Bba First Semester: Principle of Economics N103

BBA FIRST SEMESTER
PRINCIPLE OF ECONOMICS
N103
DR. SALABH MEHROTRA BBAIst semester 1

MEANING OF ECONOMICS
• The word ‘Economics’ originates from the Greek work ‘Oikonomikos’
which can be divided into two parts:
(a) ‘Oikos’, which means ‘Home’, and
(b) ‘Nomos’, which means ‘Management’.
• Thus, Economics means ‘Home Management’. The head of a family faces
the problem of managing the unlimited wants of the family members
within the limited income of the family.
• In fact, the same is true for a society also. If we consider the whole
society as a ‘family’, then the society also faces the problem of tackling
unlimited wants of the members of the society with the limited
resources available in that society.
• Thus, Economics means the study of the way in which mankind
organizes itself to tackle the basic problems of scarcity

2. What Economics is all about?
Stages & Definitions of Economics
Wealth Welfare Scarcity Growth Need

Definition Definition Definition Oriented Oriented
(Adam Smith) (Ayred (L. Robbins) Definition Definition
Marshall) (Samuelsons) (Jacob
Viner)

a. Wealth Concept :Adam Smith, who is generally regarded as father of
economics, defined economics as “ a science which enquires into the nature
and cause of wealth of nation”. He emphasized the production and growth
of wealth as the subject matter of economics.
Characteristics :
# Takes into account only material goods.
Criticism of Wealth Oriented Definition :

# Considered economics as a dismal or selfish science.
# Defined wealth in a very narrow and restricted sense which considers
only material and tangible goods.
# Have given emphasis only to wealth and reduced man to secondary
place in the study of economics.

b. Welfare Concept :According to A. Marshall “Economics is a study of mankind in
the ordinary business of life; it examines that part of individual and social action
which is most closely connected with the attainment and with the use of material
requisites of well being. Thus, it is on one side a study of wealth; and on other;
and more important side, a part of the study of man.
Characteristics of Welfare Definition:
# It is primarily the study of mankind.

#Takes into account ordinary business of life – It is not concerned with social,
religious and political aspects of man’s life.
#Emphasize on material welfare as the primary concern of economics i.e., that
part of human welfare which is related to wealth.
#Limited the scope to activities amenable to measurement in terms of money.

Criticisms of Welfare Oriented Definition :
# Criticized for treating economics as a social science rather
than a human science, Thus welfare definition restricts the scope of economics to
the study of persons living in organized communities only.
# Criticized because of the distinction made between economic and non-
economic.
# Welfare in itself has a wide meaning which is not made clear in definition.
C. Scarcity Concept : According to Lionel Robbins: “Economics is the science which

studies human behavior as a relationship between ends and scarce means which
have alternate uses”

Characteristics of Scarcity Oriented Definition:
# Economics is a positive science.
# Unlimited ends ( wants ).
# Scarce means.
# Alternative use of means.
# Choice – study of human behavior.
Superiority over Welfare Definition :
# Tried to bring the economic problem which forms the foundation of economics
as a social science.
# The scarcity definition of economics is most universal in nature.
# Has taken both sciences in account i.e. Social and Human.
# It takes into account all human activities.
# Consideration of neutral science was considered much logical.

Criticism of Scarcity Oriented Definition :
#His definition does not focus on many important economic issues of cyclical
instability, unemployment, income determination and economic growth and
development.
# Does not take into account the possibility of increase in resources over time.
# Has treated economics as a science only. But in fact it is both a science and an
art.
D. Growth/Development Concept : According to Prof. Samuelson “Economics is

the study of how men and society choose with or without the use of money, to
employ the scarce productive resources which have alternative uses, to produce
various commodities over time and distribute them for consumption now and in
future among various people and groups of society.

Characteristics of Growth Oriented Definition:
# The definition is not merely concerned with the allocation of given resources but
also with the expansion of resources, tries to analyze how the expansion and
growth of resources to be used to cope with increasing human wants.
# More dynamic approach.
# According to him problem of resource allocation is a universal problem whether
it is a better economy or an exchange economy.
#Definition is comprehensive in nature as it is both growth oriented as well as
future oriented.
E. Need Oriented Definitions : According to Jacob Viner “Economics is what

economists do”

IS ECONOMICS A SCIENCE OR AN ART?
• Economics is science in its methodology and an art in its application, because it has theoretical as well as practical aspects
What is Science?
• Science is a systematized body of knowledge ascertainable by observation and experiment. It is a body of generalizations, principles,
theories or laws which traces out a casual relationship between causes and results.
Kinds of Science:
• There are two kinds of science:
• Positive Science
• Normative Science or Prescriptive Science
Positive science only explains "what is" and normative science tells us "what ought to be"-i.e., positive science describes while normative
science evaluates. Thus, in positive science we derive propositions, theories and laws following certain rules of logic, which explain the
cause and effect relationship between economic variables. While normative science is concerned with describing what should be the
things.
Positive microeconomics is concerned with explaining the determination of relative prices and allocation of resources between different
commodities. Whereas, positive macroeconomics is concerned with how the level of national income and employment, aggregate
consumption and investment, and general price levels are determined.
Normative economics is concerned with what price for a product should be fixed, what wage rate should be paid, how income should
be distributed, etc.

What is Art?
Art is the practical application of scientific laws, principles and theories.
Economics is a positive science because:
• Firstly, economists collect the facts.
• Secondly, they analyze them and derive result.
• Thirdly, they determine the relationship between facts and results.
• Finally, they give a title to the bosomed relationship.
Economics is normative science because:
• Firstly, economists points out different economic problems.
• Secondly, they analyze them in the light of statistics or facts and figures.
• Finally, they advise policies, laws, theories to solve the problems.
Economics is an art because:
• Economists suggest policies along with their implementation procedures to solve the economic problem.Thus,
economics is a science as well as an art.

utility
• Defined as amount of satisfaction he get from the
consumption of goods.
• Unit of utility is utilis.
• Utility is of two types:
• Total &marginal utility
• Total utility: sum total of utility derived from the
consumption of all the units of the commodity
• Marginal utility: refers to additional utility from
the consumption of additional unit of commodity
UNITS TU MU
O 0 0
Relationship b/w TU &
MU 1 8 8
1. When TU is max. MU 2 14 6
became zero 3 18 4
2. When TU increases 4 20 2
MU remains positive. 5 20 0
3. When TU starts to 6 18 -2
decline Mu becomes
negative.

MARGINAL UTILITY ANALYSIS
Assumptions
The basic propositions of this traditional approach are:
 Cardinal measure of utility: Utility is a measurable and quantifiable concept.

A person can specify that he gets five units of utility by consuming one unit of
good A etc. Utilis is an imaginary unit of measuring utility.
 Independent utilities: Utility is additive; i.e. the utilities derived from

different independent goods can be added to get the measure of total utility.
 Constant marginal utility of money: The marginal utility of money remains

constant for a particular consumer when he spends money on various goods.
All other commodities except money are subject to the law of diminishing
Cont….
marginal utility.
The Law of Diminishing Marginal Utility
Marginal utility refers to the change in satisfaction which results when a little more or little
less of that good is consumed. For example, when a thirsty person takes five bottles of cold
drink continuously, the consumption of first bottle gives him utility, second bottle gives him
lesser utility than first but his total utility increases. Third bottle gives him still less utility
but increases total utility. The utility from fourth bottle may be zero as he is no more thirsty.
But the fifth bottle may cause uneasiness and thus give negative utility, i.e., the total utility
may now actually go down.
Bottle consumed Total Utility (Units) Marginal Utility (Units)

0 0 –
1 14 14
2 23 9
3 27 4
4 27 0
5 24 –3
6 18 –6
Cont….

T.U.
M.U.
Cont….

Consumer's Equilibrium
Law of Equi-marginal Utility or the principle of Equi-marginal utility says that the consumer
would maximize his utility if he allocates his expenditure on various goods he consumes
such that the utility of the last rupee spent on each good is equal i.e.
MUx=MUy
Suppose the consumer's income is RS 5
He wants to spent on two commodities i.e. orange & apple
1unit of each goods costs 1RS
Rs spent Mu of orange MU of apple

1 10 (1) 9(2)
2 8(3) 6(4)
3 6(5) 4
4 4 2
Cont….
5 2 1
Concept of Demand
Demand is one of the crucial requirements for the existence of any business enterprise. A
firm is interested in its own profit and/or sales, both of which depend partially upon the
demand for its product. The decisions which management takes with respect to production,
advertising, cost allocation, pricing, etc., call for an analysis of demand.
Demand for a commodity implies
 Desire to acquire it
 Willingness to pay for it, and
 Ability to pay for it.
Cont….

Demand Function and Demand Curve
Demand function is a comprehensive formulation which specifies the factors that influence
the demand for the product.
Dx = f (Px, Py, Pz, B, E, T, U)
Where Dx = Demand for item x
Px = Price of item x
Py = Price of substitutes
Pz = Price of complements
B = Income of consumer
E = Price expectation of the user
T = Taste or preference of user
U = All other factors
Cont….

Demand schedule & demand curve
• Demand schedule: it refers to a table / tabular
statement which shows relationship b/w price
& demand. It is of two types: individual &
market.
• Demand curve: it is a graphic representation
of demand schedule expressing the
relationship b/w price & demand . It is of two
types: individual & market.

An Individual's Demand Schedule for Commodity x
Price x Quantity of x demanded
(per Unit) Px (in Units) Dx
2.0 1.0
1.5 2.0
1.0 3.0
0.5 4.5
Demand Curve
Cont….

• A demand curve follow the law of demand: when a price rises,
quantity demanded falls, and vice versa
• Exceptions to law of demand:

• Giffen goods(income effect of a price is greater than its substitution
effect
• Necessity of life
• Articles of conspicuous consumption (status symbol)
• Ignorance
• Abnormal conditions
• Expectations regarding future price

Change in demand
Shifts in the Demand Curve

If any of the components held constant in drawing a demand
curve change, there is a shift in the demand curve. It is of two
types.
a. Increase in Demand (demand increases due to other
factors price remains constant)
b. Decrease in demand (demand decreases due to other
factors price remains constant)
Cont….

Increase in Demand Decrease in Demand
Movement along demand curve
• Extension of demand: demand increases due
to fall in price
• Contraction of demand: demand decreases
due to rise in price

P
D
P3
P1
Price
P2
D
c extension
Q
D1 D2
Quantity
Movement along a Demand Curve
Cont….

P
D
P2
Price of Tea
P1
D
D1
Q
Q2 Q1
Amount demanded of coffee/milk

SUBSTITUTE GOODS CASE
P D
P2
Price of Butter
P1
D D
D1
Q
Q2 Q1
Cont….
Amount demanded of butter per day
COMPLEMENTARY GOODS CASE
Types of Demand
For a purposeful demand analysis for managerial decisions, it is necessary to classify the
large number of goods and services available in every economy. Policy decisions are also
facilitated by an understanding of demand at various levels of aggregation. A classification
in these respects is as follows:
a. Consumer good (goods& service used for final consumption for human& other living
being )and producer goods( used for production of other goods plant, machine, raw
material etc.)
b. Perishable ( demand depends on present conditions to meet present needs)and

durable goods ( it is more complicated for demand analysis because it is subject to future
needs)
c. Autonomous (whose demand is independent of any other goods)and derived

demand. But there is hardly any product which is autonomous but degree varies Cont….

d) Individual's demand and market demand (firm should be
concern with market demand& consumer should be with
individual demand)
e) Firm and industry demand
f) Demand by market segments and by total market( if market

is large in terms of geog. Area, product use, customer size
distribution channel etc) then it is imp. to distinguish market
by specific segments for a meaningful analysis.

determinants of demand
• Price of the commodity
• Income of consumer: 1)normal/ superior goods .2) inferior
goods
• Price of related commodity: substitute goods & complementary
goods
• Taste & preference
• Population
• Future expectations
• Distribution of income (i.e. if it is in favor of poor demand for
necessity good increase)
• Govt policy.(favorable/ un favorable)
• Promotional effect on demand

Elasticity of
Demand
• DEMAND ELASTICITIES
• The contribution of the concept of elasticity
lies in the fact that it not only tells us that
consumer's demand responds to price
changes but also the degree of responsiveness
of consumers to a price change.

Classification of Demand Curves According to Their Elasticity
• when price changes we can classify all demand curves in

the following five categories:
i. Perfectly inelastic demand curve (Ed=o) fig a
ii. Inelastic demand curve(Ed<1) fig d
iii. Unitary elastic demand curve(Ed=1) fig b
iv. Elastic demand curve(Ed>1) fig e
v. Perfectly elastic demand curve(Ed=∞) fig c

(b)
(a)
Cont….
(c)
Ed<1 Ed>1
• fig d • fig e
10 10
50 150
50 70

Price Elasticity of Demand (Ed) How total revenues or expenditures
are affected by price changes
Ed Value Term for Price increases Price decreases

Elasticity of
demand
Zero Perfectly revenue Increase Decrease

inelastic Proportionally proportionally
with price with price
0 < Ed <1 Relatively increase less Decrease less
Inelastic than than
proportionally proportionally
with price with price
Ed = 1 Unitary elastic Unaffected
by price
changes
a > Ed >1 Relatively Decrease but Increase, but
elastic less than less than
proportionally proportionally
Perfectly elastic Total revenue Increase more
8
falls to zero than

proportionally

Factors Determining Elasticity of Demand
Some important factors that determine the elasticity of demand are:
i. Luxury or Necessity Goods (nature of goods)
ii. Percentage of Income spent on the commodity
iii. Habitual necessities
iv. Substitutes
v. Time
vi. Number of uses the commodity satisfied
vii. Shifting of requirement

Income Elasticity
The income elasticity of demand is a numerical measure of the degree to which quantity
demanded responds to a change in income, other determinants of demand being kept
constant.
For example, let there be two goods, clothing and salt. Let the consumers income increase
by 5%. Then the percentage change (increase) in quantity demanded would be different for
clothing and different for salt (the percentage increase in quantity demanded for clothing is
likely to be much higher than that for salt). Thus, clothing and salt are said to have a
different income elasticity of demand. Thus, for the same percentage increase in income
(i.e., 5%) the percentage increase in the quantity demanded for different goods is different.
Income elasticity of demand provides us with a numerical measure of this difference.
Thus, income elasticity of demand allows us to compare the sensitivity of the demand for
various goods for the same change in income. From the definition,
e1 = %change in quantity demanded
%change in income

Cross Elasticity of Demand
The concept of cross elasticity provides a numerical measure of the percentage change in
quantity demanded due to a change in price of other commodities. It measure the degree
to which quantity demanded is a function of the price of all other commodities. From the
definition,
%change
= in
quantity
demanded o f good X
E c
%change inprice ofgood Y
Cont….

Advertising or promotional elasticity of
demand
• In case of several products the market demand is
influenced through advertisement or promotional
efforts.the demand function in this case
• Qx=f(A)
• Qx = demand for the product x measured through
quantity sold in the market.
• A= advertisement expenditure of the firm
• eA =% or proportionate change in sales
• % or proportionate change in advertisement expenditure

Importance of Elasticity of Demands
• The concept of elasticity of demand is quite

useful.
 To business firms
 In international trade
 In fiscal policy

Concept of Indifference Curve
• An indifference curve is a locus of combinations of goods which

derive the same level of satisfaction, so that the consumer is
indifferent to any of the combination he consumes. If a consumer
equally prefers two product bundles, then the consumer is
indifferent between the two bundles. The consumer gets the
same level of satisfaction (utility) from either bundle. Graphically
speaking, this is known as the indifference curve. An indifference
curve shows combinations of goods between which a person is
indifferent.
• Symbolically, in the equation form,
• An Indifference Curve =U=f(x1,x2,x3,.....xn)=k
• ......where, k is a constant.

INDIFFERENCE CURVE ANALYSIS
Assumptions
The following assumptions about the consumer psychology are implicit in this analysis:
 Transitivity: If a consumer is indifferent to two combinations of two goods, then he
is unaware of the third combination also.
 Diminishing marginal rate of substitution: The scarcer a good the greater is its
substitution value.
 Rationality: The consumer aims to maximize his total satisfaction and has got
complete market information.
 Ordinal Utility: Utility in this approach is not measurable. A consumer can only
specify his preference for a particular combination of two goods, he cannot specify how
much.
Cont….

Properties of indifference curve
• Slopes downwards from left to right.
• Two indifference curve never intersect each
other.
• Higher indifference curve yield higher
satisfaction

The Indifference Curve
If a consumer is asked whether he prefers combination 1 of two goods X
and Y (assuming that the market price of X and Y are fixed) or combination
2, he may give one of the following answers:
 he prefers combination 1 to 2
 he prefers combination 2 to 1
 he is indifferent about combinations 1 and 2.
Indifference Combination of X and Y goods
Combination Units of X Units of Y
1 3 21
2 4 15
3 5 11
4 6 8
5 7 6 Cont….

The Indifference Curve
Set of indifference curves is called

Indifference map
Cont….

The Budget Line
The budget line is also known as the price
line, the consumption possibility line or the
price opportunity line. It represents
different combinations of two goods X and
Y which the consumer can buy by spending
all his income.
Example
A consumer having Rs 1200 as income can buy
600 units of Y at Rs 2 per unit or 300 units of X at
Rs 4 per unit as shown in Figure. The straight line
joining the two points A and B is called the A
budget line.
At any point on AB, the consumer spends all his
income but point C is unattainable. At point D or
any other point in DOAB he does not spend all his
income. Cont….

Income and Substitution Effects
• Economists decompose the effect of a change in price on the
quantity demanded into an income and a substitution effect.
• Income effect: due to the increase in real income associated
with a fall in prices (you can buy more with the same nominal
income) or the loss of real income associated with a rise in
prices (you cannot buy as much as you once did with the
same nominal income).
• Substitution effect: due to the change in the relative price of
the good, cheaper goods are substituted for more expensive
ones.

The Production Process
Production is a process in which economic resources or inputs (composed of natural
resources like labour, land and capital equipment) are combined by entrepreneurs to create
economic goods and services (outputs or products).
Production Management
Labour Pollution O
I
N U
Natural T
P
U Resources, Land P
T U
Capital, Equipment Goods & Services T
S
Machines S
CONTROL

Some basic concepts
• Short period in which only variable factors can be
changed
• long period in which both variable & fixed factors can
be changed
• total product: is the total quantity produced by the
many units of variable & fixed factor
• Average product: is the total output divided by the
number of units of the variable factor .APL=TP/L
• Marginal product: is the addition in total product due
to per units change in variable factors .MPL=∆TP/ ∆L
The Production Function
The task of a production unit is to organize a production process – a process of combining
the different factors in some proportion so that those inputs can be efficiently transformed
into products or outputs. Various terms are used for inputs and outputs.
INPUTS OUTPUTS
Factors Quantity (Q)
Factors of production Total Product (P)
Resources Product
'A production function defines the relationship between inputs and the maximum amount
that can be produced within a given period of time with a given level of technology‘
Q=f(L,K,N,R,E)
Q= output N= Land input
L= Labour R= Raw material
k=capital E= efficiency parameter
Two special features of a production function are given below:
Cont….
a. Labour and capital are inputs to produce any quantity of a good, and
b. Labour and capital are substitutes to each BBAIst
DR. SALABH MEHROTRA othersemester
in production. 50
Types of production function
• Short Run Production function or Law of
Variable Proportion or One variable input
Case
• long Run Production or Production with all
variable input

Short Run Production function or Law of
Variable Proportion
• It shows the maximum output a firm can
produce when only one of its inputs can be
changed ,5eother inputs remaining fixed, it
can be , Q=f(L,K)
• Q= output, L= labour ,K= fixed amount of capital
• thus it is possible to substitute some capital by labour
• As a result ratio b/w fixed & variable inputs also changes
• This law states that beyond a certain a certain point further increase in
employment of variable factors will lead to smaller increase in total output
• Therefore it is also called Diminishing Marginal Returns

Law of Variable Proportion has three stages
• increasing returns to Variable Factors
• Diminishing returns to Variable Factors
• Negative returns to Variable Factors

Production function: One variable input Case: Short Run Analysis or Law of
Variable Proportion or Diminishing Marginal Returns
Production Function with One Variable Input

Number of Total Product Average Marginal
land Labour Units (L) of Labour (TPL) Product Product stages
of Labour (APL) of Labour (MPL)
1 20 20 –
1 2 50 25 30 increasing
3 90 30 40 returns
4 120 30 30
1 5 140 28 20 Diminishing
6 150 25 10 returns
7 150 21.5 0
8 130 16.25 -20
9 100 11.1 - 30 Negative
1
returns
Cont….

The Three Stages of Production
Total Physical Product Marginal Physical Product Average Physical Product
Stage I
Increases at an Increases and reaches Increases (but
increasing rate its maximum slower than MPP)
Stage II
Increases at a Starts diminishing Starts diminishing
diminishing rate and becomes equal to zero
and becomes maximum
Stage III
Reaches its maximum, Keeps on declining continues to
becomes constant and becomes negative diminish but must
and then starts declining always be greater
than zero
Cont….

Fixed inputs Specialization Fixed inputs
grossly under and teamwork capacity is
utilized, continue and reached,
specialization and result in greater additional X
team work cause output when causes output to
APP to increase additional X is fall
when additional X used, fixed input
is used is being properly
Cont….
utilized.

The Production Function with Two Variable Inputs
A firm may increase its output by using more of two variable inputs that are substitutes for
each other, e.g., labour and capital.
The technical possibilities of producing an output level by various combinations of the two
factors can be graphically represented in terms of an isoquant (also called iso-product
curve, equal-product curve or production indifference curve).

Isoquants
Isoquants are a geometric representation of the production function. The same level
of output can be produced by various combinations of factor inputs. Assuming
continuous variation in the possible combination of labour and capital, we can draw
a curve by plotting all these alternative combinations for a given level of output. This
curve which is the locus of all possible combination is called the 'isoquant'.
OR
it is defined as the locus of various combinations of two inputs in the existing state
of technology to produce a given level of output.
OR
It is a curve that shows all possible combinations of inputs that gives same level of
output

Typical Isoquants

Characteristics of Isoquants
Isoquants show the following characteristics:
a. They slope downward to the right.
b. It is convex to origin. means a situation may come when it

becomes difficult to substitute labor with capital
c. Two isoquants do not intersect.
d. Higher isoquant represents a higher output
Cont….

The Isoquant Curve
• Marginal rate of substitution – the rate at
which one factor must be added to
compensate for the loss of another factor, to
keep output constant.
 It is the slope of the isoquant curve.

The Isoquant Curve
• Isoquant map – a set of isoquant curves that
show technically efficient combinations of
inputs that can produce different levels of
output.

An Isoquant Map

The Isocost Line
• Isocost line – a line that represents alternative
combinations of factors of production that
have the same costs.

Isocost Lines
If a firm uses only labour and capital, the total cost or expenditure of the firm can be
represented by
C = wL + rK
where C = total cost
w = wage rate of labour
L = quantity of labour used
r = rental price of capital
K = quantity of capital used
Isocost line
Cont….

Returns to Scale
Returns to scale are classified as follows:
1. Increasing Returns to Scale (IRS)
2. Constant Returns to Scale (CRS)
3. Decreasing Returns to Scale (DRS)
Cont….
Returns to scale

Economies of Scale
• These occur when mass producing a good results
in lower average cost.
• Average costs fall per unit – Average costs per unit
= total costs / quantity produced
• Economies of scale occur within an firm (internal) or
within an industry (external).

Internal and External Economies
• Internal Economies of Scale
As a business grows in scale, its costs will fall due to
internal economies of scale. An ability to produce units
of output more cheaply.
• External Economies of Scale
Are those shared by a number of businesses in the
same industry in a particular area.

Types of internal Example
economy of scale
Production / Technical •Larger firms can use computers / technology to replace workers
Economies on a production line
•Mass production lowers cost per unit
•Large scale producers can employ techniques that are unable to
be used by a small scale producer.
•Able to transport bulk materials.
Purchasing / Marketing • Advertising costs can be spread across products

Economies •Large businesses can employ specialist staff
• Bulk buying – if you buy more unit cost falls
Financial Economies •Larger firms have better lending terms and lower rates of interest
•Easier for large firms to raise capital.

•Risk is spread over more products.
• Greater potential finance from retained profits.
• Administration costs can be divided amongst more products
Managerial Economies • More specialised management can be employed, this increases

the efficiency of the business decreasing the costs
Risk-bearing Economies • large firms are more likely to take risks with new products as
they have more products to spread the risk over

External Economies of Scale
• These are advantages gained for the whole
industry, not just for individual businesses.

Examples of External Economies
• As businesses grow within an area, specialist skills
begin to develop.
• Skilled labour in the area – local colleges may begin
to run specialist courses.
• Being close to other similar businesses who can
work together with each other.
• Having specialist supplies and support services
nearby.
• Reputation
Diseconomies of Scale
• Occur when firms become too large or inefficient
• Average costs per unit start to rise

Diseconomies of Scale
Types of diseconomy of Example
scale
Communication •When firms grow there can be problems with communication

•As the number of people in the firm increases it is hard to get
the messages to the right people at the right time
•In larger businesses it is often difficult for all staff to know
what is happening
Coordination and control •As a business grows control of activities gets harder
problems •As the firm gets bigger and new parts of the business are set
up it is increasingly likely people will be working in different
ways and this leads to problems with monitoring
Motivation •As businesses grow it is harder to make everyone feel as
though they belong
•Less contact between senior managers and employees so
employees can feel less involved
•Smaller businesses often have a better team environment
which is lost when they grow

Producer’s equilibrium
• Producer’s equilibrium refers to a situation where profits are
maximized or losses are minimized.
• TR-TC Approach and Producer's Equilibrium
• Under perfect competition, TR (Total Revenue) curve is a straight line
passing through origin as price of the product (AR) is constant. TC
curve is inverted S-shaped as discussed in the earlier chapter.
• Equilibrium is struck when the difference between TR and TC is
maximised. Implying that π = TR - TC is maximised. Geometrically, it
occurs when tangents to TR and TC curves are parallel or when Slope
of TR= Slope of TC. Since TR curve is a straight line under perfect
competition, the equilibrium condition can be restated as a situation
when the tangent to TC is parallel to TR. Fig. 1 illustrates this situation.

Fig. 1
In diagram, tangent to TC
(Total Cost) is parallel to
TR (Total Revenue) at OQ
level of output. We observe
that total profit of the firm
is maximum at OQ level of
output as the gap between
TR and TC is maximum
here. At any other level of
output, the profit level will
reduce.

• MR-MC Approach
• Under perfect competition, a firm is in equilibrium
in short-run when following two conditions are
fulfilled.
• (i) MR = MC
• (ii) MC cuts MR from below or MC is rising at the
point of equilibrium. Fig. 2 illustrates this situation.
• In diagram, MR = MC at two levels of output: Q and
Q1 . However, Q1 is not equilibrium level of output. Corresponding to
point Q1 there is point E1 which, no doubt, indicates that MR = MC. However, MC is not
rising here, rather it is falling. Therefore, second condition is not fulfilled here. Clearly E is
the point where not only MR = MC, but MC is also rising. So Q is the equilibrium level of
output.
• In short-run, when a producer or firm is in

equilibrium three situations are possible:
• (i) SNP, (ii) NP, (iii) Minimum Loss.
• (i) Super Normal Profit (SNP): Super normal profits
occur to the firm when its AR > AC and both the
conditions of equilibrium are also met. Therefore, in
this case AR > AC, MR = MC and MC cuts MR from
below.

• In Fig. 3 E is the point of equilibrium
Fig. 3 and corresponding to this Q is
equilibrium level of output.
• Here, AR is EQ, AC is FQ and clearly
AR > AC.
• π per unit = AR ? AC
• = EQ ? FQ = EF. Firm is producing GF
output.
• Total Super Normal Profit of the
firm is GF _ EF = EFGP
• (ii) Normal Profit: Normal profits
occur when AR = AC and both the
conditions of equilibrium are also
met.

• In Fig. 4, E is the point of equilibrium, with normal
profit.
• Here, AR = EQ, AC = EQ
Fig. 4 • π per unit = AR ? AC
• = 0 as AR = AC
• Firm is in equilibrium when it produces OQ level of
output and it is earning just normal profit.
• Point E is also known as Break-even point as AR =
AC or TR = TC. The firm is just recovering its costs.
• Important
• Normal profit is a part of total cost of the firm. It is
equal to reward to the producer for his
entrepreneural services. This is included in the
estimation of TC. Thus, when AR = AC and it
generally refers to the absence of super normal
profit.
• (iii) Minimum Loss: A firm incurs loss when its AR <
AC (or TR < TC) and still, the firm is in equilibrium.

• In Fig. 5, firm is in equilibrium at point
Fig. 5 E where not only MR = MC, but MC is
also rising. OQ is equilibrium output.
However, firm is incurring loss as:
• AR = EQ
• AC = FQ
• Clearly, AR < AC, per unit Loss
• = AR ? AC
• = EQ ? FQ
• = EF
• Total Loss = Loss per unit of output _
Total output
• = ? EF _ PE
• = ? EFGP

Fig. 7 illustrates the situation of
• Break-even Point and Shut-down Point
break-even point. • In microeconomics, break-even is said to
occur when:
• TR = TC
• Or, or P = AC
• A firm is just covering all its costs.
• Break-even is struck at point Q where AR
(= Price) = AC = LQ = OP. A firm is just
covering its costs as price (= OP) happens
to be equal to AC (average cost) = LQ.
Equilibrium is at point Q. It is to be
carefully noted that the break-even point
Q also happens to be the point of firm’s
equilibrium where both the conditions of
equilibrium are satisfied, viz (i) MC = MR,
and (ii) MC is rising.

• Shut-down Point
Fig. 8 illustrates the situation • Shut-down point occurs when a firm is just
of shut-down point. covering its variable costs only. Or, it is a situation
when:
• TR = TVC or or AR = AVC
• Here, the firm is incurring loss of fixed cost. Does
it mean that the firm will suspend production of
the commodity? Not necessarily. It may continue
to produce because the loss of fixed cost is to be
incurred even when output is suspended.
• Shut-down is struck at point Q where
• AR (Price) = AVC = LQ = OP.
• A firm is operating with a price just covering its
AVC. Thus, price (or average revenue = OP) =
average variable cost (= LQ). Note that shut-down
point Q also happens to be a point of equilibrium
where both the conditions of equilibrium are
satisfied, viz.
• (i) MR = MC, and (ii) MC is rising.

Recap………………..

Market and Criteria for Market Classification
Market
A market is any organization whereby buyers and sellers of a good are kept in close
touch with each other. It is precisely in this context that a market has four basic
components i. consumers ii. sellers iii. a commodity iv. a price.
Criteria for Market Classification
There are many possible ways of categorizing market structures, the following
characteristics are frequently employed.
i. Classification by area
ii. Classification by the nature of transactions
iii. Classification by the volume of business
iv. Classification on the basis of time
v. Classification by the status of sellers
vi. Classification by the nature of competition
BBA DR SALABH MEHROTRA (MANAGERIAL
83
ECONOMICS)
Perfect competition
• Infinite buyers and sellers – Infinite consumers with the willingness and ability to buy the
product at a certain price, and infinite producers with the willingness and ability to supply the
product at a certain price.
• Zero entry and exit barriers – It is relatively easy for a business to enter or exit in a perfectly
competitive market.
• Perfect factor mobility - In the long run factors of production are perfectly mobile allowing
free long term adjustments to changing market conditions.
• Perfect information - Prices and quality of products are assumed to be known to all
consumers and producers.
• Zero transaction costs - Buyers and sellers incur no costs in making an exchange (perfect
mobility).
• Profit maximization - Firms aim to sell where marginal costs meet marginal revenue, where
they generate the most profit.
• Homogeneous products – The characteristics of any given market good or service do not
vary across suppliers.
• a perfectly competitive market exists when every participant is a "price taker", and no participant
influences the price of the product it buys or sells. Specific characteristics may include :

84
ECONOMICS)
Monopolistic competition
• There are six characteristics of monopolistic

competition
• product differentiation
• many firms
• free entry and exit in long run
• Independent decision making
• Market Power
• Buyers and Sellers have perfect information
85
ECONOMICS)
Causes of Monopoly
• Barriers to entry which are factors that
prevent new firms from entering a market are
the source of all monopoly power.
• There are two general types of barriers to
entry
– Technical barriers
– Legal barriers

86
ECONOMICS)
Technical Barriers to Entry
• A primary technical barrier is when the firm is
a natural monopoly because it exhibits
diminishing average cost over a broad range of
output levels.
– Hence, a large-scale firm is more efficient than a
small scale firm.
• A large firm could drive out competitors by
price cutting.

87
ECONOMICS)
Technical Barriers to Entry
• Other technical barriers to entry.
– Special knowledge of a low-cost method of
production.
– Ownership of a unique resource.
– Possession of unique managerial talents.

88
ECONOMICS)
Legal Barriers to Entry
• Pure monopolies can be created by law.
– The basic technology for a product can be
assigned to only one firm through a patent.
• The rational is that it makes innovation profitable and
encourages technical advancement.
– The government can award an exclusive franchise
or license to serve a market.
• This may make it possible to ensure quality standards

89
ECONOMICS)
Monopoly
• Single seller: In a monopoly there is one seller of the good who produces
all the output.[ Therefore, the whole market is being served by a single firm,
and for practical purposes, the firm is the same as the industry.
• Market power: Market power is the ability to affect the terms and conditions
of exchange so that the price of the product is set by the firm (price is not
imposed by the market as in perfect competition).Although a monopoly's
market power is high it is still limited by the demand side of the market. A
monopoly faces a negatively sloped demand curve not a perfectly inelastic
curve. Consequently, any price increase will result in the loss of some
customers.
• Firm and industry: In a monopoly, market, a firm is itself an industry.
Therefore, there is no distinction between a firm and an industry in such a
market.
• Price Discrimination: A monopolist can change the price and quality of the
product. He sells more quantities charging less price against the product in
a highly elastic market and sells less quantities charging high price in a less
elastic market. BBA DR SALABH MEHROTRA (MANAGERIAL
90
ECONOMICS)
Market Structure comparison
Profit
Elasticity Product
Number Market Excess maximizat Pricing
of differentia Efficiency
of firms power profits ion power
demand tion
condition
Perfect
Perfectly
Competitio Infinite None None No Yes P=MR=MC Price taker
elastic
n
Monopolist
Highly Yes/No
ic Price
Many Low elastic High (Short/Lon No[ MR=MC
competitio setter
(long run) g)
n
Absolute
Relatively Price
Monopoly One High (across Yes No MR=MC
inelastic setter
industries)

91
ECONOMICS)
What is an oligopoly?
• An oligopoly is an economic condition in which there are so few
independent suppliers of a particular product
• .Oligopoly is a form of market where there is domination of a limited
number of suppliers and sellers called Oligopolists.In an oligopoly,
there are at least two firms controlling the market.
• An oligopoly is a market dominated by a few large suppliers. The
degree of market concentration is very high. Firms within an
oligopoly produce branded products and there are also barriers to
entry.
• Another important characteristic of an oligopoly is interdependence
between firms. This means that each firm must take into account the
likely reactions of other firms in the market when making pricing and
investment decisions.
• The retail gas market is a good example of an oligopoly because a
small number of firms control a large majority of the market.

92
ECONOMICS)
What is an Oligopoly?
• Oligopoly is best defined by the market conduct
(behaviour) of firms
Key
• A market dominated by a few large firms I.e. issue is
“Competition amongst the few” behavi
our of
• High level of market concentration a few!
• Concentration ratio is the market share of the leading

firms
• Each firm tends to produce branded / differentiated
products

93
ECONOMICS)
What is an Oligopoly?
• Entry barriers – long run supernormal profits
• Mutual interdependence between competing firms
(important)
• Intensive non-price competition is common
• Periodic aggressive price wars
• Strong tendency for many market structures to tend
towards oligopoly in the long run
– Market consolidation
– Exploitation of economies of scale
– Interdependence - either firm will not take an action unless
it considers the reaction from the other firms

94
ECONOMICS)
Ingredients for a successful cartel
• Control a large share of the market
• Inelastic and stable demand for the
product
• Similar costs among cartel members
• Fairly homogenous product
• Few number of firms
• Ways of preventing cheating on the
agreement

ECONOMICS) 95
Kinked demand curve model of oligopoly:
assumption, rivals will match all price cuts
but not price increases. Under this
assumption, its as if each firm faces a
“kinked” demand curve, with 2 sections to
it: more elastic above the existing price,
since rivals won’t match a price increase,
and less elastic below the existing price,
since rivals quickly match price cuts.
ECONOMICS) 96
Kinked demand curve model is an attempt
to explain rigid prices in oligopoly: That is,
firms might not change price very often.
Why? Firm is reluctant to raise price if its
competitors do not, since it could lose sales
to them, and little reason is seen to lower
price if competitors quickly match the price
cut, since little will be gained.

ECONOMICS) 97
Price
Kinked Demand Curve

Starting price
P1 E
MR Gap
MR D
Q1 Quantity
98 98
ECONOMICS)
• Above the kink, demand is relatively elastic because all other
firms' prices remain unchanged. Below the kink, demand is
relatively inelastic because all other firms will introduce a similar
price cut, eventually leading to a price war. Therefore, the best
option for the oligopolist is to produce at point E which is the
equilibrium point and the kink point.
• Graph explanation: Let P1 and Q1 be the existing price and
quantity for this oligopoly firm: due to the assumptions of this
model, the demand curve has a kink in it at this price and
output. Because of the strange shape of the demand curve, the
MR curve is discontinuous, or has a gap in it

99
ECONOMICS)

Bba First Semester: Principle of Economics N103

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BBA FIRST SEMESTER

DR. SALABH MEHROTRA BBAIst semester 1

DR. SALABH MEHROTRA BBAIst semester 2

Wealth Welfare Scarcity Growth Need

DR. SALABH MEHROTRA BBAIst semester 3

Criticism of Wealth Oriented Definition :

DR. SALABH MEHROTRA BBAIst semester 4

Characteristics of Welfare Definition:

# It is primarily the study of mankind.

DR. SALABH MEHROTRA BBAIst semester 5

C. Scarcity Concept : According to Lionel Robbins: “Economics is the science which

DR. SALABH MEHROTRA BBAIst semester 6

Superiority over Welfare Definition :

DR. SALABH MEHROTRA BBAIst semester 7

D. Growth/Development Concept : According to Prof. Samuelson “Economics is

DR. SALABH MEHROTRA BBAIst semester 8

E. Need Oriented Definitions : According to Jacob Viner “Economics is what

DR. SALABH MEHROTRA BBAIst semester 9

DR. SALABH MEHROTRA BBAIst semester 10

Art is the practical application of scientific laws, principles and theories.

DR. SALABH MEHROTRA BBAIst semester 11

DR. SALABH MEHROTRA BBAIst semester 13

The basic propositions of this traditional approach are:

 Cardinal measure of utility: Utility is a measurable and quantifiable concept.

 Independent utilities: Utility is additive; i.e. the utilities derived from

 Constant marginal utility of money: The marginal utility of money remains

Bottle consumed Total Utility (Units) Marginal Utility (Units)

DR. SALABH MEHROTRA BBAIst semester 15

DR. SALABH MEHROTRA BBAIst semester 16

Rs spent Mu of orange MU of apple

Demand for a commodity implies

 Willingness to pay for it, and

 Ability to pay for it.

DR. SALABH MEHROTRA BBAIst semester 18

Where Dx = Demand for item x

DR. SALABH MEHROTRA BBAIst semester 19

DR. SALABH MEHROTRA BBAIst semester 20

Price x Quantity of x demanded

(per Unit) Px (in Units) Dx

DR. SALABH MEHROTRA BBAIst semester 21

• Exceptions to law of demand:

DR. SALABH MEHROTRA BBAIst semester 22

Shifts in the Demand Curve

DR. SALABH MEHROTRA BBAIst semester 23

DR. SALABH MEHROTRA BBAIst semester 25

Movement along a Demand Curve

DR. SALABH MEHROTRA BBAIst semester 26

Amount demanded of coffee/milk

b. Perishable ( demand depends on present conditions to meet present needs)and

c. Autonomous (whose demand is independent of any other goods)and derived

DR. SALABH MEHROTRA BBAIst semester 28

e) Firm and industry demand

f) Demand by market segments and by total market( if market

DR. SALABH MEHROTRA BBAIst semester 29

DR. SALABH MEHROTRA BBAIst semester 30

DR. SALABH MEHROTRA BBAIst semester 31

• when price changes we can classify all demand curves in

i. Perfectly inelastic demand curve (Ed=o) fig a

ii. Inelastic demand curve(Ed<1) fig d

iii. Unitary elastic demand curve(Ed=1) fig b

iv. Elastic demand curve(Ed>1) fig e

v. Perfectly elastic demand curve(Ed=∞) fig c

DR. SALABH MEHROTRA BBAIst semester 32