FY BA Micro Economics

F.Y.B.A Dr.
Ranga Sai
Lecture Notes Vaze College,
Mumbai
First Year Bachelor of Arts

Micro Economics
Micro Economics
[With effect from 2007-08]
With effect from June 2007

Dr.Ranga Sai
First Year Bachelor of Arts

Micro Economics
With effect from June 2007
Section I
Module 1: Introduction Meaning and scope of micro economics, Ceteris paribus
assumption, concepts and types of equilibrium: partial and general
Module 2 Consumer Behavior: Cardinal and ordinal approaches – Indifference
curve – consumers’ equilibrium, income, price and substitution effects;
Giffen’s paradox – Revealed preference Hypotheses – elasticity of
demand: price, income, cross and promotional – consumer surplus, Engel
curve
Module 3: Production and costs
Production; short run and long run – law of variable proportions –
isoquants, iso-cost line and producers’ equilibrium – returns to scale –
economies of scale – Cobb-Douglas production function
Module 4: Costs and revenue
Costs: short run and long run cost, derivation of short run cost curves and
their relationship – derivation of long run average cost curve and its
features.
Revenue: Total revenue, average revenue and marginal revenue:
relationship between AR and MR under different market structures:
relationship between AR, MR and elasticity of demand.
Section II
Module 5: Theory of firm
Objectives of a firm: Profit, sales and growth maximization – breakeven
analysis – analysis of equilibrium of a firm – pricing methods in practice:
marginal cost and full cost approaches
Module 6: Perfect competition
Perfect competition: features; short run equilibrium of the firm and
industry: derivation of supply curve of the firm and industry; long run
equilibrium of firm and industry
Module 7: Monopoly
Monopoly : features, short run equilibrium and monopolist under different
cost conditions and long run equilibrium of the monopolist; discriminating
monopoly, equilibrium under discriminating monopoly, dumping –
comparison between perfect competition and monopoly with respect to out
put and price
Module 8: Monopolistic competition and oligopoly
Monopolistic competition; features, equilibrium in the short and in the
long run , wastages under Monopolistic competition, features of oligopoly.
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Micro Economics, F.Y.B.A. (w.e.f. June 2007) 2

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CONTENT
Introduction
Meaning and scope of micro economics,
Ceteris paribus assumption,
Types of equilibrium
Consumer Behavior:
Cardinal and ordinal approaches
Indifference curve – consumers’ equilibrium,
Income, price and substitution effects; Giffen’s paradox
Revealed preference Hypotheses
Elasticity of demand: price, income, cross and promotional
Consumer surplus,
Engel curve
Production and costs
Production function
Law of variable proportions
Isoquants, producers’ equilibrium –
Returns to scale – economies of scale –
Cobb-Douglas production function
Costs and revenue
Cost concepts:
Short run
Long run cost,
Revenue concepts
Relationship between AR and MR.
Theory of firm
Objectives of a firm
Pricing methods in practice: marginal cost and full cost approaches
Perfect competition
Perfect competition: features;
Short run equilibrium of the firm and industry:
Derivation of supply curve of the firm and industry;
Long run equilibrium of firm and industry
Monopoly
Monopoly: features, short run equilibrium and different cost conditions
long run equilibrium
Discriminating monopoly
Dumping
Comparison between perfect competition and monopoly
Monopolistic competition and oligopoly
Monopolistic competition; features,
Equilibrium in the short and in the long run ,
Wastages under Monopolistic competition,
Features of oligopoly.

Dr.Ranga Sai
Dear Student friends…
During these days of commercialization it becomes very difficult to find

information on web which is relevant, authentic as well as free.
We believe that knowledge should be free and accessible to all those who
need.
With this intention the notes, which are originally intended for the
students of Vaze College, Mumbai, are made available to all, without any
restrictions.
These notes will be useful to all the F.Y.B.A students of University of
Mumbai, who will be writing their Micro Economics examinations on or
during and after 20007-08. Distance Education students are advised to
refer the recommended syllabus.
This is neither a text book nor an original work of research. It is simple
reading material, complied to help the students readily understand the
subject and write the examinations. We no way intend to replace text
books or any reference material.
This is purely for academic purposes and do not have any commercial
value.
Feel free to use and share.
We solicit your opinions and suggestions on this endeavor.
Dr. Prof. Ranga Sai

rangasai@rangasai.com
June 2010

Dr.Ranga Sai
Module 1: Introduction
Nature and scope of Micro Economics
Micro economics is that branch of economics which analyzes the market
behavior of individual consumers and firms to understand the decision-
making process of firms and households.
Microeconomics deals with economics decisions made at individual

level. The individual can be a consumer, the producer/firm, or a
household.
"Microeconomics deals with the decision making and

market results of consumers and firms".
In detail the microeconomics deals with decisions at

1. Consumption: The consumer aims at maximizing consumer
satisfaction, he has to optimize his performance within the
limitations of income and prices
2. Production: The producer has to coordinate inputs to produce
goods so that the out put is maximized and the cost is minimized.
The producer has to optimize, costs and factors.
3. Exchange: The buyers and sellers meet at the market. They have
conflicting interests. Depending on the market the prices are
determined which fulfill the consumer objectives as well as the
firm objectives.
4. Distribution: Distribution deals with determinations of factor
prices. It is important in the determinations of factor incomes/
household incomes.
5. Welfare: Welfare economics uses micro economic tools in defining
and optimizing welfare of a society.
Micro economic theories help in the designing the models of demand

forecasting, consumer behavior models, pricing and determination of
factor prices.
Most micro economic theories are partial equilibriums which provide in
depth details of a specific economic activity.
Ceteris paribus
Ceteris paribus is a Latin phrase, which means “all other things being
equal or held constant”

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A ceteris paribus assumption is used to formulate scientific laws, for

separating factors which interfere while studying a cause and effect
relationship.
By holding all the other relevant factors constant, a cause and effect
relationship can be studies in greater detail.
In economics the laws are made based on the cause and effect
relationship. These functional relationships relate one dependent variable
and several independent variables.
Ceteris paribus represent relationships (such as demand and supply)

between two variables (such as price and quantity), holding all other
things constant, (or ceteris paribus), in order to isolate the influence of
one independent variable (such as price) on the dependent variable (such
as quantity).
The demand function relates the quantity demanded-Q, as an effect of

several factors like price-P, income-Y, advertising-A, and tax-T.
Quantity demanded, Q = f (P, Y,A,T/F)
Yet while studying the relationship as a law, it assumes all factors to be

constant and isolates one major determinant. The clause of keeping other
factors constant by retaining one major determinant for the purpose of
forming a law is called as ceteris paribus.
Economic equilibrium
Equilibrium is a state of rest where there is no urge to change. The
equilibrium is attained by a set of two or more economic forces.
At equilibrium, the objectives of economic activity are achieved.
• Consumer equilibrium – consumer satisfaction is maximized;

• Producers’ equilibrium – the cost are minimized
• Market equilibrium – the price and quantity are so determined that
are acceptable to both buyers and sellers.
Economic equilibrium is not permanent. The equilibrium is valid as long

as the factors determining it remain unchanged. Any change in any one of
the factor, the equilibrium will undergo a change.

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Static equilibrium: In economics static equilibrium refers to rigid models

which do not accept more or changing variables. Subject to the given
set of variables, the equilibrium is attained. Such equilibrium may
not have large policy applications;
e.g. circular flow of incomes- it explains the relationship between various
economic activities
Dynamic equilibrium: It is an advanced economic model which gives

relationships between several economic variables and can also
accommodate change. Such economic models have large application
in policy making
e.g. input-output matrix of national income accounting provide
relationships as well as determinants at each level of economic
activity. The output of one sector becomes the input for the other
sector. This is an advanced model of explaining circular flow of
incomes. .
Partial and General Equilibrium
Partial equilibrium deals with a state of rest between few variable but has
a large ceteris paribus clause. The equilibrium explains only a part of
the economic activity.
Micro economic theories deal with partial equilibrium. Since the

theories deal with a specific activity, al other related variables are kept
constant.
These are specialized theories providing in-depth details.
Micro economic theories are mostly partial equilibriums. They are
applied in pricing, consumer decisions, demand forecasting etc.
General equilibrium in turn deals with macro economic state. General

equilibrium was first used by Lean Walrus to explain unity of
equilibrium at consumption and production. It is the state of rest at
macro level. Circular flow of incomes, effective demand, input output
tables are example of general equilibrium.
Equilibrium at macro level has to provide description at aggregate

level. So the general equilibrium may not provide depth of details as
in case of partial equilibrium.
General equilibrium is useful in policy and planning.

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Module 2 Consumer Behavior
Utility analysis of consumer behavior given by Marshall is based on the

cardinal measure of utility. The theory is based on the basic assumption
that the utility can be measured.
Accordingly, the theory describes utility as the want satisfying capacity
of a good. Such utility is classified as time utility- a good changes form
time to time depending on the seasons; place utility- a good changes
utility form place to place; form utility- where the good changes utility
with changing form.
Use value is the value of a good in use. It depends on thr want satisfying
capacity of the good.
Exchange value, on the other hand deals with what a good can get in
return in the market.
The value paradox states that use value and exchange value are inversely
proportional. With increasing use value of good its exchange value
decreases. e.g. water, air.
Similarly with increasing exchange value its use value decrease .e.g.
diamonds, gold
But a transaction can take place only when use value is equal to exchange
value. This conflict is called as value paradox.
Under the utility theory the consumer behavior is explained by the Law of
diminishing marginal utility. According to the law ‘with the increasing
use of a good its marginal utility decreases’.
The consumer maximizes his satisfaction by equating marginal utilities of

all the goods he consumes. This is called the law of equi-marginal
utilities.

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Indifference Curve Analysis
Consumption theory in economics contains two parts. Firstly, the theory

studies the consumer behavior and secondly, the theory will suggest the
consumer the way in which satisfaction van be maximized.
In utility analysis, the Law of Diminishing marginal utility studies
consumer behavior and the law of Equi-marginal utilities suggested a
method of maximizing consumer satisfaction.
Indifference curve analysis is a consumption theory given by Hicks and

RGD Allen. The theory is an improvement over Utility analysis. Utility
analysis had a major draw back that it measured utility in cardinal terms.
Indifference curve analysis measures utility in ordinal terms. Further, IC
analysis provides wider descriptions and details as compared to utility
analysis.
IC deals with various combinations of two goods which give the

consumer the same amount of satisfaction.
Indifference Schedule
X Y
1 12
2 10
3 7
4 3
All these combinations give the consumer same amount of satisfaction. In

this case the consumer will not be able to choose any combination as
better than other. The consumer will be indifferent between these
combinations. The curve drawn indifference schedule is called the IC.
Hicks use an IC to explain the consumer behavior.
ICs can be understood better with the help of its properties.

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Properties of Indifference curves
1. Indifference curves towards the axis represent lower satisfaction and

IC away from the axis represents higher satisfaction.
In the diagram IC 1 represents lower satisfaction and IC2 represents

higher satisfaction.
This is because on higher IC the consumption increases and on lower IC
consumption decreases.
It can be seen that for the same amount of Y the consumer gets +2 on IC2
and gets -2 on IC1. Higher the consumption higher the satisfaction and
lower the consumption lower the satisfaction
2. Indifference curves never touch the axis. By touching the axis the
indifference curve will represent only one good. In fact an IC should
necessarily represent two goods always.
3. Indifference curve is a down ward sloping curve. It slopes down

from left to right. A consumer has to sacrifice one goods to gain the

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other. This is essential to keep the level of satisfaction constant on an

IC.
4. On an indifference curve the marginal rate of substitution decreases.
The marginal rate of substitution, is the rate at which a substitutes one

commodity with the other.
By gaining one commodity the consumer shall sacrifice the other. This is
needed to keep the level of satisfaction constant on an IC.
the slope of an indifference curve, MRS = ∆y/∆x.
The marginal rate of substitution decreases on an IC. On the diagram it

can be seen that
On the upper half, the consumer sacrifices 4 Y for 1 X, that is the rate of
substitution is 4/1

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On the Lower half it can be seen that the rate of substitution is 1/ 4 i.e. the
consumer equates 1Y with 4 X.
This is because on the upper half the consumer has more of Y so he likes
more of X and lower half he has more of X so he likes more of Y.
In this process the rate of substitution decreases from 4/1 to 1/ 4.
On an IC the consumer expresses his utility behavior through decreasing

Marginal rate of substitution.
Comparing the IC analysis and the Utility analysis it can be seen that
the marginal rate of substitution is equal to the ratio of the marginal
utilities,
MRS = ∆Y/∆X = - MUx/MUy
5. An indifference curve is convex to the origin. Only on a convex curve

the marginal rate of substitution decreases. Slope of an IC is found by
drawing a tangent. The slope of the tangent is the slope of IC at that
point.
On a concave curve the slope of IC increases that is MRS increases. So it

is not an IC. Similarly, a straight line has constant slope or constant MRS
hence not an IC.

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A curve convex to the origin has decreasing slope or decreasing MRS,

hence, an IC.
6. Indifference curves need not be parallel. Converging indifference

curves are accepted to be correct.
7. Indifference curves do not intersect. Indifference curves need not be

parallel. Converging indifference curves are accepted to be correct but
they shall not intersect. Intersection of Indifference curves is considered
to be illogical, inconsistent and irrational.
In the diagram it can be seen that
Combination A gives larger satisfaction, because it is on a higher

indifference curve IC1
And
Combination B gives smaller satisfaction, because it is on a lower
indifference curve IC2
But
Combination C gives same satisfaction, yet it is on two indifference
curves IC1 and IC2.
Two indifference curves can not give same satisfaction. This is illogical,
inconsistent and irrational.
Foundations of Assumptions of Indifference curves:
Indifference curve analysis is based on the following assumptions:

1. Transitivity: It is assumed that the combinations are continuous to form
a curve. The combinations between two tested sets are given.
2. Ordinality: The indifference curve analysis considers ordinal measure
of utility. That is utility is compared but not qualified.

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2. Rationality: The consumer is rational. He always prefers higher

satisfaction to the lower and he knows all the combinations giving him
same satisfaction or different satisfactions.
3. Convexity: A convex indifference curve represents the consumer
behavior. The convex IC shows the utility behavior with out actually
measuring utility in cardinal terms.
4. Scale of preference: On a series of indifference curves the consumer
has a preference increases from low to high. The consumer always prefers
higher satisfaction to lower. This is called the scale of preference.
Price Line
The price line represents the budget of the consumer. It is made up of the
money income of the consumer and the prices of two goods. The price
line deals with various combinations of two good that a consumer can
buy with in his limited income. This is only the possibility of buying and
does not represent the choice of the consumer. Given the price line, the
consumer can buy any combination on the line or combinations below the
line.
When the price of a good decreases the real income of the consumer
increases. Real income is what the consumer can buy with his money
income. With this, the price line will shift upwards on a single axis (shift
on X axis if the price of X decreases)

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Similarly, if the money income increases the price line will shift upwards
parallel on both axes.
Consumer equilibrium
The consumer equilibrium suggests the method in which he consumer can

maximize satisfaction with in the given limitations of money income and
prices.
The indifference curve analysis is an improvement over the utility

analysis. It is given by Hicks and RGD Allen. As an improvement IC
analysis uses ordinal measure of utility in place of cardinal measure.
Assumptions
Consumer equilibrium is based on the following assumptions:
1. The prices of two goods are given and constant.
2. The money income of the consumer remains constant
3. The tastes and preferences of the consumer remain same
4. The consumer is rational, i.e. the consumer prefers larger satisfaction
to smaller satisfactions.
5. The theory follows all the foundations of indifference curves, like
convexity, transitivity, ordinality and scale of preference.
The consumer equilibrium considers the indifference map and the price
line.
The indifference map represents the consumer behavior, tastes and
preferences of the consumer. On the other hand the price line represents
income and the prices of two goods.
The indifference curve is made up of combinations the consumer wants to

consume on the other hand the hand the price line denote the
combinations the consumer can buy. Consumer equilibrium determines
such combinations which the consumer can buy, those which he likes and
finally gets maximum satisfaction.

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The consumer equilibrium is derived by combing the indifference curves

and the price line.
In the diagram
IC3 is possible because the consumer can not reach this with
his limited income.
IC1 is possible because there are several combinations with
in the budget; price line
IC2 and the price line have one combination common. At the
point of tangency between the IC and price line i.e. E.
This is the consumer equilibrium. A combination which offers maximum
satisfaction and is also falls with in the price line.
Conditions of Consumer Equilibrium

The consumer equilibrium is found at a place where Indifference Curve
(IC) and Price Line (PL) are tangential.

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Slope of the price line = Slope of the Indifference curve

Or Slope of the price line = Marginal Rate of substitution
[Equilibrium condition]
In the diagram
E1 is not equilibrium because slope of IC > Slope of PL
E2 is not equilibrium because slope of IC < Slope of PL
At E Slope of IC= Slope of PL, hence equilibrium
There are two conditions of consumer equilibrium
a. Necessary Condition: Tangency is a necessary condition.

It is case of optimizing satisfaction. In the diagram E2 is a
necessary condition. Yet it is not the equilibrium.

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b. Sufficient condition: Tangency + convexity is sufficient

condition. Tangency represents mathematical
optimization and convexity denotes consumer behavior. In
the diagram E2 is necessary condition. It fulfills tangency as
well as convexity.
Such consumer equilibrium remains valid as long as the price and money
income remain unchanged.
Income Effect
Income effect shows the effect of changes in the money income of a
consumer on his consumption.
All other things remaining constant if the money income of the consumer
increases, the price line will shift upwards parallel. An upward shift of
price line indicates an increase in the income. With an increase in the
income the consumer will consume more. The IC will shift upwards on
the new price line. The increase in the consumption of a commodity is
called income effect.
When the money income increases the consumer shifts on to IC2. The
increase in consumption of X is called income effect. If we join the points
of equilibrium an income consumption curve can be drawn.
Income consumption curve shows changes in the consumption of a

commodity for changes in money income. The nature shape of the ICC
indicates the nature of commodity, whether normal good, inferior or
Giffen’s good.

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With increase in the money income if the consumption increases it is

called positive income effect and if consumption decreases with
increasing income it is called negative income effect.
The nature of income effect determines the shape of the Income

Consumption Curve.
ICC1: If the ICC slopes upwards to the right both X and Y are normal
goods with positive income effect.
ICC2: If the ICC slopes backwards, Y is inferior with negative income
effect and X is normal with positive income effect.
ICC3: If the ICC slopes forwards to the right, X is inferior with negative
income effect and Y is normal with positive income effect.
Assumptions
Income effect is based on the following assumptions:
1. The prices of two goods are given and constant.
2. The money income of the consumer is given and subject to changes.
Substitution Effect
When the price of commodity decreases the consumer substitutes a
costlier commodity with a cheaper commodity with out affecting the level
of satisfaction. This is called Substitution effect.

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In the diagram, the movement from Eq1 to E2 is called substitution

effect. The consumer consumes more of X by sacrificing Y. The
movement is on the same IC showing that the level of satisfaction
remains same.
The substitution effect is always positive for normal as well as inferior
goods. For Giffen’s goods substitution effect is positive but very weak.
Substitution effect together with income effect constitutes the price effect.
Price Effect
Price effect shows the effect of changes in the price of a good on
consumption.
All other things remaining constant if the price of a commodity increases,

the price line will shift upwards on that axis. An upward shift of price line
indicates an increase in the real income. With an increase in the real
income the consumer will consume more. The IC will shift upwards on
the new price line. The increase in the consumption of a commodity is
called price effect.
When the price decreases the consumer shifts on to IC2. The increase in
consumption of X is called price effect. If we join the points of
equilibrium a price consumption curve can be drawn.
Price consumption curve shows changes in the consumption of a

commodity for changes in price. The nature shape of the PCC indicates
the nature of commodity, whether normal good, inferior or Giffen’s good.
Assumptions
Price effect is based on the following assumptions:

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1. The prices of two goods are given and the price of one good only
changes.
2. The money income of the consumer is given and constant.
Composition of Price Effect

Price effect is made up of income effect and substitution effects. When
the price of a commodity decreases:
a. The real income increases and the consumer consume

more of a commodity. This is called income effect.
b. When a commodity becomes cheaper the consumer has a
natural tendency to substitute the costlier commodity with a
cheaper commodity. This is called as substitution effect.
Thus, Price Effect= Income Effect+ Substitution Effect

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In the diagram
E1 is the consumer equilibrium

With a decrease in the price of X the price line shifts upwards and
the consumer will shift on to IC2 at equilibrium E2. The
movement from E1 to E2 is called Price effect
To separate income effect from price effect-
Shift the price line parallel from E2 downwards, so as to reach IC1
at E3.
A parallel downward shift indicates decrease in the income.
The price line shall be shifted to such level on IC1 that the
consumer comes back on to his original level if satisfaction.
With a decrease in income effect the consumption is reduced to E3,

The consumption from E1 to E3 is substitution effect, found on the
same IC.
According to Hicks the price line should be shifted on to lower IC

such that the ‘consumer is neither better off nor worse off’
Nature of Price Effect

Positive price effect means with a decrease in the price the consumption
increases. This is same as the law of demand. The exception to the law of
demand is negative price effect.
The price effect is positive for normal goods and inferior goods. There
are some inferior goods where the price effect is negative. These goods
with negative price effect are called Giffen’s goods.
The price effect depends on the components - income and substitution

effects.
Income Effect Substitution Effect Price effect

Normal Goods +ve +ve +ve
Inferior goods -ve (weak) +ve (strong) +ve
Giffen’s Goods -ve (strong) +ve (weak) -ve
For normal goods the price effect is positive because the components
income and substitution effects are positive.
Inferior Goods
In case of inferior goods in general, the price effect is positive.
The income effect is negative but very weak. The substitution effect is
positive and very strong. So finally, the price effect remains positive.
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In the diagram:
The movement from E3 to E2 is negative income effect. This is negative
The movement from E1 to E2 is positive substitution effect which positive
and strong.
So, finally, the movement from E1 to E2 is positive price effect.
Inferior goods in general follow the law of demand with positive price
effect.
Giffen’s Goods
Giffen’s goods are those inferior goods where the income effect is
strongly negative and substitution effect is weak.

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Giffen’s goods re inferior goods but all inferior goods are not Giffen’s
goods. Giffen’s goods are those inferior good which have a negative price
effect.
In the diagram:
The movement from E3 to E2 is negative income effect. This is negative
and strong
The movement from E1 to E2 is positive substitution effect which positive
but week.
So, finally, the movement from E1 to E2 is negative price effect.
Derivation of demand curve from Price Consumption Curve

For drawing the demand curve there is a need for a set of prices and
corresponding quantities. The Price Consumption curve shows different
price lines. Each price line represents one price of commodity X. The
corresponding quantities can be read fro the X axis at different
equilibriums.
The quantities from different equilibriums are drawn on the lower graph
with X axis marked quantity. The price at different quantities can be
plotted on the Y axis. By joining all the points the demand curve can be
drawn on
the lower panel.

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Elasticity of Demand
Elasticity of demand measures intensity of changes in the quantity of a

commodity for changes in the price, income or the price of a related
commodity. Accordingly, it is called price elastic, income elasticity or
cross price elasticity of demand.
Price Elasticity of demand

Price elasticity of demand measures proportionate changes in the quality
of a commodity for proportionate changes in the price.
Price elasticity relates quantity demanded and the price.
Price elasticity is measured as
The price elasticity has a negative value, because the price decreases for
an increase in the quantity demanded.
ep = 1, Unitary elastic, reference elasticity
ep > 1, Relatively elastic, luxury goods
ep < 1, Relatively inelastic, necessary goods
ep = ∞, Perfectly elastic, hypothetical
ep = 0, Perfectly inelastic, hypothetical

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The value of elasticity changes with changing responsiveness of quantity

changes for changes in the price. Larger the responsiveness greater will
be the elasticity. No change in the quantity the elasticity will be zero. For
highly sensitive quantity, the elasticity will be infinity.

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Income Elasticity of demand

of a commodity for proportionate changes in the income.
Income elasticity relates quantity demanded and the income.

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With an increase in the income the consumer increases the consumption.

This happens in case of normal goods. Incase of inferior goods with
increase in the income the consumer degreases the consumption. This is
called negative income effect.
For normal goods the value of income elasticity is positive for inferior
goods it is negative,
ey = 1, Unitary elastic, reference elasticity positive income effect

ey > 1, Relatively elastic, luxury goods positive income effect
ey < 1, Relatively inelastic, necessary goods positive income effect
ey < 0, Inferior goods negative income
effect
ey = 0, Perfectly inelastic, hypothetical
ey = ∞, Perfectly elastic, hypothetical
Cross Price Elasticity of Demand

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of one commodity for proportionate changes in the price of a related
commodity.
Cross Price elasticity relates quantity demanded of one commodity and
the price of a related commodity.
The value of cross price elasticity depends on the type of relationship

between the goods.
exy < 0, Complementary goods

When the price of X increases, the demand for x decreases, the consumer
decreases the demand for Y. Since, X and Y are complementary goods.
Complementary goods are those which give utility only in combinations.
These are called joint goods having joint demand. e.g. shoe and shoe lace,
pen and ink
exy > 0, Substitute goods

When the price of X increases, the demand for x decreases, the consumer
increases the demand for Y. Since, X and Y are substitutes.
Substitute gods are those goods which give similar utility. Since the
goods give similar utility the consumer can consume one in the place of
the other.

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exy = 0, Unrelated goods

If the price of X increase the demand for Y remains unchanged this is
because the goods are unrelated and independent in consumption and
utility.
Point Elasticity of Demand

According to Lucas all goods tend to be elastic at higher prices and
inelastic at lower prices. This principle can be shown geometrically on a
demand curve using point elasticity of demand method.
It is ratio of lower segment to the upper segment.
The elasticity increase as it moves upon the demand curve to the left.
The demand curve is extended on both sides so as to make a right angle

triangle.
Then the elasticity at point is measured as
E= Lower segment
Upper segment
Or BC
AB
So
e = 1, Unitary elastic, reference elasticity
e = 0, Perfectly inelastic, hypothetical
e > 1, Relatively elastic, luxury goods
e < 1, Relatively inelastic, necessary goods
e = ∞, Perfectly elastic, hypothetical
Promotional Elasticity of Demand
Promotional elasticity of demand measures proportionate changes in the

sales of a commodity for proportionate changes in the promotional
budget.
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Price elasticity relates sales and the promotional budget.
Promotional elasticity is a managerial tool of corporate decision making.

It enables the enterprise to decide whether a sales promotion budget is
desirable or not in terms of generating corporate incomes and sales.
An elastic promotional elasticity means that the sales are in larger

proportions than the promotional budget and desirable. If the promotional
elasticity is less than one that inelastic it means that the promotional
budget has failed in promoting proportionate sales, hence undesirable.
The promotional budget may have components like media, advertising,
sales promotions, free samples, gifts, promotional offers etc.
Revealed preference Theory

Revealed preference theory s based on the observed behavior of the
consumer. A consumer during his consumption selects a combination of
goods. By selecting a combination of goods he rejects all other
combinations revealing his preference for consumption.
The revealed preference theory is given by Paul Samuelson.
The consumer selects combination P o the price line MN. By doing so the
consumer optimizes his satisfaction within the limitations of income and
prices. This is the case of revealed preference.
The consumer continues to be with this combination as long as the price

and income remains same. This is a case of strong order preference.
It is assumed that the consumer has not arrived at saturation. So the
consumer can always go for higher satisfaction. This is called as the non-
satiety condition.

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The consumer will leave this combination only when he can no longer
afford. If the price of A increases, the price line will shift down wards.
The consumer can no longer afford P . So he leaves combination P.
However, if there is an increase in money income the consumer will
rearrange his preference in a manner to attain P again
Consumer Surplus
Consumer surplus is the excess of Utility drawn over the price paid.
According to the law of demand the price decreases with increasing
quantity. This is because the utility decrease with in creasing
consumption as per the law of diminishing marginal utility.
A consumer pays the price according to the utility drawn on the last
commodity. This price is uniform for all the earlier units. In this process
the consumer derives surplus utility over the price paid on earlier units.
This surplus utility is called the Consumer Surplus.
Consumer surplus = Utility derived – price paid

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Consumer surplus is the excess of utility derived by consumer. The

producer surplus is the surplus of price charged by the producer over the
supply price. The supply curve shows that the price increases with
increasing quantity. The price is charged as per the last unit produced,
whereas the producer receives a surplus over the supply price. This is
called producers’ surplus. The producers’ surplus can be increased by
reducing consumer surplus. This is called consumer exploitation.
Assumptions
1. The concept believes in the law of diminishing marginal utility
2. The law of demand is considered for determining the price.
3. The price remains uniform.
4. The supply of goods is uniform.
5. The tastes of the consumer remain constant
6. There is perfect competition.
Limitations
The concept of consumer surplus has several limitations due to its rigid
assumptions.
1. The utility can not be measured
2. Consumer surplus can not be easily quantified.
3. Market imperfections deny consumer surplus to the consumer.

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4. Marketing techniques increase consumer surplus by showing greater

utility and then in crease price.
5. Consumer surplus encourages the government to levy tax.
Applications:
Consumer surplus is a very useful concept applied in marketing, product

design and pricing.
1. It helps in determining the price. Larger the consumer surplus, greater
the possibility of increasing the price.
2. The Government can determine tax based on consumer surplus.
3. Under monopoly, the producer charges different prices for the same
commodity depending on the consumer surplus. It helps on price
discrimination.
4. Necessities have larger consumer surplus than luxury goods.
5. Consumer surplus helps in demand forecasting.
Engel Curve
Engel curve relates changes in consumption for changes in the income.
The Income consumption curve tells us about changes in consumption
from changes in income. ICC can be used for deriving the Engel curve
Each shift in the price line represents increase in the money income. With
such shift the ICs shift upwards and the consumption increases.
Such increase in consumption is marked on the lower graph against

corresponding changes in the money income. Thus Engel’s curve is
derived on the lower graph.
The shape and slope of Engel curve depends on the shape and slope of
ICC.
ICC depends on the nature of goods whether, normal or inferior,
necessary good or luxury.

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Module 3: Production and costs
Production function
A production function provides the relationship between out put and

various factors of production. A production function is a functional
relation between the inputs and out put.
The production function can be classified as per time period. There can
be short run production function and the long run production function.
Between time periods the nature of factors can change.
In the long run all factors change; when all factors change there can be
large changes in the out put can be brought, the technology can change,
the cost structure may be totally renewed. So, the expression of long run
production function will be

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Quantity of out put,

Q = f ( Labour, raw material, power, land, buildings, machinery / T)
Where T, is technology; an embedded (associated) factor of production. It

is the qualitative description of capital,
In the short run certain factors are fixed certain other variable. Fixed
factors remain fixed even with changing out put. On the other hand
variable factors change with changes in the out put. So the expression of
production function will have fixed and variable factors.

Q, = f ( labour, raw material, power/ F , T)
Where F represents the fixed factors which remain unchanged in the short
run and T is the level of technology given and constant.
The short run production function will always carry the expression fixed
and variable, separately.
Law of variable proportions
The law of variable proportions studies the relationship between one

variable factor and the out put. It studies the behavior of out put for
changing variable factor. It deals with a short run production function
with one variable factors with all other factors are given and kept
constant.
Q, = f ( labour / F , T)
Where F represents the fixed factors which remain unchanged in the short
run and T is the level of technology given and constant.
According to the law of variable proportions, ‘all other factors remaining

constant, if the usage of one variable factor increases, the out put will
increase rapidly, then slowly and finally decreases’.
I Stage: Stage of increasing returns

During the first stage the out put increase rapidly because
a. The variable factors become more and more productive, initially.
b. The fixed factors become more productive.
c. The elasticity of production is more than 1 ( Ep>1)

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During the first stage AP, MP and TP are increasing. MP reaches a

maximum called as the point of inflexion. From this point onwards there
will be a change in the level of factor productivity.
At the end of the stage, AP=MP and TP continues to increase.
Total Average Marginal Production Stages of production

Labour Product Product Product Elasticity
Units TP AP MP
1 5 5 0 Increasing
2 8 4 3 Ep>1 returns
3 15 5 7 I Stage
4 24 6 9
5 30 6 6
6 30 5 0 Ep<1 Diminishing returns
II Stage
7 28 4 -2 Ep<0 Negative returns
III Stage
II Stage: Stage of diminishing returns

During the second stage the out put increase slowly because
a. The factor substitution becomes limited
b. Other factors become less and less productive
c. The elasticity of production is more less 1 ( Ep<1)

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During the second stage AP decreases but it is slower than MP. Further,
MP<AP, MP decreases and TP is increasing, but slowly. At the end of the
stage MP=0
II Stage: Stage of negative returns

During the third stage the out put decreases because
a. There will overcrowding of one variable factor
b. Fixed factors also become less productive.
c. The elasticity of production is less than o ( Ep<0)
During the third stage, AP, MP and TP are all decreasing.
Assumptions:
1. All factors re given and remain constant and only labour changes
2. The level of technology remains same.
3. There is perfect competition in product and factor markets.
4. Variable factors are of similar productivity.
Isoquants
An isoquant is made up of various combinations of two factors which
give rise to a fixed amount of out put.
Isoquant deals with a production function with two variable factors.
Output = f (K,L / F ,T)

where K - Capital, L – labour, F – fixed factors, kept constant in the short
run and T – the technology given.
Each Isoquant deal with a specific level of out put. Isoquants away from
the origin represent higher out put and isoquants towards the axis
represent lower out put.
The Isoquant depends on the level of factor substitutability. Factors of

production are not perfect substitutes. The ridge lines give the limits of
factor substitutability. The area between the ridge lines is called the
economic zone. This is the area where there is factor substitutability. The

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analysis is confined to this area alone. The area out side the ridgelines can
not be used for any study, because the factor substitutability ends.
The slope of the Isoquant represents the Marginal rate of technical

substitution (MRTS). It is the ratio of change in K for changes in L.
The Marginal rate of technical substitution is the manner one factor is

substituted by the other factor so as to give a fixed output through out the
isoquant. Such slope of isoquant depends on the nature of factors and
intensity of production.
Producers' equilibrium (Least cost combination)
Producers’ equilibrium deals with a least cost combination of producing a

specific level of out put the producer would like to produce.
A producer will be a t a state of equilibrium when he produces a desired
level of out put at a cost which is least. This can be done by using
isoquants. By choosing isoquant we consider a production function with
two variable factors all other factors and technology remaining constant.

Where K - Capital, L – labour, F – fixed factors, kept constant in the short

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Firstly the producer will determine the level of out put to be produced;
the isoquant is selected. The producers' equilibrium is found at a place
where the slope of the isoquant is same as the factor price ratio line.
Mathematically, the slope of the isoquant is equal to the slope of the price
ratio line. Or the slope of the price ratio line is same as the Marginal rate
of Technical Substitution.
The producers' equilibrium finds the least cost combination. Least cost
combination is the combination of two factors which will produce a given
level of out put at least cost.
There are different least cost combinations for different levels of out put.
Assumptions
1. Producers’ equilibrium considers a production function with two
variable factors.
2. The level of technology remains same
3. All other factors are given and constant
4. There is perfect competition in factor and product markets.
The prices of two factors are given and remain unchanged.
Least cost combinations are found at different levels of out put by

following the condition of producers’ equilibrium. When all the points of
equilibriums or the least cost combinations at different levels of out put
are joined, the production path or the scale line can be derived.

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The shape and position of the scale line will indicate the type of
technology or the intensity of factor usage. If the production path is
towards the capital axis it is capital intensive, if it is toward the labour
axis the technology is labour intensive.
Laws of Returns to Scale
The laws of returns to scale deals with the long run production function.
In the long run all factors change; when all factors change there can be
large changes in the out put can be brought, the technology can change,
the cost structure may be totally renewed. So, the expression of long run
production function will be

Q = f ( Labour, raw material, power, land, buildings, machinery /
T)

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Where T, is technology; an embedded (associated) factor of production. It

is the qualitative description of capital,
According to the laws of returns to scale -

In the long run when the scale of production increase,
a. The out put may increase in larger proportions than the inputs
used called Increasing returns to scale
OR
b. The out put may increase in the same proportions as the inputs
used called Constant returns to scale
OR
c. The out put may increase in lesser proportions than the in puts
used called Diminishing returns to scale.
The laws of returns to scale can be explained with the help of isoquants.
By choosing isoquant we consider a production function with two
variable factors all other factors and technology remaining constant.

Where K - Capital, L – labour, F – fixed factors, kept constant in the short
1. Increasing returns to Scale

According to Increasing returns to scale
In the long run when the scale of production increase, the out put may
increase in larger proportions than the inputs used called increasing
returns to scale
Increasing returns to Scale
- The gap between E1, E2, E3,

and E4 decreases
- Economies of scale
- Decreasing costs

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The out put responds positively because; it operates on economies of

scale. In the long run the firm derives certain advantages called
economies of scale. These economies of scale can come from within
called internal economies or come from out side the firm called external
economies.
Due to economies of scale the costs keep on decreasing. This is called
decreasing costs.
In the diagram it can be seen that the gap between the isoquants keep on
decreasing thus showing that lesser and lesser factors are needed for
producing additional output.
2. Constant returns to scale
In the long run when the scale of production increase, the out put
may increase in the same proportions as the inputs used called
Constant returns to scale
Constant returns to Scale
- The gap between E1, E2, E3,

and E4 remains constant
- Neutral Economies of scale
- Constant costs
In case of constant returns to scale the out put increases in the same
proportions as the inputs. The firm is a said to be operating on neutral
economies. The firms neither get nor loose any advantages due to large
scale production.
In the diagram it can be seen that the gap between the isoquants remain
constant thus showing that same ratio of factors are needed for producing

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additional output. The per unit costs remain constant. This is case of
constant costs
3. Diminishing returns to scale.
In the long run when the scale of production increase, the out put
may increase in lesser proportions than the in puts used called
Diminishing returns to scale.
Diminishing returns to
Scale
- The gap between E1, E2,

E3, and E4 increases
- Diseconomies of scale
- Increasing costs
The out put responds discouragingly, because; it operates on

diseconomies of scale. In the long run the firm may face certain
disadvantages called diseconomies of scale. These diseconomies of scale
can come from within called internal diseconomies or come from out side
the firm called external diseconomies.
Due to diseconomies of scale the costs keep on increasing. This is called
increasing costs.
In the diagram it can be seen that the gap between the isoquants keep on
increasing thus showing that more and more factors are needed for
producing additional output.
Assumptions:
1. It is case of long run production function
2. The scale of production increases

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3. Technology remains same

4. There is a perfect completion in factor and product markets.
5. Each isoquant represents a fixed increment of output.
Economics of Scale
In the long run all factors becomes viable and the firm can increases its
scale of production. When the firm increases the scale of production it
gets certain advantages. These advantages are called economies of scale.
A. Internal economies of scale

These are the advantages the firm gets from the factors within the firm.
These factors are endogenous to the production function.
1. Managerial economies: In the long run the firm will have better
managerial talent in organizing factors for better productivity.
2. Technical economies: The firms will have improved
technology in the long run and the firm will progressively
reduce costs.
3. Economies of by product: The firm will be able to develop
waste into marketable by product in the long run. This will
add to the revenues of the firm.
4. Economies of supervision: Better supervision will improve the
factor productivity in the long run.
5. Economies of cost: With improved supply chain and labour
productivity the costs will reduce in the long run.
6. Economies of integration: In case of forward integration the
firm will undertake an additional process of production and
add value o the out put. The revenue will increase
Similarly, backward integration will enable a firm produce
such factors which were earlier bought form the factor
markets. This again reduces the cost and adds to the profit
margins.
7. Risk bearing economies: Firms will greatly increase capacity to
take risk with new products and technologies in the long run.
This is due to established market and strong finances.
8. Economics of specialization: The firm may develop certain
specialization in the long run depending on the production
function and acceptance in the market. This may create niche
and better price.
B. External economies of scale

These are the advantages the firm gets from the factors out side the firm.
These factors are exogenous to the production function.

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1. Economies of marketing: The firms will be able to market with

ease due to establishment of brand and dealership network
2. Economies of finance: The firms will have better financial
position in the long run due to accumulated profits. The firm will
also have better institutional axis for raising more finance easily.
3. Economies of environment: In the long run the firm becomes
more environmentally friendly with larger investment on
pollution control and resource conservation
Cobb-Douglas production function

The Cobb-Douglas production function represents the relationship
between output to inputs
The Cobb-Douglas production function deals with short run production
with two variable factors.
The function they used to model production was of the form:
Where:
• P = total production (the monetary value of all goods
produced in a year)
• L = labor input (the total number of person-hours worked
in a year)
• K = capital input (the monetary worth of all machinery,
equipment, and buildings)
• b = total factor productivity
• α and β are the output elasticities of labor and capital,
respectively.
These values are constants determined by available technology.
Output elasticity measures the responsiveness of output to a change in

levels of either labor or capital used in production, ceteris paribus. For
example if α = 0.15, a 1% increase in labor would lead to approximately
a 0.15% increase in output.
Further, if:
α + β = 1,
The production function has constant returns to scale. That is, if L and K
are each increased by 20%, then P increases by 20%.

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Returns to scale refers to a technical property of production that examines

changes in output subsequent to a proportional change in all inputs
(where all inputs increase by a constant factor). If, output increases by
that same proportional change then there are constant returns to scale.
If output increases by less than that proportional change, there are

decreasing returns to scale. If output increases by more than that
proportion, there are increasing returns to scale.
However, if
α + β < 1,
Returns to scale are decreasing, and
If
α + β > 1,
Returns to scale are increasing.
Module 4: Costs and revenue

Costs
There are several concepts of cost developed, each suitable for a different
purpose. There are financial cost and social costs, accounting cost and
economic costs, short run and long run costs and the opportunity cost.
1. Accounting cost and economic costs: Accounting costs consider

documentation of expenditure for purpose of future analysis. It is
the analysis in retrospection. The analysis deals with spent money.
As against this, the economic cost study the nature of costs, their
behavior and methods of optimizing cists for minimizing cost of
production and maximizing profits.
2. Financial cost and social costs: Financial costs are private costs, the
costs paid by a firm to procure factors for creating out put. The
major consideration is optimizing usage of factors for cost
reduction and maximizing profits.
On the other hand the social cost deal with the burden of
production on the society, environment, and resource conservation.
Most of the social costs can not be quantified. But these cots are
very important in terms of social objectives and justice.
3. Financial costs and physical costs: Financial costs are economic costs
mentioned in uniform value terms. Since all the factors are

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mentioned in uniform terms, it is easy to apply any quantitative or

statistical method for regulating their usage and optimizing for
profits.
Physical costs on the other hand are factors mentioned in dissimilar
units. Since they are dissimilar in expression and quantitative, it is
not easy to apply techniques of quantitative analysis. Yet physical
costs are important for production planning and procurement of
factors.
4. Opportunity Cost: Opportunity cost is the cost of a factor in its
alternative use. This is the minimum which needs to be paid to
bring a factor in use. Any payment less than this will make the
factor leave the production function and join an alternative use.
The concept of opportunity cost is useful in determining the factor
price. The factor price needs to be equal to or greater than the
opportunity cost. Larger the opportunity cost higher will be the
factor price.
Short run Cost curves

In the short run certain factors are fixed certain other variable.
Accordingly, certain costs are fixed and certain costs variable.
In the shot run there are three costs - total fixed cost, total variable cost
and total cost. In addition there are four per unit costs- average fixed cost,
average variable cost, average cost and the marginal cost.
Illustration: for a given TFC of 100 and TVC over 8 units, the costs will
be

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Out TFC TVC TC AFC AVC AC MC

put
1 1000 100 1100 1000 100 1100 -
2 “ 180 1180 500 90 590 80
3 “ 240 1240 333 80 413 60
4 : 340 1340 250 85 335 100
5 “ 480 1480 200 96 296 140
6 “ 680 1680 166 113 179 200
7 “ 980 1980 142 140 282 300
8 “ 1480 2480 125 185 310 500
1. Total Fixed cost

The fixed cost remains constant in the short run at level of out put. The
fixed cost curve is a horizontal curve parallel to x axis. At zero level of
out put the total cost is equal to total fixed cost.
2. Total variable cost

The total variable cost increases with increasing cost. The shape of the
variable cost curve is drawn form the law of variable proportions. This
it has three segments. At zero level of out put the variable cost is zero.
3. Total cost
Total cost = Total fixed cost + Total variable cost
The total cost is the sum of total fixed cost and total variable cost. At
zero level of out put the total cost is equal to total fixed cost. The
shape and size of total cost is similar to total variable; cost but it starts
form total fixed cost.
4. Average Fixed cost

Average Fixed Cost = Total fixed cost
Out put
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Average fixed cost curve is a downward sloping curve. It keeps on

decreasing, but never touches the axis. It is asymptotic to x axis.
Geometrically, on this curve the product of coordinates always a
constant.
5. Average Variable Cost
Average Variable Cost = Total Variable Cost
output
Average variable cost is a broad U shaped curve; the shape of the
curve is drawn from the behavior of variable facto and the law of
variable proportions.
6. Average Cost
Average Cost = Total cost
Out put
Or Average Cost = Average Fixed cost + Average Variable
Cost
Average cost curve is a U shaped curve; the shape is derived by the

combination AC and AVC. AC curve lies above AVC. Average cost is
minimum when AC = MC
7. Marginal cost
Marginal cost = TC (n-1) - TC n
Marginal cost curve is a J shaped curve. It passes through the minimum
point of AC. When AC=MC, Marginal cost is minimum. The shape is
derived from the behavior of marginal product in the law of variable
proportions.
The short run Average Cost Curve is a U shaped Curve

The U shape of the average cost curve is made up of three segments;
down ward part, change in the trend and upward trend:
a. Initially, AVC and AFC are both decreasing so the resultant

AC also decreases
b. There after, AFC continues to decrease but AVC increases.
There is a change it the trend. The decreasing curve now
changes trend towards increase.
c. Finally, the increasing AVC is stronger than decreasing AFC
and AC now continues to increase.
The Ac curve takes a U shape.

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Further, Average Cost = Average Fixed cost + Average Variable Cost

So, the gap between AVC and AC is equal to AFC.
Long run costs

The long run cost curves are derived from the short run cost curves. The
long run AC is derived from the short run AC. In the long run when the
scale of production increases, the AC curves shift down wards showing
decreasing costs. This is due to economies of scale. This is case of
decreasing costs
In the long run, when the scale of production increases, the AC curves
may shift horizontally to the right. This is due to neutral economies of
scale. This is case of constant costs.

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In the long run when the scale of production increases, the AC curves
shift upwards showing increasing costs. This is due to diseconomies of
scale. This is case of decreasing costs
The long run AC is made up of these three segments. Thus the LAC is
flatter than the SACs. The LAC is also called the envelope curve. For this
reason “The long run average cost curve is flatter than the
short run average cost curve.”
Long run Marginal cost curve passes through the minimum point of LAC.

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Following are the long run factors responsible for flatter long run average
cost curve:
1. Population
Though population changes even in the short run. The effect of
population can be seen only in the ling run, by way of changes in
the pattern of demand and labor force.
2. Technology
Technology helps in the ling run in reducing costs and making
production function efficient.
3. Alternative sources of raw material and energy
Alternative and cheaper sources of raw material and energy
change the production function and help in expanding out put and
making it economical.
4. Expanding markets
Expanding markets provide purpose for the industry to produce
and distribute. In the long run, mass consumption in the economy
increases.
Revenue concepts
Total revenue (TR): This is the revenue got by the firm by selling certain
amount of out put.
Average Revenue (AR): This is the average proceeds per unit. This is
same as the price. For this reason, the demand curve is same as the
average revenue curve.
Marginal Revenue (MR): This is the additional revenue got by affirm by
selling an additional unit.
Revenue relationships under perfect competition

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The price under perfect competition is determined by the industry. A

single firm is too insignificant to determine the price. Larger number of
firms together determines the price. Under perfect competition the
number of firms is so large that no single firm can, alone, influence the
price.
A firm can produce only an insignificant part of the total out put. This is
the reason why a firm continues to get the same price at any level of out
put. It means that the fir has a demand curve with infinite elasticity.
Quality Price TR AR MR
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
6 10 60 10 10
Under perfect completion the firm is a price taker and it has to determine
that level of out put which will give maximum profits. The firm has also
AR=MR in revenue relationships.
Revenue relationships under imperfect competition
A monopolist faces a downward sloping demand curve: Under monopoly,

there is no distinction between firm and industry. The demand is direct on
to the firm. Incase of perfect competition, the industry faces down ward

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sloping demand curve and the firm gets the perfectly elastic demand
curve. In case of monopoly the firm directly faced the downward facing
demand curve.
It means that the firm can sell more only by reducing price. With this
difference, the relation ship between AR and MR also changes
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
Relationship between AR and MR
AR and MR are downward sloping curves. MR curve lies below AR

curve. MR curve cuts the plane below AR curve into two halves.
Geometrically, it has a property:
A perpendicular drawn on Y axis will show
ab = bc.

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Relationship between Elasticity of demand and Revenues
Where e – is the point elasticity of Demand, AR is average revenue and

MR is Marginal Revenue.

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Section II
Theory of firm
Objectives of Firm
The firm may have several objectives ranging from, economic, short run,
long run material and non material in nature. All objectives are important.
However the firm may decide its own priorities in objectives. Certain
firms may have material objectives significant certain other firms may
have normative objectives significant. Some objectives are uniformly
significant for all firms.
Following are some of the important objectives of a firm.
a. Economic objectives
Economic objectives are material objectives which may be short as well
as long run. Economic objectives are normally considered by all firms.
These economic objectives can be classified as follows:
1. Profit maximization:
Each firm tries to maximize profits. This is a universal objective

for firms. The firms aim at maximizing the difference between
total revenue and total cost.

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The firm will produce such out put which will give maximum
profit. The gap between TR and TC can be maximized by
drawing two tangents, one on each with same slope.
The slope of TC is MC and slope of TR is MR. By equating

slopes; MC is equated with MR.
So, MC=MR emerges as equilibrium condition for optimizing out
put for a firm.
Firms may aim at maximizing rate of profit or profit. The rate of
profit is maximized by pricing so that there is larger gross profit
margin. On the other hand maximizing profit may be attained by
maximizing out put.
2. Workers welfare
Workers welfare helps in maintaining harmonious relationships
and also maintaining high levels of productivity and loyalty.
3. Consumer satisfaction
Consumer satisfaction helps in maintaining brand image, market
share, prevents defection of consumers to another brand.
4. Investors benefit
In case of joint stock companies, the firm will aim at increasing the
net asset value of the company. Accordingly, it will have a investor
friendly policy in dividends and bonus.
5. Specialization
Specializing in certain product or service will be useful in
establishing brand image, market share and growth.
6. Creating brand equity
Every firm aims at creating a brand and as large consumer
following as possible. This is in the long run interest of the firm.
b. Long run objectives

1. Survival
The basic objective of firm is to survive in the long run. In the long
run the competition may increase, in such a market the basic
principle is to survive.
2. Market leadership
The firm wills always aim at being the market leader. This is a
material objective as well as normative objective. In most cases
profit depends on this objective.
3. Increasing market share
The firms will initially aim at increasing market share. This is the
objective before aspiring for market leadership.

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4. Growth: forward and backward integration

The firm may go for forward integration thus adopting an
additional process of production or take up backward integration
whereby, produce locally such component which was earlier
brought form the factor market.
c. Non material objective

1. Social responsibility
The forms may assume social responsibility as an important
factor. It is give back from the society from where the firm makes
a living.
2. Environmental protection
The firm may work in the direction of protecting the
environment. This is dome by being eco-friendly and having less
pollution.
3. Resource conservation
The resource conservation may help in reducing costs but it also
helps in reducing social costs. The society benefits form resource
conservation
4. Creating social infrastructure
The firm may create social infrastructure by constructing
educational institutions, hospitals, townships, and aforestation.
Break even Analysis
Break even out refers to the level of output where TR = TC. This is the
minimum out put the firm need to produce its costs. Any output there
after will grant profit to the firm. Usage of break even point for corporate
decision making is called Break even analysis.
At break even point total cost is equal to total revenue. After break even
point the profitability begins. The out put less than break even out put
shows losses.
Every firm aims at break even level of output in the beginning. The break
even level is a no profit no loss condition. In other words it is case of
normal profits. The costs cover only the manager’s remuneration and
there is no surplus over that. It is similar to the condition AR = AC.

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At break even point there are no profits, so TR = TC
Where,
TR is total revenue
TC is total cost
P is price
AVC is average variable cost
TFC is total fixed cost
Q is out put
Break even analysis is based on the following assumptions

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1. The cost and revenue functions are linear functions. This is for the
sake of simplicity.
2. The firm can estimate the cost and revenues in advance.
3. Price remains uniform at all levels of out put.
4. The costs are made up of fixed and variable costs.
Angle of Incidence
The angle of incidence is the angle made by the TR and TC functions at

the break even point. In break even analysis the angle of incidence is very
important in selecting a project among various competing projects.
The angle of incidence decides the nature of break even point.
If the angle of incidence is larger the break even out put will be smaller.
In other words, if the angel of incidence is smaller the break even out put
will be larger.
While comparing competing projects on the basis of break even points, a
project with larger angle of incidence will be selected. Because a firm
will always wishes to keep the Break even out put small so that, it can
operate on profits hat sooner.
Application of Break even analysis
A firm will firstly, attain the break even out put so that it can be out of
losses and start making profits.

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However, the firm needs to allot revenues for different purposes

depending on the earnings of profit or revenue.
Firstly, the firm will slot revenue for depreciation on assets. Depreciation
is a nominal expenditure. It is that part of fixed assets that is consumed
during the year and that part of fixed cost that can be charged to the out
put. Depreciation is the first priority after attaining break even out put.
When a firm makes profits it has to pay taxes. The firm now provides for
taxes after deducting depreciation.
Thereafter, marketing overheads can be deducted. These marketing

overheads are for more than one year. So if the revenue permits the firm
may provide for durable marketing overheads.
Finally, the revenue in excess of all these provisions yield profits that can
be distributed among owners or retained as reserves and surplus.
Limitations
1. Break-even analysis is only a supply side analysis, as it

tells you nothing about what sales are actually likely to be
for the product at these various prices.

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2. It assumes that the price remains uniform at levels of out

put
3. It assumes that fixed costs are constant
4. It assumes average variable costs are constant per unit of
output,
5. It assumes that the quantity of goods produced is equal to
the quantity of goods sold
6. In multi-product companies, it assumes that the relative
proportions of each product sold and produced are constant
Pricing Methods in practice
Marginal Cost Pricing
The Conventional pricing is followed when MC = MR, the price is

determined by AR curve. The conventional pricing is described by the
theory of firm and pricing. Independent of markets and competition the
pot put is determined by equating MC and MR. This as an optimizing
output will help in determining the price as per the AR (demand) curve.
Marginal Cost pricing: when AR=MC, the price is equated with Marginal
Cost. The Marginal cost pricing is more advantageous than conventional
pricing because, the out put tends to be larger than the conventional
method. Further, the price tends to be smaller.

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This is the method followed by the Government in most administered

pricing methods.
Administered pricing refers to the pricing adopted by the government in

determining the price of a product independent of market and profitability
considerations.
The resources are put to efficient use when the price equated with MC.
The price is lower and the out put is higher.
Thus way the government can encourage the consumption of a product
and also utilize the production capacity fully, thus achieving efficient
allocation of resources. The Government follows this method for pricing
petroleum prices.
Under administered pricing the Government can also follow Average cost
pricing: when AR=AC, the price is equated with Average Cost. This is a
pricing where the firm will be operating at normal profits. In this case the
out put is highest and the price is lowest. The government follows this
method for pricing products like fertilizers. The consumption of fertilizers
is desirable in the national interests in increasing the output of agriculture.
Full Cost Pricing
The corporate pricing practices are mostly based on the cost sheet
approach, where the price includes all the costs chargeable to the product.
The considerations of average and marginal costs are no more valid. The
cost sheet approach to pricing includes relevant inputs of production and
overheads.
Out line of cost sheet:

Direct labour + direct material+ direct expenses = Prime cost
Prime cost + Production over heads = Works cost
Works cost + administration overheads = Cost of
production
Cost of production + selling and distribution over heads = Cost of sales
Full cost pricing considers all relevant costs and over heads. The costs
include all the variable costs and part of fixed cots. The fixed cost is
represented in different ways
As per the standard accounting procedures, the fixed cost is represented

as depreciation. It is that part of the fixed capital that is consumed during

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that year on out put. The amount charged on the out put pit depends on
the life span of the asset and cost of replacement.
Alternatively, the fixed cost can be represented as the interest on fixed

capital for that year.
In both the cases the fixed capital is represented in the cost of production.
To this cost the firm will add a profit mark up. The price so determined is
called as the price of the product as per full cost pricing or profit mark-up
method.
Price = Mc + Lc+ FC+ π

q
Where,
Mc is the cost of material
Lc is the labour cost
FC is the fixed cost apportioned to the out put
q
π is the profit mark-up
Full cost pricing a popular method of pricing method. This is because of
its several advantages
1. Represents all costs
As against the conventional pricing methods, full cost pricing is
realistic
2. Fixed costs
Fixed costs are correctly represented. The costs which can be
assigned to the out put are correctly drawn.
3. Realistic representation of creation of utility
The cost represents the actual inputs going into production
representing their scarcities and productivities.
4. Easy for firms to adopt
Since it is simple and provides great scope for analysis of cost of
production it is commonly adopted by firms.
5. Flexible
The system is very flexible. Simple cost sheet method enables the
firm to apply the system across time and products.
6. Extendable to multi commodity or multi location pricing
A firm producing multiple goods or producing from various
locations can use the method easily. The system can be
integrated in multi- product pricing and branch accounting.

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Profit mark-up
Profit mark-up is the rate of return expected by the firm on its sales. It is
the gross profit margin. Determination of Profit mark-up is matter of
great care and risk. Firms determine the Profit mark-up depending on
several factors.
The profit mark-up depends on several factors
1. Corporate policy
The policy of the firm will determine the level of profit mark-up
2. Nature of product
The product can be consumer good, further, consumer durable,
luxury good, perishable or similar. Profit mark-up changes in
each case.
3. Nature of market and competition
Market and competition have great bearing on the Profit mark-up.
Highly competitive markets will have lower Profit mark-ups.
4. Pricing strategy
Having a certain degree of Profit mark-up can be matter of
corporate strategy. It is an internal matter for a firm.
5. Industry standard
Every industry has its own standard of Profit mark-up. May it be
hospitality, automobile, housing or consumer goods; each has its
own degrees of Profit mark-up.
6. Product life cycle
The product life cycle decides the degree of Profit mark-up.
Whether the product is at introduction, growth, competition,
stagnant or decay will all have a Profit mark-up of their own.
7. Cost of capital
The cost of capital has a direct bearing on the levels of Profit
mark-up expected. There is a direct relation between these.
7. Expected rate of return or profitability
Each firm will have its own expected rate pf return on
investment. The Profit mark-up will depend on that.
Module 6: Perfect competition

Perfect competition: features; short run equilibrium of the firm and
industry: derivation of supply curve of the firm and industry; long run
equilibrium of firm and industry
Perfect competition refers to a competition between large umber of

buyers and sellers dealing in homogenous product at uniform price.

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Features of perfect competition
1. Large number of buyers and sellers

The number of buyers and sellers should be so larger that no firm can
determine the supply or no single buyer can determine demand and no
singe person can determine the price.
2. Homogenous product
The product is homogenous, so that no form has a reason to charge a
different price.
3. Free entry and exit of firms:
When there is free entry and exit of firms, the firms keep joining the
production as long as there are profits. With new firms joining the super
normal profits, get distributed among more and more firms.
At the same time when the profits decrease the less efficient firms leave
the industry. So in the long run, efficient firms which can operate at
normal profits only exist. In the long run the perfect competition has only
firm which operate on normal profits.
4. Perfect knowledge
The buyers and sellers have perfect knowledge of \demand, supply and
price.
5. Free mobility of factors of production
Free mobility of factors ensures that the cost of factors is same across all
the regions. Equal factor prices give all the firms same opportunity to
make profits and survive. So, efficiency of firms will determine the
profitability of firms.
6. No transport cost
The transport cost should be insignificant as compared wt the cost of
production. This is possible only when the firms cater to local markets.
7. No advertising
The firms need not advertise, because each firm will have infinite market
at the given price. Advertising will add to cost and reduce profits
8. Uniform price
Uniform price ensures that the consumers have choice between firms and
the firms have no reason to charge different price due to homogenous
product.
9. No Government restrictions
There are no government interventions by way of taxes or mobility of
goods.
Price determination under perfect competition (Industry)

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The price under perfect competition is determined by the industry. Perfect

competition is a market condition where the buyers and sellers are
equally important in the determination of price. It is an ideal situation
whether both the buyers and the sellers are equally represented.
Under perfect competition the price is determined by the firms and

buyers, no single firm or buyer can influence the price. The buyers are
represented by demand curve and the firms are represented by supply
curve.
The demand curve indicates

The choice and tastes of the consumers
The utility of the good
The utility behavior of the consumer
The capacity and willing of the consumer to pay the
price
Similarly, the supply curve indicates
The willing ness of the firm, to sell goods at different
price
The cost conditions
Nature of factor markets
Supply and demand curve together determine the equilibrium price. The
equilibrium price is the one which is acceptable to both buyers and
sellers. This is determined by the large number of buyers and spellers.

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Price Quantity Quantity Supplied Market

demanded
10 600 1000 D<S Surplus
9 700 900 D<S Surplus
8 800 800 D=S Equilibrium
7 900 700 D>S Scarcity
6 1000 600 D<S Scarcity
At P1 D<S, Goods are not being sold, price is high

At P2 D<S, there is scarcity, the firms do not accept low price
At P3 D=S, the price is acceptable to both sellers and buyers
This is the equilibrium price. The price remains unchanged as long as the
demand and supply remain constant.
Nature of perfect competition:
Demand and supply are both responsible in the determination of

equilibrium.
According to classical economics, the equilibrium is a natural process;
the demand and supply get equated automatically.
Perfect competition encourages efficiency of firms. It leads to efficient
allocation of resources.
Perfect competition is an assumption for all the theories of economics.
The equilibrium quantity and price remain unchanged as long as the
demand and supply remain constant.
Out put determination under perfect competition by a firm
Perfect competition is a market condition where the buyers and sellers are
equally important in the determination of price. It is an ideal situation
whether both the buyers and the sellers are equally represented.
The price under perfect competition is determined by the industry. A

single firm is too insignificant to determine the price. Larger number of
firms together determines the price. Under perfect competition the
number of firms is so large that no single firm can, alone, influence the
price.
A firm can produce only an insignificant part of the total out put. This is
the reason why a firm continues to get the same price at any level of out
put. It means that the fir has a demand curve with infinite elasticity.

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1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
6 10 60 10 10
Under perfect completion the firm is a price taker and it has to determine
that level of out put which will give maximum profits. The firm has also
AR=MR in revenue relationships.
Given, these condition the firm will optimize its out put at a point where
MC=MR,
Conditions of out put determination:

While maximizing out put the firm shall follow two conditions
I Order condition: MC=MR
II Order Condition: MC cuts MR from below.
At a point where MC=MR the difference between TC and TR will be
maximum.
The gap between TR and TC can be maximized by drawing two tangents,

one on each with same slope.
The slope of TC is MC and slope of TR is MR. By equating slopes; MC

is equated with MR.

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So, MC=MR emerges as equilibrium condition for optimizing out put for
a firm.
Nature of firm
A firm can make profits or incur losses depending on the price and costs.
A firm can earn profits; normal profits and super normal profits or incur
losses; maximum bearable loss and shut down condition. Each on of this
will determine the nature of firm. This is true in case of any firm, whether
perfect competition or imperfect competition.
Normal profit:
A firm is said to be making normal profit when AR = AC. The price (AR)
covers the costs. The cost includes the managers’ remuneration. However
there is no surplus above managers’ remuneration. If the entrepreneur
him self is the manager, he will receive normal profit as his share of
remuneration

Dr.Ranga Sai
Normal profit is also called ‘no profit no loss’ condition or break even
point in managerial economics.
Super Normal profit:

A firm is said to be making supernormal profits if AR > AC. The price
charged by the firm covers all the costs and also generates a surplus over
the expenditure. In this case the firm receives the managers’ remuneration
(normal profits) and also a surplus over it. Hence it is called super normal
profits.
Losses
Dr.Ranga Sai
A firm is said to be making losses if, AR < AC. In case of loss there is a
need for further analysis. The firm needs to decide whether to stay in
production or shut down. In such a case Average variable cost (AVC) is
considered.
Maximum bearable loss:

If AR = AVC the firm is said to be at maximum bearable loss.
The price received covers the AVC and the fixed cost is not covered. So
even if the firm closes down, in the short run the fixed cost remains as
loss. This is a case where, the loss remains same (fixed cost) whether the
firm stays in production or shuts down. This is called the maximum
bearable loss.
Shut down Condition

If AR < AVC, the firm needs to close down.
The price received fails to cover fixed cost as well as a part of variable
cost. So if the firm closes down the loss is equal to fixed cost. If the firm
continues to produce the loss will be fixed cost and a part of variable cost.
So, the firm can reduce losses by closing down. This is called Shut down
condition

Dr.Ranga Sai
Derivation of Supply curve from MC
Supply curve of a firm can be derived from the MC curve. A firm

determines its out put at a point where MC=MR. Under perfect
competition, it is known that AR = MR = P. So, MR can be considered as
price.
If MR keeps changing, the out put of the firm also changes. These
changes can draw the supply curve.
The form produces certain out put at MR1. As the MR keeps changing
from MR1 to 2 to 3 to 4; the out put also changes from Q1 to 2 to 3 to 4.

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This data of out put and prices can be drawn a different graph to get the
supply curve.
The out put and price remains directly proportional. The nature and shape
of MC curve determines the nature and shape of the supply curve.
Long run equilibrium under perfect competition
In the long run the following factors operate:
The supply becomes more elastic: With time, supply becomes more and
more elastic. So the price tends to decrease. The AR=MR received by the
firm also decrease. However, at the same time the average cost curve also
becomes flatter, showing decline in costs. Flatter AVC means more out
put being produced at lesser cost.
There is free entry and exit of firms: When there is free entry and exit of
firms, the firms keep joining the production as long as there are profits.
With new firms joining the super normal profits, get distributed among
more and more firms.

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The long run average cost curve becomes flatter than short run cost curve
Following are the long run factors responsible for changes in average cost
curve in the long run:
1. Population
Though population changes even in the short run. The effect of
population can be seen only in the ling run, by way of changes in
the pattern of demand and labor force.
2. Technology
Technology helps in the ling run in reducing costs and making
production function efficient.
3. Alternative sources of raw material and energy
Alternative and cheaper sources of raw material and energy
change the production function and help in expanding out put and
making it economical.
4. Expanding markets
Expanding markets provide purpose for the industry to produce
and distribute. In the long run, mass consumption in the economy
increases.
Hence in the long run the equilibrium of the firm is arrived at a point
where:
LAC = MR (long run) = LMC = AR(long run)
Where
MR (long run) =MC represents determination of optimum out put,
LAC = LMC indicate the firm operating at optimum level, and

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LAC = AR (long run) means the firm is operating on normal

profits
Module 7: Monopoly
Monopoly refers to an imperfect market situation where a single seller
sells the product in different markets at uniform or discriminating prices.
Monopoly is identified with single firm large number of buyers and the
monopolist as the price maker.
Following are the features of monopoly market.
Features of Monopoly
1. Single seller: The monopoly market has a single firm. There is no

distinction between firm and industry. Since a single firm supplies to the
large number of buyers, the firm tends to be large and specializing in its
production
2. Large number of buyers: There is a large market even under monopoly.
However there may be differences in the elasticity of demand in each
segmented market.
3. Product: The product may be homogenous or even differentiated
depending on the nature of market and division of submarkets.
4. Monopoly power: The entry into monopoly market for other firms is
restricted. This is due to the monopoly power the firm has. The monopoly
power is got by the firm due to following factors.
a. Legal restriction: The law may prevent other firms from
entering. E.g. Government monopolies on entry
b. Exclusive ownership of technology of production: If the
technology of production is known only to a single
firm the monopoly power remains un effected.
c. Exclusive ownership of raw material: Access to raw
material is held by a single firm, the monopoly
power remains intact
d. Registered trade marks and brands: I case of registered
trade marks; firms can not duplicate and compete in a
market. It remains as monopoly.
e. Personal monopolies: Personal monopolies have
individual branding. They can not be duplicated. The
personal monopolies continue

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5. Price discrimination: With price discrimination a monopolist sells the

same product at different prices in different markets at the same time. The
objective of price discrimination is profit maximization.
6. A monopolist faces a downward sloping demand curve: Under
monopoly, there is no distinction between firm and industry. The demand
is direct on to the firm. Incase of perfect competition, the industry faces
down ward sloping demand curve and the firm gets the perfectly elastic
demand curve. In case of monopoly the firm directly faced the downward
facing demand curve.
It means that the firm can sell more only by reducing price. With this
difference, the relation ship between AR and MR also changes
Relationship between Average revenue and Marginal revenue

under monopoly
A monopolist faces a downward sloping demand curve, so he can sell

more only by reducing the price. This will change the AR and MR
relationship. Since it is an imperfect market, AR is not equal to MR. It
can be seen that AR is greater than MR. Further, AR and MR are related
through elasticity of demand.
Q Price TR AR MR
1 10 10 10 -
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2

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Geometrically, AR curve cuts the plain below AR into two halves. So any
perpendicular drawn on Y axis will show the property, ab = bc
Equilibrium under simple monopoly
Under monopoly, the demand curve is downward sloping, so the AR and

MR curves also slope down wards and look different. However the
optimizing condition for out put remains same as in case of perfect
competition.
At a point where MC = MR the firm finds its equilibrium out put. When
MC = MR the difference between TC and TR will be maximum.
The output is found on the x axis. The price determination is done by AR
curve. This is the demand curve which will tell the maximum price that
can be charged for this level of out put.
In case of simple monopoly, there will be only one product and single
price. In case of differentiated monopoly

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Nature of firm
A firm can make profits or incur losses depending on the price and costs.
A firm can earn profits; normal profits and super normal profits or incur
losses; maximum bearable loss and shut down condition. Each on of this
will determine the nature of firm. This is true in case of any firm, whether
perfect competition or imperfect competition.
Normal profit:
A firm is said to be making normal profit when AR = AC. The price (AR)
covers the costs. The cost includes the managers’ remuneration. However
there is no surplus above managers’ remuneration. If the entrepreneur
him self is the manager, he will receive normal profit as his share of
remuneration
Normal profit is also called ‘no profit no loss’ condition or break even
point in managerial economics.
Super Normal profit:

A firm is said to be making supernormal profits if AR > AC. The price
charged by the firm covers all the costs and also generates a surplus over
the expenditure. In this case the firm receives the managers’ remuneration
(normal profits) and also a surplus over it. Hence it is called super normal
profits.

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Losses
A firm is said to be making losses if, AR < AC. In case of loss there is a
need for further analysis. The firm needs to decide whether to stay in
production or shut down. In such a case Average variable cost (AVC) is
considered.
Shut down Condition

condition.

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Monopolist under different Cost Conditions
Changing cost conditions are determined by changing returns to scale.

Increasing returns to scale leads to decreasing costs and decreasing
returns to scale leads to increasing costs. Constant costs are due to
constant returns to scale.
In case of increasing costs, the physical out put shows decreasing returns.
AC and MC curves will be upward sloping.
The monopolist will find his equilibrium at a point where

MC = MR and accordingly, the out put is determined.
The price is determined as per AR.

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In case of constant costs, the physical out put shows proportional returns.
AC and MC curves will same and horizontal.

In case of decreasing costs, the physical out put shows increasing returns.
AC and MC curves will be downward sloping.

Long run equilibrium under monopoly

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In the long run the monopolist will find his equilibrium at a point where
MR (Long run) = MC (Long run)
In the long run the AC curve becomes flatter an the firm will be able to
produce more out put at lesser cost.
At the equilibrium the monopolist can

Determine price P1 by restricting the out put at Q1. In this case the
monopolist will have super normal profits.
OR
Determine price P2 price with larger output Q2 and optimize the cost by
producing at minimum AC in the long run. In this case the monopolist
will have normal profits.
Discriminative Pricing
Price discrimination means the firm selling the same product in different
markets at the same time at different prices. The objective of price
discrimination is profit maximization.
Price discrimination is generally followed by a monopolist.
Price discrimination is not always possible. There are certain conditions

to be fulfilled for practice of price discrimination.
Price discrimination is possible only under the following conditions
1. Legal sanction

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The practice of price discrimination shall be accepted by the law.

In absence of legal sanction price discrimination will be called
cheating.
2. Geographically distant markets
The markets with different pieces shall be geographically far. The
markets should be far enough to prevent resale of goods.
3. No possibility of resale
Resale should be prohibited. In case of resale the monopoly
profits will be drained out by those reselling the goods.
4. No storage possible
Resale is not possible only I those goods whether storage is not
possible.
5. Apparent product differentiation
The firm shall follow apparent product differentiation. In such
cases the buyers will find justification for paying a different
price.
6. Let go attitude of the consumer
The consumers should have a let go attitude. In case of consumer
resistance, price discrimination is not possible.
7. Difference in elasticities of demand
Difference in elasticities is an essential condition for price discrimination.

There will be as many sub markets as the differences in elasticities.
In an elastic market, the firm can not charge higher price. Any increase in
price will greatly decrease quantity demanded. So the price tends to be
low. In an inelastic market, the quantity is not sensitive to price, so the
firm will charge a higher price.
The inelastic market: Market A has higher price and lower out put.
The elastic market; Market B has lower price and higher out put

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Equilibrium with price discrimination
Firstly, the market is divided into sub markets depending on the elasticity
of demand. Each market will have a different elasticity of demand.
Suppose the firm can divide the markets into two sub markets: market A -
an inelastic market and Market B - an elastic market.
1. Out put determination

MC = Σ MR
2. Out put distribution
Σ MR = MRa = MRb
3. Price determination
The prices are determined as per ARs.
Though the markets are different, the place of production is centralized.

The firm will produce at a single place. Depending on the component
markets, the aggregate market is constructed.
The firm will determine the equilibrium out put; this is the out put which
will be distributed among different markets. The firm will consider the
aggregate MR i.e. Σ MR for determining the equilibrium.

MC = Σ MR
This is the optimum out put determined at the aggregate market.
Σ MR = MRa = MRb

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The out put is distributed in different markets by equating Marginal

revenues. The equilibrium level of MR is passed over to different
markets, this way the equilibrium is created in sub markets. The
equilibrium level of MR will indicate the out put in different markets.
The prices are determined in different markets as per the Average
revenues (demand) in different markets.
It can be seen that the

The inelastic market: Market A has higher price and lower out put.
The elastic market: Market B has lower price and higher out put
Dumping
Dumping is a special case of price discrimination where the firm is a
monopolist in the home market and faces competition in the foreign
market.
In the home market the firm faces a downward sloping (demand) AR
curve whereas in the foreign market the AR curve is perfectly elastic with
AR=MR=Price relation.
The firm firstly, determines the out put to be produced for the local as
well as the foreign markets. There after, the out put needs to be
distributed among home and foreign markets. Finally, the price is
determined.
MC = MR ( maximum possible MR)
MRh = MRf
Dr.Ranga Sai
The prices are determined as per AR in the home market

and at the existing price at the foreign market.
The out put is determined by equating MC=MR. This is the profit

maximizing out put. The out put is distributed by equating MRs in
different markets. i.e. MRf = MRh
At this point the out put is allotted for home market and he price is
determined as per the downward sloping demand curve. The remaining
out put is sold in the foreign market at the price prevailing as per
AR=MR=Price.
It can be seen that the firm sells a small out put in the home market at
high price and a large out put in the foreign market at low price. This is
called dumping.
Comparison between Imperfect and perfect competitions
A comparison between perfectly competitive firm and that of

imperfect competition shows that there are differences in the
methods of out put and price determination.
Out put determination

The out put under imperfect competition is lesser than the
competitive output. By restricting the out put the firm can charge
higher price.
Both firms determine the out put at a point where MC = MR.
With perfectly elastic AR curve the competitive firm produces
more than the monopolist.
Price determination
A firm determines price as per the AR curve. Under perfect
competition the firm being a price taker has a perfectly elastic AR
demand curve.. The monopolist determined price on a down ward
sloping demand curve.
While pricing on the down ward sloping AR, the out put is
restricted so as to charge a higher price.
The monopolist charges price as per the down ward sloping

demand AR curve. So by restricting out put the monopolist can
charge a higher price.

Dr.Ranga Sai
The price monopolistic competition is higher than the competitive

price. The AR being high at the equilibrium out put the firm
charges higher price.
In both these case, Monopolist firm is exploitative as compared

with a competitive firm.
Module 8: Monopolistic competition and oligopoly
Monopolistic Competition
Monopolistic competition is a case of imperfect competition where

limited number of firms, compete with differentiated product at dissimilar
prices.
Following are the features of monopolistic competition:
1. Large number of buyers: The number of buyers is large. It is a large

market where firms compete.
2. Limited number of firms: The number of firms remains limited due to

intense competition. The entry is not restricted by law, but competition
discourages new firms.

Dr.Ranga Sai
3. The prices need not be uniform. Each firm produces goods as per their
own market, so the product quality, utility differ. In such a case the prices
also differ.
4. Product differentiation
Product differentiation means the same product being projected different,
by modifying with additional utility, quality or term of sale.
The product differentiation is done in flowing ways:
a. By an additional quality: the firm may show a different quality
of the product which may not exist in the market. The quality
should be such that the utility of the product gets enhanced.
b. Additional quality: The product can be designed with an
additional utility. Products with different utilities have elastic
and larger demand. This is one method of improving the appeal
of the product. It is seen that dual utilities have improved the
quality of the product like the two-in-one products.
c. By different term of sale: the fir may offer a different terms of
sale. It may be by way of guarantees, after sale service, quizzes,
contests, prices, Etc.
The objective of price differentiation is to claim monopoly power in an

imperfect market. This is done by creating unique selling proposition.
Product differentiation means differences in cost. With differences in cost

the price also changes. Firms sell at different prices. The competition
between firms with different prices is called non-price competition. The
firms justify the price by either different image/ brand equity or by
different qualities/utility of the product.
Non-price competition benefits the firms. The consumer is made to pay

higher pries which are falsely justified through advertising.
5. Selling cost
Selling cost is the cost of generating demand. Under monopolistic

competition, the firms engage in non price competition. The firms
charging different prices justify their prices by advertising, publicity,
field campaign and similar promotional activities.
Selling cot helps in generating demand, brand image and justifying the
price. Selling cost does not give utility. Selling cost is a burden on the
consumer.

Dr.Ranga Sai
Production cost on the other hand generates utility. The production cost
decreases with increasing out put in, proportion. This is due to economies
of scale. Whereas, the selling cost increases in larger proportions to
increasing out put. This is because, advertising becomes more and more
expensive, with increasing out put.
Selling cost makes demand elastic and shifts demand curve u wards.
In the diagram it can be seen that, selling cot has increased the average
cost. Yet, the demand curve has shifted upwards and also became elastic.
This is the advantage the firm receives by spending selling cost.
Short run Equilibrium under Monopolistic Competition
A firm under monopoly competition arrives at equilibrium like a

monopoly firm. For a firm, the demand curve is downward sloping, so the
AR and MR curves also slope down wards and look different. However
the optimizing condition for out put remains same as in case of perfect
competition.
At a point where MC = MR the firm finds its equilibrium out put. When
Dr.Ranga Sai
MC = MR the difference between TC and TR will be maximum.
The output is found on the x axis. The price determination is done by AR

curve. This is the demand curve which will tell the maximum price that
can be charged for this level of out put.
Profits: A firm is said to be making supernormal profits if AR > AC. The

price charged by the firm covers all the costs and also generates a surplus
over the expenditure. In this case the firm receives the managers’
remuneration (normal profits) and also a surplus over it. Hence it is called
super normal profits.
Losses: A firm is said to be making losses if, AR < AC. In case of loss
there is a need for further analysis. The firm needs to decide whether to
stay in production or shut down. In such a case Average variable cost
(AVC) is considered.

Dr.Ranga Sai
Shut down Condition

condition.

Dr.Ranga Sai
Long run equilibrium under monopolistic competition
There is free entry and exit of firms under monopolistic competition.

When there is free entry and exit of firms, the firms keep joining the
production as long as there are profits. With new firms joining the super
normal profits, get distributed among more and more firms.
In the long run the equilibrium is drawn at a point where LMC = MR. In
he ling run all firm will operate at normal profits. It means the firm
covers only the manager’s remuneration and there is no surplus over and
above this. At this point AR = MR = AC, where AC = AR is a condition
of normal profits.
Wastages in Monopolistic competition

A comparison between perfectly competitive firm and that of imperfect
competition shows that there are wastages and exploitation under,
imperfect competition.

Dr.Ranga Sai
1. The price monopolistic competition is higher than the

competitive price. The AR being high at the equilibrium out put
the firm charges higher price.
2. The out put under imperfect competition is lesser than the
competitive output. By restricting the out put the firm can charge
higher price.
3. Imperfect competition leads to less than optimum size of out put:
The monopoly firm restricts the out put so that it can realize
higher price. In the process it produces less than optimum size of
out put. The firm will be producing at higher cost, but the price
charged, will be much higher granting larger profits to the
monopoly firm.
4. Imperfect competition will lead to unfair competition.

Monopolistic competition has wasteful advertising. Advertising
leads to increases in cost and dos not yield any utility to the
consumer.
5. Non price competition leads to price exploitation of consumers.
Under non price competition the firms sell goods at different
price and justify higher price by advertising. In case of perfect
competition the prices are low and uniform.

Dr.Ranga Sai
Oligopoly
Oligopoly is an imperfect market condition identified with limited
number of firms with high interdependence competing with differentiated
or uniform product at uniform prices.
Following are the features of oligopoly market
1. Limited number of firms:
The number of firms is limited due to intense competition. The industry
remains as a small group of firms.
2. Large number of buyers

The number of buyers will be very large. There will be huge market for
which the firms compete.
3. High degree of interdependence between firms

The firms will have high degree of interdependence in terms of price and
product design. The firms almost share the same demand curve.
However, the demand is made elastic or remains inelastic depending on
the nature of advertising.
No firm can deviate and change the product description. Any change
made by the firm will lead to the consumer shifting to other competing
firms. The demand remains very flimsy for a firm. The demand is
maintained carefully by maintaining the same price, similar product
details and advertising.
4. Rigid and uniform prices

The price will remain uniform and rigid. When the price is accepted by
the firms and the buyers, it continues for a long time. A consumer will not
pay a higher price because he can continue to get the same price from
other firms. A firm will not reduce the price because the consumer is
willing to pay the given price. On the other hand reduction in the price
may be treated as a loss of quality. This is called as price illusion.
5. Advertising
Advertising is an essential part of oligopoly market. Advertising is
essential for registering the product with the consumer. Advertising
allows the product to have the required exposure to the consumer so that
the consumer can include the product in his options.
Further, advertising make the demand elastic. By making the demand
elastic, the firm will be able to sell more goods at the given price.

Dr.Ranga Sai
6. Types of oligopoly
There are different types of oligopoly each based in a different marketing
practices followed to manage competition.
a. Pure and differentiated oligopoly

Pure oligopoly deals with goods are homogenous whereas differentiated
oligopoly may have apparent product differentiation. The market offers
flexibility the firms to change the nature of the product keeping the base
utility same. In ace of pure oligopoly it is easy to maintain price
uniformity. With product differentiation, the price tends to change
because of cost variations. Even in theses conditions the firms need to
maintain the uniform prices. For this reasons the firma can only adopt
apparent product differentiation without changing the cost structure.
b. Complete and partial oligopoly

Complete oligopoly refers to market where all the firms are equally
placed in terms of competition, price and market share. Whereas in case
of partial oligopoly, there can be one large firm emerging as the leader.
The leader will have the advantage of giving a lead price to the product
which other firma will follow. The leadership firm will have the privilege
of designing the product, price and the nature of competition.
Pure oligopoly may at times change to partial oligopoly by frequent
mergers. Firms merge among themselves to form a large firm so that a
leadership role can be achieved.
c. Collusive and Non collusive oligopoly

Non collusive oligopoly refers to a market where the forms operate
independently, however with interdependence. In case of collusive
oligopoly, the firms may collide, enter into agreements to lessen
competition and share the market to exploit the consumers.
7. Cartels
Cartels are a case of collusive oligopoly. Firms in market with intense
competition form arrangements to avoid competition by making
agreements so that all firms tend to benefit at the cot of the consumer.
Cartels are harmful business organization formed to enhance exploitation
and increase profits.
There can be different types of cartels depending on agreements.

a. In a cartel, the firms with high price may insist that its price
prevail, so that all firms can maximize profits.
b. At the same time the firm with lesser price may insist on its price
to be followed so that larger out put can be sold.

Dr.Ranga Sai
These are price cartels. In both these cases competition is avoided

and market becomes lucid.
c. The firms may divide the market geographically and restrict mutual
entry in respective territory. In this case the market has one
monopoly firm selling the product.
d. The firms may have system of marketing royalties as consideration
for sharing territory for attaining monopoly power. A firm
operating in market as an exclusive monopolist may have to pay
market royalty to other firms restricting entry.
The cartels can be operating at international levels, where the regions

are shared on the basis of trading currencies or countries. The counter
may form commodity agreements, bilateral agreements, and
multilateral agreements for a specific time. All these agreements
where the firms or the counties get captive markets belong to cartels.
Duopoly
Duopoly is a model of oligopoly market with two firms designed to study
the interdependence of firms for pricing.
Following are the feature of a model duopoly market:
1. Two firms:
The number of firms is limited to two. This is for the purpose of studying
the details of interdependence. Hence it is a model of oligopoly.
2. Large number of buyers

The number of buyers will be very large. There will be huge market for
which the firms compete.
3. High degree of interdependence between firms

The two firms will have high degree of interdependence in terms of price
and product design. Two firms almost share the same demand curve.
However, the demand is made elastic or remains inelastic depending on
the nature of advertising.
Single firm can deviate and change the product description. Any change
made by the firm will lead to the consumer shifting to other competing
firm. The demand remains very flimsy for a firm. The demand is
maintained carefully by maintaining the same price, similar product
details and advertising.

Dr.Ranga Sai
4. Rigid and uniform prices

The price will remain uniform and rigid. When the price is accepted by
both the firms and the buyers, it continues for a long time. A consumer
will not pay a higher price because he can continue to get the same price
from other firm. A firm will not reduce the price because the consumer is
willing to pay the given price. On the other hand reduction in the price
may be treated as a loss of quality. This is called as price illusion.
5. Advertising
Advertising is an essential part of oligopoly market. Advertising is
essential for registering the product with the consumer. Advertising
allows the product to have the required exposure to the consumer so that
the consumer can include the product in his options.
Further, advertising make the demand elastic. By making the demand
elastic, the firm will be able to sell more goods at the given price.
6. Kinky demand curve

The demand curve for the duopoly market is med up of the individual
demand curves of two forms. These are the demand curves made by the
firms by the independent advertising campaigns and publicity.
Yet the firms will have demand curves with different elasticities. The
demand curve for the market is made up of these tow demand curves.
The inelastic segment of the demand curve at lower price s and the elastic
segment of demand curve ay higher prices form the segmented demand
curve in duopoly.

Dr.Ranga Sai
It is learn in point elasticity of demand that all goods tend to be elastic at

higher prices and inelastic at lower prices.
The firms will be operating on the segmented demand curve which forms
a kink at P. P is the point which is common on both the demand curves.
This is the price which can be followed on both the firms.
P is the uniform and rigid price followed by firms under duopoly.
(19006)5-05-2010

Dr.Ranga Sai
Other books in this series
Business Economics Paper I B.Com First Year

Business Economics Paper II B.Com Second Year
Business Economics Paper III B.Com Third Year
Introduction to Economics B.M.M. First Year
Micro Economics First Year B.Com Accounting and Finance I Semester

First Year B.Com Banking and Insurance I Semester
Macro Economics First Year B.Com Banking and Insurance II Semester
Second Year BCom Accounting and Finance IIISemester
Based on University of Mumbai curriculum
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F.Y.B.A Dr.

First Year Bachelor of Arts

With effect from June 2007

First Year Bachelor of Arts

Available for free and private circulation

Micro Economics, F.Y.B.A. (w.e.f. June 2007) 2

Micro Economics, F.Y.B.A. (w.e.f. June 2007) 3

Dear Student friends…

During these days of commercialization it becomes very difficult to find

Dr. Prof. Ranga Sai

Micro Economics, F.Y.B.A. (w.e.f. June 2007) 4

Microeconomics deals with economics decisions made at individual

"Microeconomics deals with the decision making and

In detail the microeconomics deals with decisions at

Micro economic theories help in the designing the models of demand

Micro Economics, F.Y.B.A. (w.e.f. June 2007) 5

A ceteris paribus assumption is used to formulate scientific laws, for

Ceteris paribus represent relationships (such as demand and supply)

The demand function relates the quantity demanded-Q, as an effect of

Quantity demanded, Q = f (P, Y,A,T/F)

Yet while studying the relationship as a law, it assumes all factors to be

• Consumer equilibrium – consumer satisfaction is maximized;

Economic equilibrium is not permanent. The equilibrium is valid as long

Micro Economics, F.Y.B.A. (w.e.f. June 2007) 6

Static equilibrium: In economics static equilibrium refers to rigid models

Dynamic equilibrium: It is an advanced economic model which gives

Partial and General Equilibrium

Micro economic theories deal with partial equilibrium. Since the

General equilibrium in turn deals with macro economic state. General

Equilibrium at macro level has to provide description at aggregate

Micro Economics, F.Y.B.A. (w.e.f. June 2007) 7

Module 2 Consumer Behavior

Utility analysis of consumer behavior given by Marshall is based on the

The consumer maximizes his satisfaction by equating marginal utilities of

Micro Economics, F.Y.B.A. (w.e.f. June 2007) 8

Indifference Curve Analysis

Consumption theory in economics contains two parts. Firstly, the theory

Indifference curve analysis is a consumption theory given by Hicks and

IC deals with various combinations of two goods which give the

All these combinations give the consumer same amount of satisfaction. In

ICs can be understood better with the help of its properties.

Micro Economics, F.Y.B.A. (w.e.f. June 2007) 9

Properties of Indifference curves

1. Indifference curves towards the axis represent lower satisfaction and

In the diagram IC 1 represents lower satisfaction and IC2 represents

3. Indifference curve is a down ward sloping curve. It slopes down

Micro Economics, F.Y.B.A. (w.e.f. June 2007) 10

other. This is essential to keep the level of satisfaction constant on an

4. On an indifference curve the marginal rate of substitution decreases.

The marginal rate of substitution, is the rate at which a substitutes one

the slope of an indifference curve, MRS = ∆y/∆x.

The marginal rate of substitution decreases on an IC. On the diagram it

Micro Economics, F.Y.B.A. (w.e.f. June 2007) 11

On an IC the consumer expresses his utility behavior through decreasing

5. An indifference curve is convex to the origin. Only on a convex curve

On a concave curve the slope of IC increases that is MRS increases. So it

Micro Economics, F.Y.B.A. (w.e.f. June 2007) 12

A curve convex to the origin has decreasing slope or decreasing MRS,

6. Indifference curves need not be parallel. Converging indifference

7. Indifference curves do not intersect. Indifference curves need not be

In the diagram it can be seen that

Combination A gives larger satisfaction, because it is on a higher