogeneous.
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Business Economics
 The demand curve (AR curve) of the monopolistic competition is slightly flatter
than the demand curve under monopoly. This is because, monopolist does not
face any competition but the firm under monopolistic competition faces close
substitutes.
 A firm under monopolistic competition may earn supernormal profit or normal
profit or supernormal losses under monopolistic competition in short-run.
 A firm in long-run operates at a normal profit situation like that of the firm under
perfect competition.
 The average cost equal to the unit price of the product at the point of equilibrium.
 Since AR is negatively sloped, it becomes tangents to the falling portion of the
U-shaped AC curve and never touches the lowest point of the AC curve.
15.9 KEY TERMS

 Monopolistic  Perfect competition
competition
 Monopolist  Equilibrium price- output
 Product differentiation  Efficiency
 Supernormal profit  Normal profit
 Supernormal losses  Profit maximization

 Bhutani, Prem J. (2008), Principles of Economics, Taxmann Allied Services
Private Limited.
 Chamberlin, E. (1993), The Theory of Monopolistic Competition, Harvard
University Press.
 Gould, J.P. and Edward, P.L. (2003), Microeconomic Theory, Richard D. Irwin
Inc. Publishing.
 Koutsoyiannis, A. (2007), Modern Microeconomics, Second edition, Macmillan
Press Ltd.
 Mansfield, E. (1996), Managerial Economics, Macmillian Press Limited.
 Roy, U. (2008), Managerial Economics, Second edition, Asian Books Private
Limited.
 Salvatore, Dominick (2010), Managerial Economics, Sixth adapted version,
Oxford University press.
 Samuelson, P.A. and Nordhaus, W.D. (2008), Economics, Tenth edition, Tata
McGraw Hill Publishing Company Limited.
 Thomas, C.R. and Murice, S.C. (2005), Managerial Economics: Concepts and
Applications, Tata McGraw Hill publishing Private Limited.
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Monopolistic
Competition

1. Examine the similarities between the monopolistic competition with monopoly
and perfect competition.
2. Explain with suitable diagram the case of a normal profit in long-run. Why the
firms only incur normal profit but not supernormal profit?
3. Write a short note on individual equilibrium derivation under monopolistic
competition.
4. Write a short note on product differentiation in monopolistic competition.
5. Enumerate the characteristics of a monopolistic competition.
6. What is selling cost? Explain the significance of selling costs under
monopolistic competition.
7. Are selling costs necessarily items of waste? Justify your answer with sufficient
reasons.
8. Distinguish between product differentiation and product variation.
9. Write a short note on selling cost.
10. Define monopolistic competition. How price and output is determined under
monopolistic competition in short run?
11. Differentiate with the help of suitable diagrams the individual and group
equilibrium conditions under monopolistic competition.
12. Write a short note on symmetric assumption.
13. Write a short note on uniformity assumption.
14. Enumerate with suitable diagrams the product equilibrium condition under
monopolistic competition.
15. Explain the causes why product between two producers in an industry are so
close substitutes, but not homogeneous?
16. Explain the concept on choice related variables for a firm under monopolistic
competition.
17. Select a firm from mobile handset industry. Does it satisfy characteristics of
monopolistic competition?
18. Choose a firm from LED-TV manufacturing industry. Examine whether it incur
selling cost? If yes, calculate how much?
19. Watch recent TV advertisements. Select a product of your choice. Examine
whether this industry is experiencing monopolistic competition.
20. Take a firm of your choice. Examine whether it incur selling cost? Are selling
costs regularly incurred by the firm?
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UNIT 16 OLIGOPOLY
Objectives
After completion of this chapter, the students will be able to understand:
 About oligopoly market structure
 The characteristics of oligopoly market
 Various theories on price-out put determination under oligopoly
 Distinction between oligopoly and duopoly market
Structure:
16.1 Introduction
16.2 Characteristics of oligopoly
16.3 Classification of oligopoly market
16.4 Determination of price-output under oligopoly
16.4.1 The classical oligopoly model or Cournot’s model
16.4.2 Price-leadership model
16.4.3 Kinked demand curve model and
16.4.4 Collusive oligopoly
16.5 Let us sum up
16.6 Key words
16.7 Selected readings
16.1 INTRODUCTION
Oligopoly is that form of imperfect market condition where there are a few firms in the
market which are producing either homogeneous product or producing products which
are close but not perfect substitutes of each other. Where as, in case of monopoly there is
one seller of the product and both in case of perfect competition and monopolistic
competition both, there are many sellers. The oligopolist market situation has been named
differently by the economists based on the usefulness like ‘limited competition’,
‘incomplete monopoly’, ‘competition among the few’, ‘multiple monopoly’, etc. The
simplest case of oligopoly is the duopoly which has only two sellers of the product.
16.2 CHARACTERISTICS OF OLIGOPOLY
Like all other market situations already discussed, oligopoly market scenario has its own
characteristics. These characteristics are the yard mark to identify an oligopoly market.
The analysis of price-output determination under oligopoly plays very crucial role in the
operation of an economy. Hence, price-output can be determined better by understanding
the basic characteristics that the market condition possesses. Following are few important
characteristics of oligopoly:
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Oligopoly
(i) Interdependence:
One of the most important features of oligopoly is the interdependence in the decision-
making among the few firms in the industry. It happens because since the numbers of
competitors in the industry are few, hence, any change in the product either in price or
output or even style and colour etc., by any one firm, affects the sale of the rival firms. In
such a situation, the rival firms have to react immediately to sustain in the industry. Thus,
it is clear that an oligopolist firm while taking decision not only considers the existing
market demand but also considers the way the rivals will react for any action taken by it.
But such a case of interdependence does not exist either in perfect competition or
monopoly or monopolistic competition.
(i) Indeterminate demand curve:

Another important feature of oligopoly is the indeterminateness of the demand curve. The
demand curve shows the quantity of output that the firm is willing to sell at different
prices. But, since under oligopoly, there is interdependency between the firms, hence, a
firm cannot trust another firm that its action will not be repeated by other rivals. As a
result of this uncertainty in the industry the demand curve facing an oligopolist losses its
definiteness and determinateness. For which the oligopolist’s demand curve is
indeterminate. Where as, the demand curve of a perfectly competitive firm is fixed, a
monopolist safely ignores the effects of its own price change on its rivals and in
monopolistic competition any change in price has negligible effect to the rival firms.
(ii) Conflicting attitudes of the firms:

A peculiarity of oligopoly form of market situation is that there exists conflicting
attitudes among the firms who are operating in the industry. At one time, the firms realize
the disadvantages of mutual competition and desire to operate with unity to maximize
profit. This tendency when develops between the firms is called as ‘group behavior’. But
this type of tendency among the firms is rare to exist neither in case of perfect
competition nor in monopoly or monopolistic competition. Further more there increases
expectations among the firms to get maximum profit. This expectation creates huge
competitive atmosphere among the firms in the industry. In such a scenario, firms instead
of co-operating with each other, clash with each other. Therefore, two conflicting trends
works under oligopoly i.e., one wish for co-ordination and united action and the other is
for conflict and competition.
iv. Importance of advertising and selling cost:

As a direct effect of interdependence, the oligopolists have to adopt various aggressive
and defensive marketing weapons either to get lion’s share in the market or to protect self
from any anticipated loss. This is why the oligopolists allocate a large portion of their
cost towards advertising and other sales promotion techniques. For this, Prof. Baumol
rightly pointed out that ‘it is only under oligopoly that advertising comes fully into its
own’. Where as advertising expenditure neither plays any role in perfect competition nor
in monopoly but plays little role in case of monopolistic competition.
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Business Economics
v. Price rigidity:
Rigidity in price of the product is another important characteristic of oligopoly. As
already discussed, there exists interdependence among the firms who are operating under
oligopoly. Since, there is interdependence, a small change in price by a firm will lead to a
change in price by the other firms. This tendency of the firms leads to ‘price war’
situation in the market. To prevent the existence of this price war between the firms, by
mutual agreement, in normal course of time each oligopolist avoids altering the existing
price of its product. Thus, price of the product remains rigid in oligopoly.
16.3 CLASSIFICATION OF OLIGOPOLY MARKET
Oligopoly can be classified into few categories as discussed below:
i. By product differentiation:
On the basis of product differentiation, an oligopoly form of market structure is divided
into two type’s viz., pure oligopoly and differentiated oligopoly. An oligopoly situation is
called as pure oligopoly where the product that the firms are producing in a group is
identical or homogeneous. Because the product is identical, hence, there is no question of
product differentiation in case of pure oligopoly. Where as, in differentiated oligopoly
structure, there is product differentiation in each firms in the industry. In other words, the
product is not identical or homogeneous. Each firm’s product in the industry is different
from each other and is also close substitute.
ii. By price-leadership:
The oligopoly form of market structure is also differentiated on the basis of presence or
absence of price-leadership quality. On the basis of price leadership, oligopoly is either
partial oligopoly or full oligopoly. The partial oligopoly is a form of oligopoly structure
where any one firm in the industry acts as a price leader. This leading firm takes the
decision on fixation of price. Thus, what ever price the leader fixes, other firms simply
follow the decision without having any reaction in the market. Where as no firm in the
industry is a leader in case of full oligopoly market structure. Each firm in the industry
acts independently without concerning other rivals while taking the decision on fixation
of price of their own product.
iii. By agreements:
Oligopoly may be classified into collusive oligopoly or non-collusive oligopoly on the
basis of agreement among them. An oligopoly structure is called as collusive oligopoly
where the firms that are operating in the industry join their hands together in a group for
the purpose of fixation of price and output. They combine together in order to avoid any
cut-throat competition in price i.e., called as ‘price war’. Where as, in case of non-
collusive oligopoly each firm in the industry takes their independent decisions on fixation
of price.
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Oligopoly
iv. By freedom on entry of firms:

On the basis of freedom to entry into the industry, oligopoly form of market structure is
classified into open oligopoly and closed oligopoly. Any new firm is free to enter into the
industry when there operates open oligopoly market structure. Where as, no new firms
are free to enter into the industry when there operates closed oligopoly structure.
16.4 DETERMINATION OF PRICE-OUTPUT UNDER OLIGOPOLY
There is not any single determinate solution to explain the price-output equilibrium under
oligopoly. But in due course of time various models have been developed. The models
are outlined as follows:
16.4.1 The Classical oligopoly model (Cournot’s Model)
16.4.2 Price-leadership model
16.4.3 Kinked-demand curve model
16.4.4 Collusive oligopoly
16.4.1 The Classical oligopoly model or Cournot’s model:

This model is a duopoly model. It has the merit that it can be applicable to the cases
where there will be more than two sellers. It was Augustin Cournot, a French economist,
who is credited for the development of this theory more than 160 years ago. Cournot has
elaborated duopoly model by taking the case of two such firms which owned spring of
mineral water. Consumers came to the springs carrying their own containers, so that the
marginal cost of production was zero for both the firms. Following are the few important
assumptions of the model:
i. There are only two firms engaged in production of the commodity
ii. Each firm owns a spring of mineral water
iii. The firms are operating under zero production cost i.e., no marginal cost as no
cost is required to produce water
iv. The market demand curve for the product are downward slopping
v. The two firms are close competitors of each other
vi. Each firm assumes that the other firm will not change the output and accordingly
decides the quantity of output that will give them profit
With these basic assumptions, the Cournot’s duopoly model is explained in detail as
below. In the figure-16.1 given below, OX-axis measures output and OY-axis measures
price of the product.
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Business Economics
12
Price
6 A
3 B
ARA=DDA
MRA
X
O 3 6 12
Quantity
MRB ARB=DDB
Figure No. 16.1
In the figure, DD is the market demand curve for spring water. Let us now assume that
there is only one firm i.e., firm-A operating in the market. Since, it is the only firm
operating in the market, hence, it faces the total market demand. Thus, the market
demand DD will be the demand curve for firm-A which is DDA. The marginal revenue
corresponding to the demand curve or average revenue curve DD A is MRA. It can be
noted that the cost of production of the mineral water is zero for the firm-A. Since cost is
zero, marginal cost for the firm is also zero. The MC curve for zero marginal cost is one
which coincides with the horizontal axis i.e., OX-axis. Under these circumstances, firm-A
maximizes total profits where MR A = MC = 0. From the figure, MR = MC at point E
where the firm sells 6 units of spring water at price of Rs. 6/- per unit. The total revenue
that firm-A is obtaining 6 units at a price of Rs. 6/- per unit (total earning is Rs. 36/-). It is
at point A in the DDA demand curve or average revenue curve where the firm-A is
maximizing profit. Further it can also be marked in the figure that point A is at the
midpoint in the demand curve DD A, at which price elasticity of demand will be one.
Since total cost of production is zero, hence, the entire amount that the firm-A acquired
i.e., Rs. 36/- is its profit.
Now, let us assume another firm (firm-B) enters the market and believes that firm-A will
continue to sell the quantity of 6 units. The demand curve for firm-B is DDB, which can
be obtained by subtracting from market demand curve DD the unit sold by firm-A, i.e., 6
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Oligopoly
units. Thus firm-B’s demand curve starts from unit 6 of the OY-axis and touches OX-
axis. Then the MR curve corresponding to the demand curve DD B is MRB. Here, the
firm-B maximizes total profits where MRB = MC = 0. Therefore, firm-B sells 3 units at
Rs. 3 /- per unit at the midpoint of demand curve DD B.
Further, reacting and assuming that firm-B sells 3 units, firm-A continues to sell at the
midpoint of new demand curve (total of 12 units- 3units sold by firm-B = 9 units) and
sells 4.5 units. Firm-B then further reacts to firm-A’s sale of 4.5 units and continues to
sell 3.75 units (i.e., 12-4.5=7.5/2) with new demand curve. This process continues until
both the duopolists faces an equilibrium demand curve and maximizes profits by selling 4
units at price of Rs. 4 /- per unit. This price and output will be the equilibrium price and
output. Among both the firms, whichever reaches at the equilibrium quantity first, the
other will also reach at this point of equilibrium. Since, each duopolist is selling 4 units,
hence, a combined total of 8 units will be sold in the market at price per unit of Rs. 4/-.
Thus, the duopolists supply one-third, or 4 units each (and two-thirds or 8 units together),
of the total of 12 units. On the other hand, if it would be a case of monopoly market
condition, then the equilibrium price and quantity would be Rs. 6/- per unit and 6 units
respectively. Whereas, in case of perfectly competitive market, there would be no
equilibrium price and the output would be 12 units.
Activity-1
It has been observed that there are only two firms operating in the milk powder segment?
Examine under which type of market does this segment operate?
16.4.2 The price leadership model:

One of the greatest characteristics of oligopoly market structure is that sometime any one
firm in the industry acts as the industry leader. It fixes the price of it’s product and
gradually the other rivals also sets the price of their products as per the leader. This trend
in oligopoly market structure is called as ‘price leadership’. The price leadership model
of oligopoly is based on the assumption that there are eleven firms in a particular
industry. Out of these eleven firms, the size of operation of ten firms is quite smaller than
one firm, which is the dominant firm and is the leader of that industry.
Types of Price Leadership

The main types of price leadership are:
(i) Price Leadership of a Dominant Firm:

Under this type of price leadership, there is generally one firm which produces the bulk
of the product of the industry. By virtue of position, it dominates the entire market. It sets
the price and the other firms simply accept this price. The other firms are not in a position
to exercise any influence on the market price. So, the dominant firm fixes a price so as to
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Business Economics
maximize its profits. The other firms have to adjust their output to the price so fixed by
the dominant firm.
(ii) Barometric Price Leadership:

Under this type of price leadership, an old, experienced and the largest firm assumes the
role of a leader. Besides, it protects the interests of all firms instead of merely promoting
its own interest. In a way, it acts as the custodian of firms operating in the industry. It
fixes a price which is found to be suitable for all the firms in the industry. This price is
fixed by taking into consideration the market conditions with regard to the demand for
the product, cost of production, competition from the rival producers, etc.
(ii) Exploitative or Aggressive Price Leadership:

Under this category, one big firm comes to establish its supremacy in the market by
following aggressive price policies. This firm compels other firms to follow it and accept
the price fixed by it. In case the other firms show any independence, this firm threatens
them and coerces them to follow its leadership with the result that the price set by this
firm comes to be accepted.
Determination of equilibrium price-output under price leadership:

The equilibrium price-output determination in case of price leadership oligopoly is as
follows:
Y Panel-A Y Panel-B
S
Price
E MC
P 50
x y
P1 40 AC
S D
AR=D
X X
O 20 30 40 Quantity O 20 Quantity
MR
Figure No.-16.2
The figure-16.2 has two panels viz., panel-A and panel-B. The OX-axis in both the panels
represents quantity and OY-axis measures price (per unit) of the product. In panel-A, DD
is the total demand curve for the product and SS is the total supply curve of the ten firms
in the industry for the product. The DD demand curve is intersecting the SS supply curve
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Oligopoly
at point E. At point E the price of the product is OP, for simplicity let it be Rs. 50/-.
Hence, Rs. 50/- per unit is the equilibrium price of the product in the industry.
Further, at any price less than the equilibrium price i.e., OP, it can be seen that the total
market demand is greater than the total supply by the ten firms. For example, lets see at a
price of Rs. 40/- per unit. At this price there is excess of demand by a quantity of ‘xy’ to
the supply by the ten firms. Now, since the ten firms are smaller in size, they could not
supply more than their capacity. Thus, this gap will be automatically covered by the
dominating firm.
Now in the panel-B of the figure-16.2, DD is the demand curve of the dominant firm
which is determined by measuring the gap between DD and SS below the equilibrium
point E i.e., at Rs. 40/- per unit. This is that part of the demand curve which cannot be
met by the total supply curve of the ten other firms. For more clarity, at price Rs. 50/- per
unit, the total industry demand for the product equals total quantity supplied by the ten
firms. As a result of which, at price of Rs. 50/-, the demand facing the dominant firm will
be zero. Further, when price of the product falls to Rs. 40/- per unit, total market demand
increases from 30 units to 40 units, but aggregate supply of the ten small firms reduces
from 30 units to 20 units , causing a shortfall of supply by 20 units. Here, it can be noted
that this gap of 20 units i.e., 40 units -20 units= 20 units is the demand for the dominant
firm.
The equilibrium price-output will be the price and output that is determined by the leader.
It is known to us that the DD demand curve of the dominating firm is also his average
revenue curve. MR is the marginal revenue curve of the dominating firm corresponding
to AR curve and MC is the marginal cost curve. For getting profit, two conditions, that is,
MC = MR and the MC curve must intersect the MR curve from below should satisfy for
the dominant firm. In the figure, the MC curve of the dominating firm is intersecting the
MR curve at point ‘a’. The point ‘a’ in the figure satisfies both the profit maximizing
conditions. Thus, it is determined that Rs. 40/- per unit is the equilibrium price that the
dominating firm determines at 20 units of output. Hence, once the profit maximizing
price of the leader is determined, the followers will automatically follow the leader. In
this case the ten smaller firms will also charge Rs. 40/- per unit of the product.
Activity-2
Do you think that the Coco-cola and PepsiCo are the bright example of price leadership
strategy in the cold drinks market in India? Are other players simply followers?
Comment by examining the reality behind the claim.
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Business Economics
16.4 3 The Kinked demand curve model:

In the year 1939, Paul M. Sweezy, an American economist and R.L.Hall and C.J. Hitch,
Oxford University economists, published two separate research papers on the oligopoly
market structure. It was a coincidence that both the groups of authors published their
respective papers separately but the subject matter was the same, i.e., the kinked demand
curve model. On the central logic of price rigidity this model explains why in an
oligopolistic market scenario, price of the product remains fixed. Other wise this model
explains various causes of price rigidity of the model.
The model relies on two basic assumptions as discussed below:
i. Any fall in the price of the product by a firm causes the other rival firms to
reduce their prices. This is done because that firm whose price is reduced becomes
cheaper in the market. Being cheaper, it may attract more customers. So to maintain their
stand on the market other firms also reduce their price level.
ii. Any rise in price by a firm does not cause the rivals to raise their respective
prices of the product.
With the above assumptions, the kinked demand curve model can be well understood
with the help of the figure-16.3 given below.
Y
A
Price, Cost & Revenue
P1
P0 MC
1
MC
P2
2
AR
v
X
O Q1 Q0 Q2 w Output
MR
2
Figure No.-16.3
In figure-16.3, the OX-axis measures output and the OY-axis measures price, cost and
revenue. AR and MR are the average and marginal revenue curves, respectively.
Similarly, MC1 and MC2 are the marginal revenue curves. From the figure let us start
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Oligopoly
with the assumption that the present price of the product is OP 0. At this price OP0 the
firm produces an output of quantity OQ0. Further, we have assumed that any firm does
not want to raise the price from the existing level. Suppose there is a rise in price of the
product by the firm from OP 0 to OP1. At this new price OP1, the new reduced demand for
the firm’s product is OQ 1. Thus Q0Q1 quantity of the demand is reduced because of the
rise in the price of the firm. But since no firm will react to the rise in price of the product
by the firm, hence, this reduction in demand may be advantageous to the rivals. So, it will
be unwise for a rational oligopolist to raise the price of the product as the change in
quantity demanded as a result of change in price will not lead to a better situation from
the firm’s point of view.
On the other hand, suppose that a firm sets a price below the existing price OP 0, that at
OP2. This will lead to increase in the quantity demanded from OQ 0 quantity to OQ2, i.e.,
an additional quantity of Q0Q2 due to a fall in price. But as per the assumption, every firm
operating in the industry will react by reducing its price level to the fall in the price of the
other firm. However, it can be seen that a price cut by an oligopolist results in a relatively
small increase in sales. But this increase in sales is not achieved because of the rivals’
share. It has increased simply because the total demand increases as all oligopolists
charge lower prices. In other words, the total market demand increases as the price of the
product falls. In such a situation, every firm will get their respective customers based on
their strength in attracting the customers.
In the figure, the kink in the AR curve (i.e., the demand curve) implies that there will be a
discontinuity (the portion uv), in the MR curve. The MR curve corresponding to the AP
segment of the AR curve is Au and the MR curve corresponding to the PP segment of the
AR curve is represented by vw.
This kink in the demand curve causes discontinuity in the MR curve. As long as the MC
curve passes through any point in the range ‘uv’, the equilibrium price will stick to OP 0.
Other wise the cost curve of the firm also supports the price rigidity along with the
revenue curves. It is well understood that, under an oligopoly market situation, it is quite
common that all the firms produce the same product with very minor variations. This
may be because all the firms use the same or similar technology and inputs. As a result, it
can be imagined that the marginal cost faced by almost all the firms are almost similar in
nature for which when it is drawn in the figure, passes within a narrow range. As long as
the MC curve corresponding to different technologies passes within the range ‘uv’ in the
figure, the price will be determined at P 0, i.e., the price will be OP0.
Though the model provides enough explanation behind the causes of price rigidity, a
major criticism against it is that it only explains the rigidity of price at a point in the
figure. The model does not explain how the initial price of the product (i.e., OP 0 price in
this case) is determined.
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16.4.4 Collusive oligopoly:

In the kinked demand curve model, it is observed that an oligopolist always competes
with the rivals to earn profit. In other words, the kinked-demand curve does not tell
anything about the price-output determination in case of a collusion form of situation.
When competing firms make some kind of joint agreement about pricing and output, it is
called as collusion. Collusion can be overt or explicit, as in centralized and market-
sharing cartels, or tacit or implicit, as in price-leadership models. However, formal or
open collusions are illegal in most of the countries all over the world. Collusion is of two
types, viz., (a) imperfect collusion and (b) perfect collusion. The conditions of price-
output determination in case of imperfect competition are nothing but the analysis of
price-leadership model. The detailed analysis on the price leadership models are
discussed in the above section of the analysis. The conditions of price-output
determination under perfect collusion are discussed as follows:
Perfect collusion is of two types, viz., (i) centralized cartels and (ii) market-sharing
cartels.
(i) The centralized cartels:

The most well known type of cartel is the centralized cartel. This is a formal agreement
among the oligopolistic firms of a product to set the price, allocate output among its
members, and determine how profits are to be shared. The greatest real-world example of
such a form of oligopoly is the existence of OPEC, the organization of petroleum
exporting countries. A simple case of two-firm centralized cartel is explained below with
the help of a figure.
Let us start by assuming that there are two firms in the industry. The central cartel board
of the industry knows about the demand for the industry product, i.e., the average revenue
curve. Since the average revenue curve is known, hence, the marginal revenue curve
corresponding to the AR curve can also be determined. Further, the board also determine
the combined marginal cost (CMC) curve for the industry product (the CMC curve is
calculated by taking sum of marginal cost of both the firms, i.e., Σ MC). The profit
maximizing output-price of the industry will be that one where the combined marginal
cost curve is equal to the MR curve and intersects from below. In figure-16.4, the OX
axis measures output and the OY-axis measures price, cost and revenue. AR is the
average revenue curve or demand curve of the industry. CMC and CMR are the
combined marginal cost curve and marginal revenue curve respectively. The industry is
in equilibrium at point E where the CMC = CMR. At this point of equilibrium the
industry produces OQ quantity of output at price OP. Here, the question is how the output
quota of each firm is determined. In such a case, each firm is asked by the board to
produce that much of output with the determined price at which marginal cost (MC) of
each individual firm becomes equal to MC at the total equilibrium output. If MC of firm-
1 will be greater than MC of firm-2 at the point of production, the total costs of the cartel
as a whole can be reduced by shifting production from firm-1 to firm-2 until MC of firm-
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Oligopoly
1= MC of firm-2. The same procedure would be applied where there are more firms in
the industry.
EMC
Cost and Revenue

R
P
E
AR(D)
CMR
O X
Q Output
Figure No-16.4
(ii) Market sharing cartel:

There are two methods to determine price-output in the case of market sharing cartel viz.,
(a) market sharing by non-price competition and (b) market-sharing by quota.
(a) Market sharing by non-price competition: This form of cartel in oligopoly is one
where the firms agree to sell at an agreed uniform price. But the condition is that the
member firms are free to produce and sell that quantity of output at which they can
maximize their individual profits. It is within the limits of the firm to choose their own
design, colour, means of advertisement to capture customers. This cartel continues
successfully till the cost of production of the product is same for all the firms. But in case
of difference in cost of production, the cartel becomes unstable and disturbance occurs in
the operation of the firms.
(b) Market sharing by quota: Sometimes the firms operating in the industry and
agreed into cartel accepts to sell at a uniform price but with a quota of output produced
by each firm. If products and costs of different firms are identical then price and output
quota of each are determined in such a way that joint profits are maximized. This leads to
rise of monopoly situation. Whereas, in any difference in cost of production, the quotas
of different firms are decided by their bargaining power. This bargaining power of the
firm is based on their past sales or productive capacity.
Activity-3
The Organization of Petroleum Exporting Countries (OPEC) with 11 members countries
has established a cartel of petroleum exports that seeks to increase the petroleum earnings
of its members. Discuss
(i) Who are the members countries present in the cartel?
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(ii) How are they influencing the price of the petroleum products?
(iii) Is this cartel beneficial for India or not? Why?
Activity-4
Do you have any idea on the cartel arrangements in any of the oligopolistic industries in
India? If yes, explain your observation.
It has been experienced that most of the theories of oligopoly are good predictors of the
behaviour of the firms in the short-run. But most of them are found to be inefficient as a
good predictor in the long-run. The obvious reasons may be that in long-run the firms are
getting enough time to grow or decline, economic or human resources are getting enough
time to move frequently from one place to another place. Again, firms come under the
impact of technological changes and also there is frequent change in the consumers taste
and preferences for the existing product. All these activities always create uncertainty in
the economy. Thus, efficient determination of price-output in oligopoly market is a hard
task in reality.
16.5 LET US SUM UP

 Oligopoly is competition among the few. It is marked by interdependence among
rivals, possibility of collusion, rigid pricing, restricted entry, expensive
advertisements, etc.
 Each seller in the industry consciously takes into consideration the actions and
reactions of rival sellers while making price-output decisions.
 Duopoly is a special case involving exactly two sellers.
 The classical model (Cournot’s model) is flawed by the assumption that each
seller persistently fails to anticipate the rival sellers behaviour, even after
observing the behaviour over long time.
 Formal agreements or cartels are the way in which the sellers have dealt with
oligopoly problem. Cartels typically involv market sharing arrangements, taking
the form of non-price competition and produce as per the quota.
 Price leadership is that form of oligopoly market where a firm acts as the leader
in the market and decides price of the product. Other firms simply follow the
decision of the leader.
 Kinked demand curve model of oligopoly provides an explanation of price
rigidity. Because of the two assumptions, the average revenue curve is having a
kink and the marginal revenue curve becomes discontinuous. As long as the
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Oligopoly
marginal cost curve passes through the discontinuous range of marginal revenue
curve, price remains fixed at the point of the kink.
16.6 KEY WORDS
 Oligopoly  Duopoly
 Kinked demand curve  Cost leadership
 Price rigidity  Cartels
 Revenue maximization  Dominant firm
16.7 SELECTED READINGS

 Sweezy, Paul M. (1939), Demand under Conditions of Oligopoly, Journal of
Political Economy, Vol. 37.
 Gould, J.P. and Lazear, E.P. (2003), Microeconomic Theory, Richard D. Irwin,
Inc.
 Chamberlin, E.H. (1962), The Theory of Monopolistic Competition, Harvard
University Press.
 Roy, U. (2008), Managerial Economics, Asian Books Private Limited.
 Salvatore, D. (2010), Managerial Economics, Sixth adapted version, Oxford
University Press.
1. Identify the distinguishing characteristics of oligopoly in relation to the

monopoly form of market situation and discuss the differences.
2. Explain the uniqueness of average revenue curve under oligopoly.
3. Define oligopoly. Why does a firm under oligopoly face a kinked demand
curve?
4. Explain the characteristics of oligopoly. How is it different from monopolistic
competition?
5. What are the reasons for the normal trend towards price-rigidity under oligopoly
market?.
6. ‘It has been observed that under oligopoly marginal revenue curve is
discontinuous’. Explain.
7. Select a group of firms in an industry and examine the presence or absence of
oligopoly characters in them.
8. Explain the economic interpretation of the kinked demand curve.
9. In which sector of the Indian economy is oligopoly most present? Justify why?
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10. Enumerate the process of determining the demand curve of the dominant firm
operating under oligopoly.
11. In an oligopoly market, when competition increases among the firms, why
would a firm prefer slashing its prices to some other way of competing with the
rivals?
12. What is meant by Cournot’s model? Why do we study this model proves to be
unrealistic?
13. What do you understand by collusion? Have you come across this situation of
collusive oligopoly in any of your life experience? Discuss your findings with
suitable reasons.
14. ‘Oligopoly is a competition among few’. Explain elaborately.
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Business Economics
UNIT 17 THEORY OF DISTRIBUTION
Objectives
After reading this unit, you should be able to understand:
 The importance of determination of factor price or wage
 The essence and importance of marginal productivity theory of distribution
 How factor price is determined under perfect competition and monopoly
 The concept of monopolistic exploitation
Structure
17.1 Marginal productivity theory of distribution
17.1.1 Phases of development of the theory
17.1.2 Assumptions of the theory
17.1.3 Objectives of the theory
17.1.4 Implications of the theory
17.2 Determining factor prices
17.2.1 Determination of price when there is perfect competition in both factor
and product market
17.1.2 Determination of price when there is monopoly in product and
monopsony in factor market
17.3 Observations of the theory
17.4 Monopolistic exploitation
17.5 Let us sum up
17.6 Key terms
17.8 Know your progress
There are two important theories of distribution namely (a) the marginal productivity
theory of distribution or wage and (b) the modern theory of wage. The subject matter of
analysis of this unit is the marginal productivity theory of distribution. The modern
theory of wage is discussed in the next unit of this block.
17.1 MARGINAL PRODUCTIVITY THEORY OF DISTRIBUTION
There is always need to answer a common question as to what determines the price of
factor of production. In the literature of economics, there exists a theory which tries to
answer the raised question and is practically analysed by a numbers of professional
economists is known as marginal productivity theory of distribution.
A central part of this theory of value is the marginal cost of production and its possible
reflection in the supply curve. Costs and supply, in turn, depend on the technological
conditions of production and the cost of productive services. So far as it is assumed that
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Distribution
both are given, the physical conditions of production are technologically given and do not
change over the time period. It therefore, necessitates to determine the prices of
productive services i.e., the ‘value and distribution’. The marginal productivity theory of
distribution constitutes a framework and, hence, is treated as a useful analytical tool for
economic theorists.
17.1.1 Phases of development of the theory:

The origin of marginal productivity theory is not much highlighted. Perhaps John Bates
Clark is most widely associated with the development of this theory. However, earlier
hints appeared in Von Thunen’s ‘der isolierte staat (1826), Longfield’s ‘Lectures on
political economy (1834)’, and Henry George’s ‘Progress and Poverty (1879). Further, it
has been observed that towards 1880’s and 1890’s, Clark was not alone in developing the
marginal productivity concept. Jevons, Wicksteed, Marshall, Wood, Walras, Barone and
others also contributed to the theory.
There were two groups of opinions on the marginal productivity theory. Economists like
Clark and his followers treated this theory as the theory of wage. But Marshall and few
others strictly criticized the Clarks view and treated this theory as a separate theory than
theory of wage. Marshall pointed out that ‘this doctrine (the marginal productivity
principle) has some times been put forward as the theory of wages. But there is no valid
ground for any such pretension. The essence of this theory is that the price of a factor of
production depends upon its marginal productivity. However, there is slight change in
each one’s view over the fixation of price of factors of production.
According to J.B. Clark, in a static society where the stock of capital, techniques of
production and all other factors are constant, every employer to maximize their profit has
to employ more quantities of labour. But the condition is that the firm can go on
employing additional quantities of labour for the production of each additional quantity
of output till the marginal productivity of the labour employed will be equal to its wage.
Each firm will gain profit till the marginal productivity of labour is greater than the wage
they are paying. The equilibrium point can be determined at that level where the marginal
productivity is equal to wage. Any rational producer will not employ additional quantity
of labour beyond this equilibrium level.
Marshall explains the theory with similar logic to Clark but in slightly different manner.
He has taken into account the demand for and supply of labour as the two forces that
determine the wage rate in the market. He uses a new concept of marginal net
productivity that is derived by subtracting the marginal productivity of labour from
marginal production of all the factors.
17.1.2 Assumptions of the theory:

The theory of marginal productivity is based on following assumptions:
i. the theory holds good only when there exists perfect competition in both factor
and product market
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ii. all the factor units are homogeneous

iii. factors of production can be replaced one for another
iv. perfect mobility of the factors of production
v. there is elasticity in supply of the factors of production
vi. each factor of production is paid as per its marginal productivity
vii. reward for each factor of production is same for every use
viii. in the long run, under the condition of perfect competition each factor will get its
remuneration equal to marginal revenue productivity (MRP), which is equal to average
revenue productivity (ARP)
ix. there exists full employment in the industry
17.1.3 Objective of the theory

The ultimate object of each firm is to maximize profit. To maximize profit, an employer
must compare the remuneration paid to the factor of production employed to its marginal
revenue product. Marginal revenue product is equal to the marginal physical product
(MPP) multiplied by marginal revenue (MR) i.e., MRP = MPP × MR.
Under the condition of perfect competition at both factor and goods market, marginal
revenue product is equal to the value of marginal product (VMP). The marginal revenue
product curve is a declining function of the quantities of labour employed due to the
operation of the law of diminishing marginal returns. In other words, marginal revenue
product (MRP) will be less and less as the employer employees more and more quantity
of labours. A rational producer will continue to employ factor till the marginal cost i.e.,
the wage is equal to its marginal revenue curve (MRC). Further, as marginal wage is
assumed to remain constant, any increase in employment beyond the point of equality
between MRP and MC will result in higher cost than the revenue gained. Thus, a rational
employer will never employ a factor beyond the point of equality. More over, any
quantities of employment prior to the point of equality are not considered as the condition
of profit. This is because there is the tendency of an increase in profit with each increase
in quantity of employment. It is, hence, clear that an employer will be in equilibrium at
that point where the marginal revenue product (MRP) will be equal to wage i.e., MRP =
Wage
17.1.4 Implication of the theory:

One of the important implications of this theory is that the price of the factor of
production remains same irrespective of the type of industry and type of use. In other
words, the price of the factor of production in the economy as a whole remains the same.
This happens because of the perfect mobility of the factors of production from one place
of the economy to other place and also from one use to another use.
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Activity-1
What do you mean by factors of production? Justify their role in the process of
production.
17.2 DETERMINING FACTOR PRICE
The determination of factor price can be analysed under different market conditions. This
is because the marginal revenue product as one of the important factor for determining
factor price is different under different market conditions. For this the concepts of
marginal revenue product (MRP) and average revenue product (ARP) have been used in
below derived markets to determine the factor price. Both the type of markets includes:
17.2.1 Determination of factor price (wage) when there is perfect competition both in
factor market and product market, and
17.2.2 Determination of factor price (wage) when there is monopoly in goods and
monopsony in factor market
Both the market conditions are discussed in detailed as below.
17.2.1 Determination of factor price (wage) when there is perfect competition both
in factor market and product market
In the perfect competitive market (both in goods and product market), the marginal
revenue product (MRP) becomes equal to the value of marginal product for any level of
output. The MRP curve in such a market condition is the demand curve for labour. In
other words, the MRP curve measures the quantity of labour that a firm is willing to
employ at different wage rates. Since there is perfect competition in the goods market, the
firm can be able to sell any quantities of output at the prevailing price of the product
without any hesitation. The MRP curve can be determined by multiplying the marginal
physical product (MPP) with the price of the product. This is why the shape of the MRP
is almost same to that of the MPP. The MRP is an increasing function to labour when the
firm is operating under law of increasing marginal returns. The condition of
determination of equilibrium factor price (wage) can be well explained with the help of
the figure.
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Wage Rate E1
W1 AW1=MW1
E
W AW=MW
E2
W2 AW2=MW2
MRP
Q ARP
X
O N1 N N2
Labour Employed
Figure No.-17.1
OX-axis of the above derived figure-17.1 measures quantity of labour employed and OY-
axis measures various wage rate. MRP and ARP are the marginal revenue and average
revenue curves of the firm respectively. Since perfect competition prevails in the factor
market, hence, the shape of the supply curve is perfectly elastic which is parallel to the
OX-axis. In the figure, AW is the supply curve of the firm. This perfectly elastic supply
curve implies that the firm can employ any quantity of labour at wage rate OW. Now
given the demand and supply of labour for the firm, the firm will be in equilibrium at a
point where the MRP curve is equal to the wage paid. At this point of equilibrium the
ARP may or may not be equal to the MRP. When the MRP is equal to ARP, and then the
firm is earning normal profit. Further, when MRP is less than ARP, at this condition the
firm is earning supernormal profit. On the contrary, when MRP is greater than ARP, the
firm is earning supernormal losses.
Earning abnormal profit is a case of short-run. But generally in long-run, all the firms
earn normal profit only. This happens because in long-run there is possibility of entry of
new firm or exit of old firms in the industry. Occurrence of any one cause among the two
points highlighted causes the firms to earn normal profit in long-run. It can be seen from
the figure that, at OW wage rate the MRP = ARP = MW = AW. The point E is an
equilibrium condition where the firm is earning normal profit. At the point of equilibrium
the firm is employing ON quantities of labour. Let suppose a condition in the market
where the wage rate is increased from OW to OW1. As a reaction to the increase in wage
rate, the firm reduces the number of employment. In the figure, the quantity of
employment has reduced from ON to ON1. It can be seen from the figure that at ON1
quantity of employment, the MRP > ARP. For this the firm is incurring losses at this
stage of employment. Because of increase in wage rate in the market in the long-run, few
firms may close down their business which causes the wage rate to go down and the wage
rate will reach at the equilibrium wage rate once again.
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Theory of
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To further, the wage rate in the market is reduced from OW amount to OW 2 amount. It
can be seen that at this wage rate the firm is earning supernormal profit because MRP =
MW = AW < ARP. The conditions of supernormal profit will attract the new players to
enter into the industry. With the entry of new players, the demand for labour increases.
With the increase in demand for labour, supply of the labour being constant, wage rate
will increase. The increase in wage finally, reaches at OW which is the equilibrium wage
rate.
To sum up, a firm will be in equilibrium where the MRP of any factor of production
equals to its MC. The industry in the long-run attends equilibrium when all the existing
firms in the industry are earning normal profit.
17.2.2 Determination of factor price (wage) when there is monopoly in product

market and monopsony in factor market:
Determination of wage as per the marginal productivity theory of distribution when
monopoly exists in the goods market and monospony exists in the factor market is
slightly different from the wage determination of perfect competitive market as
discussed. The difference in the analysis between both the market situations is the
consequences of difference of MRP curve and marginal wage curve.
Monopolist is a single buyer. There can be a single buyer both in product and factor
market. But a market situation where there is a single buyer of a product called as
monopsonist in the product market. But in this analysis, the existence of monopsonist in
the factor market is considered. For example, in some areas, there is only one employer
of a specific type of labour, that employer is called as the monopsonist of that labour.
Practically, the existence of monopsonist is a rare phenomenon in case of product market
but is more often found in the factor market.
Under the conditions of monopoly, the product market demand for the labour is
determined by its existing MRP. But the shape of the MRP curve in monopoly is a more
declining one than that of the MRP curve that is determined in case of perfect
competitive market. The demand curve that the monopolist facing is a downward
slopping curve from left to right. MRP is derived by multiplying MPP with marginal
revenue. Where as, the marginal wage (MW) of the monopolist is an increasing function
of quantities of labour employed. It implies that the employer has to pay higher wages for
each additional unit of labour employed. This implies that a monopolist can attract more
labour by increasing the wage rate. It happens because, here, the employer is only the
buyer of the factor of production. Following to the MW curve the average wage (AW)
curve lies below the MW curve. Following figure explains the determination of wage
under monopoly as under:
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MW
Wage Rate
P
Q
AW
S
R
MRP
ARP
X
O M
Labour Employed
Figure No.-17.2
In the figure-17.2, OX-axis measures quantity of labour employed and OY-axis measures
wage and revenue. MW and AW are the marginal wage and average wage curves
respectively. It can be seen from the figure that MW is greater than AW for each
additional unit of employment of labour. MW is the supply curve of the labour in the
market. In the figure, at OM quantity of labour employed, the firm reaches at its
equilibrium as at this quantity MRP = MW. Further, at this quantity of labour employed,
MRP is also equal to ARP. At this point of equilibrium a firm can earn maximum profit.
But at this situation the firm is getting abnormal profit because the ARP > AW. The total
profit that the firm is earning is equal to the area PSRQ.
Activity-2
Explain why determination of factor prices is important in an economy?
17.3 OBSERVATIONS OF THE THEORY

In a comparison between two market situations as discussed above, few important
observations can be highlighted. They are
(i) Under perfect competition MW = AW. Where as in monopoly, at the point of
equilibrium the MW curve intersects the AW curve.
(ii) The price of the product remains constant in the perfect competition where as
price under monopoly falls as the output increases. As a result marginal revenue
product (MRP) falls rapidly under monopoly.
(iii) MRP of labour is equal to AW under perfect competition. But under monopoly
MW is higher then AW.
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(iv) Under perfect competition value of marginal product (VMP) is equal to marginal
revenue product (MRP). Under monopsony, exploitation of monopolist occurs.
Activity-3
Briefly review the usefulness of marginal productivity theory of distribution in today’s
economy.
17.4 MONOPOLISTIC EXPLOITATION
It is discussed in the above section that under monopoly in product market and
monopsony in the factor market, the firm is earning supernormal profit. This earning of
abnormal profit by the firm is named as monopolistic exploitation. The employer is
gaining this abnormal profit by using both the factor and product market. The demand
curve of the firm is a downward slopping curve under monopoly. For this, the average
revenue remains greater than the marginal revenue for all the quantities of output. Since,
MR < AR, hence, MRP (i.e., MPP×MR) remains less than the value of marginal product
(VMP) (i.e., MRP < VMP). As the employer is paying the wage equal to MRP, he
manages the extra revenue between VMP and MRP. Hence, the extent of exploitation
depends upon the difference between the two. The condition of monopolistic exploitation
is explained with the help of a figure-17.3.
Y
Coat & Revenue
MC
P
S
AC
N T
R Q AR
MR
X
O M Output
Figure No.-17.3
In the figure-17.3, OX-axis represents output and OY-axis represents cost and revenue.
MR and AR are the marginal and average revenue curves respectively. Similarly, MC
and AC are the marginal and average cost curves of the firm. It can be seen from the
figure that, at OM quantity of output MC = MR of the firm. Thus T is the equilibrium
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point and the firm is getting maximum profit by selling OM quantity of output at
equilibrium point T. In the figure, to produce the equilibrium level of output, the firm is
acquiring MT amount of marginal revenue and MP amount of average revenue. If it
would be a perfect competition, the firm would get PTNS amount of profit. But since the
firm is operating in monopoly, hence, it is acquiring PQRS amount of total profit.
In the same passion as discussed above for the product market, the employer can earn
abnormal profit due to the advantage of its monopolistic position in the industry. Because
of monopolistic position in the factor market, an employer, in order to employ large
quantities of labour has to pay higher wages. Thus, the average wage curve is an
increasing function of quantity of output. For this the marginal wage curve lies above the
average wage curve. At the point of equilibrium MRP = MW, whereas, the employer is
paying wage as per the rate of average wage. Higher marginal wage implies higher wage
rate. Thus, the monopolist is able to extract the revenue which is the difference between
AW and MW. The condition of derivation of equilibrium under monopsony in factor
market is explained with the help of a figure as below.
Y
Revenue & Product
MW
K
Q
AW
T
L MRP
ARP
X
O M
Labour Employed
Figure No.-17.4
In the figure-17.4, OX-axis measures labour employed and OY-axis measures revenue
and wage. MW and AW are the marginal wage and average wage curves respectively.
MRP and ARP are the marginal revenue product and average revenue product of the
firm. It can be seen that MRP = MW at OM quantities of employment. At this
employment, average wage rate is ML and marginal wage rate is MK. The amount LK is
the rate of exploitation. The total profit that the firm is earning is LKQT.
Thus from the above analysis it is clear that the firm is earning abnormal profit at the
point of equilibrium. The total profit that the firm is earning from both the markets is the
area LKQT + PQRS (figure-17.3). This amount as a whole is the amount of exploitation.
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Activity-4
Point out if, any case of monopolistic exploitation you have been experienced in Indian
economy so far. Justify your answer with proper logic.
In search of a dream
The gist of both the marginal productivity theory of distribution and the modern theory of
wage is based on the correlation between rate of wage to that of the demand and supply
of labour. The wage rate in an economy (or industry) depends upon the demand and
supply of required labour force. A simple live example of this trend is highlighted below
for the clarity of both the theory.
When we recall 1990’s, the global demands for IT-professionals (more particularly
software) were at the peak. Whereas, the availability of there professionals were limited.
This caused payment of higher wage. The wage that these professionals were getting was
almost three times then the normal wage rate that other professionals were getting in the
business market. The higher remuneration attracted others to enter into the profession.
Most of the institutions and universities in India started IT related courses to meet the
emerging global demand. This caused gradual increase in the supply of IT professionals
in the business environment. The professionals from reputed institution and universities
were recruited by large IT firms like TCS, Satyam, Infosis, Wipro and others. The
requited professionals were trained by these firms to meet their requirements. The
situation was so that most of the professions hardly completed their two-three years job
tenure under a single company. The switchover resulted to gain many fold compensation
(wage). This phenomenon was a result of large vacancies in supply side which was due to
the excess of demand in comparison to supply in the industry.
Within a few years, the supply of these professionals increased because of higher wage
and other compensation. With the increasing trend of supply, the wage rate started
falling, the supply of and demand for the professions reached at a saturation point (i.e.,
equilibrium point) resulting into maturity of wage level. This resulted into:
a. stability of wage rate
b. minimizing the hopping trend of It professionals
This decreasing trend in demand was clearly visualized during the year 2006-2007 when
the world was experienced with high global recession. Here the supply increased more
than the demand. Due to excess in demand than supply, wage rate started falling further
from the point of saturation. This fall in wage discouraged others to choose IT profession
as a carrier. Most of the institutions were started closing down admissions in IT related
disciplines. However, the recent worries of Infosys (as mentioned below) seem to open a
bright future for the IT professions again.
Infosys battles worker exodus:
Infosys was founded in 1981 when seven engineers, including N.R. Narayana Murthy,
pooled $250-mostly borrowed from their wives. The company's rapid growth kick-started
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Business Economics
the outsourcing movement in India and coined the term 'to be Bangalore-d'. New
company hires are put on a 23-week training programme regarded as among the best in
the industry, and work in a Silicon Valley-style headquarters campus on sprawling
grounds, with multi-cuisine food courts and state-of-the-art gymnasiums. Employee stock
options helped make some of India's first salaried millionaires.
Infosys Ltd(INFY.NS), once a bellwether for India's $100 billion-plus IT outsourcing
industry, is losing its cachet as the employer of choice for a generation of young IT
workers, with staff leaving at an unprecedented pace as the Bangalore-based company
struggles to regain ground lost to rivals. Current and former Infosys staffs when asked
say morale has been dented by a series of senior management exits and worries about
career prospects as the company's revenue and pay increases grow at a slower rate than at
competitors such as Tata Consultancy Services Ltd (TCS) (TCS.NS). Annual revenue in
the year to end-March rose 24.2 percent, lagging growth of 29.9 percent at TCS.
The annualized rate of attrition at Infosys-effectively the number of staff leaving or
retiring - was a record 18.7 percent at end-March 2014, 2.4 percentage points higher than
a year earlier. That's close to a fifth of the company's workforce of more than 160,000.
The attrition rate at market leader TCS was 11.3 percent.
India's outsourcing services industry has relied for years on an army of engineering
graduates to build so-called bench strength, key to winning new contracts in an
increasingly competitive industry. A strong bench signals to prospective clients that the
firm can assign enough technicians to new projects. That signal is weaker when the
number of staff quitting a company rises to uncomfortable levels. It also does little to
attract new hires in the close-knit IT world.
Taking steps:
 Infosys announced an average 6-7 percent pay rise last month for India-based
staff, below the average 10 percent raise at TCS. Third-ranked Wipro Ltd (WIPR.NS)
said it plans raises of 6-8 percent from June 2014.
 Offering lower pay increases than its rivals could mean attrition levels at Infosys
will rise further,
 Infosys President Pravin Rao said Infosys is taking steps to stem the flow of
those leaving: restoring regular April 2014, pay rises, having more frequent reviews for
promotion, fast-tracking promotion for high achievers and increasing the fixed
component in paychecks. In the past year, it has also held more 'town hall' meetings and
'jam sessions' where staff can speak informally with management.
17.5 LET US SUM UP
 It necessitates to determine the price of productive services i.e., the ‘value and
distribution’. The marginal productivity theory of distribution constitutes a
framework and, hence, is treated as a useful analytical tool for economic
theorists.
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Distribution
 According to J.B. Clark, in a static society where the stock of capital, techniques
of production and all other factors are constant, every employer to maximize
their profit has to employ more quantities of labour.
 The condition is that the firm can go on employing additional quantities of
labour for the production of each additional quantity of output till the marginal
productivity of the labour employed will be equal to its wage.
 Each firm will gain profit till the marginal productivity of labour is greater than
the wage they are paying.
 The equilibrium point can be determined at that level where the marginal
productivity is equal to wage. Any rational producer will not employ additional
quantity of labour beyond this equilibrium level.
 The theory holds good only when there exists perfect competition in factor and
product market,
 All the factor units are homogeneous, factors of production can be replaced one
for another and so on.
 The marginal revenue product curve is a declining function of the quantities of
labour employed due to the operation of the law of diminishing marginal
returns.
 The firm reaches at its equilibrium at that quantity of labour employed where
the MRP = MW. Further, at this quantity of labour employed, MRP is also equal
to ARP. At this point of equilibrium a firm can earn maximum profit.
 The earning of abnormal profit by the firm is named as monopolistic
exploitation. Under such condition, a monopolist gets abnormal profit in both
the product and factor markets.
17.6 KEY TERMS
 Wage  Distribution
 Marginal productivity  Monopolist
 Factor market  Monopolistic exploitation
 Product market  Equilibrium
 Monopsony  Marginal Revenue Productivity
 Begg, D., Fisher, S. and Dornbusch, R. (1994), Economics, McGraw Hills

Compant Ltd.
 Lipsey, R.G. and Chrystal, K.A. (1995), An Introduction to Positive Economics,
Eighth edition, ELBS with Oxford University Press.
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Business Economics
 Maddala, G.S. and Miller, E. (2004), Microeconomics: Theory and Application,

Tata McGraw Hill Publishing Company Pvt. Ltd.
 Pindyck, R.S. and Rubinfeld, D.L. (2001), Microeconomics, Pearson Education.
17.8 KNOW YOUR PROGRESS
1. State the assumptions of the marginal productivity theory of distribution. Are

they valid till today? Justify your answer.
2. What are the basic objectives of marginal productivity theory of distribution?
3. With the help of assumptions, explain how factor price is determined when there
is perfect competition in factor and product markets.
4. Define the need of the marginal productivity theory of distribution. How factor
price is determined when there is monopoly situation in product market and
monopsony in the factor market.
5. Critically discuss the marginal productivity theory of wage.
6. Discuss the marginal productivity theory of distribution. Explain how it is
different from the modern theory of wage?
7. Point out few differences between the marginal productivity theory and modern
theory of wage.
8. Write a short note on Monopolistic exploitation.
9. Write a short note on monopsony market situation.
10. Discuss the importance of determining factor price in an industry. Make a
review of the marginal productivity theory and modern theory of wage in doing
this task.
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Distribution of Income:I
Wages and Interest
UNIT 18 DISTRIBUTION OF INCOME-I: WAGES AND INTEREST
Objectives:
After reading this unit, students should be able to understand in details about the
following concepts:
 To understand the concept of wage
 To estimate wage based on modern thought
 To understand the concept of interest
 To examine various theories of interest
Structure:
18.1 Modern theory of wage: Introduction
18.1.1 Equilibrium wage determination
18.1.2 Wage determination under collective bargaining
18.1.3 Wage determination under the condition of bilateral monopoly
18.2 Theories of interest: Introduction
18.3 The classical theory of interest
18.3.1 Demand for capital or investment of capital
18.3.2 The supply of capital or savings of capital
18.3.3 Determining the equilibrium rate of interest
18.3.4 Criticism of the theory
18.4 The loanable fund theory of interest
18.4.1 Factors determining demand for loanable fund
18.4.2 Factors determining supply of loanable fund
18.4.3 Determination of equilibrium
18.5 Keynesian liquidity preference theory of interest
18.6 Let us sum up
18.7 Key words
18.1 MODERN THEORY OF WAGE: INTRODUCTION
The modern theory of wage is also known as demand and supply theory of wage. This
theory determined the price of the factors in the same logic as that of the prices of the
commodities are determined. But the need for a separate theory to determine wage is
emerged because the demand for the factors is the derived demand and the supply curve
of the factors is less elastic. In modern theory of wage, the equilibrium wage is
determined at that level where the demand for the labour equals to the supply of the
labour. In other words, equilibrium wage in an industry is determined by the interaction
of two forces viz., the demand for the labour and the supply of the labour.
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Assumptions of the modern theory:

The modern theory of wage is based on following assumptions:
(i) there exists perfect competition in both factor and product market
(ii) all units of measurement of factors are homogeneous
(iii) the law of variable proportion is applicable in production process
(iv) each factor of production is perfectly divisible
Derivation of demand and supply curve:
Given the assumptions, it is required to derive the demand curve for and supply curve of
the labour. The demand for the labour is the derived demand. In other words, labour is
demanded not for its own shake but for the demand for the commodity it manufactures or
produces. Thus, the quantity demanded for labour depends upon the quantity demanded
for the good it produces. It is the elasticity of demand for the product upon which the
elasticity of demand for the labour depends on. The demand for labour in an industry is
the sum total of demand for labour by the individual firms. A firm’s individual demand
depends upon the marginal revenue productivity of the labour along with the wage paid
to him to produce the good. Given the marginal productivity of labour, it is known that
more labours are employed by the employees at lower wage and vice versa. The MRP
curve is the decreasing function of quantities of labour employed. For this, the MRP
curve slopes downward to the right after a certain peck is reached as the quantity of
labour employed goes on increasing. The demand curve for the labour is derived in the
figure below.
The figure-18.1 has two types of figures. In both the figures, OX-axis measures quantity
of labour employed and OY-axis measures wage and demand for the labour. MRP is the
marginal revenue productivity curve. This curve shows the net revenue added to the total
revenue with each additional unit of labour employed. Given the marginal revenue
productivity curve, the firm is employing OM quantity of labour at OW wage rate.
Suppose that the wage rate is increased from OW to OW1. It can be seen from the figure
that the quantity of labour employment is reduced from OM quantities to OM1 with a net
reduction of MM1 quantities. Further, for a reduction in the wage rate from OW to OW 2,
the quantity of labour employed is increasing from OM quantities to OM 2 quantities with
a net increase in MM2 quantity. Thus the MRP curve experiences the nature of demand
for the product can be determined.
Where as the industry demand for the product is the sum of demand drawn on the basis of
MRP curve of each individual firm. Hence, the lateral summation of the demand for the
labour by all the firms at a particular wage rate is the demand for labour in the industry.
The industry demand for the labor also falls or rises with the increase or decrease in wage
rate of the labour respectively. In the other type of figure, DD is the market demand curve
of the labour in the industry. This demand curve is derived by the lateral summation of
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Wages and Interest
the MRP curve of all the firms of the industry. Hence, it is observed that the demand side
of the labour depends on the MRP of the labour.
Y Y
D
W1 P1
W P
W2 P2
Wage
Wage
MRP
D
X X
O M1 M M2 O N1 N N2
Quantity of Labour Demand Quantity of Labour Demand
Figure No.-18.1
On the other hand, the nature of supply curve of labour depends upon the size of
production process of the firms and the working hours of the labourers in the desired
industry. Population of any country remains more or less constant in short-run. The
labour supply in the economy can be increased by increasing the working hours of the
existing labourers. The labour supply increases with the increase in wage rate and
decreases with the decrease in wage rate. This happens because the general preference of
labour is to gain income than the leisure at a higher wage rate. However, the labour curve
increases upto a point and reaches at the peck then starts diminishing. At higher wage
rates a desired level of income is aimed with less duration of workings. As a result the
labour supply curve slopes backward after a particular rate of wages. The supply curve of
labour is drawn in the figure-18.2 as below.
In the figure-18.2 derived, OX-axis measures labour supply in the industry and OY-axis
measures wage rate. It can be seen form the figure that with the gradual increase in labour
supply at ‘OW’ rate of wage, the supply curve reaches at its maximum. Any further
increase in wage rate beyond OW wage, the supply of labour reduces for which the
supply curve slopes backward. It implies that the quantity of labour supply decreases at
higher wage rate.
The industry supply curve of labour is an upward slopping supply curve. Any rise in
wage in the economy as a whole may not compensate the rise in labour demand in the
economy; hence, the supply of labour may not increase. But a rise in wage rate in a
particular industry may attract labour from other industries, which may lead to increase in
labour supply.
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W2 P
W Q
Wage
W1 R
X
O
Labour Supply
Figure No-18.2
Thus, with the increase in wage rate the supply of labour in the industry increases and
vice versa is also true with that of fall in wage rate. In figure-18.2, OS is the supply curve
of the labour. It can be seen that it slopes upward to the right. It implies that more labour
can be supplied at higher wage and vice versa.
18.1.1 Equilibrium wage determination:

The equilibrium rate of wage in an economy can be determined by intersecting both the
labour demand curve and labour supply curve. The point at which the quantity demanded
for the labour is equal to the quantity supplied of labour is called as equilibrium point in
the economy. The wage rate that exists at the equilibrium point is the equilibrium wage
rate and the quantity supplies corresponding to the equilibrium point are called as
equilibrium quantities of labour supply. The condition of determination of equilibrium
wage is derived in figure-18.3.
In the figure-18.3 derived, OX-axis measures labour demand and supply and OY-axis
measures wage rate in the industry. DD is the labour demand curve and SS is the labour
supply curve of the industry. It can be seen that, the DD demand curve is intersecting the
SS supply curve at point E. OW is the equilibrium wage rate. At this wage rate the
quantity of labour demanded by the industry and the quantity of labour supplied in the
industry is OM.
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Wages and Interest
S
D
F K
W1
Wage Rate
W E
S D
X
O M1 M
Labour Supply & Demand

Figure No.-18.3
Any wage rate more or less than the equilibrium wage rate OW leads to an increase or
decrease in labour supply in the industry. Thus the equilibrium wage rate can only change
if either demand condition or supply condition for labour changes. If the demand curve
shifts upward, given the supply curve, wage rate will be higher. On the other hand, if
demand curve shifts downward, with no change in supply condition, wage rate will fall.
Where as, increase in supply, with the given demand curve of the labour, the wage rate
falls and wage rate rises with the reduction in labour supply. Any shift in equilibrium
position depends largely upon the change in either demand condition or supply condition
or both. Students should note that the logic behind the drawing of figure when the
equilibrium position changes are same that are already stated in the derivation of
individual demand curve. The only difference lies here, is the measurement of axis.
The modern theory of wage as discussed above offers more clear and analytical
explanation on how to determine the wage rate in the industry. This theory has the
advantage of simplicity and usefulness than the marginal productivity theory of
distribution/wage. However, few important criticisms which are mostly based on the
unrealistic assumptions, makes the theory to think on the reliability. But there is no doubt
that this theory is the best theory to determine wage rate.
18.1.2 Wage determination under collective bargaining:

Trade unions play an important role in determination of wage in few market situations.
However, the classical economists considered trade unions are ‘super flows’. To them,
labour unions cannot raise the wage rate without decreasing the level of employment. But
the present economic situation is some thing different than that which was prevailing in
previous few decades. The modern economic scenario demands to consider the role of the
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trade unions while determining wage rate. Following are few conditions which clarifies
the role of trade union.
One of the assumptions that the classical economists considered is that MRP curve is the
employees demand curve for labour. With the given MRP curve, an increase in the wage
rate by trade unions will definitely result a situation of unemployment in the industry. But
in reality, wage rate also increases due to increase in efficiency of labour. Hence, the
MRP curve may shift upwards. It implies that trade unions may raise the wage rate in an
industry.
The next argument in favour of trade unions is that the increase in wage rate generally
leads to increase in the price of the product. An increase in price of the product implies
that the burden due to increase in wage has been transformed to consumers. An increase
in price of the product reduces the demand for the product. Reduction in demand leads to
reduction in production. This ultimately reduces the level of employment. Thus, a rise in
wage rate by the trade unions will reduce the supply of the labour but do not create any
unemployment in the industry due to the backward nature of the labour supply curve.
Further, under the condition of imperfect competition wage determination leads to

monopolistic exploitation. Trade union may minimize the exploitation by raising the
wage rate. The monopolistic position of the employer may be a counter act by the trade
unions without affecting the level of employment. In these market situations, the average
wage remains less than the marginal wage and the marginal wage remains equal to
marginal product. Hence, at the point of equilibrium marginal wage becomes equal to
MRP. As average wage lies below the marginal wage, labours are paid fewer wages than
the marginal productivity. In such scenarios, the trade unions can raise the wage rate.
18.1.3 Wage determination under the condition of bilateral monopoly:

Bilateral monopoly refers to a situation in which there is trade union of both the
employers and the employees. The labour trade union acts as monopoly in labour supply
in the sense that the union controls the supply of labour according to its own decision.
For this the supply curve of labour is a perfectly elastic curve at the wage demanded by
the union. On the other hand, the union of the employees also acts as a monopolist. The
existence of such a dual monopoly situation is referred as collective bargaining. So under
the scenario of collective bargaining a single buyer of labour faces a single seller of
labour. This situation refers to bilateral monopoly. In reality, wage determination under
the condition of bilateral monopoly is uncertain and unpredictable.
Theoretically, it is not possible to determine a fixed wage at which both the parties agree.
It is rather, a minimum and maximum limit that can be determined between which the
wage can be finalized. It is true that the relative strength of the trade union that
determines the actual wage rate. If the labour trade union is strong, then it will accept a
higher wage rate and the reverse will happen when the trade union of the employee will
be stronger than the labour union. The determination of wage rate under collective
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bargaining is difficult to analyse because of the various objectives that each trade union
aims at. A labour trade union may pressurize to maximize the income of its members or
may try to maximize the number of its members or may have some other political
objectives of its own. Hence, it is not possible to explain the determination of actual wage
rate without considering the objectives of trade union.
Activity-1
Differentiate between the marginal productivity theory of wage with the modern theory
of wage.
Activity-2
Do you think that modern theory of wage is an improvement over the marginal
productivity theory of wage? If yes, point out few claims you consider.
18.2 THEORIES OF INTEREST: INTRODUCTION
Capital is of two categories viz., physical capital and financial capital. Interest is a reward
for using the capital. One concept of interest is the real rate of interest which is the rate of
return on physical capital. These assets like machines, vehicles etc., are such capital
which are used for producing more return from the production process. In case of
physical interest, the returns on available physical instruments are considered. Where as
when price is paid for the use of capital funds borrowed from other persons is called as
money rate of interest. Thus financial capital is the return on financial assets like money.
No physical instruments are taken into account while calculating the rate of interest or
rate of return. There are numbers of theories available in the literature of economics.
Each theorist has proved their own logic on determination of monetary interest. Among
them the opinions of few important groups are discussed below:
18.3 the classical theory of interest
18.4 the neo-classical theory or loanable fund theory of interest and
18.5 the Keynesian Liquidity preference theory of interest
18.3 THE CLASSICAL THEORY OF INTEREST
The classical theory of interest considers interest as the price paid for obstinacy.
According to the principle of this theory, rate of interest is determined by the demand for
capital and supply of saving. This theory of interest is also popularly known as the real
theory or saving-investment theory of interest. The theory of interest includes the real
economic forces like shifts, time preference and productivity of capital. Economists like
Fisher, Bohm-Bawerk, J.V. Clerk etc., are the popular experts whose scholarly
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contributions have initiated this theory. To them, interest is to be paid for the productivity
of capital.
It is quite natural phenomenon that people basically prefer present for future. Hence,
present wants are to be discounted at a particular rate. The rate at which the present wants
of the people are discounted for a specific period of time is the rate of interest. The
classical economists relied on two forces viz., the demand for capital and the supply of
saving that determines the rate of interest in the economy.
18.3.1 Demand for capital or investment of capital:

Capital is determined for its productivity. Productivity of capital depends on technology
adopted for production. The technology adopted for production is very dynamic, hence,
changes frequently with the change in time. Thus, marginal productivity of capital more
or less is determined by the technological factors.
It is assumed that the technology is given or remaining constant for the time being.
Entrepreneurs demand capital because it is highly productive. So, higher is the
productivity of capital, higher will be the demand for capital. As technology is assumed
to be given, the investment demand for capital depends only upon the rate of interest.
Thus investment schedule over a period represents the amount of capital demanded at
different rates of interest. An entrepreneur while demanding the capital takes two factors
into consideration viz., the marginal productivity of capital and the rate of interest to pay.
The marginal productivity of capital is the rate of return of the last unit of capital
invested. It must be equal to the cost of investment. In other words, the income that an
entrepreneur will earn from the last investment unit of capital must be equal with the
price paid for the use of the last unit of capital. As the marginal productivity depends
upon the technology of production adopted (which is assumed to be constant), the
investment demand for capital will be only influenced by the rate of investment. At
higher rate of investment lesser is the demand for capital for investment. Alternatively if,
lower will be the rate of interest, higher will be the demand for capital. For this reason the
investment schedule shows the existence of inverse relationship between the investment
demand for capital and the rate of interest. The investment curve is a downward slopping
curve from left to right.
18.3.2 The supply of capital or savings of capital:

The supply schedule measures the amount of capital saved by the people at different rates
of interest. Saving is the function of willingness and ability of the people to save.
Generally, people wants to save certain part of their income to make their future secure.
Banks offer various attractive rate of interest to encourage people to save. It is, hence, the
rate of interest that is offered in the economy mostly upon which the amount of savings
depends. Higher the rate of interest, larger will be the quantity of saving and vice versa.
While the supply schedule is developed, certain factors like level of income, standards of
living, family action, political condition of the economy etc., are assumed to be
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Wages and Interest
remaining constant. Thus the supply curve when drawn with the help of the supply
schedule will be an upward slopping curve from left to right.
18.3.3 Determining the equilibrium rate of interest:

As stated above, the demand for investment and the supply of saving are the two forces
that determine the rate of interest in the economy. Thus the equilibrium rate of interest is
one at which the amount of capital demanded for various investments are just equal to the
amount of saving. Any interest higher than the equilibrium rate of interest, the amount to
be invested will be greater than the amount of saving. The determination of equilibrium
rate of interest is explained with the help of the figure drawn below.
In the figure-18.4, OX-axis measures amount demanded and supplied in the economy and
OY-axis measures prevailing rate of interest. II and SS are the investment demand and
saving curves respectively. It can be seen that, II investment curve is intersecting the SS
savings curve at point E. This interaction between the two determines OR as the
equilibrium rate of interest. For example, if, that the rate of interest has increased form
OR to OR1. At this new rate of interest P and Q are the two points in investment and
savings curves respectively. It can be seen from the figure that, due to increase in the rate
of interest, saving in the economy has increased but demand for capital has reduced. PQ
is the excess supply of capital in the economy. This happens because with the increase in
interest rate people are attracted towards saving. More over, because of this excess
savings in the economy, now, the banks will take initiative to attract demand for
investment and discourage saving. The rate of interest falls and again reaches to the
equilibrium level.
Y
Rate of Interest
S
P Q
R1
R E
R2
I
O
M
X
Demand and Supply of Capital

Figure No-18.4
On the other hand, suppose that the rate of interest has fallen from OR to OR 2 amount. At
this new low rate of interest, the demand for investment or capital will be more. Further
since the rate of interest is low, people are discouraged for savings which reduces the
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amount of saving. This situation creates a scenario of excess investment demand. More
over, because of more demand for capital than availability, the interest rate will definitely
rise and it will again reach at the point of equilibrium. It is, hence, with the given
assumptions, OR will be the equilibrium rate of interest in the economy.
18.3.4 Criticism of the theory:

As discussed, the classical theory of interest has been badly criticized by numbers of
experts for its unrealistic assumptions. Prof. J. M. Keynes is one among few critiques of
the theory. Few important criticisms are:
(i) Ignorance of change in income:

The determination of rate of interest by the classical theory is based on the assumption of
constant income of the people. In other words, rate of interest can be determined with the
assumption of constant rate of interest in the economy. But the reality is that the rate of
income of the people never remains constant for certain period. Further, saving activity in
the economy mostly depends on the income category of the people. An increase in
income may increase savings. Thus it will not be worthwhile to assume that the level of
income in the economy will remain constant.
(ii) Assumption of existence of full employment:

The classical theory of interest works well if the factors of production are fully employed
in an economy. It implies that all factors of production are fully employed. But this is not
the reality. In reality certain factors of production always remains unemployed. Hence,
under the condition of unemployment, an increase or decrease in amount of investment
may not change the rate of interest. Thus this assumption of existence of full employment
is seems to be practically unrealistic.
(iii) Independent saving curve:

The theory holds good under the assumption of independent saving function. It implies
that both investment and saving functions parallel with each other. Investment has no
impact on savings. Suppose that investment is reduced. For which the investment curve
shifts downward. This new downward investment curve is intersecting the original saving
curve at a lower point than the equilibrium point. It shows that saving remains ideal,
hence, plays no influence on investment. But in reality, any fall in investment results in a
decline of income of the people. A decline in income results a decline in savings. Thus
investment and savings are inter related but not necessarily independent with each other.
(iv) The rate of interest should not be same:

It is observed that the economy is experiencing two different interest rates both for the
purpose of investment and saving. In other words, commonly the rate of interest upon
which the financial sector (mutual funds, share markets, bond market etc.,) offering
capital to the people are quite higher than the rate of interest that the people are getting
out of savings of their capital (in banks). Thus the assumption of existence of same rate
of interest for both the types of investments are seems to be unrealistic.
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Wages and Interest
(v) Ignores the monetary effect:

Prof. Keynes has pointed out that the rate of interest is purely a monetary phenomenon. It
also determines the demand for and supply of money in an economy rather than savings
and investments. Keynes in his liquidity preference theory of interest has rightly
explained that the speculative demand for money determines the liquidity preferences of
the people. This factor is accepted as the important determining factor of the rate of
interest.
Activity-3
Examine whether the classical theory of interest is practically applicable or not?
18.4 THE LOANABLE FUNDS THEORY OF INTEREST
The neo-classical economists like Robertson, Myrdal, Ohlin, Viner, Lindahl, Wicksell
etc., are among the few important contributors to the theory. This theory is developed by
considering two important forces like the demand for loanable fund and supply of the
loanable fund as the determinants of interest. Thus it is the interplay of monetary forces
and non-monetary forces that determines the rate of interest. The exponents have pointed
out few important factors which determine both the demand for the loanable fund and the
supply of loanable fund. The details of the factors that cause demand and supply of
loanable fund to exit in the economy are discussed below:
18.4.1 Factors determining the demand for loanable funds:

The different sources of loanable funds are:
(a) Investment demand: This is the factor which the businessman basically demands
to expand their inventories or purchase of new physical capital goods. As per the theory,
the demand for investment demand depends upon the MRP of capital. When the rate of
interest is higher, businessmen will not ask more investment for capital, hence, the
demand for the capital in the loanable fund reduces. The vice versa will happen when the
rate of interest will fall. This shows that demand for loanable funds for investment is
interest elastic.
(b) Consumption demand: This demand for capital in loanable fund is from
consumer’s reaction. As per the theory, when the consumers demand for capital to
purchase goods in the economy, the demand for loanable fund increases. In such a case, a
lower rate of interest will encourage and higher rate of interest on capital will discourage
the demand for capital.
(c) Increase of saving: The habit of people to save above the part of their basic
required income for future certainty is another important factor of the demand for
loanable capital. People borrow more and more capital to increase their liquidity. Thus,
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this motive of people demands for capital to increase, ultimately the demand for loanable
fund.
18.4.2 Factors determining the Supply of loanable fund:

Few important factors that determine the supply of loanable funds are:
(a) Savings by the people: The saving habit of people from their income is one of the
important sources of loanable fund. These savings are called as planned savings. People
are generally attracted towards more and more saving when they realize that the rate of
interest that they will get is more than the normal rate of interest. In other words, savings
will increase with higher rate of interest and vice versa.
(b) Dis-hoarding: People sell their liquidity hoarding basically for two reasons. The
hoardings include the purchase of various bonds and securities. Some times because of
their personal need people sell their hoardings. Otherwise at a higher rate of interest,
people possessing idle cash balances will be induced to acquire more money. For a lower
rate of interest, people are not encouraged to sell out their idle cash.
(c) Disinvestment: The act of disinvesting a loss making unit of business is one of
the important source of supply of loanable funds. This is the act either done by the
government to disinvest the government undertakings to the act of private businessmen to
disinvest their loss making unit. In both the above acts, huge source of capital is supplied
to the economy. At higher rate of interest, the businessmen are generally encouraged for a
greater amount of disinvestment.
(d) Banking operations: The increase in bank’s operations towards sanctioning
higher loans to people is one of the important sources of increasing supply of loanable
fund. Bank sanctions higher loans to businessmen and individuals. This creates increase
of loanable fund in the economy. Commonly, the bank sanctions more money by
charging higher rate of interest which is higher than what banks’ pay to depositor (for
saved money)
18.4.3 Deriving the equilibrium:

The interaction of demand for and supply of loanable funds determines the equilibrium
rate of interest. The demand curve of loanable fund is a downward slopping curve for rate
of interest and the supply curve is an increasing curve from left to right. Thus the
equilibrium rate of interest is determined where the supply of loanable fund will be equal
to the demand for loanable fund.
18.5 KEYNESIAN LIQUIDITY PREFERENCE THEORY OF INTEREST
Load Keynes is one of the leading contributors to the theories of interest. To him,
‘interest is the reward for parting with liquidity for a specific period’. Keynes explains his
theory by taking an example of a common man. A common man takes two decisions of
his derived income. A part of income is utilized for consumption of goods and services
and a part of his income is saved for future requirements. The consumption behaviour is
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Wages and Interest
called by Keynes as the propensity to consume. Given this propensity to consume, the
individual will go for saving. To Keynes, the saving activity is further divided into two
types. A part of saving can be kept in the form of hard cash or physical money and a part
of the saving can be kept in the form of interest receiving savings. This activity of the
common man to decide the part of his saving as hard money is called as liquidity
preferences. Liquidity preference means the demand for money to hold by the common
men in an economy.
Keynes then explains three motives behind the common men that encourage them for
liquidity preference. All the three motives are discussed below:
(a) The transaction motive of the people: People are either individual or business
men keep a certain amount of money with their pockets to meet the day-to-day
expenditures. This money is kept by people to bridge the gap between the income
received and expenditure incurred. When individual keep the money it is called as
‘income motive’ and when businessmen keeps the amount is called as ‘business motive’.
This liquid money in people’s hand for the expenditure is called by Keynes as
transactions motive.
(b) The precautionary motive of the people: This motive includes that money which
people hold with them to meet any unforeseen situations in the life. Any one may face a
situation like accidents, sickness, loss of job etc.
(c) The speculative motive of the people: This motive of people includes the desire
of people to get higher return in future. Money held for this motive serves as a store of
value. Purchase of bonds, shares, mutual funds etc., are such holdings. Thus less money
will be held by the people if current rate of interest is high and vice versa.
According to Keynes, the demand for money i.e., the liquidity preferences and the supply
of money determines the rate of interest. The above derived three motives determine the
demand for money in the economy. The demand curve, therefore, is a downward
slopping curve from left to right. As for the supply of money, according to Keynes
depends upon the policies of government and the central bank of the country. The total
supply of money consists of coins plus notes plus bank deposit. Thus the supply of
money in the economy is fixed for which the supply curve is parallel to OY-axis. The
simple case of determination of rate of interest is derived with the help of a figure as
derived below.
In the figure-18.5 derived above, OX-axis measures amount of money demanded and
supplied in the economy and OY-axis measures rate of interest. LP is the liquidity
preference curve i.e., the demand curve for capital. SS is the money supply curve in the
economy. It can be seen that, the SS curve is touching OX-axis at point S indicating that
the economy has fixed amount of money supply of a quantity as OS. The liquidity
preference curve PL is intersecting the SS curve at point E in the figure. Thus OI is the
rate of interest that is determined. From this equilibrium point, any further increase in
demand for money will cause the LP curve to shift upward. An upward shifting LP curve
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implies increase in the rate of interest as the supply of money is fixed. The reverse will be
the case for rate of interest when demand for money will fall from the equilibrium point.
Rate of Interest
E
I
LP
X
O S Amount of money
Figure No-18.5
18.6 LET US SUM UP

 The modern theory of wage is also known as demand and supply theory of wage.
The modern theory of wage as discussed, offers more clearer and analytical
explanation on how to determine the wage rate in the industry.
 Equilibrium wage in an industry is determined by the interaction of two forces
viz., the demand for the labour and the supply of the labour.
 The theory is based on two important assumptions like existence of perfect
competition in the industry and the units of measurement of wage is
homogeneous.
 The MRP curve is the decreasing function of quantities of labour employed. For
this, the MRP curve slopes downward to the right after a certain pick is reached
as the quantity of labour employed will go on increasing.
 The industry supply curve of labour is an upward slopping supply curve. Any rise
in wage in the economy as a whole may not compensate the rise in labour
demand in the economy; hence, the supply of labour may not increase.
 The modern economic scenario forces to consider the role of the trade unions
while determining wage rate.
 Bilateral monopoly refers to a situation in which there is trade union of both the
employers and the employees. The labour trade union acts as monopoly in labour
supply in the sense that the union controls the supply of labour according to its
own decision.
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Wages and Interest
 The classical theory of interest considers interest as the price paid for obstinacy.
According to the principle of this theory, rate of interest is determined by the
demand for capital and supply of saving.
 The loanable fund theory is developed by considering two important forces like
the demand for loanable fund and supply of the loanable fund.
 As per the Keynesian theory, ‘interest is the reward for parting with liquidity for
a specific period’. It is the interaction of demand for capital i.e., the liquidity
preference and the supply of capital that determines the rate of interest in an
economy.
18.7 KEY WORDS
 Wage  Marginal productivity

 Interest  Loanable fund
 Demand for capital  Supply of capital
 Bilateral monopoly  Motives of people

Compant Ltd.

1. Define wage? Discuss how wage is determined as per the modern theory.
2. Define collective bargaining. Explain with the help of a diagram, how wage is
determined in case of collective bargaining?
3. Critically discuss the modern theory of wage.
4. ‘The modern economic scenario forces to consider the role of the trade unions
while determining wage rate’. Discuss.
5. Write a short note on bilateral monopoly.
6. Define interest. Explain how interest is different form rent. Critically discuss the
classical theory of interest.
7. ‘The classical theory of interest considers interest as the price paid for
obstinacy’. Enumerate the statement.
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8. Define interest. How interest is determined as per the loanable fund theory?
9. Define interest. Explain the factors causing demand for loanable funds and
supply of loanable funds.
10. Write a short note on demand for loanable funds
11. Write a short note on supply of loanable funds.
12. ‘Interest is the reward for parting with liquidity for a specific period’. Discuss
the Kensian approach of determining interest.
13. Explain the various motives of people as discussed in the Keynesian theory of
interest.
14. Differentiate between the loanable fund theory and Keynesian theory of interest.
Explain which is best among the two.
15. Differentiate between interest and profit. Briefly discuss the central theme of
both the theories.
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Distribution of Income:II
Rent And Profits
UNIT 19 DISTRIBUTION OF INCOME-II: RENT AND PROFITS
Objectives:
After completing this unit, you will be able to understand:
 The concept of rent
 How rent is determined in an economy
 The unique nature of demand and supply curve of land
 The concept of quasi rent
 What profit is?
 How profit is determined?
 What are various theories to acquire profit
Structure:
19.1 Theories of rent: Introduction
19.2 The Ricardian theory of rent
19.2.1 Assumptions of the theory
19.2.2 Rent as scarcity of land
19.3 The modern theory of rent
19.3.1 Determination of rent for the economy
19.3.2 Determination of rent for the factors of production
19.4 Quasi-rent
19.5 The theories of profit: Introduction
19.6 The dynamic surplus theory of profit
19.7 The innovations theory of profit
19.8 The risk and uncertainty theory of profit
19.9 Monopoly and profits
19.10 Let us sum up
19.11 Key terms
19.1 THEORIES OF RENT: INTRODUCTION
The concept of rent has been opined differently by different economists from time-to-
time. Basically in economic literature two groups of views on the meaning and definition
of rent have emerged viz., the classical thought and the modern thought. Both the group
of experts has proved their logic strategically. The classical thought follows from the
view of classical writers like West, Torrents, Malthus and Ricardo. However, the theory
developed by David Ricardo has become more popular. Where as, the modern theory of
rent or alternatively called as the scarcity rent is associated with the name of Mrs. J.
Robinson. The essences of both the theories are discussed in detailed below.
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19.2 THE RICARDIAN THEORY OF RENT
Ricardo in his theory considered rent as a payment for the use of land only. As he defines
‘rent is that portion of the procedure of earth which is paid to the landlord for the use of
the original and indestructible powers of the soil’. Hence, Ricardian concept of rent is
only land rent. Following are few assumptions on which the theory is based on:
19.2.1 Assumptions of the theory:

(i) There exists perfect competition in the land market where the theory needs to be
applied.
(ii) The supply of land is assumed to be fixed. At any price, there is no chance to
increase the supply of land. Land includes the land available in entire economy.
Thus, the supply curve of land is perfectly inelastic in the economy.
(iii) The use of land is only for agricultural purpose i.e., for cultivating only one crop
‘corn’ always. Beside this use, it has no further use.
(iv) Land differs in quality of fertility and also on location
19.2.2 Rent as scarcity of land:

Rent by the Ricardian theory is determined by two forces- the demand for and the supply
of land. One of the assumptions of the theory is that the supply of land is always fixed. It
implies that supply cannot be increased at any cost. Since supply of land is assumed to be
fixed, hence, the supply curve of land is perfectly inelastic. The shape of perfectly
inelastic supply curve is a straight line parallel to OY-axis.
Further, it is again assumed by Ricardo that land is only used to cultivate one crop i.e.,
corn. Because it is having only one use, hence, the demand for land depends on the
demand for corn in the market. Thus, the demand for land ultimately depends on the price
of corn. The higher the price of corn, the more profitable business it will to grow corn.
The higher will be the demand for land to grow corn, the higher will be the prices for the
land. Thus scarcity rent will arise only when the available quantity of land in the
economy will be scarce in relation to the increase in demand for corn, hence, land.
The Ricardian theory of scarcity rent is derived with the help of a figure as derived
below. In the figure-19.1, OX-axis measures land use and OY-axis measures rent. DD is
the demand curve for land and SS is the supply curve of land in the economy.
It can be seen from the figure derived that, the SS supply curve is parallel to OY-axis. It
touches to OX-axis at point S. This implies that OS quantity of total land is available in
the economy as a whole is fixed.
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D S
Rent
3
R1 F
D
2
D
R 1
E
D
0 D
D 3
X
O K S 2Land
D1
D
Figure No-19.10
Various demand curves such as D0D0, D1D1, D2D2 and D3D3 are drawn respectively based
on various levels of demand for land. It is already stated that this demand for land
depends upon the demand for corn. The aggregate demand for land in an economy is
determined by summing up the individual marginal revenue productivity curves of each
farmer cultivating the land.
Now, let us discuss all the four conditions of demand curves shown in the figure. At the
demand curve D0D0 which is intersecting OX-axis at point K, no rent is charged from the
farmers. This is because at this demand, the demand for land is OK quantity; where as,
the supply of land is OS quantity. It is thus, supply is more than the demand at this
scenario. If the demand for the land is increased for which the demand curve shifts
upward and the new demand curve for land is D 1D1. It can be seen that the new demand
curve is intersecting the supply curve at point S in the OX-axis. At this stage of demand,
the supply of land is equal to the demand for land. Since supply is equal to demand, thus,
there will be neither surplus nor scarcity of land in the economy. For this, at this situation
also there will be no rent. Where as, further increase in demand for land shifts the
demand curve upward and D 2D2 is the new demand curve for land in the economy. This
new demand curve is intersecting the fixed supply curve at point E. The rent that is
determined at this demand is (OR). With further increase in demand for land to D 3D3,
rent rises to OR1. Malthus has opined that this increase in demand for land may be due to
the increase in the population in the society.
Activity-1
Make a summery in your own words about what you learnt from Ricardian theory of rent?
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19.3 THE MODERN THEORY OF RENT
This theory is developed by Mrs. J. Robinson. Robinson by criticizing the Ricardian logic
of rent has tried to develop this theory in a better manner. Ricardo, one of the great
classical economist, considered rent as the reward for the use of original and
indestructible power of soil. To him rent arises due to difference in fertility or difference
in place of land from the other land. Thus the Ricardian logic is only applicable to the
free gift of nature. But the modern theory of rent is quite different from the Ricardian
principles. It has wide applications in all factors of production. Mrs. Robinson defines
rent as ‘surplus earned by a particular part of factor of production over and above the
minimum earnings necessary to include it to do work’.
Robinson opines rent due to scarcity of land in proportion to its demand. Similarly, all the
factors of production which are less than perfect elastic in supply curve, earns some
surplus of income. The surplus gained over and above the opportunity cost is the
economic rent. This theory considers two forces like the demand for land and the supply
of land as the factors that determined rent of land for a particular industry. This logic of
expression of rent latter on generalized to all other factor of production where it can be
applicable.
The supply curve of land:

The nature of supply curve of land is perfectly inelastic so far as the economy as a whole
is concerned but it is elastic in shape for a particular industry. It implies that if there is an
increase in price for the use of land due to the increase in demand for the land for the
specific purpose, the supply of land can also rise. This happens because of the increase in
demand for the use of land for a specific purpose. When demand for the land for a
specific purpose increases, it increases the price of the land to be in use. As a result of
which the land that are under other uses are transformed to the demanded use to earn
more revenue. This return from the price of land is called as rent. Thus, rent is defined as
the surplus of income earned by a factor over and above the earnings in from of its best
alternative use. SS is the supply curve of the land in the figure.
The demand curve for the land:

It is quite obvious that the demand curve for the land is a decreasing function of rent
paid. It implies the existence of inverse relationship between the use of land and rent to
be paid for the use of land. More clearly, the quantity demanded for the land increases
with the fall in rent of the land and quantity demanded decreases with the rise in the rent.
This shows that the demand curve must be a downward sloping curve from left to the
right. The nature of demand curve remains same irrespective of the use either in industry
or for economy. DD is the demand curve for land in the derived figure. It is the
interaction between the demand for and supply of land that determines the rent. Below
derived figures are drawn to determine rent in different conditions of use.
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Rent And Profits
19.3.1 Determination of rent for the economy:

The supply of land for the economy as a whole is perfectly inelastic. It implies that all
free gifts of nature are perfectly inelastic in supply. As such, the shape of the supply
curve is a vertical straight line drawn on OX-axis. In the derived figure, SS is the supply
curve of land for the economy as a whole. Further, since the shape of demand curve does
not change irrespective of the use, hence, DD is the demand curve of land as represented
in the figure-19.2.
S
Rent
E
R
S
X
O Demand and Supply
Figure No.-19.2
In the figure-19.2, OX-axis measures demand and supply of land and OY-axis measures
rent of the land use. It can be seen that the demand curve DD is intersecting the supply
curve SS at point E. Thus, the rent for the factor (land here) is OR. In this case, the total
income of the factor is the rent because the transfer earnings of the perfectly inelastic
supply of land are zero. The greatest possibility that lies to raise the rate of rent is that of
raising the demand for the land. In the figure, ORES is the total rent. Thus it clears that
economic rent in case of free gifts of nature refers to the whole of the income of the
actors of the economy.
19.3.2 Determination of rent for factors of production:

The supply curve of the factors of production like land, labour, capital and
entrepreneurship are neither perfectly inelastic nor perfectly elastic. More over, there
arises a fixed supply price for all such factors of production. Similarly, land used for a
specific purpose is also less than perfectly elastic. Here all factors of production must be
earning at least some amount of minimum income. If the income earning is less than the
minimum, the factor will transfer for some other use. This minimum earning from the
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land or some other factors of production is known as transfer earnings. In case of less
than perfectly elastic factors a supply curve slopes upward to the right. In the figure-19.3,
SS is the supply curve.
D
S
Rent
O
n
t
R
P
S
D
O X
M
Employment
Figure No-19.3
The OX-axis in the figure-19.3, represents number of employment and the OY-axis
represents rent to be paid for each additional unit of land use. It can be seen that OP is the
price of land and PRS is the amount of rent earned by the factor with the employment of
OM quantities of labour employed. The area below the supply curve are known as
transfer earnings or opportunity cost. The area OMRS is the transfer earnings in this case.
Hence, it can be noted from the above determinations of rent is that, for the whole
economy is concerned, the total income is rent but in case of an industry, a part of the
earnings are transfer earnings and the rest are rent. Further, it is also to be noted that the
price of land differs from one use of land to the other use of land and all the units of land
need not be same in price. These differences in land prices are not because of the fertility
of the land but it is because of the difference in demand for the land. Thus the difference
in rent arises due to the difference in their transfer earnings.
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Rent And Profits
D
Rent
R
P S
D
X
O M
Supply of land
Figure No-19.4
There also emerges such possibility where the supply curve of factors of production will
be perfectly elastic in shape. In such a case of perfectly elastic supply curve of the factors
of production, no economic rent can be earned. Since the supply curve is elastic, it is a
parallel curve to the OX-axis. For this, all amounts received are the transfer earnings.
Here the price of the land is just equals the transfer earnings. In the derived figure-19.4,
OX-axis measures demand and supply of land and OY-axis measures rent received. The
supply curve is SS for the industry which is perfectly elastic in nature. It can be seen that
the demand for the land is equal to the supply of the land at point R. The price of land is
determined as OP. The OP price is equal to transfer earnings for all the units of land,
hence, cause no surplus to exist. Thus there will be no rent in such types of elastic supply
curve.
Activity-2
Point out few differences between the Ricardian theory and modern theory of rent.
19.4 QUASI RENT
Prof. A. Marshall has introduced the concept of quasi rent in economic theory to
determine rent of land. To him, rent arises due to elasticity in supply of land. Land as a
factor of production is permanently inelastic in supply. Hence, the earnings on land
depend upon demand for the land only. But there are certain factors of production like
machinery, buildings and such other capital equipments which are inelastic in supply
during the short-period. So, during short-period the earnings of such factors depend upon
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their demand conditions. Marshall named the short-run earnings of such specialized
capital equipments as quasi rent.
Thus quasi rent as a concept arises only in short-run. Where as, in long-run, the
deficiency in supply in relation to the demand disappears either because of increase in
supply or because of decrease in demand. Hence, there will be no surplus earnings from
the capital equipments in the long-run. Specialized machinery has no alternative use.
Therefore, the marginal earnings may be zero. Thus, the transfer earnings of the capital
equipments is zero in short-run. So, the total earnings of specialized capital equipments is
similar to rent. Therefore, quasi rent may be defined as the short-run earnings of the
machines minus the short-run cost incurred to keep it in running order.
Further, quasi rent arises due to temporary inelasticity in supply condition of factors of
production. It implies that the products of such factors of production cannot increase the
production of the capital equipments due to its nature. Production of goods in short-run
necessitates increasing the capacity of machinery. But expansion of machinery is not
possible in short-run. This process requires quite a long-time to expand the machinery of
any company. This indicates that the supply of such factors remains fixed in short-run.
The Marshallian concept of quasi rent is different from the concept of rent. The first
difference between the two is that quasi rent is a short-run phenomenon where as rent is
the usual earning i.e., it may either in short-run or in long-run. Secondly, supply of land is
fixed in both short-run and long-run. But the supply of specialized capital machinery is
fixed only in short-run. The working of quasi rent can be illustrated with the help of an
example for more clarity on the concept.
For Example:
Let us consider a case of warship. The nature of production of a warship is such that it
requires numbers of variety of machinery. Generally, it requires at least two years to prior
planning for the production of machinery required for the warship. When a war is
announced, the demand for warships increases but the supply cannot be increased
suddenly. There fore, producers of warships became able to earn certain surplus over and
above the usual price. This surplus is known as quasi rent. After two years when there
will be full-phased supply of warships, the price will definitely come down to the original
price of the warship. Thus quasi rent disappears.
The concept of quasi rent is also defined as the difference between the total revenue and
total variable cost. In the short-run, fixed cost of the industry remains constant. Here, the
amount of variable factors to be used depends on the quantity of output to be produced.
The ultimate aim of the industries is to recover the variable cost in the short-run rather it
may cause squeeze in production process. Thus, the excess of earnings over and above
the variable cost in the short-run is the quasi rent.
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19.5 THE THEORIES OF PROFITS: INTRODUCTION
The ultimate aim of each entrepreneur is to get profit. Each firm is in search of a unique
game plan to drive profit against their rivals. Profits can be arrived by increasing sale.
Sales will increase when there will be increase in the numbers of customers. But the
million dollar question is that how profit can be achieved? The economics literature is not
having any unique view on answering the above asked question. In other words, there are
numbers of theories defining and deriving profit. Some important ones are discussed in
this section of analysis.
Let us first understand what is meant by profit for a common man. For a common man
profits are residual income left after the payments of all cost of the firm. In other words,
an entrepreneur while producing goods and services in his industry engages in various
factors of production. It promises certain obligations to pay to these factors of production
as rewards of their work. He, thus, pays wages to the workers, rent to land employed,
interest on the loanable capital, payments towards fixed assets like security, electric bills,
maintenances etc. Thus during a process of production, the residuals left after the
payment to all these factors of production is meant as profit.
Again, there is no certainty that an entrepreneur will get profit always. Since profits are
treated as non-contractual income of the entrepreneurs, for which, it may be positive or
negative. A situation of getting positive profits are the scenarios of getting supernormal
profit or normal profit as discussed in equilibrium price-output determination of firm and
industry. Where as a situation of getting negative profits are acquiring losses to the firm.
No firm wants to acquire loss in their business. It implies each firm wants to over cross
his competitors in the market and acquire profit. For this each firm’s are always in search
of a master plan to overcome their competitors. Following are few theories that shares the
experts view on when one can earns profits?.
19.6 The dynamic surplus theory of profit
19.7 The innovations theory of profit
19.8 The risk and uncertainty theory of profit
19.9 The monopoly and profit
The essences of each theory are elaborated in details as below:
19.6 THE DYNAMIC SURPLUS THEORY OF PROFIT
The credit for developing the dynamic surplus theory of profit is associated with the
name of one of the leading economists J.B. Clark. It is Clark, who for the first time said
that profits are earned as a reward for dynamic surplus. Clark is of the opinion that profit
will arise in a dynamic economy. Dynamic economy implies that economy which
changes frequently. To him, in a stationary stage of economy where no changes in the
conditions of demand and supply of the product is occurring, the prices paid as
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remuneration to the factors of production on the basis of their marginal productivity

would exhaust the total value of production and no profits would be there for the
entrepreneurs. Profits will result when selling prices of the goods and services exceeds
their cost of production.
Moreover, it is the state of disequilibrium in the demand and supply condition that leads
to profit. Any change in the demand and supply conditions creates a situation of
disequilibrium. Due to frequent changes, price is exceeding to the costs of production
incurred. Now because of this excess price, the entrepreneur is experiencing a positive
profit. Changes not necessarily always lead to profit. If because of a change price falls
below the cost of production, negative profit may occur. Negative profit implies loss to
the entrepreneur.
J. B. Clark to prove his theory more competently among the others has clearly mentioned
five changes that lead to change in an economy. The changes are like (i) changes in the
method of production, (ii) changes in the amount of capital, (iii) changes in the taste and
preference of customers, (iv) changes in the techniques of production and (v) changes in
the operation or form of business organization. These changes are quite common in the
economy and, hence, are always changing. Because of these changes the disequilibrium
in the economy is always accruing. This disequilibrium is leading either positive profit or
negative profit.
Thus, it can be rightly pointed out that the factors of change in an economy are bringing
profits into existence. If there will be no change, there can be no profits. If there is no
uncertainty about the future, so there will be no risk and no profits.
19.7 THE INNOVATIONS THEORY OF PROFIT
The innovations theory of profit is developed by Joseph Schumpter. To him the task of
the managers is to innovate or introduce some thing new in the market. The reward of
these new developments is the profit. Schumpter explains innovation as a process in the
management which either reduces the cost of production or creates demand in the market.
Due to the introduction of new technology, machinery, exploitation of raw materials in
cheap prices, development of new distribution system etc., the cost of production may
reduce. Reduction in cost of production, keeping the price of the product constant, will
definitely lead to profit. Where as the second type of innovation is one where a new
product is introduced with changed features, implementation of new means of promotion
strategy, changing the packs and colours of the product to attract the consumers etc. In all
these activities, the demand for the product may increase. Increase in the demand will
increase sales. Thus keeping price constant, increase in sales will definitely lead to profit.
However, Schumpter is of the opinion that, such type of innovations is very temporary in
nature. A firm is expected to gain profit till the technology has not been by other
competitors. Once the innovations have been copied, profit has been shared by other
firms who introduced this technology.
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For example, the recent developments in mobile phones, development of new varieties of
LED TVs and much many such life experiences exists in the business economy.
19.8 RISK AND UNCERTAINTY THEORY OF PROFIT
The risk and uncertainty theory of profit is also popularly called as Knight’s theory of
profit. According to F. H. Knight, profit is a reward for arising uncertainty in the
economy. Knight has distinguished between risk and uncertainty in one hand and
predictable and unpredictable changes on the other hand. According to him, dynamic
changes in the economy give rise to profits and their consequences are unpredictable.
Thus he concluded by saying that those changes whose behaviour cannot be predictable
will give rise to profit. One cannot expect profit where the changes can be predictable
easily.
Entrepreneurs have to take risk during uncertainty. By taking risk they have to continue
production. However, he has to act intellectually. He should be so sharp in his mind that
he can predict the future demand for his product, any possibilities of change in and
around the business environment, advance policies to tackle the unexpected situations
etc. Thus it is the divergence of actual conditions from those which have been expected
and on the basis of which business arrangements have been made that give rise to
uncertainty and profit. Hence, uncertainty, that is, ignorance about the future conditions
of demand and supply, is the cause of profit. Thus positive profits accrue to those
entrepreneurs who make correct estimates of the future or whose anticipations prove to
be correct. Any wrong anticipation would result into losses.
19.9 MONOPOLY AND PROFITS
Existence of monopoly power with an entrepreneur can bring profits. Monopolistic

position gives rise to profits both in static and dynamic conditions of economy. A
monopolist has strong command over the price of the product. These commands regulate
the decision while supplying goods. All these activities lead to profit. Monopoly is a
market situation where there are no close substitutes of the product. This results the
monopolist to charge price as per the elasticity of demand. The determination of price
and output under various monopoly situations like in case of pure monopoly,
discriminating monopoly, monopolistic competition, oligopoly and duopoly have been
analysed in detail in preceding units.
Activity-3
The pen industry in India has undergone a numbers of innovations in its technology.
Recall few innovations and point out them one by one.
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Activity-4
What would be the future uncertainty according to you in the computer manufacturing
industries? Point out the remedies with necessary rectifications.
19.10 LET US SUM UP
 The modern theory of rent considers rent as surplus earning. It is the surplus of
earnings of a factor over and above its transfer earnings or opportunity cost.
 The entire earnings are treated as free gift of the nature when calculated for the
economy as a whole. Thus total earnings from the factor of production are the
rent for the economy.
 For an industry, rent is equal to the surplus over and above the transfer
earnings. This is not same for all the units of land.
 All factors of production which are less than perfectly elastic, earns rent as
income. Hence, labour, capital and entrepreneur etc., earns rent as the part of
their income.
 Factors of production which are perfectly elastic in supply earn no rent in the
economy.
 During short-period the earnings of such factors depend upon their demand
conditions. Marshall named the short-run earnings of such specialized capital
equipments as quasi rent.
 During a process of production, the residuals left after the payment to all these
factors of production is meant as profit.
 In a stationary stage of economy where no changes in the conditions of demand
and supply of the product is occurring, the prices paid as remuneration to the
factors of production on the basis of their marginal productivity would exhaust
the total value of production and no profits would be there for the entrepreneurs.
Profits will results when selling prices of the goods and services exceeds their
cost of production.
 To Schumpter, the task of the managers is to innovate or introduce some thing
new in the market. The reward of these new developments is the profit.
 Dynamic changes in the economy give rise to profits as far as changes and their
consequences are unpredictable. Thus Knight, concluded by saying that those
changes whose behaviour cannot be predictable will give rise to profit. One
cannot expect profit where the changes can be predictable easily.
 Existence of monopoly power with an entrepreneur can bring profits.
Monopolistic position gives rise to profits both in static and dynamic conditions
of economy.
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19.11 KEY TERMS
 Rent  Land
 Scarcity of land  Profit
 Innovation  Risk and uncertainty
 Monopoly  Dynamic change

Compant Ltd.

1. Critically examine the Ricardian theory of rent.
2. Do you agree with ‘rent as a scarcity of land’?
3. ‘Rent is hat portion of the procedure of earth which is paid to the landlord for the
use of the original and indestructible powers of the soil’. Discuss this statement.
4. Define rent. How rent of an economy is determined. Is the modern theory
practically applicable? Comment.
5. What do you mean by rent? How rent of factors of production is determined?
6. Write a short note on quasi rent.
7. ‘Land differs in quality of fertility and also on locational advantages’. Opine on
this assumption or Ricardo.
8. Write a short note on scarcity of land.
9. ‘The concept of quasi rent is also defined as the difference between the total
revenue and total variable cost’. Explain.
10. ‘During a process of production, the residuals left after the payment to all these
factors of production is meant as profit’. Comment on the statement.
11. Explain how innovations lead to profit as defined by Schumpter.
12. What is the Knights theory of profit? How it is different from Schumpter’s
theory.
13. Differentiate between Clark’s theory and Knight’s theory of profit. Which
according to you is more applicable now-a-days?
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14. Select refrigerator as a product. Analyze how many technologically up gradations

have been done in the refrigerators so far. Suggest few future innovative designs
for the industry.
15. Can it be a good idea to produce refrigerators by attaching a micro oven in it?
Will it be treated as innovation? Justify your answer.
16. Write a short note on monopoly theory of profit.
17. Suggest what are the future uncertainty that lies with the mobile handset
industry? Being the manager, what remedies would you suggest for your
company?
18. Recall the past few changes that occurred in the Indian motorized two-wheeler
industry. Point out few innovative thought from the observations.
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UNIT 20 INEQUALITY OF INCOME
Objectives:
After the reading of this chapter, students are able to know
 the meaning of income inequality
 the methods of measurement of inequality
 the logic and usefulness of Gini coefficient
 the use and procedure of drawing Lorenz curve
 recent trends of inequality in international and national arena
Structure:
20.1 Introduction
20.2 Concept of income inequality
20.3 International inequality scenario
20.4 Trends of income inequality at national and state level
20.5 Measurement of inequality
20.5.1 The positive measure of inequality
20.5.2 The normative measure of inequality
20.6 Lorenz curve and the inequality measure
20.6.1 Gini coefficient and the Lorenz curve
20.6.2 Decomposition of inequality by population sub-group
20.6.3 Decomposition of inequality by factor components
20.7 Let us sum up
20.8 Key Terms
20.1 INTRODUCTION
In recent years much attention has been given to the conceptualization, measurement and
interpretation of relative deprivation. A researcher may pickup one or the other
dimension of this complexity and tries to analyse it threadbare. Generally, the study on
inequality primarily forces on four size distributions namely, income, wealth,
consumption and earning. Various simple and esoteric indices are applied to compute the
inequality measure of theses distributions. Availability of a profile (of income, wealth,
consumption and earning) marks the beginning of all empirical studies on inequality.
While data is drawn from the household income, expenditure and asset surveys, the
demographic variability of these units is whished away or given a casual treatment. Given
the sensitiveness of these issues, the measurement of inequality require careful handling
to take into account of household size and it’s composition.
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10.2 CONCEPT OF INCOME INEQUALITY
Inequality signifies departure from the state of equality. The tools used for measuring the
extent of such departure are known as measures of inequality. Measure of inequality is
roughly be defined as a scalar representation of interpersonal income differences within a
given population.
Kuznets (1953) in his pioneering study stated that, when we say income inequality, we
mean simply differences in income, without regard to their desirability as a system of
reward or undesirability as a scheme running counter to some ideal of equality of
economic opportunity. Thus, measures of inequality are employed to study and compare
the commonly recognized phenomenon of inequality in personal distribution of income
or wealth which exists at different times and in different places.
Sen(1976), Ahluwalia (1974, 1976) and Anand and Kanbur (1993) defined inequality as
an unequal distribution of income, irrespective of the income level or the corresponding
state of deprivation of the people at the bottom end of the income scale.
According to United Nation Organization (1975) relative poverty is the inequality in

income distribution which changes with time, and is invariably different for each society.
Varadarajan (1977) argues that relative poverty implies the extent of poverty in a society,
which can be estimated in terms of the degree of general inequality.
Jain (1981) defined a person is relatively poor who is above the poverty line with income
above the absolute level, but below the income level required to meet the national
average consumption expenditure.
20.3 INTERNATIONAL INEQUALITY SCENARIO
Simon Kuznets initiated the discourse on the links between economic growth and income
inequality in the mid-1950s, it had a multiplier effect on cross-country investigations on
the determinants of income inequality. Results from a sample of recent studies are
summarized in table-20.1. Mostly the results are in line with a priori expectations,
affirming, for instance, the positive impact of educational expansion and the negative
impact of land concentration on income inequality. Specifically, it is adjusted for
differences between income based and expenditure based coefficients by systematically
increasing the latter by 6.6 per cent, this being the average difference between two
components- income and expenditure. A consequence of this uniform adjustment is to
believe that equal-expenditure Gini coefficient must mean equal income Gini coefficient
with neither a theoretical nor intuitive basis.
For the first time, Gini ratios on the basis of per capita income for 49 countries are
available in 1999 in the World Development Indicators Report (World Bank, 1999). Most
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of the Gini coefficients refer to a year from the late 1990s. Lowest Gini values of less
than 0.3 are found in the regions of the former communist block and the welfare states of
Western Europe. The same comment broadly holds good for Gini coefficient in the 0.3-
0.4 range. Gini coefficients of a little over 0.4 are found for US and China. Latin America
has always had very high Gini coefficient and the trend is continuing. Malaysia, the only
East Asian economy in the data set, is in the high Gini category (Table-20.1). The pattern
indicated by the groups of countries from the lowest Gini to the highest seems to affirm
that the way to reduce the extent of income inequality is just to reduce it as a matter of
policy via socialism or welfares.
Table – 20.1: Gini ratios for per capita expenditure
Countries Year Gini Coefficient

Brazil 1998 0.601
Chile 1998 0.571
USA 1998 0.401
Bolivia 1998 0.422
United Kingdom 1998 0.326
Canada 1998 0.315
France 1998 0.327
Belgium 1998 0.251
German 1998 0.281
East Asian Countries
Hong Kong 1998 0.451
Korea 1997 0.403
Malaysia 1998 0.484
Taiwan 1998 0.302
Thailand 1998 0.504
China 1998 0.415
South Asian Countries
Bangladesh 1992 0.28
India 1994 0.294
Srilanka 1990 0.301
Pakistan 1995 0.312
Nepal 1995-96 0.367
Source : World Development Indicators, 1999.
East Asia: A summary picture of the income Gini coefficient in East-Asian, South-East
Asian and some other developed and developing countries of the world is provided in
table-20.1. These Gini coefficients have a serious limitation, since they are all based on
income per household and not per capita household income. Notwithstanding the
limitation for comparisons, it is possible to note that each economy has a ‘normal’ Gini
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ratio that characterised the income disparities typical to its economic and social structure
and institutions, around which fluctuation take place over time.
One could discern three patterns of income inequality in East Asia. First, there is the
Taiwan pattern that is due to the explicit pursuit of egalitarian policies, which included
land reform and emphasis on the growth of small and medium enterprises to avoid the
excessive growth of monopolies and conglomerates. Second, Korea falls into the middle
pattern with a Gini of 0.4. The Koreans had their share of land reform but they relied on
the so called chaebols for their industrial development, deliberately fostering some degree
of wealth concentration. Finally, there is the third pattern of the Gini of 0.45 to 0.5 in
countries as diverse as Hong Kong and Malaysia and Thailand. These are the result of
market forces coupled with minimal socialism/welfarism. It is of note too that the
Malaysian policy-makers had a focus on correcting racial income and wealth inequalities
and not overall inequalities.
South Asia: Few countries in South Asia have data on income distribution. The
consumption expenditure Gini coefficient in Table-20.1 does not provide an indication of
high levels of inequality, but with poverty levels (that is, percentage of people in poverty)
as high as 30 per cent or more in most of the countries. The low expenditure Gini
coefficients are merely a reflection of shared poverty. It is to be noted that the
expenditure Gini coefficient makes the considerable income inequality prevailing in these
countries.
None of the South Asian countries have had the pervasive land reforms of the type
implemented in China or Taiwan. In the South Asian economies in general and India in
particular, there are a wide variety of subsidies-on fertilizer, food, diesel oil, electricity,
road and rail transport and education and health. In addition, trade unions are powerful in
the organized sector. Despite subsidies and unionization, given the lack of targeting in
case of the former and the limited coverage of the latter, their overall impact must be
considered negligible and hence income inequality must be relatively high. Also, given
the extent to which global forces are putting downward pressure on lower income groups
and upward pressure at the top, it is unlikely that income inequality will decline
significantly in the near future in the absence of rapid economic growth and institutional
changes specifically aimed at lowering inequality.
20.4 TRENDS OF INEQUALITY AT NATIONAL AND STATE LEVEL
Poverty trends in India in the nineties have been a matter of intense controversy. The
debate has often generated more heat then light, and confusion still remains about the
extent to which poverty has declined during the period. In the absence of conclusive
evidence, widely divergent claims have flourished. Some have argued that the nineties
have been a period of unprecedented improvement in living standards. Others have
claimed that it has been a time of widespread impoverishment. So far, the debate on
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poverty in the nineties has focused overwhelmingly on changes in the ‘headcount ratio’ –
the proportion of the population below the poverty line.
Accordingly, we begin with a reassessment of the evidence on headcount ratios, related

poverty indices and inequality indices based on National Sample Survey (NSS) data. The
broad picture emerging from these estimates is one of sustained poverty decline in most
states (and also in India as a whole) during the nineties. It is important to note, however,
that the increase in per capita expenditure associated with this decline in poverty is quite
modest, e.g. 10 per cent or so between 1993-94 and 1999-2000 at the all-India level.
The evidence on inequality has focused mainly on the period between 1993-94 and 1999-
2000. Based on further analysis of National Sample Survey data and related sources,
Deaton and Dreze (2002) argued that there has been a marked increase in inequality in
the nineties, in several forms. Firstly, there has been strong ‘divergence’ of per capita
expenditure across states, with the already better off states (particularly in the Southern
and western regions) growing more rapidly than the poorer states. Secondly, rural-urban
disparities of per capita expenditure have risen. Third, inequality has increased within
urban areas in most of the states. The combined effects of these different forms of rising
inequality are quite large. In the rural areas of some of the poorest states, there has been
virtually no increase in per capita expenditure between 1993-94 and 1999-2000.
Meanwhile, the urban population of most of the better-off states has enjoyed increase of
per capita expenditure of 20 to 30 per cent, with even larger increases for high-income
groups within these populations. Three aspects of rising economic inequality in the
nineties have come up so far in most of the states. Firstly, there is strong evidence of
divergence in per capita consumption across states. Secondly, the estimates of the growth
rates of per capita expenditure between 1993-94 and 1999-2000 indicate a significant
increase in rural-urban inequalities at the all India level, and also in most individual
states. Thirdly, the decomposition exercise of FGT poverty index has reflected the rising
inequality within states, particularly in the urban sector, has moderated the effects of
growth on poverty reduction.
Table-20.2 provides more systematic evidence on recent changes in consumption

inequality within each sector of each state using two different measures of inequality. We
show the logarithm of the difference of the arithmetic and geometric means
(approximately the fraction by which the arithmetic mean exceeds the geometric mean),
as well as the variance of the logarithm of per capita expenditure.
The direct use of the unit record data in the 55th Round, with no adjustment, shows a
substantial reduction in inequality within the rural sectors of most states, with little or no
increase in the urban sectors. With the correction, one can observe, within-state rural
inequality has not fallen, and that there has been marked increase in within-state urban
inequality. We suspect that the main reason why the unadjusted data are so misleading in
this context is the change from 30 to 365 days in the reporting period for the low
frequency items (durable goods, clothing and footwear, and institutional medical and
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educational expenditures). The longer reporting period actually reduces the mean
expenditures on those items, but because a much larger fraction of people report
something over the longer reporting period, the bottom tail of the consumption
distribution is pulled up, and both inequality and poverty are reduced. Whether 365-days
are a better or worse reporting period than 30-days could be argued either way, but the
main point here is that the 55th (1999-00) and 50th (1993-94) rounds are not comparable,
and that the former artificially shows too little inequality compared with the latter. Once
the corrections are made in addition to increasing inequality between states, there has
been a marked increase in consumption inequality with the urban sector of nearly all
states.
Table-20.2 State wise Inequality Measures
Log (AM)-Log (GM) Variance of Logs

50th 55th 55th Round 50th 55th 55th Round
Round Round Adjusted Round Round Adjusted
Andhra Pradesh 0.14 0.09 0.13 0.24 0.17 0.22
Assam 0.05 0.07 0.06 0.10 0.13 0.11
Bihar 0.08 0.07 0.08 0.16 0.13 0.16
Gujrat 0.10 0.09 0.11 0.17 0.18 0.18
Haryana 0.16 0.10 0.23 0.28 0.19 0.31
Himanchal Pradesh 0.13 0.10 0.14 0.22 0.17 0.24
Jammu and Kashmir 0.10 0.06 0.07 0.16 0.12 0.14
Karnatak 0.12 0.10 0.12 0.21 0.18 0.22
Kerala 0.15 0.14 0.16 0.26 0.24 0.27
Madhya Pradesh 0.13 0.10 0.12 0.22 0.18 0.22
Maharastra 0.16 0.11 0.16 0.27 0.20 0.28
Orissa 0.10 0.10 0.12 0.18 0.18 0.21
Punjab 0.13 0.10 0.14 0.22 0.19 0.24
Rajasthan 0.12 0.07 0.10 0.20 0.14 0.18
Tamilnadu 0.16 0.14 0.15 0.27 0.23 0.24
Uttar Pradesh 0.13 0.10 0.12 0.23 0.18 0.21
West Bengal 0.11 0.09 0.08 0.17 0.15 0.15
All-India Rural 0.14 0.11 0.14 0.23 0.21 0.24
Andhra Pradesh 0.17 0.16 0.17 0.30 0.29 0.33
Assam 0.13 0.16 0.14 0.25 0.30 0.27
Bihar 0.15 0.17 0.17 0.27 0.30 0.30
Gujrat 0.14 0.14 0.14 0.25 0.25 0.26
Haryana 0.13 0.14 0.15 0.24 0.27 0.28
Himanchal Pradesh 0.38 0.16 0.42 0.37 0.29 0.40
Jammu and Kashmir 0.13 0.09 0.12 0.24 0.16 0.21
Karnatak 0.16 0.18 0.17 0.31 0.32 0.34
Kerala 0.20 0.17 0.22 0.31 0.32 0.37
Madhya Pradesh 0.18 0.17 0.18 0.29 0.29 0.33
Maharastra 0.21 0.21 0.21 0.40 0.36 0.40
Orissa 0.15 0.14 0.16 0.29 0.26 0.29
Punjab 0.13 0.14 0.14 0.23 0.25 0.25
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Rajasthan 0.14 0.13 0.14 0.25 0.23 0.26

Tamilnadu 0.21 0.27 0.20 0.39 0.34 0.35
Uttar Pradesh 0.17 0.18 0.19 0.31 0.31 0.34
West Bengal 0.19 0.20 0.19 0.34 0.31 0.35
Delhi 0.29 0.21 0.30 0.43 0.39 0.46
All-India Urban 0.19 0.20 0.21 0.34 0.34 0.37
All-India 0.17 0.18 0.19 0.29 0.29 0.32
Source: Deaton and Dreze, 2001
It is interesting to compare the growth rate of real wages for agricultural labourers with
that of public sector salaries. The real agricultural wages have grown at 2.5 per cent or so
in the nineties. Public sector salaries have also grown at almost 5 per cent per year during
the same period. Given that public sector employees tend to be much better off than
agricultural labourers, this can be taken as an instance of rising economic disparities
between different occupation groups. Since agricultural labourers and public sector
employees typically reside in rural and urban areas, respectively, this finding may just be
another side of the coin of rising rural-urban disparities. It also strengthens the evidence
presented earlier on aspects of rising economic inequality in the nineties.
To sum up, except for the absence of clear evidence of rising intra-rural inequality within
states, we find strong indications of a pervasive increase in economic inequality in the
nineties. This is a new development in the Indian economy: until 1993-94, the all-India
Gini coefficients of per capita consumer expenditure in rural and urban areas were fairly
stable. Further, it is worth noting that the rate of increase of economic inequality in the
nineties is far from negligible. For instance, the compounding of inter-state ‘divergence’
and rising rural-urban disparities produces sharp contrasts in APC growth between the
rural sector of the slow growing states and the urban sector of first growing states. This is
further compounded by accentuation of intra-urban inequality which is itself quite
substantial, bearing in mind that the change in measure over a short period of six years.
Table-20.3 provides systematic evidence on the recent changes in consumption inequality
within each state with the use of Gini-Coefficient of inequality. It is evident from the
table that during 1990’s there is substantial reduction of rural poverty with a little
increase in urban inequality. A perusal of the Gini coefficient figures for rural areas
reveal that the inequality and the distribution of consumption expenditure was the highest
in Orissa followed by M.P. It is even more then the all India figure in rural areas. For all
most all the states the inequality has declined except Orissa and Assam during the period
1983 to 1999-00. In the urban areas, the inequality figures show a rising trend. The
inequality in the distribution of consumption rose in all most all states except Haryana
and Punjab but it is marginally declined in urban Orissa during the above period.
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Table-20.3: Trends of Inequality (Gini Coefficient) at National and State Level
Rural Urban
States
1983 1993-94 1999-00 1983 1993-94 1999-00
Andhra Pradesh 0.284 0.26 0.245 0.284 0.324 0.315
Assam 0.20 0.182 0.214 0.235 0.286 0.315
Bihar 0.257 0.236 0.225 0.283 0.324 0.341
Gujarat 0.25 0.226 0.226 0.255 0.281 0.281
Haryana 0.27 0.251 0.209 0.29 0.282 0.285
Karnataka 0.291 0.26 0.235 0.302 0.322 0.312
Kerala 0.288 0.239 0.213 0.301 0.305 0.314
Madhya Pradesh 0.291 0.271 0.259 0.274 0.313 0.315
Maharashtra 0.282 0.286 0.254 0.294 0.336 0.322
Orissa 0.272 0.258 0.280 0.278 0.315 0.313
Punjab 0.261 0.21 0.201 0.288 0.268 0.283
Rajasthan 0.343 0.236 0.203 0.282 0.296 0.277
Tamil Nadu 0.331 0.273 0.256 0.301 0.321 0.313
Uttar Pradesh 0.282 0.271 0.241 0.292 0.329 0.339
West Bengal 0.294 0.23 0.226 0.29 0.326 0.314
ALL India 0.291 0.266 0.255 0.293 0.327 0.327
The inequality figures (in table-20.3) confirm that rural economy in most of the states are
moving towards a homogeneous unit unlike the urban economy during the post-reform
period, the urban attracts more private investment than the rural areas. That is why
growth remains concentrated in urban areas of most of the states. Urban areas are viewed
as the growth pole of the economy. But the fruits of growth reach a small section of
population in the urban areas of most of the states.
Table-20.4 derived below presents basic information on population, mean consumption

expenditure and inequality in the distribution consumption expenditure from 1970-71 till
2009-10. To obtain consumer expenditure at constant prices, the consumer price index of
agricultural labourers (CIPAL) as the deflator in the rural areas, and the consumer price
index of industrial workers (CPIIW) in the urban areas have been considered. It can be
seen from the table that there has been a small but steady increase in mean per capita
expenditure over the reference years, with inequality, as measured by using Gini
coefficient, displaying a sudden spurt in urban India in the 2000s-plausibly the result of a
combination of liberalized economic policy and increases in government salaries
following on the implementation of the recommendations of two pay commissions of the
government.
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Table-20.4: Data on Population, Mean Consumption Expenditure, and Inequality

in the Distribution of Consumption Expenditure in India
Year Population Mean Consumption Gini Coefficient2
(in 000s) Expenditure1
Rural Urban Rural Urban Rural Urban
1970-1971 4,39,046 1,09,114 18.99 28.42 0.2889 0.3469
1972-1973 4,50,833 1,17,716 19.55 30.64 0.3067 0.3446
1977-1978 4,96,830 1,42,307 21.32 29.66 0.3420 0.3480
1983 5,43,330 1,69,693 21.54 30.29 0.3162 0.3392
1987-1988 5,95,213 1,98,232 24.34 34.01 0.3016 0.3568
1993-1994 6,60,900 2,36,233 24.51 39.37 0.2855 0.3442
1999-2000 7,30,353 2,78,395 27.14 44.28 0.2630 0.3465
2004-2005 7,77,563 3,19,532 28.31 44.88 0.3048 0.3759
2009-2010 8,23,566 3,66,836 31.26 54.69 0.2992 0.3932
Note: 1. MCE is calculated at 1960-61 constant prices (INR); 2. Distribution of

consumption expenditure
Source: Jayaraj & Subramanian, Economic and Political Weekly, November, 2012.
Activity-1
Collect the recent quinquinnial round of NSSO report. Examine the state wise inequality
from the report.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
Activity-2
Study the level of poverty from the NSSO report. Make an analysis of the table in your
own words.
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
20.5 MEASURES OF INEQUALITY
The inequality measures are broadly classified into two categories viz. (i) the positive
measures which make no explicit use of any concept of social welfare, (ii) the normative
measures which are based on some explicit formulation of the social welfare function and
loss of welfare incurred due to unequal distribution of income in the society.
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Business Economics
20.5.1 Positive measures of inequality:

The different inequality indices found in the literature are defined in terms of income
distribution. Let the vector y   y1 , y 2 ... , y n  denote an income distribution among
‘n’ persons, where yi  0 is the income of ith person i  1,2,..., n . Let the arithmetic
n
1
mean income of the distribution be, so that  
n
y
i 1
i . Henceforth, ‘y’ is the vector
of all possible income of a profile having a discrete income distribution.
(a) The Range

It is defined as the difference between the highest and the lowest income divided by the
mean of the income profile (distribution). It is the simplest positive measure of inequality
and is denoted as
Max yi  Minyi
i i
R= (20.1)

where μ is the average income of the income profiles. It’s value lies between zero
(perfect equality) and ‘n’ (perfect inequality). The major problem with range as a
measure of inequality is that it ignores the entire distribution in between the extreme
values. Hence, fails to satisfy many desirable properties of an inequality measure.
(b) Measures based on income shares of selected ordinal groups:

The most widely used measures of inequality of this category are the ratios of shares of
total income held by two different income groups, such as the ratio of the upper and the
lower 25 per cent income distribution (quartiles), the upper and the lower 20 per cent of
the income distribution (quintiles) and the upper and the lower 10 per cent of the income
distribution (deciles) and also the method of percentiles. Such ratios are popularly known
as rich-poor gap ratio. Changes in the lower/upper brackets of the income profile are of
primary interest for policy formulation. Such measures, however, do not meet the
principle of transfers. Bhattacharya and Iyengar (1961) used the ratios of selected
percentiles to the arithmetic mean to study inter-temporal changes in the distribution of
persons by monthly per capita consumer expenditure.
(i) Bowely’s quartile measure: Bowely (1937) proposes a quartile measure of inequality
which is denoted as
Q 3  Q1
BQM =
Q 3  Q1
(20.2) where Q1 and Q3 are the first and the third quartiles respectively. It is a measure of
relative dispersion and is independent of units of measurement.
(ii) Normalized inter-quartile range: Taussig (1948) proposed the following measure of
inequality which is denoted as
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Q 3  Q1
TIR = (20.3)
Q2
where Q1, Q2 and Q3 are the first, second and third quartiles respectively. It suffers the
same defects as BQM (Bowely’s Quartile Measure).
(iii) Taussig’s percentile measure: Taussig (1949) considers another non-parametric

measure of skewness based on percentiles as a measure of income inequality which is as
follows:
P80  P50
TPM = (20.4)
P50  P10
where P10, P50 and P80 are the 10th, 50th and 80th percentiles respectively. Taussig argued
that this measure is a useful supplement to Gini Coefficient and Variance of Logarithms
as it is sensitive to the lowest and the highest levels of income.
(iv) Lydall’s percentile measure: Lydall’s Percentile (LP) Measure is defined as the ith
percentile (Pi) from the top of the income distribution expressed as the percentage of the
50th percentile or the median of the income distribution and it is denoted as follows:
LPi = 100 Pi / P50 (20.5)
So LP20 and LP40 indicate about the relative dispersion at the lower tail whereas LP 80, LP90
and LP95 indicate about the relative dispersion at the upper tail of the income distribution.
Generally, Lydall’s percentile measures are calculated with the help of log-linear
interpolation.
(v) Kusnet’s index: Kusnet’s index of income inequality is obtained by taking the sum of
the absolute value of the difference between the proportions of income units and it’s
corresponding income shares in different income brackets and dividing the sum by two
(Kusnets, 1963). It is written as
k
KI= 1/2 p
i
i  qi (20.6)
where pi (=ni/n) and qi (=yi/Y) are the population and income share respectively of the ith
group and Y is the total income of the income profile. This measure is also called the
maximization equalization percentage. It indicates the percentage of total income that has
to be transferred from one group to another in order to bring about perfect equality of
incomes. If the multiplier ‘1/2’is disregarded and ‘KI’ is expressed in percentage, then it
is called as the total disparity measure. Although the measure is simple and appealing, it
has the shortcoming that one percentage of income taken from the rich has the same
impact on inequality as same one percentage of income given to the poor.
(vi) Theil’s Entropy index: There are two inequality measures proposed by Theil (1967).
The first is Theil’s entropy index T based on the notion of entropy in information theory.
It is defined as
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Business Economics
n
1 yi yi
T 
n

i 1 
log

(20.7)
n
where n  y i  Y is total income and  y i /   is simply the slope of the Lorenz
i 1
curve at the percentile corresponding to income level y i . Hence, ‘T’ can be computed
directly from the Lorenz curve of the income distribution.
(vii) The Gini coefficient: The most common definition of the Gini coefficient is in terms
of the Lorenz diagram. It is the ratio of the area between the Lorenz curve and the line of
equality, to the area of the triangle below this line. In measures derived below individuals
are labeled in non-descending order of income so that y1  y 2  ...  y n .
(a) Kendall and Stuart (1963) define the Gini coefficient as one-half the relative mean
difference, that is, one-half the average value of absolute differences between all pairs of
incomes divided by the mean income. Thus,
n n
1
G1 
2n 2 
 y
i 1j 1
i  yj (20.8)
This definition implies that 2n G1 is the sum of every element of the symmetrical n 
2
n matrix whose (i,j)th elements is y i  y j .
(b) Sen (1973) defines the Gini coefficient using rank order weights to individuals
labeled in non-descending order of income. As per Sen’s definition the Gini coefficient
is
n
1 2
G2  1   2
n n 
 (n  1  i ) y
i 1
i
n 1 n
 n  1  i  y
2
  2 (20.9)
n 
i
n i 1
This form makes clear the income-weighting scheme in the welfare function behind the
Gini coefficient. Rank-order weights are applied to different people’s income levels so
that the poorest person receives a weight of n, the ith poorest person a weight of (n + 1 –
i), and the richest (or nth poorest) person a weight of unity.
20.5.2 The normative measures:

In the preceding sub-section only positive measures of inequality which makes no
explicit use of any concept of social welfare are examined. Dalton (1920) was the first to
argue that the choice of any inequality measure involves an implicit normative judgment
as to whether one income profile is to be preferred in some sense to another. He was then
argued that the normative criteria concerning measures of inequality should be made
explicit through the use of a social welfare function (SWF) which simply ranks all
possible states of the income profiles in the order of the society’s preference. This
308
Inequality of
Income
approach is based on individual preferences to derive a social ranking of different income

profiles, and hence some implicit measure of inequality based on social values. This
section deals with some of the following widely referred normality inequality measures.
(i) Atkinson’s measure: Atkinson (1970) argued that Dalton’s measure is not invariant
under any positive linear transformation of the utility function. He modified Dalton’s
measure of inequality to rectify this defect. Atkinson defined the ‘equally distributed
equivalent income  ye  of a given profile of a total income as that level of income which
if enjoyed by every unit would result total welfare exactly equal to the total welfare
generated by the actual profile. The inequality measure proposed by Atkinson is equal to
one minus the ratio of the equally distributed equivalent level of income  ye  to the
mean income () of actual income profile. It is denoted by
ye
A 1 (20.10)

Following Dalton, Atkinson assumes a utilitarian additive welfare function given by
n
w   u y 
i 1
i i (20.11)
where u i  y i  is the utility function (of income) of the ith individual having income yi
and is assumed to be homothetic and symmetric. By symmetry of the utility function we
mean,
ui  yi   u  yi   i  1,2,..., n (20.12)
and by homothetic of the utility function, we mean,
u  y i  y 
 f i  for i  j
u  y j 
(20.13)
y 
 j 
(ii) Sen’s measure: Sen (1973) extended Atkinson’s concept to a situation where welfare
functions are neither additive nor individualistic but depends simply on the income levels
of the individuals. The welfare function is
w  w y1 , y 2 , ..., y n  (20.14)
where
(i.) ‘w’ is a increasing function in individual incomes.
(ii.) ‘w’ is symmetric i.e. w(PY) = w(Y) for any permutation
matrix ‘P’ of order ‘n’.
(iii.) ‘w’ in strictly quasi concave i.e.
w x  1    y  min wx , wy 
for all x, y  Y and 0    1 .
Sen defines a more general measure of inequality as
yf
S  1 (20.15)

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Business Economics
20.6 LORENZ CURVE AND THE INEQUALITY MEASURES
Most of the important results in inequality measurement, and many inequality indices
themselves, are based on the Lorenz curve for an income distribution. The Lorenz curve
for a continuous income distribution is specified by an income density function, f  y  .
Let F  x    f  y  dy
x
be the cumulative population share corresponding to income
o
level ‘x’, so that F(x) is the proportion of the population that receives income less than or
equal to ‘x’. Let  x   1 /   yf  y  dy be the cumulative income share
x
0

corresponding to income level x, where    yf  y  dy is the mean of the income
0
distribution. This defines an implicit relation between ‘F’ and ‘’ in terms of the
parameter x. The graph of F(x) against (x) is said to be the Lorenz curve of the income
distribution, f(y).
Alternatively, starting with the pth percentile in the income distribution, we can define x
as the income level which cuts off the bottom p percent, that is,
p  F x  or x  F 1  p  . The income share of the bottom ‘p’ percent in the
 
distribution is then L(p) =  F 1  p  . This function gives the Lorenz curve of the
distribution, L (p), which shows the cumulative income share corresponding to percentile
p 0  p  1. It is easy to check the following propositions, which are illustrated in
figure-1.
i. 0  F  1 , 0    1 ; F 0  0  0, F     1.
ii. The Lorenz curve L p  0  p  1 is convex, and it’s derivative is given by
F 1  p 
L  p   . Where x  F 1  p  is the income level which cuts off the
x

 
bottom ‘p’ percent.
iii. The slope of the Lorenz curve equals unity at the percentile, p   F   , so that
the fraction of the population receiving income less than or equal to the mean ‘’ can be
read off immediately.
The Lorenz curve corresponding to the distribution in which everyone receives the same
income is the line OD in Figure-20.1. This is referred to as the line (or diagonal) of
perfect equality or the egalitarian line. There are several inequality indices which attempt
to measure the divergence between the Lorenz curve for a given income distribution and
the line of perfect equality. The best known and most widely used among these is the
Gini coefficient. It is described below together with some other indices based on the
Lorenz diagram.
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Inequality of
Income
20.6.1 Gini coefficient and the Lorenz curve:

An illuminating manner of viewing the Gini coefficient is in terms of the Lorenz curve
due to Lorenz (1905). It is generally defined on the basis of the Lorenz curve. It is
popularly known as the Lorenz ratio. The most common definition of the Gini coefficient
is in terms of the Lorenz diagram is the ratio of the area between the Lorenz curve and
the line of equality, to the area of the triangle OBD below this line (figure-20.1). The
Gini coefficient varies between the limits of 0 (perfect equality) and 1 (perfect
inequality), and the greater the departure of the Lorenz curve from the diagonal, the
larger is the value of the Gini coefficient. Various geometrical definitions of Gini
coefficient discussed in the literature and useful for different purposes are examined here.
An alternative definition for the Gini coefficient can be specified in algebraic terms as
G
1
 /   (20.16)
2
 
where     x  y f  x  f  y  dx dy is the absolute mean difference (Kendall
0 0
and Stauart, 1963). Thus G can also be defined as one-half the relative mean difference.
 (1,1)
(0,1)
Figure-20.1: The Lorenz diagram

P
(1,0)
O F
P*=F
()
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Business Economics
 1
Cumulative Income Share

i + 1
0
O F1 Fi + 1 1 F
Cumulative Population Share
Figure-20.2 The Lorenz Curve for a Discrete Income Distribution

It is shown that G1 is equivalent to the geometric definition of the Gini coefficient (Gini,
1921) given below.
n 1
G1  1   F
i0
i 1  Fi   i 1   i  (20.17)
Figure-20.2 illustrates the Lorenz curve for the discrete income distribution,
y   y1 , y 2 , ..., y n  where y1  y 2  ...  y n . The shaded part shows a typical
segment of the area below the Lorenz curve. The total area below the Lorenz curve is
n 1
 F  Fi   i  1   i 
1
 i 1
2 i0
(20.18)
Therefore, the Gini coefficient, G1 is written as
1 1 1 n  1 
G1     Fi  1  Fi   i  1   i 
1/ 2  2 2 i  0 
n 1
 1  F
i0
i 1  Fi   i  1   i  (20.19)
The Gini Coefficient, G2 defined above was further simplified by Rao (1969) as
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Inequality of
Income
n 1
G2   F 
i0
i i 1  Fi  1  i  (20.20)
The above two measure – G1 and G2 are, generally, used for computing Gini coefficient
from grouped data.
20.6.2 The decomposition of inequality by population sub-groups:

One of the most interesting questions in applied inequality studies is the contribution of
different population subgroups to overall inequality. Suppose if the population was
subdivided by occupation, it might be important to know how much of the overall
inequality was caused by the differences between different occupational groups and how
much by the difference within the occupational groups. Inequality measures that are
additively decomposable are designed to answer such questions. An additively
decomposable inequality measure is one for which total inequality in the population can
be expressed as the sum of the inequality existing within the subgroups of the population
and of the inequality existing between the (same) subgroups. Such measures have
obvious attraction as they permit judgment on the relative influence of population
subgroups in determining overall inequality and also have some importance in the
identification of such measures. Since, every additively decomposable index will not
necessarily be satisfactory index of inequality, therefore, it is important to identify such
measures which also satisfy the desirable properties like scale invariance, population
homogeneity, principle of transfer etc. The problem of identifying the class of additively
decomposable inequality measures has been addressed by a number of researchers.
20.6.3 The decomposition of inequality by factor components:

In the previous section, we have examined the decomposition of an aggregate inequality
index in term of a set of collectively exhaustive and mutually exclusive population sub-
group additively decomposable inequality indices by allowing overall inequality to be
decomposed into ‘within subgroup’ and ‘between subgroup’ contributions. A different
question relating to inequality decomposition is the contribution of inequality in the
distribution of different types of income (wage and salary, property, investment, etc.) to
the inequality in distribution of the total income. For example, one might be interested to
know the contribution inequality in the distribution of wage income to overall inequality.
20.7 LET US SUM UP

 The existence of large disparities in living standards between regions and
between classes of people is widely believed to be an important cause of
prevailing social tensions and unrest.
 Many hold the view that inequalities are growing and this trend, if unchecked,
would aggravate tensions and endanger the country’s stability. The precise
relationship between economic inequalities and socio-political tensions may be
debatable. But there can be no denying that the prevalence of inequalities
constitutes a major problem.
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Business Economics
 Practically every shade of political opinion is exercised about it. Development

policies of the Government are increasingly judged not merely by their success
in achieving a rapid expansion of aggregate real output but also in terms of how
the fruits of development are distributed between different classes and regions.
 It is public policy that matters: policy directly aimed at reducing inequality such
as socialism or welfarism or a combination of the two. Market or state-mediated
polices aimed at producing economic growth, including the promotion of
education and economic freedom may not help to reduce income inequality.
 Prospects are rather dim for reduced income/ wealth inequalities because
include there is no convincing evidence that economic growth per se could
lower income and wealth inequalities. The acceptance and emulation of
socialism and / or welfarism on the decline, institutions that work for the decline
of inequalities such as land reform and fully Government funded public and
social services get marginalised.
 In the face of increasingly free global investment and trade flows, and the
relatively negligible freedom for the flow of manpower, there is no prospect of
the continuing partial globalisation to be a moderating force on inequalities. If
anything, politicians and policy advisers could conveniently plead helplessness
and point to the compulsions of globalisation.
 Within Asia and probably elsewhere as well, a change that could eventually
legitimize growing inequalities is the rapid growth of China coupled with
growing income inequality, heralding perhaps a new brand of socialism.
20.8 KEY TERMS
 Consumption expenditure  National sample survey organization

(NSSO)
 Inequality of income  Gini coefficient
 Lorenz curve  Poverty
 Measures of inequality  Welfarism

 Ahluwalia, M.S., (1978), Rural Poverty and Agricultural Performance in India,
Journal of Development Studies, Vol. 14.
 Anand, S and Kanbur, S.M.R. (1993), The Kuznets Process and the Inequality-
development Relationship, Journal of Development Economics, Vol. 40.
 Atkinson, A.B., (1987), On the Measurement of Poverty, Econometrica, Vol. 55,
pp. 749-64.
 Deton, A. and Dreze, J. (2002), Poverty and Inequality in India: A
Reexamination, Economic and Political Weekly, September 7.
314
Inequality of
Income
 Jayaraj, D. and Subramanian, S. (2012), On the Interpersonal Inclusiveness of

India’s Consumption Expenditure Growth, Economic and Political Weekly, Vol.
XLVII, No. 45.
 Kuznets, Simon (1955), Economic Growth and Income Inequality, American
Economic Review, March, pp.18.
 Sarangi, P. and Panda, B.K (2010), Inequality and Consumption in Orissa,
Discovery Publishing House, New Delhi.
 Sen, A.K. (1976), Poverty: An Ordinal Approach to Measurement,
Econometrica, Vol. 44, No. 2, (reprinted in Sen [1982]), pp. 219-31.
 World Bank (2000), World Development Report 2000/2001: Attacking poverty,
Oxford University Press, Oxford.

1. Define Inequality. Explain few normative measures of inequality.
2. Define poverty. Explain in your own words that how poverty leads to
inequality.
3. ‘It has been said by the experts that the economic inequality in India is
increasing gradually’. Examine this statement with the help of few reports
available in the literature.
4. ‘Indian economy leads to capitalistic economy’. Due you agree with this
statement. Opine.
5. What may be the consequences of increasing inequality in a country? State in
your own words.
6. What measures, being a leading economist of the country, you suggests for
India to counter act income inequality?
7. Formulate a consumer expenditure questionnaire. Gather 20 samples in and
around you. Examine the disparity in consumption expenditure.
8. Do you agree with the concept that ‘the poorer are becoming poorer and the
richer are becoming richer in India’? Validate your answer with proper logic.
9. Read few journals related to economics. Search the experts view on recent
changes in the world inequality scenario.
10. Make a detailed analysis of the table-no-20.4 incorporated above. What
conclusions you can draw from the table?
315

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BUSINESS ECONOMICS

Under Graduate Commerce Programmes

Centre for Distance and Open Learning

Prof. Talat Ahmad Prof. M. Mujtaba Khan

Prof. Mohammad Miyan Mr. Prashant Negi

Prof. Y.P. Singh Dr. Arvind Kumar

Prof. K.V. Bhanu Murthy Dr. Ritu Sapra

Prof. Madhu Tyagi Dr. Sunayana

Prof. Attam Prakash

Dr. Prashant Sarangi, Assistant Professor, APJIT, Noida, Uttar Pradesh,

Prof. Talat Ahmad Prof. M. Mujtaba Khan

Prof. Mohammad Miyan Mr. Prashant Negi

Prof. Y.P. Singh Dr. Arvind Kumar

Prof. K.V. Bhanu Murthy Dr. Ritu Sapra

Prof. Madhu Tyagi Dr. Sunayana

Prof. Attam Prakash

Dr. Prashant Sarangi, Assistant Professor, APJIT, Noida, Uttar Pradesh,

Block: 1 Fundamental Problems of Economic Systems and Basic Concepts

Block: 2 Consumer Behavior and the Demand Theory

Block: 3 Theory of Production

Block: 4 Theory of Price

Block: 5 Distribution of Income

Fundamental Problems of Economic Systems and Basic Concepts

UNIT - 1 FUNDAMENTAL PROBLEMS OF ECONOMIC SYSTEMS

After reading this unit, you should be able to

1.2 CONCEPT OF ECONOMIC SYSTEM AND BUSINESS ECONOMICS

1.3 ECONOMY- AN OVERVIEW

1.3.1 An economy- A system that ensures living to the people

1.3.2 An Economy – As a Cooperation of Producers

Therefore, in the production activity, it is necessary that there should be somebody to

1.3.3 An economy – A system of mutual transaction

2. Division of Labor and Specialization- In traditional economy, natural division

 The revolution in information and communication technology has made it

1.4 PROCESS OF AN ECONOMY

1.5 FUNDAMENTAL PROBLEMS OF AN ECONOMY

1.5.1 What goods to produce?

1.5.2 How to produce the goods

1.5.3 For whom to produce the goods?

1.6 PRICE MECHANISM

1.6.1 Price Mechanism and Determining Techniques

1.6.2 Price Mechanism and Distribution

1.6.3 How effective is the price mechanism

1.7 PRODUCTION POSSIBILITY CURVE

Production possibility curve or PPC is a graphical representation of all the possible

Table 1 Alternative Production Possibilities

A PPC is an economy‟s range of available options. If an economy chooses to produce any

As regard to the third problem, an indication on distribution of national product can be

Basic consumer goods

1.8 LET US SUM UP

Production possibility curve or PPC is a graphical representation of all the possible

1.9 KEY WORDS

 Economics- It is a study of how societies employ restricted resources to produce

1.10 TERMINAL EXERCISES

1.10.1 Objective Questions

2. The central problem relating to allocation of resources are-

4. Wastes of competition are found in

5. Price mechanism is an important feature of

1.10.2 Descriptive Questions

1.11 Suggested Readings

UNIT - 2 BASIC CONCEPTS OF BUSINESS ECONOMICS

Economics is a science of making choices between different alternative uses of the

After reading this unit you should be able to