UNIT-1

Definition of 'Economics'
There are a variety of modern definitions of economics. Some of the differences may reflect
evolving views of the subject itself or different views among economists.
A social science that studies how individuals, governments, firms and nations make choices on
allocating scarce resources to satisfy their unlimited wants. Economics can generally be broken
down into: macroeconomics, which concentrates on the behavior of the aggregate economy; and
microeconomics, which focuses on individual consumers.

The title page gave as its subject matter "population, agriculture, trade, industry, money, coin,
interest, circulation, banks, exchange, public credit and taxes".
The philosopher Adam Smith (1776) defines the subject as "an inquiry into the nature and causes
of the wealth of nations," in particular as:a branch of the science of a statesman or legislator
[with the twofold objective of providing] a plentiful revenue or subsistence for the people ...
[and] to supply the state or commonwealth with a revenue for the publick services.
J.-B. Say (1803), distinguishing the subject from its public-policy uses, defines it as the science
of production, distribution, and consumption of wealth. On the satirical side, Thomas Carlyle
(1849) coined 'the dismal science' as an epithet for classical economics, in this context,
commonly linked to the pessimistic analysis of Malthus (1798). John Stuart Mill (1844) defines
the subject in a social context as:
The science which traces the laws of such of the phenomena of society as arise from the
combined operations of mankind for the production of wealth, in so far as those phenomena are
not modified by the pursuit of any other object.
Alfred Marshall provides a still widely cited definition in his textbook Principles of Economics
(1890) that extends analysis beyond wealth and from the societal to the microeconomic level:

Economics is a study of man in the ordinary business of life. It enquires how he gets his income
and how he uses it. Thus, it is on the one side, the study of wealth and on the other and more
important side, a part of the study of man.
Lionel Robbins (1932) developed implications of what has been termed "[p]erhaps the most
commonly accepted current definition of the subject.
Economics is a science which studies human behaviour as a relationship between ends and
scarce means which have alternative uses.
Robbins describes the definition as not classificatory in "pick[ing] out certain kinds of
behaviour" but rather analytical in "focus[ing] attention on a particular aspect of behaviour, the
form imposed by the influence of scarcity."
Some subsequent comments criticized the definition as overly broad in failing to limit its subject
matter to analysis of markets. From the 1960s, however, such comments abated as the economic
theory of maximizing behavior and rational-choice modeling expanded the domain of the subject
to areas previously treated in other fields. There are other criticisms as well, such as in scarcity
not accounting for themacroeconomics of high unemployment.
Gary Becker, a contributor to the expansion of economics into new areas, describes the approach
he favors as "combin[ing the] assumptions of maximizing behavior, stable preferences, and
market equilibrium, used relentlessly and uninchingly." One commentary characterizes the
remark as making economics an approach rather than a subject matter but with great specificity
as to the "choice process and the type of social interaction that [such] analysis involves."

BASIC CONCEPT OF ECONOMICS

The basic concept or elements of economics are: wants, scale of preference, choice, and
opportunity cost.
1. Wants
Want may be defined as an insatiable desire or need by human beings to own goods or services
that give satisfaction. The basic needs of man include; food, housing and clothing. Human needs
are many. They include tangible goods like houses, cars, chairs, television set, radio, e.t.c. while
the others are in form of services, e.g. tailoring, carpentary, medical,e.t.c. Human wants and
needs are many and are usually described as insatiable because the means of satisfying them are
limited or scarce.
2. Scarcity
Scarcity is defined as the limited supply of resources which are used for the satisfaction of
unlimited wants. In other words, scarcity is the inability of human beings to provide themselves
with all the things they desire or want. These resources are scarce relative to their demand. As a
student you will need to buy school materials, e.g books worth $100 but you have only $50. It
can be seen that the money you have, which is your resources, will not be sufficient to buy all
you need. The available resources within the environment can never at any time be in abundance
to satisfy all human wants. Since wants are numerous and insatiable relative to the available
resources, human beings have to choose the most important ones and leave the less important
ones. There would be no economic problem if resources were not scarce hence economics is
sometime defined as the study of scarcity.
3. Scale of preference
It is defined as a list of unsatisfied wants arranged in the order of their relative importance. In
other words, it is list showing the order in which we want to satisfy our wants arranged in order
of priority. In the scale of preference, the most pressing wants come first and the least pressing
ones come last. It is after the first in the list has been satisfied that there will be room for the

satisfaction of the next. Choice therefore arises because human wants are unlimited or numerous,
while the resources for satisfying them are limited or scarce.
4. Choice
Choice can be defined as a system of selecting or choosing one out of a number of alternatives.
Human wants are many and we cannot satisfy all of them because of our limited resources. We
therefore decide which of the wants we can satisfy first. Choice arises as a result of the resources
used in satisfying these wants. Choice therefore arises as a result of scarcity of resources. Since it
is extremely difficult to produce everything one wants, choice has to be made by accepting or
taking up the most pressing wants for satisfaction based on the available resources.
5. Opportunity Cost
Opportunity cost is defined as an expression of cost in terms of forgone alternatives. It is the
satisfaction of ones want at the expense of another want. It refers to the wants that are left
unsatisfied in order to satisfy another more pressing need. Human wants are many, while the
means of satisfying them are scarce or limited. We are therefore faced with the problem where
we have to choose one from a whole set of human wants, to choose one means to forgo the other.
A farmer who has only $20 and wants to buy a cutlass and a hoe may discover that he cannot get
both materials for $20. He would therefore choose which one he has to buy with the money he
has. If he decides to buy a cutlass, it means he has decided to forgo the hoe. The hoe is thus what
he has sacrificed in order to own a cutlass. The hoe he has sacrificed is the forgone alternative
and this is what is referred to as opportunity cost. Opportunity cost should not be confused with
money cost. Money cost refers to the total amount of money that is spent in order to acquire a set
of goods and services. For example, a customer who spent $20 to buy a pair of trousers has
dispensed with cash. The $20 spent is the money cost.

MAIN DIVISION OF ECONOMICS

There are two divisions or branches of economics; these are called as Macroeconomics and
Consumption, the Distribution, the Exchange, and the Public Finance.

1.Production in terms of economics means as the manufacturing process of goods to provide and
satisfy the different needs of consumers. utilization of products, goods and services by the
consumers in a given amount of time.
2.Distribution means the way the goods products and services are delivered to the consumers, as
well as the way the products, goods and services are allocated to the consumers through the
different economic outlets.
3.Exchange means the way the products, goods or services are transferred to one person to
another.
4.The Public Finance means the way the government implement financial activities such as on
taxation, on expenditures and other else.
There are certain factors that involved in the production in economics; these are the Land, the
Labor, the Capital, the Entrepreneur, and the Foreign Exchange.
(a)The Land is one of the important factors in production. Land refers to the natural resources
that are going to be utilized in order to produce products or goods.
(b)Labor means the people or the workforce or the manpower that will do specific activities in
order to produce goods or services. They are the employee or the workers of a certain company.
(c)Capital means the physical productive capacity such as machines, tools, factories, money and
other attributes that are needed to produced products or goods.
(d)Entrepreneur means an individual who organizes some other factors and brings all these
factors together in order to produce products or goods. This activity may also be performed by
groups of individual as in the form of cooperative of corporation.
(e)Foreign Exchange means the foreign money or currencies that are reserved in order to import
material or raw materials that are needed in the production processes.

There are two divisions or branches of economics; these are called as Macroeconomics and
Microeconomics.
Macroeconomics is the economics the deals with the behavior of the whole or entire economy.
This branch of economics is concerned about the level of production, the rate of unemployment
as well as in the gross national product and others.
Microeconomics is the economics that deals with the behavior of a specific segment such as the
consumers, different business firms, the prices of products in the market and others. It is
concerned with the individual unit and not as a whole.

THE SUBJECT MATTER OF ECONOMICS

Economics is a social science concerned with the administration of scarce resources.
Resources are objects and services that are capable of satisfying human wants either
directly or indirectly by helping to produce other objects and services whose use
satisfies human wants. The administration of resources does not always create
economic problems. Some resources are so plentiful that they are more than
sufficient to satisfy completely all the human wants which depend on them. Air, for
example, is such a resource. These resources are called free resources; and there is
no need for organizing their use, because any waste or inefficiency in their utilization
can be made good from their excess supply and need not abridge the satisfaction of
human wants.
By contrast, scarce resources are those that are insufficient to fill completely all the
wants they cater to; these wants therefore can only be satisfied partially. This raises
problems of administration which are the subject matter of economics.1 To begin
with, one problem of administration is to insure the full utilization of scarce
resources, because their incomplete utilization would result in a loss of human
satisfaction. Second, when scarce resources are fully utilized, there is the further
administrative problem of properly allocating these resources among their different
uses and to the satisfaction of different wants. For when scarce resources are fully
utilized, the fuller satisfaction of any one want can only be achieved at the cost of

thelesser satisfaction of some alternative want or wants. Third, yet another problem
of administration is the proper distribution among consumers of these resources or of
the goods and services produced with their aid.

Most of these problems would present themselves even to an isolated and completely
self sufficient person. Such a person, to fill his needs, would have to rely on his
limited capacity to work and would face the problem of how best to husband his
energy and divide his time between leisure and different types of work. This is a
problem of administering the scarce resources of his time and energy; but it is his
private problem, which he may be left to solve as best he can, because its solution
has no repercussions on other people's welfare. Only when several people cooperate
for the purpose of satisfying their wants do one man's actions affect other people's
welfare. Only in this case does the use and allocation of scarce resources and the
distribution of their products raise problems of social organization; and it is only
these problems that are of interest to the economist.
The foregoing makes it obvious how important the distinction between free and
scarce resources is. That distinction however depends on the quantitative relation
between human wants and the supply of resources available to satisfy them; and this
relation is always changing. Free resources can become scarce and scarce ones free
with the passage of time, as wants and resource availabilities change. For example,
the population explosion and our increased affluence are rapidly turning parking
space from a free into a scarce resource; the same is happening, and for much the
same reasons, to fresh air in the cities and to fresh water everywhere. The opposite
change, once scarce resources becoming free, is exemplified by the thousands of
abandoned cars, appliances, plumbing fixtures, empty bottles, etc., that dot the
American countryside, most of which would be considered valuable (i.e., scarce) in
less affluent societies. If these examples also point to some of the more intractable
problems of our tune, the reason is new problems are always harder to resolve than
routine ones. Society finds it especially difficult to recognize and deal with a

problem where none existed before or to treat as valuable and learn to budget
resources that, within memory, could be considered free and ignored with impunity.

People cooperate in the use of their scarce resources even in the most primitive
societies, because specialization improves their efficiency and the division of labor
increases their total product. The more specialization and division of labor there is
among the members of a society, the better use they can make of their limited
resources for the satisfaction of human wants. Most economic progress consists in
increasing these potentialities; and, from the economist's point of view, almost every
innovation and technical invention is merely a new and more efficient method of
specializing and dividing up the task of catering to human wants.
The blessings of economic progress however are gained at the cost of the increasing
complexity of economic organization. The more division of labor there is among the
,members of a society, the more they lose their economic self sufficiency and become
dependent on each other. Economic interdependence is not a bad thing; but it turns
the administration of scarce resources into a social problem. Means must be found
whereby different members of society can exchange their respective products,
whereby they can be induced to work and to produce different goods in the
proportions wanted by society; and when a good embodies the contributions of
several people, these must be brought together, their work coordinated, and the fruit
of their joint effort shared among them. The organization that this requires may be
efficient or inefficient, equitable or unjust; it may function smoothly or be subject to
occasional breakdowns. The farther the division of labor is pushed, the more
intricate does economic organization become, and the greater is the likelihood of
something going wrong with it. The task of economics is to study economic
organization, to appraise its efficiency and equity, and to suggest ways and means
whereby its imperfections can be lessened or eliminated.
To appraise the efficiency of economic organization, a standard of perfection is, if
not always essential, at least very desirable. In the natural sciences such standards
are easily established. A perfect locomotive, for example, would be one that

transforms all the heat energy of its fuel into traction; and the efficiency of an actual
locomotive can be measured by the percentage of energy so transformed. In the
social sciences the establishment of standards of perfection is usually very difficult
and constitutes one of the main problems. The function of economic institutions is to
organize economic life in conformity with the community's wishes; and to find out
how well they fulfill this function, one must first ascertain the community's wishes.
Sometimes these are expressed through the politically appointed organs of the
community. For example, the community's wish to assure a minimum income to the
old and to the unemployed may be expressed by a legislative body when it enacts
laws providing old age assistance and unemployment relief. It is even conceivable
that all the wishes of the community might be expressed collectively through its
politically appointed organs. This is more or less the case in the communist state. In
such a state, appraising the efficiency of economic organization is very simple and
consists of little else than ascertaining the extent to which and the speed with which
the central production plan has been fulfilled assuming, of course, that this plan is a
true expression of the community's wishes.
In a democratic society, most of the community's wishes are not expressed
collectively but must be found out by ascertaining the wishes of each member of the
community. In some cases, this is relatively simple. For example, an approximate
indication of the community's desire to work is found in the individual actions of its
members who accept employment or register with employment exchanges. A
comparison of the total number of people who have thus expressed their willingness
to work with the number actually employed gives a rough measure of the economic
system's efficiency in providing employment.
As a rule, however; to ascertain the community's wishes in a democratic society is a
difficult problem; and a large part of this book will be taken up with it. We shall
have to ascertain the way in which the market reflects people's preferences between
different consumers' goods, between different types of work, and between leisure and
the income to be earned by work; for the efficiency of economic organization will to
a large extent be judged by its conformity to the community's preferences in these
matters.

Having stated the subject matter of economics and the problems that economic
organization must solve, we proceed to consider the nature and forms of economic
organization. Economic organization consists partly in bringing together different
resources in farms, workshops, factories, and other centers of production for the
purpose of producing with their aid new, produced resources. These centers of
production may be owned by private persons and managed for their personal profit or
may be owned by the state and managed by public officials according to rules and
directives issued by the state. The two types of production centers exist side by side
in most economies; but, depending on which is the dominant type, we distinguish
between private enterprise and socialism.
In addition, economic organization also consists in coordinating the activities of
different centers of production, allocating resources among them, and distributing
their products. This, too, may assume two forms. One is trade, which we shall
interpret in its broadest possible sense to mean all exchange of goods and services.
The other is direct regulation by a system of duties and rights. Trade is a
coordinating factor because, in the course of trade, prices are established which to a
greater or lesser extent reflect the preferences of the trading parties and which enable
both the trading parties and others to act in conformity with these preferences. That
the activities of different production centers can be coordinated also by direct
regulation goes without saying. Trade and direct regulation occur side by side in
most economies; moreover, trade itself may be subject to regulation by the state.
But, according to whether trade or direct regulation predominates, we distinguish
between market and planned economies.
It has long been a tradition to associate private enterprise with the market economy
and socialism with planning, although such a pairing of the two sets of concepts is
not necessary nor invariable; and we are increasingly getting away from it. Nazi
Germany provided an example of planning in a private enterprise economy, so did
the United States and Great Britain during the Second World War, and so does
France today with respect to the very important area of investment planning. As to a
market economy under socialism, its theoretical possibility was proved a long time

ago,2 and an increasing number of communist countries today are recognizing the
advantage and instituting the practice of market prices and profit incentive. Their
adoption by them is no more a betrayal of socialism than our occasional use of
planning is of capitalism.
Under private enterprise in a market economy, trade determines most of the relations
of firms with each other and with the suppliers of original resources and the
consumers of final products. The firm itself, however, may own and control several
production centers; and the activities of the several plants and workshops of the firm
are coordinated through direct regulation by the management of the firm, which in
such an economy is the authority that makes production decisions.
In a planned economy, most or all relations between the different centers of
production are subject to direct regulation and central control by the state; but, for
securing the services of labor and distributing final products among consumers, even
the planned economy often relies on trade and the market mechanism. Not to rely on
the market mechanism at all would necessitate the direct regulation of everybody's
economic relations by a system of duties and rights. The state would have to
determine who had the duty of performing labor, in what occupation, and for how
many hours per day; and it would also have to determine who had the right to
consume how much of each commodity.
Such a direct regulation of all economic relations by a system of duties and rights
may be conceivable within the family circle or in a primitive tribe; but it would be
insupportably rigid and oppressive in a more complex economy. It would require an
excessive amount of regulation; and the connection between duties and rights would
become so remote as to obscure the fact that the performance of duties is the
payment, the quid pro quo, for the enjoyment of rights. In consequence, people
would soon regard their duties as oppressive, unfair, or unreasonably hard.
Moreover, the assignment of duties and the granting of rights can hardly allow for
personal differences and preferences and is bound to be rigid and lead to inefficiency
and injustice.

Trade is free from many of these shortcomings. It stresses the principle of give and
take and renders the connection between services performed and benefits received
very explicit. As a result, a man who would resent as slavery the state imposed duty
to work may consider himself a free man when working for a wage even if he is
forced to work by economic necessity. The market gives people a freedom of choice
in consumption and in the selection of occupation that direct regulation can hardly
provide. Furthermore, in the course of trade, market prices are established for the
goods and services exchanged; and, provided that certain conditions are fulfilled,
these prices express the preferences of the trading parties and their valuation of the
resources exchanged. This characteristic of prices enables the market mechanism to
register people's preferences and to organize production, allocate resources, and
distribute products according to these preferences. In fact, the pricing system
provides such a simple means of ascertaining the community's wishes and is so
powerful an aid to economic organization that no economy except the most primitive
can afford to do without it.
But trade is not superior, to direct regulation in every respect. To begin with, the
principles of equity and social justice are easily forgotten and ignored when people
rely exclusively on the automatism of the market. Moreover, trade is not always
efficient as a means of organizing economic life. Its degree of efficiency depends on
the nature of markets the number of people in the market, their sureness of judgment,
the degree of equality in their economic power, and so forth; and to insure the
efficiency of trade often requires legal safeguards. Hence, even in the market
economy, trade is often subject to legal regulation. This may take several forms.
Most commonly, it consists of restrictions and corrective measures imposed on
private trading. Antitrust legislation and the public regulation of railroad fares and
rates are examples of restriction in the interest of the greater efficiency of trade.
Minimum wage legislation, unemployment insurance, and progressive taxation are
correctives aimed at modifying the distribution of income as determined by the
market.
Finally, there are many goods and services in whose provision and distribution trade
and the market cannot play an efficient role, even under the best circumstances.

These are called collective or public goods and services. Obvious examples are
defense, police protection, communications, all of which are better provided
collectively, through public action, even though they too had their origin (and
occasionally still have their counterpart) in private bodyguards, vigilante groups,
private messengers, and private pigeon posts. The distinguishing feature of
collective goods is partly that they affect several people simultaneously and cannot
therefore be distributed to each according to his different wants, partly that they are
usually easier and cheaper to provide collectively. Police and fire protection
provided for my neighbor benefit me too to some extent; and they can easily and
cheaply be extended to give me full protection.
The dividing line, however, between collective and individual goods is blurred: a
public park benefits the whole neighborhood but even a private garden gives some
pleasure to neighbors and passersby. Moreover, this dividing line is not only blurred
but continuously shifting, just as the dividing line between free and scarce resources
is shifting. For example, the substitution of private for public transportation is one of
the manifestations of our rising standard of living; at the same time however, the rise
in the standard of living, together with the increasing density of population, also
increases our potential to disturb the environment and step on each other's toes,
which turns many hitherto private enjoyments into matters of public concern.
We shall try to deal with all these issues; but the main concern of this book is with
private enterprise in a market economy. It is customary to distinguish between two
types of problems in such an economy. One pertains to the degree of employment of
scarce resources, and the other has to do with the efficiency and equity of their
employment and of their allocation and distribution. Throughout this book, we shall
only be concerned with the latter type of problem. In particular, we shall analyze the
behavior of firms and the functioning of markets; and we shall try to appraise the
efficiency and equity of the economic organization which results from the
independent production decisions of private firms whose behavior is coordinated by
the market mechanism. Before doing so, however, we must say a few words on the
problem of employment and on the exact relation that this problem bears to the
problems with which we shall be concerned.

We mentioned at the beginning of this chapter that free resources, being more than
sufficient to fill all the wants they cater to, exist in excess supply. This means that
they remain underemployed. Scarce resources, however, may on occasion also
remain underemployed, because, though insufficient to fill all the wants they cater to,
they may be more than sufficient to fill the demand for them. For the wants whose
satisfaction depends on scarce resources are filled only to the extent that they are
backed up with purchasing power and become effective as demand in the market.
Demand therefore need not correspond to wants; and the failure of the economic
system to register wants properly and make them effective as demand results in the
underemployment of scarce resources and a consequent loss of human satisfactions.
When demand is insufficient to call for the full employment of a scarce resource, the
only way to increase the satisfaction of wants that depend on this resource is to raise
the demand for it. Hence when a scarce resource becomes underemployed, it no
longer matters whether it is used efficiently or not. The only consideration that
remains relevant is that of equity. It is not worthwhile to eliminate inefficiency in the
utilization of underemployed resources, because, as long as demand is insufficient to
maintain full employment, inefficiency diminishes unemployment and not the
satisfaction of wants.3 Similarly, it does not matter if too large a proportion of
underemployed resources is devoted to the satisfaction of one particular want,
because this again results in less unemployment and not in the lesser satisfaction of
other wants.4 Efficiency in the use of underemployed scarce resources is as
irrelevant as it is in the administration of free resources, and for exactly the same
reason. In both cases, there is an unemployed reserve of resources, which is drawn
upon to offset losses due to wasteful or improper use. Here however the parallelism
ends. For the underemployment of free resources is due to the saturation of the
wants they cater to and therefore causes no loss; whereas the underemployment of
scarce resources is due to imperfection in the economic system and does result in
economic loss.
A situation in which there is both underemployment and an inefficient use of scarce
resources may be compared to that of a prisoner who serves two sentences

concurrently. He would gain by having his longer sentence revoked or revised; but
as long as this sentence stands unchanged, he would derive no benefit from proving
his innocence of the crime that earned him the shorter sentence, because it would not
set him free sooner. Similarly, at a time when the insufficiency of demand causes
unemployment, the only way to increase the satisfaction of human wants is to raise
demand; for the mere existence of unemployment proves that the loss of satisfactions
due to the insufficiency of demand exceeds and absorbs any loss that may be due to
faulty allocation. Hence if insufficient demand and inefficient administration were
equally important, unemployment would disappear. The existence of unemployment
is proof that the effect of inefficiency is less important than the effect of insufficient
demand.
The problem of unemployment has first claim to the economist's attention. Only in a
fully employed economy does allocation become an economic problem. In other
words, only when scarce resources are fully employed does the way in which they
are employed and allocated among alternative uses become relevant from the
economist's point of view. This is why the problems of allocation and distribution
dealt with in this book are described as the economic problems of a fully employed
economy.
Nevertheless, the usefulness of the following analysis is not confined to those
comparatively short periods of high prosperity when all resources are fully
employed. For if it seldom happens that all resources are fully employed, it is
equally rare that all scarce resources are underemployed. Neither labor nor
productive equipment is homogeneous; and the underemployment of labor as a whole
or of equipment as a whole seldom means that all kinds of labor or all kinds of
equipment are underemployed. As a rule, underemployment in some occupations
and of some types of equipment exists side by side with full employment in other
occupations and of other types of equipment; and the proper use and allocation of the
fully employed resources do create economic problems.
Furthermore, the problems to be discussed in the following chapters are not entirely
irrelevant even at a time of general underemployment. For the efficiency or
inefficiency of economic organization at any one time inevitably bequeaths a legacy

of efficiency or inefficiency to the future. Accordingly, although the efficiency with

which employed resources are used and allocated during a period of
underemployment is of no immediate relevance, it does become relevant later, when
full employment has been restored. For example, technological improvements
introduced during a depression often fail to raise output while the depression lasts
and only aggravate unemployment. Nevertheless, their introduction at that stage may
still be desirable, because it may be the condition of higher output in the subsequent
prosperity. Similarly, an employment policy adopted in depression must be judged
not only by its immediate effectiveness in raising demand and relieving depression
but also by its effects on efficiency. For as soon as the increase in demand has
eliminated unemployment, problems of allocation will arise; and the seriousness of
these problems may depend on the particular way in which full employment was
achieved. While unemployment exists, all cures seem equally good if they are
equally effective. But equally effective cures of unemployment may affect the
allocation of resources differently; and if they do, they will be differently appraised
once full employment has been restored and the proper use and allocation of
resources have again become the primary aim of economic policy.5 Hence, the
subject matter of this book, although it is confined to the problems of a fully
employed economy, has a bearing even on the choice of employment policies if their
long run effects are taken into consideration.

Microeconomics

Macroeconomics

1. It is the study of individual economic units of It is the study of economy as a whole and its
an economy

aggregates.

2. It deals with individual income, individual

It deals with aggregates like national income,

prices and individual output, etc.

general price level and national output, etc.

3. Its Central problem is price determination and Its central problem is determination of level of
allocation of resources.

income and employment.

4. Its main tools are demand and suply of a

Its main tools are aggregate demand and

particular commodity/factor.

aggregate supply of economy as a whole.

5. It helps to solve the central problem of what,

It helps to solve the central problem of full

how and for whom to produce in the economy

employment of resources in the economy.

6. It discusses how equilibrium of a consumer, a

producer or an industry is attained.

It is concerned with the determination of

equilibrium level of incoem and employment of
the economy.

7. Price is the main determinant of

Income is the major determinant of

microeconomic problems.

macroeconomic problems.

8. Examples are: individual income, individual

Examples are: National income, national

savings, price determination of a commodity,

savings, general price level, aggregate demand,

individual firm's output, consumer's equilibrium. aggregate supply, poverty, unemployment etc.

Scope of Economics
Scope means the sphere of study. We have to consider what economics studies and what lies
beyond it. The scope of economics will be brought out by discussing the following.
a) Subject matter of economics: Economics studies mans life and work, not the whele of it,
but only one aspect of it. It does not study how a person is born, how he grows up and dies, how
human body is made up and functions, all these are concerned with biological sciences, Similarly

Economics is also not concerned with how a person thinks and the human organizations being
these are a matter of psychology and political science. Economics only tells us how a man
utilizes his limited resources for the satisfaction of his unlimited wants, a man has limited
amount of money and time, but his wants are unlimited. He must so spend the money and time
he has that he derives maximum satisfaction. This is the subject matter of Economics.
Economic Activity: It we look around, we see the farmer tilling his field, a worker is working in
factory, a Doctor attending the patients, a teacher teaching his students and so on. They are all
engaged in what is called Economic Activity. They earn money and purchase goods. Neither
money nor goods is an end in itself. They are needed for the satisfaction of human wants and to
promote human welfare

To fulfill the wants a man is taking efforts. Efforts lead to satisfaction. Thus wants- EffortsSatisfaction sums up the subject matter of economics.
b) Economics is a social Science: In primitive society, the connection between wants efforts and
satisfaction is close and direct. But in a modern Society things are not so simple and straight.
Here man produces what he does not consume and consumes what he does not produce. When
he produces more, he has to sell the excess quantity. Similarly he has to buy a product which is
not produced by him. Thus the process of buying and selling which is called as Exchange comes
in

between

wants

efforts

and

satisfaction.

Nowadays, most of the things we need are made in factories. To make them the worker gives his
labour, the land lord his land, the capitalist his capital, while the businessman organizes the work
of all these. They all get reward in money. The labourer earns wages, the landlord gets rent the
capitalist earns interest, while the entrepreneurs (Businessman) reward is profit. Economics
studies how these incomewages, rent interest and profits-are determined. This process in
called

Distribution:

This

also

comes

in

between

efforts

and

satisfaction.

Thus we can say that the subject-matter of Economics is

1. Consumption- the satisfaction of wants.
2. Production- i.e. producing things, making an effort to satisfy our wants
3. Exchange- its mechanism, money, credit, banking etc.

4. Distribution sharing of all that is produced in the country. In addition,

Economics also studies Public Finance
Macro Economics When we study how income and employment is generated and how the
level of countrys income and employment is determined, at aggregated level, it is a matter of
macro-economics. Thus national income, output, employment, general price level economic
growth

etc.

are

the

subject

matter

of

macro

Economics.

Micro-Economic When economics is studied at individual level i.e. consumers behavior,

producers behavior, and price theory etc it is a matter of micro-economics.
c) Economics, a Science or an Art? Broadly different subjects can be classified as science
subjects and Arts subjects, Science subjects groups includes physics, Chemistry, Biology etc
while Arts group includes History, civics, sociology Languages etc. Whether Economics is a
science or an art? Let us first understand what is terms science and arts really means.
A science is a systematized body of knowledge. A branch of knowledge becomes systematized
when relevant facts hove been collected and analyzed in a manner that we can trace the effects
back to their and project cases forward to their effects. In other words laws have been discovered
explaining facts, it becomes a science, In Economics also many laws and principles have been
discovered and hence it is treated as a science. An art lays down formulae to guide people who
want to achieve a certain aim. In this angle also Economics guides the people to achieve aims,
e.g. aim like removal poverty, more production etc. Thus Economics is an art also. In short
Economics is both science as well as art also.
d) Economics whether positive or normative science: A positive science explains ''why" and
"wherefore" of things. i.e. causes and effects and normative science on the other hand rightness
or wrongness of the things. In view of this, Economics is both a positive and. normative science.
It not only tells us why certain things happen, it also says whether it is right or wrong the thing to
happen. For example, in the world few people are very rich while the masses are very poor.
Economics should and can explain not only the causes of this unequal distribution of wealth, but
it should also say whether this is good or bad. It might well say that wealth ought to be fairly
distributed. Further it should suggest the methods of doing it.

UNIT-2
CONSUMPTION OF HUMAN WANTS

Introduction
Consumption is a branch of economics, which deals with the satisfaction of human wants. The
existence of human wants is the starting point of all economic activity in the world. When a want
is satisfied, the process is known as consumption. In plain language, consumption means usage.
Thus, we speak of the consumption of food. But in economics we can speak of the consumption
of the services of lawyer or a doctor. The point we have to note here is that consumption applies
both to commodities and services.
Consumption is a study about the theory of wants. Under consumption, we study about the
nature of wants, the classification of wants, the laws relating to consumption such as the Law of
diminishing Utility, Engels Law of Family Expenditure and the Law of Demand and so on.
Some goods are consumed in order to produce other goods. Such goods are known as production
goods. Thus, for example, cotton used in making cloth may be considered as a production good.
Some goods satisfy final wants. They are known as consumption goods. Examples of the latter
category are food, clothing and services directly rendered by certain categories of labor such as
doctors and actors.
The early economists emphasized only the production of wealth. They considered economics
mainly as a study of the production of wealth. Now economists pay more attention to
consumption. For wealth is produced only for consumption. Not only that, they have realized
now that production of wealth in a country at any time depends on the level of consumption. For
it determines demand and it is demand that stimulates production.

Characteristics of Human Wants

1. Wants are unlimited: It means that human wants are without number. Even if some wants
are satisfied now some other wants will appear again. For example, a student may want a
bicycle and he may get one. But soon he wants a scooter or a motor-cycle. Suppose he
gets one. After sometime, he may develop a desire for a motor-car. Again, suppose a poor
man becomes rich suddenly, we may think his sudden riches will solve all his troubles.
But it is not the case. For the rich man will have his own economic problems. His wants
may be unlimited in relation to his limited means. Another thing ehave to note is that no
man is completely satisfied forever. If one want is satisfied, another want will spring up
in its place.
2. Wants are satiable: Though wants are unlimited in number, they are limited in their
capacity for satisfaction. That is, any particular want can be satisfied for a while. For
example, a child cannot get continuous satisfaction from eating some sweets, say
chocolates. It is only because we cannot get continuous satisfaction from a single good,
we go in search of new goods. The fact that wants are satiable is an important
characteristic of wants. It is the basis of the Law of Diminishing Utility.
3. Wants are alternative: Wants are largely alternative. It means a particular want may be
satisfied in a number of ways, that is, by more than one commodity. If a man is hungry,
his hunger may be satisfied by taking some bread or rice or fruits. Again if we want some
recreation, we may go to cinema or drama or listen to the radio.
4. Wants are competitive: Our wants are unlimited but means (time, money and other
resources) are limited. So there is competition among wants. Wants compete for our
limited means. For example, take the case of a student. He may get a gift of $50 from his
uncle. He may want to do so many things with it. But his money on hand can buy only
one thing. All the things that he wants compete for those fifty dollars. So he has to choose
among them. This results in the choice of the most urgent or important thing. Thus, the
competition among wants results in choice. That is why we say Economics is the science
of choice.
5. Wants are complementary: Sometimes to satisfy a particular want we need more than one
good. One commodity may be useless without another. Thus, a single shoe is practically

useless. A pen is of little service without ink. So we require two or more things to satisfy
a want. Examples are (1) carriage and horse and (2) car and petrol. Sometimes a
commodity taken by itself may satisfy a want independently. Thus, bread alone may
satisfy the want of a hungry man. But if it is taken together with butter and jam, one may
get greater satisfaction.
6. Wants are recurring in nature: No one person can be free from wants forever. Even if
some wants are satisfied for a while, they will again appear sometimes at regular
intervals. For example, we feel hungry in the morning. Our hunger is satisfied when we
take some breakfast. But again we feel hungry in the afternoon and at night. The same
thing is repeated the next day and it goes on forever. Thus, wants recur.
7. Wants become habits: Some wants become habits. Suppose you take a cup of coffee in
the morning. Soon you will find it becomes a habit with you. Like that, many wants
become habits. Suppose for some days in the summer season you sleep under a fan. Soon
you will feel you cannot sleep without it. It will become a habit with you. A smoke after
lunch is another case in point.

Classification of Human wants

Wants may be classified into necessaries, comforts, luxuries and collective wants.
Necessaries
Necessaries may be further classified into necessaries for existence, necessaries for efficiency
and conventional necessaries.
(a) Necessaries for existence: There are certain things without which man cannot live. They are
absolutely essential for human existence on this earth. They are known as necessaries for
existence or necessaries for life. Examples for this are food, clothing and shelter.
(b) Necessaries for efficiency: There are certain things, which are necessary to promote
efficiency. For example, an educated person will be any times more efficient than an uneducated
person. Thus, education is one of the necessaries for promoting efficiency. By education, we
mean both general education and technical education. The working class in a country where a

majority of the people are educated will be much more efficient than workers in a country with a
high rate of illiteracy. Efficiency depends also on the standard of health of the working people.
For that, extension of public health measures are necessary. Hospitals, and periodic medical
check-up of the working classes are all necessary to promote efficiency of the people.
(c) Conventional necessaries: Certain wants become necessary by force of habit or custom or
convention. Such things are known as conventional necessaries. There are many examples for
this. For instance, a cup of coffee in the morning becomes a necessity with some people and with
others a smoke after lunch. A dinner during marriage celebration and new clothes for the bride
and the bride-groom on the marriage day may also be given as examples of conventional
necessaries.
Comforts
Comforts are not strictly necessary for life but they give pleasure and add to the efficiency of the
consumer. Thus, a car to a doctor is not merely a comfort to him. It promotes his efficiency. If he
is a busy doctor with a good practice, he can visit a number of patients without waiting for long
hours at bus-stops. Similarly, a fan in a shop may promote the efficiency of a business man. If
there is a fan, he can stay on in the shop and do some business even during the afternoon, which
is usually hot particularly in summer. Otherwise, he has to shut his shop for two or three hours in
the afternoon. Similarly, if some comforts are provided for a student, he may study well.
Luxuries
Luxuries add to the pleasure of a person but they do not add anything to his efficiency. Some
enjoy luxuries to show off their wealth and riches. Luxuries have prestige value. And some
luxuries are pure waste. Diamonds and pearls are all luxuries. They have prestige value. Usually
they sell at very high prices. Sometimes we find a single person owns many cars. It is definitely a
luxury. Kings of the past enjoyed many luxuries. Even today, some merchant-princes enjoy
many luxuries.
However, we have to remember that there is nothing rigid about the classification of wants into
necessaries, comforts and luxuries. We cannot take any good and say this is a necessary good or

comfort or luxury. For what is a luxury to one person may be a necessity to another person. A car
may be a necessity to a big business man in a city but it is a luxury to a poor teacher working in
an elementary school. Again travel by airplane may be a necessity to the President of a country
but it is definitely a luxury to a clerk or a teacher. Again what is necessity in one country may
not be a necessity in another country. Thus, woolen clothing is a necessity in a rich country like
England with cold climate but it is a luxury in a country with a hot climate.
Again what is luxury at one time may become a necessity at another time. Thus, when electricity
was first introduced in England, it was used only by rich families. It was then a luxury. Now it is
necessity with most of us. Further, whether a particular want is a necessity or comfort or luxury
also depends upon the income of the people and price of the good in question. So the point is
this. In classifying wants into necessaries, comforts and luxuries, we have to take into account
many things such as the income of the consumers, the status of consumers, the climate of the
country, prices of the commodities and so on.
Collective Wants
The term collective wants refers to the wants of the people as a whole. If I want a shirt, I can
pay for it. Similarly, if I want the services of a doctor, I can pay for them. But I cannot afford to
pay for a policeman to protect my house at night. The government helps in such cases. It
provides goods and services, which meet the wants of the people for which individually they
could not afford to pay. Such wants are called collective wants and the goods that are supplied by
the government to satisfy such wants may be called collective goods. To satisfy collective wants,
the government employs soldiers, police, teachers, doctors and so on. We do not pay anything
directly for such services. Of course, we have to pay for them when we pay our taxes.

Human Wants and their Classification

Man is a bundle of desires. His wants are infinite in variety and number. Some wants are natural,
for example foods, air, clothing and shelter without which existence of mans life is not possible.
Similarly wants vary from individual to individual and they multiply with civilization.
Characteristics of Human Wants:
1. Human wants are unlimited: Mans mind is so made that he never completely satisfied
and hence there is no end to human wants. One want is satisfied another want will crop
up to take its place and thus it is never ending cycle of want.
2. Any particular want is satiable: Though the wants are unlimited, but it is possible to
satisfy a particular want, provided has the means (resource).
3. Wants are complementary: It is a common experience that we want things in groups. A
single article out of group can not satisfy human wants by it self. It needs other things to
complete its use e.g. a motor-car needs petrol and mobile oil it starts working. Thus the
relationship between motor-car and petrol is complementary.
4. Wants are competitive: Some wants competes to other. We all have a limited amount of
money at our disposal; therefore we must choose some things and reject the other. E.g.
sugar and jaggery, tea and coffee.
5. Some Wants are both complimentary and competitive: When use of machinery is
done the use of labour needs to be reduced. This indicates competitive nature. But to run
the machinery the labour is also required and as such it indicates complimentary
relationship.
6. Wants are alternative: There are several ways of satisfying a particular want. If we feel
thirsty, we can have water, lassi, in summer while coffee, tea in winter. The final choice
depends upon availability of money and the relative prices.
7. Wants vary with time place and person: Wants are not always the same. It varies with
individual to individual. People want different things at different times and in different
places.
8. Wants vary in Urgency and Intensity: All wants are not equally urgent and in tense.
Some wants are urgent while some are less urgent.

9. Wants multiply with civilization: With the advancement the wants multiply. Therefore
the wants of people living in urban area are more than the villagers. With civilization the
demand for radio, T.V, motor-car etc, are increasing.
10. Wants are recur: Some wants are recurring in nature, e.g. food we require again and
again.
11. Wants change into habits: If a particular want is regularly satisfied a person becomes
used to it and it grows into habit e.g. smoking of cigarate and use of drugs.
12. Wants are influenced by income, salesmanship and advertisement: It income is
higher more wants can be satisfied. Many things we buy of particular brands due to
salesmanship or advertisement.
13. Wants are the result of custom or convention: As a part of custom and convention we
buy many thins. Really they are not required but unlikely we have to purchase it e.g.
expenses on social ceremonies.
14. Present wants are more important then future wants: Future is uncertain and hence
man is more concerned with the satisfaction of the present wants rather than future wants.

Classification of wants
The wants can be classified as under.
A. Necessaries: These can be sub divided as

Necessaries of existence: The things without which we can not exist e.g. water, food,
clothing, shelter.

Conventional necessaries: The things which we are forced to use by social custom.

B. Comforts: After satisfying our necessaries we desire to have some comforts. For
example table and chair for a student help to increase the efficiency. But cushioned costly
chair is not a comfort.
C. Luxuries: Luxury means superfluous consumption. After getting comforts, man desire
luxury. The luxury articles need not required e.g. gold and silver, costly furniture, etc.

Diminishing marginal utility

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

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

from

the

additional

units,

i.e

marginal

utility

goes

on

decreasing.

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

Definition
According to Marshall, The additional benefit a person derives from a given increase of his
stock of a thing diminishes with every increase in the stock that he already has
he concept that marginal utilities diminish across the ranges relevant to decision-making is called
the "law of diminishing marginal utility" (and is also known as Gossen'sFirst Law). This refers to
the increase in utility an individual gains from increase in the consumption of a particular good.
"The law of diminishing marginal utility is at the heart of the explanation of numerous economic
phenomena, including time preference and the value of goods... The law says, first, that the
marginal utility of each homogenous unit decreases as the supply of units increases (and vice
versa); second, that the marginal utility of a larger-sized unit is greater than the marginal utility
of a smaller-sized unit (and vice versa). The first law denotes the law of diminishing marginal
utility, the second law denotes the law of increasing total utility."[15]
The law of diminishing marginal utility is similar to the law of diminishing returns which states
that as the amount of one factor of production increases as all other factors of production are held
the same, the marginal return (extra output gained by adding an extra unit) decreases.
As the rate of commodity acquisition increases, marginal utility decreases. If commodity
consumption continues to rise, marginal utility at some point may fall to zero, reaching

maximum total utility. Further increase in consumption of units of commodities causes marginal
utility to become negative; this signifies dissatisfaction. For example,

beyond some point, further doses of antibiotics would kill no pathogens at all, and might
even become harmful to the body.

to satiate thirst a person drinks water but beyond a point consumption of more water
might make the person vomit,hence leading to diminishing marginal utility

it takes a certain amount of food energy to sustain a population, yet beyond a point, more
calories cannot be consumed and are simply discarded (or cause disease).

Diminishing marginal utility is traditionally a microeconomic concept and often holds for an
individual. For an individual, the marginal utility of a good or service might actually be
increasing. For example:

bed sheets, which up to some number may only provide warmth, but after that point may
be useful to allow one to effect an escape by being tied together into a rope;

tickets, for travel or theatre, where a second ticket might allow one to take a date on an
otherwise uninteresting outing;

dosages of antibiotics, where having too few pills would leave bacteria with greater
resistance, but a full supply could effect a cure.

the third leg is more useful than the first two when building a chair.

As suggested elsewhere in this article, occasionally one may come across a situation in which
marginal utility increases even at a macroeconomic level. For example the provision of a service
may only be viable if it accessible to most or all of the population, and the marginal utility of a
raw material required to provide such a service will increase at the "tipping point" at which this
occurs. This is similar to the position with very large items such as aircraft carriers: the numbers
of these items involved are so small that marginal utility is no longer a helpful concept, as there
is merely a simple "yes" or "no" decision.

Assumptions:
1.All the units of a commodity must be same in all respects

2.The unit of the good must be standard

3.There should be no change in taste during the process of consumption
4.There must be continuity in consumption
5.There should be no change in the price of the substitute goods

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

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

Plotting the above data on a graph gives

Here, from the MU curve we can see that MU is declinig as consumer consumes more of
the commodity.

When TU is maximum, MU is Zero.

After that, TU starts declining and MU becomes negative.

Exceptions:

Money

Hobbies and Rare Things

Liquor and Music

Things of Display

Importance:

Basis of Law of Demand

Basis of Consumption Expenditure

The basis of Progressive Taxation

Law of equi-marginal utility

INTRODUCTION:
It is a classical theory of consumer behavior, law of substitution in consumption or
maximum satisfaction.
STATEMENT OR DEFINITION OF LAW:
The law of equi-marginal utility states that A rational person in order to get
maximum satisfaction allocates his expenditures on purchase of different goods in such a
way that marginal utility of the last Rs. Spent in each direction is the same.
This is called the law of satisfaction because we substitute more useful goods to less
useful goods. This is called the law of maximum satisfaction because through it we get
maximum satisfaction and it is called the law of equi-marginal utility because through it
when the marginal utilities are equalized, through the process of substitution, the
maximum satisfaction is attained.
EXPLAINATION WITH THE HELP OF SCHEDULE:
The law can be explained with the help of schedule.
A hypothetical person has to spend Rs. 7. He is going to buy two commodities A & B.
the price of each commodity is Rs. 1 unit. Our hypothetical consumer is a rational person.

Rs.

MU of commodity A

B1

40

MU of commodity
35

35

30

30

25

25

20

20

15

15

10

10

05

SUM

175

140

SCHEDULE:

It is clear from the above scheduling that when our hypothetical consumer spends Rs. 4
on commodity A and Rs. 3 on commodity B. The marginal utilities are equal at that
point. The total utility is 220, which is maximum in any other case.
Suppose, 6 rupees spend on A and 1 rupee on B [40+35+30+25+20+15+35 = 200]
If he changes his plan i.e. spends more on commodity B and less on commodity A.
The marginal utilities would not be equal and he would not gain maximum satisfaction.
The total utility would also be less in any case other than when the marginal utilities are
equal and satisfaction is maximum.

EXPLAINATION WITH THE HELP OF DIAGRAM:

Diagram:
In this figure on the axis OX is the quantity of commodity A and on the axis OX is the
quantity of good B on the axis OY is the marginal utility of the amount of money spend
on goods A and B.
It is clear that when consumer spends Rs. 4 on good A and Rs. 3 on good B. The
marginal utilities are same and satisfaction is maximum. On the right side of OY is the
curve UA that represents the MU of Aand is down ward sloping from left to right.
On the left hand side of OY is the curve of UB which represents the MU of B and is also
down wardfrom right to left. If the consumer spends more Rs On commodity A and less
on commodity B themarginal utilities are not equal and satisfaction is less e.g. if he
spends 5 on commodity B and 2 on commodity A OR spends 3 on A and 4 on B the
satisfaction is not maximum.

It can be shown with the help of a figure.

Diagram:
In both figures the gain in utility is less than the first and the satisfaction is also decrease.

ASSUMPTIONS:
Following are the assumptions of the law.

Independent Utilities:
The marginal utilities of different commodities should be independent of each
other and diminishes with more and more purchase.
Marginal Utility of Money:

The marginal utility of money should remain constant for the consumer as he
spends more and more of it on the purchase of goods.
Rationality:
Every consumer should be rational in the purchase of goods. His aim should be to
maximize the total utility and nothing else.
Substitution of Goods:
It is assumed that goods are naturally substitutes of each other. The result of
substitution will be the MU of one commodity will fall and that of another commodity
will rise.
Awareness of Market:
It is assumed that consumer has much awareness about the market.
Divisibility of Goods:
The law is based on the assumption that goods are divisible in small units.

CRITICIZM OR LIMITATIONS:
Following are the limitations of the law.
No Rational Calculation:
The law involves rational calculations. But in the busy and routine life we are not
capable to do so that who is rational and who is irrational.
Consumers Ignorance:
The consumer may not aware of the goods which are more useful than the goods
which they are going to purchase. So, they cannot substitute more useful goods to the less
useful goods and hence the law is not applicable to them.
Indivisibility of Goods:
Sometimes the goods are not divisible to small units. So MU cannot be
calculated and law is not applicable.
Wrong Assumptions:
It assumed that utilities are measurable but in actual utility cannot be calculated
because it is a state of mind. It is assumed that marginal utility of money remains

constant but the law of DMU applies to money equally.

PRACTICAL IMPORTANCE:
This law is applied to all problems of scarce (limited) resource against unlimited
wants.
This law plays an important role in the theory of distribution and exchange.
It extends over the field of the theory of production.

CONCLUSION:
Thus the law of substation applies in all branches of economic theories.

Law of demand
In economics, the law states that, all else being equal, as the price of a product increases,
quantity demanded falls; likewise, as the price of a product decreases, quantity demanded
increases.
In other words, the law of demand states that the quantity demanded and the price of a
commodity are inversely related, other things remaining constant. If the income of the consumer,
prices of the related goods, and preferences of the consumer remain unchanged, then the change
in quantity of good demanded by the consumer will be negatively correlated to the change in the
price of the good. There are, however, some possible exceptions to this rule (see Giffen goods
and Veblen goods).

Mathematical expression
Mathematically, the inverse relationship may be expressed as a causal relation:

Where,
is

is
the

function

of

the
independent

quantity

demanded

variables

contained

within

of
the

x
parenthesis,

goods
and

is the price of x goods.

Hence, in the above model, the function ( ) is a varying one: i.e., the law of demand postulates
as the causal factor (independent variable) and

as the dependent variable.

Graphical depiction
A demand curve is a graphical depiction that abides by the law of demand. It shows how the
quantity demanded of some product during a specified period of time will change as the price of
that product changes, holding all other determinants of the quantity demanded constant. Price is
measured on the vertical axis and quantity demanded on the horizontal axis.
There are two important things to note about the demand curve:

It is downward sloping indicating that between the price of a product and the quantity
demanded a negative or inverse relationship exists. In other words, as the price declines
the quantity demanded increases. This is indicated by a downward movement along the
demand curve. An increase in price decreases the quantity demanded, and an upward
movement along the demand curve occurs.

The movement along a given demand curve due to a change in price is referred to as
"change in quantity demanded". As the price changes, the quantity demanded changes.
The term "change in demand" refers to a shift of the demand curve because of factors
other than price.

Assumptions
Every law will have limitations or exceptions. While expressing the law of demand, the
assumption is that other factors of demand, except the price of a good, are unchanged. If they
don't remain constant, the inverse relation may not hold well. In other words, it is assumed that
the income and tastes of consumers and the prices of related goods are constant. This law
operates when the price of the good changes and all other non-price factors do not change.
The main assumptions are:

The function shows the relationship between Price and Quantity Demanded at a static time (t).

Habits, tastes and fashions remain same.

Income of the consumer does not change.

Prices of related goods remain constant.

Number of buyers remain constant.

The commodity is a normal good and has no prestige or status value.

People do not expect changes in the price.

Price is independent and quantity demanded is dependent.

income level should remain constant

Exceptions to the law of demand

Generally, the amount demanded of a good increases with a decrease in price of the good and
vice versa. In some cases, however, this may not be true. Such situations are explained as in
below.
Giffen goods

Initially discovered by [vasudeva], economists disagree on the existence of Giffen goods in the
market. A Giffen good describes an inferior good that as the price increases, demand for the
product increases. As an example, during the Irish Potato Famine of the 19th century, potatoes
were considered one of Giffen good's. Potatoes were the largest staple in the Irish diet, so as the
price rose it had a large impact on income. People responded by cutting out on luxury goods such

as meat and vegetables, and instead bought more potatoes. Therefore, as the price of potatoes
increased, so did the demand.[2] However, this change of demand did not mean movement along
the demand curve, but rather a shift of the whole demand curve. What occurred was not an
increase in demanded quantity due to increase in price (which would be a violation of law of
demand), but rather, a change in the relationship between price and demanded quantity. Thus, the
Giffen good confuses the change in demanded quantity with the change in the relationship
between price and quantity. .
Veblen Goods

Some expensive commodities like diamonds, expensive cars, etc., are used as status symbols to
display ones wealth. The more expensive these commodities become, the higher their value as a
status symbol and hence, the greater the demand for them. The amount demanded of these
commodities increase with an increase in their price and decrease with a decrease in their price.
Also known as a Veblen good.
Expectation of change in the price of commodity

If a household expects the price of a commodity to increase, it may start purchasing a greater
amount of the commodity even at the presently increased price. Similarly, if the household
expects the price of the commodity to decrease, it may postpone its purchases. Thus, some argue
that the law of demand is violated in such cases. In this case, the demand curve does not slope
down from left to right; instead it presents a backward slope from the top right to down left. This
curve is known as an exceptional demand curve. Technically, this is not a violation of the law of
demand, as it violates the ceteris paribus condition.

The Law of Demand and Change in Demand

The law of demand states that, other things remaining same, the quantity demanded of a good
increases when its price falls and vice-versa. Note that demand for goods changes as a
consequence of changes in income, tastes etc. Hence, demand may expand or contract and
increase or decrease. In this context, let us make a distinction between two different types of
changes that affect quantity demanded, viz., expansion and contraction; and increase and

decrease. While stating the law of demand i.e., while treating price as the causative factor, the
relevant terms are Expansion and Contraction in demand (which means movement along the
curve of demand). When the demand is changing due to a price change alone, we should not say
increase or decrease but expansion or contraction. If one of the non-price determinants of
demand, such as the prices of other goods, income, etc. change & thereby demand changes, the
relevant terms are increase and decrease in demand (which means shift of the demand curve to
the right or to the left). The expansion and contraction in demand are shown in the diagram. You
may observe that expansion and contraction are shown on a single DD curve. The changes
(movements) take place along the given k.

Limitations

Change in taste or demand.

Change in income

Change in other prices.

Discovery of substitution.

Anticipatory change in prices.

Rare or distinction goods.

consumer surplus
In mainstream economics, economic surplus (also known as total welfare or Marshallian
surplus (named after Alfred Marshall)) refers to two related quantities. Consumer surplus or
consumers' surplus is the monetary gain obtained by consumers because they are able to
purchase a product for a price that is less than the highest price that they would be willing to pay.
Producer surplus or producers' surplus is the amount that producers benefit by selling at a
market price that is higher than the least that they would be willing to sell for.

In Marxian economics, the term surplus may also refer to surplus value, surplus product
and surplus labour.

Overview
Economist Paul A. Baran introduced the concept of "economic surplus" to deal with novel
complexities raised by the dominance of monopoly capital. With Paul Sweezy, Baran elaborated
the importance of this innovation, its consistency with Marx's labor concept of value, and
supplementary relation to Marx's category of surplus value.[1]
On a standard supply and demand diagram, consumer surplus is the area (triangular if the supply
and demand curves are linear) above the equilibrium price of the good and below the demand
curve. This reflects the fact that consumers would have been willing to buy a single unit of the
good at a price higher than the equilibrium price, a second unit at a price below that but still
above the equilibrium price, etc., yet they in fact pay just the equilibrium price for each unit they
buy.
Likewise, in the supply-demand diagram, producer surplus is the area below the equilibrium
price but above the supply curve. This reflects the fact that producers would have been willing to
supply the first unit at a price lower than the equilibrium price, the second unit at a price above
that but still below the equilibrium price, etc., yet they in fact receive the equilibrium price for all
the units they sell.

Consumer surplus
Consumer surplus is the difference between the maximum price a consumer is willing to pay and
the actual price they do pay. If a consumer would be willing to pay more than the current asking
price, then they are getting more benefit from the purchased product than they initially paid. An
example of a good with generally high consumer surplus is drinking water. People would pay
very high prices for drinking water, as they need it to survive. The difference in the price that
they would pay, if they had to, and the amount that they pay now is their consumer surplus. Note
that the utility of the first few liters of drinking water is very high (as it prevents death), so the
first few liters would likely have more consumer surplus than subsequent liters.
The maximum amount a consumer would be willing to pay for a given quantity of a good is the
sum of the maximum price they would pay for the first unit, the (lower) maximum price they
would be willing to pay for the second unit, etc. Typically these prices are decreasing; they are
given by the individual demand curve. For a given price the consumer buys the amount for
which the consumer surplus is highest, where consumer surplus is the sum, over all units, of the
excess of the maximum willingness to pay over the equilibrium (market) price. The consumer's
surplus is highest at the largest number of units for which, even for the last unit, the maximum
willingness to pay is not below the market price
The aggregate consumers' surplus is the sum of the consumer's surplus for all individual
consumers. This can be represented graphically as shown in the above graph of the market
demand and supply curves.
Calculation from supply and demand

The consumer surplus (individual or aggregated) is the area under the (individual or aggregated)
demand curve and above a horizontal line at the actual price (in the aggregated case: the
equilibrium price). If the demand curve is a straight line, the consumer surplus is the area of a
triangle:

Where Pmkt is the equilibrium price (where supply equals demand), Qmkt is the total quantity
purchased at the equilibrium price and Pmax is the price at which the quantity purchased would
fall to 0 (that is, where the demand curve intercepts the price axis). For more general demand and
supply functions, these areas are not triangles but can still be found using integral calculus.
Consumer surplus is thus the definite integral of the demand function with respect to price, from
the market price to the maximum reservation price (i.e. the price-intercept of the demand
function):

where

This shows that if we see a rise in the equilibrium price and a fall in the equilibrium quantity,
then consumer surplus falls.
Distribution of benefits when price falls

When supply of a good expands, the price falls (assuming the demand curve is downward
sloping) and consumer surplus increases. This benefits two groups of people: Consumers who
were already willing to buy at the initial price benefit from a price reduction; also they may buy
more and receive even more consumer surplus, and additional consumers who were unwilling to
buy at the initial price but will buy at the new price and also receive some consumer surplus.
Consider an example of linear supply and demand curves. For an initial supply curve S0,
consumer surplus is the triangle above the line formed by price P0 to the demand line (bounded
on the left by the price axis and on the top by the demand line). If supply expands from S 0 to S1,
the consumers' surplus expands to the triangle above P1 and below the demand line (still bounded
by the price axis). The change in consumer's surplus is difference in area between the two
triangles, and that is the consumer welfare associated with expansion of supply.
Some people were willing to pay the higher price P0. When the price is reduced, their benefit is
the area in the rectangle formed on the top by P0, on the bottom by P1, on the left by the price
axis and on the right by line extending vertically upwards from Q0.

The second set of beneficiaries are consumers who buy more, and new consumers, those who
will pay the new lower price (P1) but not the higher price (P0). Their additional consumption
makes up the difference between Q1 and Q0. Their consumer surplus is the triangle bounded on
the left by the line extending vertically upwards from Q0, on the right and top by the demand
line, and on the bottom by the line extending horizontally to the right from P1.
Rule of one-half

The rule of one-half estimates the change in consumer surplus for small changes in supply with
a constant demand curve. Note that in the special case where the consumer demand curve is
linear, consumer surplus is the area of the triangle bounded by the vertical line Q=0, the
horizontal line

and the linear demand curve. Hence, the change in consumer surplus

is the area of the trapezoid with i) height equal to the change in price and ii) mid-segment length
equal to the average of the ex-post and ex-ante equilibrium quantities. Following the figure
above,

where:

CS = Consumers' Surplus

Q0 and Q1 are, respectively, the quantity demanded before and after a change in supply

P0 and P1 are, respectively, the prices before and after a change in supply

Price elasticity of demand

Price elasticity of demand (PED or Ed) is a measure used in economics to show the
responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its
price. More precisely, it gives the percentage change in quantity demanded in response to a one
percent change in price (ceteris paribus, i.e. holding constant all the other determinants of
demand, such as income).

Price elasticities are almost always negative, although analysts tend to ignore the sign even
though this can lead to ambiguity. Only goods which do not conform to the law of demand, such
as Veblen and Giffen goods, have a positive PED. In general, the demand for a good is said to be
inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is,
changes in price have a relatively small effect on the quantity of the good demanded. The
demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one (in
absolute value): that is, changes in price have a relatively large effect on the quantity of a good
demanded.
Revenue is maximized when price is set so that the PED is exactly one. The PED of a good can
also be used to predict the incidence (or "burden") of a tax on that good. Various research
methods are used to determine price elasticity, including test markets, analysis of historical sales
data and conjoint analysis

Definition
It is a measure of responsiveness of the quantity of a raw good or service demanded to changes
in its price.[1] The formula for the coefficient of price elasticity of demand for a good is:[2][3][4]

The above formula usually yields a negative value, due to the inverse nature of the relationship
between price and quantity demanded, as described by the "law of demand".[3] For example, if
the price increases by 5% and quantity demanded decreases by 5%, then the elasticity at the
initial price and quantity = 5%/5% = 1. The only classes of goods which have a PED of
greater than 0 are Veblen and Giffen goods.[5] Because the PED is negative for the vast majority
of goods and services, however, economists often refer to price elasticity of demand as a positive
value (i.e., in absolute value terms).[4]
This measure of elasticity is sometimes referred to as the own-price elasticity of demand for a
good, i.e., the elasticity of demand with respect to the good's own price, in order to distinguish it
from the elasticity of demand for that good with respect to the change in the price of some other

good, i.e., a complementary or substitute good.[1] The latter type of elasticity measure is called a
cross-price elasticity of demand.[6][7]
As the difference between the two prices or quantities increases, the accuracy of the PED given
by the formula above decreases for a combination of two reasons. First, the PED for a good is
not necessarily constant; as explained below, PED can vary at different points along the demand
curve, due to its percentage nature.[8][9] Elasticity is not the same thing as the slope of the demand
curve, which is dependent on the units used for both price and quantity.[10][11] Second, percentage
changes are not symmetric; instead, the percentage change between any two values depends on
which one is chosen as the starting value and which as the ending value. For example, if quantity
demanded increases from 10 units to 15 units, the percentage change is 50%, i.e., (15 10) 10
(converted to a percentage). But if quantity demanded decreases from 15 units to 10 units, the
percentage change is 33.3%, i.e., (10 15) 15.[12][13]
Two alternative elasticity measures avoid or minimise these shortcomings of the basic elasticity
formula: point-price elasticity and arc elasticity.
Point-price elasticity

One way to avoid the accuracy problem described above is to minimise the difference between
the starting and ending prices and quantities. This is the approach taken in the definition of pointprice elasticity, which uses differential calculus to calculate the elasticity for an infinitesimal
change in price and quantity at any given point on the demand curve: [14]

In other words, it is equal to the absolute value of the first derivative of quantity with respect to
price (dQd/dP) multiplied by the point's price (P) divided by its quantity (Qd).[15]
In terms of partial-differential calculus, point-price elasticity of demand can be defined as
follows:[16] let

be the demand of goods

as a function of parameters

price and wealth, and let

with respect to price

be the demand for good . The elasticity of demand for good

is

However, the point-price elasticity can be computed only if the formula for the demand function,
, is known so its derivative with respect to price,

, can be determined.

Arc elasticity

A second solution to the asymmetry problem of having a PED dependent on which of the two
given points on a demand curve is chosen as the "original" point and which as the "new" one is
to compute the percentage change in P and Q relative to the average of the two prices and
theaverage of the two quantities, rather than just the change relative to one point or the other.
Loosely speaking, this gives an "average" elasticity for the section of the actual demand curve
i.e., the arc of the curvebetween the two points. As a result, this measure is known as the arc
elasticity, in this case with respect to the price of the good. The arc elasticity is defined
mathematically as:[13][17][18]

This method for computing the price elasticity is also known as the "midpoints formula",
because the average price and average quantity are the coordinates of the midpoint of the straight
line between the two given points.[12][18] This formula is an application of the midpoint method.
However, because this formula implicitly assumes the section of the demand curve between
those points is linear, the greater the curvature of the actual demand curve is over that range, the
worse this approximation of its elasticity will be.[17][19]

History

The illustration that accompanied Marshall's original definition of PED, the ratio of PT to Pt

Together with the concept of an economic "elasticity" coefficient, Alfred Marshall is credited
with defining PED ("elasticity of demand") in his book Principles of Economics, published in
1890.[20] He described it thus: "And we may say generally: the elasticity (or responsiveness) of
demand in a market is great or small according as the amount demanded increases much or little
for a given fall in price, and diminishes much or little for a given rise in price". [21] He reasons
this since "the only universal law as to a person's desire for a commodity is that it diminishes...
but this diminution may be slow or rapid. If it is slow... a small fall in price will cause a
comparatively large increase in his purchases. But if it is rapid, a small fall in price will cause
only a very small increase in his purchases. In the former case... the elasticity of his wants, we
may say, is great. In the latter case... the elasticity of his demand is small."[22] Mathematically,
the Marshallian PED was based on a point-price definition, using differential calculus to
calculate elasticities.[

Determinants
The overriding factor in determining PED is the willingness and ability of consumers after a
price change to postpone immediate consumption decisions concerning the good and to search
for substitutes ("wait and look").[24] A number of factors can thus affect the elasticity of demand
for a good:[25]

Availability of substitute goods: the more and closer the substitutes available, the higher the
elasticity is likely to be, as people can easily switch from one good to another if an even minor
price change is made;[25][26][27] There is a strong substitution effect.[28] If no close substitutes are
available, the substitution effect will be small and the demand inelastic.[28]

Breadth of definition of a good: the broader the definition of a good (or service), the lower the
elasticity. For example, Company X's fish and chips would tend to have a relatively high elasticity
of demand if a significant number of substitutes are available, whereas food in general would
have an extremely low elasticity of demand because no substitutes exist.[29]

Percentage of income: the higher the percentage of the consumer's income that the product's
price represents, the higher the elasticity tends to be, as people will pay more attention when
purchasing the good because of its cost;[25][26] The income effect is substantial.[30] When the
goods represent only a negligible portion of the budget the income effect will be insignificant
and demand inelastic,[30]

Necessity: the more necessary a good is, the lower the elasticity, as people will attempt to buy it
no matter the price, such as the case of insulin for those that need it.[10][26]

Duration: for most goods, the longer a price change holds, the higher the elasticity is likely to
be, as more and more consumers find they have the time and inclination to search for
substitutes.[25][27] When fuel prices increase suddenly, for instance, consumers may still fill up
their empty tanks in the short run, but when prices remain high over several years, more
consumers will reduce their demand for fuel by switching to carpooling or public transportation,
investing in vehicles with greater fuel economy or taking other measures.[26] This does not hold
for consumer durables such as the cars themselves, however; eventually, it may become
necessary for consumers to replace their present cars, so one would expect demand to be less
elastic.[26]

Brand loyalty: an attachment to a certain brandeither out of tradition or because of

proprietary barrierscan override sensitivity to price changes, resulting in more inelastic
demand.[29][31]

Who pays: where the purchaser does not directly pay for the good they consume, such as with
corporate expense accounts, demand is likely to be more inelastic.[31]

Interpreting values of price elasticity coefficients

Perfectly inelastic demand[10]

Perfectly elastic demand[10]

Elasticities of demand are interpreted as follows:[10]

Value

Descriptive Terms
Perfectly inelastic demand

Inelastic or relatively inelastic demand

Unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand
Elastic or relatively elastic demand
Perfectly elastic demand

A decrease in the price of a good normally results in an increase in the quantity demanded by
consumers because of the law of demand, and conversely, quantity demanded decreases when
price rises. As summarized in the table above, the PED for a good or service is referred to by
different descriptive terms depending on whether the elasticity coefficient is greater than, equal
to, or less than 1. That is, the demand for a good is called:

relatively inelastic when the percentage change in quantity demanded is less than the
percentage change in price (so that Ed> - 1);

unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand when the percentage
change in quantity demanded is equal to the percentage change in price (so that Ed = - 1); and

relatively elastic when the percentage change in quantity demanded is greater than the
percentage change in price (so that Ed< - 1).[10]

As the two accompanying diagrams show, perfectly elastic demand is represented graphically as
a horizontal line, and perfectly inelastic demand as a vertical line. These are the only cases in
which the PED and the slope of the demand curve (P/Q) are both constant, as well as the only
cases in which the PED is determined solely by the slope of the demand curve (or more
precisely, by the inverse of that slope).[10]

Relation to marginal revenue

The following equation holds:

where
R'

is

the
is

marginal
the

revenue
price

Proof:
TR

Effect on total revenue

See also: Total revenue test

Total

Revenue

A set of graphs shows the relationship between demand and total revenue (TR) for a linear demand
curve. As price decreases in the elastic range, TR increases, but in the inelastic range, TR decreases. TR is
maximised at the quantity where PED = 1.

A firm considering a price change must know what effect the change in price will have on total
revenue. Revenue is simply the product of unit price times quantity:

Generally any change in price will have two effects:[32]

theprice effect : For inelastic goods, an increase in unit price will tend to increase revenue, while
a decrease in price will tend to decrease revenue. (The effect is reversed for elastic goods.)

thequantity effect : an increase in unit price will tend to lead to fewer units sold, while a
decrease in unit price will tend to lead to more units sold.

For inelastic goods, because of the inverse nature of the relationship between price and quantity
demanded (i.e., the law of demand), the two effects affect total revenue in opposite directions.
But in determining whether to increase or decrease prices, a firm needs to know what the net
effect will be. Elasticity provides the answer: The percentage change in total revenue is
approximately equal to the percentage change in quantity demanded plus the percentage change
in price. (One change will be positive, the other negative.)[33] The percentage change in quantity
is related to the percentage change in price by elasticity: hence the percentage change in revenue
can be calculated by knowing the elasticity and the percentage change in price alone.
As a result, the relationship between PED and total revenue can be described for any good:[34][35]

When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price
do not affect the quantity demanded for the good; raising prices will always cause total revenue
to increase. Goods necessary to survival can be classified here; a rational person will be willing
to pay anything for a good if the alternative is death. For example, a person in the desert weak

and dying of thirst would easily give all the money in his wallet, no matter how much, for a
bottle of water if he would otherwise die. His demand is not contingent on the price.

When the price elasticity of demand for a good is relatively inelastic (-1 < Ed< 0), the percentage
change in quantity demanded is smaller than that in price. Hence, when the price is raised, the
total revenue increases, and vice versa.

When the price elasticity of demand for a good is unit (or unitary) elastic (Ed = 1), the percentage
change in quantity is equal to that in price, so a change in price will not affect total revenue.

When the price elasticity of demand for a good is relatively elastic( - < Ed< -1), the percentage
change in quantity demanded is greater than that in price. Hence, when the price is raised, the
total revenue falls, and vice versa.

When the price elasticity of demand for a good is perfectly elastic (Ed is ), any increase in the
price, no matter how small, will cause demand for the good to drop to zero. Hence, when the
price is raised, the total revenue falls to zero. This situation is typical for goods that have their
value defined by law (such as fiat currency); if a 5 dollar bill were sold for anything more than 5
dollars, nobody would buy it, so demand is zero.

Hence, as the accompanying diagram shows, total revenue is maximized at the combination of
price and quantity demanded where the elasticity of demand is unitary.[35]
It is important to realize that price-elasticity of demand is not necessarily constant over all price
ranges. The linear demand curve in the accompanying diagram illustrates that changes in price
also change the elasticity: the price elasticity is different at every point on the curve.

Effect on tax incidence

When demand is more inelastic than supply, consumers will bear a greater proportion of the tax burden
than producers will.
Main article: tax incidence

PEDs, in combination with price elasticity of supply (PES), can be used to assess where the
incidence (or "burden") of a per-unit tax is falling or to predict where it will fall if the tax is
imposed. For example, when demand is perfectly inelastic, by definition consumers have no
alternative to purchasing the good or service if the price increases, so the quantity demanded
would remain constant. Hence, suppliers can increase the price by the full amount of the tax, and
the consumer would end up paying the entirety. In the opposite case, when demand is perfectly
elastic, by definition consumers have an infinite ability to switch to alternatives if the price
increases, so they would stop buying the good or service in question completelyquantity
demanded would fall to zero. As a result, firms cannot pass on any part of the tax by raising
prices, so they would be forced to pay all of it themselves.[36]

In practice, demand is likely to be only relatively elastic or relatively inelastic, that is,
somewhere between the extreme cases of perfect elasticity or inelasticity. More generally, then,
the higher the elasticity of demand compared to PES, the heavier the burden on producers;
conversely, the more inelastic the demand compared to PES, the heavier the burden on
consumers. The general principle is that the party (i.e., consumers or producers) that has fewer
opportunities to avoid the tax by switching to alternatives will bear the greater proportion of the
tax burden.[36] In the end the whole tax burden is carried by individual households since they are
the ultimate owners of the means of production that the firm utilises (see Circular flow of
income).
PED and PES can also have an effect on the deadweight loss associated with a tax regime. When
PED, PES or both are inelastic, the deadweight loss is lower than a comparable scenario with
higher elasticity.

Optimal pricing
Among the most common applications of price elasticity is to determine prices that maximize
revenue or profit.
Constant elasticity and optimal pricing

If one point elasticity is used to model demand changes over a finite range of prices, elasticity is
implicitly assumed constant with respect to price over the finite price range. The equation
defining price elasticity for one product can be rewritten (omitting secondary variables) as a
linear equation.

where
is the elasticity, and

is a constant.

Similarly, the equations for cross elasticity for n products can be written as a set of n
simultaneous linear equations.

where

and

and

are

constants;

and

appearance of a letter index as both an upper index and a lower index in the same term implies
summation over that index.

This form of the equations shows that point elasticities assumed constant over a price range
cannot determine what prices generate maximum values of
prices that generate maximum

; similarly they cannot predict

or maximum revenue.

Constant elasticities can predict optimal pricing only by computing point elasticities at several
points, to determine the price at which point elasticity equals -1 (or, for multiple products, the set
of prices at which the point elasticity matrix is the negative identity matrix).
Non-constant elasticity and optimal pricing

If the definition of price elasticity is extended to yield a quadratic relationship between demand
units ( ) and price, then it is possible to compute prices that maximize

, and revenue.

The fundamental equation for one product becomes

and the corresponding equation for several products becomes

Excel models are available that compute constant elasticity, and use non-constant elasticity to
estimate prices that optimize revenue or profit for one product[37] or several products.[38]

Limitations of revenue-maximizing and profit-maximizing pricing strategies

In most situations, revenue-maximizing prices are not profit-maximizing prices. For example, if
variable costs per unit are nonzero (which they almost always are), then a more complex
computation of a similar kind yields prices that generate optimal profits.
In some situations, profit-maximizing prices are not an optimal strategy. For example, where
scale economies are large (as they often are), capturing market share may be the key to long-term
dominance of a market, so maximizing revenue or profit may not be the optimal strategy.

Different types of goods demand

Negative demand: If the market response to a product is negative, it shows that people are not
aware of the features of the service and the benefits offered. Under such circumstances, the
marketing unit of a service firm has to understand the psyche of the potential buyers and find out
the prime reason for the rejection of the service. For example: if passengers refuse a bus
conductor's call to board the bus. The service firm has to come up with an appropriate strategy to
remove the misunderstandings of the potential buyers. A strategy needs to be designed to
transform the negative demand into a positive demand.
No demand: If people are unaware, have insufficient information about a service or due to the
consumer's indifference this type of a demand situation could occur. The marketing unit of the
firm should focus on promotional campaigns and communicating reasons for potential customers
to use the firm's services. Service differentiation is one of the popular strategies used to compete
in a no demand situation in the market.
Latent demand: At any given time it is impossible to have a set of services that offer total
satisfaction to all the needs and wants of society. In the market there exists a gap between
desirables and the availables. There is always a search on for better and newer offers to fill the
gap between desirability and availability. Latent demand is a phenomenon of any economy at
any given time, it should be looked upon as a business opportunity by service firms and they
should orient themselves to identify and exploit such opportunities at the right time. For example

a passenger traveling in an ordinary bus dreams of traveling in a luxury bus. Therefore, latent
demand is nothing but the gap between desirability and availability.
Seasonal demand:Some services do not have an all year round demand, they might be required
only at a certain period of time. Seasons all over the world are very diverse. Seasonal demands
create many problems to service organizations, such as:- idling the capacity, fixed cost and
excess expenditure on marketing and promotions. Strategies used by firms to overcome this
hurdle are like - to nurture the service consumption habit of customers so as to make the demand
unseasonal, or other than that firms recognize markets elsewhere in the world during the offseason period. Hence, this presents and opportunity to target different markets with the
appropriate season in different parts of the world. For example the need for Christmas cards
comes around once a year. Or the, seasonal fruits in a country.
Demand patterns need to be studied in different segments of the market. Service organizations
need to constantly study changing demands related to there service offerings over various time
periods. They have to develop a system to chart these demand fluctuations, which helps them in
predicting the demand cycles. Demands do fluctuate randomly, therefore, they should be
followed on a daily, weekly or a monthly basis.
DEMAND MEASUREMENT
Terms commonly used in Demand Measurement/Sales Forecasting
Let us first explain certain expressions that are commonly used in relation to demand
measurement and sales forecasting.

Market

Company

Market

Company
Market

potential

(or

potential
demand
demand
forecast

Company forecast (or sales forecast)

(or
(or

(or

company
(or

industry

potential)

sales

potential)

industry

demand)

sales

possibilities)

industry

forecast)

Market potential is a quantitative estimate of the total possible sales by all firms selling the same
product in a given market. It gives an indication of the ultimate potential for the product for the
industry as a whole, assuming that the ideal marketing effort is made.
Company potential refers to a part of the market potential; what an individual firm can achieve at
the maximum in a given market; again under ideal conditions and on the assumption that the
ideal marketing effort is made.
Market demand and company demand refer to those portions of market potential and
company potential that are achievable under existing conditions.
Market forecast is narrower in scope in comparison to market demand. It refers to that part of the
market demand that will materialize with the level of marketing effort the industry will put in
during the period of the forecast.
Company forecast means the sales forecast of the company. It refers to that portion of the
company demand, which the company expects to capture with the chosen marketing effort.
It can be easily seen that company potential is just a part of market potential
company demand is just a part of market demand, and company forecast, is
just a part of market forecast.
Forecasting demand / sales, A Complex Exercise
Forecasting demand/ sales is normally a difficult and complex exercise. Peter Drucker the well
known management expert said that about the future we can be certain of only three things.

It
It

cannot
will

be

be
different

known
from

with
what

It will be different from what we expect it to be!

One has to appreciate the complexity inherent in sales forecasting.

it

certainty!
is

now!

A Twin Task
It is obvious that two separate, though related, tasks are involved here.
1.

Measuring

market

demand.

2. Forecasting company sales.

This is so because firms need to assess two entities: demand and sales i.e. market demand and
company sales.
Measuring Market Demand
Firms need to assess,
(i) Current market demand

(ii) Future market demand.

Measuring Current Market Demand
Here again, firms need to assess
a.

Total

demand.

b. Area demand.
Measuring area market demand:
Area market demand refers to the demand within a particular city, district, state, zone, or
country. The two main methods used for estimating area market demand are: the market-buildup
method and the market factor index method. The market-build up method calls for identifying
how many potential buyers there are in each market and estimating the size of their potential
purchases. The market-factor index method identifies market factors that correlate with market
potential and then combines them into a weighted index, such as the index of buying power.

Forecasting future market demand

In forecasting future market demand too, we have two components: forecasting total demand and
forecasting area demand. Once total demand is forecast, area demand can be forecast, using the
same principles as in the case of measuring current demand.
Forecasting Company Sales
Now let us turn to company sales. Here, current company sales are already known from internal
records. So, firms need to find out/forecast only the likely sales in a future (specified) period.
This is what one means by the familiar term, sales forecasting. The sales forecast indicates how
much of a product is likely to be sold during a specified future period in a specified market, at
specified prices.
To sum up all business firms would like to know the current as well as the likely demand for
their products. More specifically, they would like to know how much of a given product they
would sell in a given market in a given period; whether the sales would increase or decrease
from the current levels and by how much; and what would be their market share. This knowledge
is very essential for a firm. Without this knowledge, it cannot plan any of its activities. Demand
measurement and sales forecasting provides this vital knowledge. In this article we have briefly
outlined above various aspects of Demand Measurement considering its importance for
the industry / business firms.

Unit-3
Factors of production

In economics, factors of production are the inputs to the production process. Finished goods are
the output. Input determines the quantity of output i.e. output depends upon input. Input is the
starting point and output is the end point of production process and such input-output
relationship is called a production function. There are three basic factors of production: land,
labour, capital. Some modern economists also consider entrepreneurship for a factor of
production. These factors are also frequently labeled "producer goods" in order to distinguish
them from the goods or services purchased by consumers, which are frequently labeled
"consumer goods." All three of these are required in combination at a time to produce a
commodity. In economics, production means creation or an addition of utility. Factors of
production (or productive 'inputs' or 'resources') are any commodities or services used to produce
goods or services.
Factors of production may also refer specifically to the primary factors, which are stocks
including land, labor (the ability to work), and capital goods applied to production. Materials and
energy are considered as secondary factors in classical economics because they are obtained
from land, labour and capital. The primary factors facilitate production but neither become part
of the product (as with raw materials) nor become significantly transformed by the production
process (as with fuel used to power machinery). Land includes not only the site of production but
natural resources above or below the soil. The factor land may, however, for simplification
purposes be merged with capital in some cases (due to land being of little importance in the
service sector and manufacturing). Recent usage has distinguished human capital (the stock of
knowledge in the labor force) from labor.[1] Entrepreneurship is also sometimes considered a
factor of production.[2] Sometimes the overall state of technology is described as a factor of
production.[3] The number and definition of factors varies, depending on theoretical purpose,
empirical emphasis, or school of economics.[4]

Historical schools and factors

In the interpretation of the currently dominant view of classical economic theory developed by
neoclassical economists, the term "factors" did not exist until after the classical period and is not
to be found in any of the literature of that time.[5]
Differences are most stark when it comes to deciding which factor is the most important. For
example, in the Austrian viewoften shared by neoclassical and other "free market"
economiststhe primary factor of production is the time of the entrepreneur, which, when
combined with other factors, determines the amount of output of a particular good or service.
However, other authors argue that "entrepreneurship" is nothing but a specific kind of labor or
human capital and should not be treated separately. The Marxian school goes further, seeing
labor (in general, including entrepreneurship) as the primary factor of production, since it is
required to produce capital goods and to utilize the gifts of nature. But this debate is more about
basic economic theory (the role of the factors in the economy) than it is about the definition of
the factors of production.
Physiocracy

In French Physiocracy, the main European school of economics before Adam Smith, the
productive process is explained as the interaction between participating classes of the population.
These classes are therefore the factors of production within physiocracy: capital,
entrepreneurship, land, and labor.

The farmer labors on land (sometimes using "crafts") to produce goods.

The landlord is only a consumer of food and crafts and produces nothing at all.

The merchant labors to export food in exchange for foreign imports.

Classical

An advertisement for labour from Sabah and Sarawak, seen in JalanPetaling, Kuala Lumpur.

The classical economics of Adam Smith, David Ricardo, and their followers focuses on physical
resources in defining its factors of production, and discusses the distribution of cost and value
among these factors. Adam Smith and David Ricardo referred to the "component parts of
price"[6] as the costs of using:

Land or natural resource naturally-occurring goods like water, air, soil, minerals, flora and
fauna that are used in the creation of products. The payment for use and the received income of
a land owner is rent.

Labor human effort used in production which also includes technical and marketing expertise.
The payment for someone else's labor and all income received from ones own labor is wages.
Labor can also be classified as the physical and mental contribution of an employee to the
production of the good(s).

The capital stock human-made goods which are used in the production of other goods. These
include machinery, tools, and buildings.

The classical economists also employed the word "capital" in reference to money. Money,
however, was not considered to be a factor of production in the sense of capital stock since it is

not used to directly produce any good. The return to loaned money or to loaned stock was styled
as interest while the return to the actual proprietor of capital stock (tools, etc.) was styled as
profit. See also returns.
Marxism

Marx considered the "elementary factors of the labor-process" or "productive forces" to be:

Labor

The subject of labor (objects transformed by labor)

The instruments of labor (or means of labor).[7]

The "subject of labor" refers to natural resources and raw materials, including land. The
"instruments of labor" are tools, in the broadest sense. They include factory buildings,
infrastructure, and other human-made objects that facilitate labor's production of goods and
services.
This view seems similar to the classical perspective described above. But unlike the classical
school and many economists today, Marx made a clear distinction between labor actually done
and an individual's "labor power" or ability to work. Labor done is often referred to nowadays as
"effort" or "labor services." Labor-power might be seen as a stock which can produce a flow of
labor.
Labor, not labor power, is the key factor of production for Marx and the basis for Marx's labor
theory of value. The hiring of labor power only results in the production of goods or services
("use-values") when organized and regulated (often by the "management"). How much labor is
actually done depends on the importance of conflict or tensions within the labor process.
Neoclassical economics

Neoclassical economics, one of the branches of mainstream economics, started with the classical
factors of production of land, labor, and capital. However, it developed an alternative theory of
value and distribution. Many of its practitioners have added various further factors of production
(see below).

Further distinctions
Further distinctions from classical and neoclassical microeconomics include the following:

Capital This has many meanings, including the financial capital raised to operate and
expand a business. In much of economics, however, "capital" (without any qualification)
means goods that can help produce other goods in the future, the result of investment. It
refers to machines, roads, factories, schools, infrastructure, and office buildings which
humans have produced in order to produce goods and services.

Fixed capital This includes machinery, factories, equipment, new technology,

factories, buildings, computers, and other goods that are designed to increase the
productive potential of the economy for future years. Nowadays, many consider
computer software to be a form of fixed capital and it is counted as such in the National
Income and Product Accounts of the United States and other countries. This type of
capital does not change due to the production of the good.

Working capital This includes the stocks of finished and semi-finished goods that
will be economically consumed in the near future or will be made into a finished
consumer good in the near future. These are often called inventory. The phrase "working
capital" has also been used to refer to liquid assets (money) needed for immediate
expenses linked to the production process (to pay salaries, invoices, taxes, interests...)
Either way, the amount or nature of this type of capital usually changed during the
production process.

Financial capital This is simply the amount of money the initiator of the business has
invested in it. "Financial capital" often refers to his or her net worth tied up in the
business (assets minus liabilities) but the phrase often includes money borrowed from
others.

Technological progress For over a century, economists have known that capital and
labor do not account for all of economic growth. This is reflected in total factor
productivity and the Solow residual used in economic models called production functions
that account for the contributions of capital and labor, yet have some unexplained
contributor which is commonly called technological progress. Ayres and Warr (2009)
present time series of the efficiency of primary energy (exergy) conversion into useful

work for the US, UK, Austria and Japan revealing dramatic improvements in model
accuracy. With useful work as a factor of production they are able to reproduce historical
rates of economic growth with considerable precision and without recourse to exogenous
and unexplained technological progress, thereby overcoming the major flaw of the Solow
Theory of economic growth.[8

A fourth factor?
As mentioned, recent authors have added to the classical list. For example, J.B. Clark saw the coordinating function in production and distribution as being served by entrepreneurs; Frank
Knight introduced managers who co-ordinate using their own money (financial capital) and the
financial capital of others. In contrast, many economists today consider "human capital" (skills
and education) as the fourth factor of production, with entrepreneurship as a form of human
capital. Yet others refer to intellectual capital. More recently, many have begun to see "social
capital" as a factor, as contributing to production of goods and services.
Entrepreneurship

Consider entrepreneurship as a factor of production, leaving debate aside. In markets,

entrepreneurs combine the other factors of production, land, labor, and capital, in order to make a
profit. Often these entrepreneurs are seen as innovators, developing new ways to produce and
new products. In a planned economy, central planners decide how land, labor, and capital should
be used to provide for maximum benefit for all citizens. Of course, just as with market
entrepreneurs, the benefits may mostly accrue to the entrepreneurs themselves.
The word has been blown apart by the government. The sociologist C. Wright Mills refers to
"new entrepreneurs" who work within and between corporate and government bureaucracies in
new and different ways.[ Others (such as those practicing public choice theory) refer to "political
entrepreneurs," i.e., politicians and other actors.
Much controversy rages about the benefits produced by entrepreneurship. But the real issue is
about how well institutions they operate in (markets, planning, bureaucracies, government) serve

the public. This concerns such issues as the relative importance of market failure and
government failure.
Non tangible forms of capital
Human capital

Contemporary analysis distinguishes tangible, physical, or nonhuman capital goods from other
forms of capital such as human capital. Human capital is embodied in a human being and is
acquired through education and training, whether formal or on the job.
Human capital is important in modern economic theory. Education is a key element in explaining
economic growth over time (see growth accounting). It is also often seen as the solution to the
"Leontief paradox" in international trade.
Intellectual capital

A more recent coinage is intellectual capital, used especially as to information technology,

recorded music, written material. This intellectual property is protected by copyrights, patents,
and trademarks.
This view posits a new Information Age, which changes the roles and nature of land, labour, and
capital. During the Information Age (circa 1971present), the Knowledge Age (circa 1991 to
2002), and the Intangible Economy (2002present) many see the primary factors of production
as having become less concrete. These factors of production are now seen as knowledge,
collaboration, process-engagement, and time quality.
According to economic theory, a "factor of production" is used to create value and allow
economic performance. As the four "modern-day" factors are all essentially abstract, the current
economic age has been called the Intangible Economy. Intangible factors of production are
subject to network effects and the contrary economic laws such as the law of increasing returns.

Social capital

Social capital is often hard to define, but to one textbook it is the stock of trust, mutual
understanding, shared values, and socially held knowledge that facilitates the social coordination
of economic activity.[11] Knowledge, ideas, and values, and human relationships are transmitted
as part of the culture. This type of capital cannot be owned by individuals and is instead part of
the common stock owned by humanity. But they are often crucial to maintaining a peaceful
society in which normal economic transactions and production can occur.
Another kind of social capital can be owned individually. This kind of individual asset involves
reputation, what accountants call "goodwill", and/or what others call "street cred," along with
fame, honor, and prestige. It fits with Pierre Bourdieus definition of social capital as an
attribute of an individual in a social context. One can acquire social capital through purposeful
actions and can transform social capital into conventional economic gains. The ability to do so,
however, depends on the nature of the social obligations, connections, and networks, available to
you.
This means that the value of individual social assets that Bourdieu points to depend on the
current "social capital" as defined above.
Natural resources

Ayres and Warr (2009) are among the economists who criticize orthodox economics for
overlooking the role of natural resources and the effects of declining resource capital. See also:
Natural resource economics
Energy

Energy can be seen as individual factor of production, with an elasticity larger than labor. A
cointegration analysis support results derived from linear exponentional (LINEX) production
functions.

PRODUCTION CHARACTERTICS
In the writings of Karl Marx and the Marxist theory of historical materialism, a mode of
production (in German: Produktionsweise, meaning 'the way of producing') is a specific
combination of:

productive forces: these include human labour power and means of production (e.g. tools,
equipment, buildings and technologies & knowledge, materials, and improved land).

social and technical relations of production: these include the property, power, and
control relations governing society's productive assets (often codified in law), cooperative
work relations and forms of association, relations between people and the objects of their
work, and the relations between social classes.

Marx regarded productive ability and participation in social relations as two essential
characteristics of human beings and that the particular modality of these relations in capitalist
production are inherently in conflict with the increasing development of human productive
capacities.[1]
A precursor to this concept was Adam Smith's concept of mode of subsistence, which delineated
a progression of society types based on the way in which society's members provided for their
basic needs.[2]
According to Marx, the combination of forces and relations of production means that the way
people relate to the physical world and the way people relate to each other socially are bound up
together in specific and necessary ways. People must consume to survive, but to consume they
must produce, and in producing they necessarily enter into relations which exist independently of
their will.
For Marx, the whole 'secret' of why/how a social order exists and the causes of social change
must be discovered in the specific mode of production that a society has. He further argued that
the mode of production substantively shaped the nature of the mode of distribution, the mode of
circulation and the mode of consumption, all of which together constitute the economic sphere.
To understand the way wealth was distributed and consumed, it was necessary to understand the
conditions under which it was produced.

A mode of production is historically distinctive for Marx, because it constitutes part of an

'organic totality' (or self-reproducing whole) which is capable of constantly re-creating its own
initial conditions, and thus perpetuate itself in a more or less stable ways for centuries, or even
millennia. By performing social surplus labour in a specific system of property relations, the
labouring classes constantly reproduce the foundations of the social order. Normally a mode of
production shapes the mode of distribution, circulation and consumption, and is regulated by
thestate.
New productive forces will cause conflict in the current mode of production. When conflict
arises the modes of production can evolve within the current structure or cause a complete
breakdown.
The process of socioeconomic change
The process by which social and economic systems evolve is based on the premise of improving
technology. Specifically, as the level of technology improves, existing forms of social relations
become increasingly insufficient for fully exploiting technology. This generates internal
inefficiencies within the broader socioeconomic system, most notably in the form of class
conflict. The obsolete social arrangements prevent further social progress while generating
increasingly severe contradictions between the level of technology (forces of production) and
social structure (social relations, conventions and organization of production) which develop to a
point where the system can no longer sustain itself, and is overthrown through internal social
revolution that allows for the emergence of new forms of social relations that are compatible
with the current level of technology (productive forces).[3]
The fundamental driving force behind structural changes in the socioeconomic organization of
civilization are underlying material concerns - specifically, the level of technology and extent of
human knowledge and the forms of social organization they make possible. This comprises what
Marx termed the materialist conception of history (see also: materialism), and is in contrast to an
idealist analysis, which states that the fundamental driving force behind socioeconomic change
are the ideas of enlightened individuals.
Main modes of production in history
In a broad outline, Marxist theory recognizes several distinctive modes of production
characteristic of different epochs in human history:
Primitive communism

Human society is seen as organized in traditional tribe structures, typified by shared values and
consumption of the entire social product. As no permanent surplus product is produced, there is
also no possibility of a ruling class coming into existence. As this mode of production lacks
differentiation into classes, it is said to be classless. Palaeolithic and Neolithic tools, pre- and
early-agricultural production, and rigorous ritualized social control have often been said to be the
typifying productive forces of this mode of production. However, the foraging mode of
production still exists, and often typified in contemporary hunter-gatherer societies. Past theories
of the foraging mode of production have focused on lack of control over food production. [4]
More recent scholarship has argued that hunter-gatherers use the foraging mode of production to
maintain a specific set of social relations that, perhaps controversially, are said to emphasize
egalitarianism and the collective appropriation of resources.[5]
Asiatic mode of production
This is a controversial contribution to Marxist theory, initially used to explain pre-slave and prefeudal large earthwork constructions in China, India, the Euphrates and Nile river valleys (and
named on this basis of the primary evidence coming from greater "Asia"). The Asiatic mode of
production is said to be the initial form of class society, where a small group extracts social
surplus through violence aimed at settled or unsettled band communities within a domain.
Exploited labour is extracted as forced corveelabour during a slack periodof the year (allowing
for monumental construction such as the pyramids, ziggurats, ancient Indian communal baths or
the Chinese Great Wall). Exploited labour is also extracted in the form of goods directly seized
from the exploited communities. The primary property form of this mode is the direct religious
possession of communities (villages, bands, hamlets) and all those within them. The ruling class
of this society is generally a semi-theocratic aristocracy which claims to be the incarnation of
gods on earth. The forces of production associated with this society include basic agricultural
techniques, massive construction and storage of goods for social benefit (granaries).
Antique or Ancient mode of production
Similar to the Asiatic mode, but differentiated in that the form of property is the direct
possession of individual human beings. Additionally, the ruling class usually avoids the more
outlandish claims of being the direct incarnation of a god, and prefers to be the descendants of
gods, or seeks other justifications for its rule. Ancient Greek and Roman societies are the most
typical examples of this mode. The forces of production associated with this mode include

advanced (two field) agriculture, the extensive use of animals in agriculture, and advanced trade
networks.
Feudalism
The feudal mode of production is usually typified by the systems of the West between the fall of
the classical European culture and the rise of capitalism, though similar systems existed in most
of the earth. The primary form of property is the possession of land in reciprocal contract
relations: the possession of human beings as peasants or serfs is dependent upon their being
entailed upon the land. Exploitation occurs through reciprocated contract (though ultimately
resting on the threat of forced extractions). The ruling class is usually a nobility or aristocracy.
The primary forces of production include highly complex agriculture (two, three field, lucerne
fallowing and manuring) with the addition of non-human and non-animal power devices
(clockwork, wind-mills) and the intensification of specialisation in the craftscraftsmen
exclusively producing one specialised class of product.
Capitalism
Main article: Capitalist mode of production
Early Capitalism
The introduction of the capitalist mode of production spans the period from Mercantilism to Imperialism
and is usually associated with the emergence of modern industrial society. The primary form of property
is the possession of objects and services through state guaranteed contract. The primary form of
exploitation is wage labour (see Das Kapital, wage slavery and exploitation). The ruling class is the
bourgeoisie, which exploits the proletariat. Capitalism may produce one class (bourgeoisie) who possess
the means of production for the whole of society and another class who possess only their own labour
power, which they must sell in order to survive. The key forces of production include the overall system
of modern production with its supporting structures of bureaucracy, and the modern state, and above all
finance capital.
Late Capitalism
State capitalism and Corporate capitalism (also known as Monopoly capitalism), is a universal form
encompassing all recent actually existing economic forms based on the nation state and global process of
capital accumulation, whether avowedly capitalist or socialist, which was known only in its more or less
pure capitalist forms in Marx and Engels time. Today this form predominates in the so-called modern
mixed economy based largely on oligarchial multinational corporations with its highly socialized and
globalized system of production. In particular, the failed centrally-planned economic systems of the
defunct communist bloc nation states are not to be confused with communism as an actually existing

mode of production in spite of, or more to the point as a result of, their (failed [6]) realization of central
planning. Fredrick Engels hypothesized that state capitalism would emerge as the final form of capitalism
before the contradictions reach a point where capitalism cannot sustain itself and socialism emerges as its
successor.
The hallmark of late capitalism is consumerism and financialization, a process whereby "making money",
literally, becomes the dominant industry - both of these practices are a means to sustain the flow and
accumulation of capital.[7]
Socialism
Socialism (Lower-stage communism)
The socialist mode of production is the post-capitalist economic system that emerges when the
accumulation of capital is no longer sustainable due to falling rates of profit in (real) production, and
social conflict arising from the contradictions between the level of technology and automation in the
economy with the capitalist form of social organization. A socialist society would consist of production
being carried out, organized in a manner to directly satisfy human needs, with the working-class
cooperatively or publicly owning the means of production.
Communism (Upper-stage communism)
The ideal of communism did and does refer to a hypothetical future state of affairs where the good of all
is obtained by scientificmanagement (whence the name "scientific socialism") to obtain democratically
determinedsocial goals. Karl Marx made a distinction between "lower stage communism" and "upperstage communism", with the former usually being called socialism.
Prefiguring forms of communism can be seen in communes and other collective living experiments.
Communism is meant to be a classless society, with the management of things replacing the management
of people. Particular productive forces are not described, but are assumed to be more or less within the
reach of any contemporary capitalist society. Despite the imminent potential for communism, some [8]
economic theorists have hypothesized that communism is more than a thousand years away from full
implementation and of course it is the position of anti-communists and those who have "buried" socialism
that it will never be realized at all, that the capitalist mode is the end to which historical development
drives and halts having reached its "perfect and eternal" form or that the whole concept of mode of
production is a falacyall together. Engels[9] and Marxist doctrine identify the emergence of communism as
the reciprocal process to the "withering away" of the nation-state and the class system it supports.
Articulation of modes of production
In any specific society or country, different modes of production might emerge and exist alongside each
other, linked together economically through trade and mutual obligations. To these different modes
correspond different social classes and strata in the population. So, for example, urban capitalist industry

might co-exist with rural peasant production for subsistence and simple exchange and tribal hunting and
gathering. Old and new modes of production might combine to form a hybrid economy.
However, Marx's view was that the expansion of capitalist markets tended to dissolve and displace older
ways of producing over time. A capitalist society was a society in which the capitalist mode of production
had become the dominant one. The culture, laws and customs of that society might however preserve
many traditions of the preceding modes of production. Thus, although two countries might both be
capitalist, being economically based mainly on private enterprise for profit and wage labour, these
capitalisms might be very different in social character and functioning, reflecting very different cultures,
religions, social rules and histories.
Elaborating on this idea, Leon Trotsky famously described the economic development of the world as a
process of uneven and combined development of different co-existing societies and modes of production
which all influence each other. This means that historical changes which took centuries to occur in one
country might be truncated, abbreviated or telescoped in another. Thus, for example, Trotsky observes in
the opening chapter of his history of the Russian Revolution of 1917 that "Savages throw away their bows
and arrows for rifles all at once, without travelling the road which lay between these two weapons in the
past. The European colonists in America did not begin history all over again from the beginning", etc.
Thus, old and new techniques and cultures might combine in novel and unique admixtures, which cannot
be understood other than by tracing out the history of their emergence.

Product management .
The role may consist of product developmentProduct management is an organizational
lifecycle function within and product marketing, which are different (yet complementary) efforts,
with the objective of maximizing sales revenues, market share, and profit margins. The product
manager is often responsible for analyzing market conditions and defining features or functions
of a product. The role of product management spans many activities from strategic to tactical and
varies based on the organizational structure of the company. Product management can be a
function separate on its own, or a member of marketing or engineering.
While involved with the entire product lifecycle, the product management's main focus is on
driving new product development. According to theProduct Development and Management
Association (PDMA), superior and differentiated new products ones that deliver unique

benefits and superior value to the customer are the number one driver of success and product
profitability.[1]
Depending on the company size and history, product management has a variety of functions and
roles. Sometimes there is a product manager, and sometimes the role of product manager is
shared by other roles. Frequently there is Profit and Loss (P&L) responsibility as a key metric for
evaluating product manager performance. In some companies, the product management function
is the hub of many other activities around the product. In others, it is one of many things that
need to happen to bring a product to market and actively monitor and manage it in-market.
Product management often serves an inter-disciplinary role, bridging gaps within the company
between teams of different expertise, most notably between engineering-oriented teams and
commercially oriented teams. For example, product managers often translate business objectives
set for a product by Marketing or Sales into engineering requirements. Conversely they may
work to explain the capabilities and limitations of the finished product back to Marketing and
Sales. Product Managers may also have one or more direct reports who manage operational tasks
and/or a Change Manager who can oversee new initiatives.

Product Marketing

Product Life Cycle considerations

Product differentiation

Product naming and branding

Product positioning and outbound messaging

Promoting the product externally with press, customers and partners

Conducting customer feedback and enabling (pre-production, beta software)

Launching new products to market

Monitoring the competition

Product Development

Testing

Identifying new product candidates

Gathering the voice of customers

Defining product requirements

Determining business-case and feasibility

Scoping and defining new products at high level

Evangelizing new products within the company

Building product roadmaps, particularly technology roadmaps

Developing all products on schedule, working to a critical path

Ensuring products are within optimal price margins and up to specifications

Inbound and Outbound Product Management

Many refer to inbound (product development) and outbound (product marketing) functions.[2]
Inbound product management (aka inbound marketing) is the "radar" of the organization and
involves absorbing information like customer research, competitive intelligence, industry
analysis, trends, economic signals and competitive activity[3] as well as documenting
requirements and setting product strategy.[4]
In comparison, outbound activities are focused on distributing or pushing messages, training
sales people, go to market strategies and communicating messages through channels like
advertising, PR and events.[3][4]
In many organizations the inbound and outbound functions are performed by the same person.[5]

Definition of Law

The Law of Variable Proportions which is the new name of the famous Law of Diminishing
Returns.

According to Stigler "As equal increments of one input are added, the inputs of other

productive services being held constant, beyond a certain point, the resulting increments of
produce will decrease i.e., the marginal product will diminish".

According to Paul Samulson "An increase in some inputs relative to other fixed inputs
will in a given state of technology cause output to increase, but after a point, the extra
output resulting from the same addition of extra inputs will become less".
The law of variable proportions states that as the quantity of one factor is increased, keeping the
other factors fixed, the marginal product of that factor will eventually decline. This means that
upto the use of a certain amount of variable factor, marginal product of the factor may increase
and after a certain stage it starts diminishing. When the variable factor becomes relatively
abundant, the marginal product may become negative.
Assumptions of Law.
Constant technology--- This law assumes that technology does not change throughout the
operation of the law.
Fixed amount of some factors.One factor of production has to be fixed for this law.
Possibility of varying factor proportionsThis law assumes that variable factors can be
--changed in the short run.

KEY WORDS

1,Total Product It is the total of output, resulting from efforts of all factors of production.
TP= P*Q
2Average ProductIt is the total product per unit of the variable factor.

AP=TP/N
3.MarginalProductIt is addition made to the Total Product as a result of production of one
more unit of
output.

Diagramatic Representation

Following table explains the working of law.

Schedule:

Diagrammatic Representation of Law.

Working of Law

This law has THREE stages

1.Increasing Returns .
2. Diminishing Returns.
3. Negative Returns.
Increasing Returns:
In this stage, Average Product increases, Marginal Product increases and also Total Product. TP
increases at more proportionate rate . TP increases from 10 to 25 units. This stage is known as
increasing returns. This stage of increasing output by increasing labour does not last for a long
time. This continues upto 3rdunits. The point F onwards TP increases at a diminishing rate. In the
first stage, marginal product curve of a variable factor rises in a part and then falls. The average
product curve rises throughout and remains below the MP curve. MP reaches maximum in this
stage.
Diminishing Returns:
s This is the most important stage in the production function. In stage 2, the total production
continues to increase at a diminishing rate until it reaches its maximum point where the 2nd stage
ends. In this stage both the marginal product (MP) and average product of the variable factor are
diminishing but are positive. When TP reaches the maximum, MP is zero.MP intersects the X
axis in this stage.
As more and more variable factors are used on fixed factor, marginal and average product begins
to decrease. Factors of production are indivisible. Economically this is the most viable area of
production.

3.Negative Returns.
In the 3rd stage, the TP decreases. The TP, curve slopes downward (From point H onward). The
MP curve falls to zero at point L2 and then is negative. When we increases the labour even after
MP becomes zero, then MP becomes negative and it goes below the X axis.This is the most
unviable region. In our table from 8th unit onwards, this stage starts.
Any sensible producer will stop the production in the second stage where AP and MP begins to
decrease, but MP has not become negative.The producer will employ the variable factor (say
labor) up to the point where the marginal product of the labor equals to the wage rate.
Click here for video clip

ACtivity

1.Imagine you are studying to take an easy test. Lets assume that you can learn everything in
about 10 hours of study. The first 10 hours of studying will have a much greater impact on your
test score than your second 10 hours of studying. After a certain point, any extra studying will be
a waste of time because you already knows the material.
2. Imagine now that you are going to clean your messy bedroom. The first hour of cleaning will
make the most difference, the second hour should make less difference than the first hour, and
eventually, if you continue cleaning your room, your extra time spent cleaning wont make much
difference at all because your room will already be clean.

Recapitalisation

This law is based on short production function.

The gist of law is that if quantity of variable factors is increased keeping constant, other
factors, eventually AP and MP will decline.
This law is applicable in all industries, but more In agriculture.
Rationale producer prefers second stage where TP reaches maximum, MP become zero, not
negative. and AP decreases.
Third stage is unfeasible because MP is negative, so no meaning in paying additional wages
to labours.

Economies of scale
From Wikipedia, the free encyclopedia

As quantity of production increases from Q to Q2, the average cost of each unit decreases from C to C1.

In microeconomics, economies of scale are the cost advantages that enterprises obtain due to
size, output, or scale of operation, with cost per unit of output generally decreasing with
increasing scale as fixed costs are spread out over more units of output.

Often operational efficiency is also greater with increasing scale, leading to lower variable cost
as well.
Economies of scale apply to a variety of organizational and business situations and at various
levels, such as a business or manufacturing unit, plant or an entire enterprise. For example, a
large manufacturing facility would be expected to have a lower cost per unit of output than a
smaller facility, all other factors being equal, while a company with many facilities should have a
cost advantage over a competitor with fewer.
Some economies of scale, such as capital cost of manufacturing facilities and friction loss of
transportation and industrial equipment, have a physical or engineering basis.
The economic concept dates back to Adam Smithand the idea of obtaining larger production
returns through the use of division of labor.[1]Diseconomies of scale are the opposite.
Economies of scale often have limits, such as passing the optimum design point where costs per
additional unit begin to increase. Common limits include exceeding the nearby raw material
supply, such as wood in the lumber, pulp and paper industry. A common limit for low cost per
unit weight commodities is saturating the regional market, thus having to ship product
uneconomical distances. Other limits include using energy less efficiently or having a higher
defect rate.
Large producers are usually efficient at long runs of a product grade (a commodity) and find it
costly to switch grades frequently. They will therefore avoid specialty grades even though they
have higher margins. Often smaller (usually older) manufacturing facilities remain viable by
changing from commodity grade production to specialty products.[2][3]

Overview
The simple meaning of economies of scale is doing things more efficiently with increasing size
or speed of operation.[4] Economies of scale often originate with fixed capital, which is lowered
per unit of production as design capacity increases. In wholesale and retail distribution,
increasing the speed of operations, such as order fulfillment, lowers the cost of both fixed and

working capital. Other common sources of economies of scale are purchasing (bulk buying of
materials through long-term contracts), managerial (increasing the specialization of managers),
financial (obtaining lower-interest charges when borrowing from banks and having access to a
greater range of financial instruments), marketing (spreading the cost of advertising over a
greater range of output in media markets), and technological (taking advantage of returns to scale
in the production function). Each of these factors reduces the long run average costs (LRAC) of
production by shifting the short-run average total cost (SRATC) curve down and to the right.
Economies of scale is a practical concept that may explain real world phenomena such as
patterns of international trade or the number of firms in a market. The exploitation of economies
of scale helps explain why companies grow large in some industries. It is also a justification for
free trade policies, since some economies of scale may require a larger market than is possible
within a particular countryfor example, it would not be efficient for Liechtenstein to have its
own car maker, if they only sold to their local market. A lone car maker may be profitable, but
even more so if they exported cars to global markets in addition to selling to the local market.
Economies of scale also play a role in a "natural monopoly."
The management thinker and translator of the Toyota Production System for service, Professor
John Seddon, argues that attempting to create economies by increasing scale is powered by myth
in the service sector. Instead, he believes that economies will come from improving the flow of a
service, from first receipt of a customers demand to the eventual satisfaction of that demand. In
trying to manage and reduce unit costs, firms often raise total costs by creating failure demand.
Seddon claims that arguments for economy of scale are a mix of a) the plausibly obvious and b)
a little hard data, brought together to produce two broad assertions, for which there is little hard
factual evidence.[5]

Physical and engineering basis

Some of the economies of scale recognized in engineering have a physical basis, such as the
square-cube law, by which the surface of a vessel increases by the square of the dimensions
while the volume increases by the cube. This law has a direct effect on the capital cost of such
things as buildings, factories, pipelines, ships and airplanes.[6]

In structural engineering, the strength of beams increases with the cube of the thickness.
Drag loss of vehicles like aircraft or ships generally increases less than proportional with
increasing cargo volume, although the physical details can be quite complicated. Therefore,
making them larger usually results in less fuel consumption per ton of cargo at a given speed.
Heat losses from industrial processes vary per unit of volume for pipes, tanks and other vessels
in a relationship somewhat similar to the square-cube law.[7]
Capital and operating cost

Overall costs of capital projects are known to be subject to economies of scale. A crude estimate
is that if the capital cost for a given sized piece of equipment is known, changing the size will
change the capital cost by the 0.6 power of the capacity ratio (the point six power rule).[8][9]
In estimating capital cost, it typically requires an insignificant amount of labor, and possibly not
much more in materials, to install a larger capacity electrical wire or pipe having significantly
greater capacity.[10]
The cost of a unit of capacity of many types of equipment, such as electric motors, centrifugal
pumps, diesel and gasoline engines, decreases as size increases. Also, the efficiency increases
with size.[11]
Crew size and other operating costs for ships, trains and airplanes

Operating crew size for ships, airplanes, trains, etc., does not increase in direct proportion to
capacity.[12] (Operating crew consists of pilots, co-pilots, navigators, etc. and does not include
passenger service personnel.) Many aircraft models were significantly lengthened or "stretched"
to increase payload.[13]
Many manufacturing facilities, especially those making bulk materials like chemicals, refined
petroleum products, cement and paper, have labor requirements that are not greatly influenced by
changes in plant capacity. This is because labor requirements of automated processes tend to be
based on the complexity of the operation rather than production, and many manufacturing

facilities have nearly the same basic number of processing steps and pieces of equipment,
regardless of production.
Economical use of byproducts

Karl Marx noted that large scale manufacturing allowed economical use of products that would
otherwise be waste.[14] Marx cited the chemical industry as an example, which today along with
petrochemicals, remains highly dependent on turning various residual reactant streams into
salable products. In the pulp and paper industry it is economical to burn bark and fine wood
particles to produce process steam and to recover the spent pulping chemicals for conversion
back to usable form.

Economies of scale and returns to scale

Economies of scale is related to and can easily be confused with the theoretical economic notion
of returns to scale. Where economies of scale refer to a firm's costs, returns to scale describe the
relationship between inputs and outputs in a long-run (all inputs variable) production function. A
production function has constant returns to scale if increasing all inputs by some proportion
results in output increasing by that same proportion. Returns are decreasing if, say, doubling
inputs results in less than double the output, and increasing if more than double the output. If a
mathematical function is used to represent the production function, and if that production
function is homogeneous, returns to scale are represented by the degree of homogeneity of the
function. Homegeneous production functions with constant returns to scale are first degree
homogeneous, increasing returns to scale are represented by degrees of homogeneity greater than
one, and decreasing returns to scale by degrees of homogeneity less than one.
If the firm is a perfect competitor in all input markets, and thus the per-unit prices of all its inputs
are unaffected by how much of the inputs the firm purchases, then it can be shown that at a
particular level of output, the firm has economies of scale if and only if it has increasing returns
to scale, has diseconomies of scale if and only if it has decreasing returns to scale, and has
neither economies nor diseconomies of scale if it has constant returns to scale.[15][16][17] In this
case, with perfect competition in the output market the long-run equilibrium will involve all

firms operating at the minimum point of their long-run average cost curves (i.e., at the borderline
between economies and diseconomies of scale).
If, however, the firm is not a perfect competitor in the input markets, then the above conclusions
are modified. For example, if there are increasing returns to scale in some range of output levels,
but the firm is so big in one or more input markets that increasing its purchases of an input drives
up the input's per-unit cost, then the firm could have diseconomies of scale in that range of
output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have
economies of scale in some range of output levels even if it has decreasing returns in production
in that output range.
The literature assumed that due to the competitive nature of reverse auction, and in order to
compensate for lower prices and lower margins, suppliers seek higher volumes to maintain or
increase the total revenue. Buyers, in turn, benefit from the lower transaction costs and
economies of scale that result from larger volumes. In part as a result, numerous studies have
indicated that the procurement volume must be sufficiently high to provide sufficient profits to
attract enough suppliers, and provide buyers with enough savings to cover their additional
costs.[18]
However, surprisingly enough, Shalev and Asbjornsen found, in their research based on 139
reverse auctions conducted in the public sector by public sector buyers, that the higher auction
volume, or economies of scale, did not lead to better success of the auction. They found that
Auction volume did not correlate with competition, nor with the number of bidder, suggesting
that auction volume does not promote additional competition. They noted, however, that their
data included a wide range of products, and the degree of competition in each market varied
significantly, and offer that further research on this issue should be conducted to determine
whether these findings remain the same when purchasing the same product for both small and
high volumes. Keeping competitive factors constant, increasing auction volume may further
increase competition.[18]

Merit and demerits of production

The concept of a merit good introduced in economics by Richard Musgrave (1957, 1959) is a
commodity which is judged that an individual or society should have on the basis of some
concept of need, rather than ability and willingness to pay. The term is, perhaps, less often used
today than it was in the 1960s to 1980s but the concept still lies behind many economic actions
by governments which are not performed specifically for financial reasons or by supporting
incomes (e.g. via tax rebates). Examples include the provision of food stamps to support
nutrition, the delivery of health services to improve quality of life and reduce morbidity,
subsidized housing and arguably education.
In many cases, merit goods provide services which it is argued should apply universally to
everyone in a particular situation, a view that is close to the concept of primary goods found in
work by philosopher John Rawls or discussions about social inclusion. On the 'supply' side, it is
sometimes suggested that there will be more support in society for implicit redistribution via the
provision of certain kinds of goods and services, rather than explicit redistribution through
income.[1] Alternatively, it is sometimes suggested that society in general may be in a better
position to determine what individuals need (such arguments are often criticised for being
paternalistic, often by those who would like to reduce to a minimum economic activity by
government).
Sometimes, merit and demerit goods are simply seen as an extension of the idea of externalities.
A merit good may be described as a good that has positive externalities associated with it. Thus,
an inoculation against a contagious disease may be seen as a merit good. This is because others
who may not now catch the disease from the inoculated person also benefit.
However, merit and demerit goods can be defined in a different way which makes it different
from externalities. The essence of merit and demerit goods is to do with an information failure to
the consumer. This arises because consumers do not perceive quite how good or bad the good is
for them: either they do not have the right information or lack relevant information. With this
definition, a merit good is defined as good that is better for a person than the person who may
consume the good realises.[2]

Other possible rationales for treating some commodities as merit (or demerit) goods include
public-goods aspects of a commodity, imposing community standards (prostitution, drugs, etc.),
immaturity or incapacity, and addiction. A common element of all of these is recommending for
or against some goods on a basis other than consumer choice.[3] However, there is no reason why
governments should not consult their populations on such issues as they increasingly do in a
number of economic contexts (e.g., development planning by the World Bank or resource
allocation in health systems using information on health-benefits).
In the case of education, it can be argued that those lacking education are incapable of making an
informed choice about the benefits of education, which would warrant compulsion (Musgrave,
1959, 14). In this case, the implementation of consumer sovereignty is the motivation, rather than
rejection of consumer sovereignty.[3]
Public Choice Theory suggests that good government policies are an under-supplied merit good
in a democracy.
A merit good can be defined as a good which would be under-consumed (and under-produced) in
the free market economy. This is due to two main reasons:
1. When consumed, a merit good creates positive externalities (an externality being a third
party/spill-over effect which arises from the consumption or production of the
good/service). This means that there is a divergence between private benefit and public
benefit when a merit good is consumed (i.e. the public benefit is greater than the private
benefit). However, as consumers only take into account private benefits when consuming
merit goods, it means that they are under-consumed (and so under-produced).
2. Individuals are myopic, they are short-term utility maximisers and so do not take into
account the long term benefits of consuming a merit good and so they are underconsumed.

FUNCTION OF ENTREPRENUER
An entrepreneur performs a series of functions necessary right from the genesis of an idea up to
the establishment and effective operation of an enterprise. He carries out the whole set of
activities of the business for its success. He recognises the commercial potential of a product or a
service, formulates operating policies for production, product design, marketing and
organisational structure. He is thus a nucleus of high growth of the enterprise.
According some economists, the functions of an entrepreneur is classified into five broad
categories:
1. Risk-bearing function,
2. Organisational function,
3. Innovative function,
4. Managerial function, and
5. Decision making function.
1. Risk-bearing function:
The functions of an entrepreneur as risk bearer is specific in nature. The entrepreneur assumes all
possible risks of business which emerges due to the possibility of changes in the tastes of
consumers, modern techniques of production and new inventions. Such risks are not insurable
and incalculable. In simple terms such risks are known as uncertainty concerning a loss.
The entrepreneur, according to Kinght, "is the economic functionary who undertakes such
responsibility of uncertainty which by its very nature cannot be insured nor capitalised nor
salaried too."
Richard Cantillon conceived of an entrepreneur as a bearer of non-insurable risk because he
described an entrepreneur as a person who buys things at a certain price and sells them at an
uncertain price.

Thus, risk bearing or uncertainty bearing still remains the most important function of an
entrepreneur which he tries to minimise by his initiative, skill and good judgement. J.B. Say and
other have stressed risk taking as the specific function of the entrepreneur.
2. Organisational Function:
Entrepreneur as an organiser and his organising function is described by J.B. Say as a function
whereby the entrepreneur brings together various factors of production, ensures continuing
management and renders risk-bearing functions as well. His definition associates entrepreneur
with the functions of coordination, organisation and supervision. According to him, an
entrepreneur is one who combines the land of one, the labour of another and the capital of yet
another and thus produces a product. By selling the product in the market, he pays interest on
capital, rent on land and wages to labourers and what remains is his/her profit. In this way, he
describes an entrepreneur as an organiser who alone determines the lines of business to expand
and capital to employ more judiciously. He is the ultimate judge in the conduct of the business.
Marshall also advocated the significance of organisation among the services of special class of
business undertakers.
3. Innovative Function:
The basic function an entrepreneur performs is to innovate new products, services, ideas and
informations for the enterprise. As an innovator, the entrepreneur foresees the potentially
profitable opportunity and tries to exploit it. He is always involved in the process of doing new
things. According to Peter Drucker, "Innovation is the means by which the entrepreneur either
creates new wealth producing resources or endows existing resources with enhanced potential for
creating wealth". Whenever a new idea occurs entrepreneurial efforts are essential to convert the
idea into practical application.
J.A. Schumpeter considered economic development as a descrete dynamic change brought by
entrepreneurs by instituting new combinations of production, i.e. innovation. According to him
innovation may occur in any one of the following five forms.

The introduction of a new product in the market with which the customers are not get familiar
with.
Introduction of a new method of production technology which is not yet tested by experience in
the branch of manufacture concerned.
The opening of a new market into which the specific product has not previously entered.
The discovery of a new source of supply of raw material, irrespective of whether this source
already exists or has first to be created.
The carrying out of the new form of oranisation of any industry by creating of a monopoly
position or the breaking up of it.
4. Managerial Function:
Entrepreneur also performs a variety of managerial function like determination of business
objectives, formulation of production plans, product analysis and market research, organisation
of sales procurring machine and material, recruitment of men and undertaking, of business
operations. He also undertakes the basic managerial functions of planning, organising, coordinating, staffing, directing, motivating and controlling in the enterprise. He provides a logical
and scientific basis to the above functions for the smooth operation of the enterprise thereby
avoids chaos in the field of production, marketing, purchasing, recruiting and selection, etc. In
large establishments, these managerial functions of the entrepreneur are delegated to the paid
managers for more effective and efficient execution.
5. Decision Making Function:
The most vital function an entrepreneur discharges refers to decision making in various fields of
the business enterprise. He is the decision maker of all activities of the enterprise. A. H. Cole
described an entrepreneur as a decision maker and attributed the following functions to him.
He determines the business objectives suitable for the enterprise.

He develops an organization and creates an atmosphere for maintaining a cordial relationship

with subordinates and all employees of the organization.
He decides in securing adequate financial resources for the organisation and maintains good
relations with the existing and potential investors and financiers.
He decides in introducing advanced modern technology in the enterprise to cope up with
changing scenario of manufacturing process.
He decides the development of a market for his product, develops new product or modify the
existing product in accordance with the changing consumer's fashion, taste and preference.
He also decides to maintain good relations with the public authorities as well as with the society
at large for improving the firms image before others.

Long run and short run

"Long run" redirects here. For other uses, see Longrun (disambiguation).
In microeconomics, the long run is the conceptual time period in which there are no fixed
factors of production as to changing the output level by changing the capital stock or by entering
or leaving an industry. The long run contrasts with the short run, in which some factors are
variable and others are fixed, constraining entry or exit from an industry. In macroeconomics, the
long run is the period when the general price level, contractual wage rates, and expectations
adjust fully to the state of the economy, in contrast to the short run when these variables may not
fully adjust.[1]

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

enter an industry in response to (expected) profits

leave an industry in response to losses

increase its plant in response to profits

decrease its plant in response to losses.

The long run is associated with the long-run average cost (LRAC) curve in microeconomic
models along which a firm would minimize its average cost (cost per unit) for each respective
long-run quantity of output. Long-run marginal cost (LRMC) is the added cost of providing an
additional unit of service or commodity from changing capacity level to reach the lowest cost
associated with that extra output. LRMC equalling price is efficient as to resource allocation in
the long run. The concept of long-run cost is also used in determining whether the long-run
expected to induce the firm to remain in the industry or shut down production there. In long-run
equilibrium of an industry in which perfect competition prevails, the LRMC = Long run average
LRAC at the minimum LRAC and associated output. The shape of the long-run marginal and
average costs curves is determined by economies of scale.
The long run is a planning and implementation stage.[2][3] Here a firm may decide that it needs to
produce on a larger scale by building a new plant or adding a production line. The firm may
decide that new technology should be incorporated into its production process. The firm thus
considers all its long-run production options and selects the optimal combination of inputs and
technology for its long-run purposes.[4] The optimal combination of inputs is the least-cost
combination of inputs for desired level of output when all inputs are variable. [3] Once the
decisions are made and implemented and production begins, the firm is operating in the short run
with fixed and variable inputs.[3][5]

Short run
All production in real time occurs in the short run. The short run is the conceptual time period
in which at least one factor of production is fixed in amount and others are variable in amount.
Costs that are fixed, say from existing plant size, have no impact on a firm's short-run decisions,
since only variable costs and revenues affect short-run profits. Such fixed costs raise the
associated short-run average cost of an output long-run average cost if the amount of the fixed

factor is better suited for a different output level. In the short run, a firm can raise output by
increasing the amount of the variable factor(s), say labor through overtime.
A generic firm already producing in an industry can make three changes in the short run as
response to reach a posited equilibrium:

increase production

decrease production

shut down.

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

increase production if marginal cost is less than marginal revenue (added revenue per
additional unit of output);

decrease production if marginal cost is greater than marginal revenue;

continue producing if average variable cost is less than price per unit, even if average
total cost is greater than price;

shut down if average variable cost is greater than price at each level of output.

Transition from short run to long run

The transition from the short run to the long run may be done by considering some short-run
equilibrium that is also a long-run equilibrium as to supply and demand, then comparing that
state against a new short-run and long-run equilibrium state from a change that disturbs
equilibrium, say in the sales-tax rate, tracing out the short-run adjustment first, then the long-run
adjustment. Each is an example of comparative statics. Alfred Marshall (1890) pioneered in
comparative-static period analysis.[6] He distinguished between the temporary or market period
(with output fixed), the short period, and the long period. "Classic" contemporary graphical and
formal treatments include those of Jacob Viner (1931),[7]John Hicks (1939),[8] and Paul
Samuelson (1947).[9]
[10]

The law is related to a positive slope of the short-run marginal-cost curve.[11]

Macroeconomic usages
The usage of 'long run' and 'short run' in macroeconomics differs somewhat from the above
microeconomic usage. [John Maynard Keynes] (1936) emphasized fundamental factors of a
market economy that might result in prolonged periods away from full-employment.[12] In later
macro usage, the long run is the period in which the price level for the economy is completely
flexible as to shifts in aggregate demand and aggregate supply. In addition there is full mobility
of labor and capital between sectors of the economy and full capital mobility between nations. In
the short run none of these conditions need fully hold. The price is sticky or fixed as to changes
in aggregate demand or supply, capital is not fully mobile between sectors, and capital is not
fully mobile due to interest rate differences among countries & fixed exchange rates.[13]
A famous critique of neglecting short-run analysis was by John Maynard Keynes, who
wrote that "In the long run, we are all dead," referring to the long-run proposition of the
quantity theory of, for example, a doubling of the

Relation between Average Revenue and Marginal Revenue Curves under

Different Market Conditions

The relation between average revenue and marginal revenue can be discussed under
pure competition, monopoly or monopolistic competition or imperfect competition.
(1) Under Pure Competition:
The average revenue curve is a horizontal straight line parallel to the A-axis and the
marginal revenue curve coincides with it. This is because under pure (or perfect)
competition the number of firms selling an identical product is very large.
The price is determined by the market forces of supply and demand so that only one
price tends to prevail for the whole industry, as shown in Table 1.

It is OP as shown in panel (A) of Figure 1. Each firm can sell as much as it wishes at the
market price OP. Thus the demand for the firms product becomes infinitely elastic.
Since the demand curve is the firms average revenue curve, the shape of the AR curve is
horizontal to the -axis at price OP, as shown in panel (B) and the MR curve coincides
with it. This is also shown in Table 1 where AR and MR remain constant at Rs 20 at
every level of output. Any change in the demand and supply conditions will change the
market price of the product, and consequently the horizontal AR curve of the firm.

(2) Under Monopoly or Imperfect Competition:

The average revenue curve is the downward sloping industry demand curve and its
corresponding marginal revenue curve lies below it. The relation between the average
revenue and the marginal revenue under monopoly can be understood with the help of
Table 2. The marginal revenue is lower than the average revenue.

Given the demand for his product, the monopolist can increase his sales by lowering the
price, the marginal revenue also falls but the rate of fall in marginal revenue is greater
than that in average revenue. In Table 2, AR falls by Rs. 2 at a time whereas MR falls by
Rs. 4. This is shown in Figure 2, in which the MR curve is below the AR curve and lies
half way on the perpendicular drawn from AR to the T-axis. This relation will always
exist between straight line downward sloping AR and MR curves.

In order to prove it, draw perpendiculars CA and CM to the -axis and X-axis
respectively from point on the AR curve. CA cuts MR at and CM at D. We have to
prove that AB = BC. In Figure 2, the rectangle ACMO is the total revenue of OM output
at CM price and the area PDMO also represents total revenue in terms of aggregate
marginal revenue (

MR) at OM output.

ACMO = PDMOa
or ABDMO + BCD = ABDMO +
or BCD = PAB
But <PAB = <BCD, being right <s.

PAB

And <PBA = <CBD, being vertically opposite <s.

Thus BCD = PAB
Hence AB = BC.
Thus the MR curve will lie half way on the perpendicular drawn from the AR curve.
In case the AR curve is convex to the origin as in Figure 3 (A), the MR curve will cut any
perpendicular from a point on the AR curve at more than half-way to the T-axis. MR
passes to the left of the mid-point on CA.
On the other hand, if the AR curve is concave to the origin, MR will cut the
perpendicular at less than half-way towards the -axis. In Figure 3 (B) MR passes to the
right of the mid-point on the CA.

AR, MR and Elasticity:

However, the true relationship between the AR curve and its corresponding MR curve
under monopoly or imperfect competition depends upon the elasticity of the AR curve.
We know that elasticity at point in Figure 4 is

E = CM/PA = CM/CD ( PA = CD being the sides of similar

s.)

E = CM/CM-DM AR/AR-MR (where CM is AR and DM is MR).

E = A/A-M (where E is elasticity, A average revenue and M marginal revenue.)
By solving, we have, EA- EM =A
EA-A = EM
A (E-1) = EM
A = EM/E-1
A = ME /E-1
Similarly, marginal revenue can also be known, E = A/A-M

By solving E (A M) = A
EA-EM = A
EA-A = EM
or EM = EA A
EA-A/E
M= A (E-l)/E
M = A E-1/E

On the basis of this formula the relationship between AR and MR is explained in terms
of the Figure 5 (A). At point on the average revenue curve, PA, the elasticity of demand
is equal to 1. According to the formula,
R = AR1-1/1= AR- = 0/1= 0
The MR curve is zero when it touches the X-axis at point F. Thus, where elasticity of AR
curve is unity, MR is always zero.
In case the elasticity of the AR curve is unity throughout its length like a rectangular
hyperbola, the MR curve will coincide with the X-axis, shown as a dotted line in Figure 5
(B).

If the elasticity of the AR curve at point D is greater than unity, say3, MR =AR 3-1/3
=2/3
It shows that when the elasticity of AR is greater than one, MR is always positive. It is
EH in Figure 5 (A).
Where the elasticity of the AR curve is less than unity, say , MR = AR -1 = -/
= -1. It shows MR to be negative. At point on the AR curve, elasticity is less than unity
and MR is negative KG.
If the elasticity of AR is infinity (E =), MR coincides with it at point P in Figure 5 (A).
Lastly, when the elasticity of the AR curve is zero, the gap between AR and MR curves
becomes wider and MR lies much below the X-axis.
(3) Under Monopolistic Competition:
This relationship between AR and MR curves holds under monopolistic competition
with one exception that the AR curve is somewhat more elastic than under monopoly.
This is shown in Figure 6. That is why, goods are close substitutes under it. The firm can
increase its sales by reducing the price a little.

4. Under Oligopoly:
The average and marginal revenue curves do not have a smooth downward slope. They
possess kinks. Since the number of sellers under oligopoly is small, the effect of a price
cut or price increase on the part of one seller will be followed by some changes in the
behaviour of other firms. If a seller raises the price of his product, the other sellers will
not follow him in order to earn large profits at the old price.
So the price-raising seller will experience a fall in the demand for his product. His
average revenue curve in Figure 7(A) becomes elastic after and its corresponding MR
curve rises discontinuously from a to b and then continues its course at the new higher
level.

On the other hand, if the oligopolistic seller reduces the price of his product, his rivals
also follow him in reducing the prices of their products so that he is not able to increase
his sales. His AR curve becomes less elastic from onwards as in Figure 7(B). The
corresponding MR curve falls vertically from a to b and then slopes at a lower level.

Perfect competition
In economic
theory, perfect
competition (sometimes
called pure
competition) describes markets such that no participants are large enough to
have the market power to set the price of a homogeneous product. Because the
conditions for perfect competition are strict, there are few if any perfectly
competitive markets. Still, buyers and sellers in some auction-type markets, say
for commodities or some financial assets, may approximate the concept. As
a Pareto efficient allocation of economic resources, perfect competition serves as
a natural benchmark against which to contrast other market structures.
Basic structural characteristics[edit]
Generally, a perfectly competitive market exists when every participant is a "price
taker", and no participant influences the price of the product it buys or sells. Specific
characteristics may include:

A large number buyers and sellers A large number of consumers with the
willingness and ability to buy the product at a certain price, and a large
number of producers with the willingness and ability to supply the product at a
certain price.
No barriers of entry and exit No entry and exit barriers makes it extremely
easy to enter or exit a perfectly competitive market.
Perfect factor mobility In the long run factors of productionare perfectly
mobile, allowing free long term adjustments to changing market conditions.
Perfect information - All consumers and producers are assumed to have
perfect knowledge of price, utility, quality and production methods of
products.
Zero transaction costs - Buyers and sellers do not incur costs in making an
exchange of goods in a perfectly competitive market.
Profit maximization - Firms are assumed to sell where marginal costs meet
marginal revenue, where the most profit is generated.
Homogenous products - The qualities and characteristics of a market good
or service do not vary between different suppliers.
Non-increasing returns to scale - The lack of increasing returns to scale (or
economies of scale) ensures that there will always be a sufficient number of
firms in the industry.
Property rights - Well defined property rights determine what may be sold,
as well as what rights are conferred on the buyer.
Rational buyers - buyers capable of making rational purchases based on
information given
No externalities - costs or benefits of an activity do not affect third parties

In the short run, perfectly-competitive markets are not productively efficient as

output will not occur where marginal cost is equal to average cost (MC=AC). They
are allocatively efficient, as output will always occur wheremarginal cost is equal

to marginal revenue (MC=MR). In the long run, perfectly competitive markets are
both allocatively and productively efficient.
In perfect competition, any profit-maximizing producer faces a market price equal to
its marginal cost (P=MC). This implies that a factor's price equals the factor's
marginal revenue product. It allows for derivation of the supply curve on which the
neoclassical approach is based. This is also the reason why "a monopoly does not
have a supply curve". The abandonment of price taking creates considerable
difficulties for the demonstration of a general equilibrium except under other, very
specific conditions such as that of monopolistic competition.
Approaches and conditions[edit]
In neoclassical economics there have been two strands of looking at what perfect
competition is. The first emphasis is on the inability of any one agent to affect prices.
Usually justified by the fact that any one firm or consumer is so small relative to the
whole market that their presence or absence leaves the equilibrium price very nearly
unaffected. This assumption of negligible impact of each agent on the equilibrium
price has been formalized by Aumann (1964) by postulating a continuum of
infinitesimal agents. The difference between Aumann's approach and that found in
undergraduate textbooks is that in the first, agents have the power to choose their
own prices but do not individually affect the market price, while in the second it is
simply assumed that agents treat prices as parameters. Both approaches lead to the
same result.
The second view of perfect competition conceives of it in terms of agents taking
advantage of and hence, eliminating profitable exchange opportunities. The
faster this arbitrage takes place, the more competitive a market. The implication is
that the more competitive a market is under this definition, the faster the average
market price will adjust so as to equate supply and demand (and also equate price
to marginal costs). In this view, "perfect" competition means that this adjustment
takes place instantaneously. This is usually modeled via the use of the Walrasian
auctioneer (see article for more information). The widespread recourse to the
auctioneer tale appears to have favored an interpretation of perfect competition as
meaning price taking always, i.e. also at non-equilibrium prices; but this is rejected
e.g. by Arrow (1959) or Mas-Colell et al.[1]
Steve Keen notes,[2] following George Stigler, that if firms do not react strategically
to one another, the slope of the demand curve that a firm faces is the same as the
slope of the market demand curve. Hence, if firms are to produce at a level that
equates marginal cost and marginal revenue, the model of perfect competition must
include at least an infinite number of firms, each producing an output quantity of
zero. As noted above, an influential model[3] of perfect competition in neoclassical
economics assumes that the number of buyers and sellers are both of the power of
the continuum, that is, an infinity even larger than the number of natural numbers. K.
Vela Velupillai[4] quotes Maury Osborne as noting the inapplicability of such models
to actual economies since money and the commodities sold each have a smallest
positive unit.

Thus nowadays the dominant intuitive idea of the conditions justifying price taking
and thus rendering a market perfectly competitive is an amalgam of several different
notions, not all present, nor given equal weight, in all treatments. Besides product
homogeneity and absence of collusion, the notion more generally associated with
perfect competition is the negligibility of the size of agents, which makes them
believe that they can sell as much of the good as they wish at the equilibrium price
but nothing at a higher price (in particular, firms are described as each one of them
facing a horizontal demand curve). However, also widely accepted as part of the
notion of perfectly competitive market are perfect information about price distribution
and very quick adjustments (whose joint operation establish the law of one price), to
the point sometimes of identifying perfect competition with an essentially
instantaneous reaching of equilibrium between supply and demand. Finally, the idea
of free entry with free access to technology is also often listed as a characteristic of
perfectly competitive markets, probably owing to a difficulty with abandoning
completely the older conception of free competition. In recent decades it has been
rediscovered that free entry can be a foundation of absence of market power,
alternative to negligibility of agents.[5]
Free entry also makes it easier to justify the absence of collusion: any collusion by
existing firms can be undermined by entry of new firms. The necessarily long-period
nature of the analysis (entry requires time!) also allows a reconciliation of the
horizontal demand curve facing each firm according to the theory, with the feeling of
businessmen that "contrary to economic theory, sales are by no means unlimited at
the current market price" (Arrow 1959 p. 49). Sraffian economists[6] see the
assumption of free entry and exit as characteristic of the theory of free competition
in Classical economics, an approach that is not expressed in terms of schedules of
supply and demand.
Results[edit]

In the short run, it is possible for an individual firm to make an economic profit. This
situation is shown in this diagram, as the price or average revenue, denoted by P, is
above the average cost denoted byC .

However, in the long run, economic profit cannot be sustained. The arrival of new
firms or expansion of existing firms (if returns to scale are constant) in the market
causes the (horizontal) demand curve of each individual firm to shift downward,
bringing down at the same time the price, the average revenue and marginal
revenue curve. The final outcome is that, in the long run, the firm will make only
normal profit (zero economic profit). Its horizontal demand curve will touch its
average total cost curve at its lowest point. (See cost curve.)
In a perfectly competitive market, a firm's demand curve is perfectly elastic.
As mentioned above, the perfect competition model, if interpreted as applying also
to short-period or very-short-period behaviour, is approximated only by markets of
homogeneous products produced and purchased by very many sellers and buyers,
usually organized markets for agricultural products or raw materials. In real-world
markets, assumptions such as perfect information cannot be verified and are only
approximated in organized double-auction markets where most agents wait and
observe the behaviour of prices before deciding to exchange (but in the long-period
interpretation perfect information is not necessary, the analysis only aims at
determining the average around which market prices gravitate, and for gravitation to
operate one does not need perfect information).
In the absence of externalities and public goods, perfectly competitive equilibria are
Pareto-efficient, i.e. no improvement in the utility of a consumer is possible without a
worsening of the utility of some other consumer. This is called the First Theorem of
Welfare Economics. The basic reason is that no productive factor with a non-zero
marginal product is left unutilized, and the units of each factor are so allocated as to
yield the same indirect marginal utility in all uses, a basic efficiency condition (if this
indirect marginal utility were higher in one use than in other ones, a Pareto
improvement could be achieved by transferring a small amount of the factor to the
use where it yields a higher marginal utility).
A simple proof assuming differentiable utility functions and production functions is
the following. Let wj be the 'price' (the rental) of a certain factor j, let MP j1 and

MPj2 be its marginal product in the production of goods 1 and 2, and let p 1 and p2be
these goods' prices. In equilibrium these prices must equal the respective marginal
costs MC1 and MC2; remember that marginal cost equals factor 'price' divided by
factor marginal productivity (because increasing the production of good by one very
small unit through an increase of the employment of factor j requires increasing the
factor employment by 1/MPji and thus increasing the cost by wj/MPji, and through the
condition of cost minimization that marginal products must be proportional to factor
'prices' it can be shown that the cost increase is the same if the output increase is
obtained by optimally varying all factors). Optimal factor employment by a pricetaking firm requires equality of factor rental and factor marginal revenue product,
wj=piMPji, so we obtain p1=MC1=wj/MPj1, p2=MCj2=wj/MPj2.
Now choose any consumer purchasing both goods, and measure his utility in such
units that in equilibrium his marginal utility of money (the increase in utility due to the
last unit of money spent on each good), MU1/p1=MU2/p2, is 1. Then p1=MU1,
p2=MU2. The indirect marginal utility of the factor is the increase in the utility of our
consumer achieved by an increase in the employment of the factor by one (very
small) unit; this increase in utility through allocating the small increase in factor
utilization to good 1 is MPj1MU1=MPj1p1=wj, and through allocating it to good 2 it is
MPj2MU2=MPj2p2=wj again. With our choice of units the marginal utility of the amount
of the factor consumed directly by the optimizing consumer is again w, so the
amount supplied of the factor too satisfies the condition of optimal allocation.
Monopoly violates this optimal allocation condition, because in a monopolized
industry market price is above marginal cost, and this means that factors are
underutilized in the monopolized industry, they have a higher indirect marginal utility
than in their uses in competitive industries. Of course this theorem is considered
irrelevant by economists who do not believe that general equilibrium theory correctly
predicts the functioning of market economies; but it is given great importance by
neoclassical economists and it is the theoretical reason given by them for combating
monopolies and for antitrust legislation.
Profit[edit]
In contrast to a monopoly or oligopoly, it is impossible for a firm in perfect
competition to earn economic profit in the long run, which is to say that a firm cannot
make any more money than is necessary to cover its economic costs. In order not to
misinterpret this zero-long-run-profits thesis, it must be remembered that the term
'profit' is also used in other ways. Neoclassical theory defines profit as what is left of
revenue after all costs have been subtracted, including normal interest on capital
plus the normal excess over it required to cover risk, and normal salary for
managerial activity. Classical economists on the contrary defined profit as what is
left after subtracting costs except interest and risk coverage; thus, if one leaves
aside risk coverage for simplicity, the neoclassical zero-long-run-profit thesis would
be re-expressed in classical parlance as profits coinciding with interest in the long
period, i.e. the rate of profit tending to coincide with the rate of interest. Profits in the
classical meaning do not tend to disappear in the long period but tend to normal
profit. With this terminology, if a firm is earning abnormal profit in the short term, this
will act as a trigger for other firms to enter the market. As other firms enter the

market the market supply curve will shift out causing prices to fall. Existing firms will
react to this lower price by adjusting their capital stock downward. [7] This adjustment
will cause their marginal cost to shift to the left causing the market supply curve to
shift inward.[7] However, the net effect of entry by new firms and adjustment by
existing firms will be to shift the supply curve outward.[7] The market price will be
driven down until all firms are earning normal profit only.[8]
It is important to note that perfect competition is a sufficient condition for allocative
and productive efficiency, but it is not a necessary condition. Laboratory
experiments in which participants have significant price setting power and little or no
information about their counterparts consistently produce efficient results given the
proper trading institutions.[9]
The shutdown point[edit]
In the short run, a firm operating at a loss [R < TC (revenue less than total cost) or P
< ATC (price less than unit cost)] must decide whether to continue to operate or
temporarily shutdown.[10] The shutdown rule states "in the short run a firm should
continue to operate if price exceeds average variable costs."[11] Restated, the rule is
that for a firm to continue producing in the short run it must earn sufficient revenue
to cover its variable costs.[12] The rationale for the rule is straightforward. By shutting
down a firm avoids all variable costs.[13] However, the firm must still pay fixed
costs.[14] Because fixed cost must be paid regardless of whether a firm operates
they should not be considered in deciding whether to produce or shutdown. Thus in
determining whether to shut down a firm should compare total revenue to total
variable costs (VC) rather than total costs (FC + VC). If the revenue the firm is
receiving is greater than its total variable cost (R > VC) then the firm is covering all
variable cost plus there is additional revenue ("contribution"), which can be applied
to fixed costs. (The size of the fixed costs is irrelevant as it is a sunk cost. The same
consideration is used whether fixed costs are one dollar or one million dollars.) On
the other hand if VC > R then the firm is not even covering its production costs and it
should immediately shut down. The rule is conventionally stated in terms of price
(average revenue) and average variable costs. The rules are equivalent (If you
divide both sides of inequality TR > TVC by Q gives P > AVC). If the firm decides to
operate, the firm will continue to produce where marginal revenue equals marginal
costs because these conditions insure not only profit maximization (loss
minimization) but also maximum contribution.
Another way to state the rule is that a firm should compare the profits from operating
to those realized if it shutdown and select the option that produces the greater
profit.[15][16] A firm that is shutdown is generating zero revenue and incurring no
variable costs. However, the firm still has to pay fixed cost. So the firm's profit
equals fixed costs or FC.[17] An operating firm is generating revenue, incurring
variable costs and paying fixed costs. The operating firm's profit is R VC FC.
The firm should continue to operate if R VC FC FC, which simplified is R
VC.[18][19] The difference between revenue, R, and variable costs, VC, is the
contribution to fixed costs and any contribution is better than none. Thus, if R VC
then firm should operate. If R < VC the firm should shut down.

A decision to shut down means that the firm is temporarily suspending production. It
does not mean that the firm is going out of business (exiting the industry). [20] If
market conditions improve, and prices increase, the firm can resume production.
Shutting down is a short-run decision. A firm that has shut down is not producing.
The firm still retains its capital assets; however, the firm cannot leave the industry or
avoid its fixed costs in the short run. Exit is a long-term decision. A firm that has
exited an industry has avoided all commitments and freed all capital for use in more
profitable enterprises.[21]
However, a firm cannot continue to incur losses indefinitely. In the long run, the firm
will have to earn sufficient revenue to cover all its expenses and must decide
whether to continue in business or to leave the industry and pursue profits
elsewhere. The long-run decision is based on the relationship of the price and longrun average costs. If P AC then the firm will not exit the industry. If P < AC, then
the firm will exit the industry. These comparisons will be made after the firm has
made the necessary and feasible long-term adjustments. In the long run a firm
operates where marginal revenue equals long-run marginal costs.[22]
Short-run supply curve[edit]
The short run supply curve for a perfectly competitive firm is the marginal cost (MC)
curve at and above the shutdown point. Portions of the marginal cost curve below
the shut down point are not part of the SR supply curve because the firm is not
producing in that range. Technically the SR supply curve is a discontinuous function
composed of the segment of the MC curve at and above minimum of the average
variable cost curve and a segment that runs with the vertical axis from the origin to
but not including a point "parallel" to minimum average variable costs. [23]
Monopoly

A monopoly is distinguished from a monopsony, in which there is only onebuyer of a

product or service; a monopoly may also have monopsony control of a sector of a
market. Likewise, a monopoly should be distinguished from a cartel (a form
of oligopoly), in which several providers act together to coordinate services, prices or
sale of goods. Monopolies, monopsonies and oligopolies are all situations such that one
or a few of the entities have market power and therefore interact with their customers
(monopoly), suppliers (monopsony) and the other companies (oligopoly) in ways that
leave market interactions distorted.[citation needed]
Monopolies can be established by a government, form naturally, or form by integration.
In many jurisdictions, competition laws restrict monopolies. Holding a dominant position
or a monopoly of a market is often not illegal in itself, however certain categories of
behavior can be considered abusive and therefore incur legal sanctions when business
is dominant. A government-granted monopoly or legal monopoly, by contrast, is
sanctioned by the state, often to provide an incentive to invest in a risky venture or
enrich a domestic interest group. Patents, copyright, and trademarks are sometimes

used as examples of government granted monopolies. The government may also

reserve the venture for itself, thus forming a government monopoly.
Market structures[edit]
In economics, the idea of monopoly will be important for the study of management
structures, which directly concerns normative aspects of economic competition, and
provides the basis for topics such as industrial organization and economics of
regulation. There are four basic types of market structures by traditional economic
analysis: perfect competition, monopolistic competition, oligopoly and monopoly. A
monopoly is a structure in which a single supplier produces and sells a given product. If
there is a single seller in a certain industry and there are not any close substitutes for
the product, then the market structure is that of a "pure monopoly". Sometimes, there
are many sellers in an industry and/or there exist many close substitutes for the goods
being produced, but nevertheless companies retain some market power. This is
termed monopolistic competition, whereas by oligopoly the companies interact
strategically.[citation needed]
In general, the main results from this theory compare price-fixing methods across
market structures, analyze the effect of a certain structure on welfare, and vary
technological/demand assumptions in order to assess the consequences for an abstract
model of society. Most economic textbooks follow the practice of carefully explaining
the perfect competition model, only because of its usefulness to The boundaries of what
constitutes a market and what doesn't are relevant distinctions to make in economic
analysis. In a general equilibrium context, a good is a specific concept entangling
geographical and time-related characteristics (grapes sold during October 2009 in
Moscow is a different good from grapes sold during October 2009 in New York). Most
studies of market structure relax a little their definition of a good, allowing for more
flexibility at the identification of substitute-goods. Therefore, one can find an economic
analysis of the market of grapes in Russia, for example, which is not a market in the
strict sense of general equilibrium theory monopoly. [citation needed] understand "departures"
from it (the so-called imperfect competition models).[citation needed]

Characteristics[edit]

Profit Maximizer: Maximizes profits.

Price Maker: Decides the price of the good or product to be sold, but does so by
determining the quantity in order to demand the price desired by the firm.
High Barriers to Entry: Other sellers are unable to enter the market of the monopoly.
Single seller: In a monopoly, there is one seller of the good that produces all the
output.[5] Therefore, the whole market is being served by a single company, and for
practical purposes, the company is the same as the industry.
Price Discrimination: A monopolist can change the price and quality of the product.
He or She sells more quantities charging less price for the product in a very elastic
market and sells less quantities charging high price in a less elastic market.

Sources of monopoly power[edit]

Monopolies derive their market power from barriers to entry circumstances that
prevent or greatly impede a potential competitor's ability to compete in a market. There
are three major types of barriers to entry: economic, legal and deliberate.[6]

Economic barriers: Economic barriers include economies of scale, capital

requirements, cost advantages and technological superiority. [7]
Economies of scale: Monopolies are characterised by decreasing costs for a
relatively large range of production.[8] Decreasing costs coupled with large initial
costs give monopolies an advantage over would-be competitors. Monopolies are
often in a position to reduce prices below a new entrant's operating costs and
thereby prevent them from continuing to compete.[8] Furthermore, the size of the
industry relative to the minimum efficient scale may limit the number of
companies that can effectively compete within the industry. If for example the
industry is large enough to support one company of minimum efficient scale then
other companies entering the industry will operate at a size that is less than
MES, meaning that these companies cannot produce at an average cost that is
competitive with the dominant company. Finally, if long-term average cost is
constantly decreasing, the least cost method to provide a good or service is by a
single company.[9]
Capital requirements: Production processes that require large investments of
capital, or large research and development costs or substantial sunk costs limit
the number of companies in an industry.[10] Large fixed costs also make it difficult
for a small company to enter an industry and expand.[6]
Technological superiority: A monopoly may be better able to acquire, integrate
and use the best possible technology in producing its goods while entrants do not
have the size or finances to use the best available technology. [8] One large
company can sometimes produce goods cheaper than several small
companies.[11]
No substitute goods: A monopoly sells a good for which there is no close
substitute. The absence of substitutes makes the demand for the good relatively
inelastic enabling monopolies to extract positive profits.[citation needed]
Control of natural resources: A prime source of monopoly power is the control of
resources that are critical to the production of a final good.[citation needed]
Network externalities: The use of a product by a person can affect the value of
that product to other people. This is the network effect. There is a direct
relationship between the proportion of people using a product and the demand
for that product. In other words the more people who are using a product the
greater the probability of any individual starting to use the product. This effect
accounts for fads and fashion trends.[12] It also can play a crucial role in the
development or acquisition of market power. The most famous current example

is the market dominance of the Microsoft operating system in personal

computers.

Legal barriers: Legal rights can provide opportunity to monopolise the market of a
good. Intellectual property rights, including patents and copyrights, give a
monopolist exclusive control of the production and selling of certain goods.
Property rights may give a company exclusive control of the materials necessary
to produce a good.[citation needed]
Deliberate actions: A company wanting to monopolise a market may engage in
various types of deliberate action to exclude competitors or eliminate
competition. Such actions include collusion, lobbying governmental authorities,
and force (see anti-competitive practices).[citation needed]
In addition to barriers to entry and competition, barriers to exit may be a source of
market power. Barriers to exit are market conditions that make it difficult or
expensive for a company to end its involvement with a market. Great liquidation
costs are a primary barrier for exiting.[13] Market exit and shutdown are separate
events. The decision whether to shut down or operate is not affected by exit
barriers. A company will shut down if price falls below minimum average variable
costs.
Monopoly versus competitive markets[edit]
While monopoly and perfect competition mark the extremes of market
structures[14] there is some similarity. The cost functions are the same. [15] Both
monopolies and perfectly competitive companies minimize cost and maximize profit.
The shutdown decisions are the same. Both are assumed to have perfectly
competitive factors markets. There are distinctions, some of the more important of
which are as follows:

Marginal revenue and price: In a perfectly competitive market, price equals

marginal cost. In a monopolistic market, however, price is set above marginal
cost.[16]
Product differentiation: There is zero product differentiation in a perfectly
competitive market. Every product is perfectly homogeneous and a perfect
substitute for any other. With a monopoly, there is great to absolute product
differentiation in the sense that there is no available substitute for a monopolized
good. The monopolist is the sole supplier of the good in question.[17] A customer
either buys from the monopolizing entity on its terms or does without.
Number of competitors: PC markets are populated by an infinite number of
buyers and sellers. Monopoly involves a single seller.[17]
Barriers to Entry: Barriers to entry are factors and circumstances that prevent
entry into market by would-be competitors and limit new companies from
operating and expanding within the market. PC markets have free entry and exit.
There are no barriers to entry, exit or competition. Monopolies have relatively
high barriers to entry. The barriers must be strong enough to prevent or
discourage any potential competitor from entering the market.[citation needed]

Elasticity of Demand: The price elasticity of demand is the percentage change of

demand caused by a one percent change of relative price. A successful
monopoly would have a relatively inelastic demand curve. A low coefficient of
elasticity is indicative of effective barriers to entry. A PC company has a perfectly
elastic demand curve. The coefficient of elasticity for a perfectly competitive
demand curve is infinite.[citation needed]
Excess Profits: Excess or positive profits are profit more than the normal
expected return on investment. A PC company can make excess profits in the
short term but excess profits attract competitors, which can enter the market
freely and decrease prices, eventually reducing excess profits to zero.[18] A
monopoly can preserve excess profits because barriers to entry prevent
competitors from entering the market.[19]
Profit Maximization: A PC company maximizes profits by producing such that
price equals marginal costs. A monopoly maximises profits by producing where
marginal revenue equals marginal costs.[20] The rules are not equivalent. The
demand curve for a PC company is perfectly elastic flat. The demand curve is
identical to the average revenue curve and the price line. Since the average
revenue curve is constant the marginal revenue curve is also constant and
equals the demand curve, Average revenue is the same as price (AR = TR/Q =
P x Q/Q = P). Thus the price line is also identical to the demand curve. In sum, D
= AR = MR = P.
P-Max quantity, price and profit: If a monopolist obtains control of a formerly
perfectly competitive industry, the monopolist would increase prices, reduce
production, and realise positive economic profits.[21]
Supply Curve: in a perfectly competitive market there is a well defined supply
function with a one to one relationship between price and quantity supplied. [22] In
a monopolistic market no such supply relationship exists. A monopolist cannot
trace a short term supply curve because for a given price there is not a unique
quantity supplied. As Pindyck and Rubenfeld note, a change in demand "can
lead to changes in prices with no change in output, changes in output with no
change in price or both".[23] Monopolies produce where marginal revenue equals
marginal costs. For a specific demand curve the supply "curve" would be the
price/quantity combination at the point where marginal revenue equals marginal
cost. If the demand curve shifted the marginal revenue curve would shift as well
and a new equilibrium and supply "point" would be established. The locus of
these points would not be a supply curve in any conventional sense.[24][25]

The most significant distinction between a PC company and a monopoly is that the
monopoly has a downward-sloping demand curve rather than the "perceived"
perfectly elastic curve of the PC company.[26] Practically all the variations mentioned
above relate to this fact. If there is a downward-sloping demand curve then by
necessity there is a distinct marginal revenue curve. The implications of this fact are
best made manifest with a linear demand curve. Assume that the inverse demand
curve is of the form x = a by. Then the total revenue curve is TR = ay by2 and
the marginal revenue curve is thus MR = a 2by. From this several things are
evident. First the marginal revenue curve has the same y intercept as the inverse
demand curve. Second the slope of the marginal revenue curve is twice that of the

inverse demand curve. Third the x intercept of the marginal revenue curve is half
that of the inverse demand curve. What is not quite so evident is that the marginal
revenue curve is below the inverse demand curve at all points. [26] Since all
companies maximise profits by equating MR and MC it must be the case that at the
profit-maximizing quantity MR and MC are less than price, which further implies that
a monopoly produces less quantity at a higher price than if the market were perfectly
competitive.
The fact that a monopoly has a downward-sloping demand curve means that the
relationship between total revenue and output for a monopoly is much different than
that of competitive companies.[27] Total revenue equals price times quantity. A
competitive company has a perfectly elastic demand curve meaning that total
revenue is proportional to output.[27] Thus the total revenue curve for a competitive
company is a ray with a slope equal to the market price.[27] A competitive company
can sell all the output it desires at the market price. For a monopoly to increase
sales it must reduce price. Thus the total revenue curve for a monopoly is a
parabola that begins at the origin and reaches a maximum value then continuously
decreases until total revenue is again zero.[28] Total revenue has its maximum value
when the slope of the total revenue function is zero. The slope of the total revenue
function is marginal revenue. So the revenue maximizing quantity and price occur
when MR = 0. For example assume that the monopolys demand function is P = 50
2Q. The total revenue function would be TR = 50Q 2Q 2 and marginal revenue
would be 50 4Q. Setting marginal revenue equal to zero we have

So the revenue maximizing quantity for the monopoly is 12.5 units and
the revenue maximizing price is 25.
A company with a monopoly does not experience price pressure from
competitors, although it may experience pricing pressure from potential
competition. If a company increases prices too much, then others may
enter the market if they are able to provide the same good, or a
substitute, at a lesser price.[29] The idea that monopolies in markets with
easy entry need not be regulated against is known as the "revolution in
monopoly theory".[30]
A monopolist can extract only one premium,[clarification needed] and getting
into complementary markets does not pay. That is, the total profits a
monopolist could earn if it sought to leverage its monopoly in one market
by monopolizing a complementary market are equal to the extra profits it
could earn anyway by charging more for the monopoly product itself.
However, the one monopoly profit theorem is not true if customers in the
monopoly good are stranded or poorly informed, or if the tied good has
high fixed costs.

A pure monopoly has the same economic rationality of perfectly

competitive companies, i.e. to optimise a profit function given some
constraints. By the assumptions of increasing marginal costs, exogenous
inputs' prices, and control concentrated on a single agent or
entrepreneur, the optimal decision is to equate the marginal
cost andmarginal revenue of production. Nonetheless, a pure monopoly
can unlike a competitive company alter the market price for its own
convenience: a decrease of production results in a higher price. In the
economics' jargon, it is said that pure monopolies have "a downwardsloping demand". An important consequence of such behaviour is worth
noticing: typically a monopoly selects a higher price and lesser quantity of
output than a price-taking company; again, less is available at a higher
price.[31]
The inverse elasticity rule[edit]
A monopoly chooses that price that maximizes the difference between
total revenue and total cost. The basic markup rule can be expressed as
(P MC)/P = 1/PED.[32] The markup rules indicate that the ratio between
profit margin and the price is inversely proportional to the price elasticity
of demand.[32] The implication of the rule is that the more elastic the
demand for the product the less pricing power the monopoly has.
Market power[edit]
Market power is the ability to increase the product's price above marginal
cost without losing all customers.[33]Perfectly competitive (PC) companies
have zero market power when it comes to setting prices. All companies of
a PC market are price takers. The price is set by the interaction of
demand and supply at the market or aggregate level. Individual
companies simply take the price determined by the market and produce
that quantity of output that maximizes the company's profits. If a PC
company attempted to increase prices above the market level all its
customers would abandon the company and purchase at the market price
from other companies. A monopoly has considerable although not
unlimited market power. A monopoly has the power to set prices or
quantities although not both.[34] A monopoly is a price maker.[35] The
monopoly is the market[36] and prices are set by the monopolist based on
his circumstances and not the interaction of demand and supply. The two
primary factors determining monopoly market power are the company's
demand curve and its cost structure.[37]
Market power is the ability to affect the terms and conditions of exchange
so that the price of a product is set by a single company (price is not
imposed by the market as in perfect competition).[38][39] Although a
monopoly's market power is great it is still limited by the demand side of
the market. A monopoly has a negatively sloped demand curve, not a
perfectly inelastic curve. Consequently, any price increase will result in
the loss of some customers.

Price discrimination[edit]
Price discrimination allows a monopolist to increase its profit by charging
higher prices for identical goods to those who are willing or able to pay
more.[40][41] For example, most economic textbooks cost more in the
United States than in developing countries like Ethiopia. In this case, the
publisher is using its government-grantedcopyright monopoly to price
discriminate between the generally wealthier American economics
students and the generally poorer Ethiopian economics students.
Similarly, most patented medications cost more in the U.S. than in other
countries with a (presumed) poorer customer base. Typically, a high
general price is listed, and variousmarket segments get varying
discounts. This is an example of framing to make the process of charging
some people higher prices more socially acceptable.[citation needed] Perfect
price discrimination would allow the monopolist to charge each customer
the exact maximum amount he would be willing to pay. This would allow
the monopolist to extract all the consumer surplus of the market. While
such perfect price discrimination is a theoretical construct, advances
in information technology and micromarketing may bring it closer to the
realm of possibility
It is important to realize that partial price discrimination can cause some
customers who are inappropriately pooled with high price customers to
be excluded from the market. For example, a poor student in the U.S.
might be excluded from purchasing an economics textbook at the U.S.
price, which the student may have been able to purchase at the Ethiopian
price'. Similarly, a wealthy student in Ethiopia may be able to or willing to
buy at the U.S. price, though naturally would hide such a fact from the
monopolist so as to pay the reduced third world price. These are
deadweight losses and decrease a monopolist's profits. As such,
monopolists have substantial economic interest in improving their market
information and market segmenting.[citation needed]
There is important information for one to remember when considering the
monopoly model diagram (and its associated conclusions) displayed
here. The result that monopoly prices are higher, and production output
lesser, than a competitive company follow from a requirement that the
monopoly not charge different prices for different customers. That is, the
monopoly is restricted from engaging in price discrimination (this is
termed first degree price discrimination, such that all customers are
charged the same amount). If the monopoly were permitted to charge
individualised prices (this is termed third degree price discrimination), the
quantity produced, and the price charged to the marginal customer,
would be identical to that of a competitive company, thus eliminating the
deadweight loss; however, all gains from trade (social welfare) would
accrue to the monopolist and none to the consumer. In essence, every

consumer would be indifferent between (1) going completely without the

product or service and (2) being able to purchase it from the
monopolist.[citation needed]
As long as the price elasticity of demand for most customers is less than
one in absolute value, it is advantageous for a company to increase its
prices: it receives more money for fewer goods. With a price increase,
price elasticity tends to increase, and in the optimum case above it will be
greater than one for most customers.[citation needed]
A company maximizes profit by selling where marginal revenue equals
marginal cost. A company that does not engage in price discrimination
will charge the profit maximizing price, P*, to all its customers. In such
circumstances there are customers who would be willing to pay a higher
price than P* and those who will not pay P* but would buy at a lower
price. A price discrimination strategy is to charge less price sensitive
buyers a higher price and the more price sensitive buyers a lower
price.[42] Thus additional revenue is generated from two sources. The
basic problem is to identify customers by their willingness to pay.
The purpose of price discrimination is to transfer consumer surplus to the
producer.[43] Consumer surplus is the difference between the value of a
good to a consumer and the price the consumer must pay in the market
to purchase it.[44] Price discrimination is not limited to monopolies.
Market power is a companys ability to increase prices without losing all
its customers. Any company that has market power can engage in price
discrimination. Perfect competition is the only market form in which price
discrimination would be impossible (a perfectly competitive company has
a perfectly elastic demand curve and has zero market power)
There are three forms of price discrimination. First degree price
discrimination charges each consumer the maximum price the consumer
is willing to pay. Second degree price discrimination involves quantity
discounts. Third degree price discrimination involves grouping consumers
according to willingness to pay as measured by their price elasticities of
demand and charging each group a different price. Third degree price
discrimination is the most prevalent type.[citation needed]
There are three conditions that must be present for a company to engage
in successful price discrimination. First, the company must have market
power.[48] Second, the company must be able to sort customers
according to their willingness to pay for the good. [49] Third, the firm must
be able to prevent resell.
A company must have some degree of market power to practice price
discrimination. Without market power a company cannot charge more
than the market price.[50] Any market structure characterized by a
downward sloping demand curve has market power monopoly,

monopolistic competition and oligopoly.[48] The only market structure that

has no market power is perfect competition.[50]
A company wishing to practice price discrimination must be able to
prevent middlemen or brokers from acquiring the consumer surplus for
themselves. The company accomplishes this by preventing or limiting
resale. Many methods are used to prevent resale. For example persons
are required to show photographic identification and a boarding pass
before boarding an airplane. Most travelers assume that this practice is
strictly a matter of security. However, a primary purpose in requesting
photographic identification is to confirm that the ticket purchaser is the
person about to board the airplane and not someone who has
repurchased the ticket from a discount buyer.
The inability to prevent resale is the largest obstacle to successful price
discrimination.[45] Companies have however developed numerous
methods to prevent resale. For example, universities require that
students show identification before entering sporting events.
Governments may make it illegal to resale tickets or products. In
Boston, Red Sox baseball tickets can only be resold legally to the team.
The three basic forms of price discrimination are first, second and third
degree price discrimination. In first degree price discrimination the
company charges the maximum price each customer is willing to pay.
The maximum price a consumer is willing to pay for a unit of the good is
the reservation price. Thus for each unit the seller tries to set the price
equal to the consumers reservation price.[51] Direct information about a
consumers willingness to pay is rarely available. Sellers tend to rely on
secondary information such as where a person lives (postal codes); for
example, catalog retailers can use mail high-priced catalogs to highincome postal codes. First degree price discrimination most frequently
occurs in regard to professional services or in transactions involving
direct buyer/seller negotiations. For example, an accountant who has
prepared a consumer's tax return has information that can be used to
charge customers based on an estimate of their ability to pay. [54]
In second degree price discrimination or quantity discrimination
customers are charged different prices based on how much they buy.
There is a single price schedule for all consumers but the prices vary
depending on the quantity of the good bought. The theory of second
degree price discrimination is a consumer is willing to buy only a certain
quantity of a good at a given price. Companies know that consumers
willingness to buy decreases as more units are purchased. The task for
the seller is to identify these price points and to reduce the price once
one is reached in the hope that a reduced price will trigger additional
purchases from the consumer. For example, sell in unit blocks rather than
individual units.

In third
degree
price
discrimination or
multi-market
price
]
discrimination the seller divides the consumers into different groups
according to their willingness to pay as measured by their price elasticity
of demand. Each group of consumers effectively becomes a separate
market with its own demand curve and marginal revenue curve. The firm
then attempts to maximize profits in each segment by equating MR and
MC, Generally the company charges a higher price to the group with a
more price inelastic demand and a relatively lesser price to the group with
a more elastic demand.[] Examples of third degree price discrimination
abound. Airlines charge higher prices to business travelers than to
vacation travelers. The reasoning is that the demand curve for a vacation
traveler is relatively elastic while the demand curve for a business
traveler is relatively inelastic. Any determinant of price elasticity of
demand can be used to segment markets. For example, seniors have a
more elastic demand for movies than do young adults because they
generally have more free time. Thus theaters will offer discount tickets to
seniors.
Example
Assume that by a uniform pricing system the monopolist would sell five
units at a price of $10 per unit. Assume that his marginal cost is $5 per
unit. Total revenue would be $50, total costs would be $25 and profits
would be $25. If the monopolist practiced price discrimination he would
sell the first unit for $50 the second unit for $40 and so on. Total revenue
would be $150, his total cost would be $25 and his profit would be
$125.00.] Several things are worth noting. The monopolist acquires all the
consumer surplus and eliminates practically all the deadweight loss
because he is willing to sell to anyone who is willing to pay at least the
marginal cost. Thus the price discrimination promotes efficiency.
Secondly, by the pricing scheme price = average revenue and equals
marginal revenue. That is the monopolist behaving like a perfectly
competitive company.[62] Thirdly, the discriminating monopolist produces
a larger quantity than the monopolist operating by a uniform pricing
scheme.[63]
Qd Price

50

40

30

20

10

Classifying customers[edit]
Successful price discrimination requires that companies separate
consumers according to their willingness to buy. Determining a
customer's willingness to buy a good is difficult. Asking consumers
directly is fruitless: consumers don't know, and to the extent they do they
are reluctant to share that information with marketers. The two main
methods for determining willingness to buy are observation of personal
characteristics and consumer actions. As noted information about where
a person lives (postal codes), how the person dresses, what kind of car
he or she drives, occupation, and income and spending patterns can be
helpful in classifying.[citation needed]
Monopoly and efficiency[edit]

Surpluses and deadweight loss created by monopoly price setting

The price of monopoly is upon every occasion the highest which can be
got. The natural price, or the price of free competition, on the contrary, is
the lowest which can be taken, not upon every occasion indeed, but for
any considerable time together. The one is upon every occasion the
highest which can be squeezed out of the buyers, or which it is supposed

they will consent to give; the other is the lowest which the sellers can
commonly afford to take, and at the same time continue their
business.[64]:56
Adam Smith (1776), Wealth of Nations
Monopoly, besides, is a great enemy to good management. [64]:127
Adam Smith (1776), Wealth of Nations
According to the standard model, in which a monopolist sets a single
price for all consumers, the monopolist will sell a lesser quantity of goods
at a higher price than would companies by perfect competition. Because
the monopolist ultimately forgoes transactions with consumers who value
the product or service more than its cost, monopoly pricing creates
a deadweight loss referring to potential gains that went neither to the
monopolist nor to consumers. Given the presence of this deadweight
loss, the combined surplus (or wealth) for the monopolist and consumers
is necessarily less than the total surplus obtained by consumers by
perfect competition. Where efficiency is defined by the total gains from
trade, the monopoly setting is less efficient than perfect competition.[citation
needed]

It is often argued that monopolies tend to become less efficient and less
innovative over time, becoming "complacent", because they do not have
to be efficient or innovative to compete in the marketplace. Sometimes
this very loss of psychological efficiency can increase a potential
competitor's value enough to overcome market entry barriers, or provide
incentive for research and investment into new alternatives. The theory
of contestable markets argues that in some circumstances (private)
monopolies are forced to behave as if there were competition because of
the risk of losing their monopoly to new entrants. This is likely to happen
when a market's barriers to entry are low. It might also be because of the
availability in the longer term of substitutes in other markets. For
example, a canal monopoly, while worth a great deal during the late 18th
century United Kingdom, was worth much less during the late 19th
century because of the introduction of railways as a substitute.[citation needed]
Natural monopoly[edit]
Main
Article: Natural
monopoly
A natural monopoly is a company that experiences increasing returns to
scaleover the relevant range of output and relatively high fixed costs. [65] A
natural monopoly occurs where the average cost of production "declines
throughout the relevant range of product demand". The relevant range of
product demand is where the average cost curve is below the demand
curve.[66] When this situation occurs, it is always cheaper for one large
company to supply the market than multiple smaller companies; in fact,
absent government intervention in such markets, will naturally evolve into
a monopoly. An early market entrant that takes advantage of the cost

structure and can expand rapidly can exclude smaller companies from
entering and can drive or buy out other companies. A natural monopoly
suffers from the same inefficiencies as any other monopoly. Left to its
own devices, a profit-seeking natural monopoly will produce where
marginal revenue equals marginal costs. Regulation of natural
monopolies is problematic.[citation needed] Fragmenting such monopolies is
by definition inefficient. The most frequently used methods dealing with
natural monopolies are government regulations and public ownership.
Government regulation generally consists of regulatory commissions
charged with the principal duty of setting prices.[67]
To reduce prices and increase output, regulators often use average cost
pricing. By average cost pricing, the price and quantity are determined by
the intersection of the average cost curve and the demand curve. [68] This
pricing scheme eliminates any positive economic profits since price
equals average cost. Average-cost pricing is not perfect. Regulators must
estimate average costs. Companies have a reduced incentive to lower
costs. Regulation of this type has not been limited to natural
monopolies.[68] Average-cost
pricing
does
also
have
some
disadvantages. By setting price equal to the intersection of the demand
curve and the average total cost curve, the firm's output is allocatively
inefficient as the price exceeds the marginal cost (which is the output
quantity for a perfectly competitive and allocatively efficient market).
Government-granted monopoly[edit]
Main article: Government-granted monopoly
A government-granted monopoly (also called a "de jure monopoly") is a
form of coercive monopoly by which a government grants exclusive
privilege to a private individual or company to be the sole provider of a
commodity; potential competitors are excluded from the market
by law, regulation,
or
other
mechanisms
of
government
enforcement.[citation needed]
Monopolist shutdown rule[edit]
A monopolist should shut down when price is less than average variable
cost for every output level[69] in other words where the demand curve is
entirely below the average variable cost curve. [69] Under these
circumstances at the profit maximum level of output (MR = MC) average
revenue would be less than average variable costs and the monopolists
would be better off shutting down in the short term.[69]
Breaking up monopolies[edit]
When monopolies are not ended by the open market; sometimes a
government will either regulate the monopoly, convert it into a publicly
owned monopoly environment, or forcibly fragment it (see Antitrust law
and trust busting).Public utilities, often being naturally efficient with only

one operator and therefore less susceptible to efficient breakup, are often
strongly regulated or publicly owned. American Telephone &
Telegraph (AT&T) and Standard Oilare debatable examples of the
breakup of a private monopoly by government: When AT&T, a monopoly
previously protected by force of law, was broken up into various
components in 1984, MCI, Sprint, and other companies were able to
compete effectively in the long distance phone market.[citation needed]
Law[edit]
The existence of a very high market share does not always mean
consumers are paying excessive prices since the threat of new entrants
to the market can restrain a high-market-share company's price
increases. Competition law does not make merely having a monopoly
illegal, but rather abusing the power a monopoly may confer, for instance
through exclusionary practices (i.e. pricing high just because you are the
only one around.) It may also be noted that it is illegal to try to obtain a
monopoly, by practices of buying out the competition, or equal practices.
If one occurs naturally, such as a competitor going out of business, or
lack of competition, is not illegal until such time as the monopoly holder
abuses the power.
First it is necessary to determine whether a company is dominant, or
whether it behaves "to an appreciable extent independently of its
competitors, customers and ultimately of its consumer". [70] As with
collusive conduct, market shares are determined with reference to the
particular market in which the company and product in question is sold.
The Herfindahl-Hirschman Index (HHI) is sometimes used to assess how
competitive an industry is.[71] In the US, the merger guidelines state that a
post-merger HHI below 1000 is viewed as unconcentrated while HHIs
above that will provoke further review.[72]
By European Union law, very large market shares raise a presumption
that a company is dominant,[73] which may be rebuttable.[74] If a company
has a dominant position, then there is "a special responsibility not to allow
its conduct to impair competition on the common market".[75] The lowest
yet market share of a company considered "dominant" in the EU was
39.7%.[76]
Certain categories of abusive conduct are usually prohibited by a
country's legislation.[77] The main recognised categories are:

Limiting supply
Predatory pricing
Price discrimination
Refusal to deal and exclusive dealing
Tying (commerce) and product bundling

Despite wide agreement that the above constitute abusive practices,

there is some debate about whether there needs to be a causal
connection between the dominant position of a company and its actual
abusive conduct. Furthermore, there has been some consideration of
what happens when a company merely attempts to abuse its dominant
position.
Historical monopolies[edit]
Origin[edit]
The term "monopoly" first appears in Aristotle's Politics. Aristotle
describes Thales of Miletus's cornering of the market in olive presses as
a monopoly ().[78][79]
The meaning and understanding of the English word 'monopoly' has
changed over the years.[80]
Monopolies of resources[edit]
Salt[edit]
Vending of common salt (sodium chloride) was historically a natural
monopoly. Until recently, a combination of strong sunshine and low
humidity or an extension of peat marshes was necessary for producing
salt from the sea, the most plentiful source. Changing sea levels
periodically caused salt "famines" and communities were forced to
depend upon those who controlled the scarce inland mines and salt
springs, which were often in hostile areas (e.g. the Sahara desert)
requiring well-organised security for transport, storage, and distribution.
The Salt Commission was a legal monopoly in China. Formed in 758, the
Commission controlled salt production and sales in order to
raise tax revenue for the Tang Dynasty.
The "Gabelle" was a notoriously high tax levied upon salt in the Kingdom
of France The much-hated levy had a role in the beginning of the French
Revolution, when strict legal controls specified who was allowed to sell
and distribute salt. First instituted in 1286, the Gabelle was not
permanently abolished until 1945.[81]
Coal[edit]
Robin Gollan argues in The Coalminers of New South Wales that anticompetitive
practices
developed
in
the
coal
industry of
Australia's Newcastle as a result of the business cycle. The monopoly
was generated by formal meetings of the local management of coal
companies agreeing to fix a minimum price for sale at dock. This
collusion was known as "The Vend". The Vend ended and was reformed
repeatedly during the late 19th century, ending by recession in the
business cycle. "The Vend" was able to maintain its monopoly due to
trade union assistance, and material advantages (primarily coal

geography). During the early 20th century, as a result of comparable

monopolistic practices in the Australian coastal shipping business, the
Vend developed as an informal and illegal collusion between the
steamship owners and the coal industry, eventually resulting in the High
Court case Adelaide Steamship Co. Ltd v. R. & AG.[82]
Petroleum[edit]
Standard Oil was an American oil producing, transporting, refining, and
marketing company. Established in 1870, it became the largest oil refiner
in the world.[83] John D. Rockefeller was a founder, chairman and major
shareholder. The company was an innovator in the development of the
business trust. The Standard Oil trust streamlined production and
logistics, lowered costs, and undercut competitors. "Trust-busting" critics
accused Standard Oil of using aggressive pricing to destroy competitors
and form a monopoly that threatened consumers. Its controversial history
as one of the world's first and largest multinational corporations ended in
1911, when theUnited States Supreme Court ruled that Standard was an
illegal monopoly. The Standard Oil trust was dissolved into 33 smaller
companies; two of its surviving "child" companies are ExxonMobil and
the Chevron Corporation.
Steel[edit]
U.S. Steel has been accused of being a monopoly. J. P.
Morgan and Elbert H. Gary founded U.S. Steel in 1901 by
combining Andrew Carnegie's Carnegie Steel Company with Gary's
Federal Steel Company and William Henry "Judge" Moore's National
Steel Company.[84][85] At one time, U.S. Steel was the largest steel
producer and largest corporation in the world. In its first full year of
operation, U.S. Steel made 67 percent of all the steel produced in the
United States. However, U.S. Steel's share of the expanding market
slipped to 50 percent by 1911,[86] and anti-trust prosecution that year
failed.
Diamonds[edit]
De Beers settled charges of price fixing in the diamond trade in the
2000s.
Utilities[edit]
A public utility (or simply "utility") is an organization or company that
maintains the infrastructure for a public service or provides a set of
services for public consumption. Common examples of utilities
are electricity, natural
gas, water, sewage, cable
television,
and telephone. In the United States of America, public utilities are
oftennatural monopolies because the infrastructure required to produce
and deliver a product such as electricity or water is very expensive to
build and maintain.[87]

Western Union was criticized as a "price gouging" monopoly in the late

19th century.[88]
American Telephone & Telegraph was a telecommunications giant. AT&T
was broken up in 1984.
In the case of Telecom New Zealand, local loop unbundling was enforced
by central government.
Telkom is
a
semi-privatised,
African telecommunications company.

part

state-owned South

Deutsche Telekom is a former state monopoly, still partially state owned.

Deutsche Telekom currently monopolizes high-speed VDSL broadband
network.[89]
The Long Island Power Authority (LIPA) provided electric service to over
1.1 million customers in Nassau andSuffolk counties of New York, and
the Rockaway Peninsula in Queens.
The Comcast Corporation
is
the
largest mass
media and communications company in the world by revenue.[90] It is the
largest cable company and home Internet service provider in the United
States, and the nation's third largest home telephone service provider.
Comcast has a monopoly in Boston, Philadelphia, and Chicago.[citation
needed]

Transportation[edit]
The United Aircraft and Transport Corporation was an aircraft
manufacturer holding company that was forced to divest itself of airlines
in 1934.
Iarnrd ireann, the Irish Railway authority, is a current monopoly
as Ireland does not have the size for more companies.
The Long Island Rail Road (LIRR) was founded in 1834, and since the
mid-1800s has provided train service between Long Island and New York
City. In the 1870s, LIRR became the sole railroad in that area through a
series of acquisitions and consolidations. In 2013, the LIRR's commuter
rail system is the busiest commuter railroad in North America, serving
nearly 335,000 passengers daily.[91]
Foreign trade[edit]
Dutch East India Company was created as a legal trading monopoly in
1602. The Vereenigde Oost-Indische Compagnie enjoyed huge profits
from its spice monopoly through most of the 17th century.[92]
The British Honourable East India Company was created as a legal
trading monopoly in 1600. The East India Company was formed for
pursuing trade with the East Indies but ended up trading mainly with
the Indian subcontinent, North-West Frontier Province, and Balochistan.

The
Company
traded
in
basic
commodities,
included cotton, silk, indigo dye, salt, saltpetre, tea and opium.

which

Professional sports[edit]
Major League Baseball survived U.S. anti-trust litigation in 1922, though
its special status is still in dispute as of 2009.
The National Football League survived anti-trust lawsuit in the 1960s but
was convicted of being an illegal monopoly in the 1980s.
Other examples of monopolies[edit]

Microsoft has been the defendant in multiple anti-trust suits. They

settled anti-trust litigation in the U.S. in 2001. In 2004 Microsoft was
fined 493 million euros by the European Commission[93] which was
upheld for the most part by the Court of First Instance of
the European Communities in 2007. The fine was US$1.35 billion in
2008 for noncompliance with the 2004 rule.[94][95]
MPAA (Motion Picture Association of America) has a monopoly over
film ratings in the U.S.
Joint Commission is an organization that accredits more than 20,000
health care organizations and programs in the United States.[96] The
Commission has a monopoly over determining whether a U.S.
hospital
can
participate
in
the
publicly
funded Medicare and Medicaid healthcare programs.
Monsanto has been sued by competitors for anti-trust and
monopolistic practices. They have between 70% and 100% of the
commercial seed market.
AAFES has a monopoly on retail sales at overseas U.S. military
installations.
State stores in certain United States states, e.g. for liquor.
The Registered Dietitian union seeks monopoly over nutrition services
through state-level licensing schemes.

Countering monopolies[edit]
This
section
requires expansion.(January
2010)
According to professor Milton Friedman, laws against monopolies cause
more harm than good, but unnecessary monopolies should be countered
by removing tariffs and other regulation that upholds monopolies.
A monopoly can seldom be established within a country without overt and
covert government assistance in the form of a tariff or some other device.
It is close to impossible to do so on a world scale. The De Beers diamond
monopoly is the only one we know of that appears to have succeeded

(and even De Beers are protected by various laws against so called

"illicit" diamond trade). In a world of free trade, international cartels
would disappear even more quickly.[97]
However, professor Steve H. Hanke believes that although private
monopolies are more efficient than public ones, often by a factor of two,
sometimes private natural monopolies, such as local water distribution,
should be regulated (not prohibited) by, e.g., price auctions.[98]
Thomas DiLorenzo asserts, however, that during the early days of utility
companies where there was little regulation, there were no natural
monopolies and there was competition.[99] Only when companies realized
that they could gain power through government did monopolies begin to
form.

Monopolistic competition
From Wikipedia, the free encyclopedia

Short-run equilibrium of the firm under monopolistic competition. The firm maximizes its
profits and produces a quantity where the firm's marginal revenue (MR) is equal to its
marginal cost (MC). The firm is able to collect a price based on the average revenue
(AR) curve. The difference between the firms average revenue and average cost,
multiplied by the quantity sold (Qs), gives the total profit.

Long-run equilibrium of the firm under monopolistic competition. The firm still produces
where marginal cost and marginal revenue are equal; however, the demand curve (and
AR) has shifted as other firms entered the market and increased competition. The firm
no longer sells its goods above average cost and can no longer claim an economic
profit
Monopolistic competition is a type of imperfect competition such that many producers
sell products that aredifferentiated from one another (e.g. by branding or quality) and
hence are not perfect substitutes. In monopolistic competition, a firm takes the prices
charged by its rivals as given and ignores the impact of its own prices on the prices of
other firms.[1][2] In the presence of coercive government, monopolistic competition will
fall into government-granted monopoly. Unlike perfect competition, the firm maintains
spare capacity. Models of monopolistic competition are often used to model industries.
Textbook examples of industries with market structures similar to monopolistic
competition include restaurants, cereal, clothing, shoes, and service industries in large
cities. The "founding father" of the theory of monopolistic competition is Edward
Hastings Chamberlin, who wrote a pioneering book on the subject, Theory of
Monopolistic Competition (1933).[3] Joan Robinsonpublished a book The Economics of
Imperfect Competitionwith a comparable theme of distinguishing perfect from imperfect
competition.
Monopolistically competitive markets have the following characteristics:

There are many producers and many consumers in the market, and no business
has total control over the market price.
Consumers perceive that there are non-price differences among the competitors'
products.
There are few barriers to entry and exit.[4]
Producers have a degree of control over price.

The long-run characteristics of a monopolistically competitive market are almost the

same as a perfectly competitive market. Two differences between the two are that
monopolistic competition produces heterogeneous products and that monopolistic
competition involves a great deal of non-price competition, which is based on subtle
product differentiation. A firm making profits in the short run will nonetheless only break
even in the long run because demand will decrease and average total cost will increase.
This means in the long run, a monopolistically competitive firm will make zero economic
profit. This illustrates the amount of influence the firm has over the market; because of
brand loyalty, it can raise its prices without losing all of its customers. This means that
an individual firm's demand curve is downward sloping, in contrast to perfect
competition, which has aperfectly elastic demand schedule.
Major characteristics
There are six characteristics of monopolistic competition (MC):

Product differentiation
Many firms
No entry and exit cost in the long run
Independent decision making
Some degree of market power
Buyers and Sellers do not have perfect information (Imperfect Information)
Product differentiation
MC firms sell products that have real or perceived non-price differences. However, the
differences are not so great as to eliminate other goods as substitutes. Technically, the
cross price elasticity of demand between goods in such a market is positive. In fact,
the XED would be high.[7] MC goods are best described as close but imperfect
substitutes.[7] The goods perform the same basic functions but have differences in
qualities such as type, style, quality, reputation, appearance, and location that tend to
distinguish them from each other. For example, the basic function of motor vehicles is
the sameto move people and objects from point to point in reasonable comfort and
safety. Yet there are many different types of motor vehicles such as motor scooters,
motor cycles, trucks and cars, and many variations even within these categories.
Many firms
There are many firms in each MC product group and many firms on the side lines
prepared to enter the market. A product group is a "collection of similar products". The
fact that there are "many firms" gives each MC firm the freedom to set prices without
engaging in strategic decision making regarding the prices of other firms and each firm's

actions have a negligible impact on the market. For example, a firm could cut prices and
increase sales without fear that its actions will prompt retaliatory responses from
competitors.
How many firms will an MC market structure support at market equilibrium? The answer
depends on factors such as fixed costs, economies of scale and the degree of product
differentiation. For example, the higher the fixed costs, the fewer firms the market will
support.[9] Also the greater the degree of product differentiationthe more the firm can
separate itself from the packthe fewer firms there will be at market equilibrium.
No entry and exit costs
In the long run there are no entry and exit costs. There are numerous firms waiting to
enter the market, each with their own "unique" product or in pursuit of positive profits.
Any firm unable to cover its costs can leave the market without incurring liquidation
costs. This assumption implies that there are low start up costs, no sunk costs and no
exit costs.
Independent decision making
Each MC firm independently sets the terms of exchange for its product. The firm gives
no consideration to what effect its decision may have on competitors. The theory is that
any action will have such a negligible effect on the overall market demand that an MC
firm can act without fear of prompting heightened competition. In other words each firm
feels free to set prices as if it were a monopoly rather than an oligopoly.
Market power
MC firms have some degree of market power. Market power means that the firm has
control over the terms and conditions of exchange. An MC firm can raise its prices
without losing all its customers. The firm can also lower prices without triggering a
potentially ruinous price war with competitors. The source of an MC firm's market power
is not barriers to entry since they are low. Rather, an MC firm has market power
because it has relatively few competitors, those competitors do not engage in strategic
decision making and the firms sells differentiated product.[11] Market power also means
that an MC firm faces a downward sloping demand curve. The demand curve is highly
elastic although not "flat".
Imperfect information
No sellers or buyers have complete market information, like market demand or market
supply.[12]
Market Structure comparison

Mark
Excess
Numb
Elasticit Product
et
er of
y
of differentiati profits
powe

Efficien Profit
Pricing
maximizati power
cy
on

firms

demand on

condition

Perfect
Perfectl
Competitio Infinite None
None
y elastic
n

Monopolis
tic
Many
competitio
n

Monopoly One

Low

High

Highly
elastic
(long
run)[15]

High

[16]

Relative Absolute
ly
(across
inelastic industries)

No

Yes

[13]

P=MR=MC[1
4]

Price
taker[14
]

Yes/No
(Short/Long)[ No[18]

MR=MC

[14]

17]

Yes

Price
setter[1
4]

No

MR=MC

[14]

Price
setter[1
4]

Inefficiency
There are two sources of inefficiency in the MC market structure. First, at its optimum
output the firm charges a price that exceeds marginal costs, The MC firm maximizes
profits where marginal revenue = marginal cost. Since the MC firm's demand curve is
downward sloping this means that the firm will be charging a price that exceeds
marginal costs. The monopoly power possessed by a MC firm means that at its profit
maximizing level of production there will be a net loss of consumer (and producer)
surplus. The second source of inefficiency is the fact that MC firms operate with excess
capacity. That is, the MC firm's profit maximizing output is less than the output
associated with minimum average cost. Both a PC and MC firm will operate at a point
where demand or price equals average cost. For a PC firm this equilibrium condition
occurs where the perfectly elastic demand curve equals minimum average cost. A MC
firms demand curve is not flat but is downward sloping. Thus in the long run the
demand curve will be tangential to the long run average cost curve at a point to the left
of its minimum. The result is excess capacity.
Problems
While monopolistically competitive firms are inefficient, it is usually the case that the
costs of regulating prices for products sold in monopolistic competition exceed the
benefits of such regulation.. A monopolistically competitive firm might be said to be
marginally inefficient because the firm produces at an output where average total cost is
not a minimum. A monopolistically competitive market is productively inefficient market
structure because marginal cost is less than price in the long run. Monopolistically
competitive markets are also allocatively inefficient, as the price given is higher than

Marginal cost. Product differentiation increases total utility by better meeting people's
wants than homogenous products in a perfectly competitive market.
Another concern is that monopolistic competition fosters advertising and the creation
of brand names. Advertising induces customers into spending more on products
because of the name associated with them rather than because of rational factors.
Defenders of advertising dispute this, arguing that brand names can represent a
guarantee of quality and that advertising helps reduce the cost to consumers of
weighing the tradeoffs of numerous competing brands. There are unique information
and information processing costs associated with selecting a brand in a monopolistically
competitive environment. In a monopoly market, the consumer is faced with a single
brand, making information gathering relatively inexpensive. In a perfectly competitive
industry, the consumer is faced with many brands, but because the brands are virtually
identical information gathering is also relatively inexpensive. In a monopolistically
competitive market, the consumer must collect and process information on a large
number of different brands to be able to select the best of them. In many cases, the cost
of gathering information necessary to selecting the best brand can exceed the benefit of
consuming the best brand instead of a randomly selected brand. The result is that the
consumer is confused. Some brands gain prestige value and can extract an additional
price for that.
Evidence suggests that consumers use information obtained from advertising not
only to assess the single brand advertised, but also to infer the possible
existence of brands that the consumer has, heretofore, not observed, as well as
to infer consumer satisfaction with brands similar to the advertised
Monopolistic Competition,Features and Price and Output determination under it
Nov18
Definition:Monopolistic Competition
Monopolistic/Imperfect competition as the name signifies is a blend of monopoly and
competition. It is a systematic and realistic theory of price analysis in this imperfectly
competitive world.Monopolistic competition is a market situation in which there are relatively
large number of small firms which produce or sell similar but not identical commodities to the
customers.
According to Leftwitch:Monopolistic competition is a market situation in which there are many
sellers of a particular product, but the product of each seller is in some way differentiated in the
minds of consumers from the product of every other seller.

In the words of J.S. Bain:Monopolistic competition is found in the industry where there is a
large number of small sellers selling differentiated but close substitute products.
Examples of Monopolistic Competition:
For example, a firm supplies branded good Lux Soap in the market. There are many other firms
in the market which sell similar soaps (not identical) with different brand names like Rexona,
Palm Rose, etc., etc. The firm supplying Lux Soap enjoys a monopoly position over the sale of
its own product. It also faces competition from firms selling similar products.Same is the case
with many other firms in the market like plywood manufacturing, jewellery making, wood
furniture, book stores, departmental stores, repair services of all kinds, professional services of
doctors, technicians, etc., etc. These firms and others which have an element of monopoly power
and also face competition over the sale of product or service in the market are called
monopolistically competitive firm
Characteristics of Monopolistic/Imperfect Competition:
The main characteristic or features of monopolistic competition are as under:
(i) A fairly large number of sellers: The number of firms in monopolistic competition is fairly
large. Each firm produces or sells a close substitute for the product of other firms in the product
group or industry. .Product differentiation is thus the hallmark of monopolistic competition.
(ii) Differentiation in products: Under monopolistic competition, the firms sell differentiated
products. Product differentiation may be real or imaginary. Real differentiation is done through
differences in the materials used, design, color etc. Imaginary differences may be created through
advertisement, brand name, trade marks etc. The firms producing similar products in .this
imperfectly competitive world cannot raise the price of product much higher than their rivals. If
they do so, they will lose much of their sale, but not all the sale. In case, they lower the price, the
total sale can be increased to a certain extent. How much will the sale increase or decrease by
lowering or raising the price will depend upon the product differentiation of the different firms.
If the product of the various firms are very close substitutes of one another and no imaginary or
real difference exists in the mind of the buyers, then a slight rise or fall in the price of the product
of one firm will appreciably decrease or increase the demand for the product. If the product of
one firm differs from that of other firm, (though the difference may be an imaginary one) a slight
rise in the price of the product of one firm will not drive away all its customers. A few faithless
buyers may be attracted by the low price of the other rival product but not all the buyers.
(iii) Advertisement and propaganda: Another very important characteristic of the monopolistic
competition is that each firm tries to create difference in its product from the other by
advertising, propaganda, attractive packing, nice smile, etc., etc. When it succeeds in its object,
the firm occupies almost the position of a monopolist. It is, thus, in a position to raise-the price
of the product without losing its customers.
(iv) Nature of demand curve: Since the existence of close substitutes limits
the monopoly power, the demand curve faced by a monopolistically competitive firm is fairly
elastic. The precise degree of elasticity will however, depend upon the number of firms in the

group product or industry. If the number of firms is fairly large and the product of each firm is
not very similar, the demand curve of a firm will be quite elastic. In case, there is close
competition among the rival firms for the sale of similar products, the demand curve of a firm
will be less elastic.
(v) Freedom of entry and exit of firms: The entry of new firms in the monopolistically
competition industry is relatively easy. There are no barriers of the new firm to enter the product
group or leave the industry in the long run.
(vi) Sales efforts: With heterogeneous products, the sale of the products by the firms can no
longer be taken for granted sale depends upon sale efforts.
(vii) Non-price competition: In monopolistic competition, the firms make every effort to win
over the customers. Other than price cutting, the firms may offer after sale service, a gift scheme,
discount not declared in the price list etc.
Short Run Equilibrium Under Monopolistic/Imperfect Competition:

Monopolistic competition refers to the market organization where there are a fairly large number
of firms which sell somewhat differentiated products.
A single firm in the product group (industry) has little impact on the market price. However, if it
reduces price, it can expect a considerable increase in its sales. The firm may also attract buyers
away from other firms by creating imaginary or real difference through advertising, branding and
through many other sales promotion measures (non-price competition). If the firm raises its
price, it will not lose all its customers. This is because of the fact that the product is differentiated
from competing firms due to price and non-price factors. The demand curve (AR curve) of the
monopolistic firm is therefore, highly elastic and is downward sloping. As regards the marginal
revenue curve, it slopes downward and lies below the demand curve because price is lowered of
all the units to sell more output in the market.
Firms Equilibrium Price and Output:
In the short-run, the number of firms in the product group remains the same. The size of the
plant of each firm remains unaltered. The firm whether operating under perfect competition, or
monopoly wants to maximize profits. In order to achieve this objective, it goes on producing a
commodity so long as the marginal revenue is greater than marginal cost. When MR = MC, it is
then in equilibrium and produces the best level of output. If a firm produces less than or more
than the MR = MC output, it will then not be making maximum of profits.
In the short-run, a monopolistically competitive firm may be realizing abnormal profits or
suffering losses. If it is earning profits, no new firms can enter the industry in the short-run. In
case, it is suffering, losses but covering full variable cost, the firm will continue operating so that
the losses are minimized. If the full variable cost is not met, the firm will close down in the
short-run. The short-run equilibrium with profits and short run equilibrium with losses of a
monopolistically competitive firm are explained with the help of two separate diagrams as under.

Diagram:
In the figure (17.1), the downward sloping demand curve (AR curve) is quite elastic. The MR
curve lies below-the average curve except at point N. The SMC curve which includes advertising
and sales promotional costs is drawn in the usual fashion. The SMC curve cuts the MR curve
from below at point Z. The firm produces and sells an output OK, as at this level of output MR =
MC. The firm sells output OK at OE/KM per unit price. The total revenue of the firm is equal to
the area OEMK, whereas the total cost of producing output OK is OFLK. The total profits of the
firm are equal to the shaded rectangle FEML. The firm earns abnormal profits in the short run.
Short Run Losses:
If the demand and cost situations are not favorable in the market, a monopolistically competitive
firm may incur losses in the short-run. The short-run equilibrium of the firm with losses is
explained with the help of a diagram.
Diagram:
In the Figure (17.2), marginal cost (SMC) equates marginal revenue MR curve from below at
point Z. The firm produces output OK and sells at OF/KT per unit-price. The total receipt of the
firm is OFTK. The total cost of producing output OK is equal to OEMK. The firm suffers a net
loss equal to the area FEMT on the sale of OK output
Long Run Zero Economic Profits:
In the long run, the firms are able to alter the scale of plant according to the changed conditions
of demand for a product in the market. They can also leave or enter the industry. If the firms are
earning abnormal profits in the short run, then new firm will enter the product group (industry).
The tendency of the new firms to enter the industry continues till the abnormal profits are
competed away and the firms economic profits are zero. In case the monopolistically competitive
firms realize losses in the short-run, then some of the firms will leave the industry. The exit of
the firm continues till zero economic profits are restored with the operating firms.
In the long-run, there are no entry barriers for the new firms. The incoming firms install latest
machinery and try to differentiate their products from those of the established firms. The old
firms operating with .the used machinery try to match up with the new entrants by improved
variety of products in their group. They increase expenditure on advertisement and on other sales
promotional measures. They employ more qualified staff for. making technical improvement in
their products. Since all the firms for their existence incur additional expenditure for improving
the quality of the products, the cost curves of all the firms move up. Due to entry of new firms in
the industry and higher costs of production, the output of each competing firm is reduced. There
is, therefore, a waste in the economic resources of the country. The equilibrium price and output
in the long-run is explained with the help of a diagram.

Diagram:
In the figure (17.3), the higher shifted long-run marginal cost curve intersects the higher shifted
marginal revenue curve at point M. The firm at this raised equilibrium point, produces the
reduced level of output OK. It sells this output at price TK as at point T, LAC is a tangent to the
demand or average revenue curve at its minimum point. The total revenue of the firm is equal to
the area OETK. The total costs of the firm are also equal to the area OETK. The firm is earning
only zero or normal economic profits. As the monopolistically competitive firm sets a price
higher than that minimum average cost in the long-run, the firm therefore produces a
smaller output. Since all the firms in the product group produce less at higher price, there is,
therefore, an apparent waste of resources and exploitation of the consumers.
The advocates of monopolistic competition are of the opinion that if consumers get differentiated
products at slightly higher prices (than with no choice under perfect competition), the consumers
are then not exploited. There is no wasting of resources either, as the consumers welfare
increases with the product differentiation.

UNIT -5
Marginal Productivity Theory of Distribution
The Marginal Productivity Theory is the general theory of distribution. The theory
explains how the prices of the various factors of production would be determined under
conditions of perfect competition and full employment.
According to the Marginal Productivity Theory, the price of any factor will be equal to the
value of its marginal product. For example, we know that a consumer will demand a
commodity up to the point at which its marginal utility is proportional to the price he pays
for it. Similarly, a firm will go on employing more and more units of a factor until the
price of the factor is equal to the value of the marginal product. In other words, each
factor is rewarded according to its marginal productivity. The marginal productivity is
equal to the value of the additional product, which an employer gets when he employs
an additional unit of that factor, the supply of all other factors remaining constant.
In theory at least, all units of a factor are uniform and are interchangeable. So the
productivity of the marginal unit of a factor determines the rate that is to be paid to all
units of the factor. The employer adopts what is known as the principle of substitution
and combines land, labor and capital in such a way that the cost of production is
minimum. Then the reward for each factor is determined by its marginal productivity.
The Marginal Productivity theory of distribution has been used to explain the

determination of rent, wages, interest and profits. That is why, it is called the general
theory of distribution.
Assumptions of the Theory
The theory is based on the following assumptions:
1. There is perfect competition.
2. All units of a factor are homogeneous. It means that one unit is the same as the
other unit in all respects.
3. One factor of production can be substituted for another. In other words, all factors
are interchangeable.
4. The theory is based on the Law of Diminishing Returns as applied to a business
organization. In consumption, the Law of Diminishing Utility tells us that marginal
utility diminishes for every increase in the stock of a good. Similarly, the Law of
Diminishing Marginal Returns tells that if you go on employing more and more units
of a factor, say labor, its marginal productivity will diminish. So an employer, when
once he comes to know that the increase of a certain factor is resulting in
diminishing returns, he will substitute it by some other factor. Thereby, he will try to
reduce the cost of production.
5. There is full employment.
Criticism of the Theory
The Marginal productivity Theory has been criticized on many grounds. The following
are some of the points or criticism.
1. Every product is a joint product and its value cannot be separately attributed to
either capital, or labor or land. It is almost impossible to measure the specific
product of each of the factors. The problem becomes more complex when we have
to measure the productivity of certain categories of labor that render services
(Example: doctors, teachers and actors). If, for instance, some labor is engaged in
the production of some commodity, then there is some scope for quantitative
measurement. But with regard to those who render services, the problem of
determination of their reward becomes rather a difficult one.
2. The theory takes into account only the factors operating on the side of demand and
ignores the influences acting on the side of supply. It tells that a factor is demanded
because it is productive and it is paid according to its marginal productivity. But this
cannot be the case always. There are many instances where a factor of production
has to be paid much more than its normal price on account of the scarcity of the
factor in relation to the demand for it.

3. The theory assumes perfect competition and full employment. But in the real world,
imperfect competition is the rule. There is no perfect competition.
4. In practice, it is not easy to vary the use of the factors of production.
5. Lastly, the theory does not carry with it any ethical justification. If the theory is
accepted, it means that factors get the value of what they produce. Suppose wages
are low in a firm. The employer may say wages are low because productivity is low.
But the real cause of low wages might be the exploitation of labor by the employer.
Hence the theory should not be applied to justify the present system of distribution.
In spite of the above points of criticism against the theory, it should not be forgotten that
it explains the role of productivity in the determination of reward for any factor. There is
no doubt that the Marginal Productivity Theory is an incomplete explanation of the
problem of distribution. But as Marshall puts it, the doctrine throws into clear light one
of the causes that govern wages.

Ricardian distribution theory

The importance of David Ricardos model is that it was one of the first models used in
Economics, aimed at explaining how income is distributed in society.

Starting assumptions:
-there is only one industry, agriculture; only one good, grain;

-there are three kinds of people:

Capitalists: they start the economic growth process by saving and investing. In return, they
receive profits (P), which is what is left once wages and rents have been subtracted from the
gross revenue. Capital can be divided into fixed capital (machines, for example) and working
capital (wage fund, WF).
Workers: they represent the labour force, in return for wages (w).
Landlords: they allow production(y) to take place in their lands in return for rent (R).
-law of diminishing returns: affects labour (variable factor of production) and land (fixed factor).
-principle of margin: marginal product of labour, which, along with the average product of land,
is decreasing.
-principle of economic surplus: profits are determined as a surplus of production.
Analysis:
At a given initial situation, production is at a y0 level, which we can divide into wages, w0, and
profits, P0. Rent paid to landlords corresponds to R0. From w0 and the level of labour, L0, we
determine the wage fund at the initial situation, WF0.
In the long term, wages will arrive at a subsistence level, ws, which can be defined as the wage a
worker needs in order to survive. From this, and the level of labour being employed, we
determine the wage fund in the long run, WF*. As this level is the same as labours marginal
product, the capitalist will not obtain any profits. On the other hand, landlords will get higher
rents, R*.
Steady state:
Real wages will stagnate at subsistence level, the interest rate of capital will stay at 0 and rents
will reach its maximum level.
Ricardo explains how this steady state is painful, especially for the working class. However, this
steady state can be delayed with technological progress or international trade, as is shown
in Ricardian trade theory.

Modern Theory Of Factor Pricing Under Perfect Competition

The modern economist discards the marginal productivity theory on the ground that it
completely ignores the supply side of a factor of production. Moreover, it simply states
as to how many units of a factor of production will be employed at different prices but it

does not explain the real issue, i.e., the determination of the price of the factor of
production.
Modern theory of factor pricing under perfect competition can be understood when we
know about factor price and perfect competition separately. The modern economist
discards the marginal productivity theory on the ground that it completely ignores
thesupply side of a factor of production. Moreover, it simply states as to how many units
of a factor of production will be employed at different prices but it does not explain the
real issue, i.e., the determination of the price of the factor of production. They,
therefore, use the tools of demand and supply in solving the problem of determination
of factor prices. Just as the price of a commodity in the market, they say, is determined
by matching of demand and supply, similarly the price of an agent of production is
determined by their forces of demand and supply in the factor market. The demand for
and supply of a factor in a resource market under conditions of perfect competition is
new explained in brief.
The Demand for a factor of production:
The demand for factors is a derived demand. They are not demanded for their own
sake but their services are required for the production of other goods and services which
the consumers need. For instance, labour is hired because it helps in the production
of the commodities. Similarly, land is not desired for itself. It is demanded for the things
which It grows or for the construction of a factory or shop, etc., on it.
The demand for a factor of production, like the price of commodity, is a function of
price. How much a factor of production will be demanded in the market depends upon
two parameters
(1) the magnitude of demand and
(2) the elasticity of demand for that factor.
The Magnitude of Demand:
(i) If a factor of production is very important in the process of production of a particular
commodity or commodities, it will have a higher demand in the factor market.
(ii)
If the demand for final product is expected to be high, then the demand for all
the factors which produce the product will go Lill
(iii) If a factor of production has close substitutes, then its demand will not rise even if
the demand for final product in which it is used increase. The reason is that the

employers of factors of production would prefer to engage a substitute which is available

in the marketat an attractive price.
Elasticity of Demand for Factors: By elasticity of demand for factors is Meant the
degree of responsiveness of demand for the various factors to changes in their prices.
The main propositions on which the elasticity of demand for the factors of production
depends are as fellows:
(i)
If the price of a factor of production forms a very small proportion in the total
costs of a product, then its demand will be inelastic. If cost forms a greater proportion of
the total cost, then its demand will be elastic.
(ii)
The demand for a factor of production also depends upon the elasticity of
demand for a commodity in which it is used. If the demand for a commodity is fairly
elastic, then the demand for factors which go to make the product will also be elastic
and vice versa.
(iii) If a factor of production is easily substitutable in the market, then its demand
will be fairly elastic. In case, it is indispensable, the demand will be inelastic.
The Market Demand Curve for a Factor: We have stated earlier that the demand
curve for a factor is the marginal revenue productivity curve of a firm. If we add up
laterally individual demand curves of all the firms, we get market demand curve for a
factor. This is illustrated with the help of the curve.
Firm Demand Curve
Market Demand Curve
Y

a) when the wage is OW1 the firm s in equilibrium at point K and the demand for the
factor is OR. When wage is OW2, the firm is in equilibrium at point M. The firm
engages OSunits of a facto( If we sum up laterally the individual demand curves of all
the firms, we get DD market demand curve for a factor. It is clear from this Fig. 18.3 (b)
that with the fall in wages, the demand for a factor increases and vice versa. For
instance, at OW1, market is OK units (in thousand) of factor are demanded. When wage
falls to OW, the demand for factor increases from OK to OR. With further fall in wage to
OW2, the market demand for factor increase from OR to OS. The market
demand curve for a factory is a. negatively sloped curve indicating inverse relationship
between price of a factor and its quantity demanded
The Supply of a Factor of Production:
The supply of a factor of production can be defined as a schedule of the various
quantities of a factor of production that would be offered for sale at all possible prices at
any one instant of time. We have stated earlier that the demand far various factors of
production is a derived demand. Just as the supply and stock of a commodity can be
different, similarly the supply and stock of a factor of production can also vary. If
the supply price of a factor is high, other things remaining the same, larger will be
the units of factor offered for sale. If the supply price is low, less quantity of factors of
production will be supplied in the factor market. The supply of a factor to an
industry
depends
upon the transferearnings
of
the
various units
of factor. Another characteristic of factors of production is that they do not bear direct
relation between the prices of services offered by the factors of productton and their cost
of production.

The supply of factors of production is very complicated because each kind of factor
presents a peculiar problem of its own. Land, for instance, is fixed in quantity and its
totalsupply cannot be increased even if its price rises. However, for a particular use,
its supplycan be varied. Similar is the case with labour. The total supply of labour in the
country depends upon various factors, such as size of population, labour efficiency,
expenses of training and education, geographical distribution, attitude towards work,
etc. The totalsupply of labour in the country is fixed but for a particular occupation it
can be increased by drawing workers from other occupations and by increasing the
working hours of the labour already employed. The supply of capital is also complicated
as it depends upon the power and willingness of the people to save. The marginal
efficiency of capital and the rate of interest also play a very important role in
the supply of capital in the country.
In nutshell, we can say that the supply of a factor is also a function of price.
The higher the price of a factor of production, other things remaining the
same, the greater will be its supply and vice versa. The supply curve of a
factor of production is positively inclined, i.e., its slopes upward from left to
right as is shown below:In the diagram (18.4) we measure units of a factor, say labour, along OX axis and wage
on OY axis. If the wage is OP, 01_ workers are supplied. At wage OR, the supply of
workers increases from OL to the normal supply curve of a factor is P
positively sloped. If rises from left to right Upward indicating that at higher factor
prices, greater quantity of factor is offered in the factor market and vice
versa.
Units of a Factor
In a perfect competitive. market, there are large number of firms to demand the services
of a factor of production and also large number of households to supply the services of a
factor. In such a factor market, the price of a factor is determined by the interaction of
the forces and demand and supply as is shown in the figure below:
In this diagram 18.5, DIY is the demand curve and SS is the supply curve of a factor.
The demand and supply curves intersect at point E.
The equilibrium factor price is OP The price of a factor cannot be stable at the level
higher than or lower than OP. For example, the price cannot be established at OW. Since
at price OP1, the quantity offered to supply is greater than the quantity demand (QM),

therefore, the competition between the owners of the factor will force down the price to
OP level. Similarly, the price of factor cannot be determined at the level of OP 2 -because
at this price, the supply of a factor is less than demand by M1Q1. The competition among
the producers demanding the factor. of production will push the price to OP level. We
thus find that the reward of a factor of production is determined by the interaction of
the forces of demand and supply.

Criticism.
The theory of factor pricing is criticized on the ground of its weak assumptions.
(1) The theory is based on the assumption of perfect competition in both the product
and factor markets. While in reality, it is the imperfect competition which prevails in
both
the markets.

(2) The theory assumes that all the unit of a factor are homogenous. .But in the real life
they are different from each other.
(3) The theory assumes that different factors of production are capable of being
substituted for one on other. In the real world, we find that factors of production are
not close substitutes of one another.
(4) The theory ignores the increasing returns in factor pricing.
THEORIES OF DISTRIBUTION
Personal and Functional Distribution of Income: Personal distribution of national
income means the distribution of national income among various individuals in a
society. It shows how inequalities of income emerge in the country.
On the other hand, the theory of functional distribution studies how the various factors of
production are rewarded for their services. It studies how prices of factors such as rent
of land, wages of labour, interest on capital and profits of entrepreneur are determined.
The theory of distribution is concerned with functional distribution of income which is
also called theory of factor pricing.
The Marginal Productivity Theory: According to the Marginal Productivity Theory the
payment made to the factors of production is just equal to the value of their marginal
product (VMP = MPxP) or the marginal revenue product(MRP).
If the prevailing wage is less than the marginal productivity of labour, then more labour
will be demanded. Competition among employers will raise the wage to the level of
marginal productivity. On the other hand, if the marginal productivity is less than the
wage, the employers are losing and they will reduce their demand for labour. As a
result, the wage will come down to the level of marginal productivity. In this way, by
competition, wage tends to equal the marginal productivity. This applies also to other
factors of production and their rewards.
Wage Differential: Since labours are neither identical nor homogeneous different
workers are paid different wages. Wage differentials may arise due to
(1) Dynamic (or disequilibrium) causes, and (2) Static (or equilibrium) causes.
Dynamic wage differentials arise due to disequilibrium in commodity and labour
markets. Such differentials are therefore temporary and exist only till the disequilibrium
persists.

The static wage differentials are those that persist in the state of labour market
equilibrium. Such differences are not removed by the competitive forces of the market.
Wage differentials of this type arise mainly due to the following reasons:
(i) qualitative differences in labour, i.e., non-homogeneity of labour;
(ii) difference in the nature of occupations in which labour is employed;
(iii) differences in the prices of product produced by labour; and (iv) market
imperfections.
Bilateral Monopoly/Collective Bargaining: Bilateral monopoly exist in the factor
market when there is a single buyer and a single seller of labour. Under such conditions
labour is supplied by monopolist (a labour union) and demanded by a monopsonist
(employers union). Wage determination in this kind of market situation is generally
analysed under collective bargaining. It may be noted that the outcome of collective
bargaining is not certain. That is, solution to a bilateral monopoly situation is
indeterminate. The economic analysis of collective bargaining bring out the upper and
lower limits within which the wage rate can be determined through the process of
collective bargaining. The determination of wage rate, ultimately depends on a number
of factors like bargaining powers and skills, economic and political power of labour
unions and of employers union, the effect of government intervention, etc.
Scarcity Rent: Land is limited in quantity and with the growth of population it becomes
scarce in relation to the demand for it. As the price of the agricultural produce (e.g.
wheat) rises, the worst land is also subjected to intensive cultivation and it yields a
surplus over cost. This surplus is not a differential one compared to no-rent land, which
does not exist. It is due to the scarcity of land as such. Hence, it is called scarcity rent.
Differential Rent: Different pieces of land are not uniform in quality. Hence, with the
increase in population successive inferior lands are taken into cultivation. In the process
rent immediately arises on the better quality lands. The amounts of rent certainly
depend on the difference of productive powers of these various grades of land. The
marginal land gets no rent at all. Thus, rent arises on account of natural differential
advantages enjoyed by a piece of land over the marginal land. The natural differential
advantage may be due either to superior quality of land or its better situation. This is
Ricardos theory of differential rent.
Quasi-Rent: The concept of quasi-rent was first introduced in Economics by Marshall.
Quasi-rent refers to the whole of the income which some agents of production earned
during the short period when their supply cannot be increased in response to an
increase in the demand for them. For example, during war the demand for houses in
towns increases but the supply cannot be increased because of scarcity of building
material. This abnormal increase in the return on capital invested in buildings is quasirent. Quasi-rent is only a temporary surplus. It is not pure rent, because the supply of
houses can be increased in the long run and quasi-rent disappears.

Quasi-rent may also be defined as the excess of total revenue (TR) earned in the shortrun over and above the total variable costs (TVC). Thus, Quasi-rent = TR TVC.
Transfer Earning: Transfer earning or opportunity cost is the amount which a factor of
production could earn in its next best alternative use. In other words, it is the amount
that a factor must earn to remain in its present occupation. For example, suppose a
doctor earns Rs 10,000 per month from his private clinic. The alternative available to
him is to serve in a hospital as an employee where he could earn Rs 8,000 per month.
Thus, the doctors transfer earning is Rs 8,000 per month. He must earn a minimum of
Rs 8,000 to remain in his private practice.
Economic Rent: Economic rent is the excess of actual earning of a factor over its
transfer earning. It is a factors actual earning minus its transfer earning. For example, if
the actual earning of a doctor in his private clinic is Rs 10,000 per month and if his next
best alternative job (transfer earning) is to work as a hospital employee where he could
earn Rs 8,000. Then, Rs 2,000 (Rs 10,000 Rs 8,000) is the economic rent.
Abstinence or Waiting Theory of Interest: According to the Abstinence Theory saving
is an act of abstaining from consumption. Since to abstain is painful, it is necessary to
reward people for this act. This reward is in the form of the interest paid to those who
saved, rather than consumed their incomes.
However, this theory has been criticized on the ground that it suggested positive
discomfort, while the rich people save without the least inconvenience.Marshall then
substituted the term waiting for abstinence. When a person saves, he does not
refrain from consumption for all time but merely postpones present consumption to a
future date. Thus, saving involves waiting. But since most people do not like to wait, an
inducement is necessary to encourage this postponement of consumption.
Austrian or Agio Theory of Interest: According to this theory put forward by Bohm
Bawerk, interest arises because people prefer present goods to future goods and
therefore there is an agio or premium on present goods. In other words, future
satisfactions when viewed from the present angle undergoes a discount. Interest is this
discount which must be paid in order to induce people to lend money or postpone
present satisfaction to a future date.
Fishers Time Preference Theory of Interest: Fishers Time Preference theory
emphasizes the fact that individuals prefer present satisfactions to future satisfactions.
They are thus impatient to spend their incomes now. The degree of impatience depends
on the size of the income, the distribution of income, the degree of certainty, and the
temperament and character of the individual. Thus, the rate of individual time
preference, after having been determined, tend to become equal to the rate of interest.
Wage theories

Wage Determination Theories Acc. To Prof. J. Dunlop the history of wage theory may
be divided in to 3 periods : Up to 1870 , Which was dominated by WAGE FUND

THEORY 1870-1914 : THEORY OF MARGINAL PRODUCTIVITY 1914- till date :

Process of Collective bargaining & Keynesian Equity & the General Wage Level &
Employment.

3. Subsistence Theory by David Ricardo(1772-1823) Also called as Iron Law of Wages

Assumptions Law of diminishing returns apply to the industry. Population increases or
decreases on the basis of subsistence wages paid to the workers. Labor demand
constant No wage differentials.

4. Subsistence Theory by David Ricardo(1772-1823) This theory states that The

laborers are paid to enable them to subsist & perpetuate the race without increase or
diminution

5. PROCESS OF actual wage level adjusting to Subsistence level Prosperous Worker

(2) Less food ie Deaths(6) Wage level > Subsistence(1) Fewer Deaths (3) Labor
increase In supply (4) Labor demand < Supply(5) Wages will decrease from
Subsistence level(6) Decrease in Labor supply & increase in wages(7)

6. Wage Fund Theory by Adam Smith(1723-1790) It assumes that there is a

predetermined fund of wealth which lays surplus with wealthy persons as a result of
savings & wages are paid out of it. MAGNITUDE of Wage fund determines :- Demand
of Labor Wages paid to the labor, higher the fund higher would be the demand for labor
& wages paid to the labor & vice virsa.

7. Wage Fund Theory by Adam Smith(1723-1790) Wages depends on Demand &

Supply of Labor. Wage fund is fixed So to increase the wages 2 things can be doneLarge size of wage fund Reduction in labor

8. Wage Fund Theory by Adam Smith(1723-1790) Criticism It is not clear from where
wage fund will come. No emphasis on efiiciency & productivity No light on wage
differencials

9. Surplus Value Theory by Karl Marx(1818-1883) Acc to this theory Workers was an
article of commerce which could be purchased on the payment of subsistence price.
The price of any product is determined by the labor TIME needed for producing it. The
workers were not paid acc to their contribution.

10. Surplus Value Theory by Karl Marx(1818-1883) CRITICISM Labor is treated as

commodity Price can not be determined by labor time No emphasis on productivity Not
applicable in organized sector

11. MARGINAL PRODUCTIVITY THEORY by P H Wicksteed (England) & J B

Clark(USA) It assumes that wages depend upon the demand for & supply of LABOR.
Wages are based on entrepreneur s estimate of the value that will be produced by the
last or marginal worker wages are paid on the base of economic worth

12. MARGINAL PRODUCTIVITY THEORY by P H Wicksteed (England) & J B

Clark(USA) Homogeneous factor of production Full employment of resources Perfect

competition Perfect mobility of factor of production Law of diminishing returns Perfect

knowledge

13. MARGINAL PRODUCTIVITY THEORY by P H Wicksteed (England) & J B

Clark(USA) CRITISM No importance to supply of labor In practice employer gives lower
wages than marginal productivity of laborer Unrealistic assumptions

14. Residual Clainmant Theory by Francis A Walker(1840-1897) 4 factor of productionland ,labor, capital & entrepreneurship. Wages = value of production (rent+ interest+
profit) Criticism Demand & supply factor ignored Based on wrong notion of residual
clainmant Productivity & efficiency ignored.

15. Investment Theory by H M Gitelman Acc to this theory workers are paid in terms of
their investment in education, experience & training. Worker must be having attributes.
Higher attributes higher payments.

16. Bargaining Theory of Wages by John Davidson Acc. To this theory Wages are
determined by relative bargaining power of workers or trade unions and of the
employers. Applicable in organized sector. If union is strong workers will be paid more.
& vica virsa.

17. The Contingency Theory No single best way to evolve the payment system Acc to
Lupin & Bowey essentially, a contingency approach is that in some industry & in some
envt conditions one managerial practice will contribute to some desired objectives while
the same will not happen in other industry.

18. Demand & Supply Theory Alfred Marshall , the chief exponent to this theory,
explained the complexity of the economic world tried to provide a less rigid &
deterministic theory. According to him, the determination of wages is affected by the
whole set of actors which govern demand for & supply of labour. The demand price of
labour, however, determined by the marginal productivity of the individual worker The
term supply & labor can be expressed in a number of senses. First, it refers to the
number of workers seeking employment; these are the workers who have no alternative
livelihood & join the labor market seeking employment for wages. Secondly, supply &
labor may refer to the number of hours each worker is available for work. The supply of
labour in this sense increases with any increase in the number of working hours.

19. Behavioral Theories of Motivation Equity Theory Equity can be external or external.
Internal equity refers to the pay differential between & among the various skills & levels
of responsibility. External equity refers to concerns regarding how wage levels for
similar skill levels in one firm compare with those in other firms in similar or the same
industry & location. Expectancy theory It suggests that motivation depends on
individuals expectations about their ability to perform tasks & receive the desired
rewards. An employers responsibility is to help employees meet their needs &, at the
same time, attain organizational goals. Employers must try to find out match between
employees skills & abilities & the job demands.

20. Agency Theory Focuses on the goals & objectives of stakeholders & the way the
employees remuneration can be used to align these interest & goals. Employers &
employees are 2 stakeholders Employers principals & employees agents. The
agency theory says the principal must choose a contracting scheme that helps in
aligning the interests of agents with the principals own interests

21. So behavioral Theories are based on Employers concern for workers Employees
acceptance of wage levels Internal wage structure Wages & other motivators

22. Wage Differential

23. Wage differential refers to differences in wage rates due to the location of company,
hours of work, working conditions, type of product manufactured, or other factors. It may
be the difference in wages between workers with different skills working in the same
industry or workers with similar skills working in different industries or regions. Wages
Differential Employees in MNCs are paid higher. Different industries have different wage
structures resulting in disparities in remuneration for identical works. Wide gaps exist
between wages of employees of organised sector vs. unorganised sector.

24. Occupational Differentials Different occupations require different qualifications, skills

and different degree of responsibility 1. To induce workers to undertake more
demanding, more risky jobs. 2. Encourage workers to develop skills in anticipation of
higher earnings in future. 3. To perform social function by way of determining the social
status of workers.

25. Inter-Industry Differentials Extent of unionization Employers ability to pay/ product

demand in market Provides opportunity for workers to switch to higher wage industries.
Arise when the workers in the same occupation and in the same area but in different
industries are paid different wages. Story about a foundry Shakti Industries in Haora,
West Bengal that makes New York Citys manhole covers. , November 26, 2007

26. Personal Wage Differentials Arise because of differences in personal characteristics

(age or sex) of workers who work in the same plant and the same occupation. In
occupations which involve muscular work, women workers are employed but paid less
than men workers Equal pay for equal work I.L.O. convention (No. 100) Industrial
courts Labour Tribunals Minimum Wages Committee Fare Wage Committee

27. Why all the labor is not done by hardened hands?

28. Sector Differentials Depends upon nature of workers group (organized/

unorganized) and level of economic development of the sector. Agricultural workers are
not able to better their living conditions, whereas workers in industrial sectors have their
own unions to fight for them.

29. Regional (Inter-Area) Differentials Workers in same industry and the same
occupational group, but living in different geographical areas, are paid different wages.
Irritating climate Isolation Disparities in cost of living

30. Summary The concepts of trade unions, wages and wage differentials are over a
century old in India. Indias economic development still needs a big push and the factors
unions, wages and wage differentials can play a vital role. Lets try to see the issues
from labours viewpoint

31. Payment for labor or services to workers, especially remuneration on an hourly,

daily, or weekly basis. Wages The demand for wages has never been fully met. Wage
raise in one company will inspire unions in other company to pitch tents demanding
similar rise in wages. Salary is a fixed periodical payment paid to a person for regular
work or services. Wage is usually paid by the day or week for work or services which
are of a more irregular nature.

32. WAGE POLICY

33. Wage Policy Wage policy refers to systematic efforts of the government in relation
to national wage and salary system. Purpose: To regulate the structure of wages and
salaries with view to achieve economic and social objectives of the government. To give
to workers a share in fruits of economic development. To set minimum wages for
workers whose bargaining power is weak. To bring about more efficient allocation and
utilization of human resources through wage and salary differential. To abolish
malpractices and abuses in wage and salary payments. To provide for a uniform, stable
and reasonably competitive compensation structure for all employees.

34. Wage Policy Organizations must develop policies as general guidelines to provide
for coordination, consistency, and fairness in compensating employees. For example,
following a pay-for-performance philosophy requires incorporating performance
appraisal results into the pay adjustment process.

35. Pay Policies Considerations Types of Job Evaluation SystemsMarket Positioning

Pay Expenditures Guidelines Affordability Constraints Linking of Performance
Appraisals and Pay Adjustments Figuring of Pay Structure adjustment Administrative
Appeals Process for Resolving Individual Pay Problems Width of Pay Ranges and
Broadbanding Number of Pay Grades

36. Broadbanding Practice of using fewer pay grades having broader ranges than
traditional compensation systems.

37. STEPS Determine your place in the market Select the types of compensation
Review your process.

38. Payment of Wages Act, 1937 Industrial Disputes Act, 1947 Minimum Wages Act,
1948 Equal Remuneration Act, 1976 To prohibit any delay or withholding of wages
Authorizing all state governments to set up industrial tribunals which would look into
disputes relating to remuneration Fixation of minimum rates of wages to workers
Prohibits discrimination in matters relating to remuneration on the basis of religion, sex
etc. With all these Acts in place, are there no disparities in wages?

39. Minimum Wages, Living Wages and Fair Wages Minimum wages- It must provide
not only for the bare sustenance of life but for the preservation of the efficiency of the
workers by providing some measures of education, medical care, etc. Criteria: It must
be calculated for a family of 4 units (numbers) It must be able to provide 2700 calories
per adult per day It should be sufficient for 18 yards of cloth per unit per annum There
should be a provision for reasonable house rent, light, fuel and miscellaneous items

40. Minimum Wages, Living Wages and Fair Wages Living wages- It is not only for the
bare essentials for the worker and his family, but also for comfort, protection against illhealth, decency, social needs and insurance for old age Fair wages- It is in-between
minimum wages and living wages, but below the living wage

41. Legal framework on wages The Government has enacted various laws to regulate
and govern the wages. They are: The payment of Wages Act 1936 The payment of
Bonus Act 1965 The Equal Remuneration Act The Minimum Wages Act The Companies
Act 1956

42. STRATEGIC PERSPECTIVE OF COMPENSATION

43. The Pay Model Business Goals Business Strategy CEO Compensation Philosophy /
activities serve Business Objectives Business Strategy This defines the direction in
which organization is going in relation to its environment in order to achieve its
objectives. Compensation Philosophy Consists of a set of beliefs which underpin the
reward/compensation strategy of the organization and govern the reward policies that
determine how reward processes operate

44. The Pay Model Business Goals Business Strategy Compensation Plan
Compensation Strategy Non-Financial Rewards Org.Structure CEO HR Head
Compensation activities serve Business Objectives Compensation strategy is
periodically reevaluated and the Compensation plan periodically developed
Compensation Strategy defines the intentions of the organization on reward policies,
processes and practices required to ensure that it has the skilled, competent and wellmotivated workforce it needs to achieve its business goals

45. The Pay Model Business Goals Business Strategy Compensation Plan
Compensation Strategy Non-Financial Rewards Org.Structure CEO HR Head
Compensation activities serve Business Objectives Compensation strategy is
periodically reevaluated and the Compensation plan periodically developed A strategic
perspective on compensation takes the position that how employees are compensated
can be a source of sustainable competitive advantage

46. The Pay Model Business Goals Business Strategy Compensation Plan Market
Surveys Compensation Strategy Job Evaluation Unit Inputs Total remuneration
Performance Management Non-Financial Rewards Org.Structure Performance linked
Pay Individual Pay Contribution /outputs Internal Equity External Equity CEO HR Head
Employee C & B/S M Pay levels / structures Compensation activities serve Business
Objectives Compensation strategy is periodically reevaluated and the Compensation

plan periodically developed Compensation Manager, along with team is responsible for
carrying out compensation related activities

47. Strategic Pay Pay structure has strategic value that assigns different pay rates for
the jobs with different values which differentiates individual employee contribution

48. Strategic compensation Using the compensation plan to support the companys
strategic aims. Focuses employees attention on the values of winning, execution, and
speed, and on being better, faster, and more competitive.. IBM

49. Strategic Compensation Planning Strategic Compensation Planning Links the

compensation of employees to the mission, objectives, philosophies, and culture of the
organization. Serves to identify the net monetary payments made to employees with
specific functions of the HR program in establishing a pay-forperformance standard.
Seeks to motivate employees through compensation.

50. Compensation Policy Issues Pay for performance Pay for seniority Salary
increases and promotions Overtime and shift pay Probationary pay Paid and unpaid
leaves Paid holidays Salary compression (A salary inequity problem, generally
caused byinflation, resulting in longer-term employees in a position earning less than
workers entering the firm today) Geographic costs of living differences

51. Strategic compensation Choices Fixed vs variable pay Internal & external equity Job
vs individual pay Above the market vs below the market pay Competency base pay or
broad banding Global compensation Process vs mechanics Paying the jobs vs laying
the person

52. Strategic compensation theory Contingency theory 3 types of business level

strategies Cost leadership Differentiation innovation

53. Aspects of compensation theory Compensation

competitiveness Administrative & implementation issues

54. Equity The perceived fairness of the relation between what a person does (inputs)
and what the person receives. PROCEDURAL AND DISTRIBUTIVE JUSTICE IN
COMPENSATION

55. Procedural justice The perceived fairness of the process and procedures used to
make decisions about employees. Distributive justice The perceived fairness in the
distribution of outcomes.

56. Equity Considerations in Compensation EXTERNAL: LABOR MARKETS Pay

survey data Competing employers policies ORGANIZATIONAL JUSTICE Distributive
Pay for performance Managerial decisions Procedural Policies and procedures
Pay structures

57. Equity Considerations in Compensation Individual Perception of inputs and

outcomes PAY OPENNESS Another equity issue concerns the degree of openness or

philosophy

External

secrecy that organizations allow regarding their pay systems. Pay information kept
secret in closed systems includes how much others make, what raises others have
received & even what pay grades and ranges exist in the organization.

58. EXTERNAL EQUITY Externally, the organization must provide compensation that is
seen as equitable in relation to the compensation provided employees performing
similar jobs in other organizations.

59. Importance of Equity and Compensation Activities consequence of an equitable

compensation program is that individuals are more likely to be attracted to and take jobs
in organizations where employees do not voice widespread concerns about equity.
Greater loyalty less turnover Higher commitment to achieve organizational performance
objectives Reduced favoritism or personality preferences of managers and supervisors

marginal productivity theory

marginal productivity theory, in economics, a theory developed at the end of the 19th
century by a number of writers, including John Bates Clark and Philip Henry Wicksteed,
who argued that a business firm would be willing to pay a productive agent only what he
adds to the firms well-being or utility; that it is clearly unprofitable to buy, for example, a
man-hour of labour if it adds less to its buyers income than what it costs. This marginal
yield of a productive input came to be called the value of its marginal product, and the
resulting theory of distribution states that every type of input will be paid the value of its
marginal product. (See distribution theory.)
Liquidity preference
This article is about liquidity preference in macroeconomic theory. For other uses,
see Liquidity preference (Venture capital).
In macroeconomic theory, liquidity preference refers to the demand for money,
considered as liquidity. The concept was first developed by John Maynard Keynes in his
book The General Theory of Employment, Interest and Money (1936) to explain
determination of the interest rate by the supply and demand for money. The demand for
money as an asset was theorized to depend on the interest foregone by not
holding bonds (here, the term "bonds" can be understood to also represent stocks and
other less liquid assets in general, as well as government bonds). Interest rates, he
argues, cannot be a reward for saving as such because, if a person hoards his savings
in cash, keeping it under his mattress say, he will receive no interest, although he has
nevertheless refrained from consuming all his current income. Instead of a reward for
saving, interest, in the Keynesian analysis, is a reward for parting with liquidity.
According to Keynes, demand for liquidity is determined by three motives:[1]

1. the transactions motive: people prefer to have liquidity to assure basic

transactions, for their income is not constantly available. The amount of liquidity
demanded is determined by the level of income: the higher the income, the more
money demanded for carrying out increased spending.
2. the precautionary motive: people prefer to have liquidity in the case of social
unexpected problems that need unusual costs. The amount of money demanded
for this purpose increases as income increases.
3. speculative motive: people retain liquidity to speculate that bond prices will fall.
When the interest rate decreases people demand more money to hold until the
interest rate increases, which would drive down the price of an existing bond to
keep its yield in line with the interest rate. Thus, the lower the interest rate, the
more money demanded (and vice versa).
The liquidity-preference relation can be represented graphically as a schedule of the
money demanded at each different interest rate. The supply of money together with the
liquidity-preference curve in theory interact to determine the interest rate at which the
quantity of money demanded equals the quantity of money supplied (seeIS/LM model).
Loanable funds
In economics, the loanable funds market is a hypothetical market that brings savers
and borrowers together, also bringing together the money available in commercial
banks and lending institutions
available
for
firms
andhouseholds to
[1]
finance expenditures, either investments or consumption. Savers supply the loanable
funds; for instance, buying bonds will transfer their money to the institution issuing the
bond, which can be a firm or government. In return, borrowers demand loanable funds;
when an institution sells a bond, it is demanding loanable funds. Another term for
financial assets is "loanable funds", funds that are available for borrowing, which consist
of household savings and sometimes bank loans. Loanable funds are often used to
invest in new capital goods, therefore, the demand and supply of capital is usually
discussed in terms of the demand and supply of loanable funds.

Interest rate[edit]
The suppliers are people who save money. The demanders are people who borrow the
money. The interest rate is the cost of borrowing or demanding loanable funds and is
the amount of money paid for the use of a dollar for a year. The interest rate can also
describe the rate of return from supplying or lending loanable funds. It is typically
measured as an annual percentage rate. As an example, consider this: a firm that
borrows $10,000 in funds for one year, at an annual interest rate of 10%, will have to
pay the lender $11,000 at the end of the year. This amount includes the original
$10,000 borrowed plus $1,000 in interest; in mathematical terms, this can be written as
$10,000 1.10 = $11,000. To continue with this example, if the firm borrows $10,000
for two years at an annual interest rate of 10%, it will have to repay the lender $12,100

at the end of two years. Because the loan lasts for two years, the firm will not have to
pay the lender until the end of the second year. The firm is chargedcompound
interest during the second year.[3][4]
Equilibrium[edit]
In the loanable funds market, when savings equal investment, equilibrium occurs. To
determine the equilibrium, the following formula is used:[2][4]
or

Rate of return on capital[edit]

The "rate of return on capital" is taken into account when determining the
demand for loanable funds. This is the additional revenue that a firm can earn
from its employment of new capital, and is usually measured as a percentage
rate per unit of time, which is why it is called the rate of return on capital. As long
as the rate of return on capital is greater than or equal to the interest rate on paid
on funds borrowed, firms will continue to demand loanable funds. [3][4]
Economists need their own uncertainty principle

Bad risk management contributed to the current financial crisis. Two

economists believe the situation could be improved by gaining a
deeper understanding of what is not known, as Philip Ball explains.
Philip Ball
Former US defense secretary Donald Rumsfeld is an unlikely prophet of risk
analysis, but that may be how posterity will anoint him. His remark about
'unknown unknowns' was derided as a piece of meaningless obfuscation, but
more careful reflection suggests he had a point. It is one thing to recognize
the gaps and uncertainties in our knowledge of a situation, and another to
acknowledge that unforeseen circumstances might entirely change the
picture.
The economy is as prone to any human endeavour to unknown unknowns but economic decision-making is commonly misled by confusing them with
known unknowns. Financial speculation is risky by definition. Yet the danger
is not that the risks exist but that the highly developed calculus of risk in
economic theory for which Nobel prizes have been awarded gives the
impression that the risks are under control.

The reasons for the current financial crisis have been picked over endlessly,
but one widespread view is that it involved failures in risk management.
Facing up to these failures could prompt the bleak conclusion that trying to
anticipate the economic future is an impossible task. That's the position
taken by Nassim Nicholas Taleb in his influential book The Black Swan1,
which argues that big disruptions in the economy can never be foreseen, and
are much more common than is evident from conventional theory.
How should those still working in financial markets absorb this pessimistic
message? In a preprint on arXiv2, Andrew Lo and Mark Mueller of the Sloan
School of Management at the Massachusetts Institute of Technology, in
Cambridge, suggest that what economists grappling with uncertainty need is
a proper taxonomy of risk not unlike, as it turns out, Rumsfeld's infamous
classification. In this way, they state, risk assessment in economics can be
united with the way uncertainties are handled in the natural sciences. It may
then become clearer where conventional economic theory is a reliable guide
to planning and forecasting, and where its predictive value fails.
Physics envy
The current approach to uncertainty in economics, write Lo and Mueller,
suffers from physics envy. "The quantitative aspirations of economists and
financial analysts have for many years been based on the belief that it
should be possible to build models of economic systems that are as
predictive as those in physics," they point out.
Much of the foundational work in modern economics took its lead directly
from physics. One of the principal architects of modern economics, Paul
Samuelson, acknowledged that his seminal bookFoundations of Economic
Analysis3, published in 1947, was inspired by the work of mathematical
physicist Edwin Bidwell Wilson, who was a protg of the pioneer of
statistical physics J. Willard Gibbs.
When Samuelson formulated his ideas, physicists had come to recognize
that the uncertainties of random thermal noise could be described by a
normal, or Gaussian, distribution of fluctuations (the classic bell curve).

Economists should recognise the existence

of uncertainty that their models can't capture.
Economists have known since the 1960s that fluctuations in commodity
prices are different. They don't fit a Gaussian distribution but are 'fat-tailed',
meaning that they have a greater proportion of big deviations, compared
with a bell curve. Even so, many standard economic theories have failed to
accommodate this deviation from the Gaussian form, most notably the
celebrated BlackScholes formula used by traders to calculate the price they
should pay when trading with the financial instruments known as options.
Incorrect statistical handling of economic fluctuations is a minor issue
compared with the failure of market traders and managers to distinguish
fluctuations that can in principle be modelled from those that are more
qualitative to distinguish, as Lo and Mueller put it, trading decisions
(which need maths) from business decisions (which need experience and
intuition).
Quantifying uncertainty
The conventional view of the origin of economic fluctuations that they are
caused by 'external' shocks to the market, delivered, for example, by
political events has truth in it. And these external variables can't be
meaningfully factored into the equations. Irreducible uncertainty, write Lo
and Mueller, "cannot be modeled quantitatively, yet has substantial impact
on the risks and rewards of quantitative strategies".
They propose a five-tiered categorization of uncertainty in any system,
whether it be physical, economic or political. The classification ranges from
complete deterministic certainty, exemplified by Newtonian mechanics
(where once you have the equations, you can predict the future perfectly),
through noisy systems and those that must be described statistically
because of incomplete knowledge about deterministic processes (as in coin
tossing), to 'irreducible uncertainty'.

They describe this last type of uncertainty as "a state of total ignorance that
cannot be remedied by collecting more data, using more sophisticated
methods of statistical inference or more powerful computers, or thinking
harder and smarter" something like the "unknown unknowns". Physical
systems tend to have more upper-level, easily modeled uncertainty; social
systems more of the lower-level, imponderable kind.
The authors think that this is more than just an enumeration of categories,
because it provides a framework for thinking about uncertainty. "It is
possible to 'believe' a model at one level of the hierarchy but not at
another," they write. It's rather like saying we can place some trust in daily
weather forecasts, but not much in monthly ones. And they sketch out ideas
for handling some of the more challenging unknowns, for example when
qualitatively different models may apply to the behaviour of markets at
different times or under different conditions.
They call for more support of postgraduate economic training to create a
cadre of better informed practitioners, who are more alert to the limitations
of the current economic models, such as those used to calculate expected
daily returns on investments in a 'business-as-usual' market. They point out
the dangers of devolving business management decisions to financial
analysts who have become accustomed to thinking that their models capture
all there is to say about economic risk. But to truly eliminate the ruinous
false confidence engendered by the clever, physics-aping maths of economic
theory, why not make it standard practice to teach everyone who studies
economics at any level that their models apply only to specific and highly
restricted varieties of uncertainty?

money supply doubling the price level.[14]