Unit 1.

Introduction
1.1 Concept of microeconomics
Microeconomics is the study of the individual parts of the economy. It is that part of the
economic analysis, which is concerned with the behavior of individual units: consumers,
households, and firms. It examines how consumers choose between goods, how workers choose
between jobs, and how a business firm decides what to produce and what production methods to
use.
Microeconomics, often called the price theory, is mainly concerned with the equilibrium
in the particular markets ( markets for potato, onion, cloths, cars and so on), assuming that there is
equilibrium of the market system as a whole. This implies that microeconomics is concerned with
the demand and supply of particular goods and services, and resources.
The word micro refers to small. Thus under microeconomics, we separate a particular
economic activity from the rest and study it individually. In doing so, we suppose that the
behavior of the particular activity under consideration is not affected by the behavior of the other
economic activities.
While studying microeconomics, we assume the existence of full employment in the
economy. Full employment is the situation in which total job seekers just equal total job
vacancies i.e. it is a situation where those able and willing to work at the prevailing wage rate
could get the job or employment.
Given the assumption of full employment, microeconomics proceeds to know how a
consumer and a producer attain equilibrium, and how the resources of the economy are allocated.
For example, in order to study market demand of a commodity, it is assumed that the price and
output of related goods are constant. The assumption of other things remain same, or ceteris
paribus is the main assumption of microeconomics. Under the ceteris paribus assumption,
microeconomic analysis is often called the partial equilibrium.
Thus, microeconomics has the following basic features:
* It concerned with individual parts of the economy.
* It studies economy in disaggregate manner.
* Its concern is about individual firms and consumers.
* It presupposes the existence of full employment in the whole economy.
* It analyses economic phenomena under the ceteris paribus assumption and hence it is a
method of partial equilibrium analysis.
* Its objective is to analyze the process by which scarce resources are allocated among
alternative uses.
1.2 Types of Microeconomics
Microeconomics can be divided into three principle types- microstatics, comparative
microstatics and microdynamics.
I. Microstatics:
It is a notion (concept) having no motion or change. So, microstatics is concerned with
the analysis of economic variables such as price, demand, supply etc. in a given period of time.
Microeconomics is concerned mainly with the equilibrium position in a particular market. Thus,
microstatics deal with the relationship between different micro economic variables at a given
period under condition of equilibrium. Microstatics assume that equilibrium position is given and
no change occurs in it. Given this assumption, microstatics tries to specify the relationships
between micro variables in the system. It deals with the condition which the system must satisfy
for all equilibrium exists.

Price P

It assumes that there is no disturbance in the equilibrium and analysis situation such as the
equality between demand and supply, marginal revenue and marginal cost, factor supply, and
factor demand and so on at given period of time. Take the case of price of a commodity at a
market, determined by the equality between demand and supply at a given time. Her microstatics
assume that there is no change in demand and supply function and the price determined by the
interaction of two prevails in the market. Figure 1.1 is an illustration of static equilibrium between
demand and supply.
D
S

S
0

Quantity

The above figure shows a simple microeconomic model of a static equilibrium. This
model contains three variables. They are quantity of commodity supplied which is denoted by line
SS; quantity of commodity demanded which is shown by line DD; and price of commodity P
which is determined by the interaction between DD and SS. The above model also contains three
relationships among the three variables. Under the given condition, the equilibrium price P has
been determined by the equality between demand and supply. Microstatics analyze this conditionthe condition of equilibrium between demand and supply at a particular point of time. It does not
deal with the process by which the forces of demand and supply have reached the equilibrium
position. It simply studies the variables-demand, supply, and price as they are. It ignores passage
of time and the process of change in the above model. It only indicates the position of the model
in the given period. It does not tell us what the position would be in any other period.
Thus, the model analyzed by the microstatics is that to a static equilibrium.
II Comparative microstatics:
To make comparison, we need at least two comparable items or things. In the comparative
microstatics, we make comparison between two equilibrium situations. Thus, comparative
microstatics make a comparative analysis of equilibrium position of micro variables at different
points of time. Microstatics deals with equilibrium position at a given point of time assuming the
micro variables remain constant. But with the course of time, the micro variables changes which
disturb the original equilibrium position. After certain adjustment, a new equilibrium is reestablished between micro variables. Comparative microstatics make a comparison between the
equilibrium positions- the original and the new one.
Thus, comparative microstatics deal with the comparison of two or more successive
equilibrium situation in a system or model. More precisely, comparative microstatics is concerned
with a comparative study of different equilibrium at different points of time. However, it does not
deal with the transitional period involved in the movement from one equilibrium position to other.
It merely compares the initial equilibrium state with the final equilibrium state. Consider figure
1.2 for an illustration of a comparative microstatics.

D1

S
P1

price

E1

D1

D
Q

Q1

Quantity
Fig 1.2: comparative Microstatics
In figure 1.2, simple microeconomic model of the comparative microstatics is presented.
The original equilibrium point is E where the demand curve DD and the supply curve SS intersect
with each other. Any change in the micro variables such as income, tastes of the buyer, price of
alternatives goods, inputs prices and others would disturb the equilibrium position. Suppose such
a change have shifted the demand curve in the figure to D1D1 and a new equilibrium has been
established at point E1. Comparative microstatics enables us to trace the direction and magnitude
of the change in the micro variables that has shifted the demand curve. In figure 1.2, changes in
the micro variables have raised the equilibrium price from 0P to 0P 1 and the equilibrium quantity
from Q to Q1. A new equilibrium point has resulted due to an upward shift in the demand curve,
given the supply. Comparative microstatics also enables us to analyze a shift in both the demand
and supply curves giving rise a new equilibrium point. However, the result would be the same i.e.
either a rise or fall in the equilibrium price or quantity.
Thus, comparative microstatics compares the equilibrium positions- point E and E in
above example in figure 1.2- as they are. It does not still deal with the process by which the forces
of demand and supply have reached the new equilibrium position. It simply compares the micro
variables- demand, supply and price in our example- as they are at different points of time. It still
ignores the passage of time involved in reaching the new equilibrium position E after a departure
from the old equilibrium position E. It is interested only in the equilibrium values of the micro
variables involved in the analysis implying an instantaneous adjustment to disturbances to
equilibrium. It tells nothing about the transition from one equilibrium point to another and jumps
straight away from on equilibrium to another.
III Microdynamics:
Comparative microstatics is useful in explaining the situation when a new equilibrium
succeed the old one. This model is incapable of tracing the path followed by the system over time
in moving from the old equilibrium to the new one. It simply comapares the two equilibrium
positions as given and jumps from the old equilibrium to the new . it tells us nothing about how
we move from one position to another.
However, the world is dynamic one where changes take place every now and then.
Therefore, positions of disequilibrium are more common than those of equilibrium. This is
because change in the prices and outputs are in constant motion in an economy today. Frequent
changes in tastes and technology are the principle causes. Micro variables such as demand, supply
and prices change quite frequently in market. Therefore, we are interested in learning how
equilibrium prices and quantities come to settle down in a market despite there being such

disturbances in the real world. Microdynamics help us do so. It explains not only the original and
new equilibrium situations but also the time taken by the system to reach a new equilibrium after
getting disrobed from its initial equilibrium position. It also tells us how prices and quantities are
still determined when the system is still under process to adjustment.
Thus microdynamics analyses the process by which the system moves from one
equilibrium to another. It explains the happenings on the way to a transition from one equilibrium
to another. It is concerned mainly with the states of disequilibrium rather than equilibrium and,
thus takes time into consideration. It studies systems or models involving time and explains how
the present value of a micro variable bears a relationship with the past or future value of a micro
variable. The microdynamics has been explained in figure 1.3.
D

P1
P4 D
P0

price

P2
P

D
S
D
Q Q2

Q0

Q 3 Q1

Quantity
Fig.1.3 Microdynamics
In above figure, the system is initially in equilibrium at point E where Q and P are
equilibrium quantity and price respectively. Suppose demand shift to DD due to change in micro
variables which raises price to P1. Producers expect this price to prevail for at least one year.
Hence, in year 1, Q1 is produced. But the demand curve DD shows that Q 1 can be sold only at P2
price. Therefore, P2 becomes the price for year 1. In year 2, producers will base their output on
price P2 and produce Q2. But the new demand curve shows that Q 2 amount can be sold at price P 4.
This induces them to produce Q3 in year 3. But it can be sold at lower price and so on. This
process continues until the new equilibrium point establish. At new equilibrium, again, demand
and supply are equal and new price P0 and quantity Q0 is determined.
Thus microdynamics does not only compares the equilibrium situations but also the
process how a system reaches a new equilibrium position from an old one.
1.3 Dependence of microeconomics on macroeconomics:
Actually micro and macro-economics are interdependent. Microeconomics depends upon
the macroeconomic variables to some extent. For example the determination of rate of interests or
profit of a firm depend on the aggregate economy. If the level of national income has decreased, it
decreases the aggregate demand which also affects demand for a firms product. It reduces the
profits of the firm. Similarly a fall in general price level also affects the profit earned by firm.
This situation occurs when the economy is passing through recession.
Another classical example of how macroeconomics affects microeconomics is the national
income. If the national income of a country is low, the per capita GNP is low which limits
purchasing power of the consumers. This limits the profits of the firms. Thus a change in
macroeconomic variables affect microeconomic variables.

It follows from the above discussion that microeconomics and macroeconomics are not
independent from each other in general. Though the two branches of economic study different
subjects, they are interdependent. In fact, it is only a combination of the micro and
macroeconomics that provides an adequate solution to an economic question.
1.4 Importance and Limitations of Microeconomics:
Microeconomics or the price theory is of paramount importance theoretically as well
practically in many respects. Its theoretical importance lies on the fact that microeconomic
explanations and predictions are based on the theoretical foundations. We may list the uses of
microeconomics under following headings.
1. Understanding an economy: Micro economic theory helps in understanding the
mechanism of a free market economy. It helps in understanding how commodity prices are
determined by competition among the producers. It helps in understanding how the various
enterprises of an economy function. It is microeconomics that makes it possible to understand
how the million of consumers and sellers behave in an economy.
2. Use in designing economic policies: Microeconomics is an instrument of the
government when it designs an economic policy for the country. Microeconomics helps in
formulating a policy that is best suited for promoting productive efficiency in the country.
Microeconomic tools are useful in designing price policies, taxation policies and others in an
economy dominated by public sector. It is also useful in designing price of public utilities in an
economy.
3. Allocation of Resources: The theoretical importance of microeconomics lies in the fact
that it helps in efficient allocation of resources. We know that productive resources are scares in
supply but production needs are numerous. Particularly, developing and least developed countries
are characterized by low availability of resources and multiple development projects. As such
microeconomics helps in sorting out the most urgent project and thereby allocating the resources
accordingly.
4. Distribution of Goods and Services: The market mechanism dealt in by
microeconomics helps in understanding how goods and services in an economy are distributed
among consumers. This in turn helps in understanding the condition of economic welfare.
Economic welfare depends on maximization of social welfare. The amount of goods and services
consumed by the society in totally determines its welfare. Microeconomics helps in understanding
the amount of goods and services consumed in a society, hence state of its welfare.
5. Making business decisions: The most important use of microeconomics is that it helps
business executives in making production decision. As it provides an analytical tool for
examining the market mechanism, business firms decide their production and pricing policies
based on this analysis. The knowledge about the working of an economy and the prevailing
market situation helps firms to make their pricing policy on goods produced by them and the
prices of the factors of production.
6. Useful in making sectoral decisions: Microeconomics provides a practical tool to the
government in making decisions related to the various sectors of an economy. An economy is
consisted of several sectors such as industry, tourism, trade and others. An understanding of each
of these sectors is imperative before an appropriate policy is designed for them. Microeconomics
provides an useful tool to the government while doing so.
Thus microeconomics is of great use in several ways. It provides an analytical tool in
understanding the working of individual units in an economy and the micro variables therein. It is
useful in understanding how a particular price comes to settle in a market, how some goods are

abundant in supply while others are still scarce, and why some factors receive high remuneration
than others. Nevertheless, microeconomics suffers from one fundamental limitation.
Microeconomics fails to explain the working of the entire economy taken together. The individual
conclusions drawn by microeconomics may not be true in aggregate. For example, a particular
firm in an industry might have decided to lay off some workers but the economy as a whole may
still be in shortage of workers. Similarly, sugar price in the economy may still be high even if a
firm has reduced it price. However, the limitation of microeconomics does not omit the use of the
price theory at all it is still useful in analyzing individual units in an economy. Microeconomics
provides a better tool in understanding the economy in totally.
1.5 Distinction between Microeconomics and Macroeconomics:
a] Micro economics:- Micro economics is the study of the individual parts of the
economy. It is that part of the economic analysis, which is concerned with the behavior of
individual units such as a consumer, a household, and a firm. It examines how consumers choose
between goods, how workers choose between jobs, and how a business firm decides what to
produce and what production methods to use.
In same way microeconomics concerns with price determination process of consumer
goods and of factor of production. Therefore microeconomics, often called the price theory, is
mainly concerned with the equilibrium in the particular markets (market for consumer goods and
factors of production), assuming that there is equilibrium of the market system as whole. This
implies that microeconomics is concerned with the demand and supply of particular goods and of
factor of production.
b] Macro economics: - It is the study of the behavior of the economy as a whole. Thus, it
is concerned with aggregate demand and aggregate supply. Here, aggregate demand refers to the
total amount of spending in the economy. It generally includes total consumption demand, total
investment demand, government spending and net exports (demand of domestic goods and
services by foreigners). Aggregate supply refers to the total national output of the economy.
Macroeconomics concerns with the determination of national income and employment
level thus it is also called income theory. With national income and employment level it also
concern with the amount of money circulation, rate of inflation, investment level etc.

Difference between micro and macro economics

1
2
3
4
5

Micro economics
It concerns with individual economic
units such as a consumer, a house
hold a firm
It is also called price theory.
It assumes that there is always full
employment in an economy.
It concerns with the optimum
allocation of resources.
Its principal variables are relative
prices, individual demand and
supply, output of individual firms and
industries and so on.

Macro economics
It concern with economy as whole such as national
income, national output, total employment etc.
It is also called income theory.
It assumes that under full employment equilibrium is
possible in an economy.
It concerns with the optimum utilization of
resources.
Its principal variables are national income, level of
employment, inflation, money supply and their
growth rates overtime.

Unit-2 Consumer Behavior

2.1 Meaning of utility
Consumer spent their income on goods according to their taste or desire or preference for
them. They buy goods because they satisfy their wants. This want satisfying power of goods is
known as utility in economics. Utility is the satisfaction that a consumer derives from a
commodity. The basic idea that the theory of utility analysis tries to convey is that a consumer
buys a certain commodity or service because of its utility that satisfy wants. Every economic
good has the power to satisfy a particular want of consumer- whatever its nature may be. Utility is
an economic concept that resides in the mind of the consumer. The consumer knows it by
introspection. The concept of utility is ethically neutral and the commodity need not be useful in
the ordinary sense of the world. Thus, alcohol and cigarettes still satisfy drunkards and smokers
and therefore possess utility although they are harmful to health. Whatever the case may be, the
consumer must be able to compare the utility derived from different commodities.
Economists employ two basic approaches: cardinalist approach and ordinalist approach
to compare utility derived from commodities. Neoclassical economists believed that utility can be
measured cardinally in units and the unit of measurement is called utis. Ordinalists on the other
hand maintain that utility is a psychological concept and it is immeasurable, theoretically and
conceptually as well as practically.
2.2 The cardinal utility analysis
The cardinal utility analysis is based on the assumption of measurability of utility.
Neoclassical economists like Marshall and Pigou popularized the idea. According to them the
utility derived by the consumer from the consumption of certain goods or servies can be measured
in concrete terms and the measurement can be given by assigning definite numbers such as
1,2,3,4 etc. Besides measurability, the cardinal utility approach is based on the following
assumptions:
I. Rational behavior of the consumer.
II Independent utilities.
III Constant marginal utility of money.
IV Diminishing marginal utility.

Limitations of cardinal utility analysis

I Measurement of Utility in number is not possible
II Utilities are not Independent.
III Marginal Utility of money is not constant.
2.3 Ordinal utility analysis (Indifference curve approach)
The ordinal utility analysis rejects the idea of measurability of utility. Utility cannot be
measured in absolute terms and it is difficult to say by how much the utility of one commodity is
more than that of the other. Therefore, the ordinalists have developed an alternative approach to
the utility analysis. This approach is known as the indifference curve technique.
Under this technique, it is not necessary to measure the amount of utility derived from the
consumption of goods and services. It just suffices to rank the various combinations of goods in
order of their preference. This technique assumes that the consumer make choice of a particular
combination of goods based on their preference for them. If a consumer is in between two
combinations of goods, he is indifference between them for while. Finally, makes choice of a
particular combination that he likes the best.
The indifference curve technique was first invented by F.Y. Edgeworth and put into use by
Vilfredo Pareto. J.R. Hicks and R.G.D. Allen brought it into extensive use.

Apples

2.3.1 Indifference curve and indifference map:

An indifference curve is the locus of all those combinations of different goods, which
yield the same utility (the level of satisfaction) to the consumer. Therefore, the consumer is
indifferent to purchase the particular combinations he selects. Each points on the indifference
curve gives the same total utility as any other points on it. Therefore the consumer is indifferent
between the various combinations of the two goods.
Construction of an indifference curve can be illustrated with the help of an example as
follows. Suppose a consumer is considering buying apples and oranges. We suppose that the
consumer is able to rank the various combinations of the two fruits based on their importance to
him. We also suppose that the consumer ranks those combinations on the basis of the satisfaction
he derives from them. He has several combination of apples and oranges before him such as 300
apples and 60 oranges or 240 apples and 70 oranges etc. This is shown in table below.
Indifference schedule
Combinations
Apples
Oranges
A
300
60
B
240
70
C
200
80
D
170
90
E
150
100
F
140
110
The above table is known as the indifference schedule, which shows alternative
combination to the consumer. Thus, the consumer gets as total satisfaction from 300 apples and
60 oranges as from 140 apples and 110 oranges as well as from any other combinations of apples
and oranges. From the information is table, we can now construct an indifference curve which is
done in figure below.

An indifference curve

Y
300

A
Oranges

An60indifference
curve
90
80
70
B
240 and oranges are measured along the vertical axis, and horizontal
In above figure, apples
axis X respectively. The consumer will get equal satisfaction
at point A with 300 apples and 60
C
200
D
oranges and at point B with 240 apples and 70 oranges. Similarly, combinations C and D would
170
IC and D, we get a downward
yield him the same level of satisfaction. If we join points A, B, C,
sloping curve, which shows that the consumer is indifferent between the various combinations of
the two goods. This curve is known as the indifference curve (IC). All the combinations of apples
and oranges along the curve IC yield the same total utility to the consumer.

Apple

We can draw more than one indifference curve showing combinations of two goods
representing higher and lower level of satisfaction. Each indifference curve shows combination of
two goods, e.g. apple and orange, which give equal satisfaction to the consumer. They yield the
same total utility to the consumer. Any curve which lies to the right of another curve representing
higher level of satisfaction and the one to the left of another represents lower level of satisfaction.
Similarly, those combinations on higher indifference curve are preferred to those on the lower
one. When we say that a consumer is indifferent, he is moving along any one of the several ICs.
Preference on the other hand, means movement to a new IC and that yields either higher or
lower level of satisfaction. A set of indifference curve can be shown graphically and it is called an
indifference map. Y

II

III

IV

Orange

An indifference Map
The indifference curves I, II, III, IV and V in above figure are the different indifference
curves showing the different level of combination of apples and oranges. Thus combination of
apples and oranges along IC curve-II gives a higher satisfaction to the consumer than those along
IC curve-I. Similarly, the combinations along IC-III would give a higher level of satisfaction than
those of IC-II and so on.
The consumer is indifferent between different combinations of apples and oranges along
IC-II but the satisfaction at those points of combination are higher than those along IC-I. So is the
case along IC-III, IC-IV, and IC-V. On the other hand IC-IV yields a lower level of satisfaction
than on IC-V and so on.
2.3.2 Marginal rate of substitution (MRS)
When the consumer moves from one point to another along an indifference curve, he is
substituting one combination of the two commodities with another combination. That is why
when our consumer moved from point A to B along IC in above figure. He in fact gave up
combination A (300 apples + 60 oranges) for combination B (240 apples + 70 oranges). What our
consumer actually did was that he substituted 60 apples for 10 oranges i.e. he gave up 60 apples
in order to get 10 more units of oranges. The rate at which the consumer trades of apples for
oranges is called marginal rate of substituting.
Marginal rate of substituting shows the rate at which one commodity is substituted for
another. It shows the rate at which the consumer is willing to substitute one commodity for
another. The slope of the indifference curve confirms this. If we denote our earlier two
commodities, apple and orange, by X and Y then marginal then marginal rate of substitution
(MRS) between X and Y can be defined as the amount of Y a consumer is willing to give up
( Y) so as to obtain one more unit of X (X).
Thus, MRSXY= Y/X
The concept of marginal rate of substitution is parallel to the concept of diminishing
marginal utility.

Apple

Y
6

Oranges

B
4Marginal Rate of Substitution
C
The above 3figure, shows an indifference
curve IC sloping downward to the right. Y-axis
ICPoints A, B and C are the different combinations
represents units of apple and X that of oranges.
of the two goods. 0Indifference curve IC shows the combinations of apples and oranges, which
2
3 4
provide same level of satisfaction to the consumer.
In above figure, slope of the IC shows the trades the consumer would make between the
two goods. Thus when the consumer moves from point A to B he gives up 2 apples to get one
additional unit of orange. In other words, two units of apple are given up in exchange for 1 unit of
orange. This is to say that MRS is approximately 2. That is:
MRSXY= Y/X= -2/1= -2
We can say that MRS between points A and B is -2 and the consumer is willing to give up
two apples in order to get one more orange. Here MRS XY is negative implying that to get the same
level of satisfaction, reduction of one good must be accompanied by additional of the other.
Marginal rate of substation varies along the IC curve. At point A in above figure, the
consumer has enough apples and is more willing to trade them for oranges. However, at C the
consumer is willing to give up only one unit of apple for one extra unit of orange. We can,
therefore draw an important conclusion about the consumers behavior that as more and more of a
good, say apple is substituted for another good, say orange, the marginal rate of substitution
diminishes. This is called the principle of diminishing marginal rate of substitution.
The principle of diminishing marginal rate of substitution is illustrated in above figure, as
we move along the IC curve from A to C. When the consumer moves from point A to B, he gives
up 2 apples to get one more orange. The MRS here is 2. When he moves from point B to C, he
gives up only one apple to get one additional orange. Here MRS has declined to 1, indicating that
the consumer now is less interested in giving up apples for oranges.
2.3.3 Properties of indifference curves:
There are some important properties of indifference curve. These are as follows.
1. Negatively slopped:
Indifference curves are negatively sloped. This indicates that when the consumer wants to
have more of a commodity, the quantity of the other commodity decreases so that he remains on
the same level of satisfaction. That is, if a consumer consumes more of X then the must be
prepared to consume less of Y so that he remains on the same level of satisfaction. This is
possible only when the indifference curves are negatively sloping downward. A negative slope of
IC is also important for the principle of diminishing marginal rate of substitution to hold true.
2. Non-intersecting:

10

Indifference curves do not intersect or touch with each other. If they intersect, the
consumers preference would not be consistent or transitive. We have assumed that if a consumer
prefers A to B and B to C, he also prefers A to C. This assumption would not remain valid if two
indifference curves intersect. An intersection of two indifference curves would imply that the
consumer gets two different levels of satisfaction along the same IC, which is absurd. Let us see it
with figure: Y

Apples

IC2

IC1

Oranges

A Curves
Intersecting Indifference
In above figure, IC1 and IC2 B
intersect at point A, which represents a combination of both
IC2

apple and oranges. On IC1 combination

A and C yield the same level of satisfaction. Similarly,
C
IC1 of satisfaction. Combination B on IC 2 contains more
combination A and B on IC2 yield same level
of both apples0and oranges than C. As A and B lie on the same IC 2, yielding same level of
satisfaction, they are equally preferred. Similarly, combination A and C are also equally preferred
as they yield the same level of satisfaction being on IC1. Thus, it follows that B is equal to A and
A is equal to C. Now according to the transitivity assumption, B is equal to C and they are equally
preferred.
But this is absurd and contradictory because B contains more of both apples and oranges
and is preferred to C (more is preferred to less). To avoid such a contradiction and absurd
conclusion, indifference curves do not intersect with each other.
3. Convexity:
Indifference curves are more convex to the origin. This implies that as the consumer goes
on consuming more and more of the commodity on the horizontal axis (say X) and less and less
of the one on the vertical axis (say Y), MRS of X for Y must be falling. This is necessary for the
principle of diminishing rate of substitution of hold true. If the indifference curve were a straight
line MRS of the two commodities would be same (constant). And if it were concave to the origin
MRS of X for Y would rather be increasing. Both the case would be against the principle of
diminishing marginal rate of substitution. Therefore, the indifference curve must be convex to the
Y
origin.

Commodity Y

Y1

A concave
Indifference
curve

Y2

Y3

Y4 X

IC
Commodity X

11

Commodity Y

In above figure, MRS of X for Y is increasing which is against the principle of

diminishing MRS. This is absurd.Y
IC
Y
X
Y
X
Y
X

IC
Commodity X

A Straight-line Indifference curve

In above figure, MRS of X for Y is constant. This too is against the principle of
diminishing MRS and is therefore absurd.
Commodity Y

Y1

Y3

Y2

IC

Commodity X

A Convex Indifference curve

The above figure shows a normal indifference curve that is convex to the origin. As we
move along the IC towards southwest, the MRS of X for Y goes on falling. The same unit of X is
substituted for lesser and lesser units of Y. Therefore, the indifference curves are generally convex
to the origin.
4. Higher satisfaction on higher IC:
Every IC lying to the right represents higher level of satisfaction than that of the preceding
one. Moreover, combinations on higher ICs are preferred to those on lower ones.
5. IC enables comparison of combinations:
Indifference curve pass through each point in the commodity space. This enables the
consumer to compare any combinations of the goods in question, so that he is indifferent between
the several combinations.
2.3.4 Budget line or the budget constraint:
Another important element in the analysis of consumer behavior is the budget line, which
is also referred to as the budget constraint. Given the indifference map and consumers
preference, the actual purchases he would make depend on the income of the consumer and prices
of two commodities. The budget line sets a limit on the combination of the two goods that a
consumer can buy. That is why it is referred to as budget constraint.
Let us suppose that a consumer is considering purchasing two commodities X and Y with
a fixed income of Rs. 300. We further suppose that the price of X per unit is Rs.20 and that of Y is
Rs 10 per unit. In this case, the consumer can choose any one of the various combinations given
in table below.

12

Alternative consumption combination with a given income

Number of goods X Number of goods Y Combinations
0
30
A
5
20
B
10
10
C
15
0
D
Given that the consumers income is limited to Rs.300, he can choose any one of the
combinations in table. The above combinations could be altered but by no means should the total
expenditure exceed Rs. 300. The above table can be translated into figure that gives us the budget
line of the consumer
A
30
B

Good Y

20

10

10

15

Good X
Budget line
Being limited with the fixed income of Rs 300, the consumer can choose any
combinations of Y and X such as in figure above. Suppose the consumer chooses combination B.
Here, he would be spending Rs. 200 (20 10) on good Y and Rs. 100 (5 20) on good X. If he
chooses combination A, he would be buying only good Y and no X. similarly, if he chooses
combination D, he would be spending all his money on X and buy no quantity of good Y.
If we join combinations A, B, C, and D with a straight line, we get a budget line such as
AD in above figure. This line acts as a constraint on the quantity of goods purchased by the
consumer. It shows that the consumer cannot choose a combination that lies above the budget line
AD. He can make a choice along the line AD or towards its left but not to the right. Thus, the
budget line is the boundary within which the consumer is made confined while making his
choices.
The budget line can be written algebraically as follows:
Px.X+ Py.Y= M------------------------------(1)
Where, Px and PY denotes the prices goods X and Y respectively and M stands for money
income. The above budget line equation (1) implies that, given the money income of the
consumer and prices of two goods, every combination lying on the budget line will cost the same
amount of money and can therefore be purchased with the given income. The budget line can be
defined as a set of combinations of two goods that can be purchased if whole of income is spent
on them and its slope is equal to the negative of the price ratio.
Solving the equation(1) for Y we have the following alternative form of the budget
equation.
M

Px

Y= Py - Py X-------------------------------(2)

13

Px

Here, the slope of the budget line is - Py and M/Py is the vertical intercept of the budget
line equation. Thus, it proves that the slope of budget line BL represents the ratio of the prices of
two goods and the negative sign shows the budget line has negative slope. It falls from left to
right.
2.3.5 Equilibrium of the consumer:
We are in position to explain with the help of indifference curves how a consumer reaches
equilibrium position. A consumer is said to be in equilibrium when he is buying such a
combination of goods as leaves him with no tendency to rearrange his purchases of goods. He is
then in a position of balance in regard to the allocation of his money expenditure among various
goods. Regarding the equilibrium, the consumer is assumed rational in the sense that he aims at
maximizing his satisfaction. Besides, we shall make the following assumptions to explain the
equilibrium of the consumer:
(i) The consumer has given indifference map exhibiting his scale of preference for various
combinations to two goods, X and Y.
(ii) He has fixed amount of money to spend on two goods. He has to spend whole of his
given money on the two goods.
(iii) Prices of the goods are given and constant for him. He cannot influence the prices of
the goods by buying more or less of them.
(iv) Goods are homogeneous and divisible.
To show the equilibrium of the consumer, consumers indifference map and his budget
line are brought together. As explained above, the indifference map exhibits the consumers scale
of preference between the various possible combinations of two goods. While the budget line
shows the various combinations which he can afford to buy with his given money income and
given prices of two goods. Consider a figure below, in which we depict consumers indifference
map together with the budget line BL. Goods X is measured on X-axis and good Y is measured
on Y-axis. With the given money to be spent and given prices of the two goods, the consumer can
buy any combination of the goods, which lies on the budget line BL. Every combination on the
budget line BL costs him the same amount of money. In order to maximize his satisfaction the
consumer will try to reach the highest possible indifference curve which he could with a given
expenditure of money and given prices of the two goods. Budget restrain forces the consumer to
remain on the given budget line, that is, to choose a combination from among only those which
lie on the given budget line. Y
B

IC5

R
S
0

Consumers Equilibrium

IC4

14
M

IC3
IC2
H IC
1

It will be seen from the above figure that the various combinations of the two goods lying
on the budget line BL and which therefore he can afford to buy do not lie on same indifference
curve; they lie on different indifference curves. The consumer will choose that combination on the
budget line BL that lies on the highest possible indifference curve. The highest indifference curve
to which the consumer can reach is the indifference curve to which budget line BL is tangent. Any
other possible combination of the two goods either would lie on the lower indifference curve and
thus yield less satisfaction or would be unattainable. In above figure, the budget line BL is tangent
at point Q on the IC3. Since the indifference curve is convex to origin, all other points on budget
line BL, above or below the point Q, would lie on the lower indifference curves. Take point R
which also lie on the budget line and which the consumer can afford to buy. The combination R
represent same cost as the combination of Q but the combination R lies on the lower indifference
curve IC1. Likewise, point S, T and H also lie on lower indifference curve, therefore, provides less
satisfaction than Q. It is therefore concluded that with the given money expenditure and the given
prices of the goods as shown by BL the consumer will obtain maximum possible satisfaction and
will be in equilibrium position at point Q. Here, the consumer purchases OM amount of X goods
and ON amount of Y.
At the tangency point Q, the slope of the budget line BL and indifference curve IC 3 are
equal. Slope of indifference curve shows the marginal rate of substitution of X for Y (MRS XY),
while the slope of the budget line indicates the ratio between the prices of two goods P x/Py . Thus,
at the equilibrium point Q,
PX
priceofgoodX
MRSXY= priceofgoodY =
. It is the condition of equilibrium of consumer in
PY
indifference curve approach.
2.3.6 Income effect:
We now turn to see the effect of a change in income of a consumer with prices remaining
constant. When there is a increase in the income of the consumer with the prices of the two
commodities remaining the same, the budget line shift outward, parallel to the old budget line. In
this case the purchasing power of the consumer gets enhanced. He will move to a higher
indifference curve along a new budget line obtaining higher level of satisfaction at a new
equilibrium pont.
Income consumption curve (ICC)

N3
N2

Good X
Income effectD
N
The above figure shows the series Cof budget line representing different levels of consumer
income. Initially, the consumer was in Bequilibrium at point A along IC1 with the budget line NM.
IC
A line shifted to N1M1 and the consumer
As his income increased, the budget
jumped to the higher
IC
indifference curve IC2 where he is in equilibrium in point B and 3so on. Each equilibrium point is
Good Y

N1

15

M1

IC1

IC2

M2

M3

where the budget line is tangent to the indifference curve. In each new equilibrium points, the
consumer purchases more of both X and Y goods.
If we join each points of equilibrium, we get the income consumption curve (ICC). The
income consumption curve shows the manner in which the consumer reacts to changing income
when the prices of the goods are constant.
In general, the ICC slopes upward to the right as in the figure above indicating that more
of the two goods are purchased with a rise in income of the consumer. In other words, the income
effect is positive when more goods are purchased with the rise in income. Such goods are called
normal goods in economics.
On the other hand, if the quantity of goods purchased decreases with the successive
increase in income, the good is called an inferior good in economics. In this case, when there is a
rise in the consumers income the quantity purchased will rise initially.
But after a certain point, the amount purchased of its starts falling with successive rise in
income. This would give rise to an income consumption curve that would first move upward to
the right hand side and then upward to the left hand side.

N2

N1

Income consumption curve (PCC)

C
IC3

B
IC2

A
Income consumption curve
of an inferior good X
IC
1

M1 good. M
The above figure
Initially,
the consumer is in
0 shows that good XMis an inferior
2
equilibrium at point A. But as the budget line shifts toN 1M1 consequent upon a rise in income,
less of X is purchased. Point B is left to the point A indicating that less of X is purchased with a
rise in income. Point C lies still left to point B indicating that the purchase of good X decreases
further with a rise in income.
2.3.7 Price effect:
In price effect, we see the effect of a change in the prices of the commodities keeping
constant the income and tastes of the consumer. Suppose the price of X falls, while the
consumers income and price of Y remains
the same. In this case, the budget line will swing
Y
outward as shown in figure below.

Price consumption curve (PCC)

Price effect
A

16

BM

M1

IC3
IC2
IC1

M2

Originally, the consumer was in equilibrium at point A along the budget line NM. If the
consumer were to spend his whole income on the purchase of X alone, he could purchase OM.
Suppose now the price pf X falls. This would mean that the consumers income in terms of X has
increased meaning he can now buy more of X. A movement has showed this in the lower foot of
the budget line towards right to NM1. Now if the consumer is to spend his whole income on only
X, he can buy OM1 of it. He would move to a higher indifference curve IC2 and would be in
equilibrium position would be C. With each fall in the price of X, the consumer moves to a new
equilibrium position on a higher indifference curve.
If we now a line joining the equilibrium points A, B and C in the figure, we get a line
slopping upward to the right. This line is known as the price consumption curve (PCC). The PCC
shows the way in which the quantity of X the consumer buys changes with a change in its price.
The slope of the price consumption curve (PCC) is positive for normal goods. If one
goods is Giffen, then the slope of price consumption curve is negative which is shown in
thefigure below. Y

Price consumption curve

N
C
B

M1

M2

2.3.8 Substitution effect:

A
We now turn to the substitution effect, see the result of a change in the relative prices of
goods, while keeping
0 the consumers income, and tastes constant. When the relative price of
goods change, the consumers money income is rearranged in such a way that he is neither better
of nor worse off than before. There is no change in the consumers income, but he has to
rearrange his purchases in accordance with the new relative prices. When there is a fall in the
price of good, say X, consumers real income increases. He can now more of X. he can buy more
not because his money income has increased, but simply because the price of X has fallen.
Therefore, the rise in the consumers real income because of fall in the price of commodity X has
to be compensated to cancel out the gain in his real income.
This compensation would put the consumer at the same level of satisfaction as he was
before. This is known as the substitution effect.
In figure below, the consumer is initially in equilibrium at point Q on IC 1. Here he is
purchasing 0Y1 of good Y and 0X1 of good X and his budget is limited to NM. Suppose price of
X falls. The budget line will shift to NM 1. With the fall in price of X, the real income or
purchasing power of the consumer has increased. To find out the substitution effect, the rise in
purchasing power of the consumer because of the fall in the price of X must be wiped out so that
he is on the same indifference curve. For this a hypothetical budget line AB parallel to NM 1 has
been drawn in figure below so that it touches IC1 at point R. This would mean that NA has
reduced the consumers income in term of good Y or M1B in term of good X to keep him on the

17

same IC. NA or M1B is sufficient to cancel out the rise in real income that occurred as result of
the fall in the price X.

Good Y

N
T

0Y

X1

X2

IC

Good2 X

M1

Y2

Substitution effect

IC1

Now AB is the new budget line facing the consumer. With the new budget, X has become
relatively cheaper and Y relatively dearer. The consumer would buy more of X and less of Y i.e.
he substitutes X for Y. Thus in above figure, the consumer is in equilibrium at point R, the
consumer is in equilibrium along the same indifference curve IC1 indicating that he is neither
better off nor worse off than before. The movement from point Q to R on IC 1 is, therefore, the
substitution effect. The relative prices of X and Y have changed but the consumer is equality well
off as before.
2.3.9 Decomposing price effect into income effect and substitution effect:
When the price of good X falls, other things remaining the same, consumer would move
to a new equilibrium position at a higher indifference curve and would buy more of good X at the
lower price unless it is Giffen good. Thus, the consumer, who is initially in equilibrium at lower
indifference curve, moves at another point on higher indifference curve. The movement from
lower indifference curve to higher indifference curve due to fall in price of good X is called price
effect. It is now highly important to understand that this price effect is the net result of two
distinct forces-substitution effect and income effect. In other words, price effect can be split into
two different parts, one being the substitution effect and the other income effect.
In this decomposition, we adjust the income of the consumer to offset the change in
satisfaction and bring the consumer back to his original indifference curve, that is, his initial level
of satisfaction, which he was obtaining before the change in price occurred. For instance, when
the price of a commodity falls and consumer moves to a new equilibrium position at a higher
indifference curve his satisfaction increases. To offset this gain in satisfaction resulting from a fall
in price of the good we must take away from the consumer enough income to force him to come
back to his original indifference curve. This required reduction in income to cancel out the gain
in satisfaction by reduction in price of a good is called compensating variation in income. This is
so called because it compensates for the gain in satisfaction resulting from a price reduction of the
commodity. How the price effect is decomposed into substitution effect and income effect is
illustrated in figure below.

18

Compensating
variation
ICC
PCC

Good Y

Income effect
Q

R
S

Substitution
effect

IC2

Price effect

IC1

Price effect Split up into Substitution and income effect.

X
M
L
L income of
Good
When
theX price of good X KfallsN and as a result
budget line Bshifts to PL 2 the real
the consumer rises, i.e., he can buy more of both the goods with his given money income. That is,
price reduction enlarges consumers opportunity set of the two goods. With the new budget line
PL2 he is in equilibrium at point R on higher indifference curve IC 2 and thus gains in satisfaction
as a result of fall in price of good X. Now, if his money income were reduced by the
compensating variation in income so that he is forced to come back to the indifference curve IC 1
as before, he would buy more of X since X has now become relatively cheaper than before. In
figure above because of the fall in price of X, budget line switches to PL2. Now with the reduction
in income by compensating variation, budget line shift to AB which has been drawn parallel to
PL2 so that it just touches the indifference curve IC 1 where he was before the fall in price of X.
since the budget line AB has got the same slope as PL 2, it represents the changed relative prices
with X relatively cheaper than before. Now, X being relatively cheaper than before, the consumer
in order to maximize his satisfaction in the new price-income situation substitute X for Y. Thus,
when the consumers money income is reduced by the compensating variation in income (which
is equal to PA in term of Y or L 2B in term of X), the consumer moves along the same indifference
curve IC1, and substitutes X for Y. With the price line AB, he is in equilibrium at S on indifference
curve IC1 and is buying MK more of X in place of Y. This movement from Q to S on the same
indifference curve IC1 represents the substitution effect since it occurs due to the change in
relative prices alone, real income remaining constant. If the amount of money income, which was
taken away from him, is now given back to him, he would move from S on indifference curve IC 1
to R on higher indifference curve IC2. This movement from S on a lower indifference curve to R
on a higher indifference curve is the result of income effect. Thus, the movement from Q to R due
to price effect can be regarded as having been taken place into two steps: first from Q to S
because of substitution effect and second from S to R because of income effect. In is thus
manifest that price effect is the combined result of a substitution effect and an income effect.
In above figure, the various effects on the purchases of good X are:
Price effect = MN
Substitution effect =MK
Income effect = KN
And MN = MK + KN
Or Price effect = Substitution effect + Income effect.
0

19

From the above analysis, it is thus clear that price effect is the sum of income and
substitution effects.

2.3.10 Derivation of demand curve with the help of Indifference curve approach:
The indifference curve technique can be used to derive the consumer demand curve for a
good. For this, we need the price consumption curve (PCC). Using the price effect, we can
construct a persons demand curve for a product.
We begin by assuming that we want to derive a persons demand curve for good X. All
that we need to demonstrate is a variation in the quantity demanded of X with changes in price of
X. For this, we
draw figure and show how an individual demand curve can be derived.
Y
PCC
Good Y

C
A

IC3

IC2

M1

IC1

Good X

M2

Price

P1
P2
P3

D
0

Q1 Q2 Q3

Quantity of X demanded

Derivation of demand curve using IC approach

Vertical axis on the upper part of the above figure shows the quantity of good Y and
horizontal axis shows the quantity of good X purchased with successive fall in the price of X. As
the price of X falls, the budget lines turn successively to the right direction and the consumer
moves to a higher indifference curve. As we join the different points of equilibrium (A, B, C) on
the upper part of figure, we get the price consumption curve (PCC).
On the lower part of figure, we plot each point of intersection between the price and
quantities of good X purchased with successive fall in price of X. These points are Q, R and S. we
then join the points with a straight line sloping down ward to the right. The line DD then stands
for the individual demand curve indicating an inverse relationship between price of X and the
quantities demanded of it. As can be seen, quantity demanded of X rises successively from Q 1 to
Q3 with a fall in price of X from P1 to P3.

20

Unit 3: Demand Function

3.1 Concept of demand:
Not every wants and desire on the part of a consumer, though they are countless, can be
termed as a demand. Demand in economics, refers to that amount of a commodity or service
which an individual buyer or a household is willing to purchase at a given price during a given
period. Only that desire or want which is backed-up by the capacity to pay for and the willingness
to buy is termed as demand in economics. Desire or want becomes effective only when the
consumer has the means to buy a particular commodity or service is the amount that would be
bought by consumers at a given price and during a given period.
* Demand is not a need or a desire. Demand is the amount of a commodity for which a
consumer is able and willingness to purchase.
* Demand has no meaning unless it is stated with price and time duration.
Demand is a multivariate variable. Many variables affect the demand. The relationship
between demand of a commodity and the variables, which affect the demand, can be expressed in
form of an equation. This is called a demand function. in other words, demand function is an
equation which shows the mathematical or functional relationship between the quantity
demanded of a good and the values of the various determinants of demand. Following is a
demand function stated in a general form.
Qx = f ( Px, T, Ps1 Ps2 Ps. Psn, Pc1 Pc2 Pcn,Y, B, PeX )
Where, Qx = Quantity demanded of commodity X
PX = Price of commodity X
T = Tastes of consumer
Ps1 Ps2 Psn= the prices of substitute goods
Pc1 Pc2 Pcn= the prices of complimentary goods
Y = consumers income
B = distribution of income
e
P x= expected price of X in future.
The above equation reads that quantity demanded (Q x) of the commodity at any given
time is a function of the price of the good itself (P x), tastes of the consumer (T), the price of
substitute goods (Ps1 Ps2Psn), the prices of complimentary goods (Pc1 Pc2.Pcn), consumers
income (Y), income distribution (B) and expected price of the good (P ex) at the some future time.
The variables in the above equation can be substituted with figures and examine what happens to
total demand when any one of the variable changes.
Very often, the above stated demand function is replaced by a simple demand function Q x
= f (Px). This implies that quantity demanded (Qx) is function of price (Px) of the same commodity
(X).
Qx = f (Px), f<0
Which implies that quantity demanded is an inverse function of its price. Here f denotes
the change in quantity demanded due to change in price of the same commodity, which is always
negative for the normal goods.
In the linear form, the demand function can be stated that
Qx= a + bPx
a>0, b<0.
This gives us a straight line vertical intercept a (0A) and slope b, in figure beow:

21

price

Linear demand curve

Qx= a+ bPx

Linear demand curve

Quantity

3.2 Determinants of demand

Besides price, demand for a commodity depends on many factors. The law of demand is
established by assuming these other factors as constant. But in real market situation, these factors
do not remain the same. They change and their change affects the amount demanded of a good. In
fact, it is the variation in those factors besides price, that determine demand. Following are the
determinants of demand:
1. Tastes and preferences of the consumers:
Taste and preferences of consumer for a good is an important determinant of demand for
it. The demand for a commodity would be larger if many people prefer it. On the other hand, its
demand would fall when nobody prefer it, even when the price has gone down. Fashion among
youths would be a peculiar example, illustrating effects of taste and preference on demand.
2. Changes in the price of substitute goods:
Changes in the price of substitute goods influence demand for a commodity. If price of the
good in question goes up, consumer buys less of it and more of its substitutes. If its price goes
down, consumer buys more of it. Substitute goods are those that perform almost the same
function. This is the reason why more people drink coffee when tea price goes up. Demand for tea
would go down and that of coffee would be higher because both tea and coffee perform the same
function. Another example is Coca-Cola and Pepsi.
3. Change in price of complementary goods:
Change in complimentary goods also influence demand for a commodity. Complementary
goods are those, which are jointly demanded. Example, pen, and ink are complementary goods.
There is negative relationship between price of one goods and quantity demanded of another
goods. When the price of pen goes down, consumer demands more pen. For more pens, more ink
is required. Thus, in case of complementary goods, demand and price have opposite relationship.
4. Change in consumer income:
The most important factor influencing demand, other than the price of the good in
question, is consumer income. As income rises people tend to buy more of almost everything
even when there is no change in price. For example, during festival season, every employee gets a
bonus and more goods are purchased even if price is constant or have gone up. On the contrary,
demand goes down even without a rise in price if peoples income goes down.
5. Expectations regarding future price:
Consumer expectation regarding future price of the commodity is yet another factor
influencing demand. If consumers expect as rise in the price of the commodity in future, they will
demand more of it at present price even when the price has not changed. On the other hand, if the
consumers expect the price to go down in the future, they will postpone their present demand.
Expectation about a rise in the income of the consumer is future also influence demand,
encouraging them to buy more at present.
22

Besides this, several other factors such as the size of the population, weather condition,
government trade policy etc. determine demand.
3.3 Elasticity of Demand:
Law of demand only explains the relation between demand and price but it does not tell us
about the quantitative relationship between demand and price. Similarly, the discussion about
demand function showed that a change in demand is caused by variation in several other
independent variables, besides price. The law of demand assumes all the other variables as
constant and goes on to the relationship between quantities demanded of a good in response to a
change in price. In other words, quantity demanded rises with a fall in price and vice-versa.
However, the law of demand gives us only the direction to which quantity demanded changes in
response to a change in price. But this information is not sufficient in economics to make the
tools of demand and price useful in market analysis. Having learned the direction of change in
quantity demanded in response to a change in price, we would definitely want to know the degree
of responsiveness of quantity demanded of a good to a change in its price and other variables as
well. In other words, we need to know how much demand responds to a change in price.
Economists employ the concept of elasticity of demand to know much or to what extent demand
for a good responds to a change in its price.
3.4 Concept of elasticity of demand
Elasticity of demand may be defined as the degree of responsiveness of demand to a
change in its determinants viz. price of that commodity, income of consumer, price of substitutes
and compliments, etc. It shows the degree to which demand stretches or contracts because of a
change in its determinants. In general, price is the most important determinant of the demand and
elasticity generally refers to the price elasticity of demand. It measures how much the quantity
demanded of a good changes when its price changes. In the word of Alfred Marshall, the
elasticity 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
Precisely speaking, elasticity of demand is the ratio of a relative change in demand to a
relative change in its determinant. If we denote elasticity by e, then elasticity of demand ed is:
Re lativechangeinquantitydemanded

Ed = Correspond ingrelativ echangeinits det er min ants

3.5 Kinds of elasticity
There are three main determinants of demand, which can be quantified. These are price of
the commodity itself, income of consumer and prices of related goods (substitutes and
compliments). Quantity demanded of a good will change because of a change in the size of any of
these determinants of demand. The concept of elasticity of demand therefore refers to the degree
of responsiveness of quantity demanded of a good to a change in its price, income or prices of
related goods. Accordingly, there are three kinds of demand elasticity: price elasticity, income
elasticity and cross elasticity. Price elasticity of demand relates to the responsiveness of quantity
demanded of a good to the change in its price. Income elasticity of demand refers to the
sensitiveness of quantity demanded to a change in income. Cross elasticity of demand means the
degree of responsiveness of demand for a good to a change in the price of a related good, which
may be either a substitute or a complimentary with it.
[I] price elasticity of demand: price elasticity of demand express the responsiveness of
quantity demanded of a good to change in its price, given the consumers income; his taste and
price of all other goods. Thus, price elasticity means the degree of responsiveness or sensitiveness
of quantity demanded of a good to a change in its prices. In other words, price elasticity of

23

demand is a measure of relative change in quantity demanded of a good in response to a relative

change in its price. Price elasticity can be precisely defined as the proportionate change in
quantity demanded in response to a small change in price, divided by the proportionate change in
price. Thus,
Price elasticity =

proportion atechangeinquantitydemanded
proportion atechangeinprice

q/q q . P
Or in symbolic term edp = P/P =
P . q

Mathematically, speaking, price elasticity of demand (epd) is negative, since the change in
quantity demanded is in opposite direction to the change in price. When price falls, quantity
demanded rises and vice versa. But for the sake of convenience in understanding the magnitude
of quantity demanded to a change in price we ignore the negative sign and take into account only
the numerical value of elasticity. But for the Giffen good, the price elasticity of demand is
positive. It implies that price of Giffen good and quantity demand moves in same direction.
[a] Kinds of price elasticity of demand: Change in demand in response to a change in its
price is not always proportionate. In other words, a small change in price may sometimes lead to a
large change in its demand. Under such situation, we say that the demand is elastic. Generally, the
price elasticity of demand is greater than one for luxury goods. On the other hand, when even a
large change in price leads to only a small or no change in demand. It is the case of an inelastic
demand. Purchase of salt, for example, would not be affected by a change in its price, whatsoever
large or small it may be. There are five types of price elasticity according to the degree of
responsiveness of demand to a change in price.
[1] Perfectly elastic demand : Demand is said to perfectly elastic when a small change in
price leads to an unlimited change in demand. In such a case, the demand curve is parallel to the
X-axis as shown in figure below. The horizontal demand curve DD shows that a tiny change in
price leads to an indefinitely large change in quantity demanded. This is the case of infinite
elasticity. It is because at the given price (P), consumer can buy as much amount as he wants.
Y

price

q0

q1

Quantity

[2] Perfectly inelastic demand: The demand is said to be perfectly inelastic when even a
large fall or rise in price leads to no change in the quantity demanded. In such a case, the demand
curve is a vertical straight line parallel to the Y-axis as shown in figure below. The vertical
demand curve DD in figure below shows that the amount demanded remains the same
whatsoever may be the change in price. This is the case of zero elasticity.

24

Y
Price

epd = 0

P
D
X
0
Q
However, in real life, we never come across the extreme cases of perfectly elastic and in
elastic demand. In real life we come across elasticity of demand between these two extreme cases
where it is more than zero and less than infinity.
3. Relatively elastic demands: When the change in demand is more than proportionate to
the change in price, elasticity is greater than unity. If for example, a change of 20% in price leads
to a change in demand by 40% then it is the case of relatively elastic demand. A relatively small
change in price (P) from P to P in figure 2.8 leads to a relatively larger Q to Q change (Q) in
demand.
D
P

Price

P
P

Q Quantity demanded
In above figure, when the price of commodity was P, the commodity was demanded only
0Q amount and as the price of the commodity falls to P the quantity demanded has increased to
Q. Here, small change in price leads to large change in quantity demanded.
4. Relatively inelastic demand: When the change in demand is less than proportionate to
the change in price, elasticity is less than unity. If for example, a change 20% in price leads to a
change in demand by 10% then it is the case of relatively inelastic demand.
Y
D
P
p
Q
P
0

D
Q Q

In above figure, when price of commodity was P and demand of it was Q. As the prie falls
from P to P, the quantity demanded increases from Q to Q. Here proportionate change in P is
greater than proportionate change in Q.
4. Unitary elastic demand: Elasticity is said to be unity when the change in demand is
exactly proportionate to the change in price. If for example, a 20% change in price leads to 20%
change in demand, then elasticity is said to be unity or 1. Thus, when a change in price (P) from

25

P to P in figure below causes a proportionate change in demand (Q) from Q to Q, the

D
proportions are equal.
P
P

Price

Quantity demanded

[II] Income elasticity of demand:

Income elasticity of demand measures the responsiveness of demand to a change in
income. It is the percentage change in the amount of a commodity purchased resulting from a
percentage change in consumers income. Thus income elasticity of demand is defined as the
ratio of percentage change in quantity demanded to the change in income. In other words, income
elasticity of demand =

Percentage change in quantity demanded

percentage change in income

If we denote income elasticity by e dy, , and let Y stand for income of the consumer, then
income elasticity can be measured by the following formula:
Q

edy= Q Y = Q Y = Y Q
For normal goods, eyd is positive, as increase in income leads to increase in the quantity of
goods demanded. For the unlikely case of an inferior good, eyd would be negative implying that
increase in income leads to decrease in quantity demanded. Thus, a negative eyd would imply that
the good is inferior and if the eyd is positive, the good is normal. Further more, when eyd >1, the
normal good is luxury otherwise it is a necessary. Nevertheless, elasticity of income for a good is
likely to vary with variation in the level of consumers income. This is so because a good
considered a luxury at low levels of income may become necessity at intermediate levels of
income and an inferior at high levels of income.
Calculation of income elasticity with a numerical example has been shown in table below.
Income elasticity of demand
Income (Y) (Rs In Quantity
1000)
Demanded(Q)
8
50
12
100
16
150
20
180
24
200
28
190
32
180

eyd
2
1.5
0.8
0.56
-0.30
-0.37

Types of Goods
Luxury
Luxury
Necessity
Necessity
Inferior
Inferior

The above table shows calculation of income elasticity using the formula defined above.
Thus, when income increases from Rs. 8,000 to Rs. 12,000 quantity demanded rises from 50 to
100 units. Using the formula,

26

100 50

8000

50

8000

eyd = Y Q =
=
=2
12000 8000
50
50 4000
As eyd >1, the good is considered a luxury. Finally, when the consumers income rises to
Rs. 28000, the quantity demanded of the good falls to 190 units from the earlier demand 200
units. It thus becomes an inferior food from being a luxury at the first instance.
The concept of income elasticity is helpful in that it helps in classifying goods into
necessities and luxuries based on the changes in their demand to change income. When income
elasticity is less than one and the quantity demanded remains the same despite a rise in income,
the good in question in a necessary. On the other hand, the good in question is a luxury if income
elasticity is greater than one.
[III] Cross elasticity of demand:
Some times two goods are so closely related that a change in the price of any one of them
brings about a change in the demand for the other good as well. Such goods are either substitutes
(tea and coffee) or complements (tea and sugar). Cross price elasticity of demand measures the
responsiveness of demand for one such good to a change in the price of another good. If we
consider the two goods as X and Y and let ecp stand for cross elasticity, then the cross elasticity of
demand is measured by the following formula:
Py Q x PY
percentage change in the quantity demanded of X Q x

ecp =
=
=
percentage change in the price of Y
Qx
Py
PY Q x
Given the above formula, we can find out whether a good is a substitute or a compliment.
In other words, if good Y is a substitute for good X, the demand for X will rise when the price of
Y rises. In this case, cross elasticity will be positive indicating that the two goods are substitutes.
If on the other hand, good Y is a complement for good X, the demand for X will fall when
the price of Y rises. In this case, cross elasticity will be negative indicating that the two goods are
compliments.
Cross price elasticity of substitutes
Before Change
After change
Commodity

Price (Rs./Cup)

Quantity/ hour

Tea (X)

Coffee(Y)

Price (Rs./Cup) Quantity/ hour

2
6

5
3

We want to see whether X and Y are substitutes or complimentary goods using the cross
elasticity formula.
Q x PY
1 4

Thus,
ecp=
= =0.5
PY Q x
2 4
This shows that when price of coffee rises from Rs.4 to Rs. 6 per cup, ( there is no change
in the price of tea i.e. Rs. 2) the demand for tea increases to 5 cups from 4 cups per hour. This
results in a cross price elasticity ( epc) of 0.5, indicating that the two goods are substitutes.
Cross price elasticity of compliments
Before Change
Commodity Price Rs/cup

Tea (X)
Milk(Z)

2
1

After change

Quantity/hr

4
2

27

Price Rs/cup

Quantity/hr

Using the same formula again, we want to know whether X and Z are substitutes or
compliments. Thus,
Q x PY 1 1

= -0.25
epc=
=
PY Q x
1
4
When the price of milk increases from Rs.1 to Rs.2 per cup, the demand for tea falls to 3
cups from 4 cups an hour. This results in a negative cross price elasticity (epc= -0.25) indicating
that the two goods are compliments to each other.
Therefore, it can safely be concluded that if the cross elasticity is positive the goods are
substitutes and if it is negative the two goods are compliments.
Measurement of Price elasticity of demand:
The most frequently used methods in the measurement of price elasticity of demand are
the Percentage method, total outlay method, point method and arc method
1. Percentage method: In this method, price elasticity of demand is measured dividing
percentage change in quantity demanded by percentage change in price. For this following
formula is used.
Q P1
Percentage change in quantity demanded

epd =
=
Percentage change in price
P Q1
Here, if the value of epd>1 then the demand is said to be elastic.
If the value of epd<1 then the demand is said to be inelastic.
If the value of epd=1 then the demand is said to be unitary elastic.
2. The total outlay method (Total expenditure method)
Alfred Marshall first proposed this method or measuring price elasticity of demand.
According to this method, price elasticity of demand can be measured by comparing the changes
in total outlay or expenditure in response to a change in the price of the commodity. Using this
method, three different cases of change in total outlay can be established resulting from a change
in the price of the commodity. This has been done in table below. For simplicity, we denote
expenditure by E, price by P, quantity by Q and price elasticity by epd as usual.
Total Outlay or Expenditure Method
Price of commodity(P)
Demand
of Expenditure (E)= P.Q
epd
In (Rs.)
commodity (Q)
8
2
16
4
3
12
epd<1
3
4
12
epd=1
2
8
16
epd>1
When the price of the commodity falls from Rs 8 to 4 then the quantity demanded has
gone to 3 units from 2 units. The expenditure made on the commodity has also fallen to Rs 12
from the Rs 16. Therefore, the price elasticity of demand is inelastic (epd<1) in this condition.
Similarly, when the price of commodity falls to Rs 3, the quantity demanded reaches to 4 units.
Here, the expenditure made on the commodity remains same as previous (Rs 12). Therefore, the

28

elasticity of demand is equal one (epd=1). Again, the price of commodity falls to Rs 2, the quantity
demanded reaches to 8 units and the expenditure made on the commodity become Rs16.
Therefore the price elasticity of demand is greater than one (epd>1).
In short, we can conclude that as price and expenditure made on the commodity moves in
same direction then the demand is said to be inelastic. If the price and expenditure move in
opposite direction then the demand is said to be elastic. If there is no change in the expenditure to
a change in price then the demand is said to be unitary elastic demand.
The total outlay method of measuring elasticity of demand is illustrated with the help of
the graphical figure.
P

epd>1

B
Price

epd=1

C
d
p

e <1

D
Expenditure

In the diagram, the curve AD measures the total outlay with respect to change in price of a
particular commodity. The movement from A to B shows elastic demand as total outlay increases
with reduction in price. The movement from B to C shows the unitary elastic demand as total
outlay remains constant even if price declines. The movement from C to D shows inelastic
demand as total outlay declines even if price declines.
3. Point method:
Point elasticity of demand, also proposed by Marshall, measures price elasticity at
different points on a demand curve. This method is adopted to measure responsiveness of demand
to a very small change in price. The change in price is assumed so small that it tends to be zero
but not actually zero.
Using the point method, price elasticity of a straight-line demand curve at any point on it
is shown by the ratio of the segments of the line to the right and to the left of the particular point.
Figure below show how elasticity at a point on a straight-line demand curve is measured. The
price elasticity of demand on a point of demand curve is measured by following formula.
Lower segment of demand curve
Upper segment of demand curve

A ep =
epd>1

Price

epd=

Pep =1

epd<1

29
d

Quantity demanded

Bep =0

In above figure, on the demand curve AB, we can find elasticity at any point by taking the
distance from B to a point on the curve divided by distance from the other end to that point. This
is elasticity at any point on the curve is given by
elasticity at point P is given by epd=

Lower segment of demand curve

. Thus
Upper segment of demand curve

BP
1
AP

Price

If P is mid point of demand curve AB then AP=BP so that e pd=1 at point P. It shows that
elasticity of demand curve at mid point of the curve is unity.
As we approach the at A, elasticity tends to infinity and at point B, it tends to zero. At the
point above P is more than one and below P elasticity is less than one. This applies to every linear
demand curve.
The above case holds true in case of non-linear demand curve. Which is shown below.

Quantity demanded
D
The aboveA figure is an illustration of how to find price elasticity at a point on non-linear
demand curve. DD is a non-linear demand curve and we have to measure the price elasticity at
point P. For this, we have to draw tangent AB that just passes through the point P. Now the price
P by the formula of linear demand curve.
elasticity at point P is calculated
Lower segment of tangent
AP
D
Here, epd= Upper segment of tangent =
BP
B
4. Arc method:
Q
0
The arc method of measuring price elasticity is employed when there is a substantial
change in price. Unlike in the point method where the elasticity is measured on a point of demand
curve, this method measures the elasticity over an arc of demand curve. An arc is a portion or
segment of demand curve. Under the point method, we measure the price elasticity by taking into
account either the original price and quantity or the new price and quantity as the basis. But as
we work out, it gives us two different results. Let us see it with an example, suppose the price
falls from Rs 25 to Rs 15 and as result amount demanded increases from 50 to 100.

Price (Rs)
25
15

Quantity demanded
50
100

30

Let us measure price elasticity by employing the formula.

Q

epd= P Q . First we take P=25 and Q=50 as the basis. Then, e pd=
50
25

2.5 . Again,
10 50
50 15

0.75
10
100

if we take P=15 and Q=100 as the basis. Then epd=

This method thus leads us in ambiguity. Price elasticity in this case, tends to vary from
one point to another point
on a demand curve.
Y
D

Price

Elasticity is measured over the arc between

point L and M

P1

P2

L
Q1

Q2 Quantity demand
M

The way out of this ambiguity is to take the average of the two prices and quantities and
D
measure elasticity at the mid point. And this is how the arc method
measures price elasticity. Thus
the arc method of measuring price elasticity takes an average of the two (old and new) prices and
average of the two ( old and new) quantities. This then gives us a single result of the measurement
of price elasticity instead of two as seen above. The formula for arc method is:

P P
P P
Q
Q
1 2
1 2
2
Ep = Q1 Q2
Q1 Q2
P
P
2
d

Q P1 P2

P Q1 Q2
Using our numerical exaple where price falls from Rs. 25 to 15 resulting in an increase of
quantity demanded from 50 to 100 units, we can calculate price elasticity with the help of the
formula for arc method.
50
25 15
50 40
4

1.3
Thus, epd=
10 50 100
10 150
3
3.6 Importance of elasticity of demand:
The different types fo elasticities discussed above are of crucial importance to business
firms in their pricing policy and for the government in designing appropriate economic policy.
1. Pricing policy of business firms:
One of the important application of price elasticity is that it helps business firms choose
appropriate pricing policy. It helps them decide whether raising price will increase or lower
revenue under a given circumstance. The total revenue of business firms is the total expenditure
made by the consumers. In other words, total revenue (TR) is equal to price (P) multiplied by
quantity (Q). Therefore, it is important for business firms to know the price elasticity before they
make any decision on whether or not to raise or lower price. This is because:

31

(a) if the demand is inelastic, a decrease in price will reduce total revenue.
(b) if the demand is elastic, a decrease in price will increase total revenue and
(c) if the demand is unit elastic a decrease in price will cause no effect in total revenue.
Therefore, the concept of price elasticity serves as an important instrument for business
firms in deciding their revenue policy with a change in their pricing policy. This is so because a
rise in price will lower consumer expenditure and therefore the total revenue of the firm. In order
that a firm follows a profit maximizing pricing policy, it has to consider price elasticity.
2. Economic policy of the government:
The concept of price elasticity is of paramount importance for the government in
designing its taxation policy. It has often been found out that government imposes higher taxes on
goods with inelastic demand. As for example, rise in price of petroleum product has not lowered
its demand substantially. It implies that the demand for petroleum is inelastic in case of Nepal.
Price elasticity of demand is also useful in designing the foreign trade policy of a country.
This is so because a country can choose to either lower or increase its exports through its foreign
exchange policy. If , for a instance, a country chooses to expand export by devaluation of its
currency and if the demand for its product happen to be inelastic, the country stands to loose. The
money received from the sell of a larger volume would be smaller because of the reduced price.
3. Pricing policy of farm products:
The concept of price elasticity has quite often been used to explain the paradox of bumper
harvest. Farmers expect higher incomes when their farm product increases. However, this is not
the case. As the demand for most farm product is inelastic, their consumption changes very little
in response to changes in price. When the supply of farm product increases, their price goes
down. It thus brings less income to the farmers despite increased production from a good harvest.
This is referred to as the paradox of bumper harvest. Therefore, the farmers should be cautions
enough to fix the price of their product with special attention paid to the elasticity of their
products.
4. Classification of goods into luxury and necessity:
The concept of income elasticity helps in classifying goods into luxury, necessity and
inferior based on whether eyd is greater or less than one. This in turn helps government in its
taxation policy as well as business firms in their pricing policy.
4. Classification of goods as substitutes and compliments:
The concept of cross elasticity of demand is useful in classifying goods into substitutes
and compliments. If cross elasticity is positive, two goods are considered substitutes. If it is
negative, they are compliments. Such classification helps firms fix the prices of products that are
close substitutes or compliments.

Unit 4. Theory of Production

4.1 Concept of production:
Production is the process of transforming inputs into output. Inputs are often called the
factor of production. Some important inputs are land, labor, capital, and raw materials. Firms
combine the inputs to produce output. The state of technology dictates how inputs can be
combined and what the resulting level of output will be if inputs are used efficiently. The
available technology imposes the constraint that there are only certain feasible ways to produce
output from inputs. When technology improves over time, more can be produced by using the
same input combinations.
4.2 Production function:

32

The technical physical relationship between inputs and output is called the production
function. It identifies the maximum output that can be produce per period by each combination of
inputs. It describes the law of productions between inputs and output and includes all the
technically efficient methods of production.
In the process of production a varying combinations of inputs can be used produce the
same amount of output. Assume that two inputs capital (K) and labor (L) are used to produce an
output, say X. These two inputs can be combined differently to produce a unit of X as shown in
the following example.
Inputs
Method
A
B
C
Units of labor (L)
8
6
4
Units of capital(K)
2
5
8
In method A, 8 units of labor and 2 unit of capital are used to produce a unit of X. In
method B, 6 units of labor and 5 units of capital are used to produce the same unit of output. In
method C, 4 units of labor and 8 units of capital are used for same level of production.
In method A, more labor is used with few capitals, therefore this method is known as
labor-intensive technology. 8 units of capital and only 4 units of labor are used to produce same
level of production. Here, more capital is used with few labors therefore this method is known as
labor-intensive technology.
4.3 Short-run production function:
In the process of production, output can be increased by increasing the inputs. But the firm
can not increase all inputs when needed. Some inputs like raw materials, fuel, and possibly labor
can be increased with no or little time. However, input like machines, buildings, and production
plants cannot be increased immediately. The first type of inputs that can be increased with short
time period or immediately are called variable inputs. The second type of inputs that cannot be
changed within the given time period are called fixed inputs.
When a firm wants to increase output immediately, it can do so by increasing the variable
factors keeping the fixed factor constant. The period during which one or more factors of
production cannot be changed is called the short-run.
[I] Law of variable proportion:
The short-run refers to a period in which some factors of production cannot be changed.
So during short-run, factors are variable as well as fixed. When at least one input is fixed, input
proportion must vary while expanding output. Therefore, the shot-run production is also called
the law of variable proportions, and it exhibits the law of diminishing returns.
In the case of two factors of production, the production function is the given by, X= f (K,
L). This function will represent the short-run if we consider capital (K) as fixed factor and labor
(L) is the only variable factor. In that case, the production function can be written as:
X f ( K ,L) here, the K means the fixed capital which does not change with expanding output.
Various economists have stated the law of variable proportions or diminishing returns in the
following manner:
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 product will decrease, i. e., the
marginal product will diminish. (G. Stigler)
As the proportion of one factor in a combination of factors is increased, after a point,
first the marginal and then the average product of that factor will diminish.(F. Benham)

33

It is obvious from the above definitions of the law of variable proportions ( or the law of
diminishing returns) that it refers to the behavior of the output as the quantity of one factor is
increased, keeping the quantity of other factors fixed and further it states that the marginal
product and average product will eventually decline.
Assumptions of law of variable proportion
The law of variable proportions (or law of diminishing returns) as stated above holds good
under the following conditions:
1. The state of technology is assumed given and unchanged. If there is improvement in
technology, then marginal and average product may rise instead of diminishing.
2. There must be some inputs whose quantities is kept fixed.
3. The law is based upon the possibility of varying the proportions in which the various
factors can be combined to produce a product. The law does not apply to those cases where the
factors must be used in fixed proportions to yield a product.
The law of variable proportion ( or diminishing returns) is illustrated in table and in
figure below.
Units of labor
Total product
Marginal product
Average product
( quintals)
( quintals)
( quintals)
Q
Q
L
Q
( L=1)
L

1
2
3
4
5
6
7
8
9
10

80
170
270
368
430
480
504
504
495
470

80
90
100
98
62
50
24
0
-9
-25

80
85
90
92
86
80
72
63
55
47

We shall first explain it by considering table. Assume that there is a given fixed amount of
capital, with which more variable factor, labor, is used to produce a product. With the fixed
quantity of capital, as a producer raises employment of labor from one unit to 8 units, total
product increases from 80 quintals to 504 quintals beyond the employment of 9 units of labor,
total product diminishes. It is worth noting that up to 3 units of labor, total product increases at an
increasing rate and afterwards it increases at a diminishing rate. This fact is clearly revealed from
column 3, which shows successive marginal products of labor as extra units of labor are used.
It will be seen from column 3 of the above table that the marginal product of labor initially
rises and beyond the use of three units of labor, it starts diminishing. Thus when three unit of
labor are employed, marginal product of labor is 100 and with the use of 4 th and 5th units of labor
marginal product falls to 98 and 62 respectively. Beyond the use of 8th unit of labor, total product
diminishes and therefore marginal product diminishes and therefore marginal product become
negative. As regards average product of labor, it rises up to the use of fourth unit of labor and
beyond that it is falling throughout.
Three stages of the law of variable proportions

34

Stage III

Stage II

Stage I

Average and marginal product

Total product

The behavior of output when the varying quantity of one factor is combined with a fixed
quantity of the other can be divided into three distinct stages. In order to understand these three
stages it is better to graphical illustrate the production function with one factor variable. This is
done in figure below. In the figure, quantity of variable factor is measured in horizontal axis and
on the vertical axis, total product is measured. In addition, in lower panel, average and marginal
product are measured in vertical axis and quantity of variable factor in horizontal axis. The total
product (TP) curve goes on increasing to a point and after that it starts declining. Average and
marginal product curves also rise in the beginning and then decline; marginal product curve starts
declining earlier than the average product curve. The behavior of these total, average and
marginal products of the variable factor consequent on the increase in its amount is generally
divided into three stages that are explained below.
H

Total
product

Point of
inflexion

Labor

Marginal
product

Average
product

MP

AP

0
L returns.
N
Labor
Stage I: Stage of increasing
InMthis stage total
product toXa point increases at an
increasing rate. In above figure, from the origin to the point F, the total product increases at
increasing rate, which means the marginal product rises. From the point F onwards during the
stage one, the total product increase but at diminishing rate i.e. the marginal product decreases
but is positive. The point F where the total product stops increasing at an increasing rate and starts
increasing at diminishing rate is called the point of inflexion. Corresponding vertically to this
point of inflexion marginal product is maximum, after which it slopes downward.
The stage I ends where the average product curve reaches its highest point. During the
stage I, where marginal product of the variable factor is falling, it still exceeds its average product
and so continues to cause the average product curve to rise. Thus, during the stage I, whereas
marginal product curve rises in a part and then falls, the average product curve rises throughout
this stage.
Stage II: Stage of diminishing returns. In this stage, the total product continues to
increase at diminishing rate until it reaches its maximum point H where the second stage ends. In

35

this stage both the marginal and average product of the variable factor are diminishing but are
positive. At the end of the second stage, that is, at point M marginal product of the variable factor
is zero. This stage is very crucial and important because the firm will seek to produce in its range.
This stage is known an the stage of diminishing returns as both the average and marginal product
of the variable factor continuously fall during this stage.
Stage III: Stage of negative returns: In this stage, total product declines and therefore the
total product curve TP slopes downward. As a result, marginal product of the variable factor is
negative and the marginal product curve MP goes below the X-axis. In this stage, variable factor
is too much relative to the fixed factor. This stage is called the stage of negative returns, since the
marginal product of the variable factor is negative during this stage.
The stage of Operation. Now an important question is in which stage a rational producer
will seek to produce. A rational producer will never choose to produce in stage III where marginal
product of variable factor is negative and total product is diminishing with increasing number of
labors. It is thus clear that a rational producer will never be producing in stage III.
A rational producer will also not choose to produce in stage I where the marginal product
of the variable factor is rising. A producer producing in stage I means that he will not be making
the best use of fixed factor and further he will not be utilizing fully the opportunities of increasing
production by increasing quantity of variable factor whose average product is continues to rise
throughout the stage I. Thus, a rational producer will not stop in stage I but expand further.
A rational producer will always seek to produce in stage II where both the marginal
product and average product of the variable factor are diminishing.
4.4 Long run production function.
The long run is a period of time during which all inputs can be varied. In this period, there
is no fixed input, all input are variable. A firm can change its old production plant, RNAC can buy
new airplanes, a farmer can buy more land in the long run, which would not be possible in the
short run.
It is to be noted that the distinction between short-run and the long-run is not based on the
calendar year. Rather, it is a matter of the possibility of changing all inputs or some of them
within a given time period. Therefore, the period of short-run and long run differ from firm to
firm.
4.4.1 Concept of Isoquant. An isoquant is the graphical representation of the different
combinations of two variable inputs (L and K) with which a firm can produce a given amount of
output. Isoquant is also called the equal produce curve and can loosely be termed as producers
indifference curve. It describes the combinations of two variable inputs which gives rise to the
same level of output. Any point on an isoquant shows the minimum amount of the variable inputs
needed to produce the given output.
The concept of isoquant can be easily understood from the table below. It is presumed that
two factors of production capital (K) and labor (L) are being employed to produce a product.
Each of the factor combinations A, B, C, D, and E produces same level of output, say 20 units. To
start with, factor combination A consisting of 1 unit of labor and 12 units of capital produces 20
units of output. Similarly, combination B consisting of 2 units labor and 8 unit of capital,
combination C consisting of 3 unit of labor and 5 unit of capital, combination D consisting 4 units
of labor and 3 units of capital, combination E consisting of 5 unit of labor and 2 unit of capital are
capable of producing the same amount of output.
Factor combination
Labor
Capital
A
1
12

36

B
C
D
E

2
3
4
5

8
5
3
2

4.4.2 Properties of isoquants: The isoquants normally possesses properties which are
similar to those generally assumed for indifference curves of the theory of consumers behavior.
Moreover, the properties of isoquants can be proved in the same manner as in the case of
indifference curves. The following are the important properties if isoquats.
1. Isoqunts slope downward from left to right( i.e., they have a negative slope): This is so
because when the quantity of factor, say labor, is increased, the quantity of other capital must be
reduced so as to keep output constant on a given isoquant.
2. No two isoquants can intersect each other: If the two isoquants, one corresponding to
higher amount of output and other lower amount intersect to each other, there will be then be a
common factor combination corresponding to the point of intersection. It means that the same
factor combination, which can produce higher amount according to one isoquant curve, can also
produce lower amount of output according to another isoquant curve. But it is quite absurd. How
can the same factor combination produce two different levels of output, techniques of production
remaining unchanged.
3. Isoquants are convex to the origin: The convexity of isoquant curves means that as we
move down the curve successively smaller units of capital are required to be substituted by a
given increment of labor so as to keep the level of output unchanged. Thus, the convexity of equal
product curves is due to the diminishing marginal rate of technical substitution of one factor for
another.
4.4.3 Marginal Rate of Technical Substitution
The marginal rate of technical substitution (MRTSLK) is the rate at which one input can be
substituted for another without changing the level of output. The slope of the isoquant gives the
rate at which one input can be substituted for another, holding the output constant. Since the slope
of an isoquant moving down the isoquant is given by -K/L,
MRTSLK =

K
Slope of the isoquant.
L

The condition that the total output should remain constant implies that marginal product of
K (i.e. MPK) must equal marginal product of L (i.e.MPL). That is,
(-K MPK) = (L MPL)
By rearranging, we get
K MPL

L MPK
MPL
K

Since, MRTSLK =
MPK
L
MPL
Or MRTSLK=
MPK
Thus, MRTS of L for K is the ratio of the marginal product (MP L) to the marginal product
of capital (MPK).
To illustrate the MRTS numerically, let us suppose that a given production function may
be presented in a tabular form as given in table below. The table present 4 alternative
37

combinations of K and L that can be used to produce a given quantity, say 10 units, of a
commodity.
Alternative methods of producing 10 units of a commodity
Capital (K)
Labor(L)
Change in K(K) Change in L(L) MRTSLK= K/L
10
2
8
4
-2
+2
-1.0
5
10
-3
+6
-0.5
1
20
-4
+10
-0.4
Note that as we move down the table, the MRTS declines. This is an important factor in
determining the shape of the isoquant. The downward movement on an isoquant indicates
substitution of labor for capital. The amount of capital decreases while the number of workers
increases, so that output remains constant. The units of labor that can substitute one unit of capital
go on increasing. As a result, the MRTS (= - K/L) decreases. The reason is that both the factors
are subject to the law of diminishing marginal return. As the number of labor increases, its
marginal productivity decreases. On the other hand, with the decrease in the quantity of capital,
its marginal productivity increases. Thus, labor whose marginal productivity is decreasing
substitutes capital whose marginal productivity increasing. Therefore, to substitute each
subsequent unit of capital, more and more units of labor are required to maintain the production at
the same level. That is why the MRTS decreases.
4.4.4 Iso-cost curve
A firm can purchase various combinations of inputs with the given total outlay. A curve
showing the combinations of any (two) inputs that can be bought with a given sum of money is
called the isocost curve. It is analogous to the consumers budget line, but it is related to purchase
of inputs by a firm.
Consider the linear cost function given in equation (1)
C= rK +wL.(1)
Given the total cost, C, we can draw a isocostline having slope (- w/r) as K= C/r (w/r)L
K
C/r
C/r

C= rK +wL
C= rK +wL

C/w

C/w

0
As long as input prices (r and w) remain constant, isocost lines remain parallel. When total
cost increases the isocost line shift parallel to the right. In above figure, when cost amount
increases from C to C remaining r and w unchanged the isocost line shift to right hand side. Here
the slope of isocost line is w/r or the ratio of per unit price of labor to price of per unit capital.
4.4.5 Producers Equilibrium ( Least cost combination)
An isoquant map represents the various factor combinations, which can yield various
levels of output. On the other hand, a family of iso-cost line represents the various levels of total

38

cost or outlay, given the price of two factors. The entrepreneur may desire to maximize his output
level for a given cost or minimize cost for producing given level of output. Therefore, the
producer always want to produce at least cost combination.
(I) Maximization of output for given cost.
For this, we have to brought isoquant map and isocost line in one place.
K

Capital

K1
D
E

L1
Labor
Producers equilibrium

X1

X0

X2

In above figure, three isoquants X0, X1, X2 and isocost line MN are shown in one panel of
capital(K) and labor(L). As we know that the every points on MN line exhibits same level of cost.
For the equilibrium of producer the slope of isocost line and the slope of isoquant must be equal
at any point of a isoquant. This condition is fulfilled at point C where the producer can maximize
the output for given cost. Thus, producer employ 0K1 amount of capital and 0L1 amount of labor
to produce X2 level of output. Instead of producing at point C, if the producer produce at point A
then he can produce less amount of output (say X 0) in same cost. It is obvious that X 0 level of
output is less than X2 level. Similarly, same thing happens at point B too.
From above discussion, we can conclude that for equilibrium of producer slope of isocost
line must be equal with the slope of isoquant at a point.
i.e. slope of isocost line= slope of isoquant
or

w MPL

r
MPK

where, w/r is the slope of isocost line and MPL/MPK is the slope of

isoquant.
MPK
MPL

or the ratios of marginal productivity to price of factors must be equal

r
w
for the equilibrium of producer. And it is noteworthy point that this condition of producer
equilibrium is only necessary condition. For the sufficient condition, the isoquant curve must be
convex to origin.

Or

(II) Minimization of cost for given output.

39

It is another way to describe producer equilibrium. In this situation, the amount is given
and which has to be produced at minimum cost. For this, we need a family of isocost lines. The
producer is in equilibrium at a point of given isoquant where slope of isoquat is equal with the
slope of an isocost line. The equilibrium condition is shown in figure below.
K
M
A

M
M

K1

L1

X0

In above figure, the given output is X0 to produce the amount we can produce at points A,
B, C, D and E. But when producer employ K 1 amount of capital and L1 amount of labor to
produce X0 amount of output then the cost is minimum. The minimum cost is represented by
MN isocost line.
At point C, the slope of isoquant and slope of isocost line are equal. Therefore, the point C
is equilibrium point of producer.
4.5.6 Law of Return to scale
In the theory of production, long run implies such a situation in which all inputs are
variable- a firm can use more labor, more raw materials, new equipment, new production plant
with improved technology, and much more. When all inputs are increased in the same proportion,
what would be its effect on the total output?
There may arise three possibilities.
Increasing return to scale (IRS)
Constant return to scale (CRS)
Decreasing return to scale (DRS)
1. Increasing return to scale (IRS)
This is the situation in which all inputs are increased in a given proportion and output
increases in a greater proportion than that of increased in inputs. For example, when
inputs are increased by 25% and output increases by more than 25%. If labor and capital
are doubled, output more than doubles. The increasing return to scale is illustrated in
figure below. The movement from point a to b on the product line 0B means doubling the
B
inputs.
Product lines
c
3K
C

1K

Q=40

2K

Q=25

40
0

Q=10
1L

2L

3L

Increasing return to scale

As the above figure shows, quantities of inputs K and L increased to 2K and 2L, the
output increased by more than double as it increased from 10 units to 25 units. Similarly the
movement from a to c indicates a trebling of inputs as a result of which the output is more than
trebled- it increases four times. This kinds of relationship between the inputs and outputs shows
increasing returns to scale.
2. Constant returns to scale.
When a proportional change in output equals the proportional change in inputs, it exhibits
constant return to scale. In other words, if quantities of both the inputs, K and L, are doubled and
output is also doubled, the return to scale is said to be constant. The phenomenon of constant
return to scale is illustrated in figure below. The lines 0A and 0B are product lines indicating three
hypothetical technique of production. The isoquants, Q=10, Q=20 and Q=30 indicate the three
different levels of output.
3K

2K

B
c

1K

Product lines
C

Q=30

Constant return to scale

Q=20
a
In the figure above, the movement from point a to b indicates doubling both the inputs.
That is, K increases to 2K and L increases to 2L. By doubling inputs, output is also doubled from
10 to 20. Likewise, the movement from a to c indicatesQ=10
trebling the inputs, as K increases to 3K
and L to 3L. This also indicates trebling1Lthe output,
as
it
increases
from 10 to 30. This relationship
2L
3L
between inputs and output exhibits the constant return to scale.
3. Decreasing return to scale
The firms are faced with decreasing return to scale when an increase in inputs, K and L,
leads to less than proportionate increase in the output. That is, when inputs are doubled, output is
less than doubled and so on. The law of decreasing return to scale is illustrated in the figure
below. As the figure shows, when inputs, K and L, are doubled 2K from K and 2L from L, output

41

increases to 18 from 10, which is less the proportionate increase. The movement from point a to b
and b to c indicates the decreasing return to scale.

3K

2K

B
Product lines

1K

C
Q=30

Decreasing return to scale

Q=18
The above figure shows that asa the inputs are doubled,
the output has increased by less
than double. Similarly when inputs are trebled the output has increased less than treble.

Unit 5. Cost and Revenue

Q=10

There are different concepts of

in economics. We must first deal with these concepts
1L cost2L
3L
before we try to look into the shapes of the different cost curves.
1.
Money cost: Money cost is the amount of money producer spend directly in the
purchase of the inputs of production. A firm spends the total money amount in
producing a commodity. Money cost includes wages and salaries paid to labor,
expenditure on machinery and equipment, their parts and repairs, expenditure
on raw materials, light, power, fuel, transportation, water, advertisement,
insurance, taxes etc. Such costs are also known as nominal cost, which are
actually the expenses incurred in terms of cash money in the process of
production.
2.
real cost: Besides money, producers also have make some serious efforts and
sacrifices so as to produce commodities. Simply spending money or investing a
huge amount of capital in an enterprise would not yield the producer profit. He
need to undergo certain pains and labors so that he makes profit out of his
investment. Such efforts and sacrifices undergone by the producer in producing
a commodity are called the real costs of production. The efforts and hardships
undergone by a businessman to save and invest, the leisure forgone by the
workers to produce commodities, the public holiday given up by accountants to
carry out the companys details and others constitute real cost of production.
The patience undergone by investor before the business starts yielding profits is
also included in the real cost of production.
3.
Explicit cost: The cost involving direct payment of money for factors of
production not owned by the firms are known as explicit costs. These are the
payments made by the firms to other factor owners for purchasing or hiring
their services. Such payments are the wages and salaries, expenses on raw
materials, power, and advertisement, transportation charges, tax paid to the

42

government, overhead cost and depreciation charges. Such expenses involve

direct payment of money. That is why they are called explicit costs.
4.
implicit cost: When a firm produces goods, it owns certain factors of
production by himself. Even though the firm is not required to make any
payments for such factors, their value has to be imputed. Such a value is equal
to what the factors owned by him could earn if they were to be hired out to
some other firms. If, for example, the manager of a firm is the owner himself,
he would have earned some salary if he were to work elsewhere. Similarly, the
capital he invests into his business would have earned him some interest if it
were lent out. Such costs are known as the implicit cost of production in
economics.
5.
Opportunity cost: Opportunity cost is defined as the cost of any activity
measured in terms of the best alternative forgone for its sake. For example a
student of economics with Rs. 500 in his pocket has got two alternatives before
him- go for a hiking with his friend or buy a text book of economics. He
chooses to buy the text book and forgone hiking with his friend. The
opportunity cost here is not the sum of Rs 500 but the entertainment and thrill
he sacrificed for the sake of buying the text book. An investment decision
involves several such sacrifice and opportunities. Such foregone opportunities
and sacrifices are also taken as costs in economics and termed as opportunity
cost.
6.
Accounting cost: Accounting costs are those costs that involve direct payment
of money by the entrepreneur to the various factors of production. An
accountant keeps a record of only those costs that involve a payment. Such cost
include money cost, wages and salaries, prices of the raw materials and such
payments that needs to be recorded by the accountant. Money cost and explicit
cost together makes up accounting cost.
7.
Social cost: Social cost of production has emerged as the most talked about
subject in modern day industrialization. Besides economic cost, production
processes also involve social costs. Such costs are the environmental affects
borne by the society. They include the cost of air pollution, water pollution,
sound pollution and all those costs that affect people surrounding a firm. An
entrepreneur counts only the cost of production that constitutes economic cost.
But the society today has been burdened with a number of costs that never
appear in the larger book of producer. They fall more on the society and the
public in general bears such costs.
5.1 Types of costs:
The cost is divided into short-run cost and long run cost. Short-run is the time period in
which some factors of production remain constant while expanding output and long run is the
time period in which all factors of production are variable. In long run, there is no fixed factor.
5.1.1 Short run cost:
In the short run some of the inputs of production are fixed while others can be changed
with changes in the level of output. Accordingly, the costs of the firm in the short run are divided
into fixed costs and variable costs. Together they make up the total cost of the firm.
[1] Total Fixed cost (TFC)

43

Cost

Total fixed costs (TFC) are associated with the fixed factors of production that cannot be
altered within short notice. They are the costs the firm has to incur irrespective of the level of
output. That is, fixed costs occur even if the firm is shut down temporarily in the short run,
producing nothing at all. Fixed costs include interests on capital, insurance fee, property taxes,
maintenance costs, administrative expenses etc. They do not vary with the level of output. They
remain the same regardless of how much is produced by the firm.
[2] Total variable cost (TVC)
Total variable costs are associated with variable factors of production which can be altered
in the short run with variation in the variable factors of production. Variable costs depend on how
much is produced by the firm. If the firm chooses to produce more in the short run, it ought to
employ more variable inputs. So it goes up. Variable cost includes expenditure on wages, salaries,
raw material price, charges on fuel and power, transportation charges and so on. They do not
occur if the firm is temporarily shut down.
[3] Total cost (TC)
Total cost in the short run is the sum total of the total fixed cost (TFC) and total variable
cost (TVC). Thus, TC = TFC + TVC
Total cost (TC) gives us the total cost of production of the firm in the short run. It includes
the cost of both fixed and variable inputs. As total variable cost changes with a change in the level
of output, total cost of production also changes with the change in it. The concepts of total cost
(TC), total fixed cost (TFC) and total variable cost (TVC) are explained in table below:
Table 5.1, TFC, TVC, TC
Output (Q)
Total fixed cost (TFC) Total variable cost (TVC)
Total cost (TC)
0
60
0
60
1
60
30
90
2
60
40
100
3
60
45
105
4
60
55
115
5
60
75
135
6
60
120
180
Column two in above table shows total fixed cost (TFC) that remains constant throughout,
irrespective of the level of output. Total variable cost (TVC) in column three increases with every
increase in output. Thus when the firm is producing 1 unit of output TVC stood at 30. when the
output rose to 6 units TVC also rose to Rs.120. It may be noted that TFC stood at Rs. 60 even
when output was nil. This is so because, the firm can not avoid fixed cost as arising out of the
fixed factors of output of input which the need to maintain in the short run. Total cost (TC) in
column four has been derived by adding up column two and three. This is the sum total of TFC
and TVC. TC rises with Y
every increase in output pushed up TC
by TVC.
TVC
Total fixed cost (TFC), total variable cost (TVC) and total cost (TC) curves are shown in
figure below.

TFC
44
0

Output

Fig.5.1, Total cost of a firm

In above figure, TFC is a straight line parallel to the X axis along with the level of output
are measured. The horizontal straight line curve indicates that TFC remains constant throughout
at each level of output. TVC starts from the origin indicating that no variable inputs will be
employed when output is zero. It rises upward from the origin indicating that the variable cost
increases with a rise in the level of output. The shape of TVC follows from the law of diminishing
returns. Initially TVC rises less rapidly as more variable factors are employed. This is so because
in the beginning, employment of additional inputs adds up to the efficiency of the firms plant and
its return more than offsets cost. But as the firm goes on employing more variable inputs, the
extra variable factor will be producing less and less extra output so that the TVC starts rising
rapidly beyond point K. Beyond point K, TVC increases at an increasing rate.
The total cost curve (TC) has been derived by adding up total fixed cost (TFC) and total
variable cost (TVC) curves vertically because TC= TVC +TFC.
(4) Average cost curves in the short run:
The above figure shows derivation of short-run cost curves. But economists are concerned
more with the form of cost per unit or average costs in the short run analysis of the firm.
Therefore, we now consider the short-run per unit cost curves or the average cost curves of a firm.
Table5.2,Short-run costs of a firm
Output
TFC(Rs) TVC(Rs.) TC (Rs.) AFC
AVC
AC
MC
(Q)
(1)
(2)
(3)
(4)=2+3
(5)=2/1
(6)=3/1
(7)=4/1
(8)=TC/Q
1
60
30
90
60
30.00
90.00
2
60
40
100
30
20.00
50.00
10
3
60
45
105
20
15.00
35.00
5
4
60
55
115
15
13.75
28.75
10
5
60
75
135
12
15.00
27.00
20
6
60
120
180
10
20.00
30.00
45
4.1 Average fixed cost (AFC):
Average fixed cost (AFC) is defined as total fixed cost divided by the level of output.
Thus, AFC= TFC/Q. Where Q stands for the units of output. As total fixed cost is constant,
dividing it by an increasing output would gradually reduce the average fixed cost. That is why
while output is just 1 unit, AFC at column 5 stood at 60. But when output expanded to 6 units
AFC fell down to 10. This would give us a steady falling average fixed cost curve. This indicates
that as a firm goes on producing and selling more units. Its overhead cost spreads over more and
more units.

AFC

60

15

12
30
20
0

45
1

AFC Output
curve

Average cost

Fig.5.2,Average fixed cost curve

In figure above, the AFC curve is a rectangular hyperbola, approaching both axes. The
AFC curve drops lower and lower as output is expanded more and more. This indicates that the
total fixed cost spreads over more and more units of output as output is expanded. When output
becomes very large, AFC approaches the horizontal axis.
4.2 Average variable cost (AVC)
Average variable cost (AVC) is defined as the total variable cost divided by the level of
output. Thus, AVC= TVC/Q, where Q stands for the units of output produced. AVC gives us the
total variable cost per unit of output. In table above (column 6), the AVC has been derived
dividing total cost by the corresponding output. Initially AVC fall steadily as output is expanded.
This is due to the occurrence of increasing returns. But as the output reaches its ideal level, AVC
starts rising. In the beginning, average product of variable input rises (AVC falls). Beyond a
certain point average product of the variable input starts falling (AVC starts rising). This would
give un an average variable cost having U shape. This is shown in figure below.

AVC

Fig. 5.3,Average variable cost

In above figure, AVC falls till the 4th unit of output. Thereafter, the AVC curve starts rising
up with the subsequent expansion in output.
Output
0
2
4
4.3 Average cost (AC)
Average cost is defined as the total cost divided by the level of output. It can also be
defined as the sum of average fixed cost (AFC) and average variable cost (AVC).
AC

TC TFC TVC

AFC AVC .
Q
Q
Q

Average cost gives us the total cost per unit of production. Since AC is the sum total of
AFC and AVC, the AC curve is derived in the same ways as AVC. That is the shape of AC is
similar to that of the AVC. In the beginning AC declines due to the occurrence of increasing
returns. When the utilization of the plant reaches its maximum level, AC reaches its minimum

46

point. Thereafter AC starts rising and so the AC curve. In table above, AC is falling till the 5 th
unit. It starts picking up from the 6th unit. If the level of output is expanded further, AC curve will
go on rising. In figure below, the AC curve has derived from the table above.
AC

Fig.5.4, Average cost curve

Average cost

500
400
300
200
10

Output
4
6
2
3
1
5
5. Marginal Cost (MC):
Marginal cost (MC) is defined as the addition to the total cost resulting from an extra unit
of output. It is the extra cost of producing one more unit of output.
Thus, MC= TC/Q. Where TC means change in total cost and Q means change in
output.
Marginal cost is calculated by successively subtracting the total cost (TC) entries in
column 4 in table above. Thus, the marginal cost of producing the second unit of output is given
by MCn= TC n TC n 1 .
Where, TCn= Total cost up to nth level of output and TCn-1= Total cost up to (n-1)th level of
output and MCn = Marginal cost of nth commodity.
It may be recalled here that in the short-run only variable cost changes with the change in
the level of output. Therefore marginal cost can be calculated by successively subtracting the total
variable cost (TVC) entries in column 3 in table above. Thus the marginal cost of producing the
second unit of output is also given by MCn = TVC n TVCn-1.
Thus, marginal cost can be calculated either from total cost or from total variable cost.
Marginal cost tells us how much it costs the firm to expand its output by one more unit.
For this and many more proposes, the concept of marginal cost is the most important cost
concept in economics.
As regard the shape of the MC curve, it is U-shaped in the short-run. It follows from the
law of diminishing returns. In the beginning as more of the variable factor is used, additional unit
60
of output costs less than the previous one. Eventually MC falls. Beyond a certain level of output,
the law of diminishing return sets in and cost per unit of additional output starts rising. As output
is expanded further,50
MC rises and additional units of output cost more and more. In figure, MC
reaches minimum at the 3rd unit of output then starts rising.
Marginal cost curve
0

40

Marginal cost

30
20

47

10
0

output

Fig. 5.5, Marginal cost.

n above figure, the marginal cost is minimum when firm produce 3 units of output.
Beyond the three units of output the marginal cost is rising. We now turn to the study of the
relationship between the average cost curves in the short run. For this,
AC we have to bring all short
AVC
run cost curves in one figure.

Average and Marginal ocst

MC

AFC

Output

Fig. 5.7, Average and marginal cost curves

6. Relationship between AC and AVC.
Since AC = AFC+AVC, AVC is a part of AC. Both the ATC and AVC are U-shaped
reflecting the operation of the law of variable proportions. Though AC and AVC fall in the initial
stage, the minimum point of AC lies to the right of the minimum point of AVC. This is because,
AFC which is a part of AC, falls continuously with every increase in output. AC continues to fall
even after AVC has started rising after reaching its minimum point because the rise in AVC is
offset by the fall in AFC. As the rise in AVC becomes greater than the fall in AFC, AC starts
rising. AC is always above the AVC because the AC is summation of AVC and AFC. Moreover,
another important point is that the distance between AC and AVC goes on decreasing when output
level goes on expanding. Nevertheless, the AVC and AC never touch each other.
7. Relationship between average and marginal cost curves.
The relationship between average and marginal cost curves holds special significance in
economic analysis. It is based on a relationship that a firm decides the level of its output. Since
AC = AFC + AVC and as TFC is fixed, the relationship we discussing is about AC and MC. This
holds true about the relationship between AVC and MC as well.

48

We know that MC is the change in TC for producing an extra unit of output. Then it
follows that the direction of MC bears a direct relationship with AC.

Average and Marginal cost

MC

AC

Output

Relationship between AC and MC

Fig.5.8,
It can be seen from above figure that so long as MC is below AC, AC is declining. This
indicates that so long as the new units of output cost less than the average cost, their production
will pull the average cost down. Here MC pulls AC down. In other words, if MC is less than AC,
AC must be falling.
When MC is above AC, AC is rising. This indicates that if the new units of output cost
more than the average, their production will pull the average cost up. Here MC pulls AC up. In
other words, if MC is greater than AC, AC must be rising. When MC is equal to AC, AC is
neither falling nor rising. It is at its minimum point. Equality between MC and AC indicates that
when the cost of producing an extra unit of output cost just as much as its average cost, its
production will not affect the average cost. That is, if MC= AC, AC must neither be falling nor
rising. In summary:
i. When MC is below AC, AC is falling.
ii. When MC is above AC, AC is rising.
iii. When MC equal AC, AC is neither falling nor rising or MC and AC are equal.
8. Derivation of the Long run Average cost (LAC) curve.
We have defined the long run as the period in which all factors are variable. The period is
long enough for the firm to vary the quantity of all inputs used. Thus in the long -run, no factors
are fixed and no fixed costs. The firm can expand its output by building any size or scale of plant.
The planning horizon of the firm is long enough to make change in the plant size. As all inputs
are variable, the law of diminishing returns does not apply in the long- run.
Since the long run is a planning horizon, the firm can plan and make a choice of the
several situations of the short runs. Thus, the long run consists of all possible short-run situations
in which the firm may choose to operate.
The long-run average cost (LAC) curve is derived from the short-run average cost (SAC)
curves. Let us assume that a firm is considering three alternative plant sizes- a small plant, a
medium plant and a large plant. The firm confronts three short run average cost curves- SAC 1,
SAC2, SAC3 for three types of plants as shown in figure below. In the long run, the firm has to
SAC1

49

choose among the three investment alternatives represented by three SAC curves. The choice will
depend on its expected or planned output.
SAC2

SAC3

C1
C21

Costs

C211

C111

C2

C11

Q1

Q11

Q111 Q2

Q 2 Q3

Output

Short-Run Cost Curves

Fig. 5.9,
Given the three plant sizes and the three SAC curves for them, if the firm plans to produce
output 0Q1, the smallest plant will be selected. If the firm plans to produce 0Q 2, the medium plant
is selected. Similarly, if the expected output is 0Q3, the largest plant size is selected. Such
decisions are made so as to produce the planned output at the lowest unit cost possible.
Suppose the firm plans to produce 0Q1 units of output. In this case, the small plant
represented by SAC1 will be selected. Here the firm will produce output at lower costs up to 0Q 1.
Hereafter costs starts rising. Once the output reaches to 0Q 1 level, the firm can either continue
with the same small plant or install the medium plant. Suppose firm wishes to produce 0Q 2 and
firm can produce that much output at C2 per unit cost with medium plant and C 2 per unit cost
with small plant. Here firm install medium size plant. Beyond Q 1 level of production and up to
Q2 level firm can produce with medium size plant. By doing so, it can produce at lower per unit
cost. Beyond Q2 level of output firm chooses the large size plant.
We could draw a number of SAC curves, each indicating for the several scales of plant
that a firm would face in the long run. if we then draw tangents to all the SAC curves, we get a
continuous curve which is the long run average cost (LAC) curve of the firm. This has been done
in figure below.

LAC
SAC5
SAC1

Costs

SAC2

SAC4
SAC3

50

Fig.5.10Long-Run Average Cost Curve (LAC)

Output

The above figure shows the LAC curve tangent to five SAC curves representing the minimum per
unit cost of producing each level of output. In reality, there may be quite a wide variety of SAC
curves with a variety of plant sizes. Many SAC curves could be drawn in between the five curves
given in figure. When the points of tangency are joined successively then we get LAC curve. The
LAC curve also has U shaped but it is more flatter than SAC curves. It is often called the envelop
curve as it envelopes all the SAC curves. This is the long-run average cost curve which is U
shaped.
9. Revenue
Every firm, whether large or small, produces output with the primary objective of selling
them in the market. The amount of money a firm receives from selling a given quantity of its
products is called its revenue. If a firm produces 20 bags and sells them at a total price of Rs. 200
forms total revenue of the firm. As with costs, three revenue concepts are distinguished: total
revenue (TR), average revenue (AR) and Marginal revenue (MR).
9.1. Total revenue (TR):
Total revenue (TR) is defined as the total sale proceeds of a firm from the sale of a
particular amount of output (Q) at a given time period at a given price (P).
It is calculated by multiplying the total output sold by the price at which it is sold. i.e. TR
= P Q
(I) Total revenue in perfect competitive market:
In perfect competitive market, a seller can sell any quantity of output at running price or at
market price. Reduction of price is not necessary to sell more. The total revenue curve, therefore,
is proportional with quantity. This can be explained with the help of following table.

Table5.3,Total, average, and marginal revenue in perfect competitive market

Output( Quanti
Price
or
Total revenue
Marginal
ty sold)
Average revenue P=
TR= P Q
revenue (addition to
(Q)
AR= TR/Q
total revenue) MR=
TR/Q
(2)
(3)
(4)
(1)
1
50
50
50

51

2
50
100
50
3
50
150
50
4
50
200
50
5
50
250
50
6
50
300
50
7
50
350
50
8
50
400
50
9
50
450
50
10
50
500
50
In above table total revenue, increases proportionally with quantity. Since price reduction
is not necessary to sell more, any quantity can be sold at same price Rs. 50. The above table can
be transformed into geometric figure.
TR curve

500
450
400
350
300
250
200
150
100
50

1
2
3
4
5
6
7
8
9 10
Fig5.11, Total Revenue curve under perfect competitive market
In above figure, the TR curve is a straight line passing through the origin.
(II) Total revenue in imperfect competitive market:
Under imperfect competition that includes monopolistic competition, oligopoly and
monopoly, the firm has comparatively larger grip in the market share. The firm is in possession of
a complete monopoly over a certain industry or product. Under such situation, the firm can fix
prices and can alter them. If it wish to sell more, it lowers price and vice-versa. Therefore total
revenue curve increases up to certain point and then starts to fall down. This is presented with the
help of table.

Table5.4, Total, average, and marginal revenue in imperfect competitive market

Output( Quanti
Price
or
Total revenue
Marginal
ty sold)
Average revenue P=
TR= P Q
revenue (addition to
(Q)
AR= TR/Q
total revenue) MR=
TR/Q
(2)
(3)
(4)

52

(1)
0
20
0
1
18
18
18
2
16
32
14
3
14
42
10
4
12
48
6
5
10
50
2
6
8
48
-2
7
6
42
-6
8
4
32
-10
9
2
18
-14
10
0
0
-18
Total revenue is just price (P) times quantity (Q). Column three in table above shows the
calculation of total revenue (TR). Total revenue in column three rises at first, reaches a maximum
at the 5th unit of output. Thereafter TR starts falling with every reduction in price. The TR curve is
drawn below with the help of above table.
50

TR curve

TR

40
30
20
10
0 1

5 6 7 8 9 10
Output
Fig.5.12, Total revenue curve under imperfect competitive market
(9.2) Average Revenue:
Average revenue (AR) is the amount the firm receives per unit of output sold. It is
calculated by dividing the total revenue (TR) by the number of units (Q) sold. Thus, AR= TR/Q.
In table 5.4, when the firm earns a total revenue of Rs. 50 (TR) by selling 5 units (Q) of
output, the revenue earned per unit of output is Rs. 10 (50/5 = 10). Thus, Rs. 10 is the average
revenue. Average revenue is just the price per unit of the output sold. It is nothing but the sale
price of the product. Thus, AR = P
In table5.4, average revenue has been shown in column two, which is also the price at
which the different units of output are sold. Therefore, average revenue is the same thing as price
so long as output is sold at the same rate. However, average revenue is not equal to price when
different units of output are sold at different prices. Column two in above table is equal to price,
since each units of product at each level of production is sold at the same rate. Thus at the 5 th level
of output all the 5 units are sold at the same rate of Rs. 10 each which gives a total revenue of Rs.
50. But when different units of output are sold at different prices, average revenue is just the
average price.
AR and MR

53

20
15
10
AR curve
MR curve

Output
1 2 3 4 5 6 7 8 9 10
Fig.5.13,AR and MR in imperfect competitive market
In imperfect market, price should be reduced to sell more. The average revenue curve or price
curve and MR curve fall from left to right but the MR curve falls faster than the AR. When the
total revenue is maximum, the MR is zero. In above figure MR is zero when the output is five
units. Beyond the 5th unit the MR is negative, therefore, MR curve falls below the output axis. It
shows that in imperfect competitive market AR and MR curves fall from left to right. But in
perfect competitive marker price reduction is not necessary to sell more therefore AR curve and
MR curve are same and they are parallel to output axis as shown in figure
AR& MR curves
50
AR & MR

1 2 3 4 5 6 7 8 9 10
Fig.5.14,AR and MR in perfect competitive market

Output

9.3 Marginal Revenue:

Marginal revenue (MR) is additional revenue generated by selling an additional unit of output. It
is the change in total revenue generated by an additional unit sold. Marginal revenue is calculated
by dividing the change in total revenue by the change in output. Thus, MR = TR/Q.
The column four of table 5.4 shows marginal revenue. The marginal revenue can be derived in
this way also. MRn = TRn- TRn-1. This shows that marginal revenue of n th unit of output is the
difference between the total revenue up to the n units and total revenue up to the (n-1) units.
In different market structure, the shape of MR curve is different. In table 5.4, the marginal
revenue is same for all levels of production. It remains unchanged. For example, marginal
revenue in column four of table 5.3 is same (50). The MR curve is parallel to the quantity axis. In
perfect competitive market MR curve and AR curve coincide and both are parallel to quantity
axis.
In imperfect competitive market, the MR is different with AR. AR and MR goes on
diminishing with expanding output but the MR falls faster than the AR. In table 5.4, we can

54

observe that MR falls faster than AR. The MR is negative after certain point. In figure 5.13, the
MR is negative after 5th unit of output.

Unit 6: Supply Function

6.1 Concept of supply
Supply refers to total quantity of a commodity offered for sale in market at a given price
during a given period. Of course, the total quantity offered for sale by the producers depends on
several factors other than price. For the moment, we assume those factors being constant (ceteris
paribus) and consider supply only as a function of price. Thus, supply is the amount producers are
willing to offer for sale in market at a given price. There is a direct relationship between price and
supply. That is, supply is a function of price. Symbolically, Qs = f (P).
When price increases, the supply also increases. This is called the law of supply. The law
states that quantity offered for sale increases with a rise in price and falls with a fall in price. In
other words, higher the price, the larger the quantity supplied and the lower the price, the smaller
is the quantity supplied.
6.2 Derivation Supply curve
When we say supply in economics, we are always referring to a supply schedule. Supply schedule
is just the list of various possible prices and the amounts offered for sale at each price. Similarly,
supply curve is the graphical presentation of the combination of different prices and the amount
supplied at those prices.
Table 6.1, Individual Supply Schedule
Price (Rs/kg)
20
30
40
50 60 70
Quantity supplied (Kg/week)
100
200
400 600 800 1000

Fig6.1: Individual
supply curve
Price

Table 6.1, is a hypothetical supply schedule of a individual supplier of sugar in a market. This
supply schedule can be presented graphically that give us an individual supply curve. This is
shown in figure 6.1.
70
60
50
40
30
20
10 S
0

Supply
100

200

300

400

500

600

800

1000

Table 6.1 shows supply schedule of an individual producer of sugar. When price is Rs.
20 per kg, a total of 100 kg is supplied in the market. As the price rises to Rs. 70 per kg, supply of
the sugar rises to 1000 kg. By plotting each pair of price and quantity supplied at that price and
joining the points we get the individual producers supply curve SS in figure 6.1. The individual
supply curve shows a positive relationship between price and quantity supplied. Thus, an
individual supply schedule and supply curve of a commodity show the relationship between the
market price and the amount offered on sale at that price, other things remaining the same.

55

The market supply schedule is just the summation of all the individual supply schedules.
Similarly, the market supply curve is a horizontal summation of supply curves of all the
individual seller in a particular market.
Table6.2, Supply Schedule
Price Rs. Per Kg Quantity supplied Quantity supplied Quantity supplied Quantity supplied
(A)
(B)
(B)
(B)
20
100
150
200
450
30
200
250
400
850
40
400
450
600
1,450
50
600
650
800
2,050
60
800
850
950
2,600
70
1,000
1,050
1,100
3,150

Price

In table 6.2, we suppose that there are only three producers of a commodity in a market,
each producing and supplying different quantities of goods at each price level. The 5 th column in
the table is the summation of the different quantities supplied by the three individual supplier A,
B, and C. This is the market supply schedule which shows total amount offered for sale at each
level of price. Figure 6.2 shows derivation of market supply curve from individual supply curves.
70
65
60
55
50
45
40
35
30
25
20
10
5
0

500

1000

1500 2000 2500

Quantity supplied
Fig 6.2, Marker supply curve

3000

35000

The market supply curve is derived in the same manner as the market demand curve. Once
we derive the individual supply curves, it is very easy to derive a market curve. The market
supply curve is horizontal summation of all the individual supply curves. For example in table 6.2
when the price is Rs.20, a producer A is ready to supply 100 kg of sugar, B 150 kg, and C 200 kg.
Together they supply a total of 450 kg of sugar. This makes up the marker supply. We can draw
separate supply curves for the three individual suppliers. Thus, the market supply curve of a
commodity shows the alternative amounts of the commodity supplied at a given period at
alternative prices by all the producers of that commodity in the market.

56

6.3 Elasticity of Supply:

Elasticity of supply is analogous to elasticity of demand. It is defined as the
responsiveness of quantity supplied to a change in price. It measures the rate at which supply
changes to a change in its price. More precisely elasticity of supply is defined as the percentage
change in quantity supplied divided by the percentage change in price. If we let es stand for
elasticity of supply then the formula for it would be; Percentage change in quantity supplied
percentage change in price.
Es =

Percentage change in quantity supplied

Q P
Q P

=
percentage change in price
Q
P
P Q

If price of hairpin rises from Rs. 20 to Rs. 25 per piece and in response supply increases
from 25 pieces to 35 pieces, then the elasticity of supply would be as under:
Es =

10 20 40

1.6
5 25 25

A rise in price is always accompanied by a rise in quantity supplied and vice-versa, in

general. In other words, price and supply move in same direction. Hence, elasticity of supply is
positive.
6.4 Measurement of elasticity of supply:
Elasticity of supply may be unity (es=1), less than unity (es<1) or greater than unity (es>1)
depending upon the nature of the supply curve.
a) when a straight line supply curve passes through the origin of the price and quantity
axis, elasticity of supply is unity or equal to 1.

Price

Es=1 P

Quantity supplied

(b)
Es<1

S
Price

(a)

Price

Quantity supplied

(c)

Es>1 P

0
Q
Quantity supplied

Fig.6.3, Varying degree of elasticity of supply

In figure 6.3(a) elasticity of supply at point P is given by the formula for increasing
elasticity at a point, which we have defined while measuring elasticity of demand. Thus at point P,
Q

MQ

PQ

es = P Q PQ MQ 1
As M is in the origin, we have replaced Q by M in the above equation to find out point
elasticity of supply. The supply curve in figure 6.3 (a) will have elasticity equal to one at every
point of the curve. Thus a straight line supply curve passing through the origin will have unitary
elasticity.
(b) When a straight line supply curve cuts the quantity axis, elasticity of supply at any
point on it is less than 1. In figure 6.3 (b) elasticity at point P is,

57

MQ

PQ

MQ

MQ

PQ

MQ

es= P Q PQ 0Q 0Q 1
Because MQ<0Q, elasticity at point P is less than one (e s<1) and supply is inelastic.
Therefore the conclusion is that when a straight line supply curve cuts the horizontal axis, the
elasticity of supply is less than unity.
(c) Similarly, when a straight line supply curve intersects the price axis, elasticity of
supply at any point on it is greater than one. In figure 6.3 (c) supply curve S intersects the price
axis at a positive point. Elasticity of supply at point P is,
es = P Q PQ 0Q 0Q 1
as MQ>0Q, elasticity at point P is greater than one (es>1) and supply is elastic
Our discussion so far confined to measuring elasticity at a point on a straight line supply
curve. However, if the supply curve is a curved line, its elasticity can be measured by the using
the same method as adopted above. Elasticity at any point on a non-linear supply curve can be
measured by drawing a tangent to that point. The same rules hold true. If the tangent passes
through the origin, elasticity of supply at that point is equal to one; if it cuts the horizontal axis,
supply is inelastic and if it cuts the vertical axis, supply is greater than one. This is shown in
figure 6.4 below.
S
T
Y
N
Price

es<1
C

S
L

es>1
A

es=1
B

Q1 P
Q2
Q3 Quantity supplied
0
Fig.6.4, Measuring elasticity on a non-linear supply curve

Unit 7: Theory of Product Pricing

7.1. Types of Markets:
In an ordinary sense, the word market is not a specific place where buyers and sellers meet
together for buying and selling goods and services. In economics, the notation of market is more
general. It is an exchange situation, not a particular place, where the presence of both buyer and
seller may or may not exist. Everything have their own market constituting two components:
demand side and the supply side. For example, there exists market for potato, market for
vegetable, market for industrial product and market for tele-communication etc. In general,
market for such goods and services is called the commodity market or product market.
In product market, price of the product depends on the demand for and supply of that
product.

58

Demand for a particular product depends on the types of demand curve a firm is facing in
the market. The type of demand curve that a firm is facing in the product market depends on the
types of the market.
Conventionally, types of market depend on:
1. the number of firms in an industry, and
2. types of the products that firms are producing.
Based on these two criteria markets can be divided into following categories.

A. Pure competition
Pure competition among firms within an industry requires the following conditions:
1. Many firms (Larger number of sellers and buyers):
Under pure competition, a large number of firms compete with each other. In the case,
each firm is so small in terms of its influence, that it has no power to influence price. Firms are
simply the price taker. Relative to the size of the industry (collection of many firms producing
homogeneous product), the output contribution of any firm is so negligible that its addition to or
removal from the market has insignificant or no effect on the market price. Each firm can sell its
output on the prevailing market price. Similarly, buyers are also numerous and they also are the
price taker ( can purchase whatever they like on the prevailing market price).
2. Homogeneous product:
Product homogeneity is another feature of pure competition. Each firm within an industry
produces identical output so that consumers have no preference of particular firms product.
3. No barrier to entry and exit:
A firm is free to choose either to remain within the industry (or particular business) or to
leave it (if it incurs losses). Because of the large market size and freedom of entry, there may be
large numbers of firms within an industry.
4. Freedom to make decision:
Under the pure competition, there must be no government intervention, and there must be
no tacit agreement among firms to make decision about their production activities. Firms are free
to make any decision about profit maximization.
Perfect competition is slightly different from pure competition. In addition to the above
mentioned characteristics, perfect competition should posses the following two addition
characteristics.
(i) Perfect knowledge of the market, and
(ii) Perfect mobility of resources (factors of production).

(B) Monopolistic competition

Perfect competition and monopoly are two extreme cases of market structures, and both
are rare in real world. The reality is the existence of imperfect competition. Under imperfect
competition, there are various forms of market structures depending on number of firms.
Monopolistic competition is one variant of imperfect competition in which there are many
firms selling closely related but not identical commodities. Other than product differentiation
monopolistic competition has all other characteristics of perfect competition. There is freedom of
entry and exit of firms. The demand curve of a monopolistic firm is more elastic than that of a
monopolist firm
(C) Oligopoly:
Oligopoly is another variant of imperfect competition. In this market structure, there are
few ( more than two but not many) seller/ producers of a commodity. Product may be either
homogeneous or differentiated. As a result of few firms and closely substitutable products, the

59

Fig.7.1, Profit maximization

condition:
TR-TC= Profit ()

actions of each firm will affect that of the other firms. Under oligopoly, there are varieties of submodels based on the specific behavioral assumptions made for the relationship among existing
firms. However, the demand curve of an oligopolist firm is downward sloping ( less elastic than
that of the monopolistic firm and more elastic than that of the monopolist firm).
(D) Duopoly:
Duopoly is a specific case of oligopoly where two firms are operating in an industry. In
this case, the demand curve is again downward sloping, but less elastic than that of oligopoly.
(E) Monopoly:
Monopoly implies a single seller of a commodity. Thus in the monopoly market, a firm is
a sole producer/seller of some commodity for which there is no close substitute and the firm faces
no competition. In such a market, the monopolist can control prices or output but not both at the
same time.
(7.2) Equilibrium of firm
A firm is said to be in equilibrium when it maximize profit because profit maximization is
one of the important objective of business firm. To maximize profit difference between TR and
TC must be highest. In other words, business firm will be in equilibrium at the level of production
in which the difference between TR and TC is highest. By doing so, firm can maximize the profit
level. Using total cost (TC) and total revenue (TR) we can analyze the equilibrium of firm. This
TR curve
approach is called total approach of equilibrium of firm.

Profit

TR TC
D

TC curve
B
A

curve
P
In above diagram, TC denotes total cost curve, TR denotes total revenue and denotes
profit curve. When output (Y) is zero, total revenue is also zero because without sale (Production)
A
revenue is always zero. In the case of cost, even if output is zero fixed cost can not be avoided in
the short-run. Here 0A denotes the fixed cost associated with the production plant, so that 0A is
0
Y2 Y
the total loss (negative profit) with no output at Y
all.
3
1
When total product is Y1, TC=TR implying that there is no profit (and no loss). When firm
increases its output from Y1 the difference between TR and TC increases as depicted by the profit
curve . The profit increases up to Y2 and starts declining. This implies that the maximum
difference between TR and TC is at Y2 units of output, where profit is at its maximum. When
profit is maximum the firm is in equilibrium.
When the difference between TR and TC is highest, the slopes of TR and TC curves are
equal. This provides another way of viewing the profit maximizing conditions (MR=MC). In this

60

case, profit maximization requires MC=MR and slope of MC> slope of MR or MC must cut MR
from below.
Assuming that MR curve is horizontal ( in case of perfect competition), the profit
maximization condition is shown below in a diagram.
MC
Y
MR, MC
E

0
Y1

Output Y

Y2

Fig.7.2, Equilibrium of firm, Marginal Approach

In the diagram, MC= MR at E and E. but profit is maximum at E not at E. Why? At Y 1
level of output (Point E), MC = MR, when output increases from Y 1, MR remains higher than
MC up to Y2 (point E). This implies that producing more units adds more to revenue (MR) than
to cost MC and profit can be increased by producing more than Y1.
At E, MC= MR and output is Y2. This is the profit maximizing output, because when
output is greater than Y2, MC> MR. This implies that when output exceeds Y2, addition to cost
exceeds addition to revenue and hence profit declines.
Therefore, profit is maximum with Y2 units of output where MR= MC.
What is the difference between points E and E? At point E, slope of MC is less than slope
of MR i.e. MC curve intersects MR from above when MC = MR (at E). At point E, slope of MC
> slope of MR, i.e. MC curve intersect MR from below.
7.3. Short-run equilibrium of industry and firms under perfect competition. (How
price and output is determined under perfect competition in short-run).
In the short-run, entry of new firm or exit of existing firm (except in the case of shutdown
where P/AR/MR = AVC) is not permissible. This implies that number of firms in the industry is
fixed in the short-run.
The market is determined by the interaction between the consumers short-run demand
and industrys short-run supply. As firms are price taker under perfect competition, existing firms
accept the market price and conduct their activities. Firms that are efficient (firm than can reduce
or lower their AC) may earn super normal profit and inefficient firm (having higher AC) may
incur loss. In addition, some firms may just earn normal profit (P=AC). All these three conditions
ACC
MCc
Pare possible in the short run as shown in the following figure.
D
S
E

MCA

Profit

ACA

MCB

ACB

Loss

eB

eA

Firm A
Industry
Q= QA+QB+Qc
0
QA with
0
Industrys equilibrium which Firms equilibrium
determines market price whereabnormal profit as
P>AC when MC=MR
D=S

Normal profit

Firm B

eC

P/AR/MR

Firm C

QC
QB
0
0 Firms equilibrium
with
Firms
equilibrium
with
61 normal profit as P=AC
when MC=MR

loss as P<AC when

MC=MR

Fig.7.3, Short-run equilibrium of firms under perfect competition

At left corner, industrys equilibrium in the short-run is shown. Market price (P) is
determined by the interaction between market supply and demand curves (point E).
As firms are price taker under perfect competition, their demand curve is perfectly elastic
(horizontal). For equilibrium, MC curve should intersect MR curve (or firms demand curve) from
below. At point e, in all three panels, MC=MR, and MC intersects MR from below. So, point e
denotes the equilibrium of all three firms in the short-run. For firm A, Firm B and firm C the
equilibrium points eA, eB and eC are shown respectively.
At equilibrium, firm A is producing QA units of outputs and selling at the given market
price, P. As P>AC, firm A is earning abnormal profit (Shaded are in firm A). At equilibrium, firm
B is just earning normal profit because the market price (P) is just equal to AC of firm B. But firm
C is incurring loss because its AC exceeds the market price at equilibrium point e C where it is
producing QC units of output. Though the firm C is incurring loss, it will continue its operation till
its AVC lies below the market price (P>AVC). If P< AVC, then it is the shutdown point.
The above discussion shows that Price and quantity is determined by the interaction
between consumers demand and industrys supply. The total industrys supply is equal with the
total sum of the supplies of all firms consisting in industry. The amounts of supply of individual
firms depend up on their cost condition.
7.4 Long-run equilibrium of industry and firms under perfect competition.
1. Excess Profit case:
In the short-run, the firm may earn either abnormal (excess) profits (P>AC), only normal
profits (P= AC) or even losses (P<AC). But in the long run, there is free entry and exit. If existing
firms are earning excess profits, then new firms will enter into the industry. Entry of new firms
may have two implications in terms of equilibrium.
* first, entry of new firms will increase the total supply of industry.
* second, entry of new firms will increase the AC due to increase in the use (demand) of
resources thereby increasing their prices as well.
The effect of the increased supply will be reflected in terms of reduced market price due to
shift in the market supply curve to the right in figure 7.4 below. The effect of the increasing use of
resources leads to shift AC curve upward. The combined effect of reduction in market price and
increase in the AC ultimately results into elimination of the excess profits in the long run.
S1

LMC

LAC
LAC

S2
e

P1

e
e

P2
S1

S2

X Output
X
(a) Industry

Output

X2 X1

62 (b)Firm
Fig7.4: Long run equilibrium of the firm Under perfect competition
(The case of short run excess profit)

MR1=AR1
MR2=AR2

Here, DD and S1S1 are the initial demand and supply situation of an industry, which
jointly determine the equilibrium market price (P1). As firms are price taker under perfect
competition, P=AR=MR is the firms demand curve. Initial equilibrium of the firm is at point e
where MC=MR, and at the point of intersection, MC is increasing. At equilibrium point e, P>AC,
so that the firm is earning excess profits. As entry and exit both are free in the long run, new firms
will enter into the industry due to the excess profit earned by the existing firms. Entry of new
firms leads to increase the total market supply so that market supply curve shift to the right (from
S1S1 to S2S2) determines new market price P2, which is lower than the previous market price
(P1>P2).
When equilibrium market price becomes P2, the firms demand curve also shifts down
ward to P2= MR2=MC2=AR. On the otherhand, entry of new firms into the industry leads to
increase resource demand, which ultimately leads to shift AC curve upward (from LAC to LAC).
Entry of new firms in the long run continues until the firms demand curve become tangent to the
LAC ( at point P). The tangency condition guarantees the normal profit situation during long run.
2. The case of short run losses
In the short run, the firms make incur losses. But in the long run firm can leave the
industry if there is only loss. When loss-incurring firms leave the industry (in the long run), there
arrive two situations.
First, when inefficient firms (incurring loss) leave the industry. It leads to reduce the total
market supply. The reduction market supply leads to shifts market supply curve to the left so that
equilibrium price will increase. Increase in equilibrium market price finally leads to shit firms
demand curve up so that existing firms losses will be eliminated.
Second, exiting of the loss-incurring firms reduces the use of resources. The reduction in
resource demand leads to lower the input price so that AC also reduces. Reduction in AC is
reflected in terms of down wards shift of the AC, which again helps to eliminate the loss.

S2

Y D

LAC1

LMC2

LAC2

S1
e
e

P2

P1
S2
0

S1

P2=MR2=AR2
P1=MR1=AR1

D
X2 X1 Output

X1 X2

Output

(a) Industry
(b) Firm
Fig.7.5: Long Run equilibrium of the firm under perfect competition. (Short Run Loss)

63

In panel (a), industrys equilibrium is shown, which determines the market price P1. At
this price (P1), some firms in the industry are incurring losses (P 1<LAC1). In the long run such
loss-incurring firms will leave the industry. The exit of loss making firms from the industry shifts
market supply curve to the left (from S 1S1 to S2S2) due to reduction in total market supply. With
the given demand curve (D), the new market price (P 2) is determined which is greater than the
previous price (P1).
The increase in market price will shift firms demand curve upward (from P 1= MR1=AR1
to P2=MR2=AR2). With the new higher price (P 2), some loss making firms now turn into normal
profit condition ( where P= AC). On the other side, AC curve may shift downward from AC 1 to
AC2 due to the reduction of inputs prices. This two effects jointly bring the long run equilibrium
of firm where P=AC, and existing firms are just earning normal profits.
Thus whether may be the situation in the short run there will be normal profit in the long
run. firms are in the equilibrium situation where
Price = minimum AC= MC= AR= MR
Not only this, equilibrium further guarantees that SMC= LMC=SAC=SMC=P, as shown
SMC SAC
in following figure.
LMC
LAC
S
D
E

P=AR=MR

S
D
0

0
Output
X
(Industry)
(Firm)
Fig.7.6, Long-run equilibrium of firm and industry.

XA

Output

In long-run every firms consisting in a industry earns only normal profit because every
firms are in equilibrium at the minimum point of LAC. From the above discussion, we can
conclude that:
* Production cost is at its minimum feasible level (AC is minimum)
* As P = AC at equilibrium, consumers pay the minimum possible price only.
* There is no excess capacity of the plant. Existing plants are used at their full capacity.
* Firms within the industry earn only normal profit.

7.5 Monopoly
Monopoly is a market structure just opposite to perfect competition. In the monopoly
market there is a single seller of a particular commodity with has no close substitutes and there is
barrier to entry. This implies that under monopoly market there is only one firm within an
industry or there is no distinction between firm and industry. Thus, the firm itself is the industry
and faces a down ward sloping industry demand curve. The downward sloping demand curve of
the monopolist firm implies that the firm cannot sell as much as it produces at the given prices (as

64

in the case of perfect competition). In order to sell more of the commodity, the monopolist must
reduce its price.
In monopoly market, the firm is the price maker (not a price taker as in the case of
perfect competition). The monopolist can raise its price and consumers have no alternative
suppliers and even no close substitutes. In this case, consumers either pay the higher price or go
without the commodity.
7.5.1 Features of monopoly market
There are some special features of monopoly market;
1. Single seller: In monopoly market, there is single seller or producer of a commodity. In
such market, close substitute the good is not available. Thus, consumers either purchase the good
or go without it.
2.No close substitute: To be a monopoly market for a commodity, the close substitute of
the goods must not available. If close substitute is available of the good then there is competition
between these goods. Producer does not have full power to control over supply.
3. Strong barrier to other firms to enter: Other firms are not allowed to produce the good.
Restriction for the entry of new firms may arise from different causes such as natural causes or
financial causes etc
7.5.2 Demand curve, average revenue and marginal revenue
In the pure monopoly, there is no difference between the firm and industry. Thus, the firm
faces the downward sloping industrys demand curve. For the firm, market price and average
revenue are always equal as:
Total revenue = Price Quantity and
Average revenue=

Total revenue (TR)

Quantity(X)

Price Quantity
price
Quantity

i.e. AR=Price
Also, AR curve is the firms demand curve. For the downward sloping demand curve, AR
curve is also negatively sloped. For the downward sloping AR curve, the MR curve is also
downward sloping which starts at the same point on the vertical axis as the AR curve but falls at
twice the rate as the AR curve.
The straight line AR and MR are shown in the following diagram
For the demand curve AD (AR curve), the MR curve is drawn by taking point X 2 which is
half way between 0 and D as the slope of MC is twice the slope of MR ( both are negative)
Y

P1

P2

B
F

C
AR

D
X1 X2

MR

X
65

Fig7.7: AR and MR curves of a Monopoly firm

fiffffffffffffffffffffffffffffffffirmms

From the figure, we can observe that:

* When price is P1, quantity demanded is X1. When the monopolists intends to increase its
sales, it has to reduce its price from P1. Here, when price is reduced to P 2, the quantity sold is X2.
This implies that, to sell more output, the monopolist firm must reduce the price of the output.
* MR curve is twice as steep as the AR so that P1E = EB, P2F= FC and 0X2 =X2D
7.5.3 Short-run equilibrium of the monopoly firm (Price and output determination of
monopoly firm under short-run)
In a monopoly market, the firm is the price maker. It can set the market price by itself. But
it cannot choose both the price and quantity demanded at a time. When the monopolist chooses
the price, the market demand curve will determine the quantity demanded. It is shown below in a
Y

Price

When price is P1, the quantity demanded is

X1. when the monopolist increases the price from P1
to P2, quantity demanded declines to X2. If price is
P
B
too high, say P, then quantity demanded will be zero.
P1
This implies that the monopolist can choose the
A
P2
price within a reasonable range, not too high.
Given the downward sloping demand curve,
AR
short run equilibrium of the monopolist requires two
conditions
(I) First, MC is equal to MR
X2
X2
0
(ii) Second, the slope of MC is greater than
the slope of MR where MC= MR (At equilibrium).
The
short
run
equilibrium of the monopolist firm is shown in the following
figure
Y
In the figure below,
MC=MR at point E and the slope of MC
MC
is greater than the slope of MR
at the point E. This implies that the
A
monopolist is at equilibrium
situation at point E, where the equilibrium price
is P and quantity sold is Q. P
E
AR

X
Output
Q
0
MR
Fig. 7.8: Short Run Equilibrium of the Monopolist is at E where MC=MR,
Slope of MC> Slope of MR
The profit or loss of the monopolist firm entirely depends on the AC and P. If AC<P, then
the monopolist will earn short run super-normal profits. If AC>P, then it is the situation of losses.
If AC=P, then there will be just normal profits (Zero economic profits).
All these three situations are depicted in the following diagram.

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MC

D
P

AC

X 0

E
MR

MC

AR=D

AC

MC

AC

AR=D

AR=D
0

MR

MR

Fig.7.9: Short Run Equilibrium of the Monopolist where MC=MR and Slope of MC> Slope of MR

In all the three panels, the monopolist is in equilibrium at point E, where quantity Q is
sold at price P. In the three panels, all conditions are similar except the average cost. In first figure
P> AC at equilibrium output level so that the firm is earning profit equal to PCBA. In middle
figure, P=AC at equilibrium so that there is only normal profit. In the figure of right corner, P<
AC, at the equilibrium, so that the firm is incurring losses. All these three situations may exist
during short run.
7.5.3 Long run equilibrium of the monopolist firm:
In long run, the monopolist can rearrange his production techniques and production plant.
A monopolist will remain in the business if he can make a profit in long run. The monopolist will
not stay in business if there is loss in long run. But in the short run, there may be profits or losses.
With entry blocked, the monopolist may earn even super normal profits (which is not possible in
the case of perfect competition) in the long run. However, for the monopolist, it is not necessary
to reach an optimal scale (minimum LAC). What is certain for a monopolist in the long run is that
is the point of interaction between MR and LMC gives its equilibrium. At the point where
MR=LMC, the SAC becomes tangent to the LAC as shown below in the diagram,.
In the diagram, MR=LMC at point E, which determines both equilibrium price (P) and
output (Q). Here the equilibrium price (P) is greater than Average cost (C). This implies that the
monopolist is earning super profit in the long run equilibrium given by the are ABPC.
Y
LMC
D

Price/cost

SMC
P

LAC

SAC

E
D=AR
0

Output

MR

Fig.7.10: long run equilibrium of the monopolist with super normal profits and underutilized plant

67

Capacity utilization of the existing plant and the size of the plant depend on the market
demand (the nature of the AR or market demand curve and hence the nature of the MR),
depending on the market conditions, the monopolist may operate (in long run):
(a) On the falling part of LAC
(b) On the raising part of LAC (beyond the minimum LAC)
(c) On the minimum point of LAC (Optimal utilization of Plant)
D

LMC

SMC

LMC

LAC
D

Price/cost

LAC

B
SMC

SAC
E

SAC

D=AR
E

D=AR
MR

(a) Over Utilized plant

Output

Output
(b)Optimal Utilized plant

MR

Fig.7.11: Long run equilibrium of monopolist firm

In the panel (a), the monopolist equilibrium is on the raising part of the LAC. This implies
that the monopolist is operating in a large market. Compared with the monopolist operating with
excess capacity, over utilized plant of the monopolist indicates that it is producing more and
selling, relatively, at a lower price.
In panel (b), the monopolist equilibrium is on the minimum LAC. In this case, the plant is
optimally utilized (minimum LAC). In all the cases, the monopolist is making super normal
profits because there is no fear of potential entry of new firms (competitors).
7.6 Comparison between perfect competition and Monopoly:
We can list some similarities and difference between perfect competition and monopoly as
follows.
Characteristics
Perfect competition
Monopoly
1. Goal
1. Profit maximization
1. profit maximization
2. Nature of product
2. Homogeneous
2. Unique
3. Number of firms
3. Many so that a firm is the 3.Single so that the firm is the
price taker
price maker
4. Entry and exit
4. Free so that there is always 4. Complete barrier so that
normal profit in long run.
there may be super normal
profit even in the long run.
5. Cost functions
5. AC and MC are U shaped 5. AC and MC are U shaped
( because of the law of ( because of the law of
variable proportion)
variable proportion)
6. Equilibrium condition
6. MC=MR, and the point of 6. MC=MR, and the point of
equilibrium, MC is increasing equilibrium, MC is increasing
( slope of MC > slope of MR) ( slope of MC > slope of MR)

68

7. demand curve
8. Price

9. Capacity utilization

7.
Perfectly
elastic
( horizontal) so that at
equilibrium P=MR=AR=MC
8. In long run, P=LAC=MC
implying that competitive
price is always at the
minimum level

7.
Inelastic
(downward
sloping) so that P>MR>
(P>MC) at equilibrium.
8. In long run price may or
may not be equal to LAC but it
is always greater than MC
implying that monopoly price
is always higher than the
competitive price.
9. Full utilization of capacity 9. Presence of excess capacity
i.e. equilibrium is at the i.e. equilibrium may not be
minimum of LAC in Long run. necessarily at the minimum of
LAC.

7.7 Price discriminating monopoly

If a monopoly firm has a strong market power, then it often divides the markets into
different sub markets and charges different price in each market. The act of selling the same
product at different prices to different buyers is called price discrimination. Quantity discount,
price differentials between wholesalers and retailers and the similar cases are not cases of price
discrimination.
Price discrimination refers to price differences that are not related to cost differentials.
Examples of price discrimination are movie show for student and common people, issues of both
paperback and hard cover edition of the same book, lower rates of electricity to business than to
household use. In all cases, the same product is sold to different customers (market) at different
prices.
7.7.1 Necessary condition for price discrimination
The goal of monopoly firm is to maximize its profits (revenue) by charging different
prices to different groups of customers. The act of price discrimination will not be possible
unless the following three conditions are fulfilled.
1. The firm must have some monopoly power:
This condition is equivalent to saying that the firm must be able to set its price. In the case
of perfect competition, firms are price taker. Thus, under perfect competition, price discrimination
is not possible. If a competitive firm charges higher price, it can not sell its product because the
customer can buy the same product from other firms at cheaper market prices.
2. Markets must be separated in such a way that no reselling can take place:
If resale is possible, then price discrimination does not work. For example, students must
not be able to resale a half-priced cinema ticket to others. At act of reselling reduces the
monopoly power of the monopolist.
3. Price elasticity of demand in each market must be different:
If price elasticities are different markets, then the firm will charge higher price in the
market where demand is less elastic and lower price where demand is more elastic. If elasticities
are not different, price discrimination is not possible.
7.7.2 Equilibrium of the price discriminating firm
Total output under discriminating monopoly is determined where MC=MR from all
segmented markets. Suppose MRA and MRB are two marginal revenues from two separate markets

69

A and B respectively. Then the price discriminating firm will be in equilibrium when MR A=MC,
and MRB=MC
This implies that, for equilibrium,
(1) MR= MRA=MRB and
(2) MC=MRA=MRB=MR
Following diagram illustrates the equilibrium of price discriminating firm having two
separate markets.
MR, C, P

MC

PA
PB
E

MR

MRA

MRB

EA

EB

ARB

MR

Q= QA+QB

(a) Equilibrium of the

firm (A+B)

MRA
QA

ARA

(b) Market A with less

elastic demand

MRB
0

B
(c) Market B with
more
elastic demand

Fig. 7.12: Profit Maximizing Output under discriminating monopoly

In panel (a), equilibrium of the monopoly firm is shown. At point E, MR=MC, and Q is
the profit maximizing output (assuming that slope of MC> Slope of MR at E).
The firm has two markets: A and B where demand is more elastic in market B (e dB>eAd).
So the firm allocates its output in these markets such that MRA=MRB=MR. By doing so, the firm
allocates QA in market A, and QB in market B such that Q= QA +QB.
From the diagram, it is evident that P A>PB because, edA<edB. This implies that the firm sells
less output (QA) with higher price (PA) in market A where demand is less elastic and it sells more
output (QB) in market B where demand is more elastic. Reallocation of sells occurs if MR AMRB.
If MRA=MRB then it is the stable equilibrium situation for the monopolist.

7.6 Monopolistic competition:

Monopolistic competition refers to the market structure in which there are many firms
producing closely related but not identical products. An American economist Edward
Chamberlain developed the concept of monopolistic competition during 1930s. The same line of
thought was also developed by Joan Robinson and Sraffa during1930s. But the entire credits go to
Chamberlain for the development of the theory of monopolistic competition.
7.6.1 Features of Monopolistic competition:
The features of monopolistic competition are as follows:
1.
There are large number of firms (both sellers and buyers) producing closely
related product (but not identical). The concept of industry is replaced by the concept of group.
Under monopolistic competition, the collection of firm producing closely substitutable product is
called the group not the industry.
2.
There is free entry and exit of firms in the group. There is no barrier to entry
as in the case of monopoly.
3.
The products of the firms are differentiated from its rival. Therefore, the firm
can raise its price without losing all its customers. Due to product

70

differentiation, each firm has some degree of monopoly power and its demand
curve is downward sloping, but relatively elastic due to the presence of large
number of competitors
4.
Goal of the firm is profit maximization.
Competition among the large number of firms, each having differentiated product, is the
basic characteristic of monopolistic competition. Product differentiation is caused by advertising,
packaging, slight differences in quality, style, services and so on. Thus, under monopolistic
competition, demand for the particular product depends on:
The pricing policy,
The product itself, and
The selling activities (like advertising, home delivery etc.)
These are the product differentiating activities and and are the source of monopoly power
of the firm. Thus, firms demand curve is downward sloping implying that the firm can raise its
price without losing all of its sales because some consumers have strong preference of particular
product over other product. Examples of differentiated product are: varieties of soap, toothpastes,
instant noodles, cigarette, medicines and so on. But due to the presence of many firms producing
close substitutes, the demand curve is highly elastic (nearly horizontal). The larger the number of
firms, the higher the elasticity of demand and the lower the monopoly power of each firm.
7.6.2 Short run equilibrium under monopolistic competition ( Price and output
determination under monopolistic competition)
Assuming the downward sloping demand curve of a representative firm in the
monopolistically competitive market, short-run equilibrium of the firm requires;
1. MC=MR, and
2. Slope of MC> Slope of MR at the equilibrium point.
The firm chooses that level of output where MR = MC and sets prices based on its
demand curve to sell that level of output. The short run equilibrium of monopolistically
competitive firm is shown in the following diagram. In the short run profit may be positive (panel
a), negative (panel b), or zero (panel c). If price is less than the short-run variable cost, the firm
will be shut down.

MC

(b)

(a)
D

MC

AC

AC

D
C

MC

(c)
B
A

B
E

AR=D

E
MR

Q
MR

Output

X 0

AR=D

AR=D

Output

Fig.7.13: Short run equilibrium of monopolistically competitive firm

71

MR

Output

SMC
SAC

P
C

LMC

Price/ Cost

Price/ Cost

In short run number of firms in the production group is constant. So some firm may earn
abnormal profits in the case of panel (a), some may earn only normal profit panel (b), and some
may incur loss panel (c). In the above diagram, firms are in equilibrium at point E producing
equilibrium output level (Q) where MC= MR. The profit and loss condition depends on the cost
component of the production. Efficient firm may earn profit while inefficient firm may incur loss
due to high cost.
Diagrammatically, the equilibrium of monopolistically competitive firm resembles that of
a monopoly. However, monopolistically competitive firm faces more elastic demand curve than
monopoly and firms demand curve does not represent the market demand curve. Due to the
product differentiation, we cannot derive the market demand curve and the market supply curve
of the monopolistically competitive firm. It is because of the problem of adding the differentiated
products having different demand elasticities. Each monopolistically competitive firm has some
market power and can set their own price with some flexibility. Therefore, under monopolistically
competitive market there is no unique market price. Instead, there is a cluster of equilibrium
prices of closely substitutable products. Thus, monopolistic competition only the equilibrium of
a representative firm is shown instead of market equilibrium.
7.6.3 Long run equilibrium under monopolistic competition:
In monopolistically competitive market, there is free entry into and exit from the
production group. So if some firms earned abnormal profits in the short run, new firms enter
into the production group in the long run. The entry of new firms shifts each firms demand
curve down making it more elastic. At the same time, cost will change due to product differential
(pricing policy, selling activities and product itself). Due to downward shits in firms demand
curve (reduction in market share due to new entry) and increase in the production cost, the short
run abnormal profits are eliminated.
In the case of short run loss, loss-incurring firms will go out from the product group so
that existing firm will just earn normal profit.
Thus, due to the unrestricted entry and exit, monopolistically competitive firms will earn
just zero economic profits in the long run as shown in the following diagram.
In the diagram, panel (a) shows the short run economic profits. So, in the long run entry
takes place. An increase in the number of firms reduces the market share of each firm resulting
into downward shift of the demand curve of each firm. To counter the reduced market share and
increased elasticity of demand, each firm spends more on product differentiation and selling
activities. This extra expenditures lead to shift average cost upward. In order to maximize profit,
each firm chooses to operate along the LAC. All adjustments ultimately result into zero economic
profit of each firm in the long run. Firms are in the equilibrium where LMC=MR, where the
firms demand curve (AR) is tangent to LAC. At the point of tangency, there will be neither
economic profit nor losses with optimal output level (Q).
SMC

E
AR=D
MR

LAC
SAC

72

AR=D
MR

Output
0
Q
Q
Fig. 7.14: Long run equilibrium of a firm under monopolistic Output
competition.

7.6.4 Comparison between monopolistic and perfect competition:

* Common element between perfect competition and the monopolistic competition is the
large number of firms with the provision of free entry and exist. With homogeneous product,
perfectly competitive firm faces elastic demand curve with given market price. With product
differentiation, monopolistically competitive firms faces downward sloping demand curve
implying that it has some power of setting its own prices within a limited range. To high price
ultimately compels the consumer to change their preference toward the cheaper product, so that
total sales will decline drastically.
* Monopolistic competition differs from the competitive market in the following respect:
(i) In perfect competitive market, there is optimal utilization of plant because firms attain
equilibrium at the minimum point of LAC in long run. But in monopolistic competition, there
remains unutilized excess capacity because in long run firm is in equilibrium at the falling part of
LAC. It happens due to downward slope of AR curve and free entry to group.
(ii) In perfect competition, resources are allocated optimally but in monopolistic
competition, resources are allocated inefficiently.
7.8 Oligopoly:
Oligopoly is a form of market structure in which a few sellers sell differentiated or
homogeneous products. How few are the seller is not easy to define numerically in the
oligopolistic market structure. The economists are not specified about a definite number of seller
for the market to be oligopolistic in its form. It may be two, three, four, five or more. In fact, the
number of sellers depends on the size of the market. If there are only two sellers then the market
structure is called duopoly.
The products traded by the oligopolist may be differentiated or homogeneous.
Accordingly, the market may be characterized by heterogeneous oligopoly or homogeneous
(pure) oligopoly. In automobile industry, Maruti Zen, Hyundais Santro, Daewoos Matis and
Tatas Indica, etc., are the outstanding examples of differentiated oligopoly. Similarly, cooking
gas of different companies is the example of homogeneous oligopoly.
7.8.1. Characteristics of Oligopoly:
The basic characteristics of oligopolistic market structure are following:
1. Intensive Competition: The characteristic fewness of their number brings oligopolist
in intensive competition with one another. Let us compare oligopoly with other market structures.
Under perfect competition, competition is non-existent because the number of sellers is so large
that no sellers are strong enough to make any impact on market condition. Under monopoly, there
is a single seller and, therefore there is absolutely no competition. Under monopolistic
competition, number of sellers is so large that degree of competition is considerably reduced. But,
under oligopoly, the number of seller is so small that any move by one seller immediately affects
the rival seller. As a result, each firm keeps a close watch on the activities of the rival firms and
prepares itself with a number of aggressive and defensive marketing strategies. To an oligopolist,
business is a life of constant struggle as market conditions necessitate making moves and

73

counter-moves. This kind of competition is not found in other kinds of market. Oligopoly is the
highest form of competition.
2.
Interdependence of business decisions: The nature and degree of competition
among the oligopolist make them interdependent in respect of decision-making. The reason for
interdependence between the oligopolists is that a major policy change made by one of the firms
affects the rival firms seriously and immediately, and forces them to make counter move to
protect their interest. Therefore, each oligopolist, while making a change in his price,
advertisement, product characteristics, etc. takes it for granted that his actions will cause reaction
by the rival firms. Thus, interdependence is the source of action and reaction, moves and countermoves by the competing firms.
3.
Barrier to entry: An oligopolistic market structure is also characterized, in the
long run, by strong barriers to entry of new firms to the industry. If entry is free, new firms
attracted by the super-normal profits, if it exists, enter the industry and the market eventually
becomes competitive. Usually barriers to entry do exist in an oligopolistic market. Some common
barriers to entry are economies of scale, absolute cost advantages to old firms, price-cutting,
control over important inputs, patent rights and licensing, preventive price and existence of excess
capacity. Such factors prevent the entry of new firms and preserve the oligopoly.

Good Bye!

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