PAPER 1 : PRINCIPLES OF ECONOMICS AND BANGLADESH ECONOMY

Full Marks : 100

Module A: Concepts of Economics and Demand Supply Analysis
Economics, Scarcity, Opportunity Cost, Micro and Macro Economics 10+10+10+10 20
Law of Demand and Supply, Changes in Demand and Supply10
Demand Supply Interaction, Market Equilibrium 10, Shortage and Surplus, Price Ceiling
and Floor (indifference curve) 12+8
Price Elasticity, Income and Cross Elasticity of Demand 5+15
Module B: Production, Cost and Market structure
Theory of Production and Cost, Law of Variable Proportions, Returns to Scale, Short and
Long-Run Costs. 4+16 8+12
Different forms of Market: Perfect Competition, Monopoly, Oligopoly and Monopolistic
Competition; Their Characteristics and Equilibrium Situations.12+8 8+12
Module C: Macroeconomics
Overview on Macroeconomics; Macroeconomic Goal, Policies and Accounts
Macroeconomic Accounts: National Income Account, Fiscal Account, Monetary Account
and BOP Account.6+6+8 12+8
Macroeconomic Policies and their Interactions 12+8
Module D: Bangladesh Economy
Structure and Macroeconomic Performance of Bangladesh Economy; Savings,
Investment and Capital Formations, Fiscal and Monetary Policies of Bangladesh; 8
Inflation, Unemployment and External Sector Situation of Bangladesh. 12 20 20
References
1 Dornbusch. R, and Fischer, S. Macroeconomics
2 Mishkin, F.S. The Economics of Money, Banking and Financial Market
3 Ministry of Finance, Bangladesh Economic Review
4 Publications of Bangladesh Bank (Economic Trend, Annual Reports and other reports)
3 Samuelson, P.A and Nordhaus, W.D. Economics
 ১। (ক.) অর্থ শাস্ত্র সম্পদের বিজ্ঞান।- আদ াচনা করুন।
(খ.) অর্থ শাদস্ত্রর সাদর্ (১) রাষ্ট্রবিজ্ঞাদনর এিং (২) পবরসংখযাদনর সম্পকথ বিদেষণ
করুন।

২। (ক.) চাবিোর মূ য-বিবিিাপিা ি দি বক িুঝায়? এর ফরমু াটি উদেখ করুন।

(খ.) বনদচ িবণথ ি অিিাত্রদয় বকভাদি মূ য পবরিিথদন ফদ একটি দ্রদিযর চাবিোর
পবরিিথন িয় িা দেখানঃ-
(১) চাবিো সম্পূণথ অবিবিিাপক িদ ,
(২) চাবিো সম্পূণথ বিবিিাপক িদ ,
(৩) চাবিোর বিবিিাপকিা ১-এর সমান িদ ।
- প্রদিযকটি উত্তদরর দেদত্র বচত্র িযিিার করুন।
(গ.) দকাদনা দ্রদিযর একক প্রবি মূ য ৫ টাকা দর্দক ৪ টাকায় হ্রাস পাওয়ার ফদ যবে
দ্রিযটির ক্রদয়র পবরমাণ ৪ একক দর্দক ৫ একদক িৃবি পায়, িদি দ্রিযটির চাবিোর মূ য
বিবিিাপকিা কি িদি।

৩। (ক.) আ দেড মাশথ া কিৃথ ক প্রেত্ত অর্থ শাস্ত্র বিষদয়র সংজ্ঞাটির িণথ না বেন এিং
এর িযাখযা করুন।
(খ.) অর্থ শাস্ত্র অধ্যয়দনর গুরুত্ব আদ াচনা করুন।

৪। (ক.) একটি দিসরকারী এিং এটি সরকারী িযিসায় প্রবিষ্ঠাদনর মূ েযগুদ া

িণথ না করুন।
(খ.) মুনাফা সদিথ াচ্চকরদণর জনয একটি দিসরকারী িযিসায় প্রবিষ্ঠান বক ধ্রদনর িাস্তি
সমসযার সমসযার সম্মুখীন িদয় র্াদক?

৫। (ক.) চাবিোর পবরিিথন’ এিং ‘চাবিোর হ্রাস-িৃবির’ মদধ্য পার্থ কয বক?

(খ.) চাবগো ও দযাগাদনর পারস্পবরক বক্রয়ায় বকভাদি ভারসাময িাজার মূ য
বনরূবপি িয় িা িযাখযা করুন।

৬। (ক.) উভদয়র মূ বিবশষ্ট্যসমূি িণথ নাপূিথক পূণথপ্রবিদযাবগিা ও একদচটিয়া

িাজাদরর মদধ্য পার্থ কয বনদেথ শ করুন।
(খ.) স্বল্পকাদ বকভাদি একটি একদচটিয়া কারিারীর ভারসাময োম এিং উৎপােদনর
পবরমাণ বিবরকৃি িয় িা বচদত্রর সািাদযয দেখান।

৭। (ক.) পূণথ-প্রবিদযাবগিামূ ক িাজাদরর বিবশষ্ট্যগুব বক?

(খ.) পূণথ-প্রবিদযাবগিামূ ক িাজাদর বকভাদি একটি ফামথ িার ভারসাময োম ও
উৎপােন বির কদর র্াদক িা দেখান।

৮। (ক.) পূণথ-প্রবিদযাবগিা ও একদচটিয়ামূ ক প্রবিদযাবগিা িাজাদরর স্বিন্ত্র

বিবশষ্ট্যসমূদির িণথ না বেন এিং উভয় িাজার-িযিিার প্রদিযকটির আওিায় সবক্রয়
অন্তিঃ একটি িযিসার উোিরণ বেন।
(খ.) একটি একদচটিয়া কারিারীর ভারসাময োম ও উৎপােদনর পবরমাণ বকভাদি বিবরকৃি
িয় িা বচদত্রর সািাদযয দেখান।

৯। (ক.) মূ য স্ফীবি ি দি বক িুঝায়?

(খ.) আপনার মদি, িাং াদেদশর িিথমান মূ যস্ফীবির প্রধ্ান কারণসমূি বক?

১০। (ক.) অর্থ শাদস্ত্র “উৎপােন” ি দি বক িুঝায়? একজন িযাংকাদরর জদনয

অর্থ শাদস্ত্রর মূ বিষয়গুদ া জানা জরুরী দকন?
(খ.) বির িযয় ও পবরিিথনীয় িযয় এর িযাখযা বেন এিং একটি বচদত্রর মদধ্য দমাট িযয় দরখা,
দমাট বির িযয় দরখা এিং দমাট পবরিিথনীয় িযয় দরখার সঠিক অিিান দেখান।
(গ.) অর্থ শাস্ত্র মানুদষর বেনবিন জীিদনর সাধ্ারণ কাযথ ািব আদ াচনা কদর। -
উবিটি িযাখযা করুন।

১১। (ক.) খরচ - সুবিধ্া বিদেষণ ি দি বক িুঝায়?

(খ.) একটি িযিসায় প্রবিষ্ঠাদনর জনয খরচ - সুবিধ্া বিদেষণ গুরুত্বপূণথ দকন?

১২। (ক.) দমাট অভযন্তরীণ উৎপােন, দমাট জািীয় উৎপােন ও নীট জািীয় উৎপােন
- এই ধ্ারণাসমূদির িযাখযা বেন।
(খ.) দকানও দেদশর দমাট অভযন্তরীণ উৎপােন পবরমাপ করদি দযসি সমসযার
সম্মুখীন িদি িয় িা আদ াচনা করুন।

১৩। (ক.) ঘাটবি িাদজট ি দি বক িুঝায়?

(খ.) বকভাদি ঘাটবি িাদজদটর অর্থ ায়ন করা দযদি পাদর? িাং াদেদশর ঘাটবি িাদজট
অর্থ ায়দনর বনরীদখ আপনার প্রদের উত্তর বেন।

১৪। (ক.) মূ যস্ফীবি কাদক িদ এিং দকন এর উদ্ভি িয়?

(খ.) সাম্প্রবিক সমদয় িাং াদেদশ উচ্চ মূ যস্ফীবির কারণ েশথ ান এিং প্রবিকার
বনদেথ শ করুন।

১৫। (ক.) িাবণদজযর ভারসাময ও দ নদেদনর ভারসাদমযর মদধ্য পার্থ কয বক?

(খ.) িাং াদেশ িযাংদকর অনুসরদণ িাং াদেদশর দ নদেন ভারসাময বিসাদির একটি
কাল্পবনক বিিরণী বিরী করুন এিং অন্তভথ ূ ি উপাোনগুব র িযাখযা বেন।

১৬। (ক.) সরকার ঋণ গ্রিণ কদরন দকন।

(খ.) িাং াদেশ সরকাদরর ঋণ গ্রিদণর অভযন্তরীণ উৎসসমূি আদ াচনা করুন এিং
দেদশর অর্থ নীবির উপর এসি ঋদণর সম্ভািয প্রভাি িণথ না করুন।

১৭। (ক.) অদর্থ র সংজ্ঞা বেন এিং এর কাযথ ািব আদ াচনা করুন।
(খ.) িাং াদেদশ অর্থ সরিরাদির উপাোনগুদ ার উদেখপূিথক আদ াচনা করুন।

১৮। (ক.) মাত্রাগি উৎপােন প্রিাি ি দি বক িুঝায়?

(খ.) বচদত্রর সািাযয বনদয় ক্রমিধ্থ মান, সমানুপাবিক এিং ক্রমহ্রাসমান মাত্রাগি উৎপােন
প্রিাদির মদধ্যিার পার্থ কয বনদেথ শ করুন।

টীকাসমূিঃ বনদচর দয-দকান চারটির উপর সংবেপ্ত টীকা ব খদি

িদিঃ

নগে অর্থ সংরেণ বিবধ্ (বস. আর. আর); সূচক সংখযা; অর্থ ননবিক প্রাবপ্তর িার; নীট
িিথমান মূ য পিবি; চ বি বিসাদির ভারসাময; মাত্রাগি উৎপােন প্রিাি; CAMELS দরটিং;
বগদফন দ্রিয; বনরদপে দরখা, োম পবরিিথদনর পবরিিথক প্রভাি; উপাোন োদম দমাট
জািীয় উৎপােন; সূচক সংখযা; মুদ্রানীবি, ছদ্ম দিকারত্ম, িাবণবজযক ভারসাময,
দ নদেদনর ভারসাময, মাত্রাগি উৎপােন প্রিাি; একবচটিয়া িযিসা; উৎপােন অদপেক;
বির িযয় ও পবরিিথনীয় িযয়; বনকৃষ্ট্ দ্রিয, অর্থ ননবিক পবরকল্পনা। দভাির উদ্বৃত্ত;
ঘনদ্রিয; ভাসমান বিবনময় িার; মুদ্রার অিচয়।
Q.1 Give an appropriate definition of Economics.

Ans.: The term economics is derived from two Greek words “OIKOS” and “NEMEIN” meaning
the role or law of the household. Economics is the study of now people and society, choose
to employ scarce resources with or without the use of money, that could have alternative
;uses in order to productive ;various commodities and to distribute them for consumption, now
or in the future among various persons and groups in society.

Q.2 How Economics is a Science and Arts?

Ans.: The term science has been defined as the systematized body of knowledge, which
traces the relationship between cause & effect. Applying this definition to economics we find
that economics is that branch of knowledge where the various facts relevant to it have been
systematically collected, classified and analyzed.
An arts is a system of rules for the attainment of a given end. An art isapplication of knowledge
and practical application. Economic has all these feature of being an art.

Q.3 How Economics is as a Normative and Positive Science?

Ans.: It deals with thing as they “ought to be”. It has no objection to discussion the moral
rightness or wrongness of things. Economics is not only explaining facts as they are but
also justifies them. Positive Science deals with things as they are means “What is”. It
explains their causes and effect but it remain strictly neutral as regards ends, it refuses to
pass moral judgments.

Both can be distinguish as follows :

Basis Positive Normative

1.Expresses What is What ought to be
2. Based on Cause & effect of facts & Ethics
3. Deal with Actual or realistic situation Idealistic situation
4. Value judgment Are not given Are given

1. Positive economics deals with what is while normative economics deals with what should
be.
2. Positive economics deals with facts while normative economics deals with opinions on
what a desirable economy should be.
3. Positive economics is also called descriptive economics while normative economics is
called policy economics.
4. Positive economic statements can be tested using scientific methods while normative
economics cannot be tested.

Scope and Meaning of Economics:-

The subject of economics is concerned with the satisfaction of human materialistic wants. It
also deals with economic problems that arise out of making a choice. These are choice of
goods and choice of technique. The problem of choice of goods arises because of _ 1.
multiplicity of wants. 2. Wants can be arranged in the order of their importance. 2.
Resources are scarce.
Economic problems relating to choice of technique arise because factor of production have
alternative uses. The root cause of an economic problem is the scarcity of resources and
the study of economics is concerned with economizing resources. How to make best uses
of resources. Thus according to Somuelson. The subject of economics is concerned with a
following fundamental problem:-
1. What to produce:- This is the major problem in front of the nation. A country has to decide
the type of product and the amount of the product to be produced by utilizing the limited
resources as its disposal. Here the firm need to decide between_
a. Choice between Consumption goods and Capital Goods.
b. Choice between Civil goods and War goods.
c. Choice between Mass goods and Luxury goods.
d. Choice between Private goods and Public goods.
2. How to produce:- How to produce is essentially a problem of choice of technique. If the
country is advanced in its technological knowledge then it may produce more production
with less fact0r of production and vice versa.
3. For whom to produce:- This is a problem related to distribution of national income among
different factors. In other words it is the problem of how much share each factor should be
provided in return of their services in the process of production.
According to ‘Hipsey’ besides the above mentioned fundamental problems other important
problems are_
1. How to achieve full employment
2. How to achieve faster growth.
3. How to achieve efficiency.
4. Productive efficiency.
5. Distributive efficiency.

Conclusion: Thus, Scarcity of resources is the root cause of all economic problems. The
subject economics is concerned with economizing resources.

Consumer’s equilibrium: - “A consumer is said to be equilibrium when he gets maximum

level of satisfaction by spending his limited income on purchase of any two goods”. A
rational consumer will therefore attempt to reach the highest possible indifferent curve and
try to obtain maximum level of satisfaction by spending his limited income.
The conditions or assumption of Consumer Equilibrium are _
Consumer equilibrium can be explained by making the following assumption”:-
1. A consumer has a scale or preference for different combination of any two goods and it
remain constant throughout the analysis.
2. A consumer has a fixed amount of income to be spend on any two goods and he is spent
his entire income on the purchase of the two goods and does not save any part of his
income.
3. Prices per unit of two goods X and Y are given and remain constant throughout the
analysis.
4. The two goods are perfectly divisible and substitutable to some extent.
5. All the units of goods are homogeneous.
6. Consumer is a rational person & attempts to get maximum level of satisfaction.

Income Elasticity of Demand.

Income Elasticity of Demand refers to the Degree of responsiveness of demand for a

commodity due to a change in consumer’s income. The formula for measuring income
elasticity of demand is as follows.
Ey = Percentage change in the quantity demanded
Percentage change in income.

Ey = ^Q X Y
^Y Q

Where:- Ey = Income elasticity of demand.

Q = original demand
Y = original income
^Q = Change in Demand
^Y = Change in Income
Practical uses of concept of elasticity of Demand.
1. Useful to Businessman:- It guides the businessman in fixing the price of his goods. He
can raise the price of those goods having inelastic demand and earn more profit. It is very
helpful to monopolists to maximize their profit.
2. Government Taxation Policy: While imposing taxes on commodities, the Finance Minister
has to keep in mind the elasticity of demand for a commodity. If he levies taxes on goods
which have elastic demand, it is not profitable for Government.
3. Price determination of joint products: In case of joint products like cotton and cotton
seeds, wool and mutton, etc. it is not possible to calculate the cost of production separately
as they are supplied together. Therefore, the price of each product depends on the elasticity
of demand.
4. Determination of wages: Industrial workers get higher wages, if the product produced by
them has inelastic demand. Because the producer is able to pay higher wages by fixing
higher price for the product which ha inelastic demand. If the demand is elastic, trade
unions cannot get their wages raised.
5. Pricing under monopoly:- Under discriminating monopoly the monopolist charges different
prices in different markets on the basis of elasticity of demand.
Features of Monopolistic Competition.
Monopolistic competition:- Monopolistic competition refers to a market where many sellers
sell similar but differentiated product to a large number of buyers. In a monopolistic
competition market, many monopolistic firms compete with each other by producing same
but differentiated products.
For example, companies selling toothpaste products like Colgate, Pepsodent, Close-up, etc.
fall under Monopolistic competition.
1. Large number of Sellers:- In a monopolistic competition market, there are large number of
sellers. Hence no single seller can control the market supply. Each seller follows his own
course of action. In other words each seller is independent.
2. Product differentiation:- Product differentiation is the most important feature of
monopolistic competition. Since all sellers sell the product which are perfect substitutes for
each other, they go for product differentiation. Every seller makes efforts to show that his
product is superior to other product. This differentiation is done through Advertisement,
brands, trademarks, designs, packaging, color etc. Thus the products are not homogeneous
under monopolistic competition.
3. Selling costs:- One of the unique features of monopolistic competition is its selling cost.
Selling cost is the cost incurred by the seller on sales promotion activities like
advertisement, salesman’s service etc. Selling cost enables the seller to persuade buyers to
buy their products than products from other sellers.
4. Large number of buyers:- There are large number of buyers in a monopolistic competition
market. Thus the buyers purchase goods by choice and not by chance.
5. Free exist and entry:- There is free entry and exist of firms under monopolistic
competition. There are no barriers for the firm to enter. Since each firm produces a product
which is little different from others, there is no possibility of more firms entering the market.
6. Competition :- Competition under monopolistic market is more as all the firms sell close
substitutes. But the competition is in two dimensional:
1. Price Competition under which the firms were compete with each other by reducing their
products price.
2. Non-price competition under which they compete through advertisement, and sales
promotion activities, etc.

Features of Monopoly market.

Monopoly:- Monopoly is a type of market in which there is only one seller producing a
commodity having no close substitute.
1. Single Seller:- In this type of market, there is only one seller producing a particular
commodity.
2. No substitutes:- Monopoly not only implies a single seller but it also means a single seller
producing a commodity having no close substitutes. If the substitutes are available, there
will be a competition among the firms. Monopoly means a complete absence of competition.
So under monopoly, the commodity has no close substitutes.
3. No distinction between a firm and industry:- Since there is only one seller of a commodity,
there is only one firm producing that commodity in the market. So there is no distinction
between the concepts of industry and firm under monopoly.
4. No free entry and exist:- In the monopoly market, there are strong barriers to the entry of
a new firm in the market. This prevents new firms from entering the market and so there is
only one firm producing that commodity.
5. Large number of buyers:- Under monopoly there are large number of buyers in the
market who compete with one another.
6. Downward sloping demand curve:- The demand curve of the monopoly firm slopes
downward indicating that the monopolist can maximize sales only by reducing the price.
Scarcity is the fundamental economic problem of having seemingly unlimited human wants
and needs in a world of limited resources. It states that society has insufficient productive
resources to fulfill all human wants and needs. Alternatively, scarcity implies that not all of
society's goals can be pursued at the same time; trade-offs are made of one good against
others. In an influential 1932 essay, Lionel Robbins defined economics as "the science
which studies human behavior as a relationship between ends and scarce means which
have alternative uses."[1]

More clearly scarcity is our infinite wants hitting up against finite resources

Goods (and services) that are scarce are called economic goods (or simply goods if their
scarcity is presumed). Other goods are called free goods if they are desired but in such
abundance that they are not scarce, such as air and seawater.

Opportunity cost is the cost of any activity measured in terms of the value of the next best
alternative forgone (that is not chosen). It is the sacrifice related to the second best choice
available to someone, or group, who has picked among several mutually exclusive
choices.[1] The opportunity cost is also the "cost" (as a lost benefit) of the forgone products
after making a choice. Opportunity cost is a key concept in economics, and has been
described as expressing "the basic relationship between scarcity and choice".[2] The notion
of opportunity cost plays a crucial part in ensuring that scarce resources are used
efficiently.[3] Thus, opportunity costs are not restricted to monetary or financial costs: the real
cost of output forgone, lost time, pleasure or any other benefit that provides utility should
also be considered opportunity costs.

Explicit costs

Explicit costs are opportunity costs that involve direct monetary payment by producers. The
opportunity cost of the factors of production not already owned by a producer is the price
that the producer has to pay for them. For instance, a firm spends $100 on electrical power
consumed, their opportunity cost is $100. The firm has sacrificed $100, which could have
been spent on other factors of production.
Implicit costs

Implicit costs are the opportunity costs in factors of production that a producer already
owns. They are equivalent to what the factors could earn for the firm in alternative uses,
either operated within the firm or rent out to other firms. For example, a firm pays $300 a
month all year for rent on a warehouse that only holds product for six months each year.
The firm could rent the warehouse out for the unused six months, at any price (assuming a
year-long lease requirement), and that would be the cost that could be spent on other
factors of production.

Criticism of opportunity cost:

1. There are some elements which are used in an specific industry and can’t be used in
any other industries. As such, those elements does not have any opportunity cost.
2. It is useful only in the perfectly competitive market. Other wise, this cost is not
included in production cost.
3. This cost is based on the assumption that utility can be measured in terms of money
because to measure opportunity cost of not supplementary goods can’t be
ascertained without the help of the price of goods.

Economics, Scarcity, Opportunity Cost, Micro and Macro Economics

Microeconomics (from Greek prefix mikro- meaning "small" and economics) is a branch of
economics that studies the behavior of individual households and firms in making decisions
on the allocation of limited resources (see scarcity).[1] Typically, it applies to markets where
goods or services are bought and sold. Microeconomics examines how these decisions and
behaviors affect the supply and demand for goods and services, which determines prices,
and how prices, in turn, determine the quantity supplied and quantity demanded of goods
and services.[2][3]

Macroeconomics (from the Greek prefix makro- meaning "large" and economics) is a
branch of economics dealing with the performance, structure, behavior, and decision-
making of an economy as a whole, rather than individual markets. This includes national,
regional, and global economies. Macroeconomists study aggregated indicators such as
GDP, unemployment rates, and price indices to understand how the whole economy
functions. Macroeconomists develop models that explain the relationship between such
factors as national income, output, consumption, unemployment, inflation, savings,
investment, international trade and international finance

Macro Vs Micro

Microeconomics focuses on the market’s supply and demand factors, and determines the
economic price levels.
Macroeconomics is a vast field, which concentrates on two major areas, increasing
economic growth and changes in the national income.

Microeconomics is more mathematical and based on individual situations.

Macroeconomics is based more on concepts and theories on economy as a whole

Microeconomics and macroeconomics are important studies within economics, which are
essential to sustain the overall growth and standard of the economy. While the two studies
are different, with microeconomics focusing on the smaller business sectors, and
macroeconomics focusing on the larger income of the nation, they are interdependent, and
work in harmony with each other. The main differences are:

1. Definitional Difference
2. Difference in variables related
3. Equilibrium Analysis: Partial Vs Complete analysis
4. Circumstances:
5. Compound variable:
6. To the point analysis:
7. Linking with other aspects
8. Country scenario
9. Assumptions using:

1. Microeconomics focuses on the market’s supply and demand factors, and determines the
economic price levels.

2. Macroeconomics is a vast field, which concentrates on two major areas, increasing

economic growth and changes in the national income.
3. Microeconomics facilitates decision making for smaller business sectors.

4. Macroeconomics focuses on unemployment rates, GDP and price indices, of larger

industries and entire economies.

Microeconomics and macroeconomics are the fundamental tools to be learnt, in order to

understand how the economic system is administered, and sustained.
Law of Demand and Supply, Changes in Demand and Supply

In microeconomics, supply and demand is an economic model of price determination in a

market. It concludes that in a competitive market, the unit price for a particular good will vary
until it settles at a point where the quantity demanded by consumers (at current price) will
equal the quantity supplied by producers (at current price), resulting in an economic
equilibrium for price and quantity.

The four basic laws of supply and demand are

1. If demand increases and supply remains unchanged, a shortage occurs, leading to a

higher equilibrium price.
2. If demand decreases and supply remains unchanged, a surplus occurs, leading to a
lower equilibrium price.
3. If demand remains unchanged and supply increases, a surplus occurs, leading to a
lower equilibrium price.
4. If demand remains unchanged and supply decreases, a shortage occurs, leading to
a higher equilibrium price.

What is Demand?
The demand for any commodity at a given price is the quantity of it which will be bought per
unit of time at that price.

Elements of Demand: According to the definition of demand here are three elements of
demand for a commodity:-

(i) There should be a desire for a commodity.

(ii) The consumer should have money to fulfill that desire.
(iii) The consumer should be ready to spend money on that commodity.
Thus we can define demand as the desire to buy a commodity which is backed by sufficient
purchasing power and a willingness to spend.

What are the Determinants of Demand?

There are many economic, social and political factors which greatly influence the demand
for a commodity. Some of these factors are discussed below:

1) Price of the Commodity

2) Price of Related Goods
a) Complementary Goods
b) Substitute Goods
c) Supplementary Goods
3) Level of Income and Wealth of the Consumer: Income of buyer
a) Necessaries
b) Inferior goods
c) Luxuries
4) Tastes and Preference
5) Government Policy: Fiscal policy of government: Tax/Vat imposing
6) Other Factors:
a) Size and Composition of Population: Change in population/ Number of potential
consumers
b) Distribution of Income and Wealth
c) Economic Fluctuations/ Trade and business condition: boom or recession
7) Change in season: rainy, cold
8) Tendency to Savings :
9) Consumers' expectations about future prices and incomes that can be checked

What is the Law of Demand?

The law of demand states that, other things being equal, the demand for a good increase
with a decrease in price and decreases in demand with an increase in price.

The term other things being equal implies the prices of related goods, income of the
consumers, their tastes and preferences etc. remain constant.
Equation:

𝑄𝑑 = 𝑓(𝑝)

Assumptions of law of demand:

1. Buyers habit and taste will not change

2. Income unchanged
3. Price of other commodities will not change
4. No of buyers will not change
What are the exceptions to the Law of Demand?

Exceptions to the law of demand refer to such cases where the law of demand does not
operate, i.e., a positive relationship is established between price and quantity demanded. The
exceptions are:

1. Possibility of future price increase/ Future Expectations About Prices

2. Income change
3. Environmental reasons/ Emergency: epidemics
4. Change in habit and taste
5. Change in Fashion
6. Giffen goods/ common necessity goods: Sir Giffen made an interesting observation
in 1845 during famine in Ireland. When price of potatoes went up, poor people
purchased more quantity of potatoes instead of less quantity as expected from the
law of demand. The reason was that between two items of food consumption meat
and potatoes- potatoes were still cheaper, with the result that the poor families
purchased more of potatoes and less of meat. This is known as Giffen effect which is
seen in cheap necessary foodstuffs. Again, the word ‘Giffen’ is not synonymous with
‘inferior’. It simply refers to those goods which have a positive relationship with price.
7. Luxury goods/ Conspicuous Necessities
8. Ignorance of buyers/ Ignorance: thinking that high price means quality good
9. Complementary goods/ Conspicuous Goods or Goods of Ostentation:

What is a Demand Curve?

Demand Curve is simply a graphic representation of demand schedule. It expresses the

relationship between different quantities demanded at different possible prices of the given
commodity.

i) Individual Demand Curve: The graphic representation of Individual

Demand is known is Individual Demand Curve. Thus individual demand curve is
the one that represent different quantities of a commodity demanded by a
consumer at different prices.
 ii) Market Demand Curve: The graphic representation of market demand
schedule is known as Market Demand Curve.
Thus market demand curve is the one that represents total quantities of a
commodity demanded by all the consumers in the market at different prices. It is
the horizontal summation of the individual demand curves.

Fig.(i) shows A’s Demand Curve, fig.(ii) shows B’s Demand Curve and fig. (iii) shows the
Market Demand Curve. Thus by adding the different points on individual demand curves one
get the market Demand Curve.

Why do Demand Curve slopes downwards?

Reasons are:-

(i) Law of Diminishing Marginal Utility: The law of demand is based on the law of
diminishing marginal utility which states that as the consumer purchases more and more
units of a commodity, the satisfaction derived by him from each successive unit goes on
decreasing. Hence at a lesser price, he would purchase more. Being a rational human beings
the consumer always tries to maximize his satisfaction and does so equalizing the marginal
utility of a commodity with its price i.e. Mux = px. It means that now the consumer will buy
additional units only when the price falls. Consumer equilibrium reaches when Marginal
utility= Price. There is an inverse relationship between consumption and MU.

(ii) New Consumers/ Change of marginal consumer: When the price of a commodity
falls many consumers who could not begin to purchase the commodity e.g. suppose when
price of a certain good ‘x’ was Tk. 50 market demand was 60 units now when the price falls
to Tk. 40, new consumers enter the market and the overall market demand rises to 80 units.

(iii) Several Use of Commodity/ Use of Complimentary goods: There are many
commodities which can be put to several uses e.g. coal, electricity etc. When the prices of
such commodities go up, they will be used for important purpose only and their demand will
be limited. On the other hand, when their price fall they are used for varied purpose and as a
result their demand extends. Such inverse relation between demand and price makes the
demand curve slope downwards.

(iv) Income Effect: When price of a commodity changes, the real income of a consumer
also undergoes a changes. Hence real income means the consumer’s purchasing power. As
the price of a commodity falls the real income of a consumer goes up and he purchases more
units of a commodity eg. Suppose a consumer buys units wheat at a price Tk. 40/kg now,
when the price falls to Tk. 30/kg. his purchasing power or the real
income increase which induces him to buy more units of wheat.

(v) Substitution Effect: As the price of a commodity falls the consumer wants to
substitute this good for those good which now have become relatively expensive e.g. among
the two substitute goods tea and coffee, price of tea falls then consumer substitutes tea for
coffee. This is caused the ‘Substitution effect’ which makes the demand curve sloped
downwards.

In a nutshell, with a fall in price more units are demanded partly due to income effect and
partly due to substitution effect. Both of these are jointly known as the ‘price effect’. Due to
this negative price effect the demand curve slopes downwards.

Demand curve vs Demand schedule

1. Definitional
2. Mathematical Vs geometric presentation
3. Left side price and right side quantity
Price in vertical axis, demand in horizontal axis

Review of the Laws of Supply and Demand:

The Law of Supply

States that at higher prices, producers are willing to offer more products for sale than at
lower prices
States that the supply increases as prices increase and decreases as prices decrease
States that those already in business will try to increase productions as a way of increasing
profits

The Law of Demand

States that people will buy more of a product at a lower price than at a higher price, if
nothing changes
States that at a lower price, more people can afford to buy more goods and more of an item
more frequently, than they can at a higher price
States that at lower price, people tend to buy the goods, as a substitute of more expensive
goods.

What is a Demand Schedule?

A demand schedule, depicted graphically as the demand curve, represents the amount of
some good that buyers are willing and able to purchase at various prices, assuming all
determinants of demand remain the same. A Demand schedule is a list of the different
quantities of a commodity which consumes purchase at different period of time. It expresses
the relation between different quantities of the commodity demanded at different prices. The
demand schedule is defined as the willingness and ability of a consumer to purchase a
given product in a given frame of time.

(i) Individual Demand Schedule: It is defined as the different quantities of a given

commodity which a consumer will buy at all possible prices.

(ii) Market Demand Schedule: Market demand schedule is defined as the quantities
of a given commodity which all consumers will buy at all possible prices at a
given moment of time.

Elements of demand forecasting:

1. Objectives of demand forecasting

2. Determining whether short or long term demand forecasting is necessary: Industry
dependent on fixed factors mostly requires long term forecasting.
3. Selecting the method:
For short term forecasting information and data on business is more important.
For long term, regression methods carry fruitful result.
4. Selecting the variables related to goods and their determinant
5. Considering the nature of the goods whether temporary, permanent, consumables,
capital goods.
6. Taking measures according to the results derived from demand forecasting
methods.

Objectives of demand forecasting:

The main objective of a business is to make profit by various strategies. For this, it has to
produce and sell the desired level of commodities. In this regard, forecasting of demand of
the good is mandatory as demand is ever changing. As such, objectives of demand
forecasting are discussed in light of the classification of demand forecasting:

1. Short term demand forecasting:

a. Determining accurate pricing policy: if low demand price low.
b. Perfect production schedule: Whether less or more to produce.
c. Financing: Financing as required by mass production or not
d. Reducing raw material cost: Keeping inventory matching the
demand forecasting.

2. Long term demand forecasting:

a. Planning for a new product: Demand for each of the goods are
ascertained to determine how much of the market demand a
company can supply.
b. Planning for long term financial requirement: long term demand
of a commodity will indicate the necessity of long term
financing.
c. Manpower planning: Requirement and training on long term
need
.

Methods of Demand forecasting

Broadly speaking, there are two approaches to demand forecasting-

One is to obtain information about the likely purchase behavior of the buyer through
collecting expert’s opinion or by conducting interviews with consumers,

The other is to use past experience as a guide through a set of statistical techniques. Both
these methods rely on varying degrees of judgment.

The first method is usually found suitable for short-term forecasting, the latter for long-term
forecasting. There are specific techniques which fall under each of these broad methods

1. Experts Opinion Poll:

 In this method, the experts are requested to give their ‘opinion’ or ‘feel’ about the
product. These experts, dealing in the same or similar product, are able to predict the
likely sales of a given product in future periods under different conditions based on their
experience. If the number of such experts is large and their experience-based reactions
are different, then an average-simple or weighted –is found to lead to unique forecasts.
Sometimes this method is also called the ‘hunch method’ but it replaces analysis by
opinions and it can thus turn out to be highly subjective in nature.

2. Reasoned Opinion-Delphi Technique:

This is a variant of the opinion poll method. Here is an attempt to arrive at a consensus
in an uncertain area by questioning a group of experts repeatedly until the responses
appear to converge along a single line. The participants are supplied with responses to
previous questions (including seasonings from others in the group by a coordinator or a
leader or operator of some sort). Such feedback may result in an expert revising his
earlier opinion. This may lead to a narrowing down of the divergent views (of the
experts) expressed earlier. The Delphi Techniques, followed by the Greeks earlier, thus
generates “reasoned opinion” in place of “unstructured opinion”; but this is still a poor
proxy for market behavior of economic variables.

3. End-user Method of Consumers Survey:

Under this method, the sales of a product are projected through a survey of its end-
users. A product is used for final consumption or as an intermediate product in the
production of other goods in the domestic market, or it may be exported as well as
imported. The demands for final consumption and exports net of imports are estimated
through some other forecasting method, and its demand for intermediate use is
estimated through a survey of its user industries.

4. Time series analysis or trend method:

Under this method, the time series data on the under forecast are used to fit a trend line
or curve either graphically or through statistical method of Least Squares. The trend line
is worked out by fitting a trend equation to time series data with the aid of an estimation
method. The trend equation could take either a linear or any kind of non-linear form. The
trend method outlined above often yields a dependable forecast.
 The advantage in this method is that it does not require the formal knowledge of
economic theory and the market; it only needs the time series data.
The only limitation in this method is that it assumes that the past is repeated in future.
Also, it is an appropriate method for long-run forecasts, but inappropriate for short-run
forecasts. Sometimes the time series analysis may not reveal a significant trend of any
kind. In that case, the moving average method or exponentially weighted moving
average method is used to smoothen the series.

5. Barometric techniques or lead or leg methods:

This consists in discovering a set of series of some variables which exhibit a close
association in their movement over a period or time.

For example, it shows the movement of agricultural income (AY series) and the sale of
tractors (ST series). The movement of AY is similar to that of ST, but the movement in
ST takes place after a year’s time lag compared to the movement in AY. Thus if one
knows the direction of the movement in agriculture income (AY), one can predict the
direction of movement of tractors’ sale (ST) for the next year. Thus agricultural income
(AY) may be used as a barometer (a leading indicator) to help the short-term forecast for
the sale of tractors.

Generally, this barometric method has been used in some of the developed countries for
predicting business cycles situation. For this purpose, some countries construct what are
known as ‘diffusion indices’ by combining the movement of a number of leading series in
the economy so that turning points in business activity could be discovered well in
advance. Some of the limitations of this method may be noted however. The leading
indicator method does not tell you anything about the magnitude of the change that can
be expected in the lagging series, but only the direction of change. Also, the lead period
itself may change overtime. Through our estimation we may find out the best-fitted lag
period on the past data, but the same may not be true for the future. Finally, it may not
be always possible to find out the leading, lagging or coincident indicators of the variable
for which a demand forecast is being attempted.

6. Simultaneous equations Methods

Here is a very sophisticated method of forecasting. It is also known as the ‘complete
system approach’ or ‘econometric model building’. Such models are called econometric
 models. Moreover, this method is normally used in macro-level forecasting for the
economy as a whole. The method is indeed very complicated. However, in the days of
computer, when package programs are available, this method can be used easily to
derive meaningful forecasts.

The principle advantage in this method is that the forecaster needs to estimate the future
values of only the exogenous variables unlike the regression method where he has to
predict the future values of all, endogenous and exogenous variables affecting the
variable under forecast. The values of exogenous variables are easier to predict than
those of the endogenous variables. However, such econometric models have limitations,
similar to that of regression method.

Shift in demand and supply

Whenever there is a change in one of the factors of supply or demand, market equilibrium
will be affected.

Shift in Demand

When there is a change of one of the factors of demand- like the price of the product and
related goods, consumer preferences, or income- there is a corresponding change in the
demand curve. For instance, if someone's income grows, then his demand for goods will
increase, shifting his demand curve to the right. This will lead to a higher quantity being
consumed at a higher price, ceteris paribus. Conversely, there can be a negative effect that
shifts the supply curve to the left where a lower quantity is consumed at a lower price,
ceteris paribus. This can occur when the price of substitutes falls or consumers begin to
lose their taste for the product.

Shift in Supply

When there is a change of one of the factors of supply- like changes in the prices of
production inputs like labor or capital; a change in production technology and its associated
productivity change; or the amount of competition in a specific product market- there is a
corresponding change in the supply curve. For example, if worker productivity improves due
to some human capital or technology investment, then the costs of production decrease.
This exerts a positive effect on the supply curve shifting it right, where the new market
equilibrium is at a higher quantity and a lower price, holding everything else constant. There
can also be a negative shift that moves the supply curve to the left, with the resulting market
clearing price being higher and quantity lower, ceteris paribus. This type of change can
occur when the price of an input like labor or raw material jumps.
Supply schedule

A supply schedule is a table that shows the relationship between the price of a good and the
quantity supplied. A supply curve is a graph that illustrates that relationship between the
price of a good and the quantity supplied.

Under the assumption of perfect competition, supply is determined by marginal cost. Firms
will produce additional output while the cost of producing an extra unit of output is less than
the price they would receive.

By its very nature, conceptualizing a supply curve requires the firm to be a perfect
competitor, namely requires the firm to have no influence over the market price. This is true
because each point on the supply curve is the answer to the question "If this firm is faced
with this potential price, how much output will it be able to and willing to sell?" If a firm has
market power, its decision of how much output to provide to the market influences the
market price, then the firm is not "faced with" any price, and the question is meaningless.

Economists distinguish between the supply curve of an individual firm and between the
market supply curve. The market supply curve is obtained by summing the quantities
supplied by all suppliers at each potential price. Thus, in the graph of the supply curve,
individual firms' supply curves are added horizontally to obtain the market supply curve.

Economists also distinguish the short-run market supply curve from the long-run market
supply curve. In this context, two things are assumed constant by definition of the short
run: the availability of one or more fixed inputs (typically physical capital), and the number of
firms in the industry. In the long run, firms have a chance to adjust their holdings of physical
capital, enabling them to better adjust their quantity supplied at any given price.
Furthermore, in the long run potential competitors can enter or exit the industry in response
to market conditions. For both of these reasons, long-run market supply curves are flatter
than their short-run counterparts.

The determinants of supply are:

1. Production costs, how much a good costs to be produced

2. The technology used in production, and/or technological advances
3. Firms' expectations about future prices
4. Number of suppliers
THE EFFECTS OF CHANGES IN DEMAND AND SUPPLY ON EQUILIBRIUM PRICE
AND QUANTITY

A. Change in Demand
1. a. A change in demand will cause equilibrium price and output to change in the
same direction.
b. A decrease in demand will cause a reduction in the equilibrium price and quantity
of a good.
2. The decrease in demand causes excess supply to develop at the initial price.
a. Excess supply will cause price to fall, and as price falls producers are willing to
supply less of the good, thereby decreasing output.
b. An increase in demand will cause an increase in the equilibrium price and quantity
of a good.
1. The increase in demand causes excess demand to develop at the initial price.
a. Excess demand will cause the price to rise, and as price rises producers are
willing to sell more, thereby increasing output.

B. Change in Supply
1. A change in supply will cause equilibrium price and output to change in opposite
directions.
a. An increase in supply will cause a reduction in the equilibrium price and an
increase in the equilibrium quantity of a good.
1. The increase in supply creates an excess supply at the initial price.
a. Excess supply causes the price to fall and quantity demanded to increase.
b. A decrease in supply will cause an increase in the equilibrium price and a
decrease in the equilibrium quantity of a good.
1. The decrease in supply creates an excess demand at the initial price.
a. Excess demand causes the price to rise and quantity demanded to decrease.
C. Changes in Demand and Supply
1. If demand and supply change in opposite directions, then the change in the
equilibrium price can be determined, but the change in the equilibrium. output
cannot.
a. A decrease in demand and an increase in supply will cause a fall in equilibrium
price, but the effect on equilibrium quantity cannot be determined.
1. For any quantity, consumers now place a lower value on the good, and producers
are willing to accept a lower price; therefore, price will fall. The effect on output will
depend on the relative size of the two changes.
b. An increase in demand and a decrease in supply will cause an increase in
equilibrium price, but the effect on equilibrium quantity cannot be detennined.
 1. For any quantity, consumers now place a higher value on the good,and producers
must have a higher price in order to supply the good; therefore, price will increase.
The effect on output will depend on the relative size of the two changes.
2. If demand and supply change in the same direction, the change in the equilibrium
output can be determined, but the change in the equilibrium price cannot.
a. If both demand and supply increase, there will be an increase in the equilibrium
output, but the effect on price cannot be determined.
1. If both demand and supply increase, consumers wish to buy more and firms wish
to supply more so output will increase. However, since consumers place a higher
value on each unit, but producers are willing to supply each unit at a lower price, the
effect on price will depend on the relative size of the two changes.
b. If both demand and supply decrease, there will be a decrease in the equilibrium
output, but the effect on price cannot be determined.
1. If both demand and supply decrease, consumers wish to buy less and firms wish
to supply less, so output will fall. However, since consumers place a lower value on
each unit, but producers are willing to supply each unit only at higher prices, the
effect on price will depend on the relative size of the two changes.

The price adjustment mechanism:

If the quantity supplied, Qs, is greater than the quantity demanded, Qd, at a price P0, then a
surplus exists at P0. Because of this surplus, consumers will bid down the market price. As
the market price decreases, the quantity demanded will increase and the quantity supplied
will decrease until the quantity demanded equals the quantity supplied, at which point the
surplus is eliminated and a market equilibrium is established.

An increase in supply S with constant demand D will decrease the equilibrium price P*
and increase the equilibrium quantity Q*. Similarly, a decrease in supply S with constant
demand D will increase the equilibrium price P* and decrease the equilibrium quantity Q*.
Alternatively, an increase in demand D with constant supply S will increase both the
equilibrium price P* and equilibrium quantity Q*. A decrease in demand D with constant
supply S will decrease both the equilibrium price P* and equilibrium quantity Q*.

Shift Vs Change in demand curve

There are two types of change in demand;

1. Movement along the demand curve
A movement along the demand curve is caused by a change in price of the good or
service. For instance, a fall in the price of the good resulting an extension of demand
(quantity demanded will increase), whilst an increase in price causes a contraction of
demand (quantity demanded will decrease).With change in the demand curve
depends on the level of price whereas the shift can be caused by other factor
political turmoil, technology, change in consumer income change in prices of other
good like the substitute good rendering the shift in the shifts etc. Demand is the
relationship between various prices and the quantities consumers are willing and
able to buy, holding all other things constant. Consumers, in general, are willing to
buy more of a product at lower prices and less at higher prices. This is movement
along the curve.

2. A shift in the demand curve is caused by a change in any non-price determinant

of demand. The curve can shift to the right or left. A shifted curve means the entire
curve is redrawn and shifts to the right or left. A shift in the D curve results from:

a) Change in the number of consumers in the market for a product,

b) Change in consumer tastes and preferences for a product,
c) Change in consumer income,
d) Change in the price of related goods—complements or substitutes of a product.

The Law of demand states that the demand curve is downward sloping. Thus the
higher the price the lower the demand for good and services and vice versa

A rightward shift represents an increase in the quantity demanded (at all prices),
whilst a leftward shift represents a decrease in the quantity demanded (at all prices).
Shift Vs movement of supply curve

There are TWO types of change in supply;

1. Movement ALONG the supply curve

A movement along the supply curve is caused by a change in PRICE of the good or
service. For instance, an increase in the price of the good results in an EXTENSION
of supply (quantity supplied will increase), whilst a decrease in price causes a
CONTRACTION of supply (quantity supplied will decrease).

The movements can be caused by the following:

d. Change in costs of production - if the costs of production

increase then the potential profit will fall. This will cause
producers to look at alternative goods to produce. Therefore,
an increase in the costs of production will cause a leftward shift
in the supply curve.
e. Role of technology - if the degree of technology employed in
production increases then firms will be able to make more
goods with their given level of inputs (factors of production).
Therefore, an improvement in technology causes the supply
curve to shift to the right.

2. SHIFT in the supply curve

A shift in the supply curve is caused by a change in any non-price determinant of

supply. The curve can shift to the right or left.

A rightward shift represents an increase in the quantity supplied (at all prices) S1 to
S2, whilst a leftward shift represents a decrease in the quantity supplied (at all
prices). S1 to S3.
Demand Supply Interaction

Price is derived by the interaction of supply and demand. The resultant market price is
dependant upon both of these fundamental components of a market. An exchange of goods
or services will occur whenever buyers and sellers can agree on a price. When an exchange
occurs, the agreed upon price is called the "equilibrium price", or a "market clearing price".
This can be graphically illustrated as follows: ( Figure 3)

In figure 3, both buyers and sellers are willing to

exchange the quantity "Q" at the price "P". At this
point supply and demand are in balance or
"equilibrium". At any price below P, the quantity
demanded is greater than the quantity supplied. In
this situation consumers would be anxious to
acquire product the producer is unwilling to supply
resulting in a product shortage. In order to ration the
shortage consumers would have to pay a higher
price in order to get the product they want; while
producers would demand a higher price in order to
bring more product on to the market. The end result
is a rise in prices to the point P, where supply and
demand are once again in balance. Conversely, if prices were to rise above P, the market
would be in surplus - too much supply relative to the demand. Producers would have to lower
their prices in order to clear the market of excess supplies. Consumers would be induced by
the lower prices to increase their purchases. Prices will fall until supply and demand are again
in equilibrium at point P.

A market price is not a fair price to all participants in the marketplace. It does not guarantee
total satisfaction on the part of both buyer and seller or all buyers and all sellers. This will
depend on their individual competitive positions within the market. Buyers will attempt to
maximize their individual well being within certain competitive constraints. Too low a price will
result in excess profits for the buyer attracting competition. Likewise sellers are also
considered to be profit maximizers. Too high a price will likewise attract additional producer
competition within the market. Therefore, there will exist different price levels where individual
buyers and sellers are satisfied and the sum total will create a market or equilibrium price.
 When either demand or supply changes, the
equilibrium price will change. For example, good
weather normally increases the supply of grains
and oilseeds, with more product being made
available over a range of prices. With no increase
in the quantity of product demanded, there will be
movement along the demand curve to a new
equilibrium price in order to clear the excess
supplies off the market. Consumers will buy more
but only at a lower price. This can be illustrated
graphically as follows: (see Figure 4.)

Likewise a shift in demand due to changing

consumer preferences will also influence the market price. In recent years there has been a
shift in demand on the part of overseas Canadian wheat buyers toward the Canada Prairie
Spring varieties, away from the Hard Red Spring varieties. A decline in the preference for
Hard Red Spring wheat shifts the demand curve inward, to the left, as illustrated in figure 5.

With no reduction in supply, the effect on price results from a movement along the supply
curve to a lower equilibrium price where supply and demand is once again in balance. In order
for prices to increase producers will have to reduce the quantity of hard red spring wheat
brought to the market place or find new sources of demand to replace the consumers who
withdrew from the marketplace due to changing preferences or a shift in demand.

Changes in supply and demand can be short run or

long run in nature. Weather tends to influence
market prices generally in the short run. Changes
in consumer preferences can have either a short
run or long run effect on prices depending upon the
goods or services, for example whether they are
luxuries or necessities. A luxury good may enjoy a
short term shift in demand due to changing styles
or snob appeal while necessities tend to have
stable or long run demand curves. Another major
factor influencing market prices is technology. A
major effect of technology in agriculture is to shift
out the supply curve rapidly by reducing the costs
of production on a per unit basis. At the same time if total demand does not increase
sufficiently to absorb the excess goods produced at lower costs, the long run impact of
technology on the market place will be to lower prices. The rapidly shifting supply curve
coupled with a slower moving demand curve has generally contributed to lower prices for
agricultural output when compared to prices for industrial products.

Market Equilibrium

In economics, economic equilibrium is a state of the world where economic forces are
balanced and in the absence of external influences the (equilibrium) values of economic
variables will not change. For example, in the standard text-book model of perfect
competition, equilibrium occurs at the point at which quantity demanded and quantity
supplied is equal. Market equilibrium in this case refers to a condition where a market
price is established through competition such that the amount of goods or services sought
by buyers is equal to the amount of goods or services produced by sellers. This price is
often called the competitive price or market clearing price and will tend not to change
unless demand or supply changes.

Three basic properties of equilibrium in general have been proposed by Huw Dixon. These
are:

Equilibrium property P1: The behaviour of agents is consistent.

Equilibrium property P2: No agent has an incentive to change its behaviour.

Equilibrium Property P3: Equilibrium is the outcome of some dynamic process (stability).

Market Surpluses & Market Shortages

Sometimes the market is not in equilibrium-that is quantity supplied doesn't equal quantity
demanded. When this occurs there is either excess supply or excess demand.
A Market Surplus occurs when there is excess supply- that is quantity supplied is greater
than quantity demanded. In this situation, some producers won't be able to sell all their
goods. This will induce them to lower their price to make their product more appealing. In
order to stay competitive many firms will lower their prices thus lowering the market price for
the product. In response to the lower price, consumers will increase their quantity
demanded, moving the market toward an equilibrium price and quantity. In this situation,
excess supply has exerted downward pressure on the price of the product.

A Market Shortage occurs when there is excess demand- that is quantity demanded is
greater than quantity supplied. In this situation, consumers won't be able to buy as much of
a good as they would like. In response to the demand of the consumers, producers will
raise both the price of their product and the quantity they are willing to supply. The increase
in price will be too much for some consumers and they will no longer demand the
product. Meanwhile the increased quantity of available product will satisfy other
consumers. Eventually equilibrium will be reached.

Price Floors and Ceilings

Price Floors and Price Ceilings are Price Controls, examples of government intervention in
the free market which changes the market equilibrium. They each have reasons for using
them, but there are large efficiency losses with both of them.

Price Floors

Price Floors are minimum prices set by the government for certain commodities and
services that it believes are being sold in an unfair market with too low of a price and thus
their producers deserve some assistance. Price floors are only an issue when they are set
above the equilibrium price, since they have no effect if they are set below market clearing
price.

When they are set above the market price, then there is a possibility that there will be an
excess supply or a surplus. If this happens, producers who can't foresee trouble ahead will
produce the larger quantity where the new price intersects their supply curve. Unbeknownst
to them, consumers will not buy that many goods at the higher price and so those goods will
go unsold.
There will be economic harm done even if suppliers can look ahead and see that there isn't
sufficient demand and cut back on production in response. There is still deadweight loss
associated with this reduction in quantity, reflected in the loss of consumer and producer
surplus at lower levels of production. Producers can gain as a result of this policy, but only if
their supply curve is relatively elastic and therefore they have no net loss. Consumers will
definitely lose with this kind of regulation, as some people are priced out of the market and
others have to pay a higher price than before.

There are numerous strategies of the government for setting a price floor and dealing with
its repercussions. They can set a simple price floor, use a price support, or set production
quotas. Price supports sets a minimum price just like as before, but here the government
buys up any excess supply. This is even more inefficient and costly for the government and
society as a whole than the government directly subsidizing the affected firms. Production
quotas artificially raise the price by restricting production using either mandated quotas or
giving businesses incentives to reduce their production. In America, this latter technique is
used widely with agriculture. The government pays farmers to keep some portion of their
fields fallow, thus elevating prices. Like price supports, the policy would be more efficient
and less costly to society if the government directly subsidized farmers instead of setting a
production restriction.

Price Ceilings

Price Ceilings are maximum prices set by the government for particular goods and services
that they believe are being sold at too high of a price and thus consumers need some help
purchasing them. Price ceilings only become a problem when they are set below the market
equilibrium price.

When the ceiling is set below the market price, there will be excess demand or a supply
shortage. Producers won't produce as much at the lower price, while consumers will
demand more because the goods are cheaper. Demand will outstrip supply, so there will be
a lot of people who want to buy at this lower price but can't. Still, if the demand curve is
relatively elastic, then the net effect to consumer surplus will be positive. Producers are truly
harmed, as their surplus is doubly hit with a reduction in the number of firms willing to take
that lower price, and those who remain in the market have to take a lower price.

The resulting shortage of goods can lead to consumers having to queue up in line to get the
good, government rationing, and even the development of a black market dealing with the
scarce goods. This is what occurred with the energy crisis in America during the 1970s,
when cars had to line up on the street in order to just get some government rationed amount
of gasoline.

If the price ceiling is above the market price, then there is no direct effect. If the price ceiling
is set below the market price, then a "shortage" is created; the quantity demanded will
exceed the quantity supplied. The shortage may be resolved in many ways. One way is
"queuing"; people have to wait in line for the product, and only those willing to wait in line for
the product will actually get it. Sellers might provide the product only to family and friends, or
those willing to pay extra "under the table". Another effect may be that sellers will lower the
quality of the good sold. "Black markets" tend to be created by price ceilings.
Figure 3.6 illustrates the shortage that occurs when a price ceiling is imposed on suppliers.
Consumers demand QD while Suppliers are only willing to supply QS. If the price ceiling is
set above the equilibrium, consumers would demand a smaller quantity than suppliers are
producing.

Price Floors

When a "price floor" is set, a certain minimum amount must be paid for a good or service. If
the price floor is below a market price, no direct effect occurs. If the market price is lower
than the price floor, then a surplus will be generated. Minimum wage laws are good
examples of price floors.

A price floor is a government- or group-imposed limit on how low a price can be charged
for a product. A price floor must be greater than the equilibrium price in order to be effective.

Elasticity

Definition of 'Elasticity'

A measure of a variable's sensitivity to a change in another variable. In economics, elasticity

refers the degree to which individuals (consumers/producers) change their demand/amount
supplied in response to price or income changes.

In economics, elasticity is the measurement of how changing one economic variable

affects others. "If we learn that a resource is becoming scarce, will people scramble to
acquire it?"

In more technical terms, it is the ratio of the percentage change in one variable to the
percentage change in another variable. It is a tool for measuring the responsiveness of a
function to changes in parameters in a unit less way.

Calculated as:

The degree to which a demand or supply curve reacts to a change in price is the curve's
elasticity. Elasticity varies among products because some products may be more essential
to the consumer. Products that are necessities are more insensitive to price changes
because consumers would continue buying these products despite price increases.
Conversely, a price increase of a good or service that is considered less of a necessity will
deter more consumers because the opportunity cost of buying the product will become too
high.

Generally, an elastic variable is one which responds a lot to small changes in other
parameters. Similarly, an inelastic variable describes one which does not change much in
response to changes in other parameters.

Frequently used elasticity’s include

1. Price elasticity of demand,

2. Price elasticity of supply,
3. Income elasticity of demand,
4. Elasticity of substitution between factors of production and
5. Elasticity of inter temporal substitution.

Elasticity is one of the most important concepts in neoclassical economic theory. It is useful
in understanding the incidence of indirect taxation, marginal concepts as they relate to the
theory of the firm, and distribution of wealth and different types of goods as they relate to
the theory of consumer choice. Elasticity is also crucially important in any discussion of
welfare distribution, in particular consumer surplus, producer surplus, or government
surplus.
In empirical work an elasticity is the estimated coefficient in a linear regression equation
where both the dependent variable and the independent variable are in natural logs.
Elasticity is a popular tool among empiricists because it is independent of units and thus
simplifies data analysis.

A. Elasticity of demand:

Marshall said “The degree of rapidity or slowness with which demand changes with every
change in price is known as elasticity of demand’’.

Lipsy: Elasticity of demand is the measure of the responsiveness of the quantity demanded
to changes in price.

1) Price elasticity of demand

Price elasticity of demand measures the percentage change in quantity demanded caused
by a percent change in price. As such, it measures the extent of movement along the
demand curve. This elasticity is almost always negative and is usually expressed in terms
of absolute value (i.e. as positive numbers) since the negative can be assumed. In these
terms, then, if the elasticity is greater than 1 demand is said to be elastic; between zero and
one demand is inelastic and if it equals one, demand is unit-elastic. A perfectly elastic
demand curve is horizontal (with an elasticity of infinity) whereas a perfectly inelastic
demand curve is vertical (with an elasticity of 0).

2) Income elasticity of demand

Income elasticity of demand measures the percentage change in demand caused by a

percent change in income. A change in income causes the demand curve to shift
reflecting the change in demand. IED is a measurement of how far the curve shifts
horizontally along the X-axis. Income elasticity can be used to classify goods as normal or
inferior. With a normal good demand varies in the same direction as income. With an inferior
good, demand and income move in opposite directions.

3) Cross price elasticity of demand

Cross price elasticity of demand measures the percentage change in demand for a
particular good caused by a percent change in the price of another good. Goods can be
complements, substitutes or unrelated. A change in the price of a related good causes the
demand curve to shift reflecting a change in demand for the original good. Cross price
elasticity is a measurement of how far, and in which direction, the curve shifts horizontally
along the x-axis. A positive cross-price elasticity means that the goods are substitute goods.

4) Cross elasticity of demand between firms

Cross elasticity of demand for firms, sometimes referred to as conjectural variation, is a

measure of the interdependence between firms. It captures the extent to which one firm
reacts to changes in strategic variables (price, quantity, location, advertising, etc.) made by
other firms.

5) Elasticity of inter temporal substitution

Combined Effects

It is possible to consider the combined effects of two or more determinant of demand. The
steps are as follows: PED = (∆Q/∆P) x P/Q. Convert this to the predictive equation: ∆Q/Q =
PED(∆P/P) if you wish to find the combined effect of changes in two or more determinants
of demand you simply add the separate effects: ∆Q/Q = PED(∆P/P) + YED(∆Y/Y)

It considers the effect in demand of a change in two of the variables. All other variables
must be held constant. Note also that graphically this problem would involve a shift of the
curve and a movement along the shifted curve.

B. Elasticity of supply

1) Price elasticity of supply

The price elasticity of supply measures how the amount of good firms wishes to supply
changes in response to a change in price. In a manner analogous to the price elasticity of
demand, it captures the extent of movement along the supply curve. If the price elasticity of
supply is zero the supply of a good supplied is "inelastic" and the quantity supplied is fixed.

2) Elasticity of scale
Elasticity of scale or output elasticity measures the percentage change in output induced by
a percent change in inputs. A production function or process is said to exhibit constant
returns to scale if a percentage change in inputs results in an equal percentage in outputs,
elasticity equal to 1. It exhibits increasing returns to scale if a percentage change in inputs
results in greater percentage change in output, elasticity greater than 1. The definition of
decreasing returns to scale is analogous.

Some common uses of elasticity include:

1. Effect of changing price on firm revenue.

2. Analysis of incidence of the tax burden and other government policies.
3. Income elasticity of demand can be used as an indicator of industry health, future
consumption patterns and as a guide to firms investment decisions.
4. Effect of international trade and terms of trade effects.
5. Analysis of consumption and saving behavior.
6. Analysis of advertising on consumer demand for particular goods.

A good or service is considered to be highly elastic if a slight change in price leads to a

sharp change in the quantity demanded or supplied. Usually these kinds of products are
readily available in the market and a person may not necessarily need them in his or her
daily life. On the other hand, an inelastic good or service is one in which changes in price
witness only modest changes in the quantity demanded or supplied, if any at all. These
goods tend to be things that are more of a necessity to the consumer in his or her daily life.

To determine the elasticity of the supply or demand curves, we can use this simple
equation:

Elasticity = (% change in quantity / % change in price)

If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less
than one, the curve is said to be inelastic.

The demand curve has a negative slope, and if there is a large decrease in the quantity
demanded with a small increase in price, the demand curve looks flatter, or more horizontal.
This flatter curve means that the good or service in question is elastic.
Meanwhile, inelastic demand is represented with a much more upright curve as quantity
changes little with a large movement in price.

Elasticity of supply works similarly. If a change in price results in a big change in the amount
supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case
would be greater than or equal to one.

On the other hand, if a big change in price only results in a minor change in the quantity
supplied, the supply curve is steeper and its elasticity would be less than one.
A. Factors Affecting Demand Elasticity

There are three main factors that influence a demand's price elasticity:

1. The availability of substitutes

2. Amount of income available to spend on the good
3. Time

1. The availability of substitutes - This is probably the most important factor influencing
the elasticity of a good or service. In general, the more substitutes, the more elastic the
demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers
could replace their morning caffeine with a cup of tea. This means that coffee is an elastic
good because a raise in price will cause a large decrease in demand as consumers start
buying more tea instead of coffee.

However, if the price of caffeine were to go up as a whole, we would probably see little
change in the consumption of coffee or tea because there are few substitutes for caffeine.
Most people are not willing to give up their morning cup of caffeine no matter what the price.
We would say, therefore, that caffeine is an inelastic product because of its lack of
substitutes. Thus, while a product within an industry is elastic due to the availability of
substitutes, the industry itself tends to be inelastic. Usually, unique goods such as diamonds
are inelastic because they have few if any substitutes.

2. Amount of income available to spend on the good - This factor affecting demand
elasticity refers to the total a person can spend on a particular good or service. Thus, if the
price of a can of Coke goes up from $0.50 to $1 and income stays the same, the income
that is available to spend on coke, which is $2, is now enough for only two rather than four
cans of Coke. In other words, the consumer is forced to reduce his or her demand of Coke.
Thus if there is an increase in price and no change in the amount of income available to
spend on the good, there will be an elastic reaction in demand; demand will be sensitive to
a change in price if there is no change in income.

3. Time - The third influential factor is time. If the price of cigarettes goes up $2 per pack, a
smoker with very few available substitutes will most likely continue buying his or her daily
cigarettes. This means that tobacco is inelastic because the change in price will not have a
significant influence on the quantity demanded. However, if that smoker finds that he or she
cannot afford to spend the extra $2 per day and begins to kick the habit over a period of
time, the price elasticity of cigarettes for that consumer becomes elastic in the long run.

B. Income Elasticity of Demand

In the second factor outlined above, we saw that if price increases while income stays the
same, demand will decrease. It follows, then, that if there is an increase in income, demand
tends to increase as well. The degree to which an increase in income will cause an increase
in demand is called income elasticity of demand, which can be expressed in the following
equation:

If EDy is greater than one, demand for the item is considered to have a high income
elasticity. If however EDy is less than one, demand is considered to be income inelastic.
Luxury items usually have higher income elasticity because when people have a higher
income, they don't have to forfeit as much to buy these luxury items. Let's look at an
example of a luxury good: air travel.

Bob has just received a $10,000 increase in his salary, giving him a total of $80,000 per
annum. With this higher purchasing power, he decides that he can now afford air travel
twice a year instead of his previous once a year. With the following equation we can
calculate income demand elasticity:

Income elasticity of demand for Bob's air travel is seven - highly elastic.

With some goods and services, we may actually notice a decrease in demand as income
increases. These are considered goods and services of inferior quality that will be dropped
by a consumer who receives a salary increase. An example may be the increase in the
demand of DVDs as opposed to video cassettes, which are generally considered to be of
lower quality. Products for which the demand decreases as income increases have an
income elasticity of less than zero. Products that witness no change in demand despite a
change in income usually have an income elasticity of zero - these goods and services are
considered necessities.

Elasticity of demand are interpreted as follows:

Value Descriptive Terms

Perfectly inelastic demand
Price change, but no change in
demand
Inelastic or relatively inelastic
demand
Price down, demand up, but
expenditure decrease
Or vice versa
Unit elastic, unit elasticity, unitary
elasticity, or unitarily elastic
demand Price changed but
expenditure unchanged
 Elastic or relatively elastic demand/
Elasticity greater than unity:
Price down, Demand increase to
the extent that expenditure rise
Or vice versa
Perfectly elastic demand
Price change a little, but demand
change unlimitedly

The overriding factor in determining PED is the willingness and ability of consumers after a
price change to postpone immediate consumption decisions concerning the good and to
search for substitutes ("wait and look"). A number of factors can thus affect the elasticity of
demand for a good:

1. Availability of substitute goods: The more and closer the substitutes available, the
higher the elasticity is likely to be, as people can easily switch from one good to
another if an even minor price change is made; There is a strong substitution effect.
If no close substitutes are available the substitution of effect will be small and the
demand inelastic.
2. Nature of goods/ Breadth of definition of a good: The broader the definition of a
good (or service), the lower the elasticity. For example, Company X's fish and chips
would tend to have a relatively high elasticity of demand if a significant number of
substitutes are available, whereas food in general would have an extremely low
elasticity of demand because no substitutes exist.
3. Price of goods: Percentage of income: The higher the percentage of the
consumer's income that the product's price represents, the higher the elasticity
tends to be, as people will pay more attention when purchasing the good because of
its cost; The income effect is substantial. When the goods represent only a negligible
portion of the budget the income effect will be insignificant and demand inelastic,
4. Necessity: The more necessary a good is, the lower the elasticity, as people will
attempt to buy it no matter the price, such as the case of insulin for those that need
it.
5. Duration: For most goods, the longer a price change holds, the higher the elasticity
is likely to be, as more and more consumers find they have the time and inclination
to search for substitutes. When fuel prices increase suddenly, for instance,
consumers may still fill up their empty tanks in the short run, but when prices remain
high over several years, more consumers will reduce their demand for fuel by
 switching to carpooling or public transportation, investing in vehicles with greater fuel
economy or taking other measures. Brand loyalty: An attachment to a certain
brand—either out of tradition or because of proprietary barriers—can override
sensitivity to price changes, resulting in more inelastic demand.
6. Who pays: where the purchaser does not directly pay for the good they consume,
such as with corporate expense accounts, demand is likely to be more inelastic.
7. Habitual demand: Cigar

Difference between elastic and inelastic demand:

1. Elastic: minimum price change causes high demand change

Inelastic: Price change causes almost no change in demand
2. Luxury goods
Necessary goods
3. More flat and small slope
More stiff and high slope
4.

II EE

Price elasticity Vs Income Elasticity

1. Definition
2. Ceterus peribus
3. Equation:
∆𝑄 𝑃
𝑋
∆𝑃 𝑄
∆𝑄 𝑌
𝑋
∆𝑌 𝑄

4. Variable: Independent variable is price, Dependent is demand

Independent variable is income, dependent is demand
 5. Value of Elasticity: Negative, as price and demand has inverse relationship
Positive
∆𝑄
6. Slope:
∆𝑃
∆𝑄
∆𝑌
7. Giffen goods: PE has positive value
IE has negative value

Indifference curve:
The substitute theorem of Francis Ysidro Edgeworth, Vilfredo Pareto, Allen, Hicks in
response to the Marshalls theory of utility to describe consumers’ behavior is known as
theory of Indifference.

An indifference curve is a graph showing different bundles of goods between which a

consumer is indifferent. That is, at each point on the curve, the consumer has no preference
for one bundle over another. One can equivalently refer to each point on the indifference
curve as rendering the same level of utility (satisfaction) for the consumer. Utility is then a
device to represent preferences rather than something from which preferences come.[1] The
main use of indifference curves is in the representation of potentially observable demand
patterns for individual consumers over commodity bundles.[2]

There are infinitely many indifference curves: one passes through each combination. A
collection of (selected) indifference curves, illustrated graphically, is referred to as an
indifference map.

Attributes or properties or characteristics of indifference curves

An indifference curve shows combination of goods between which a person is indifferent.

The main attributes or properties or characteristics of indifference curves are as
follows:

(1) Indifference curves are negatively sloped:

The indifference curves must slope down from left to right. This means that an indifference
curve is negatively sloped. It slopes downward because as the consumer increases the
consumption of X commodity, he has to give up certain units of Y commodity in order to
maintain the same level of satisfaction.
In fig. 3.4 the two combinations of commodity cooking oil and commodity wheat is shown by
the points a and b on the same indifference curve. The consumer is indifferent towards
points a and b as they represent equal level of satisfaction.

At point (a) on the indifference curve, the consumer is satisfied with OE units of ghee and
OD units of wheat. He is equally satisfied with OF units of ghee and OK units of wheat
shown by point b on the indifference curve. It is only on the negatively sloped curve that
different points representing different combinations of goods X and Y give the same level of
satisfaction to make the consumer indifferent.

(2) Higher Indifference Curve Represents Higher Level:

A higher indifference curve that lies above and to the right of another indifference curve
represents a higher level of satisfaction and combination on a lower indifference curve
yields a lower satisfaction.

In other words, we can say that the combination of goods which lies on a higher indifference
curve will be preferred by a consumer to the combination which lies on a lower indifference
curve.
In this diagram (3.5) there are three indifference curves, IC1, IC2 and IC3 which represents
different levels of satisfaction. The indifference curve IC3 shows greater amount of
satisfaction and it contains more of both goods than IC2 and IC1 (IC3 > IC2 > IC1).

(3) Indifference Curve are Convex to the Origin:

This is an important property of indifference curves. They are convex to the origin (bowed
inward). This is equivalent to saying that as the consumer substitutes commodity X for
commodity Y, the marginal rate of substitution diminishes of X for Y along an indifference
curve.
In this figure (3.6) as the consumer moves from A to B to C to D, the willingness to
substitute good X for good Y diminishes. This means that as the amount of good X is
increased by equal amounts, that of good Y diminishes by smaller amounts. The marginal
rate of substitution of X for Y is the quantity of Y good that the consumer is willing to give up
gaining a marginal unit of good X. The slope of IC is negative. It is convex to the origin.

(4) Indifference Curve Cannot Intersect Each Other:

Given the definition of indifference curve and the assumptions behind it, the indifference
curves cannot intersect each other. It is because at the point of tangency, the higher curve
will give as much as of the two commodities as is given by the lower indifference curve. This
is absurd and impossible.
In fig 3.7, two indifference curves are showing cutting each other at point B. The
combinations represented by points B and F given equal satisfaction to the consumer
because both lie on the same indifference curve IC2. Similarly the combinations shows by
points B and E on indifference curve IC1 give equal satisfaction top the consumer.

If combination F is equal to combination B in terms of satisfaction and combination E is

equal to combination B in satisfaction. It follows that the combination F will be equivalent to
E in terms of satisfaction. This conclusion looks quite funny because combination F on IC2
contains more of good Y (wheat) than combination which gives more satisfaction to the
consumer. We, therefore, conclude that indifference curves cannot cut each other.

(5) Indifference Curves do not Touch the Horizontal or Vertical Axis:

One of the basic assumptions of indifference curves is that the consumer purchases
combinations of different commodities. He is not supposed to purchase only one
commodity. In that case indifference curve will touch one axis. This violates the basic
assumption of indifference curves.
In fig. 3.8, it is shown that the in difference IC touches Y axis at point C and X axis at point
E. At point C, the consumer purchase only OC commodity of rice and no commodity of
wheat, similarly at point E, he buys OE quantity of wheat and no amount of rice. Such
indifference curves are against our basic assumption. Our basic assumption is that the
consumer buys two goods in combination.
 Module B: Production, Cost and Market structure

Production Function

The Production function shows a technical relationship between the physical inputs and
physical outputs of the firm, for a given state of the technology. It is the relationship between
the maximum amount of output that can be produced and the inputs required to make that
output. The function gives for each set of inputs, the maximum amount of output of a
product that can be produced. It is defined for a given state of technical knowledge (If
technical knowledge changes, the amount of output will change.)

Q=f(a,b,c,......z)
where a,b,c ....z are various inputs such as land, labour ,capital etc and Q is the level of the
output for a firm.

If labour(L) and capital(K) are only the input factors, the production function reduces to-
Q= f(L,K)

Production Function is

1. The tool of analysis used to explain the input-output relationship

2. Describes the technological relationship between inputs and outputs in physical
terms
3. It tells that the production of a commodity depends on specific inputs
4. It represents quantitative relationship between inputs and output
5. It represents the technology of a firm, of an industry, or of the economy as a whole

A. Short term: Time when one input (say, capital) remains constant and an addition to
output can be obtained only by using more labour.
B. Long run: Both inputs become variable.

Importance of the Concept of Production Function

In an economy there will be thousands and millions of production functions because each
firm will have one for each of the products that it is making. From the production function,
the cost curves of a firm for each of its products can be determined. Contribution of each
factor of production i.e., land, land, capital is also determined from production functions. The
price that a factor of production will command in the market will be determined by the
production functions from the demand side.

Total product or output is the total output produced in physical units by using a set of
inputs. It is given by the product function directly.

Marginal product of an input is the extra product or output produced when 1 extra unit of
that input is added while other inputs are held constant at any given set of inputs.
MP=∆𝑄/∆𝐿

Average product or output is total output divided by total units of input. It can be
calculated for each input separately also.
.AP=Q/L

Three stages of production

There are three phases or stages of production, as determined by the law of variable
proportions:
(i) Increasing returns.
(ii) Diminishing returns.
(iii) Negative returns.

Diagram/Graph: These stages can be explained with the help of graph below:

TP↑
MP<↓AP↓
WHEN TP TP↓
TP↑ HIGHEST MP=0 AP↓ >0
MP↑>AP↑ MP<0 OR -VE
PRODUCTION

TP

CRS DRS

AP

IRS INPUT VARIABLE

MP
(i) Stage of Increasing Returns. The first stage of the law of variable proportions is
generally called the stage of increasing returns. In this stage as a variable resource (labor)
is added to fixed inputs of other resources, the total product increases up to a point at an
increasing rate. In the first stage, marginal product curve of a variable factor rises in a part
and then falls. The average product curve rises throughout .and remains below the MP
curve.

Causes of Initial Increasing Returns: The phase of increasing returns starts when the
quantity of a fixed factor is abundant relative to the quantity of the variable factor. As more
and more units of the variable factor are added to the constant quantity of the fixed factor, it
is more intensively and effectively used. This causes the production to increase at a rapid
rate. Another reason of increasing returns is that the fixed factor initially taken is indivisible.
As more units of the variable factor are employed to work on it, output increases greatly due
to fuller and effective utilization of the variable factor.

(ii) Stage of Diminishing Returns. This is the most important stage in the production
function. In stage 2, the total production continues to increase at a diminishing rate until it
reaches its maximum point (H) where the 2nd stage ends. In this stage both the marginal
product (MP) and average product of the variable factor are diminishing but are positive.

Causes of Diminishing Returns: The 2nd phase of the law occurs when the fixed factor
becomes inadequate relative to the quantity of the variable factor. As more and more units
of a variable factor are employed, the marginal and average product decline. Another
reason of diminishing returns in the production function is that the fixed indivisible factor is
being worked too hard. It is being used in non-optimal proportion with the variable factor,
Mrs. J. Robinson still goes deeper and says that the diminishing returns occur because the
factors of production are imperfect substitutes of one another.

(iii) Stage of Negative Returns. In the 3rd stage, the total production declines. The TP,
curve slopes downward (From point H onward). The MP curve falls to zero at point L2 and
then is negative. It goes below the X axis with the increase in the use of variable factor
(labor).

Causes of Negative Returns: The 3rd phases of the law starts when the number of a
variable, factor becomes, too excessive relative, to the fixed factors, A producer cannot
operate in this stage because total production declines with the employment of additional
labor. A rational producer will always seek to produce in stage 2 where MP and AP of the
variable factor are diminishing. At which particular point, the producer will decide to produce
depends upon the price of the factor he has to pay. The producer will employ the variable
factor (say labor) up to the point where the marginal product of the labor equals the given
wage rate in the labor market.

A firm's production function could exhibit different types of returns to scale in different
ranges of output. Typically, there could be increasing returns at relatively low output levels,
decreasing returns at relatively high output levels, and constant returns at one output level
between those ranges.

Formally, a production function is defined to have:

• constant returns to scale if (for any constant a greater than 0)

• increasing returns to scale if (for any constant a greater than 1)

• decreasing returns to scale if (for any constant a greater than 1)

where K and L are factors of production, capital and labor, respectively.

Returns to scale:

Returns to scale reflect the responsiveness of total product when all the inputs are
increased proportionately.

The scale effect can be constant returns, decreasing returns, and increasing returns.
Stage 1: Increasing returns to scale (IRS) means if inputs are doubled, output is getting
more than double.
Stage 2: Constant returns to scale (CRS) means if inputs are doubled output also will
double.
Stage 3: Decreasing returns to scale (DRS) means if inputs are doubled output is not
doubling.

Time Horizon of Analysis

Three different time periods are used to develop theories of production and production costs

Momentary run: The period of time is so short that no change in production can take place.
Short run: The period of time in which labor and material can be changed, but all inputs
cannot be changed simultaneously. Especially, equipment and machinery cannot be fully
modified or increased.

Long run: All fixed and variable factors employed by the firm can be changed.

Technology change:

Technology change is said to occur when more output can be produced from the same
inputs.
Example: Wide-body jets increased the number of passenger-miles per unit of input by
almost 40 percent.

What is land in economics?

All natural gifts that facilitate production process in known as land in economics. Dr. Alfred
Marshall defined By Land is meant the material and the forces which Nature gives freely for
man's aid, in land and water, in air and light and heat.

By Labour is meant the economic work of man, whether with the hand or the head

By Capital is meant all stored-up provision for the production of material goods, and for the
attainment of those benefits which are commonly reckoned as part of income.

Characteristics of land:

1. Permanent
2. Non transferable
 3. Change on ownership
4. Old and un-destroyable
5. Limited supply
6. Gift of nature
7. Alternative use
8. Location
9. No production cost
10. Tendency to the law of diminishing return
11. Difference in fertility

Law of Variable Proportions/ Law of diminishing marginal returns

Definition:

There were three laws of returns mentioned in the history of economic thought up till Alfred
Marshall's time. These laws were the laws of increasing returns, diminishing returns and
constant returns. Dr. Marshall was of the view that the law of diminishing returns applies to
agriculture and the law of increasing returns to industry. Much time was wasted in
discussion of this issue. However, it was later on recognized that there are not three laws of
production. It is only one law of production which has three phases, increasing, diminishing
and negative production. This general law of production was named as the Law of Variable
Proportions or the Law of Non-Proportional Returns.

It holds that the marginal product of each unit of input will decline as the amount of that
input increases, holding all other inputs constant. The law of variable proportions is
concerned with the effect of changes in the proportion of the factors of production used to
produce output. As the proportion of one input increases relative to all other inputs, at some
point there will be decreasing marginal returns from that input. Adding more units of an
input, holding all other inputs constant will at some point cause the resulting increases in
production to decrease, or equivalently, the marginal product of that input will decline.
Among the inputs held constant is the level of technology used to produce that output.

According to Stigler "As equal increments of one input are added, the inputs of other
productive services being held constant, beyond a certain point, the resulting increments of
produce will decrease i.e., the marginal product will diminish".
According to Paul Samuelson "increases in some inputs relative to other fixed inputs will
in a given state of technology cause output to increase, but after a point, the extra output
resulting from the same addition of extra inputs will become less".

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

Assumptions of Law of Variable Proportions/ Law of diminishing marginal returns

1. Constant technology: This law assumes that technology does not

change throughout the operation of the law.
2. Fixed amount of some factors: One factor of production has to
be fixed for this law.
3. Possibility of varying factor proportions: This law assumes that
variable factors can be --changed in the short run.
4. Short run: The law assumes short run situation. The time is too
short for a firm to change the quantity of fixed factors. All the,
resources apart from this one variable, are held unchanged in
quantity and quality.
5. Homogeneous factors: Each factor unit in assumed to be
identical in amount and quality.

Schedule: Following table explains the working of law.

 Diagrammatic Representation of Law

Recapitalisation

→ This law is based on short production function.

→The gist of law is that if quantity of variable factors is increased keeping constant, other
factors, eventually AP and MP will decline.

→ This law is applicable in all industries, but more In agriculture.

→ Rationale producer prefers second stage where TP reaches maximum, MP become

zero, not negative. and AP decreases.

→ Third stage is unfeasible because MP is negative, so no meaning in paying additional

wages to labors.

Three Stages of the Law:

The law of variable proportions has vast general applicability. Briefly:

(i) It is helpful in understanding clearly the process of production. It explains the

input output relations. We can find out by-how much the total product will
increase as a result of an increase in the inputs.
 (ii) The law tells us that the tendency of diminishing returns is found in all sectors of
the economy which may be
a) Agriculture
b) Industry
c) Fisheries
d) Forestry
e) Mining

(iii) The law tells us that any increase in the units of variable factor will lead to
increase in the total product at a diminishing rate. The elasticity of the substitution
of the variable factor for the fixed factor is not infinite. From the law of variable
proportions, it may not be understood that there is no hope for raising the
standard of living of mankind. The fact, however, is that we can suspend the
operation of diminishing returns by continually improving the technique of
production through the progress in science and technology.

Iso product/ Equal Product/ Iso quant curve:

Isoquant is also called as equal product curve or production indifference curve or constant
product curve. Isoquant indicates various combinations of two factors of production which
give the same level of output per unit of time. The significance of factors of productive
resources is that, any two factors are substitutable e.g. labour is substitutable for capital and
vice versa. No two factors are perfect substitutes. This indicates that one factor can be used
a little more and other factor a little less, without changing the level of output.

It is a graphical representation of various combinations of inputs say Labour(L) and capital

(K) which give an equal level of output per unit of time. Output produced by different
combinations of L and K is say, Q, then Q=f (L, K). Just as we demonstrate the MRSxy in
respect of indifference curves through hypothetical data, we demonstrate the Marginal Rate
of Technical Substitution of factor L for K (MRTS L,K )

An isoquant (derived from quantity and the Greek word iso, meaning equal) is a contour
line drawn through the set of points at which the same quantity of output is produced while
changing the quantities of two or more inputs. While an indifference curve mapping helps to
solve the utility-maximizing problem of consumers, the isoquant mapping deals with the
cost-minimization problem of producers.
An isoquant shows the extent to which the firm in question has the ability to substitute
between the two different inputs at will in order to produce the same level of output. An
isoquant map can also indicate decreasing or increasing returns to scale based on
increasing or decreasing distances between the isoquant pairs of fixed output increment, as
output increases. If the distance between those isoquants increases as output increases,
the firm's production function is exhibiting decreasing returns to scale; doubling both inputs
will result in placement on an isoquant with less than double the output of the previous
isoquant.

Iso quant map shows all the possible combinations of labour and capital that can produce
different levels of output. The iso quant closer to the origin indicates a lower level of output.

The slope of iso quant is indicated as =MRSLk=

Table indicating various combinations of Labour and Capital to produce 1500 Units of
Output
COMBI UNITS OF UNITS OF TOTAL
NATIO CAPITAL LABOUR OUTPUT
NS

A 50(OK) 1 (OL1) 1500(IQ1)

B 45(OK2) 2(OL2) 1500(IQ1)

C 41(OK3) 3(OL3) 1500(IQ1)

D 38(OK4) 4(OL4) 1500(IQ1)

Assumptions

1. There are two factor inputs labour and capital

2. The proportions of factor are variable.
3. Physical production conditions are given
4. The Scale of operation is variable
5. The state of technology remains constant
Properties of Isoquants:

The main properties of the isoquants are similar to those of indifference curves. These
properties are now discussed in brief:

1. An Isoquant Slopes Downward from Left to Right:

This implies that the Isoquant is a

negatively sloped curve. This is
because when the quantify of factor K
(capital) is increased, the quantity of L
(labor) must be reduced so as to keep
the same level of output.

The figure (12.3) depicts that an

isoquant IP is negatively sloped curve.
This curve shows that as the amount
of factor K is increased from one unit
to 2 units, the units of factor L are
decreased from 20 to 15 only so that
output of 100 units remains constant.

2. An Isoquant that Lies Above and to the Right of Another Represents a Higher
Output Level:

It means a higher isoquant represents higher

level of output.

The figure 12.4 represents this property. It

shows that greater output can be secured by
increasing the quantity combinations of both
the factors X and Y. The producer increases
the output from 100 units to 200 units by
increasing the quantity combination of both the
X and Y. The combination of OC of capital and
OL of labor yield 100 units of production. The
production can be increased to 200 units by
increasing the capital from OC to OC1 and
labor from OL to OL1.
3. Two isoquants do not intersect each other:

The two isoquants can not intersect each

other.

If two isoquant are drawn to intersect each

other as is shown in this figure 12.5, then it is
a negation of the property that higher Isoquant
represents higher level of output to a lower
Isoquant. The intersection at point E shows
that the same factor combination can produce
100 units as well as 200 units. But this is quite
absurd. How can the same level of factor
combination produce two different levels of
output, when the technique of production
remains unchanged. Hence two isoquants
cannot intersect each other.

4. Isoquants are Convex to the Origin:

This property implies that the marginal

significance of one factor in terms of another
factor diminishes along an ISO product curve.
In other words, the isoquants are convex to
the origin due to diminishing marginal rate of
substitution.

In this figure 12.6 MRSKL diminishes from 5:1

to 4:1 and further to 3:1. This shows that as
more and more units of capital (K) are
employed to produce 100 units of the product,
lesser and lesser units of labor (L) are used.
Hence diminishing marginal rate of technical
substitution is the reason for the convexity of
an isoquant.
5. No isoquant can touch either axis

6. Isoquant is oval in shape

The iso product curve, is

elliptical. This means that the
firm produces only those
segments of the iso-product
curves which are convex to the
origin and lie between the ridge
lines. This is the economic
region of production.

7. IQs are never parallel to each other. Interspacing between them is least at the ends
and maximum in the middle.
8. IQs may be linear when labour and capital are perfect substitute.

A linear isoquant implies that either

factor can be used in proportion. If
isoquant has several linear segments
separated by kinks, the isoquant is
called kinked isoquant or activity
analysis isoquant or linear
programming isoquant. Such isoquants
are used in linear programming.
9. If Land K are prefect complements to each other, the IQ is L-shaped

. Such isoquant is known a input-output

isoquant or Leontief isoquant. There is
only one combination of L and K
available for production. It is the corner
point of L-shaped isoquant.

10. If marginal product of one of the two factors is zero, IQ is parallel to the axis on
which the factor with zero marginal products is represented.
11. If one of the two factors has negative marginal product the IQ slopes upwards from
left to right.
12. If both the factors have negative marginal products, the IQ is concave to the origin.
13. If the producer has a preference for a factor of production, the IQ is quasi linear.
14. If the factors to be employed in whole numbers units only. The IQ is discontinuous.

Iso cost curve

An isocost line shows all combinations of inputs which cost the same total amount.[1][2]
Although similar to the budget constraint in consumer theory, the use of the isocost line
pertains to cost-minimization in production, as opposed to utility-maximization. For the two
production inputs labour and capital, with fixed unit costs of the inputs, the equation of the
isocost line is

where w represents the wage rate of labour, r represents the rental rate of capital, K is the
amount of capital used, L is the amount of labour used, and C is the total cost of acquiring
those quantities of the two inputs.

The absolute value of the slope of the isocost line, with capital plotted vertically and labour
plotted horizontally, equals the ratio of unit costs of labour and capital. The slope is:
The isocost line is combined with the isoquant map to determine the optimal production
point at any given level of output. Specifically, the point of tangency between any isoquant
and an isocost line gives the lowest-cost combination of inputs that can produce the level of
output associated with that isoquant.

The isocost line is an important component when analysing producer’s behaviour. The
isocost line illustrates all the possible combinations of two factors that can be used at given
costs and for a given producer’s budget. In simple words, an isocost line represents a
combination of inputs which all cost the same amount.

Now suppose that a producer has a total budget of Rs 120 and and for producing a certain
level of output, he has to spend this amount on 2 factors A and B. Price of factors A and B
are Rs 15 and Rs. 10 respectively.

Combinations Units of Units of Total

Capital Labour expenditure
Price = 150 Price = 100 ( in BDT)
A 8 0 120
B 6 3 120
C 4 6 120
D 2 9 120
E 0 12 120
Concepts of Cost of Production:

1. Money Cost:
Cost of production expressed in monetary terms. It can be divided into two parts:
a) Explicit costs are expenses for which one must pay with cash or
equivalent. Because a cash transaction is involved, they are relatively
easily accounted for in analysis. These costs are never hidden, one
has to pay separately.
Example- Electricity Bill, wages to workers etc.

b) Implicit costs do not involve a cash transaction, and so we use the

opportunity cost concept to measure them. Implicit costs are related to
forgone benefits of any single transaction. These are intangible costs
that are not easily accounted for.
Example, the time and effort that an owner puts into the maintenance
of the company rather than working on expansion.

2. Real Cost:
Sacrifice made or difficulty faced for producing a product.

3. The opportunity cost of an asset (or, more generally, of a choice) is the highest
valued opportunity that must be passed up to allow current use. Opportunity cost is
also called economic opportunity loss. And is the value of the next best alternative
foregone as the result of making a decision

Example – I have a TV and VCR. I can either watch a movie or rent TV and
VCR.Out of 2 choices, I am selecting one. In this example, If I watch movie, then the
opportunity cost of watching the movie would be the amount of rent that I would have
earned.

Short and Long-Run Costs

In the long run, firms change production levels in response to (expected) economic profits or
losses, and the land, labor, capital goods and entrepreneurship vary to reach associated
long-run average cost. In the simplified case of plant capacity as the only fixed factor, a
generic firm can make these changes in the long run:

• enter an industry in response to (expected) profits

• leave an industry in response to losses
 • increase its plant in response to profits
• decrease its plant in response to losses.

Long-run average-cost curve with

economies of scale to Q2 and
diseconomies of scale thereafter.

The long run is associated with the long-run average cost (LRAC) curve in microeconomic
models along which a firm would minimize its average cost (cost per unit) for each
respective long-run quantity of output.

Long-run marginal cost (LRMC) is the added cost of providing an additional unit of service
or commodity from changing capacity level to reach the lowest cost associated with that
extra output. LRMC equalling price is efficient as to resource allocation in the long run. The
concept of long-run cost is also used in determining whether the long-run expected to
induce the firm to remain in the industry or shut down production there.

The long run is a planning and implementation stage. Here a firm may decide that it needs
to produce on a larger scale by building a new plant or adding a production line. The firm
may decide that new technology should be incorporated into its production process. The
firm thus considers all its long-run production options and selects the optimal combination of
inputs and technology for its long-run purposes. The optimal combination of inputs is the
least-cost combination of inputs for desired level of output when all inputs are variable.
Once the decisions are made and implemented and production begins, the firm is operating
in the short run with fixed and variable inputs.

Long-run average total cost curve. In the long-run, all factors of production are variable,
and hence, all costs are variable. The long-run average total cost curve ( LATC) is found
by varying the amount of all factors of production.
Short run

All production in real time occurs in the short run. The short run is the conceptual time
period in which at least one factor of production is fixed in amount and others are variable in
amount. Costs that are fixed, say from existing plant size, have no impact on a firm's short-
run decisions, since only variable costs and revenues affect short-run profits. Such fixed
costs raise the associated short-run average cost of an output long-run average cost if the
amount of the fixed factor is better suited for a different output level. In the short run, a firm
can raise output by increasing the amount of the variable factor(s), say labor through
overtime.

A generic firm already producing in an industry can make three changes in the short run as
a response to reach a posited equilibrium:

• increase production
• decrease production
• shut down.

In the short run, a profit-maximizing firm will:

• increase production if marginal cost is (<) less than marginal revenue (added
revenue per additional unit of output);
• decrease production if marginal cost is (>) greater than marginal revenue;
• continue producing if average variable cost is (<) less than price per unit, even if
average total cost is greater than price;
• shut down if average variable cost is (>) greater than price at each level of output.
In the short-run, some factors of production are fixed. Corresponding to each different level
of fixed factors, there will be a different short-run average total cost curve ( SATC). The
average total cost curve is just one of many SATCs that can be obtained by varying the
amount of the fixed factor, in this case, the amount of capital.

Fixed costs
Fixed costs do not alter with output. Fixed costs include:

• Land
• Machinery
• Advertising
• Indirect labour - admin, office staff etc. These must be
employed whatever level of output.
Fixed costs are shown as a straight line on a graph.
Fixed Cost
 Fixed and variable costs are categorized based on a period.
Firms have to commit costs for production capacity at the
start of a period and they have to incur these costs
irrespective of the production output. Such committed
capacity costs are termed fixed cost for a period.

Variable costs
Variable cost is incurred when production is there and it
varies with the level of output. Variable costs change with
output. They include:
• Raw materials
• Overheads - electricity, heating etc.
• Direct labour - e.g. factory workers
Variable costs rise more slowly than output at low levels of
output. As output gets bigger, diminishing returns set in and
costs rise faster than output.
The law of diminishing return states that applying more of a
factor of production gives a lower increase in output
compared to previous increases. The law applies only in the
short run when one or more factors is kept constant.

Total costs
Total cost is the cost incurred to produce a quantity of
output. A total cost schedule shows the total cost for
various output amounts. The total cost schedule is
derived from the production function of the product for a
firm. As per definition of production function and
assumption of a businessman's behavior (operating at
maximum efficiency and lowest cost), it will be the lowest
cost for that output.
TC=TFC+TVC
But Samuelson clearly highlighted that there is hard work
of the businessman involved to attain this lowest level of
costs. The firm's managers have to make efforts and
 make sure that they are paying the least possible prices
for necessary materials and supplies. The wages are to
be fixed or bargained so that neither they are high to raise
the firms production costs nor they are so low that
sufficient labor is not there to produce as per market
requirement. Also various engineering techniques are to
be utilized in equipment purchase decisions, factory
layout and production processes. Countless other
decisions are to be made in most economical fashion.

Average costs
Average fixed costs
Average fixed costs always fall as output increases
because the same cost is being spread over a larger
output.

Average variable costs

Average variable costs may fall slightly for small
levels of output due to increasing returns to scale. At
larger outputs, AVC increases because of diminishing
returns.

Average costs or Units Costs

Average cost or unit cost is the total cost divided by number
of units produced.

Average fixed cost is total fixed cost divided by number of

units produced. It keeps on decreasing as output increases.

Average variable cost is total variable cost divided by

number of units produced.
 Average costs (aka average total costs) are U shaped. At
lower levels of output, the effect of falling AFC (due to fixed
AC=TC/Q costs being spread) causes AC to fall. At higher levels, the
=TFC/Q+TVC/Q
effect of increasing AVC (due to diminishing returns) is more
=AFC+AVC
important and causes AC to increase.
The minimum point on the AC curve is the output solution
point. This is where productive efficiency is achieved. When
a firm begins to produce quantities above the output solution
point, its costs will increase (due to diminishing returns). In
this case, the firm should move to new premises or get a
new plant to overcome the problem of diminishing returns.

Minimum Average Cost

In the average cost curve, it is normally seen that average

cost initially comes down (as average fixed cost comes
down) as output increases, reaches a lowest point and then
starts rising. Hence on this curve there is a minimum
average cost point or output level. Hence average cost
curves have 'U' shape.
Marginal costs
Marginal cost is the cost of the last item produced. It crosses
AVC and AC at their minimum points. This is because when
MC is lower than AC, the additional lower cost brings the
average down, thus causing AC to fall. When MC is higher
than AC, it will pull AC up.
When costs rise, MC is affected most quickly, because it is the
last item produced. Averages take longer to reflect the full
extent of the cost increase

MC=∆𝐶/∆𝑄 At each output level or at any output level, marginal cost of

production is the additional cost incurred in producing one
extra unit of output.

Marginal cost can be calculated as the difference between the

total costs or producing two adjacent output levels. The
difference in variable cost of two adjacent output levels also
gives marginal cost, as fixed cost is constant for the two
levels.
 Marginal cost is a central economic concept with a crucial
important role to play in resource allocation decisions by
organizations.
Relationship between AC & MC

AC=TC/Q

MC=∆𝑇𝐶/∆𝑄

During initial stage, when production increases, AC and MC both decrease, but MC
decrease more than AC. So AC>MC.

When AC reaches the bottom or remains constant, AC=MC

When AC increases, MC also increases but at a faster rate than AC. So AC<MC

MC reaches the bottom before AC reaches its bottom. Hence AC>MC

Relationship among AC, AVC and AFC

TC=TFC+TVC AC=AVC+AFC

AC=TC/Q=TFC/Q+TVC/Q
AVC
Or AC=AVC+AFC
AFC

Fixed Cost Vs Variable Cost

Fixed cost is to be borne whether there is Variable cost varies with the production
no production or increased production or
decreased production
 Always remain + ve Can be ZERO

FC and market price need not to be in VC and market price must be in equilibrium
equilibrium for resuming production for resuming production

Initially, FC does not change for increased VC changes from starting of production
production

FC changes in the long run VC changes both in the short and long run

Choice of Inputs by the Firm

Every firm or entrepreneur has to decide how much of each input it should employ: how
much labor, capital, land, energy, various materials and services.

The fundamental assumption that economists make in this context is that of cost
minimization. Firms are assumed to choose their combination of inputs so as to minimize
the total cost of production.

Least-cost Rule: To produce a given level of output at least cost, a firm will hire factors
until it has equalized the marginal product per dollar spent on each factor of production. This
implies that

Marginal product of labor/price of labor = Marginal Product of Capital Equipment/Price of

capital equipment = ...

Thus the firm will choose a factor combination or resource combination that minimizes the
total cost of production.

Short Run vs. Long Run In Summary

Short Run: Some inputs variable, some fixed. New firms do not enter the industry, and
existing firms do not exit.

Long Run: All inputs variable, firms can enter and exit the market place.
The Long-run:
1. Period of time long enough for firms to change the quantities of all resources
employed including capital and new factories.
2. In the long run, there is no distinction between FC and VC because all resources
(therefore costs) are variable in the long run
3. In the long run, an industry and the individual firms it comprises can undertake all
desired resource adjustments or in other words, they can change the amount of all
inputs used.
4. The long run allows sufficient time for new firms to enter or for existing firms to leave
an industry.

Change from small scale to large scale, ATC will decrease at first, but it increase after. All
resources and costs are variable

The long-run cost curve: Why it is different from SRAC

As in the long run, all factors of production are variable and it is possible to produce
different scale in the least possible cost. LAC is drawn by joining the lease cost points of
SAC of a firm.

The green, orange, yellow, pink, blue curves are separate short run curves. The long
run curve is created by combining all the lowest ATC at any output of the short run
curves.
* If the number of possible plant sizes is very large, the long-run average-total-cost curve
approximates a smooth curve. Economies of scale, followed by diseconomies of scale,
cause the curve to be U-shaped.

SRAC Vs LRAC
 Curve is U shaped Curve is U shaped but flatter than SRAC
Slope is bigger than LRAC Slope is lower
Lowest point of SRAC is called desired Called desired level of production
point of production
SRAC can touch LRAC from top but Touches from bottom
never intersects each other
Definition
Diagram

Economies and Diseconomies of Scale

Economies of Scale: A firm achieves economies of scale when it is able to decrease the
per unit cost of production (ATC) as output increases. This can be achieved through cost
advantages such as:
1. Labor Specialization: as plant size increases, more workers are hired and
labor becomes increasingly specialized. workers work fewer and fewer tasks
and thus become more skilled at those tasks, and production is efficient
For example: Workers assemble specific parts of cars in an assembly line. Compared to
many workers working on one car at a time, the assembly line is much more efficient.
2. Workers become more proficient in their specialized area, making him highly
efficient in that one area.
3. Greater labor specialization eliminates the loss of time that comes with each
worker's shift from one task to another.
4. Managerial Specialization: a larger plant means an increasingly specialized
management.
For example, sales specialists will solely supervise sales, marketing specialists will solely
supervise marketing. Overall, efficiency increases and unit costs decrease
5. Efficient Capital: larger plants can afford better, more efficient equipment
6. Other: advertising costs fall per unit of output as more units are produced and
sold. Production and marketing skills increase as the firm produces and sells
more output. (learning by doing)

Example: The Daily Newspaper. Reporters, delivery trucks, photographers, editors,

management, printers, and all the paper resources go into making a newspaper. However,
in most large cities, this newspaper only costs 50 cents. The reason for this is that the fixed
costs are spread out and that an economy of scale is achieved. The large number of
consumers allows the publisher to specialize labor and large printing presses.
 Diseconomies of Scale: This is an increase in ATC as output increases. This is usually
attributed to the difficulty of efficiently controlling and coordinating a firm's operations as it
becomes a large-scale producer. (The beast becomes too big to handle!)
1. Overexpansion of management leads to:
• Bureaucratic red tape
• Miscommunication
• Slower decision-making
• Lower action in the face of changes in consumer tastes or technology
2. Workers are more inclined to slack or shirk if they are far removed or alienated from
employers. This also leads to greater dissatisfaction with work. More costs are
needed to hire more managers.
A good example of this is with General Motors. It became far too big to handle, and
thus split into smaller, far more profitable companies such as Cadillac etc.

Constant Returns to Scale: exist between where economies of scale end and
diseconomies scale begin. Long run AC (average cost) does not change --> ATC range
constant.

5 types of Economies of Scale:

1. Managerial Economies of scale:

The ability of a business to outsource and hire new people depending on its size
2. Technological:
The ability of a business to require new capital
3. Marketing:
The ability of a business to get discounts for supplies
4. Financial:
The ability to get loans from banks or use assets in order to purchase more technology
5. Risk Bearing:
The ability of a company to diversify

Minimum efficient scale and industry structure

• Minimum efficient scale: lowest level of output at which a firm can minimize its long-run
ATC. This is where economies of scale are reached and where, past this point,
diseconomies of scale begin to appear. The shape of the LATC and where the MES lie
determines the industry structure.
o LATC1: Where economies of scale are reached quickly and where diseconomies of scale
quickly begin, i.e. where MES is reached at a low level of input, the industry supports many
small producers.
▪ Examples: apparel, food processing, furniture, wood products, snowboard, and small-
appliance industries
o LATC2: Where economies of scale exist over a wide range and MES occurs only at high
output, efficient production will only be achieved by a few very large firms. Smaller firms,
unable to produce at small quantities efficiently, cannot compete. This can, in extreme
cases, lead to a natural monopoly.
▪ Examples: the aircraft, information technology and internet service provider industries.
▪ A natural monopoly is a relatively rare market situation in which average total cost is
minimized when only one firm produces the particular good or service.
o LATC3: Where there is an extended range of constant returns to scale, many quantities
produced have the same level of efficiency, allowing for many firms of different sizes to
coexist.
▪ Examples: the apparel, small-appliance and furniture industries.
Economies of scale. The U-shape of the LATC, depicted in Figure 1 , reflects the changing
costs of production that the firm faces in the long-run as it varies the level of its factors of
production and hence the level of its output. At low levels of output, a firm can usually
increase its output at a rate that exceeds the rate at which it increases its factor inputs.
When this situation occurs, the firm's average total costs are falling, and the firm is said to
be experiencing economies of scale.
Utility:

Meyers said “Utility is the quality or capacity of a good which enables it to satisfy
human needs.”

Utility refers to want satisfying power of a commodity.

In objective terms, utility may be defined as the “amount of satisfaction derived from a
commodity or service at a particular time”.Utility is represented in units called utils

Assumptions:

• Utility can be measured.

• Marginal Utility of money remains constant
• No change in income of the consumer, his taste & fashion to be constant
• No substitute
• Independent marginal utility of each unit of commodity

Characteristics:

1. Utility is not measurable in reality.

2. Utility is variable.
3. Utility is different from usefulness.
4. No legal or moral connotations.

Total Utility (TU)

Total Utility refers to the total satisfaction derived by the consumer from the consumption of
a given quantity of a good.
TU = Sum of all utilities.

Marginal Utility (MU)

Marginal Utility refers to the addition made to the total utility by consuming one more unit of
a commodity.
MUn = TUn - TUn-1
The utility analysis have developed two laws which have a very important place in
economics are

• Law of Diminishing Marginal Utility

• Law of Equi-Marginal Utility

Law of Diminishing Marginal Utility

Utility refers to the amount of satisfaction a person gets from consumption of a certain item
and marginal utility refers to the addition made to total utility, we get after consuming one
more unit.

An individual's wants are unlimited in number yet each individual's want is satiable. Because
of this, the more we have a commodity, the less we want to have more of it.
This law state that as the amount consumed of a commodity increases, the utility derived by
the consumer from the additional units, i.e. marginal utility goes on decreasing.

The law of diminishing marginal utility explains the downward sloping demand curve

Definition
According to Marshall, “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”

Assumptions:

1. All the units of a commodity must be same in all respect

2. The unit of the good must be standard
3. There should be no change in taste and income during the process of
consumption
4. There must be continuity in consumption
5. There should be no change in the price of the substitute goods
6. Considers a specific time
7. Constant marginal utility of money
8. Utility can be measured in terms of money.

Explanation:
As more and more quantity of a commodity is consumed, the intensity if desire decreases
and also the utility derived from the additional unit.

Suppose a person eats Bread. And 1st unit of bread gives him maximum satisfaction. When
he will add 2nd bread his total satisfaction would increase. But the utility added by 2nd
bread (MU) is less then the 1st bread. His Total utility and marginal utility can be put in the
form of a following schedule.

Plotting the above data on a graph gives

 • Here, from the MU curve we can see that MU is declining as consumer consumes
more of the commodity.
• When TU is maximum, MU is Zero.
• After that, TU starts declining and MU becomes negative.

Exceptions:

• Change in taste and income

• Quantity of commodity unit
• Time span
• Money
• Hobbies and Rare Things
• Liquor and Music
• Things of Display
• Substitute goods
• Supplementary goods
• Consumer habit like the meager

Importance:

• Basis of Law of Demand

• Basis of Consumption Expenditure
• The basis of Progressive Taxation

Law of Equi-Marginal Utility

This law states that the consumer maximizing his total utility will allocate his income among
various commodities in such a way that his marginal utility of the last rupee spent on each
commodity is equal. The consumer will spend his money income on different goods in such
a way that marginal utility of each good is proportional to its price

Limitations of Law of Equi-Marginal Utility

• It is difficult for the consumer to know the marginal utilities from different
commodities because utility cannot be measured.
• Consumers are ignorant and therefore are not in a position to arrive at equilibrium.
• It does not apply to indivisible and inexpensive commodity.
 Different forms of Market

In economics, market structure is the number of firms producing identical products which
are homogeneous. The types of market structdures include the following:

• Monopolistic competition, also called competitive market, where there is a large

number of firms, each having a small proportion of the market share and slightly
differentiated products.
• Oligopoly, in which a market is dominated by a small number of firms that together
control the majority of the market share.
o Duopoly, a special case of an oligopoly with two firms.
• Monopsony, when there is only one buyer in a market.
• Oligopsony, a market where many sellers can be present but meet only a few
buyers.
• Monopoly, where there is only one provider of a product or service.
o Natural monopoly, a monopoly in which economies of scale cause efficiency
to increase continuously with the size of the firm. A firm is a natural monopoly
if it is able to serve the entire market demand at a lower cost than any
combination of two or more smaller, more specialized firms.
• Perfect competition, a theoretical market structure that features no barriers to entry,
an unlimited number of producers and consumers, and a perfectly elastic demand
curve.

The imperfectly competitive structure is quite identical to the realistic market conditions
where some monopolistic competitors, monopolists, oligopolists, and duopolists exist and
dominate the market conditions. The elements of Market Structure include the number and
size distribution of firms, entry conditions, and the extent of differentiation.

These somewhat abstract concerns tend to determine some but not all details of a specific
concrete market system where buyers and sellers actually meet and commit to trade.
Competition is useful because it reveals actual customer demand and induces the seller
(operator) to provide service quality levels and price levels that buyers (customers) want,
typically subject to the seller’s financial need to cover its costs. In other words, competition
can align the seller’s interests with the buyer’s interests and can cause the seller to reveal
his true costs and other private information. In the absence of perfect competition, three
basic approaches can be adopted to deal with problems related to the control of market
power and an asymmetry between the government and the operator with respect to
objectives and information: (a) subjecting the operator to competitive pressures, (b)
gathering information on the operator and the market, and (c) applying incentive
regulation.[1]
 Quick Reference to Basic Market Structures

Market Seller Entry Seller Buyer Entry Buyer

Structure Barriers Number Barriers Number

Perfect
No Many No Many
Competition

Monopolistic
No Many No Many
competition

Oligopoly Yes Few No Many

Oligopsony No Many Yes Few

Monopoly Yes One No Many

Monopsony No Many Yes One

The correct sequence of the market structure from most to least competitive is perfect
competition, imperfect competition, oligopoly, and pure monopoly.

The main criteria by which one can distinguish between different market structures are: the
number and size of producers and consumers in the market, the type of goods and services
being traded, and the degree to which information can flow freely.

Perfect Competition Characteristics and Equilibrium Situations

Monopoly Characteristics and Equilibrium Situations
Oligopoly Characteristics and Equilibrium Situations
Monopolistic Competition Characteristics and Equilibrium Situations

We know that all firms will maximize profits at the output level where mr=mc. In the real
world, firms operate in a large variety of environments. These different environments, based
on different market conditions, influence the behavior of different firms in different ways.
In order to analyze this real life behavior, economists have identified characteristics that
make some firms similar to each other, and other firms different from one another. This has
led to the study of firms based on four categories of market structure: perfect competition,
monopolistic competition, oligopoly, and monopoly.

The characteristics of each market structure relate to differences in the demand curves
faced by firms in each category.

The identifying characteristics for each type of market structure include the number of firms
in the industry, whether the products are identical (homogeneous), ease of entry for new
firms in the industry, and the power that the firm has to influence the price of its products.

The following table summarizes the characteristics of the four types of market structure:

MARKET NUMBER OF TYPE OF ENTRY INTO FIRM'S EXAMPLES

STRUCTURE FIRMS PRODUCT INDUSTRY INFLUENCE
OVER PRICE

PERFECT MANY IDENTICAL EASY NONE AGRICULTURAL

COMPETITION CROPS

MONOPOLISTIC MANY DIFFERENTIATED EASY MODERATE MANY LOCAL

COMPETITION RETAIL OUTLETS

OLIGOPOLY FEW EITHER DIFFICULT MODERATE TO AUTOMAKERS

IDENTICAL OR SUBSTANTIAL
DIFFERENTIATED

MONOPOLY ONE UNIQUE IMPOSSIBLE SUBSTANTIAL LOCAL UTILITY

Perfect competition and monopoly are extremes at the opposite ends of the competitive
spectrum.
Most real world firms have characteristics that more closely resemble the monopolistic
competition and oligopoly models.
Perfect Competition Characteristics and Equilibrium Situations

Perfect competition is a market structure in which many firms sell identical products, and no
barriers to entry into the market exist for new potential sellers.

Robinson said: Perfect competition prevails where the demand for output of each producer
is perfectly elastic.

The characteristics of perfect competition are:

Generally, a perfectly competitive market exists when every participant is a "price taker",
and no participant influences the price of the product it buys or sells. Specific characteristics
may include:

1. Infinite buyers and sellers – An infinite number of consumers with the willingness
and ability to buy the product at a certain price, and infinite producers with the
willingness and ability to supply the product at a certain price.
2. Zero entry and exit barriers – A lack of entry and exit barriers makes it extremely
easy to enter or exit a perfectly competitive market.
3. Perfect factor mobiity – In the long run factors of production are perfectly mobile,
allowing free long term adjustments to changing market conditions.
4. Perfect information - All consumers and producers are assumed to have perfect
knowledge of price, utility, quality and production methods of products.
5. Zero transaction costs - Buyers and sellers do not incur costs in making an
exchange of goods in a perfectly competitive market.
6. Profit maximization - Firms are assumed to sell where marginal costs meet
marginal revenue, where the most profit is generated.
7. Homogenous products - The qualities and characteristics of a market good or
service do not vary between different suppliers.
8. Non-increasing returns to scale - The lack of increasing returns to scale (or
economies of scale) ensures that there will always be a sufficient number of firms in
the industry.
9. Property rights - Well defined property rights determine what may be sold, as well
as what rights are conferred on the buyer.
10. Rational behavior of buyers and sellers
11. No carrying cost
12. Fixed and same price
Equilibrium under perfect competition:

In the short run

Perfectly-competitive markets are not productively efficient as output will not occur where
marginal cost is equal to average cost (MC=AC). They are allocatively efficient, as output
will always occur where marginal cost is equal to marginal revenue (MC=MR). In perfect
competition, any profit-maximizing producer faces a market price equal to its marginal cost
(P=MC).

Condition 1: MC=MR=P

Condition 2: In the equilibrium point, MC would trend upward or MC curve will intersect MR
curve from below. Slope of MC curve> Slope of MR Curve
Y

SMC
SAC

T
E
P AR=MR=P
AVC
G
F

O X
Q1 Q2

Condition 1 is fulfilled by both T and E. But condition 2 supports only E.

Short term is referred to the period when a firm can’t change its production by changing the
permanent factors of production like machineries, building etc. In the short run, no new firm
can enter the market and it can only vary its production by varying the variable factors like
labor, raw materials etc.
The short term objective of a firm is to maximize profit. The producer fixed the quantity and
price as such that it can maximize its profit. That is why a firm will produce goods until and
unless the MR equals MC.

As there are many sellers in a competitive market, a single firm can’t influence the price of a
good and hence it has to sell in the available market price. As a result a firm continues until
MR equal AR equal Price.

A firm can face any one of the 3 situations-

a) Equilibrium with
abnormal profit
MC
In short run, there are fixed as
P AC
well as variable factors of D P
production. In short run, a firm MR=AR=P
maximizes its profit by IIIIIIIIIIIIIIIIIIIIIIIIIIIIIIII A
C
Price and cost

choosing an output at which C

MC=MR=price. The profit is
measured by the difference in
AC and AR and competing
the rectangle. The Profit
earned is super normal profit Production (Q)
in this case.

When the intersection of MC and AC curve falls below

the (AC<P) MC=MR=AR=P line, abnormal profit is made.

• P is the equilibrium situation in perfect

competition.
• At P, MC= MR. A firm will produce its output till
point P only because it maximizes its profit.
• AR=MR=P. (AR-AC) tells the average profit(profit
for a unit) and
• to know total profit, multiply average profit with the
number of units sold(q). So, PACD is the profit
that a firm will earn in short run.
b) Equilibrium with
normal profit

When MC=AC=MR=AR=P

(AC=P)

c) Equilibrium with loss

Not all firms make

supernormal profits in the
short run. Their profits IIIIIIIIIIIIIIIIIIIIIIIIIIIIIIII
depend on the position of P
their short run cost curves.
Some firms may be
experiencing Losses
because their average
costs exceed the current
market price. Other firms When AC>P.
may be making normal
profits where total revenue MC intersects AC over the MR=AR=P line.
equals total cost (i.e. they
are at the break-even
output). In the diagram
below, the firm shown has
high costs such that the
market price is below the
average cost curve. At the
profit maximising level of
 output, the firm is making
an economic loss .

In the long run

Perfectly competitive markets are both allocatively and productively efficient. At equilibrium
MC=MR=AC=AR.

If most firms are making super normal profits in the short run there will be an expansion of
the output of existing firms and we expect to see the entry of new firms into the industry.
Firms are responding to the profit motive and supernormal profits act as a signal for a
reallocation of resources within the market. The addition of new suppliers would result in an
increase in supply .

Making the assumption that the market demand remains same, higher market supply will
reduce the equilibrium market price until the price = long run average cost. At this point
each firm is making normal profits only. There is no further incentive for movement of firms
in and out of the industry and a long-run equilibrium is established.

• E is the equilibrium point. At this point

MR= MC.
• Drawing a straight line from E to LAC
curve gives us the cost of the product.
• Here, LAC=LAR (or price). So, the firm
is incurring normal profit. This implies
that a factor's price equals the factor's
marginal revenue product. It allows for
derivation of the supply curve on which
the neoclassical approach is based.

The long-run equilibrium of a perfectly competitive industry generates six specific

equilibrium conditions, including: (1) economic efficiency (P = MC), (2) profit maximization
(MR = MC), (3) perfect competition (MR = AR = P), (4) breakeven output (P = AR = ATC),
(5) minimum production cost (MC = ATC), and (6) minimum efficient scale (MC = ATC =
LRAC = LRMC).

How price and output of a product are determined under perfect competition
In a perfect competition, there are many sellers as well as buyer. Price is determined by
enormous bargaining. In this market condition, producers can entry and exit easily. The
goods are identical and homogeneous and price of the good is same everywhere.

The demand of a good depends on the marginal utility. Buyers pay the maximum price for a
good while the price of a good is equal to the marginal utility derived from that good. This
price represents the buyers’ willingness to pay for demand of the good.

On the other hand, supply of a good depends on the marginal cost of that good. A firm is
willing to supply at the lowest price while the price of the good is equal to its marginal cost of
production. This low price is the supply price of the firm.

The equilibrium price determined at the point where the demand and supply price of the
buyers and sellers respectively are equal. In perfect competition market, the price is fixed by
ups and downs of demand and supply.

The price determination is shown in a tabular format below:

P D S Relationship of D Pricing status
and S
20 200 1000 D<S
18 400 800 D<S
16 600 600 D=S Equilibrium price
14 800 400 D>S
12 1000 200 D>S
The list is presented in the below drawn diagram:
 D S When price increases from 16 to
20 18 demand becomes 400 but
Price

18
supply stands at 800, at D>S, price
falls to 16 again. Accordingly,
16 when price falls from 16 to 14,
demand rises to 800 but supply
14 remains short to 400, which
12 pushes up the price again to 16.

200 400 600 800 1000

Demand and Supply

Thus the price of a good is determined through stages of ups and down of the demand and
supply of that good.

Short run vs Long Run

Equilibrium in perfect competition is the point where market demands will be equal to
market supply. A firm's price will be determined at this point. In the short run, equilibrium will
be affected by demand. In the long run, both demand and supply of a product will affect the
equilibrium in perfect competition. A firm will receive only normal profit in the long run at the
equilibrium point.

Short Run

• Short run is that period of time in which a producer can not increase the supply of all
factors.
• In short run at least one factor is fixed.
• A Producer has certain commitments in the short run.

Long Run

• In the long run, the firm can change everything, all the factors of production are
variable
 • No costs are fixed, all costs become variable
• Producer can make major decisions; investments can be made in the long run.
• In long run, a firm can choose technology, can make certain investments.
• Can make long term contractual commitments.

Time Frame of short and Long run

• There is no specific length to the long or short run.

• It depends on industry to industry.
• Example - for a steel plant, 1 year is short run. But for a small industry, it is a long
run.
• Once the firm makes its long run decisions, then it chooses Long and Short Run
according to the time.

Limitations:

• Perfect competition would only apply where production techniques are simple and
expansion opportunities are limited.

• If not, a firm could grow larger and become more efficient and would be able to exert
an influence on the market.

• Markets are normally dominated by large buyers that are able to have great
influence over the market.

• The domestic market for defence could be competitive in terms of sellers but the
demand may only come from one buyer (the government).

• It is far from truthful that buyers and sellers have complete information about market
conditions.

• Research shows that buyers have little knowledge of the going rate for a product.
Perfect competition and efficiency

Perfect competition is considered to be the most efficient market structure within any given
equilibrium situation. Other market structures have some long term advantages over perfect
competition, such as: economies of scale, consumer choices, and incentives for advances
in technology.

But within any given equilibrium, perfect competition is the most efficient market structure.

Types of efficiency:

1. Productive efficiency: using the least cost combination of resources to produce a

specific output level.

2. Allocative efficiency:
producing what the consumers want at a price equal to marginal cost.

3. Economic efficiency: a situation in which both productive efficiency and allocative

efficiency exist.

Efficiency means having the maximum benefit at the least cost.

In a market (as opposed to an individual firm) supply and demand diagram, the intersection
of the supply and demand curves will set the equilibrium price and quantity.

In perfect competition, with each firm being a price taker, firms cannot stray from this
equilibrium price. The individual firm will produce a quantity so that the sum of all firms will
produce the quantity that equals market equilibrium. The least cost component of efficiency
will be a product of this market equilibrium. This will be shown in the discussion of individual
firm behavior in perfect competition.

The maximum benefit component of efficiency can be seen from the market supply &
demand diagram. Benefit in this context refers to the concept of surplus:

Consumer surplus refers to the difference between what consumers are willing to pay and
the amount that they actually pay. The amount that they are willing to pay is based on the
demand curve. The amount that they actually pay is based on the market equilibrium price.
On a supply & demand diagram, consumer surplus is measured by the area that lies both
below the demand curve and above the market price.

Producer surplus refers to the difference between the price the sellers are willing to sell
the product for and the price that the sellers actually receive. The amount that they are
willing to sell for is based on the supply curve. The amount that they actually receive is
based on the market equilibrium price. On a supply & demand diagram, producer surplus is
measured by the area both above the supply curve and below the market price.

Total surplus is the sum of consumer surplus and producer surplus. Efficiency is achieved
by maximizing total surplus.

On the market supply & demand diagram, the only area that can potentially be a part of total
surplus is the area defined by the triangle formed by these three points: market equilibrium,
the point where the demand curve intersects the price axis, and the point where the supply
curve intersects the price axis. Perfect competition is the only market structure that includes
this entire area in total surplus. This makes perfect competition the most efficient market
structure.
Monopolistic/Imperfect competition as the name signifies is a blend of monopoly and
competition. It is a systematic and realistic theory of price analysis in this imperfectly
competitive world.

Monopolistic competition is a market situation in which there are relatively large numbers of
small firms which produce or sell similar but not identical commodities to the customers.

According to Leftwitch:

"Monopolistic competition is a market situation in which there are many sellers of a

particular product, but the product of each seller is in some way differentiated in the minds
of consumers from the product of every other seller".

In the words of J.S. Bain:

"Monopolistic competition is found in the industry where there is a large number of small
sellers selling differentiated but close substitute products".

But monopolistic competition differs from perfect competition because firms in monopolistic
competition sell differentiated products. Consumers consider the products of firms in a
monopolistically competitive industry to be close substitutes for one another, but not
identical.

For example, a firm supplies branded good 'Lux Soap' in the market. There are many other
firms in the market which sell similar soaps (not identical) with different brand names like
Rexona, Palm Rose, etc., etc. The firm supplying 'Lux Soap' enjoys a monopoly position
over the sale of its own product. It also faces competition from firms selling similar products.

The characteristics of monopolistic competition (MC):

1. Independent decision making: Firms in monopolistic competition are free to set

their own prices.
2. Market Power
3. Buyers and Sellers do not have perfect information (Imperfect Information)
4. A fairly large number of sellers: The number of firms in monopolistic competition is
fairly large. Each firm produces or sells a close substitute for the product of other
firms in the product group or industry. .Product differentiation is thus the hallmark of
monopolistic competition.
5. Differentiation in products: Under monopolistic competition, the firms sell
differentiated products. Product differentiation may be real or imaginary. Real
differentiation is done through differences in the materials used, design, color etc.
Imaginary differences may be created through advertisement, brand name, trade
marks etc. The firms producing similar products in this imperfectly competitive world
cannot raise the price of product much higher than their rivals. If they do so, they will
lose much of their sale, but not all the sale. In case, they lower the price, the total
sale can be increased to a certain extent. How much will the sale increase or
decrease by lowering or raising the price will depend upon the product differentiation
of the different firms.

If the product of the various firms are very close substitutes of one another and no
imaginary or real difference exists in the mind of the buyers, then a slight rise or fall
in the price of the product of one firm will appreciably decrease or increase the
demand for the product. If the product of one firm differs from that of other firm,
(though the difference may be an imaginary one) a slight rise in the price of the
product of one firm will not drive away all its customers. A few faithless buyers may
be attracted by the low price of the other rival product but not all the buyers.

6. Advertisement and propaganda: Another very important characteristic of the

monopolistic competition is that each firm tries to create difference in its product from
the other by advertising, propaganda, attractive packing, nice smile, etc., etc. When
it succeeds in its object, the firm occupies almost the position of a monopolist. It is,
thus, in a position to raise-the price of the product without losing its customers.

7. Nature of demand curve: Since the existence of close substitutes limits the
monopoly power, the demand curve faced by a monopolistically competitive firm is
fairly elastic. The precise degree of elasticity will however, depend upon the number
of firms in the group product or industry. If the number of firms is fairly large and the
product of each firm is not very similar, the demand curve of a firm will be quite
elastic. In case, there is close competition among the rival firms for the sale of similar
products, the demand curve of a firm will be less elastic.

8. Freedom of entry and exit of firms: The entry of new firms in the monopolistically
competition industry is relatively easy. There are no barriers of the new firm to enter
the product group or leave the industry in the long run.

9. Sales efforts: With heterogeneous products, the sale of the products by the firms
can no longer be taken for granted sale depends upon sale efforts.
 10. Non-price competition: In monopolistic competition, the firms make every effort to
win over the customers. Other than price cutting, the firms may offer after sale
service, a gift scheme, discount not declared in the price list etc. Firms can use
convenience as a form of non-price competition. Store location can be a
convenience to specific consumers. So can the availability of online shopping. The
availability of other products and services offered by the seller can also be a form of
non-price competition that utilizes convenience for consumers.

Grocery stores often distinguish themselves from the competition by the overall
product selection available in their stores, as well as the addition of other products
and services at the same location. For example, a grocery store may try to lure in
customers by providing a full-service bakery, deli, pharmacy, dry cleaning business,
check cashing, video rentals, other product rentals (such as carpet cleaners),
delivery services (such as being a drop-off and pick-up location for Fedex), wire
services such as western union, an onsite gas station, recycling services, even
banking services.

Other forms of non-price competition include such things as customer service,

different product features, style, warranties, and even packaging. Such non-price
competition is often designed to separate consumers into different groups with
separate demands.

Because of the existence of many close substitutes, the demand for products in
monopolistic competition is highly elastic. Non-price competition is designed to
decrease the price elasticity of demand by rotating the demand curve.

Positive: It is a competition because of the It is a monopoly because each firm

presence of has some control over market
conditions.
i) a large number of firms and,

ii) freedom of entry

Negative: It is not a pure competition It is not a monopoly because the
because i) the products are not producer is not a single individual.
homogenous but differentiated
and, ii) the Price is not uniform. There is no restriction on entry, and the
goods are close substitutes.
Short Run Equilibrium Under Monopolistic/Imperfect Competition:

A single firm in the product group (industry) has little impact on the market price. However, if
it reduces price, it can expect a considerable increase in its sales. The firm may also attract
buyers away from other firms by creating imaginary or real difference through advertising,
branding and through many other sales promotion measures (non-price competition). If the
firm raises its price, it will not lose all its customers. This is because of the fact that the
product is differentiated from competing firms due to price and non-price factors. The
demand curve (AR curve) of the monopolistic firm is therefore, highly elastic and is
downward sloping. As regards the marginal revenue curve, it slopes downward and lies
below the demand curve because price is lowered of all the units to sell more output in the
market.

Firm's Equilibrium Price and Output:

In the short-run, the number of firms in the 'product group' remains the same. The size of
the plant of each firm remains unaltered. The firms either operating under perfect
competition or monopoly wants to maximize profits. In order to achieve this objective, it
goes on producing a commodity so long as the marginal revenue is greater than marginal
cost. When MR = MC, it is then in equilibrium and produces the best level of output. If a firm
produces less than or more than the MR = MC output, it will then not be making maximum
of profits.

In the short-run, a monopolistically competitive firm may be realizing abnormal profits or

suffering losses. If it is earning profits, no new firms can enter the industry in the short-run.
In case, it is suffering, losses but covering full variable cost, the firm will continue operating
so that the losses are minimized. If the full variable cost is not met, the firm will close down
in the short-run. The short-run equilibrium with profits and short run equilibrium with losses
of a monopolistically competitive firm are explained with the help of two separate diagrams
as under.

Diagram:
 In the figure (17.1), the downward sloping
demand curve (AR curve) is quite elastic.
The MR curve lies below-the average
curve except at point N. The SMC curve
which includes advertising and sales
promotional costs is drawn in the usual
fashion. The SMC curve cuts the MR
curve from below at point Z. The firm
produces and sells an output OK, as at
this level of output MR = MC. The firm
sells output OK at OE/KM per unit price.
The total revenue of the firm is equal to
the area OEMK, whereas the total cost of
producing output OK is OFLK. The total
profits of the firm are equal to the shaded
rectangle FEML. The firm earns
abnormal profits in the short run.

Short Run Losses:

If the demand and cost situations are not favorable in the market, a monopolistically
competitive firm may incur losses in the short-run. The short-run equilibrium of the firm with
losses is explained with the help of a diagram.

Diagram:
In the Figure (17.2), marginal cost
(SMC) equates marginal revenue MR
curve from below at point Z. The firm
produces output OK and sells at
OF/KT per unit-price. The total receipt
of the firm is OFTK. The total cost of
producing output OK is equal to
OEMK. The firm suffers a net loss
equal to the area FEMT on the sale of
OK output.
Equilibrium Price and Output in the Long Run Under Monopolistic/Imperfect
Competition:
Long Run Zero Economic Profits:
In the long run, the firms are able to alter the scale of plant according to the changed
conditions of demand for a product in the market. They can also leave or enter the industry. If
the firms are earning abnormal profits in the short run, then new firm will enter the 'product
group' (industry). The tendency of the new firms to enter the industry continues till the abnormal
profits are competed away and the firms economic profits are zero. In case the monopolistically
competitive firms realize losses in the short-run, then some of the firms will leave the industry.
The exit of the firm continues till zero economic profits are restored with the operating firms.

In the long-run, there are no entry barriers for the new firms. The incoming firms install latest
machinery and try to differentiate their products from those of the established firms. The old
firms operating with .the used machinery try to match up with the new entrants by improved
variety of products in their group. They increase expenditure on advertisement and on other
sales promotional measures. They employ more qualified staff for making technical
improvement in their products. Since all the firms for their existence incur additional
expenditure for improving the quality of the products, the cost curves of all the firms move up.
Due to entry of new firms in the industry and higher costs of production, the output of each
competing firm is reduced. There is, therefore, a waste in the economic resources of the
country. The equilibrium price and output in the long-run is explained with the help of a
diagram.

Diagram:
In the figure (17.3), the higher shifted long-run marginal
cost curve intersects the higher shifted marginal revenue
curve at point M. The firm at this raised equilibrium point,
produces the reduced level of output OK. It sells this
output at price TK as at point T, LAC is a tangent to the
demand or average revenue curve at its minimum point.
The total revenue of the firm is equal to the area OETK.
The total costs of the firm are also equal to the area
OETK. The firm is earning only zero or normal economic
profits. As the monopolistically competitive firm sets a
price higher than that minimum average cost in the
long-run, the firm therefore produces a smaller
output. Since all the firms in the product group produce
less at higher price, there is, therefore, an apparent
waste of resources and exploitation of the consumers.
Monopoly

Monopoly is from the Greek word meaning one seller. It is the polar opposite of perfect
competition. Monopoly is a market structure in which one firm makes up the entire market.
Monopoly and competition are at the two extremes. It is defined as:

"Monopoly refers to a market where there is a single seller for a product and there is no
close substitute of the commodity that is offered by the sole supplier to the buyers. The firm
constitutes the entire industry"

Professor Benham said, “The monopolist can fix whatever price he pleases or can sell
whatever amount he planes but he can’t sell as much likes whatever price he likes.”

Economist Stigler said, “Monopoly is such a firm producing a commodity of which there are
no close substitutes.

The market size can be large or small. A firm in a monopoly market structure is called a
monopolist. There are barriers to entry. In reality, Monopoly rarely exists; always some form
of substitute is available.

Characteristics:

1. There is only a single seller of a product or

service in the market. 1. Single seller
2. The goods produced by a sole seller have 2. Multi buyers
no close substitutes. 3. No substitute goods
3. The goods are homogenous. 4. Homogeneous goods
4. There are a lot of buyers 5. AR & MR slope down to
5. AR and MR slope downward to the right right
6. AR curve places over MR curve 6. AR goes over MR
7. The demand and supply of goods are 7. Producer controls D & S
controlled by the producer. 8. New entry barred
8. The entry of new firms into the industry is 9. Single firm industry
effectively barred by legal or natural 10. No advertisement
barriers. 11. Abnormal profit making
9. The firm being the sole supplier of a 12. Don’t affect others
product constitutes industry. Firm and 13. Demand curve –ve slope
industry thus have single identity. Or we 14. Size of firm does not
can say monopoly is a single firm identity. matter
 10. Zero advertising cost.
11. A monopolist makes abnormal profit due to no competition.
12. The single seller affects no other seller by its own action in the market. The
other sellers too cannot affect the price and output of the monopolist.
13. The demand curve facing the monopolist is negatively sloped. The monopolist
being the only seller of the commodity in the market can increase the total
sale by lowering the price and if, it raises the price, it would not lose entire
sale. The demand curve facing a monopolist is less than perfectly elastic, i.e.
it slopes downward from left to right.
14. For the monopoly to exist, it is not necessary that the size of a firm should .be
large. Even a small firm may have a monopoly. For instance, a local water
company or a local electricity company, supplying water and electricity in the
city possesses all the characteristics of a monopoly.

Monopoly power

Monopoly power refers to cases where the monopolist firms influence the market in some
way through their behaviour. A monopolist firm can show its power by

• Influencing prices( A monopoly firm can set its prices as high as it wants)
• Influencing output ( A monopoly firm can set its output level as high or as low)
• Raising barriers to entry
• Pricing strategies to avoid competition ( A monopoly firm has the complete control on
market)
• May not pursue profit maximisation ( It is not always true that a Monopoly firm will
aim at profit maximisation.)
• A firm having more than 25% of total market share can considered as a monopoly.

Why Monopolies Arise?

The fundamental cause of monopoly is barriers to entry and Economies of Scale. Barriers to
entry have three sources:

• Ownership of a key resource: This tends to be rare. De Beers ( diamonds) is an

example
• The government gives a single firm the exclusive right to produce some good.
Patents, Copyrights and Government Licensing.
 • Costs of production make a single producer more efficient than a large number of the
producers. Natural Monopolies

Because there is only one firm in the market, the firm's demand curve is the same as the
market demand curve. A monopolist is a price maker. It decides what price at which to sell
its product. It also decides what quantity to offer for sale. A monopolist has market power.

If a monopolist raises its price, the downward sloping demand curve means that it will sell
fewer units. By having to lower the price on all units instead of just the additional units, the
marginal revenue curve lies below the demand curve. Like any firm in any market structure,
profits are maximized at the quantity of output where marginal revenue (MR) is equal to
marginal cost (MC). With the marginal revenue curve below the demand curve, this quantity
will be lower than the profit-maximizing quantity in perfect competition. Since the monopolist
sets the quantity where MR=MC, supply is determined by marginal cost.

Profits are maximized at the quantity where MR=MC, but the monopolist can charge the
price where this quantity intersects the demand curve. Since the demand curve lies above
the marginal revenue curve, this price will be higher than what would occur under perfect
competition. Since the price is set by the demand curve, and price also equals average
revenue, the average revenue curve is the demand curve.

All else equal, then, the monopolist will sell a lower quantity at a higher price. With the
output quantity determined by the marginal revenue curve, and the price determined by the
demand curve (which lies above the marginal revenue curve), a monopolist doesn't really
have a supply curve. It has a supply point. This is because only one point in a graph factors
in price, quantity, demand, and marginal revenue.

A monopolist that sells a product with an inelastic demand can set a price higher than a
monopolist that sells a product with an elastic demand, all else equal. This means that a
monopoly for a product that is deemed to be a necessity is of special concern to the public
and to policy makers.
Why do monopolies exist?

A monopoly exists because the barriers to entry into the market are prohibitive. These
barriers prevent other firms from entering the market. Since other firms are not able to enter
the market to take advantage of profit potential, it is possible for a monopolist to earn
economic profits in the long run.

These barriers to entry can be divided into three general classes:

1. Natural barriers

A monopoly created by natural barriers is called a natural monopoly.

Economies of scale would be a natural barrier that would create a monopoly.
If the entire market demand can be met on the downward sloping portion of
the long run average total cost curve, then one firm can supply the entire
market at a lower cost than two or more competing firms could. Splitting the
market between firms would mean operating at a scale with higher costs.

Economies of scale typically involve high startup costs, high fixed costs, and
lower variable costs per unit of output. An example of a monopoly due to
economies of scale would be a plant that generates electricity for a local
market.

Economies of scale can offset the efficiency gains from a perfectly

competitive market, which does not allow for economies of scale. This is why
the discussion about a monopolist charging a higher price for a lower quantity
included the disclaimer “all else equal”.

2. Anti-competitive behavior 1. Natural barriers

2. Anti-competitive behavior
A firm that has gained market 3. Government-created
power may engage in activities monopolies.
that are designed to keep
competition out of the market. For
example, an established firm can afford to lower its price in the short run
 whenever a start-up firm threatens to take over some of the market share. A
start-up firm would not have the resources needed to survive if it were forced
to compete with prices that are substantially lower than costs. After the
competition is eliminated, the monopolist will then raise its prices again to
maximize profits.

A monopolist may be able to keep out competition by buying up a key

resource. If nobody else has access to a key resource, then no competition
can exist. For example, if a monopolist produces a product that can only be
manufactured using a specific natural resource, the monopolist may attempt
to buy all the land where this resource is known to exist.

Anti-competitive behavior is generally illegal under antitrust laws. However,

small local monopolies can often “fly under the radar”, and avoid government
scrutiny. For example, in a small town with only one restaurant, the restaurant
may lower its prices or even raise wages in order to prevent a competing
restaurant from being successful. The government may not be willing to use
its resources to catch all such violators.

3. Government-created monopolies
a. Government action can also create monopolies. Patent laws provide
monopoly protection for the owners of patents for a period of time, which in
the United States is currently 17 years.
b. Governments can also issue licenses for certain products that guarantee a
monopoly.
c. Governments can also contract for services in which the government is the
only buyer.

Monopolies/Monopolist's Demand Curve:

The monopolist is the, sole supplier of a product in the market. He has full powers to make
decisions about the pricing of his product. He is a Price Maker, if he lowers the unit price of
his product, his sale is increased. If he raises the price, he will not lose his entire sale. The
demand curve facing the monopolist thus slopes downward from left to right.
Explanation:

As the monopolist's demand curve is negatively sloped, the marginal revenue is here no
longer equal to price or average revenue. It is less than the price (AR) at every level of
output, except the first. The relation between marginal revenue and average revenue is
explained with the help of a schedule and a diagram.

Schedule:

Price Per Quantity Output Total Revenue Marginal Revenue Average Revenue
Meter in $ Meter (TR) in $ (MR) in $ (AR) in $

100 1 100 100 100

80 2 160 60 80

60 3 180 20 60

45 4 180 0 45

35 5 175 -5 35
 Diagram/Curve: In the above schedule, it is shown that as the
monopolist lowers price of his product from
$100 per meter to $80 per meter in specified
period of time, the sale increase from one unit to
two units. The total revenue resulting from the
sale of one more unit increases by $60 (MR);
whereas the additional unit has been sold for
$80. The reason for the total revenue not to
increase by the same amount is that the price
has been reduced for increasing the sale of the
extra units. The price cut is applied to two units
of output sold and not to the additional unit
alone. Same is the case with the third, fourth
and fifth units sold. The marginal revenue is less
than the price ATR (AR) for all the units of
commodity disposed off in the market.
MR = ΔTR/ ΔQ

As the marginal revenue is always less than price, the marginal revenue curve, therefore,
remains below the average revenue curve or demand curve as is illustrated. In the above
figure, the demand curve which also represents average revenue curve has a downward
slope. The demand curve is downward sloping because the monopolist can sell greater
output only by reducing the price of units of output.

The marginal revenue curve of the monopolist always lies below the demand curve because
the marginal revenue from the sale of additional unit of output is less than its price.
Monopoly Price and Its Relationship to Elasticity of Demand:

The total revenue test can be applied for explaining the monopoly price and its relationship
to price elasticity of demand. The total revenue test tells us that when demand is elastic, a
decline in price will increase total revenue. When demand is inelastic, a decline in price of a
good will decrease its revenue. Applying this test, a monopolist will fix the amount of his
product at a level where the elasticity of his average revenue curve is greater than one (E >
1). It causes total revenue to increase. Here marginal revenue is positive. A monopolist
does not push his produce to the point where the marginal revenue becomes negative. The
monopolist choice of price when faced with varying degree of elasticity is now explained
below with the help of a linear average revenue function (price line).

At midpoint on the down sloping AR curve,

elasticity of demand is equal to one, (E = 1).
Above point P, elasticity is greater than one, (E
> 1) and below less than one (E < 1). At price
MP, marginal revenue is zero. At prices above
than MP, MR is positive and below it marginal
revenue is negative. The monopolist would not
like to increase his safes up to a point where
his MR becomes negative or his total revenue
starts decreasing. The monopolist chooses the
price quantity combination where the MR is
positive and the elasticity of demand is more
than one.

Short run equilibrium price and output under monopoly:

Short Run Equilibrium of the Monopoly Firm:

In the short period, the monopolist behaves like any other firm. A monopolist will maximize
profit or minimize losses by producing that output for which marginal cost (MC) equals
marginal revenue (MR). Whether a profit or loss is made or not depends upon the relation
between price and average total cost (ATC). It may be made clear here that a monopolist
does not necessarily makes profit. He may earn super profit or normal profit or even
produce at a loss in the short ran.

Conditions for the Equilibrium of a Monopoly Firm:

There are two basic conditions for the equilibrium of the monopoly firm.
First Order Condition: MC = MR.

Second Order Condition: MC curve cuts MR curve from below.

The short run situations of a firm are explained below:

(a) Short Run Monopoly Equilibrium With Positive Profit:

In the short period, if the demand for the product is high, a monopolist increases the price
and the quantity of output. He can increase the output by hiring more labor, using more raw
materials, increasing working hours etc. However, he cannot change his fixed plant and
equipment. In case, the demand for the product falls, he then decreases the use of variable
inputs, (like labor, material etc.).

As regards the price, the monopolist is a price maker. There is a greater tendency for the
monopolist to have a price which earns positive profits. This can only be possible if the price
(AR) is higher than average total cost (ATC). The short run profit earned by the monopolist
is now explained with the help of the diagram (16.3) below.

In this diagram, the monopoly firm is in

equilibrium at point K where SMC = MR. The
short run marginal cost (SMC) curve cuts MR
from below. At point K both the equilibrium
conditions are fulfilled. As a result, therefore, OE
is monopoly price and OB, the monopoly output.
At the monopoly output OB, the average total
cost OF = BN. The profit per unit is FE. The short
run monopoly profit is ETNF, It is represented by
the area of shaded rectangle in figure 16.3.

While the output smaller than OB (say at point

P), MR > SMC. Therefore, increased output up
to B adds more to total receipts than to total
costs. When the output increases beyond OB,
MR < SMC. Hence, the increased outputs
beyond OB add more to total cost than to total
receipts. This causes profits to decrease. So the
best level of output for the monopolist firm is that
where SMC curve cuts the MC curve from below.
(b) Short Run Equilibrium With Normal Profit Under Monopoly:

There is a false impression regarding the powers of a monopolist. It is said that the
monopolistic entrepreneur always earns profits. The fact, however, is that there is no
guarantee for the monopolist to earn profit in the short run. If a monopolist firm produces a
new commodity and attempts to change the taste pattern of the consumers through
advertising campaigns etc., then the firm may operate at normal profit or even produce at a
loss minimizing price in the short run (Covering variable cost only). The normal profit short
run equilibrium of the monopoly firm is explained, in brief, with the help of the diagrams.

In figure (16.4), a firm is in the short run

equilibrium at point K, where SMC = MR.
The price line is tangent to SAC at point C.
The firm charges CB price per unit for
units of output OB. The total revenue of
the firm is equal to the area OPCB. The
total cost of the firm is also equal to the
area OPCB. The firm earns only normal
profits and continues operating.

(c) Short Run Equilibrium With Losses Under Monopoly:

A monopolist also accepts short run losses provided the variable costs of the firm are fully
covered. The loss minimizing short run equilibrium analysis is presented graphically.

In this figure (16.5), the best short run

level of output is OB units which is given
by the point L where MC = MR. A
monopolist sells OB units of output at
price CB. The total revenue of the firm is
equal to OBCF. The total cost of
producing OB units is OBHE. The
monopoly firm suffers a net loss equal to
the area FCHE. If the firm ceases
production, it then has to bear to total fixed
cost equal to GKHE. The firm in the short
 run prefers to operate and reduces its
losses to FCHE only. In the long, if the
loss continues, the firm shall have to close
down.

Long Run Equilibrium Under Monopoly:

The monopolist creates barriers of entry for the new firms into the industry. The entry into
the industry is blocked by having control over the raw materials needed for the production of
goods or he may hold full rights to the production of a certain good (patent) or the market of
the good may be limited. If new firms try to enter in the field, it lowers the price of the good
to such on extent that it becomes unprofitable for new firms to continue production etc.

When there is no threat of the entry of new firms into the industry, the monopoly firm makes
long run adjustments in the scale of plant. In case, the demand for the product is limited, the
monopolist can afford to produce output at sub optimum scale. If the market size is large
and permits to expand output, then the monopolist would build an optimum scale of plant
and would produce goods at the minimum cost per unit. However, the monopolist would not
stay in the business, if he makes losses in the long period. The long run equilibrium of a
monopoly firm is now explained with the help of the following diagram.

In the long run, all the factors of production including

the size of the plant are variable. A monopoly firm
will maximize profit at that level of output for which
long run marginal cost (MC) is equal to marginal
revenue (MR) and the LMC curve intersects the MR
curve from below. In the figure (16.6), the monopoly
firm is in equilibrium at point E where LMC = MR
and LMC cuts MR curve from below. QP is the
equilibrium price and OQ is the equilibrium output.
 At OQ level of output, the cost per unit is QH (LAC),
whereas the price per unit of the good is QP. HP
represents the per unit super normal profit. The total
super normal profit is equal to KPHN. It may here be
noted that at the equilibrium output OQ, the plant is
not being fully utilized. The long run average cost
(LAC) is not minimum at this level of output OQ. The
firm will build an optimum scale of plant only if the
demand for the product increases.

Threat of Entry of New Firms:

If there is a threat of entry of new firms into the market, the monopolist adopts price
reduction strategy and instead of charging QP price per unit lowers the price to BR. Since
the per unit price BR is equal to the cost per unit at R, the monopoly firm is earning only
normal profit in the long run. The reduction in price and so in profits is adopted to prevent
the entry of new firms in the market.

Summing up, if a monopoly firm is in a position to maintain its monopoly status, it can earn
super normal profit in the long period. However, if there is an effective threat of the entry of
potential firms in, the industry, then the firm can earn just normal profit by reducing the
price. The reduction in price depends on how strong is the threat of potential entry into the
industry.

Comparison Between Monopoly and Competitive Equilibrium or Perfect Competition:

The main points of difference and similarities of monopoly model with competitive
model are as follows:

Monopoly Perfect Competition or Competitive

Equilibrium

(1) The firm is in equilibrium at that level of (1) The most profitable output is also at a
output where MR equals MC. point where MR is equal to MC.
(2) The AR and MR curves are negatively (2) The AR and MR curves facing
inclined i.e., a firm can sell more goods at competitive producer are perfectly elastic,
lower and fewer goods at higher prices. The i.e., it is a horizontal straight line. A firm
MR curve ties below the AR curve. cannot alter the market price by selling more
or by selling less. The AR and MR curves are
equal and, therefore, coincide.
(3) The monopolist can earn supernormal (3) The firm can earn abnormal profits in the
profits in the short as well as in the long short run but in the long run only normal
period. The firm need not equate the AR profits are earned. The firm is in equilibrium
to the lowest point of AC in the long run. when MR = MC = AR = Minimum AC in the
long run.
(4) As the production of a commodity is in the (4) The competitive producer has no control
hands of a single producer, therefore, a firm over the price of the commodity. It has to sell
has control over the output and price of the at the price determined by the intersection of
commodity. the forces of demand and supply in the
market.
(5) The single firm comprises the whole (5) There are many firms comprising an
industry. The firm may not be of the optimum industry. All the firms are of the optimum size
size. The possibility of the new firms to enter in the long run. The new firms can enter the
into the industry is restricted. industry.
(6) The equilibrium price is higher than MC. (6) The equilibrium price is equal to MC.
The monopolist always tries to maximize The entrepreneur charges the price which
profits by fixing the price higher than the gives him the normal profit in the long run. So
competitive price. The consumers, therefore, customers do not stand at a disadvantage.
have to pay a higher price and thus stand at a
disadvantage.
(7) The monopoly firm is a price seeker. (7) The competitive firm is a price taker.
(8) A monopoly firm is not a price taker. (8) A competitive firm cannot exert any
Hence, it cannot have a supply curve. It influence on the price. The firm is a price
chooses output and price in a way that gives. taker and so has a supply curve. The portion
It the highest possible profit. of MC curve above AVC curve is supplied.

The monopolist cannot charge very high price for his product due to the following
reasons:

(i) Entry of new firms. If a monopolist charges high price for his
product, the new firms, lured by higher profits will creep into the
field and the very position of the monopolist will then be in danger.
 (ii) Availability of substitutes. There are a very few Commodities in
the world for which substitutes are not available. If the monopolist
charges higher price, the consumers will take to its substitutes. The
monopolist, being afraid of the use of substitutes fixes a
reasonable price of his product.

(iii) Fear of state intervention. The price fixed by monopolist for the
commodities may also be not very high due to the fear of state
intervention. The state, in the interest of the consumers, may fix a
maximum price for the product of the monopolist or may undertake
to supply the commodity itself. The fear of state intervention forces
the monopolist not to charge very high price for the product.

(iv) Fear of boycott by the consumers. Another consideration for the

monopolist to keep the price reasonable is the fear of boycott on
the part of purchasers for his product.

(v) Price elasticity of demand. Finally, the monopoly price is to a

great extent determined by the conditions of demand and supply
prevailing at that time.

From all that we have said above, it can be concluded that the monopoly price is not fixed
arbitrarily but is influenced by many factors as stated above.

Definition of Price Discrimination:

1. Entry of new
firms While discussing price determination under monopoly, it was
2. Availability of assumed that a monopolist charges only one price for his product
substitutes from all the customers in the market. But it often so happens that
3. Fear of state a monopolist, by virtue of his monopolistic position, may manage
intervention to sell the same commodity at different prices to different
4. Fear of customers or in different markets. The practice on the part of the
boycott by monopolist to sell the identical goods at the same time to different
customer buyers at different prices when the price difference is not justified
5. Price by difference in costs in called price discrimination.
elasticity of
demand
In the words of Mrs. Joan Robinson: "Price discrimination is the act of selling the same
article produced under single control at a different prices to the different buyers".

Types and Examples of Price Discrimination:

Price discrimination may be of various types. It may either be (i) personal (ii) trade
discrimination (iii) local discrimination.

1. Price discrimination. It is personal, when separate price is charged from

each buyer according to the intensity of his desire or according to the size of
his pocket.

For instance, a doctor may charge $20000 from a rich person for an eye
operation and $500 only from a poor man for the similar operation.

2. Trade discrimination. It may take place

when a monopolist charges different prices
according to the uses to which the (1) First degree price
commodity is put. discrimination,
For example, an electricity company may
(2) Second degree price
charge low rate for electric current used in an
industrial concern than for the electricity discrimination and
used for the domestic purpose. (3) Third degree price
discrimination.
3. Place discrimination. It occurs when a
monopolist charges different prices for the
same commodity at different places. This type of discrimination is called
dumping.

In Economics, a monopolist sells the same commodity at a higher price in one market and
at a lower price in the other. Dumping may be undertaken due to several reasons, (a) a
monopolist may resort to dumping in order to dispose off the accumulated stock or (b) he
may, dump the commodity with a desire to capture the foreign market, (c) dumping may
also be done to drive the competitors out of the market, (d) the motive may also be to reap.
the economies of large scale production, etc.

Degrees of Price Discrimination:

There are three main degrees of price discrimination:

(1) First degree price discrimination. The monopolist charges a different price equal to
the maximum amount for each unit of the commodity from each consumer separately. The
price of each unit is equal to its demand price so that the consumer is unable to enjoy any
consumer surplus. Such prices are charged by doctors, lawyers etc. In fact, the first degree
price discrimination manifests itself in the form of as many prices as many consumers.

(2) Second degree price discrimination. Here the monopolist divides his market into
different groups of customers and charges each group the highest price which the marginal
consumer belonging to that group is willing to pay. The railway, airlines etc., charge the
fares from customers in this way.

(3) Third degree price discrimination. In the third degree price discrimination, the
monopolist divides the entire market into a few sub-markets and charges different prices for
the same commodity in different sub-markets. The division here is among classes of
consumers and not among individual consumers. Third degree price discrimination is
possible only if the classes of consumers can be kept separate. Secondly, the various
groups of customers must have different elasticity of demand for his commodity. The
segment with a less elastic demand pays a higher price than the segment with a more
elastic demand. The consumer faces a single price in each category of consumers. He can
purchase as much as desired at that price. It is the most common type of price
discrimination. For example, movie theatres, railways, typically charge lower prices to senior
citizens, students etc.

Conditions of Price Discrimination:

Price discrimination can only be possible if the following three essential conditions are
fulfilled.
.
(1) Segregation by price. There should be no possibility, of transferring a unit of
commodity supplied from the low priced to the high priced market. For instance, a rich
patient cannot send a poor man to the doctor for his medical cheek up at a cheaper rate for
him. Similarly, if you want to send a kilogram of gold by train to a relative of yours, you
cannot get it converted into coal or iron simply because these metals are transported at a
cheaper rate.

(2) Segregation by market. Another essential characteristic of price discrimination is that

there should be no possibility of transferring one unit of demand from the high priced to the
low priced market. For instance, a banana market is divided on the basis of wealth. The
poor are supplied bananas at a concessional rate in one market. The rich people will not like
to become poor in order to get the commodity at a cheaper rate. A monopolist will maximize
his total revenue by equalizing marginal revenue from all the markets. For instance, if in a
particular market, the marginal revenue of a commodity is $20 per quintal and in the other
$15 per quintal, a monopolist will at once shift the supply of the commodity from the later to
the former till the marginal revenue from both the markets becomes equal.

(3) Segregation by demand. Price discrimination can be 1. Ignorance of buyers

possible if there is difference in the elasticity of demand in 2. Buyers psychological
different markets. If the demand for a certain commodity is satisfaction
elastic in a particular market, the monopolist will charge lower 3. Degree of price
prices. But if the demand is inelastic, the monopolist will fix discrimination
higher prices for his product.
4. Nature of goods
Here, a question can be asked as to how far is a price 5. Distance to market
discrimination beneficial to society. The answer is that if a 6. Elasticity of demand
monopolist charges low price for his product from the poor 7. Base of legality
people and higher price from the rich, then certainly we can 8. Dumping policy
say that it increases economic welfare. But if a monopolist
dumps his output in a foreign market at a low price and raises
the price of his commodity in the home market, then such a price discrimination is certainly
detrimental to society, if the production of certain commodity is subject to law of increasing
returns, then price discrimination may be to the advantage of the society. The monopolist
increases the sale of output in order to sell the commodities in the foreign market. The
monopolist fixes a low price for his output both for the home market and the foreign market.
It is from this point of view only that we say price discrimination is desirable and beneficial.

Conditions for price discrimination:

1. Ignorance of buyers: As buyers don’t know about the difference in price taken
from the buyers by the seller, price can be discriminated
2. Buyers’ psychological satisfaction: A psychology of the buyers is observed
that buyers’ think the higher the price the better the good is. So PD is possible
3. Degree of price discrimination: Buyers are reluctant and don’t react for a 1st
degree of PD, hence sellers can take different prices from different buyer.
4. Nature of goods: if goods or services are non transferable or non movable
then seller is able to discriminate price.
5. Distance to market: PD is possible where markets are distant and
communication is difficult. The distance would add cost in such a way that
 goods are not moved from low cost market to high cost market due to non
profitability.
6. Elasticity of demand: The taste, income, habit, likeness of the buyers affects
the elasticity of demand of goods. Each buyer may have different elasticity for
a good, which may cause PD.
7. Base of legality: PD is created legally like electricity use by industry and
home.
8. Dumping policy: To penetrate a foreign or new market, goods are sold higher
in abroad than in home. Such a policy is known as dumping policy.

Dumping:

Definition and Explanation:

Dumping is a special case of price discrimination. Dumping is a situation in which the price,
a firm charges for its goods in a foreign market is lower than either the price it charges in its
home market or the production cost. Dumping thus is the sale of surplus output of a firm on
foreign markets at below cost price. Dumping also occurs when a firm sells its products at a
higher price in the home market and at a lower price in the foreign market.

Reasons:

A firm may resort to dumping for a number of reasons which in brief are as under:

(1) Price discrimination: The first reason of dumping is price discrimination. If a firm has
monopoly of a good in home market, but faces strong competition in foreign market, the firm
will naturally charge a higher price in home market and lower competitive price in foreign
market.
(2) Predatory pricing: The second major reason is predatory pricing. It is the practice of
cutting prices of goods in an attempt to derive rival firms out of business.

(3) Surplus stock: A firm may resort to dumping to dispose off surplus stock.

(4) Economies of large scale production: The big firms where huge fixed capital is
required for producing the goods may resort to dumping to avail of the economies of large
scale production.

Dumping is illegal under international trade agreements of World Trade Organization

(WTO). A nation can impose anti dumping duties only on production that are being
dumped.

The necessary condition of equilibrium is the equality of marginal cost and marginal rev-
enue. The same condition applies to monopoly also. Therefore equilibrium of a monopoly
firm is established at a point where MC is equal to MR.

However, the following points should be noted with regard to short-run and long-run
equilibrium.

(i) In the short period a monopoly firm can also sustain losses.

(ii) In the long run a monopoly firm can have abnormal profits. (AR > AC) which is not possible
in the case of a competitive firm.

Monopoly Vs Monopolistic Market:

Monopoly Monopolistic
Single seller Seller Multiple seller
Controls total supply Supply Every supplier supplies only a
portion of total market supply of
goods
There is no close substitute of the Nature of Goods Though goods produced by
goods produced by a monopolist suppliers are not identical but
they are homogeneous and
close substitutes of each other
A single firm constitutes the Formation of The industry is constituted by a
industry in the monopoly market market lot of firms producing
homogeneous goods
No new entry is usually possible Entry in market No barriers in market entry by a
new firm
The slope of demand curve is Shape of demand
more curve
Oligopoly

An oligopoly is an industry with small number of firms, at least one of which produces a
significant portion of industry output. In an oligopoly there are very few sellers of the good.
The product may be differentiated among the sellers (e.g. Automobiles) or homogeneous
(e.g. Gasoline). Entry is often limited either by legal restrictions (e.g. Banking in most of the
world) or by a very large minimum efficient scale (e.g. Overnight mail service) or by strategic
behavior.

In an oligopoly

* firms know that there are only a few large competitors

* competitors take account of the effects of their actions on the overall market.
* To predict the outcome of such a market, economists must model the interaction
between firms and so often use game theory or game theoretic principles.

Examples

1. Soft drinks/Sodas : Pepsi and Cola

2. Tobacco industry
3. CPU chips – Duopoly (an industry with only two firms): Intel and AMD
4. Beer
5. Light bulbs
6. Breakfast cereals
7. Automobiles

Causes of oligopoly

A. Natural Causes

* Economies of Scale – already discussed.

* Economies of Scope – the total cost of producing given quantities of two goods in the
same firm is less than the total cost of producing those quantities in two single-product
firms.
B. Firm Created Causes –

* Mergers and Acquisitions

* Prevention of Entry of New Firms
* Advertising

Strategic Behavior :

Firms take account of the actions and reactions of their competitors.

1. Cooperative Solutions (Cartels) – A cartel is a formal (explicit) agreement among firms.

* Cartel members agree on such matters as price fixing, total industry output, market
shares, allocation of customers, allocation of territories, establishment of common sales
agencies, and the division of profits or combination of these.
* The aim of such collusion is to increase individual member's profits by reducing
competition.
* The cartel behaves like a monopoly.

Collusion –An explicit or implicit agreement between existing firms to avoid or limit
competition with one another

2. Non-Cooperative Outcomes - In non cooperative outcomes, there is no form of

negotiation and binding contracts.eg while setting up a price of its product, a firm will take
into account the other competitive firm’s behavior

Cartel problems with many firms

* Enforcement problems: few firms have incentive to “cheat” (increase their output while
other members stick to prescribed output amounts).
* Restricting entry – many successful cartels have natural barriers to entry (e.g. Oil).
Collusion –An explicit or implicit agreement between existing firms to avoid or limit
competition with one another
Collusion problems

* There are many firms in the industry

* The product is not standardized
* Demand and cost conditions are changing rapidly
* There are no barriers to entry
* Firms have surplus capacity

The characteristics that distinguish oligopoly from other market structures are:

1. Few firms, some if not all are relatively large compared to the overall market size;
and difficult, but not impossible, entry into the market. The products may be differentiated or
identical.

2. Firms have a large degree of control over the prices of their products, but the
firms are highly interdependent. Since each firm has a large market share, the actions of
each firm are dependent on the actions of competitors. If a firm does not react properly to a
competitor's actions, it could lose market share, and profits.

3. The behavior of firms in oligopoly can be described as either competitive or

cooperative. Competitive behavior includes much more than just price competition. Most
real world innovation and technological advances come from firms in oligopoly. Firms are
continually trying to stay ahead of their competitors with improvements that consumers will
want. Firms in oligopoly often spend large sums of money on research & development.

4. A large advertising budget is also typical.

5. There is no single economic model that explains all behavior in oligopoly. Two
models that are used to explain competitive behavior are the kinked demand curve and
prisoner's dilemma. Some behavior by firms in oligopoly can be described as cooperative
rather than competitive.
Instruments Of Monetary Policy

Monetary Policy means the policy by which the government of a country and the central bank
try to control the supply of the money and the availability of credit in the system , with a view
to achieve economic stability.
There are two instruments of monetary policy:-
4. Quantitative instruments
5. Qualitative instruments.

Quantitative instruments broadly include the following:-

1. Bank rate: it is the rate at which the central bank of a country is prepared to give credit to
the commercial banks. Increase in bank rate increases the interest rates, and demand for
credit gets reduced. On the other hand decrease in bank rate lowers the rate of interest and
credit becomes cheap, and demand for credit expands.
2. Open market operations: It refers to purchase and sale of securities in the open market
by the central bank. By selling the securities, central bank reduces the purchasing power of
the system.
3. Change in minimum reserve ratio: Minimum reserve ratio refers to the minimum
percentage of a bank total deposit which is required to be kept with the central bank. All the
banks have to keep with the central bank a certain percentage of their deposits in the form of
cash reserve ratio
4. Change in liquidity ratio: Every bank is required to maintain a fixed percentage of its
assets in the form of cash or other liquid assets called liquidity ratio. With a view to reducing
the flow of credit, in the market central bank enhances the liquidity ratio. However in case of
expansion of credit liquidity ratio is reduce.

Qualitative Instrument include the following-

5. Change in margin requirements of loans: the margin requirements of loans refers to the
difference between the current value of the security offered for loans and the value of loans
granted.
6. Rationing of credit: Rationing of credit refers to fixation of credit quotas for different
business activities. Rationing of credit is introduced when the flow of credit is to be checked
particularly for speculative activities in the economy. The central bank fixes quotas for
different business activities. The commercial bank cannot exceed the quotas limits while
granting loans.
7. Direct action: The central bank may initiate direct action against the member banks in
case these do not comply with its directives
8. Moral pressure: sometimes the central bank direct the commercial banks to follow the
rules framed by it to control the credit.

Types of monetary policy

Monetary Policy: Target Market Variable: Long Term Objective:

Interest rate on overnight
Inflation Targeting A given rate of change in the CPI
debt
Interest rate on overnight
Price Level Targeting A specific CPI number
debt
The growth in money
Monetary Aggregates A given rate of change in the CPI
supply
The spot price of the
Fixed Exchange Rate The spot price of the currency
currency
Low inflation as measured by the gold
Gold Standard The spot price of gold
price
Mixed Policy Usually interest rates Usually unemployment + CPI change

Policy of various nations

• Bangladesh - Inflation targeting

• Australia – Inflation targeting
• Brazil – Inflation targeting
• Canada – Inflation targeting
• Chile – Inflation targeting
• China – Monetary targeting and targets a currency basket
• Czech Republic – Inflation targeting
 • Colombia – Inflation targeting
• Hong Kong – Currency board (fixed to US dollar)
• India – Multiple indicator approach
• New Zealand – Inflation targeting
• Norway – Inflation targeting
• Singapore – Exchange rate targeting
• South Africa – Inflation targeting
• Sri Lanka – Monetary targeting
• Switzerland – Inflation targeting [23]
• Turkey – Inflation targeting
• United Kingdom[24] – Inflation targeting, alongside secondary targets on 'output and
employment'.
• United States[25] – Mixed policy dedicated to maximum employment and stable prices
(and since the 1980s it is well described by the "Taylor rule," which maintains that
the Fed funds rate responds to shocks in inflation and output)

FISCAL POLICY:

In economics and political science, fiscal policy is the use of government revenue
collection (taxation) and expenditure (spending) to influence the economy.[1] The two main
instruments of fiscal policy are changes in the level and composition of taxation and
government spending in various sectors. These changes can affect the following
macroeconomic variables in an economy:

• Aggregate demand and the level of economic activity;

• The distribution of income;
• The pattern of resource allocation within the government sector and relative to the
private sector.

Fiscal policy refers to the use of the government budget to influence economic activity.

Fiscal policy refers to budgetary policy of the government or the policy related to revenue and
expenditure of the government with a view to correcting the situations of excess demand or
deficient demand in the economy.
It is the policy concerning the revenue, expenditure and debt of the government for achieving
definite objectives.
Fiscal instrument related to government expenditure:
Higher direct taxes (causing a fall in disposable income)
• Lower Government spending
• A reduction in the amount the government sector borrows each year (PSNCR)
1) Expenditure on public works programmes such as construction of dams, roads, hospitals
etc.
2) Expenditure on education and public welfare programmes.
3) Expenditure on various types of subsidies to the producers with a view to encouraging
production/export sand on transfer payment to the public.
4) Expenditure on defence of the country and on maintenance of law and order.

Fiscal instrument is related to financing of government expenditure or public revenue. Three

fiscal instrument related to financing of government are taxation, public debt and debt
financing.
Taxation: tax means the compulsory payment to the government according to the prescribed
laws. Taxes are of two types of direct taxes and indirect taxes. Direct taxes are those taxes
which are levied on income and property of the persons. The burden of these taxes is borne
by those persons on whom these are levied. Income tax, wealth tax are examples of direct
taxes.
Indirect taxes are those taxes which are levied on goods and services. The burden of these
are may be transferred on other persons. Sales tax, value added tax, service taxes are some
of the examples of indirect taxes. With the increase in income these taxes are automatically
increasing, and with the fall in income these taxes are decreasing.
Public debt or borrowing: It is the debt or borrowing by the government from the public.
Deficit financing: It refers to issue of more currency to meet budgetary deficit. It increases
the supply of money in the economy.

Fiscal Policy in case of deficit demand

1) Decrease taxes: taxes must be decreased levying with more purchasing power and the
firms with more cash reserves. Direct taxes should be reduced. As a result both investors and
household will be encouraged to spend more; as a result demand will increase.
2) Increase deficient financing: deficient financing is increased during times of deficient
demand so that the overall level of purchasing power is enhanced in the economy.
3) Increase in public expenditure: Greater expenditure is incurred on public, health,
expenditure on education, law and defence in the economy.
4) Reduced public borrowing. Public borrowing should be reduced so that people are left with
greater purchasing power.

Fiscal policy in case of excess demand

1) Increase taxes: Taxes should be increased progressively to mop up additional p additional
purchasing power within the economy
2) Decrease government expenditure: Government expenditure should be reduced on health,
education, public works, and defence of the country subsidies.
3) Reduce deficit financing: Deficit financing should be restricted. The printing of more notes
would only increase the rate of inflation.
4) Increase public borrowings so that people are left with lesser purchasing power.

Direct Action Policy:

To combat inflation this policy moves government to take some intervening action regarding
production, distribution and measures to match supply and demand of a product.

1. Price Ceiling
2. Price Floor
3. Direct products
4. Direct import
5. Rationing / open market states operation
6. Buffer stock creation
7. Payment of subsidy

Direct controls refer to the regulatory measures undertaken with objectives of converting an
open inflation into a suppressed one. Direct control on prices and rationing of scarce goods
are the two such regulatory measures.

1. Direct Controls on Prices:

 The purpose of price control is to fix an upper limit beyond which the price of
particular commodity is not allowed and to that extent inflation is suppressed.

2. Rationing:
When the government fixes the quota of certain goods so that each person gets only
a limited quantity of the goods, it is called rationing. Rationing becomes necessary
when the essential consumer goods are relatively scarce.
The purpose of rationing is to divert consumption from those goods whose supply
needs to be restricted for some special reason, e.g., to make such commodities
available to a large number of people.
According to Kurihara, "rationing should aim at diverting consumption from particular
articles whose supply is below normal rather than at controlling aggregate
consumption."
Thus, rationing aims at achieving the twin objectives of price stability and distributive
justice.

Almost everyone thinks inflation is evil, but it isn't necessarily so. Inflation affects different
people in different ways. It also depends on whether inflation is anticipated or unanticipated.
If the inflation rate corresponds to what the majority of people are expecting (anticipated
inflation), then we can compensate and the cost isn't high. For example, banks can vary their
interest rates and workers can negotiate contracts that include automatic wage hikes as the
price level goes up.

Costs/ affects arise when there is unanticipated inflation:

1. Creditors lose and debtors gain if the lender does not anticipate inflation correctly. For those
who borrow, this is similar to getting an interest-free loan.

2. Uncertainty about what will happen next makes corporations and consumers less likely to
spend. This hurts economic output in the long run.

3. People living off a fixed-income, such as retirees, see a decline in their purchasing power
and, consequently, their standard of living.
4. The entire economy must absorb repricing costs ("menu costs") as price lists, labels, menus
and more have to be updated.

5. If the inflation rate is greater than that of other countries, domestic products become less
competitive.

People often complain about prices going up, but they often ignore the fact that wages
should be rising as well. The question shouldn't be whether inflation is rising, but whether
it's rising at a quicker pace than your wages.

Lastly, inflation is a sign that an economy is growing. In some situations, little inflation (or
even deflation) can be just as bad as high inflation. The lack of inflation may be an
indication that the economy is weakening. As you can see, it's not so easy to label inflation
as either good or bad - it depends on the overall economy as well as your personal
situation.