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Dr. Varsha Rayanade S
M.Com., MBA, M.Phil., PhD
 Shivaji University

BBA – I, SEMESTER I
Micro Economics
CC- A3

Syllabus

Unit – I Introduction to Economics

1.1. Definition, Nature, Scope and Significance of Economics
1.2. Difference between Micro and Macro Economics
1.3. Basic Economic Problem
1.4. Business Economics and Business Decisions

Unit – II Consumer Behavior and Demand Analysis

2.1. Concept of Utility - Law of Diminishing Marginal Utility
2.2. Indifference curve analysis – Properties – consumer’s equilibrium
2.3. Law of Demand – Determinants of Demand, Elasticity of Demand
2.4. Measurement of Elasticity of demand and its applications

Unit –III Factor Pricing and Production Function

3.1. Cost and Revenue – Concepts and Curves
3.2. Innovation theory of Profit, Risk and Uncertainty theory of Profit
3.3. Loanable fund theory of Interest – Liquidity Preference theory of
Interest
3.4. Production function – Long Run & Short Run Production functions

Unit – IV Market Structure

4.1. Perfect Competitive Market: Characteristics and Price determination
4.2. Monopoly – Characteristics and Price determination
4.3. Monopolistic Competition - Characteristics and Price determination
4.4. Oligopoly - Characteristics and Price leadership

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 TABLE OF CONTENTS

1. Introduction to Economics … …. 3

2. Consumer Behavior and Demand Analysis … …. 13

3. Factor Pricing and Production Function … …. 47

4. Market Structure … …. 72

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 Unit 1. - INTRODUCTION TO ECONOMICS

Introduction
The word ‘Economics’ originates from the Greek word ‘Oikonomikos’. This Greek
word can divided into two parts - ‘Oikos’ meaning ‘House’ and ‘Nomos’ meaning
Management. Thus the term ‘Economics’ means ‘House Management’.
In a family, the Head of the Family faces the problem of managing the unlimited
wants (needs) of the family members with the limited resources (income) of the
family. Similarly, if a society or state / nation is considered as a ‘family’, then this
society, state or nation also faces problem of satisfying the unlimited wants of the
members of the society / citizens of the state or nation with the limited resources
available with that society, state or nation. Economics, thus can be said to be the
study of ways in which mankind organizes itself to handle the basic problem of
scarcity of resources. Generally, the wants are more than the resources, study of
economics helps in allocation of scarce resources between the competing wants.
Economics is a developed social science that deals with economic behavior of the
individual, family, business units and the government at various levels of their
functioning. The discipline of economics has gained widespread popularity in context
of both; areas of academics and relating to formulation of policies. Today, the
understanding of economic issues has become quite indispensable for all sections in
the society - individuals, households, business units, institutions, as well as
governments. Economic problems arise on account of unlimited wants or needs and
limited resources. Wants or needs are desires which can be satisfied by making use
of resources which are scare.
Economics is thus said to be the social science that deals with production, distribution
and consumption of goods and services. From a small shop to a country economics
plays a crucial role in the efficient running of both. No business or country can flourish
without applying the principles of economics. The study of economics is extensive
and varied. The nature and scope of economics depends upon the interaction of
economic agents and the way in which the economies work.
Definitions of Economics
There is no commonly accepted definition of economics. It has been defined in
different ways by various economists. However, these definitions can broadly be
classified in four categories as mentioned below:
1. Wealth Definition – Economics is a study of wealth
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2. Welfare Definition – Economics is the study of material welfare
3. Society Definition – Economics is the study of scarcity and choice
4. Growth oriented Definition – Economics is the study of changes and growth in
means and its relation to ends.
1. Wealth Definition:
The classical economists gave wealth based definition of economics and viewed
economics as the science of wealth. According to them, economics studies creation,
distribution and consumption of wealth. Adam Smith states that people undertake
economic activities to create and earn wealth. According to J.B. Say the aim of
economics is to show the way in which wealth is produced, distributed and
consumed. Prof. Walker states that Economics is that body of knowledge which
relates to wealth.
Criticisms of Wealth Definition:
a. Undue Importance to Wealth – wealth is created for people. They are interested
in using wealth for attaining welfare. Economics cannot be restricted to only
wealth getting activities. It has to be extent it to wealth using activities. But the
wealth definition gives importance only to wealth.
b. Dismal Science – wealth generation and earning makes people greedy and selfish.
A science which makes people greedy for money cannot be studied. It was
described as mundane (boring / routine) science, Science of Bread and Butter and
the Science of illth and not wealth.
2. Welfare Definition:
Alfred Marshall stated that economics cannot be study of wealth alone. Wealth is
produced for the people and people are interested in welfare. According to him
“Economics is a study of mankind in ordinary business of life. It examines that part of
individual and social action which is most closely connected with the attainment and
the use of material requisites.”
Criticisms of Welfare Definition:
a. Limited in Scope – this definition is limited in scope because it restricts economics
only to those activities that promote welfare. But there are many activities which
do not promote human welfare.
b. Materialistic in Nature – focus of this definition is only on material welfare.
However, there are many non- material goods which also promote human welfare
and they too are equally important.

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c. Difficult to quantify Welfare – Welfare is an abstract concept that is very
subjective. Welfare refers to satisfaction and happiness which has no physical
existence as it is a state of mind. Hence, welfare cannot be quantified or
measured.
d. Ignores Scarcity – the root cause of all economic activities is the scarcity of
resources, this aspect has been overlooked and ignored.
3. Scarcity Definition:
Prof. Lionel Robbins has given this definition. According to him ‘Economics is the
science which studies human behavior as a relationship between ends and scarce
means which have alternative uses’. Wants or ends are unlimited in number as well
as in variety, while the resources to satisfy them are limited. Hence, choice needs to
be made amongst the wants or ends that can be satisfied using the scarce resources.
Economics, thus is all about scarcity and choice.
As per this definition to satisfy wants, people make efforts to earn income. People
have a variety of wants, however the income is limited as compared to their wants
and demands. Hence, people have to make a choice amongst their wants as per the
priority and necessity. The scarcity based definition of Prof. Robbins was popular
since 1932 as satisfactory definition of economics till Prof. Paul A Samuelson and K.G.
Seth came up with new growth-oriented based definition of economics in 1960.
4. Growth- Oriented Definition:
Prof. Paul A Samuelson offered a new definition of economics known as growth
oriented definition. This definition is dynamic in content and wide in scope, with
changing time, changes takes place in means as well as ends. Like Robbins, this
definition is also based on scarcity and choice however, this definition considers
changes in them.
Prof. Paul A Samuelson defines “Economics as the study of how men and society
choose, with or without the use of money, to employ scarce productive resources
which could have alternate uses to produce various commodities over time and
distribute them for consumption now and in future among various people and groups
of society.”
This definition recognizes the scarcity of means (resources) in relation to the
unlimited wants. However, it states that the resources/ means are not only scarce
but they can be used for alternate purposes. Further, this definition also considers
the element of time which makes it dynamic.

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Nature of Economics
The nature of Economics deals with the issue of ascertaining whether economics is a
science or is it a art or both. Various economists have given their argument in favor
of it being a science, while others have their reservations for arts.
Economics as a Science
Science is a systematized body of knowledge ascertainable by observation and
experimentation. It is a body of generalizations, principles, theories or laws which
trace out a causal relationship between cause and effect. For any discipline to be
science it should possess the following features:
a. It must be a systematized body of knowledge.
b. Have its own theories and laws.
c. It can be tested by observation and experimentation.
d. It is capable of measurement
e. It has the ability to forecast or make predictions
If the above features of science are applied to economics it can be said that
economics is a science.
Economics is a systematized body of knowledge in which economic facts are studied
and analyzed in a systematic manner. For instance, economics is divided into
consumption, production, exchange, distribution and public finance which have their
laws and theories on whose basis these departments are studied and analyzed in a
systematic manner.
Like any other science, the generalizations, theories or laws of economics trace out
a causal relationship between two or more economic phenomena. A definite result
is expected to follow from a particular cause in economics like all other sciences. For
e.g. The law of demand in economics explains the cause and effect relationship
between price and quantity demanded for a commodity. As per this law, if other
things remain constant, as the price rises, the demand for the commodity falls and
vice versa. Here the cause is the price and the effect is the fall in quantity demanded.
Similarly, like science it is capable of being measured, the terms of measurement is
money. It has its own methodology of study and it forecasts the future market
condition with the help of various statistical and non-statistical tools. Thus, major
portion of the economic laws are of this type and hence economics is science.

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Economics as an Art
A discipline of study is termed as an art if it tells, how to do a thing for the
achievement of an objective. In other words, art is the practical application of
knowledge for achieving particular goals. Prof. J M Keynes says that ´An Art is a
system of rules for the achievement of a given end.’ Science gives the Principles of
any discipline however, art turns all these principles into reality. Therefore
considering all the activities in economics, it can be claimed as an art also, because it
gives guidance to the solutions of all the economic problems.
Art is the practical application of scientific principles. Science lays down certain
principles while art puts these principles to practical use. To analyze the causes and
effects of poverty falls within the purview of science and to lay down principles for
removal of poverty is an art.
Scope of Economics
The areas of application of economics is gradually expanding. It is no more
considered as just a branch of knowledge that deals only with the production and
consumption. However, the basic priority, still remains on using the available
resources efficiently while giving the maximum satisfaction or welfare to the people.
In view of this, major branches of economics are as mentioned herein below:
a. Micro Economics: This is said to be the basic economics. Micro economics may
be defined as that branch of economic analysis which studies the economic
behavior of the individual unit which may be a person, a particular household or
a particular firm. It is a study of one particular unit rather than all the units
combined together. Microeconomics is also described as price and value theory
of the household, the firm and the industry.
b. Macro Economics: this may be defined as that branch of economic analysis which
studies behavior of not one particular unit but all units combined together.
Macroeconomics is a study in aggregates, hence is also known as Aggregates
economics. It is considered to be a realistic method of economic analysis which is
complicated and involves use of higher mathematics. This method studies how
the equilibrium in the economy is reached consequent to changes in the macro
variables and aggregates.
c. International Economics: its role is getting more and more significant nowadays
due to the increase in trade and commerce between the countries.
d. Public Finance: this branch of economics known as public finance or fiscal
economics has emerged to analyze the role of government in the economy.

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e. Development Economics: after Second World War many countries got freedom,
their economics required different treatment for growth and development. This
led to emergence of branch of economics known as development economics.
f. Health Economics: a new realization has emerged from human development for
economic growth. Therefore, branches like health economics are gaining
momentum. Similarly, trend of educational economics is also upcoming.
g. Environmental Economics: economic growth now, is facing new challenge from
environmental side, due to unchecked emphasis on economic growth without
caring for natural resources and ecological balance. Therefore, environmental
economics has emerged as one of the major branches of economics that is
considered significant for sustainable growth.
h. Urban and Rural Economics: role of location is very important for achievement
economic goals. Economists have realized that there should be specific focus on
urban areas and rural areas. Hence, there is expansion of branches like urban
economics and rural economics. Similarly regional economics is also being
emphasized to meet the challenges of geographical inequalities.
Further, there are many branches of economics that form scope of economics such
as monetary economics, welfare economics, energy economics, transport
economics, labor economics, agriculture economics, gender economics, economic
planning, economics of infrastructure, etc.
Significance of Economics
Economics governs the life of Individual, Society, State and the Country. This subject
also plays an important role in the International affairs. The knowledge of economics
helps in solving many problems and the study has practical advantages as mentioned
below:
 First and foremost, it helps the society to decide and formulate the ways to
optimize the allocation of its limited and scarce resources.
 Economics provides us the mechanism and analytical techniques to optimize the
utilization of the available resources and reduce wastages.
 Optimum utilization of the ‘Opportunity Cost’ is another principle in which the
scarce resources are utilized efficiently after calculating and checking the
opportunity cost. Minimizing the opportunity cost gives maximum profits. The
use of this principle by governments in budget allocations results in better
growth rates for a Country.
 Stability of an economy is a must for any Country, State, Society or individual to
survive in the long run. Hence, adoption of sound economic policies and practices

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 are very important to ensure that the economy is stable and growing at the same
time.
 Economics is equally important for the economic growth of an individual. For a
person it is not important to have knowledge and understanding of the
theoretical side of economics but he should definitely understand the basic
economic practices that must be followed to enjoy a healthy and wealthy life
style.
 Economists can advise governments in managing the economy in a better way
that can avoid inflation and unemployment through well devised economic
policies.
 Economists can also help the society by suggesting certain policies to the
government which can overcome market failures caused due to various factors
such as under or over production.
Difference between Micro Economics and Macro Economics
Micro Economics Macro Economics
It is the Study of individual economicIt is a study of economy as a whole and
units if an economy its aggregates
It deals with Individual income, It deals with aggregates like national
individual prices, individual output, etc.
income, general price level, national
output, etc.
Its central problem is price Its central problem is determination of
determination and allocation of level of income and employment
resources
Its main tools are demand and supply of Its main tools are aggregate demand
a particular commodity/ factor and aggregate supply of the economy as
a whole
It helps to solve the central problem of It helps to solve the central problem of
‘what, how and for whom ‘ to produce full employment of resources in the
in the economy economy
It discusses how equilibrium of a It is concerned with the determination
consumer, producer or an industry is of equilibrium level of Income and
attained employment of the economy
Price is the main determinant of micro Income is the major determinant of
economic problems macroeconomic problems
Examples are: Individual Income, Examples are: National Income, national
Individual Savings, price determination savings, general price level, aggregate
of a commodity, individual firm’s demand, aggregate supply, poverty,
output, consumer’s equilibrium unemployment, etc.

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Basic Economic Problem
The economic problem sometimes called as basic or central economic problem
states that an economy’s finite i.e. limited resources are insufficient to satisfy all
human wants and needs. It is therefore said that the central or basic problem of
economy is the production of goods and services to satisfy the changing needs and
wants. Thus, the basic problem revolves around scarcity and choice hence, the
following basic problems needs to be addressed in every economy:
a. What to Produce and in what Quantity: the first basic problem of an economy is
to decide what goods and services are to be produced and in what quantities.
This involves allocation of scarce resources in relation to the composition of total
output in the economy. As the resources are scare the society needs to decide
upon what goods need to be produced for e.g. Food grains, clothing, roads,
hospitals, housing, electricity, vehicles, etc.
Once, the nature of goods to be produced is decided, then their quantities are
also to be decided. Further, this decision needs to be taken on the basis of
priorities or preferences of the society as the available recourses for the same are
scare and limited.
b. How to Produce: the next basic problem of the economy is how to produce i.e.
decide about the techniques or methods to be used in order to produce the
required goods. This problem is primarily dependent upon the availability of
resources with the economy. If land is available in abundant, then extensive
cultivation may be made and in case land is scarce. Intensive method of
cultivation may be used. Similarly, if labor is in abundance, it may use labor
intensive techniques while in case of labor shortage capital intensive technique
may be used.
The technique to be used also depends upon the type and quantity of goods to
be produced. For producing capital goods and large outputs, expensive and
complicated machinery and techniques are required, while for producing simple
consumer goods and small outputs, less expensive machinery with comparatively
simple technique will be required. Further, it also needs to be decided as to which
goods and services are to be produced in public sector and which goods and
services are to be produced in private sector.
c. For whom are the Goods Produced: the third basic problem is to decide about
the allocation of goods among the members of the society. The allocation of
goods which may be necessity goods, comforts or luxury items among the
household takes place on the basis of distribution of Income. Whosoever having
the means to buy the goods may have them. A rich person may have a large share

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 of luxury goods, while the poor person may have more quantities of basic
consumer goods which he needs the most.
d. How efficiently are the resources being utilized: This is one of the important
basic problem of an economy because after making the above mentioned three
decisions, the society has to see whether the resources it owns are being fully
utilized. In case the resources are not being fully utilized, ways and means to
utilize the idle resources needs to be found out to utilize them fully. The society
thus, will have to adopt such monetary, fiscal or physical measures that are
necessary to rectify the same and make full utilization of resources.
e. Is the Economy Growing: The last and most important problem is to find out
whether the economy is growing through time or is it stagnant. If the economy is
stagnant or standstill at any point, effort needs to be taken to push up the
economy by producing larger quantities of consumer goods and capital goods.
Economic growth takes place through higher rate of capital formation which
consists of replacing existing capital goods with new and more productive ones
by adopting more efficient production techniques or through innovation.
All the above mentioned basic problems of an economy are interrelated and
interdependent. They arise from the fundamental economic problems of scarcity of
means and multiplicity of ends which lead to the problem of choice or economizing
of resources.
Business Economics and Business Decisions
Business economics also called Managerial Economics, is the application of economic
theory and methodology to business. It is the combination of economic principles
and business practices. A business is an organized activity that provides goods and
services for the satisfaction of human wants and needs. The business organization
earn profit from supply of goods and services to the consumers, which virtually is the
main aim of any business. Business economics is concerned with economic issues and
problems related to business organization, business management and business
strategy. Every business have to take several decisions with respect to various
aspects of business. Business decision is an integral part of management.
Management and decision making are to be considered as inseparable. Business
decision is the selection of a particular course of action, based on some criteria from
two or more possible alternatives. Business decisions could be either major, minor,
simple, complex, important, unimportant, urgent or less urgent, day to day decisions
or long term decisions. The day to day decisions are also known as routine or
programmed decisions and other decisions are called non-routine or non-
programmed decisions.
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There are several factors both economic and non- economic that affect a business
organization. These factors need to be classified, analyzed an interpreted to find
required solutions to problems. Economic theory provides theoretical framework
and logical analytical skill and decision making tools and techniques to solve business
problems. According to McNair and Meriam, business economics deals with the use
of economic modes of thoughts to analyze business situations. Business economics
provides the link between traditional economic theory and business decision making.
In other words, business economics is a study of behavior of firms in theory and
practice i.e. economics applied to decision making. Economics and business cannot
be separated from each other, they are closely associated with one another. Hence,
business and economics can be said to be two sides of the same coin.

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 Unit 2. - CONSUMER BEHAVIOR AND DEMAND ANALYSIS

Introduction
A person who buys products and services for satisfying his wants / needs is a
“Consumer”. For every business organization, consumer is the most important
person as the success of business revolves around him. In a market driven economy
a consumer is treated like a King who has his own expectations and preferences as
regards the quality, price and availability of product or service. The importance of
consumer, does not reduce even in case of sellers’ market, that is dominated by the
seller and the consumer has no choice and is practically forced to buy the products
or services as the terms of the seller. Hence, it is necessary for a business organization
to understand the behavior of consumer in the given conditions.
Consumer Behavior
A consumer has a set pattern of behavior. Consumer behavior is the study of
individuals, groups or organizations and the processes they use to select, secure and
use the products and services to satisfy needs and the impact that these processes
have on the individual and society.
In the theory of consumer behavior, the foremost important element is about the
choices made by normal consumer from the numerous commodities which are
available to him. Consumer theory is concerned with how a normal consumer would
make consumption decisions. Apart from the general analysis of demand and supply
theory, there is a need to study the consumer behavior is its particular structure helps
in deriving economically meaningful results. The structure arises because the
consumer’s choice sets are assumed to be defined by the consumer’s income and
wealth.
There are two significant approaches of determining consumer behavior:
- Marshallian Approach or Utility Approach
- Indifference Curve Approach
Marshallian Approach or Utility Approach
Prof. Alfred Marshal made a significant contribution in the study of consumer
behavior. He developed utility analysis of consumer behavior to derive consumer’s
equilibrium is one commodity framework. Originally, Prof. Jevans, Walras and
Menger contributed to this theory known as Utility analysis and later, Prof. Marshal
further developed the same. This theory is based on basic function wherein utility

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can be measured and quantified in numerical terms. Prof. Marshal made following
assumptions to establish this theory:
a. Utility is cardinally measurable
b. Marginal utility of money remains constant
c. Demand for any single commodity is satiable i.e. Law of diminishing marginal
utility (DMU) holds true.
d. Two different commodities can never be perfect substitute for each other.
e. Utility functions are independent for different commodities.
f. Consumer must be rational in nature.
This theory considers that the consumer allocates his income on one good and the
balance money income is composite good.
Meaning of Utility
In economic terms the word ‘Utility’ means want satisfying capacity of a commodity
or service. Anything that satisfies human want is a utility. Consumer demands a
product or service only if it has some utility. The price paid by the consumer depends
upon the utility.
Utility is sometimes confused with satisfaction; however, they both are different. A
consumer gets satisfaction only after consumption or use of a product or service.
Utility is calculated before using or buying a product or service. In other words, utility
is what the consumer thinks and satisfaction is what the consumer gets. Thus utility
implies ‘expected satisfaction’ whereas satisfaction is ‘realized satisfaction’.
Utility is also not usefulness. A product or service may have a capacity to satisfy a
want but it may not be useful. For eg. A cigarette satisfies the want of a smoker but
it is harmful to health. Thus utility is not usefulness.
Utility is in the mind of a person. It is subjective and is known to the consumer
himself. It varies from person to person as it depends upon the thinking of a person.
Prof. Marshal states that though utility is subjective it can be measured. Objectively
in terms of price that the consumer is willing to offer at a particular point of time for
a certain product.
Economics is concerned with the ‘normative’ aspect of utility. While studying the
problem of price determination of a product or service, the important factors are
limited to the ‘reasons for’ and the ‘intensity of’ its demand by the consumers. It does
not matter whether its consumption adds to their well- being or not. So long as the
consumers expect to derive some satisfaction from a product or service (that is till

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the time the product or service has utility for them), they will be ready to buy it at
some price and create demand for it in the market.
Measurement of Utility
The need for measuring utility arises so that it can be used in the analysis of demand
behavior of individual consumers and therefore, of the market as a whole. The basis
of the reasoning is that a consumer compares utility of a good with the price he has
to pay for it. He keeps buying its additional units so long as the utility from them is at
least equal to the price paid for them. In economic theory, utility can be measured in
two ways:
a. Cardinal Approach
b. Ordinal Approach
Cardinal Utility Approach
Human wants are unlimited and they are of different intensity. The means i.e. the
resources available to a person are not only scarce but they have alternative uses. A
result of scarcity of resources, the consumer cannot satisfy all his wants/ needs. He
has to choose as to which want is to be satisfied first and which afterwards, only if
the resources are available. Thus the consumer is faced with the task of making
proper choice. For eg. a person feeling thirsty goes to the market and satisfies his
thirst by buying a cold drink instead of mineral water. The consumer purchased a cold
drink because he feel it has more utility to give him satisfaction.
According to this approach, utility can be measured in cardinal i.e. basic numbers
such as 1, 3, 10, etc. The utility is expressed in imaginary cardinal numbers, which
tells a great deal about the preference of the consumer for a product or service. In
cardinal measurement, utility is expressed in absolute standard units, such as there
being 20 units of utility from the first loaf of bread and 15 units from the second.
The concept of cardinal utility faced severe criticism from an Italian economist
Pareto. According to him, utility is neither quantifiable nor addible; however, it can
be compared. He suggested that the concept of utility should be replaced by the scale
of preference.
Ordinal Utility Approach
This approach is purely subjective and is immeasurable. The theory of consumption
is based on the scale of preference and the ordinal ranks. Ordinal measurement of
utility is the one in which utility cannot be expressed in absolute units. Utility from
two or more sources is only ‘ranked’ or ‘ordered’ in relation to each other. Utility

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from one source may be ‘equal to’, ‘more than’ or ‘less than’ utility from another
source. But it is not possible to state the difference in absolute or numerical units.
Utility is considered to be subjective and hence it varies from person to person and
from one situation to another. Hence, it is neither possible to measure it in absolute
numbers nor compare utility of one product or service for two individuals. This
implies that cardinal utility is only a theoretical occurrence and has less validity in
practice. Thus utility is best measured in ordinal terms.
However, in number of cases, analysis of demand decisions requires the use of a
cardinal measurement of utility. For this reason, economists adopted a standard unit
of measuring utility called as ‘util’ (frequently used in plural form as ‘utils’). But these
utils itself are subjective, discretionary and imprecise measure and therefore, does
not determine the demand behavior of consumers.
To overcome this limitation, Prof. Marshall mentioned that utility of a product or
service to the consumer should be measured in units of money which the consumer
is willing to pay for buying these product or service. For eg. a consumer is willing to
pay Rs.500 for the first dozen of mangoes and only Rs.450 for the second dozen of
mangoes, then according to this approach, the utility of first dozen of mangoes to the
consumer equals Rs.500 and that of the second equals Rs.450. This approach was
widely accepted and seemed to be useful in analyzing demand decisions of the
consumers because in practice, the consumers pay for their purchases in monetary
terms.
Law of Diminishing Marginal Utility (DMU)
This is the fundamental law of consumer behavior which was first developed by
Gossen. It is also known as Gossen’s first law of consumption. It provides basis for
traditional demand analysis. Law of diminishing return states that, “as a consumer
increases the consumption of any one commodity, keeping constant the
consumption of all other commodities, the marginal utility of the variable commodity
must eventually decline”. The marginal utility to the consumer can even fall to zero
and also become negative.
According to this law, as a consumer consumes one unit after the other unit of the
same product or service continuously, the utility he gets goes on diminishing. This is
so because as the consumption increases the intensity of want goes down. With the
consumption of units, wants get satisfied to some extent. This tendency of the part
of utility to diminish is known as the Law of Diminishing Marginal Utility.

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 Example: A consumer is consuming mangoes. When he consumes the first mango,
he gets more utility. While consuming the second mango he is already satisfied to
some extent. Therefor he gets less utility than the first mango. Like this it happens
with all subsequent units of mango. This can be further explained with the help of
utility Schedule, which shows the list of units of a product to be consumed and utility
that can be obtained from each unit.
Utility Schedule
Units of Mango Marginal Utility (Units) Marginal Utility in terms of
Money
1 50 units Rs.30
2 40 units Rs.25
3 30 units Rs.20
4 20 units Rs.15
5 10 units Rs.10

Marginal utility is the net addition made to the total utility by consuming extra unit
of a commodity. It is expressed in terms of units of expected satisfaction. It is
measure in terms of money that a consumer is willing to spend. The marginal utility
is measured in terms of expected satisfaction is known as ‘utils’. In the above table,
the first mango is likely to give 50 utils of satisfaction and the price the consumer is
willing to spend is Rs.30. As the consumer consumes the second, third, fourth and
fifth unit, the utility starts decreasing along with the value of money he is willing to
spend.
To understand the consumer behavior, the utility schedule is represented in the form
of graph considering the units of mango and marginal utility measure in utils.

The marginal utility curve shows that as the consumption of a commodity (mangoes)
increases, the utility reduces i.e. diminishes. There is inverse relationship between

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the units consumed and utility obtained. The marginal utility curve has a negative
slope i.e. it is sloping downward towards the right hand side.
Assumptions:
a. All units of the given commodity are homogenous i.e. identical in size, shape,
quality, etc.
b. The consumption is continuous without any gap.
c. Only one type of commodity is used for consumption at a time.
d. Taste and preference of the consumer do not change
e. Consumer is a normal human being and he aims at maximum satisfaction.
f. Units can be measured cardinally i.e. it can be expressed numerically.
The law of diminishing marginal utility is violated only if or more of the assumptions
upon which it is based gets violated.
Exceptions / Limitations of the Law:
a. Hobbies: in certain hobbies like stamp or old coin collection, every addition unit
gives more pleasure. Marginal utility goes on increasing with the acquisition of
every unit.
b. Money: this law is not applicable to money. More is the money earned, greater is
the utility that the person derives from additional units of money. Money provides
a person with more purchasing power, improvement in status and lifestyle.
Hence, everyone likes to have more money.
c. Reading & Music: reading of books gives more knowledge and in turn great
satisfaction. Similarly, in case of music when people listen more and more music,
they derive more and more utility.
d. Liquor & vices: In the case of liquor or any other vices like smoking, tobacco
chewing, a person likes or enjoys to have more units of their vices i.e. liquor,
tobacco, etc. As he consumes more he gets more utility.
Uses of Law of Diminishing Marginal Utility:
a. The relationship between diminishing marginal utility of a product or service and
its price, helps in explaining the determination of its price in the market. It also
helps in explaining paradoxes i.e. inconsistencies like water which is so essential
for life being cheaper than diamonds which are luxury.
b. The law helps the consumer who is faced with the decision of dividing his total
expenditure over a number of goods or services.
c. This law is highly helpful to the authorities in working out social welfare
programmes. They can take steps by which goods and services are allocated

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 between the members of the society in such a manner that marginal utility of each
good or service tends to be the same for every individual.
Total and Marginal Utility
Marginal utility is the net addition made to the total utility by consuming extra unit
of a commodity. It is the utility from the marginal unit which the consumer is
encouraged to buy at the existing price. It therefore refers to the utility derived at
the point of margin.
Total utility is the sum total of utilities derived from the consumption of all units.
There is some relationship between marginal utility and total utility. When total
utility arises at an increasing rate, marginal utility increases. When total utility
increases at a diminishing rate, marginal utility diminishes. When total utility
increases at a constant rate, marginal utility is constant.
Total and Marginal Utility Schedule
Units of Marginal Marginal Utility in Total Utility Total Utility in
Mango Utility (Utils) terms of Money (Utils) terms of Money
1 50 units Rs.30 50 Rs.30
2 40 units Rs.25 90 Rs.55
3 30 units Rs.20 120 Rs.75
4 20 units Rs.15 140 Rs.90
5 10 units Rs.10 150 Rs.100
6 0 0 150 Rs.100
7 -1 - Rs.10 140 Rs.90

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Consumer Equilibrium
A consumer has a purchase plan, which he goes on changing till he gets the maximum
satisfaction. His aim is to derive maximum satisfaction through consumption of goods
and services. The point of equilibrium is reached by the consumer when he decides
not to change his purchase plan. Equilibrium is the balance of opposing forces. In case
of consumer the opposing forces are the price that he offers for a product or service
and the marginal utility he derives. The price he offers depends on marginal utility.
He will decide not to change his purchase plan until marginal utility equals price (MU
= P). Equilibrium can also be described as the position of rest or changelessness. This
position is reached when MU = P.

Law of Equi- Marginal Utility:

The law of equi - marginal utility is an extension of Law of diminishing marginal utility.
The law of diminishing marginal utility considered one commodity model i.e. a
consumer consumes only one commodity. But the law of equi - marginal utility is
based on multi- commodity model. i.e. a consumer consumes more than one
commodity. The law of diminishing marginal utility explains the equilibrium of a
consumer consuming only one commodity and the law of equi - marginal utility
provides equilibrium of a consumer consuming more than one commodity i.e.
minimum two commodities.
The law of equi - marginal utility is known by different names like “Gossen’s second
law of consumption”, “Law of maximum satisfaction” because every person uses his
monetary income to get maximum satisfaction. This law is also known as “Law of
substitution” because the consumer substitutes the expenditure of one commodity
over the other so as to get maximum satisfaction.
According to this law, income of the consumer is limited whereas he has various
wants and needs. The consumer therefore has to spend his limited income over the

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desired goods and services that give maximum satisfaction i.e. the consumer has to
divide his total expenditure between different goods and services by taking into
consideration their respective marginal utilities along with their per unit prices. The
law of equi - marginal utility provides solution to the consumer and guides the
consumer in decision making. The law of equi - marginal utility states that “a rational
consumer will distribute his limited money income over goods and services in such a
manner that he equates the marginal utilities of expenditure in each use.”
Lets’ assume, a consumer has limited income of Rs.50 per day. He desires to purchase
two commodities – misal and tea. The marginal utilities of expenditure from each of
them are shown in the following schedule:
Marginal Utility of Marginal Utility of
Units of Expenditure Expenditure in respect of Expenditure in respect of
Misal Tea
Rs.10 10 9
Rs.20 9 8
Rs.30 8 7
Rs.40 7 6
Rs.50 6 5

In this case we are concerned with the marginal utility of expenditure and not with
the marginal utility of the product. The various possibilities of expenditure and total
utility are as mentioned below:
Expenditure Total Utility
1. Full Rs.50 spend on Misal 50 *
2. Full Rs.50 spend on Tea 35 **
3. Rs.40 spend on Misal and Rs.10 on Tea 43 ***
4. Rs.30 spend on Misal and Rs.20 on Tea 44 ****
5. Rs.20 spend on Misal and Rs.30 on Tea 43 *****
6. Rs.10 spend on Misal and Rs.40 on Tea 40 ******

Working Note:
* 10+9+8+7+6 = 40 ** 9+8+7+6+5 = 35 *** 10+9+8+7+9 = 43
**** 10+9+8+9+8 = 44 ***** 10+9+9+8+7 = 43 ****** 10+9+8+7+6 = 40
From the above possibilities of expenditure, it can be seen that the consumer gets
maximum total utility (44) when he spends Rs.30 on Misal and Rs.20 on Tea.
Therefore, the consumer’s equilibrium with two commodities is established at that
point where the total utility is maximum and marginal utility of expenditure is equal.

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The marginal utility for Misal of Rs.30 is 8 and the marginal utility for tea of Rs.20 is
also 8.

The Law of equi - marginal utility is useful to the consumers to get maximum
satisfaction, producers to derive maximum profits, Government to maximize social
welfare and for exchange of goods and services.
Limitations
In reality, the Law of equi - marginal utility suffers from several limitations that come
in the way of its implementation. Some of the limitations are as mentioned below:
(i) Ignorance: an ignorant consumer blindly follows custom or fashion, due to which
wrong use of money is possible. On account of ignorance the consumer may not
know where the utility is greater and where it is less. Thus ignorance may prevent
the consumer from making rational use of money/ Hence, his satisfaction may not
be maximum, because the marginal utilities from his expenditure cannot ne
equalized due to ignorance.
(ii) Inefficient Organization: similar to consumer, an incompetent organizer of
business will fail to achieve best results from the factors of production like units of
land, labor and capital that is employed by them. This is so because he may not be
able to divert expenditure to more profitable channels from the less profitable ones.

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(iii) Unlimited Resources: the law does not apply where the resources are unlimited
because there is no need to divert them from one direction to another. Since there
is no scarcity of resources, they can be made available for any diversion or expansion
programme.
(iv) Custom and Fashion: there may be strong influence of customs and traditions or
fashion on the consumers due to which he will not be able to derive maximum
satisfaction out of his expenditure as he cannot give up consumption of such
commodities. This is specially true in case of conventional things such as clothing for
e.g. sarees for ladies.
(v) Frequent Changes in Prices: frequent changes in the prices of different goods
makes observation of this law very difficult. The consumer may not be able to make
necessary adjustments in his expenditure in a constantly changing price situation.
Indifference Curve Analysis
A popular alternative to the Marginal Utility Analysis of demand is the Indifference
Curve Analysis. This is based on the consumer preference and believes that it is not
possible to quantify human satisfaction in monetary terms. This approach gives an
order to consumer preferences rather than measure them in terms of money. F.Y.
Edgeworth explained this technique in 1881 which was further improved by Filfredo
Pareto and Professor Slutsky. Refinement of this technique was done by Professor J
R Hicks and R G D Allen.
Meaning
An indifference curve is a graph that shows a combination of two goods or services
that give a consumer equal satisfaction and utility, thereby making the consumer
indifferent towards these combinations. In other words, the indifference curve is the
graphical representation of different combinations of goods (generally two), for
which the consumers are indifferent, in terms of satisfaction and utility. Thus, all
combinations on indifference curve are equally good and a consumer can move along
this curve anywhere as every combination gives the same amount of satisfaction.
Assumptions of Indifference Curve
a. Only two goods or services are taken into consideration. It is assumed that the
consumer has to make a choice between two goods or services, provided their
prices remain constant.
b. It is assumed that the consumer is not saturated with both the goods or services
and look for more benefits from these two goods or services to have a higher
curve to get more satisfaction.
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c. The satisfaction level cannot be measured, hence the consumer ranks his
preferences.
d. It is assumed that the marginal rate of substitution diminishes, as more units of
one good or service have to be set off by the reduction in the units of other good
or service. Thus the indifference curve is convex to the origin.
e. It is assumed that the consumer is rational and will make his choice objectively to
have an increased utility and satisfaction.
Example: Suppose a consumer wants to consume two products viz. bread and
cheese. The different combinations of bread and cheese would give him same level
of satisfaction. When the consumer wants to increase the consumption of cheese, he
has to sacrifice some slices of bread. i.e. he has to substitute some slices of bread for
additional quantity of cheese. On this basis the Indifference schedule can be
prepared which shows the list of combination of two products that also explain the
marginal rate of substitution.
Indifference Schedule
Combination Slices of Bread Milligram of Cheese Marginal Rate of
Substitution
A 20 1 0
B 15 2 1:5
C 11 3 1:4
D 08 4 1:3 Declining
E 06 5 1:2
F 05 6 1:1

When the Indifference Schedule is represented graphically on a graph we get a curve

which is known as “Indifference Curve”. Every combination viz. A, B, C, D, E and F
gives the consumer same level of satisfaction. The consumer is indifferent to any of
these combinations.

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Properties of Indifference Curve
1. Downward Sloping: An Indifference curve slope downward, which means that
with more consumption of one good the consumption of the other is reduced to
maintain the utility. Here, the principle of the marginal rate of substitution
applies, which means the increased consumption of one commodity is to be set
off by the reduced consumption of another commodity so as to have the same
level of satisfaction or utility. Thus, the indifference curve is negatively sloped.
2. Convex to the Origin: The indifference curves are convex (curved) to the origin
because of the diminishing marginal rate of substitution. The marginal rate of
substitution diminishes because of the decline in the marginal utility, which
means with more and more consumption of one commodity, the consumer’s
utility starts declining and he is not willing to consume it more at the cost of the
other commodity. For eg. there are two chocolates, diary milk and Nestle Kitkat,
with more and more consumption of diary milk chocolates the utility continues to
decline and the consumer will no more give up Nestle Kitkat chocolates to buy
diary milk chocolate. Here, marginal rate of substitution shows the slope of the
indifference curve.
3. Higher the Indifference Curve, the higher is level of satisfaction: the consumer
derives more satisfaction from the combination of two goods on a higher
indifference curve because more units of both the commodities are used that will
surely be more satisfying than the lower quantity combinations.
4. Cannot intersect or be tangent to each other: the indifference curves cannot
intersect with each other, because if it does so then the combinations of two
commodities lying on two different curves will yield the same level of satisfaction
which is not correct.
5. Need not be parallel: the indifference curves may or may not be parallel to each
other. It is not necessary for different indifferent curves to be parallel to one
another. The space between the indifferent curves varies on the basis of
consumer satisfaction and utility, hence there is certainly gap between the
indifferent curves but it is not necessary for this gap to be uniform.
Thus, it is clear from the properties of the indifference curve that the consumer
realizes an equal satisfaction and the utility from the use of different combinations
of two commodities.
Indifference Map
One Indifference curve shows one particular level of satisfaction. The different
indifference curves show different levels of satisfaction when a set of indifference
curves are drawn on the same graph, it is known as “Indifference Map”. Thus,
Indifference Map is the graphical representation of two or more indifference curves
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showing the several combinations of different quantities of commodities, which
consumer consumes, based on his income and the market price of goods and
services.
The consumer preference gives rise to several combination of commodities with each
combination providing the same level of satisfaction. Hence, it is important to
understand the preferences of the consumer as these vary from individual to
individual and market to market. The concept of indifference map can be explained
better through below given graphical representation.

The space between X axis and Y axis is called as the Indifference Plane or Commodity
Space. This plane is comprised of finite points, each point representing different
combinations of Cheese and Bread. Thus, it is always possible to draw a number of
Indifference curves without intersecting one another. The indifference curves IC1,
IC2, IC3, IC4 drawn graphically represents the indifference map. Thus, an indifference
map may contain several IC curves positioned on the basis of the consumer’s
preferences. Here, IC1 shows lowest level of satisfaction, while IC2 shows higher level
of satisfaction than IC1, IC3 shows higher level of satisfaction than IC1 and IC2 and IC4
shows the highest level of satisfaction than IC1, IC2 and IC3.
Consumer’s Equilibrium with Indifference Curve
Every consumer aims at spending his income in a way that gives him maximum
satisfaction. When a consumer gets maximum satisfaction from his expenditure, he
is said to be in equilibrium. Consumer equilibrium refers to a situation, in which a
consumer derives maximum satisfaction, with no intention to change it and subject
to given prices and his income. The point of maximum satisfaction is achieved by
studying indifference map and budget line together.
Assumptions:
a. The consumer is rational and seeks to maximize his satisfaction through purchase
of goods or services.
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b. The consumer consumes only two goods or services
c. The goods are homogenous (similar) and perfectly divisible
d. Prices of goods or services and income of consumer are constant
e. The indifference map for two goods or services is given & it is based on the
consumer’s preferences for the goods or services.
f. The preference or habit of the consumer does not change throughout the
analysis.

Consumer’s Equilibrium is at point ‘E’ where IC 2 (highest attainable IC) is tangent to

the budget line (price line) AB. At equilibrium, OE of Bread and OF of Cheese is
consumed. IC1, IC2 and IC3 show different levels of satisfaction.
Conditions of Consumer’s Equilibrium
a. Budget line or Price line should be tangent to the indifference curve:
consumer’s equilibrium is based on the assumption that the income of a
consumer is constant and that he spends his entire income on purchasing two
goods or services whose prices are given. A budget line is a graphical
representation of various combinations of two goods or services that a consumer
can afford at specified prices of the goods or services at particular income level.
A budget line can be drawn on the basis of expenditure plan.
b. Indifference curve should be convex to the point of origin: the other condition
of equilibrium is that at the point of equilibrium, indifference curve should be
convex to the origin. It means that marginal substitution rate between two
products for eg. Bread and Cheese should be diminishing. If indifference curve is
concave and not convex to the origin, then it will not be the point of equilibrium.
Law of Demand
Meaning and Concept of Demand
Demand refers to the quantity of a commodity or a service that people are willing to
buy at certain price during a certain time interval. It can be termed as a desire with
the willingness and ability to pay for a commodity.
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A person has many desires, wants and needs. All the desires of a person cannot be
described as ‘demand’. Only such desires for which a person has capacity and
willingness to buy, can be treated as demand. A desire of a middle class person to
have a Bungalow in Mumbai cannot be regarded as demand, while similar desire of
an Bollywood actor may be considered as demand as he has the ability to buy a
Bungalow in Mumbai. In economics, demand has three important elements viz., (i)
the desire for a commodity (ii) the will to pay for the commodity (iii) the ability to pay
for it.
Demand, price and time are closely related. Demand is always expressed in relation
to price and time. Demand will be different at different prices and also at different
times. Therefore, the demand has to be expressed in relation to price and time. The
demand for any commodity or service is the amount that will be purchased at a
certain price at a particular point of time. The relationship between demand and
price is inverse i.e. whenever there is increase in the price of the commodity the
demand for that commodity decreases and when there is decrease in the price, there
is increase in the demand for that commodity. This phenomena is known as the law
of demand and is typically represented by a downward sloping line known as the
demand curve.
Determinants of Demand
The determinants of demand are factors that cause fluctuations in the economic
demand for a product of service. Some of the important determinants of demand are
as follows:
a. Price of the Product or service: price in many cases, is likely to be the most
fundamental determinant of demand since it is often the first thing that people
think about when deciding how much of an item to buy. Even the law of demand
states that with all other things being equal, the quantity demanded of an item
decreases when the price increases and vice versa. However, there are few
exceptions to this rule but they are quite a few.
b. Income of the Consumers: people definitely look at their income while deciding
how much of an item to buy. When the income of a consumer increases, he buys
more of a product or service as he has more money to spend. But the relationship
between income and demand is not as simple and straightforward as it may look.
In case of normal products like clothing, food, household appliances, etc. the
demand decreases if income decreases. However, demand for certain product
does not always increase with a rise in income. For e.g. a consumer who has a low
income and always purchased vanaspati oil for cooking as it is cheaper may opt to
buy expensive pure ghee or refined oil for cooking if his income increases. In this
case demand for vanaspati oil will reduce with increase in income. Products that
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 have reduced demand with increasing income are known as “inferior goods”.
Inferior, in this case does not mean with lower quality. A rise in income also
increases the demand for luxury products and services for e.g. car, gym or club
membership, vacations, etc.
c. Prices of related products or services: generally while deciding how much
quantity of a good to buy, consumers take into account the price of both
substitute goods and complementary goods. Substitute goods are those goods
that are used in place of one another. For e.g. Coke and Pepsi are substitutes of
one another. Complementary goods on the other hand are goods that people
tend to use together. For e.g. DVD player and DVDs, Smart phone and Internet
access. The key feature of substitutes and complements is the fact that a change
on price of one of the products has an impact on the demand for the other
product. Increase in the price of Coke would increase the demand for Pepsi as
some consumers will switch over from Coke to Pepsi and vice versa i.e. decrease
in price of Coke would decrease the demand for Pepsi. Similarly, is the case with
complementary goods for e.g. decline in internet charges, hiked the demand for
smartphones. Goods that don’t have any relationship such as substitute or
complementary are called unrelated goods.
d. Tastes and Preferences: tastes and preferences plays a major role in influencing
the individual and market demand of a product. Tastes and preferences of
consumers are affected due to various factors such as lifestyle, fashion, customs,
habits, standard of living, etc. A change in any of these factors leads to change in
the taste and preferences of consumers as a result of which there is change in the
demand of the commodity. When a commodity is in fashion or preferred by the
consumers, demand for such commodity rises. On the other hand, demand for
commodity falls in case of the commodity being outdated or is no longer in
fashion. Apart from this, demand is also influenced by the habits of consumers.
For e.g. most of the Gujaratis’ are vegetarian, hence the demand for vegetarian
products is higher in Gujarat. In addition, sex ratio also has an impact on the
demand for many products. For e.g. if females are large in number as compared
to males in a particular area, then the demand for feminine products, such as
cosmetics, make up kits, etc. would be high in that area.
e. Consumer Expectations: Another factor which influences the demand for goods
is consumers’ expectation with regard to future prices of the goods and future
income of the consumer. If due to some reason, consumers expect that in the
near future prices of the goods would rise, then consumer would demand greater
quantities of the goods now, so that they do not have to pay higher prices in the
future. While, in case the consumers expects the prices of a commodity to fall in

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 the future they would postpone their purchase of the said commodity till the price
of the commodity falls in future as a result, there will be fall in demand of the
commodity in the present time. Similarly, when the consumers hope that in future
they will have good income, then in the present time they will spend greater part
of their income resulting in increase in demand for commodity at the present
time.
f. Number of Buyers in the market: the market demand for a good is obtained by
adding up the individual demands of the present as well as the prospective
consumers or buyers of a good at various possible prices. The greater the number
of consumers of a product the greater the market demand for it.
g. Advertisement and Sales Promotions: advertisement in various media, sales
promotion events such as launch offers, discounts, free gifts, exchange schemes,
etc. are some of the measures that have a significant impact on the minds of the
consumer and influence the demand greatly. These techniques are used by the
producer or manufacturer of commodity to increase the demand for a product or
service in their favor.
Law of Demand
There is inverse relationship between quantity demanded and its price. With all other
factors that influence demand remaining constant, the demand for a commodity
goes up when its price goes down, and the demand for a commodity goes down when
its price goes up. For e.g., a consumer may demand one dozen oranges at Rs.80 per
dozen. He may demand two dozen oranges when the price is Rs.60 per dozen.
Generally a person buys more at a lower price and less at higher rate. This is not the
case with one person, but all people tend to buy more due to fall in price and vice
versa. Economists call this phenomena as Law of Demand. Hence, in simple words
Law of Demand States that other things being equal more will be demanded at lower
price and lower will be demanded at higher price.
Definition:
a. Alfred Marshal says that “the amount demanded increase with a fall in price,
diminishes with a rise in price”.
b. C.E. Ferguson says that “according to the law of demand, the quantity demanded
varies inversely with price”.
c. According to Paul A. Samuelson “law of demand states that people will buy more
at lower prices and buy less at higher prices, other things remaining the same”.
Assumptions of the Law:
a. Income of the consumer does not change
b. The taste and preferences of the consumer does not change
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c. The prices of related commodities does not change
d. There is no expectation regarding future change in price
e. Consumer is a normal and rational person
The law of demand can be explained with the help of Income and Substitution effect
of fall in price. When the price of a product falls, the consumer finds he has more
income. Money income does not change, but his real income rises. Suppose a
consumer spends Rs. 150 per week for filling 2 litres of petrol in his bike. It means the
price of petrol per litre is Rs. 75. When the price of petrol falls from Rs.75 to Rs.70 a
consumer finds his real income has increased. To get 2 litres petrol filled in his bike,
the consumer now has to spend only Rs.140 as against Rs.150. Hence he is left with
Rs.10 more after consuming same quantity that he consumed earlier. This is known
as the ‘Income Effect’. These Ten rupees a consumer may spend on filling additional
quantity of petrol or substitute it to buy some other product. This is known as the
‘Substitution Effect’.
A market consists of all types of consumers. Some of them are rich, some are poor;
some like a particular product, others do not. When price falls, the product becomes
cheaper and people with lower income also enter the market. When price is higher,
only the rich buy. With lower price, all others demand. This is how price fall leads to
extension of demand. It is this inverse relationship between price and quantity that
makes people buy more at a lower price than at a higher price.
Demand Schedule
Demand Schedule is a tabulated statement that shows the different quantities of
commodity in demand at different prices. For each price certain quantity of a
commodity is demanded by the consumers. The demand schedule indicates what
quantity of a commodity is demanded at each of these prices. The demand schedule
comprises of two columns – in one column different prices are shown and in the
other column the corresponding quantity demanded by the consumer is shown. In
brief it states the relation between the price and quantity. There are two types of
Demand Schedules viz. Individual Demand Schedule and Market Demand Schedule.
Individual Demand Schedule – it a schedule that shows the demand of an individual
customer for a commodity in relation to its price. Let us construct a hypothetical
individual demand schedule to further illustrate the law of demand.
Hypothetical Demand Schedule (Individual)
Price per unit of commodity ‘X’ ( Px) Quantity demanded of commodity 'X’ (Dx)
Rs.100 50 kg.
Rs.200 40 kg.
Rs.300 30 kg.
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 Rs.400 20 kg.
Rs.500 10 kg.

From the above table it can be seen that when the price of commodity is Rs.100, it
demand is 50 kgs., while the demanded quantity drops to 10 kgs., when the price of
the commodity rises to Rs.500. Thus it can be concluded that as the price falls the
demand increases and as the price increases the demand decreases. Hence, there
exists an inverse relationship between the price and quantity demanded.
Individual Demand Curve
It is the graphical representation of individual demand schedule. The X axis
represents the demand, while the Y axis represents the price of the commodity.

Market Demand Schedule – it a summation of the individual demand schedules and

shows the demand of different consumers for a commodity in relation to its price.
Thus, market demand schedule is a list of prices and quantities demanded in the
market at each of these prices. Let us construct a hypothetical market demand
schedule to further illustrate the law of demand.
Hypothetical Demand Schedule (Market)
Price per unit of Quantity demanded by Quantity demanded Market Demand
commodity ‘X’ ( Px) consumer - A (QA) by consumer - B (QB) QA + QB
100 50 70 120
200 40 60 100
300 30 50 80
400 20 40 60
500 10 30 40

The above schedule shows the market demand for commodity X. When the price of
the commodity is Rs.100, consumer ‘A’ demands 50 units while consumer ‘B’
demands 70 units. Thus the market demand is 120 units (50 + 70). Similarly, when
the price of commodity X is Rs.500, consumer ‘A’ demands 10 units while consumer
‘B’ demands 30 units, which means that the market demand decreases to 40 units.

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Hence, it can be concluded that whether it is the individual demand or market
demand, the law of demand governs both of them.
Market Demand Curve
It is the graphical representation of market demand schedule. The X axis represents
the demand, while the Y axis represents the price of the commodity.

Exceptions to the Law of Demand

a. Speculation – the law of demand does not hold good in case of speculation. A rise
in the price of a commodity may create an impression among the buyers that its
price will rise further i.e. there is a speculation (rumor) of price rise in the near
future of that commodity. So, people start buying or keep buying more of that
commodity in spite of increase in the price. Hence, contrary to the law of demand
in such cases of speculation, the demand for the product increases despite the
increase in its price.
b. Snob Appeal or Veblen Goods – people sometimes buy certain commodities like
diamonds at high prices not due to its basic utility but for the ‘status symbol’ or
‘snob appeal’ of the commodity. Like diamonds there are certain commodities
that have a ‘status value’ and purchase of such commodity is said to add to the
status of a person. According to noted economist Thorstein Veblen, certain
commodities which are purchased are not for the direct satisfaction they yield but
for displaying their richness to other members of the community to which they
belong. Commodities like Diamonds, Jewellery, Car, etc. are some of the examples
of such commodities which are also known as Veblen Goods. The demand for
such Veblen goods rises when its price rises and falls when its price falls, hence it
is said as an exception to the law of demand.
c. Giffen or Inferior Goods - Sir Robert Giffen, observed in the 19th century that poor
people spent major portion of their income on essential item like rice, potato, etc.
If the price of this good rises they will become so poor that they will be found to
spend less on other items and buy more of such good known as giffen or inferior
goods like rice or potato in this case, so as to get minimum food to keep
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 themselves alive. Hence, in case of such Giffen or Inferior goods people are seen
to buy less quantity of such goods at lower price and more quantity of goods at
higher price, thus challenging the law of demand
d. Fear of Shortage – when the consumers are obsessed with the fear of shortage
of particular commodity in the near future, they are seen to buy the said
commodity at any price. For instance, during the Gulf war between Iran and Iraq,
operations of Oil wells / rigs in that area were severely affected resulting in
scarcity and shortage of oil products such as Petrol, Diesel, etc. Similarly, in case
of less rainfall, people tend to buy more quantities of food grains in anticipation
of famine and scarcity or shortage of food supplies.
e. Ignorance – Sometimes a consumer may not aware of the prices prevailing in the
market. Hence, he may purchase more quantity of a commodity at a higher price.
This also happens, when the consumer believes that a high priced commodity is
better in quality than a lower priced one. Hence, consumer’s ignorance is another
factor that at times induces him to buy more quantity of product in spite of its
high price.
Elasticity of Demand
Elasticity means sensitiveness or responsiveness of demand to the change in one of
variables (factors) influencing it. There are four important factors that influence the
quantity demanded viz. (a) Price (b) Income (c) Prices of related goods and (d)
Advertisements and Promotions.
The change, sensitiveness or responsiveness in demand may be big or small i.e.
significant or insignificant. For e.g. Even if there is a big fall in the price of salt, it may
not result in significant increase in its demand. On the other hand, a slight fall in the
price of apples may cause a considerable increase in its demand. Hence in case of
demand for salt it is known as ‘inelastic’, while in case of apples it is known as ‘elastic’.
The demand is elastic when with a small change in price, there is a great change in
demand; it is inelastic or less elastic, when even a big change in price induces only a
slight change in demand. The elasticity of demand is defined as “a measure of change
in the quantity demanded in response to the change in the price of the commodity”.
In simple words the effect of change of any variable that influences demand on the
quantity demanded is called the elasticity of demand.
Types of Elasticity of Demand
The elasticity of demand is classified on the basis of the variables that affects the
demand.

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Price Elasticity of Demand
The price elasticity of demand refers to the response of quantity demanded to
change in the price of a commodity. It shows the extent of change in the demand of
quantity of a commodity due to change in its price. There are two popular methods
of measuring price elasticity viz. (a) Percentage Method and (b) Total Outlay Method.
a. Percentage Method – this method was developed by Prof. Marshall.
According to him the price elasticity of demand can be measured by considering the
percentage change in the quantity demanded and the percentage change in price of
the product.

Thus,

Where q refers to quantity demanded, p to price and to change. If Ep >1, demand

is elastic, if Ep <1, demand is said to be inelastic and when Ep = 1 demand is
considered to be unitary elastic. The following illustration shall help in explaining this
method:
i. Suppose the price of commodity X falls from Rs.5 per kg. to Rs.3 per kg and its
quantity demanded increases from 10 kgs to 30 kgs. Then,

This shows elastic demand or elasticity of demand is greater than unitary.

ii. When the price rises from Re. 1 per kg. to Rs. 3 per kg. and the quantity
demanded decreases from 50 kgs to 30 kgs. Then,

This shows inelastic demand or less than unitary elasticity of demand.

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iii. Suppose the price rises from Rs.3 per kg to Rs.5 per kg and the quantity demanded
decreases from 30 kgs to 10 kgs.

This shows unitary elasticity of demand.

Total Outlay Method – Even this method was devised by Prof. Marshall. According
to this method, the total expenditure of a purchaser is compared both before and
after the change in price to know whether his demand for a good is elastic, inelastic
or unitary. The Total outlay computed by multiplying price to the quantity of good
purchased / demanded. The following demand schedule illustration shall help in
explaining this method:
Suppose a consumer purchases a certain commodity at Rs.5/- per unit and spends
Rs.1000/- on that product. It means he has bought 200 units of that product (200 x 5
= 1000). When the price falls from Rs. 5/- per unit to Rs.4/- per unit and further to
Rs.2/- per unit the total expenditure i.e. outlay will vary. Total Outlay (expenditure)
depends upon the price and number of units purchased. Price Elasticity of demand is
measured with the assumption of quantity demanded as mentioned below:
Price per unit Quantity demanded Total Outlay Price Elasticity of Demand
Rs. 5 200 Rs.1000
Ep > 1 - Demand is
Rs. 4 280 Rs.1120
Rs. 2 600 Rs.1200 Elastic
Rs. 5 200 Rs.1000
Ep < 1 - Demand is
Rs. 4 215 Rs. 860
Rs. 2 300 Rs. 600 Inelastic
Rs. 5 200 Rs.1000
Ep = 1 - Demand is
Rs. 4 250 Rs.1000
Rs. 2 500 Rs.1000 Unitary Elastic

Types of Price Elasticity of Demand

The Price Elasticity of Demand can broadly be divided into five types as shown below:

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 Type Value of Ep Description Shape of Curve
Perfectly Elastic ( Infinity )
Consumers are willing to buy all
Demand they can at some price and
Horizontal
none at all at even a slightly
higher price
Perfectly Inelastic 0 ( Zero) Quantity demanded does not
Demand change with change in Prices Vertical
Relatively Elastic >1 < Quantity demanded changes
Demand Greater than by a larger percentage than the Flat Slope
one but less Price does
than Infinity
Relatively Inelastic < 1 > 0 Quantity demanded changes
Demand Greater than by a smaller percentage than Steep Slope
Zero but less the Price does
than One
Unitary Elastic 1 ( One) Quantity demanded changes
Demand by exactly same percentage as Rectangular
does the Price

Diagrammatic Representation of Types of Price Elasticity of Demand

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Significance of Price Elasticity of Demand
The concept of Price Elasticity of Demand has a number of practical implications and
is useful in the following ways:
a. Useful for Business – it enables the business organization to fix prices for their
products and services. By studying the nature if demand an organization can fix
higher price for those goods and services which have inelastic demand and lower
prices for goods and services having elastic demand. Thus helping the
organization in maximizing their profits.
b. Fixation of Prices – it is very useful to fix the price of jointly supplied goods or
services. In case of joint products like paddy and straw, the cost of production of
each is not known. Hence, in such cases the price of each product is fixed by its
elastic and inelastic demand.
c. International Trade – it has greater significance in the sphere of international
trade as it helps in calculating the terms of trade and also the consequent gains
from such foreign trade. If the demand for home product is inelastic, the terms of
trade will be profitable to the home country. Further, the terms of trade would
be favorable in case of those countries, whose exports are having more elastic
demand.
d. Paradox of Poverty – it explains the paradox of poverty. A bumper crop instead
of bringing prosperity may result in disaster, if the demand for it is inelastic. This
is so if the products are perishable which cannot be stored for long period of time.
For eg. Agriculture produce such as vegetables.
e. Significant for Government Economic Policies – the knowledge of elasticity of
demand is equally important for the government. As understanding of the same
helps in controlling inflationary and deflationary gaps in the economy. Similarly,
it also helps the government in stabilization and purchase / sale of stocks.
f. Incidence of Taxation – the incidence of tax lies on the person who ultimately
pays the tax. The government has to keep watch on the ultimate burden of tax
which depends on the elasticity of demand of the commodity taxed. If items of
basic necessity which have less elastic demand are taxed, burden of tax will fall
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 more on poor section of the society. Therefore, principle of justice in taxation is
based on elasticity of demand.
g. Break even Analysis - proper assessment of price elasticity of demand is required
for the break even analysis of a firm. The effect of raising or lowering the price of
a commodity and selling more output at break- even point depends upon the price
elasticity of demand for the said commodity. The greater the elasticity of demand,
the easier it is for the firm to achieve break-even at a higher output.
Income Elasticity of Demand
Consumer’s Income is one of the important determinants of demand for a product.
The demand for a product and consumer’s income are directly related to each other,
unlike price – demand relationship. According to Watson, income elasticity of
demand means “the ration of the percentage change in the quantity demanded to
the percentage in income”. For e.g., the demand for a product increases with the
increase in the consumer’s income and vice versa. The degree of responsiveness of
demand with respect to change in consumer’s income is called income elasticity of
demand.
Measurement of Income Elasticity of Demand
The income elasticity of demand Ey can be measured by using the following formula:

Change in demanded Quantity ( ) is the difference between the new demand (Q1)
and the Original demand (Q). It can be calculated as = Q1 – Q. Similarly, change
in Income ( ) is the difference between the new income (Y1) and the original
income (Y). It can be calculated as = Y1- Y.
The formula for measuring the income elasticity of demand is same as price elasticity
of demand. The only difference in the formula is that in the income elasticity of
demand, income (Y) is substituted as a determinant of demand in place of Price (P).
Suppose the monthly income of an individual increases from Rs.6000 (Y) to Rs.12000
(Y1) and his demand for clothes increases from 30 units (Q) to 60 units( Q1). The
income elasticity of demand can be calculated as follows:
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Types of Income Elasticity of Demand
Like price elasticity of demand, the degree of responsiveness of demand with change
in consumer’s income is not always the same. The income elasticity of demand is
different for different products. On the basis of numerical value, income elasticity of
demand is classified into three groups, which are as follows:
i. Positive Income Elasticity of Demand – it refers to a situation when the demand
for a product increases with the increase in consumer’s income and decreases with
decrease in consumer’s income. The income elasticity of demand is positive for
normal goods.
In the figure, the slope of the curve is upward from
left to right, which indicates that the increase in
income causes increase in demand and vice versa.
Therefore, in such a case, the elasticity of demand is
positive. The positive income elasticity of demand
are of three types which are mentioned as below:
a. Unitary Income Elasticity of Demand
When the proportionate change in the quantity demanded is equal to
proportionate change in income, it is known as unitary income elasticity of
demand. For example, if income increases by 50% and demand also rises by 50%,
then the demand would be called as unitary income elasticity of demand. In such
a case, the numerical value of income elasticity of demand is equal to one (Ey = 1).
b. More than Unitary Income Elasticity of Demand
When the proportionate change in the quantity demanded is more than
proportionate change in income, it is said to be more than unitary income elasticity
of demand. For example, if income increases by 50% and demand rises by 100%,
then the demand would be called as more than income elasticity of demand. In
such a case, the numerical value of income elasticity of demand would be more
than one (Ey > 1).
c. Less than Unitary Income Elasticity of Demand
When the proportionate change in the quantity demanded is less than
proportionate change in income, it is said to be less than unitary income elasticity
of demand. For example, if income increases by 50% and demand rises by 25%,

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 then the demand would be called as less than income elasticity of demand. In such
a case, the numerical value of income elasticity of demand would be more than
one (Ey < 1).
ii. Negative Income Elasticity of Demand – it refers to a situation when the demand
for a product decreases with the increase in consumer’s income. The income
elasticity of demand is negative for inferior goods, as Giffen goods. For example, if
the income of a consumer increases, he would prefer to purchase pure ghee instead
of vanaspati oil (Dalda).
The figure shows that when the income is Rs.10, then
the demand for goods is 3 units and as the income
increases to Rs.15 then the demand is only 1 unit. The
slope of the curve is downward from left to right, that
indicates that the increase in income causes decrease
in demand and vice - versa. Hence, the elasticity of
demand is negative.

iii. Zero Income Elasticity of Demand – it refers to a situation when there is no effect
of increase in consumer’s income on the demand of product. The numerical value of
income elasticity of demand is zero. The income elasticity of demand is zero (Ey = 0)
in case of essential goods. For example, salt is demanded in same quantity by a high
income and low income individual.
The figure shows that when the income increases
from Rs.10 to Rs. 20 there is no change in quantity
demanded, it remains same at 3 units. The slope of
the curve is parallel to Y axis i.e. the income side, which
indicates that the increase of income causes no effect
in demand. Hence, the elasticity of demand is zero.
Significance of Income Elasticity of Demand
While price elasticity plays a significant role in pricing of a product to maximize the
total revenue of an organization in the short run, income elasticity of demand is

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important for production, planning and management in the long run. Following are
some of the important uses of income elasticity of demand.
a. Helping in Investment Decisions – In developing countries like India, the rate of
growth of national income is not steady. Further in these countries rise in national
income does not result in immediate increase in the demand for certain goods.
Generally, producers or sellers prefer to invest in industries where the demand
for goods is more with respect to proportionate change in the income or where
the income elasticity of demand is greater than zero (Ey>1). For e.g. demand for
goods such as furniture, electronic appliances, vehicles, etc. increases with
increase in the national income. Therefore, producers or sellers of such goods
earn higher profits when there is increase in national income. On the other hand
in case of industries with low income elasticity of demand (Ey<1), there is gradual
increase in demand for goods, whereas the demand for goods having negative
income elasticity of demand declines when the national income grows. Thus this
income elasticity of demand helps the trade industry in taking proper investment
decisions
b. Forecasting demand – Income elasticity of demand helps in anticipating the
demand for goods in future. If change in income is certain, there would be a major
change in the demand for goods. This is due to the fact that if consumers are
aware of change in income, they may change their tastes and preferences for
certain goods. Further, if the change in income is temporary, there would be a
slow change in the demand.
c. Categorizing goods - Income elasticity of demand helps in classifying goods into
categories such as normal goods, essential goods or inferior goods. This
classification of goods enables producers or sellers to select the goods to be
produced an the quantity of goods to be produced. Further, it also helps the
producers or sellers in identifying the income group to whom the goods need to
be targeted.
Cross Elasticity of Demand
The term Cross Elasticity of Demand is the responsiveness of demand for a product
in relation to the change in the price of another ‘related product’. The important
aspect to be noted here is the word ‘related product’ because unrelated products
have no or zero elasticity of demand. An increase in the price of pulses will have no
effect on the demand for chocolates. The cross elasticity of demand thus depends on
the fact of related product being a substitute product or a complementary product.
The cross elasticity of demand has been defined by Ferguson as, “the proportional
change in the quantity of X good demanded resulting from a given relative change in
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the price of a related good Y.” Thus, cross elasticity of demand can be said to be a
measure of relative change in the quantity demanded of commodity due to change
in the price of its substitute or complementary commodity. The cross elasticity of
demand can be measured in the following manner:

Cross elasticity may be infinite or zero if the slightest change in the price of X causes
a substantial change in the quantity demanded of Y. It is always the case with goods
which have perfect substitutes for another. Cross elasticity is zero, if a change in the
price of one commodity will not affect the quantity demanded of the other. In the
case of goods which are not related to each other, cross elasticity of demand is also
zero.
Types of Cross Elasticity of Demand
a. Positive - when goods are substitute of one another, then cross elasticity of
demand is positive. For example, an increase in the price of coke leads to an
increase in the demand of pepsi.
In this figure, quantity has been measured on 0X
axis and price on 0Y axis. At price 0P for the coke,
demand of Pepsi is 0Q. Now, as the price of coke
increases to 0P1, demand of Pepsi increase to
0Q1. Thus it can be seen that the cross elasticity
Of demand is positive, as there is increase in the
demand for Pepsi, with the increase in the price
of Coke.
b. Negative – in case of complementary goods, cross elasticity of demand is negative.
A proportionate increase in price of one commodity leads to a proportionate fall
in the demand of another commodity because both are demanded jointly. Today,
no one would like to have a smartphone without internet connection. Therefore,
when the rates of Internet were high, demand for smartphone was relatively low
and when the rates of internet fell, demand for smartphones increased.
I In the figure the quantity has been measured
on 0X axis, while price has been measured on
0Y axis. When price (rate) of internet charges
Increases from 0P to 0P1, quantity demanded
of smartphones falls from 0Q to 0Q1. Thus it
can be seen that the cross elasticity of demand
is negative.
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c. Zero – cross elasticity of demand is zero, when two goods are not related to each
other. For instance increase in price of cars does not affect the demand for cloth.
The cross elasticity of demand in this case is zero, as there is no substitutability of
goods.
If substitutability is perfect, then cross elasticity of
demand is infinite; while on the hand, if there is
substitutability, the cross elasticity of demand will
be zero. The figure shows the zero cross elasticity
of demand.

Significance of Cross Elasticity of Demand

Cross elasticity of demand has lot of practical importance in trade and organization,
as it provides solution to various business problems. Some such application of cross
elasticity of demand are as mentioned below:
a. In Production – while making production plan, an organization needs to know the
cross elasticity of demand for its goods while considering the effect of change in
the price of its competitor’s goods on the demand for its own goods.
b. In Demand Forecasting and Pricing – an organization can estimate the potential
impact of pricing decision of its competitors on its sales which can help in preparing
its pricing strategies.
c. In International Trade and Balance of Payment – it significantly helps in the area
of international trade and balance of payments as it helps the Government in
understanding how the change in domestic prices shall affect the demand for
imports.
Advertising or Promotional Elasticity of Demand
In today’s competitive market economy, advertising has a great significance in
creating demand for products and services. The scope of advertising is vast which
includes various visible or verbal promotional activities done using different media
such as print, film, banners, posters, etc. for the purpose of creating awareness and
increasing the demand for its products and services. Thus, informative advertising is
very helpful for the consumer in making rational purchase decisions. The increase in
demand through advertising can be measured by advertising or promotional
elasticity of demand (Ea). Advertising or promotional elasticity of demand (Ea)
measures the expected change in demand as a result of change in other
advertisement and promotional expenses. Thus, advertising or promotional elasticity
of demand refers to the responsiveness of demand to changes in advertising or

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promotional expenses. The demand for some goods is affected more by advertising
such as demand for cosmetics, cold drinks, etc. Following is the formula for
measuring advertising or promotional elasticity of demand :

The value that is derived as a result by using the above formula of measuring the
advertising or promotional elasticity of demand varies from zero to infinity. The
below chart explains the degree of elasticity based on the results of measurement:
Value of Result Description
0 Perfectly Inelastic - increase in advertising has no effect
on the demand of a product
Less than 1 Inelastic –increase in advertising has less or low response
on the demand of a product
1 Unitary – the proportion of increase in advertising is same
Proportion of increase in demand of a product
Over 1 Elastic - increase in advertising has high response on the
demand of a product
Infinity Perfectly Elastic – the increase in advertising keeps on
generating increase in demand of a
product.

However, it is generally observed that advertising or promotional elasticity of

demand is always positive i.e. elastic as advertisements are known to increase
demand and sales.
Significance of Advertising or Promotional Elasticity of Demand
Advertising or Promotional elasticity of demand has many applications in business.
Some such application of Advertising or Promotional elasticity of demand are as
mentioned below:
a. Fixing Total Outlay on Advertisement – it helps an organization evaluate the
budgeted amount to be spend on advertisement and promotions. The
management of an organization can take decision on whether the outlay on
advertisement and promotion needs to be increased, decreased or maintained at
the present existing level.
b. Study effect of Advertising – it helps the management of an organization in
studying the effectiveness of advertisement on their sales revenue, as ultimately
increased demand for a product has direct relationship with sales.

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c. Evaluation of Effectiveness of Media – it also helps the organization in analyzing
and evaluating the effectiveness of various media of advertisement such as the
Print Media like Newspaper, Magazines, Pamplets, etc; Television and Films, Social
media like facebook, whatsapp, etc.

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 Unit III – Factor Pricing and Production Function

Cost and Revenue – Concepts and Curves

Introduction
The process of production requires different factors of production, which have to be
hired and this involves the cost of production. In a money economy, the cost is always
expressed in terms of money, which is easily understood and comparable. Cost can
be said to be the total money expenditure incurred on payment of all factors of
production for their active participation in the process of production.
Cost Concepts
The word ‘cost’ is used in different manner under different circumstances. Hence, it
is the type of business decision that determines the kind of cost concept that needs
to be used in a particular situation. Generally, people think that financial accounting
costs are practically useful for all kinds of business decisions as they are actual in the
sense that they are routinely recorded. However, it is not true at all times, according
to Prof. Joel Dean, “Cost concept differs because of differences in view point.
Financial records aim at describing what was, whereas the useful decision making
concepts of cost aim at projecting what will happen under alternative course of
action. These special purpose costs differ from ‘actual costs’ in content as well as
view point. Cost considerations enter into almost every business decision and it is
important though sometimes difficult to use the right kind of cost.”
Universally, there is no useful system for classification of cost. Prof. Joel Dean has
given about ten different cost classifications. They are not all mutually exclusive,
however it should also be remembered that cost classification used by Cost
Accountant are not usually the same as that used by the Economist because in many
cases their purposes differ. Some of the more useful cost concepts are discussed
herein below:
1. Opportunity and Outlay Costs
Opportunity costs are the costs of ‘displaced alternatives’. They represent the
sacrificed alternatives (i.e. cost of available option / alternative that was not selected)
and hence, are not recorded in any financial accounts. We have unlimited wants but
unfortunately the resources to satisfy them are limited. Therefore, one has to forego
one want for the sake of other i.e. for every satisfied want there is another
unsatisfied want. Thus the opportunity cost of any good is ‘the next best alternative
good that is sacrificed’. Hence, opportunity costs are also known as alternative costs.
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 As per Prof. Frederic Benham “opportunity cost of anything is the next best
alternative that could be produced by the same factors or by an equivalent group of
factors costing the same amount of money.” For example a piece of land can be used
to produce both paddy and sugarcane. Now if sugar is considered as the next best
alternative and the land is used to produce paddy, then the opportunity of producing
sugar is lost. Which means that non production of sugar becomes the opportunity
cost of producing paddy.
Outlay costs on the other hand are those costs which involve financial expenditure
at some time and are recorded in the books of account. Outlay costs are regarded
appropriate when there is an opportunity to buy all input factors for cash. Outlay
costs are also known as Actual costs, they consist of actual expenses in hiring land,
labor capital and management.
The difference between Opportunity and Outlay costs is based on the nature of
sacrifice.
2. Past and Future Costs
Past cost as the name suggests are those costs which have been actually incurred in
the past and have been, therefore recorded in the books of accounts. Such costs may
have been incurred on purchase of various items like land, building, machinery, etc.
Past costs can be defined as “those costs which have been actually incurred in the
past and generally find place in the income statements”. The measurement of past
costs is essentially a record keeping activity and an essentially passive function of the
management. Past costs can be observed and evaluated for the purpose of review.
In case past costs are considered to be excessive or higher, management can conduct
only the post mortem of these costs just to know the factors responsible for their
excessiveness for future guidance. The management cannot do anything to reduce
them as they are already incurred.
Future costs are such costs that are likely to be incurred in future periods. Future
costs are the most important costs as most of the executive decisions of the
management are always forward looking i.e. for the future. Since future is uncertain,
these costs are only estimations and not accurate figures. Projections and
estimations of future costs are based on the past costs. As future costs are yet to be
incurred they can be controlled and planned to avoid excessive spending. Future
costs are useful for a variety of managerial purposes such as cost control, pricing,
projection of future profits, introduction of new product, expansion and
diversification programme, capital budgeting, etc.
The difference between Past and Future costs is based on the degree of anticipation.
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3. Traceable and Common Costs
Traceable costs also known as direct costs are those costs which can be identified
easily without any dispute to the unit of operation. These costs can be attributed to
a product, unit of operation, department or a process. Wages of labor engaged in the
production of a particular product, cost of raw material used, direct supplies and
costs varying with the scale of operations, etc. are all direct costs or traceable costs
of that product. Traceable or direct costs directly enter into the cost of production
but retain their separate identity.
Common costs also known as indirect costs or non-traceable costs are such costs
which cannot be traced or assigned to any particular product or unit of operation or
plant / department. Unlike traceable costs, these costs cannot be attributed to a
product, unit of operation, department or a process. According to Prof. Joel Dean,
“Common costs are used broadly to cover costs that are not traceable to plant,
department and operation as well as those that are not traceable to individual final
products”. For example, Salary of Office Staff, Expenses of the Board of Directors of
a company, etc. cannot be easily and undisputedly separated product-wise,
department-wise or process-wise, etc.
The difference between Traceable and Common costs is based on identification and
assignment of costs.
4. Money and Real Costs
Money costs refers to the total amount of money spent for producing a commodity
in a specific period of time. It includes both explicit costs (i.e. all contractual payments
made to factors of production such as wages to labor, rent to land owner, interest on
borrowings, purchase of raw material, fuel and power, taxes, etc.) and implicit costs
(i.e. notional costs which are non- expenditure costs such as normal return on an
entrepreneur’s own capital, Salary of entrepreneur’s for his services, etc,)
Real costs are such costs which cannot be expressed in monetary terms, it is a
subjective term to denote the efforts, exertions, sacrifice, etc. made by various
people in the production of a commodity. The term ‘Real costs’ was originally
developed by J S Mill and later Prof. Marshall further developed it. Prof. Marshall
defines Real costs as “the exertion of all different kinds of labor that are directly or
indirectly involved in making the commodity, together with the abstinence or rather
the waiting required for saving the capital used in making it, all these efforts and
sacrifices together will be called the real cost of production”. Thus it states that
money rewards are paid to factors of production to compensate for their efforts and
sacrifices for eg. Workers put efforts and undergo some exertion in the production
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of a commodity, Capitalists have to sacrifice their present consumption in order to
save and provide their savings as capital for production, Entrepreneur has to wait for
the returns from his business, etc. All these together constitute the real cost of
production.
The difference between Money and Real costs is based on the terms of expression.
Due to large criticism on measurement of real cost, for all practical purpose money
cost is considered over real cost.
5. Out of Pocket and Book Costs
Out of Pocket costs also known as explicit costs are defined as “those costs which
involve immediate and current payments to outsiders in cash”. Such costs may be
recurring as well non- recurring in nature for eg. wages, salaries, rent, purchase of
machinery, etc.
Book costs are implicit costs which do not require current cash expenditure. Business
expenses such as depreciation, interest due but not paid, salary of proprietor, etc.
These costs are such business costs for which no cash payments need to be made,
only provision entries are made in the books of accounts. It is possible to convert
book costs into out of pocket costs by selling assets or having them on hire. For eg.
Instead of buying and owning a vehicle and claiming depreciation in the books of
account as book cost, vehicle can be hired and book costs can be converted into Out
of pocket costs, as vehicle hire charges or rent shall replace depreciation.
The difference between Out of Pocket and Book costs is based on explicit and implicit
costs.
6. Incremental and Sunk Costs
Incremental costs refer to the additional costs incurred due to change in the level or
nature of activity. A change in the activity may occur in various forms such as addition
of a new product, change in distribution channel, expansion of market area, addition
of new machine, etc. Conceptually, though incremental cost is closely related to
marginal cost, it has much wider meaning. Incremental cost refers to the total
additional cost associated with additional batch of output units, while Marginal cost
refers to the cost producing one more unit of output.
Sunk costs are the costs which cannot be altered, increased or decreased, even after
change in the level or nature of business activity. They are also known as Specific
costs. These costs have already been incurred and cannot be recovered. A
manufacturing firm may have a number of sunk costs, such as cost of plant and
machinery, equipment, etc. Sunk costs are excluded from future business decisions
as this cost will be the same regardless of the outcome of a decision.
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While comparing incremental and sunk costs it is seen that incremental costs are very
useful for taking business decisions, as sunk costs are not that relevant in the business
decision making process.
7. Escapable and Unavoidable Costs
Escapable costs are such costs that can be avoided or reduced, as per the
requirement of business due to market or any other conditions and compulsions.
Escapable costs are also known as decrement costs. For eg. Staff costs of unprofitable
branch can be avoided by closure of branch operations.
Unavoidable costs are the costs which cannot be avoided and continue to exist
irrespective of contraction or reduction of business activities of the firm. Costs on
these type of expenses need to be incurred. For eg. Salary of General Manager cannot
be reduced even if one of the unprofitable branch is closed.
The difference between escapable and unavoidable costs is based on the reduction
of business activity.
8. Shut-down and Abandonment Costs
Shut down costs are those costs which would be incurred in the event of suspension
or closure of plant activities that would be saved, if the operations are continued. For
eg. Dismantling, removing and shifting of machinery, construction of temporary shed
to store machinery spares and parts, etc. Further shut down cost also includes the
additional expenditure that may have to be incurred when operations are re-started
in setting up the plant, re-employment of employees and their training, etc.
Abandonment costs are the costs of retiring a plant or machinery from service.
Abandonment arises when the operation of an asset is completely ceased / stopped.
Operation of an asset are completely stopped due to various reasons such as high
operating costs, low/ no demand for product, environmental issues, obsolesce of
machinery or process, changes in technology, etc. For eg. Mining activities were
completely banned in Goa due to environmental reasons, as a result many mining
machinery and equipment were abandoned. Abandonment of assets leads to the
problem of disposal/ sale of such assets.
9. Controllable and Non-Controllable Costs
Controllable costs are such costs that can be controlled reasonably by an executive
as they are subject to regulation by him as the management has given in this
authority and responsibility. The controllability of a particular cost depends on the
level of management. The cost which cannot be regulated at the lower level of
management may be regarded as controllable at some other level of management.

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Non-controllable costs on the other hand are such costs which are not subject to
regulation by the executive and hence cannot be controlled.
Direct material and labor are controllable costs, while overhead costs are
uncontrollable.
10. Replacement and Historical Costs
Replacement costs are those cost of assets which are computed at the current prices
i.e. at prices that would have to be paid currently to acquire the same assets. In other
words, this costs denotes the cost that needs to be incurred in the present time to
purchase such assets that were purchased earlier.
Historical costs refers to the purchase value of the assets. It can be said to be the
amount originally spent to acquire the assets. Generally, historical costs are used by
the conventional financial accounts.
11. Urgent and Postponable Costs
Urgent costs are such costs that need to be incurred immediately for running the
business activity. Certain costs cannot be differed or postponed as it is an important
part of the business operation for e.g. if a firm has to continue its production
operations, then cost of material and labor can be said to urgent costs as
postponement of the same is not possible since it will affect the production.
Postponable costs are such costs that can be delayed or postponed for atleast
sometime. Costs which do not affect directly affect the business operations /
activities can be postponed and incurred at a later period. For e.g. Painting of factory
building, repair of office furniture, etc.
12. Private and Social Costs
Private costs are the costs faced by the producer or consumer directly involved in a
transaction. For the producer, private cost includes direct cost of labor, material, fuel,
power and other indirect overheads. In other words for a firm private cost would be
the direct cost of production only it does not include externalities as firm do not have
to pay for damages resulting from pollution which they generate. While in case of
consumer, private costs are those costs that they actually have to pay.
Social costs refers to the total costs to society on account of production or
consumption activity. Social costs are private costs borne by individuals directly
involved in a transaction with the external costs borne by third parties who are not
directly involved in the transaction. Hence, Social cost = Private cost + External cost.
For eg. A person wants to own and drive a car. For this he has to buy the car, pay for
the petrol, insurance and maintenance. The sum total of all these expenses incurred
by the person is known as private cost that he has o bear for owning and driving a
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car. However, the resulting externalities of the person driving car such as contributing
in polluting the atmosphere to some extent, adding to traffic congestion, etc. are not
borne by the person, but it affects other people of the society. This cost is known as
social costs which members of the society have to bear.
13. Short run and Long run Costs
Short run costs are those costs which are adaptable partially to changes in the rate
of output, as some input factors of production like plant, machinery, etc. are assumed
to be fixed and hence not capable of immediate adaption to changes in the rate of
output. In short run costs vary partially with the rate of output as there is no scope
to vary the factors of production due to shortage of time.
Long run costs are those costs which are completely adaptable to changes in the rate
of output, as some input factors of production like plant, machinery, etc. are variable
that can easily adapt to changes in the rate of output. The main reason for long run
costs to be adaptable is the ample scope of time which it has for changing all the
factors of production.
14. Fixed and Variable Costs
Fixed costs are those costs that do not change with output. The nature of these is
fixed and such costs have to be incurred even when there is no output. For eg. Costs
incurred on account of expenditure such as factory rent, Interest on loan, etc.
remains the same, irrespective of the quantity of production. Fixed costs are also
known as constant costs, supplementary costs or overhead costs. Since fixed costs
are not affected by changes in the volume of production, there exists an inverse
relationship between the volume of production and fixed costs per unit.
Variable costs are those costs that vary directly with the size of output. These costs
are also known as Prime costs or Direct costs. These costs consist of wages paid to
labor, payment made for purchase of raw material, etc. With the increase in the
volume of output, the total variable costs also increase proportionately. Thus, there
exists a linear relationship between the volume of output and variable costs.
There are many costs which are neither perfectly variable nor absolutely fixed in
relation to the changes in the size of output. These type of costs are known as semi-
variable costs. For e.g. salary of salesman may consist of both components viz.
monthly salary that is fixed and commission based on sales quantum which is
variable.
15. Total Cost, Average Cost and Marginal Cost
Total cost of production means the total monetary expenses incurred for buying the
input required for producing a commodity or a service. It includes all payments made
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towards various factor of production and all those charges which would have
otherwise been paid for the use of owner’s factor of production in producing a
commodity or a service. For e.g. a carpenter’s total cost of producing chairs will
include the amount he spends on wood, nails, fevicol, polish, labor, rent for his
premises, interest on capital and the amount for services rendered by him.
Average cost refers to the unit cost of production i.e. cost per unit of production. The
Average cost is ascertained by dividing the Total Cost of Production by the number
of units produced i.e. the quantity of production. Thus Average cost can be
formulated as follows

Where, AC stands for Average Cost, TC denotes Total Cost and Q implies the Quantity
of output produced. For e.g. a Carpenter spends Rs.12,000 for producing 10 chairs,
the average cost of production will be

Marginal Cost is the additional cost of producing one more unit of output. It is the
net addition made to the total cost of production by producing one more unit of
commodity. Since fixed costs remain fixed over a considerable range of output, they
do not affect the marginal costs. Thus marginal cost are independent of fixed costs
and are associated only with the variable costs. The fact that marginal cost is
independent of fixed cost is explained below:
MC(n) = TC(n) – TC (n-1)
= [TVC(n) + TFC] – [TVC(n-1) + TFC]
= TVC(n) –TVC (n-1)
Where, n stands for any volume of output, MC denotes Marginal Cost, TC indicates
Total Cost, TFC means Total Fixed Cost and TVC stands for Total Variable Cost.
Relationship between Marginal Cost and the Average Cost of Production
Average cost and marginal cost of production are related to each other in the
following manner:
When Average Cost is Marginal Cost is
- Falling Less than the average cost
- Constant Also constant
- Increasing More than average cost
The relationship Average cost and marginal cost of production is explained with the
help of example
a. When average cost is falling, marginal cost is less than average cost
Units of Output Total Cost Average Cost Marginal Cost
1 8 8 -

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 2 14 7 6
3 18 6 4
4 20 5 2
b. When average cost is constant, marginal cost is also constant
Units of Output Total Cost Average Cost Marginal Cost
1 8 8 -
2 16 8 8
3 24 8 8
4 32 8 8
c. When average cost is increasing, marginal cost is more than average cost
Units of Output Total Cost Average Cost Marginal Cost
1 8 8 -
2 18 9 10
3 30 10 12
4 44 11 14
This relationship between average cost and marginal cost is further represented
graphically.
Initially, average cost curve (AC) is decreasing
hence, marginal cost is less than the average
cost, which shown by MC curve that is below
the AC curve. When the MC curve lies above
the AC curve, the average cost of production
is increasing. When average cost of product-
-ion is constant, MC curve cuts the AC curve
at a minimum point marked as ‘K’ – where
both average and marginal cost are equated.

The usefulness of these three concepts of costs i.e. Total cost, Average cost and
Marginal cost lies in the fact that they are considered as tools of analyzing the break
even position, per unit profit and decision making at the firm level respectively. While
making a decision related to expansion or reduction of production, the marginal and
incremental cost concept in decision making would depend to a large extent on the
circumstances and the type of problem faced by the firm.
Cost Curves / (Cost Output Relationship)
Cost Curve basically is a graph that shows how the firm’s cost change with change in
output. Cost output relationship has very strategic importance in the economic
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analysis as the behavior of cost is estimated to a large extent directly by changes in
the size of the output. In a free market economy, productively efficient firms optimize
their production process by minimizing cost consistent with each possible level of
production and the result is a cost curve. Profit maximizing firms use cost curves to
decide output quantities. The relation between cost and output is technically
described as cost function. In economic theory there are two main types of cost
functions viz. (i) the short run cost function and (ii) the long run cost function. As the
cost curves are based on cost function, they are also divided into two main categories
viz. short run curve and long run curve.
Cost Curves in Short Run
The cost of the firm in the short run are divided into fixed costs and variable costs.
Fixed costs are such costs which are independent of output and have to be incurred
irrespective of the size of output whether it is large or small. Such costs continue to
occur even when the firm is temporarily shut down. It is the variable costs that keep
changing with the change in output. The total variable cost goes on increasing with
the increase in output and vice versa. Thus, the cost of production in short run
consists of both fixed and variable costs. The cost output relationship which is shown
by the average cost curve, in the short run consists of Average Fixed Cost (AFC) and
Average Variable Cost (AVC).
Average Fixed Cost (AFC) Curve
The Average Fixed Cost (AFC) is the fixed cost per
unit of output, it is higher at small levels of output
and lower at higher levels of output. This is shown
in the adjacent curve. The AFC curve is thus seen
to be in the shape of rectangular hyperbola.

Average Variable Cost (AVC) Curve

Since the variable costs vary with the size of the
Output of the firm, the Average Variable costs i.e.
the per unit variable cost will be rising after certain
point. They will not change to a very great extent
as output rises from zero to normal capacity of the
plant. After, the normal capacity, any further rise
in output leads to sharp increase in AVC. Therefore
the AVC curve first declines and then it starts rising
as shown in the adjacent graph.

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Average Total Cost (ATC) Curve
Since Total Cost (TC) = FC + VC in the short run, the
ATC = AFC + AVC. The ATC curve in the graph shows
the cost output relationship. In the short run, the
average cost of a firm declines to a minimum and
then rises again. The extent of decline depends on
the proportion of fixed cost to total costs. In any
event the shape of average total cost curve (ATC)
is U – shaped in short run. The sides of the curve
are steep.

Cost Curves in Long Run

The term Long run refers to a long period of time where any kind of change is
possible. In short run period, cost is divided into fixed cost and average cost. In the
long run period, there are no fixed costs, as all costs are variable in this long run
period. Long run can be defined as “the period during which supply has got enough
time to adjust itself to any change in demand and it is the period during which all
factors of production are variable”. As all costs are variable, the scale of production
also undergoes change. Hence, during long run cost curves are subject to Law of
Returns to scale as against the short run cost curves which are subject to Laws of
Variable Proportions.
The long run cost –output relationship is shown by drawing a long run cost curve
through short run curves as the long period is made up of many short periods just
like the day is made of twenty four hours. In this regard, Prof. Watson states that,
“The short run and the long run are not definite periods of calendar time. Strictly
speaking, they are set of conditions, not periods of time at all. Still it is almost
impossible to keep the idea of time out of analysis of the short run and long run. Even
if it is never mentioned calendar time lurks in the background”.
In this figure for each scale of operation, a
short run average curve is drawn. When
all these curves are combined, long run
cost curve is obtained. The long run cost
curve according to traditional economic
analysis is also U shaped, but it is flattened
U shaped. However, this type of curve will
exist only when the state of technology
remains constant.
Revenue – Concepts and Curves
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Revenue in simple words, is the amount that a firm receives from the sale of output.
According to Prof. Dooley, “The revenue of a firm is its sales receipts or income”.
Revenue is a very important concept in economic analysis. It is directly influenced by
sales level for e.g. as sales increases, revenue also increases. The concept of revenue
consists of four important terms as mentioned below:
a. Total Revenue
b. Average Revenue
c. Marginal Revenue
d. Incremental Revenue

a. Total Revenue (TR): Total Revenue refers to total receipts from the sale of a given
quantity of commodity. It is the total income of a firm. Total revenue is obtained
by multiplying the quantity of the commodity sold with the price of the
commodity. Thus, Total Revenue (TR) = Quantity X Price. For e.g. if a company sells
10 sets of sofa set at a price of Rs.16,000 per sofa set, then the total revenue of
the firm will be 10 x Rs.16,000 = Rs.160,000.
b. Average Revenue (AR): Average Revenue refers to revenue per unit of output sold.
It is obtained by dividing the total revenue by the number of units sold. Thus
Average Revenue (AR) = Total Revenue (TR) / Quantity. For e.g. if total revenue
from the sale of 10 sofa sets @ Rs.16,000 per sofa set is Rs.160,000 then, Average
Revenue (AR) = Rs.160,000 / 10 = Rs.16,000 . It can be seen that AR and Price are
same. AR is equal to per unit sale receipts and price is always per unit. Since sellers
receive revenue according to price, price and AR are one and the same thing. It can
be thus said that,
TR = Quantity x Price ……. (1)
AR = TR/ Quantity ……..(2)
Putting the value of TR from equation (1) in equation (2), we get
AR = Quantity x Price / Quantity
Thus AR = Price
c. Marginal Revenue (MR): Marginal Revenue is the additional revenue generated
from the sale of an additional unit of output. It is the change in TR from sale of
one more unit of a commodity.
MRn = TRn – TRn-1
Where, MRn = Marginal revenue of the nth unit.
TRn = Total revenue from n units.
TRn-1= Total revenue from (n-1) units. n= number of units sold.
For e.g. if the total revenue realized from sale of 10 sofa sets is Rs.16,000 and that
from the sale of 11th sofa set is Rs.17,600 then MR of the 11th sofa set will be

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 MR11 = TR11 - TR10
MR11 = Rs.17,600 – Rs.16,000 = Rs.1600
d. Incremental Revenue (IR): incremental revenue is the difference between the
total revenue and the existing total revenue. It is different than marginal revenue
as this revenue is the difference between the old revenues and the new total
revenues. It measures the impact of decision alternatives on the total revenue.
IR = R2 – R1
Where, IR = Incremental Revenue, R2 = new total revenue and R1= old total
revenue.
Relationship between AR and MR under different Market Conditions:
Under Perfect Market: Under perfect competition, an individual firm cannot by its
own actions influence the market price. The market price is influenced by the
interaction between the demand and supply forces. A firm can sell any amount of
goods at the existing market prices. Hence, the TR of the firm shall increase
proportionately with the output offered for sale. When the total revenue increases
in direct proportion to the sale of output, the AR would remain constant. Since the
market price of it is constant without any variation due to changes in the units sold
by the individual firm, the extra output would fetch proportionate increase in the
revenue. Hence, MR and AR will be equal to each other and remain constant. This
will be equal to price.
No. of Units Sold (Q) Price per Unit (P) TR = P/Q AR = TR/Q MR = TRn – TRn-1
1 8 8 8 8
2 8 16 8 8
3 8 24 8 8
4 8 32 8 8
5 8 40 8 8

Under perfect market conditions, the AR

curve will be horizontal straight line and
parallel to OX axis. It is because firm has
to sell its product at the constant existing
market price. The MR curve also coincides
with the AR curve. It is because additional
units are sold at the same constant price
in the market. Hence, AR = MR = Price.
Under Monopoly Market: Under monopoly, the relation between TR, AR and MR is
different. In the monopoly market, supplier firm decides or fixes the price. However
even then, the firm has to reduce the price to sell more quantity of a product. The
following table shows the revenue schedule

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 No. of Units Sold (Q) Price per Unit (P) TR = P/Q AR = TR/Q MR = TRn – TRn-1
1 10 10 10 -
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2

From the above table it can be seen that

in order to increase the sales, the firm is
reducing its price, hence AR also falls; TR
is increasing but at a diminishing rate AR
and MR both decline but, the fall in MR is
greater than fall in AR. Under monopoly
also AR = price. AR and MR curves slope
downwards from left to right. But the MR
curve falls on left side of AR curve because
fall in MR is greater than fall in AR.
Innovation Theory of Profit
The Innovation Theory of Profit was proposed by Joseph A Schumpeter, who believed
that an entrepreneur can earn economic profits by introducing successful
innovations. In other words, as per innovation theory of profits the main function of
an entrepreneur is to introduce innovations and the profit in the form of reward is
given for his performance. According to Schumpeter, innovation refers to any new
policy that an entrepreneur undertakes to reduce the overall cost of production or
increase the demand for his products.
Innovation can be classified into two categories. The first category includes all those
activities which reduce the overall cost of production such as the introduction of a
new method or technique of production, the introduction of new machinery,
innovative methods of organizing the industry, etc. The second category of
innovation includes all such activities which increase the demand for a product. Such
as the introduction of a new commodity or new quality of goods, emergence or
opening of a new market, finding new sources of raw material, new variety or design
of product, etc.
The innovation theory of profit suggests that the entrepreneur gains profit if his
innovation is successful either in reducing the overall cost of production or increasing
the demand for his product. Often the profits earned are for a shorter duration as
the competitors imitate the innovation, thereby ceasing the monopoly position or
the advantage in the market as the innovation was confined to himself and was
earning larger profits. But at the same time with others copying the innovation, the

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profits start reducing and disappearing. However, an entrepreneur can earn larger
profits for a long duration if the law allows them to patent the innovation.
In a dynamic world innovation in one field may induce other innovations in related
fields. For e.g. emergence of motor car industry may in turn inspires new investments
in the construction of highways, petroleum products, etc. Profit therefore, is the
cause and effect of innovation. Profit motivates and leads an entrepreneur to
innovate and innovation leads to profit. Thus, profit has a tendency to appear,
disappear and reappear. Profits are caused by innovation and disappear by imitation.
Innovational profit is thus, never permanent, in the opinion of Schumpeter.
Criticisms:
a. This theory concentrates only on innovation, which is only one of the many
functions of the entrepreneur and not the only factor.
b. This theory does not consider profit as the reward for risk taking. According to
Schumpeter it is the capitalist not the entrepreneur who undertakes risk.
c. The theory has ignored the importance of uncertainty bearing which is one of the
factors that determines profit.
d. This theory attributes profits only to innovation ignoring other functions of
entrepreneur.
e. Monopoly profits are permanent in nature while Schumpeter says that innovate
profits occur temporarily.
f. This theory has presented a very narrow view of the function of the entrepreneur.
He not only introduces innovation but he is equally responsible for proper
organization of the business. As such profit is not merely due to innovation, it is
also due to organizational work performed by the entrepreneur. Since it is well
known fact that every entrepreneur does not innovate and yet he must earn profit
to stay in the business.
g. This is an incomplete theory because it fails to explain all factors that influence
profit.
Risk and Uncertainty Theory of Profit
The Knight’s theory of profit was proposed by Frank H Knight who believed profit as
a reward for uncertainty-bearing, not to risk bearing. In simple words profit is the
residual return to the entrepreneur for bearing the uncertainty in business.
Knight had made a clear distinction between the risk and uncertainty. The risk can be
classified as a calculable and non- calculable risk. The calculable risks are those whose
probability of occurrence can be anticipated through a statistical data. Such as risks
due to fire, theft or accident are calculable and hence can be insured in exchange for
a premium. Such amount of premium can be added to the total cost of production.

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While non-calculable risks are those whose probability of occurrence cannot be
determined. Such as the strategies of a competitor cannot be accurately assessed as
well as the cost of eliminating the completion cannot be precisely calculated. Thus
the risk element of such events is not insurable. This incalculable area of risk is the
uncertainty.
Due to the uncertainty of events, the decision making becomes a crucial function of
an entrepreneur or manager. If the decisions prove to be correct by the subsequent
events, an entrepreneur makes profit and vice versa. Thus, the Knight’s theory of
profit is based on the premise that profit arises out of the decisions made under the
conditions of uncertainty.
Loanable Funds Theory of Interest
The neo classical or loanable funds theory of interest explains the determination of
interest in terms of demand and supply of loanable funds or credits. Initially, this
theory was developed by Wicksell and later was elaborated by Ohlin, Robertson,
Pigou and other new classical economists. According to this theory, the rate of
interest is the price of credit which is determined by the demand and supply for
loanable funds. In the words of Prof. Lerner, “it is the price which equates the supply
of ‘credit’ or saving plus the net increase in the amount of money in a period to the
demand for ‘credit’ or investment plus net ‘hoarding’ in the period.” Let us study
demand and supply aspects of loanable funds.
Demand for Loanable Funds
The demand for loanable funds has primarily three sources viz. government,
businessmen and consumers, who need them for the purpose of investment,
hoarding and consumption. The government borrows funds for construction of
public works, administration and security of the state/ country. The businessmen
borrows for the purchase of capital goods, starting of new business venture, etc. Such
borrowings are interest elastic and depend mostly on the expected rate of profit as
compared to the rate of interest. The consumer borrows for purchase of durable
goods like house, vehicle, etc. These borrowings are also interest elastic. The
tendency to borrow is more at a lower rate than at a higher rate in order to enjoy
their consumption soon.
Since this demand for funds is mostly met
out of past saving it is represented by the
curve DS. The demand curve for investment
for government and businessmen is shown
as curve I. It slopes downward showing that
less funds are borrowed at higher rate and
more at lower rate of interest. The curve H

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shows that funds borrowed for hoarding are also elastic. From the lateral summation
of all these curves. Viz. H, DS and I, give aggregate demand for loanable funds ΣD.
Supply of Loanable Funds
The supply of loanable funds comes from sources such as saving, dishoarding (i.e.
breaking savings) and bank credit. Though personal savings depend upon the income
level, yet taking the level of income as given, it is regarded as interest elastic. Because
higher the rate of interest, the greater will be the inducement to save and vice versa.
Corporate savings are the undistributed profits of the firm which also depend upon
the current rate of interest to some extent. In the above figure, saving curve is
indicated as S. The second source of supply is dishoarding – which means utilization
of idle cash. These funds are directly related to the rate of interest. Higher the
interest rate, larger the funds that will come out of hoardings and vice versa. These
funds are represented by the curve DH in the above figure. Lastly Bank credit i.e. loan
/ finance from bank is another important source of funding. Bank credit is also
interest elastic to some extent. More funds are lent at higher rate of interest than at
lower rate. Bank credit curve is shown as M and if all these curves viz. DH, M and S
are laterally added up we have the aggregate supply curve ΣS of loanable funds.
Determination of the Rate of Interest
When the total demand curve for loanable funds ΣD and the total supply curve of
loanable funds ΣS intersect each other at point E, OR rate of interest is determined.
Further, OQ shows the amount of funds borrowed and lent at this rate of interest i.e.
at the rate of OR.
Criticisms to Loanable Funds Theory of Interest
Though Prof. Robertson feels the loanable funds theory is a ‘commonsense
explanation’ of determination of the rate of interest, it does have certain defects for
which it has been criticized. Following some of the major criticisms:
a. Equilibrium rate reflects unstable equilibrium: the demand and supply schedules
for loanable funds determine the equilibrium rate of interest OR which does not
equate each component on the supply side with the corresponding component
on the demand side. Thus the equilibrium rate OR reflects unstable equilibrium.
For stable equilibrium it is important that planned investment must equal planned
saving at the equilibrium rate OR. In the above figure it is seen that planned
savings S exceeds planned investments I by AB. It is also seen that they are equal
at point E1 but at a lower interest rate OR1.
b. Indeterminate Theory: Prof. Hansen states that the loanable funds theory like the
classical theory and the Keynesian theory of interest is indeterminate. The supply
schedule of loanable funds is comprised of savings, dishoarding and bank credit.
But since savings vary with past income and new money along with activated
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 balances with current income, it follows that the total supply schedule of loanable
funds also varies with income. Thus the loanable fund theory is indeterminate
unless the income level is already known.
c. Cash Balance not elastic: The loanable funds theory states that the supply of
loanable funds can be increased by releasing cash balances of savings and
decreased by absorbing cash balances into savings. This implies that cash balances
are fairly elastic. However, this does not seem to be the correct view because the
total cash balance available with the community are fixed and equal the total
supply of money at any time. Whenever there are any variations in the cash
balances, they are in fact in the speed of circulation of money rather than in the
amount of cash balances with the community.
d. Savings Interest Inelastic: the theory over emphasizes the influence of the rate of
interest of savings and regards savings as interest inelastic. Generally people save
not to earn interest but to satisfy precautionary motive by safeguarding their
future. Hence, while doing savings the primary concern of a person is to secure
their future, rather than earn money by way of interest. Therefore, it can be said
that savings are interest inelastic.
e. Wrong to combine Real and Monetary factors: the loanable funds theory
combines monetary factors with real factors. It is not correct to combine real
factors like saving and investment with monetary factors like bank credit and
dishoarding without bringing in changes in the level of income. This makes the
theory unrealistic.
Superiority of Loanable Funds Theory of Interest over Classical Theory
Despite criticisms and weakness, the loanable funds theory is better and realistic
than the classical theory on various counts. Following are some of those:
a. The classical theory is a real theory of interest which neglects the monetary
influences on interest. With the inclusion of real as well as monetary factors, the
loanable funds theory becomes superior to the classical theory.
b. The classical theory does not consider the role of bank credit as a constituent of
money supply influencing the rate of interest which is an important factor in the
loanable funds theory.
c. The classical theory ignores the role of hoarding. The inclusion of desire to hoard
money in the demand for loanable funds makes the loanable funds theory more
realistic.
d. The classical theory considers money merely as a veil i.e. a cover/ protection
which passively influences the rate of interest. While loanable funds theory is
superior as it considers money as an active factor in the determination of rate of
interest.
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Liquidity Preference Theory of Interest
Keynes defines the rate of interest as the reward of not hoarding but the reward for
paring with liquidity for the specified period. It is not the price which brings into
equilibrium the demand for resources to invest with the readiness to abstain i.e. stay
away from consumption. It is the price which equilibrates the desire to hold wealth
in the form of cash with the available quantity of cash. In other words, the rate of
interest in the Keynesian sense, is determined by the demand for and the supply of
money.
Supply of Money
Out of the two determinants of the interest, the supply of money refers to the total
quantity of money in the country for all purposes at any time. Though the supply of
money is a function of the rate of interest to a degree, yet it is considered to be fixed
by the monetary authorities, that is, the supply curve of money is taken as perfectly
inelastic.
Demand for Money
For the second determinant, the demand for money, Keynes made use of the term
‘liquidity preference’ by which his theory of interest is commonly known. Liquidity
preference is the desire to hold cash. The rate of interest according to Keynes is the
“premium which has to be offered to induce people to hold the wealth in some form
other than hoarded money”. The higher the liquidity preference, the higher will be
the rate of interest that will have to be paid to the holders of cash to encourage them
to give away their liquid assets. The lower the liquidity preference, the lower will be
the rate of interest that will be paid to the cash holders.
According to Keynes, there are three motives behind the desire of the people to hold
liquid cash – a. Transaction motive, b. Precautionary motive, and c. speculative
motive.
a. Transaction Motive: it relates to the “need of cash for current transactions of
personal and business exchanges”. Transaction motive is further divided into
income and business motives. The income motive is meant to bridge the interval
between receipt of income and its disbursement. Business motive on the other
hand means the interval between the time of incurring business costs and that of
the receipt of the sale proceeds. If the time between incurring of expenditure and
receipt of income is small, less cash will be held by the people for current
transactions and vice versa. There will however, be changes in the transactions
recipients and businessmen. They depend upon the level of income, employment
and prices, the business turnover, normal period between receipt and
disbursement of income, amount of salary or income and possibility of getting a
loan.
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b. Precautionary Motive: it relates to the “desire to provide contingencies requiring
sudden expenditures and for unforeseen opportunities of advantageous
purchases”. Individuals as well as businessmen keep cash in reserve to meet
unexpected needs. Basically individuals keep reserve cash to provide for illness,
accidents, loss of job, unemployment, etc. Similarly, businessmen keep cash in
reserve for meeting unfavorable conditions or to take advantage of unexpected
deals. The precautionary demand for money depends upon the level of income,
business activity, opportunities, availability of cash, etc. According to Keynes, the
transaction and precautionary motives are relatively interest inelastic but are
highly income elastic.
c. Speculative Motive: Money held under speculative motive is for “securing profit
from knowing better than market what the future will bring forth”. The excess
funds with Individuals and businessmen, after keeping aside enough money for
transactions and precautionary purposes can be used to invest in bonds, to make
more gains. Bond prices and the rate of interest are inversely related to each
other. Low bond prices are indicative of high interest rates and vice versa.
According to Keynes, it is the expectations about change in bond prices or in the
current market rate of interest that determine the speculative demand for
money.

Determination of the Rate of Interest

Like price of any product or service, the rate of interest is determined at a level where
the demand for money equals the available supply of money.
In the adjacent figure the vertical line Q1M
represents the supply of money and L total
demand for money curve. Both intersect at
E where the equilibrium rate of interest OR
is established. If there is any deviation from
this equilibrium position, a adjustment will
take place via the rate of interest and the
equilibrium level E is re-established as E1.
The E1 position of equilibrium is unstable
as the supply of money OM is greater than demand for money OM1. Consequently,
the rate of interest will start declining from OR1 till the equilibrium rate of interest
OR is reached. Similarly, at OR2 level of interest rate the demand for money OM2 is
greater than the supply OM. As a result the rate of interest OR2 will start rising till it
reaches equilibrium rate OR. If the supply of money is increased, but the Liquidity
curve L remains the same, the rate of interest will fall. This can be seen in the below
given figure.
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 Given the L curve, supply of money curve
being QM, the rate of interest is R5. With
increase in supply of money from QM to
Q1M1 and Q2M2, rate of interest falls from
OR5 to OR3 to OR2. But further, increase
in supply of money however, has no effect
on rate of interest because the liquidity
curve L is perfectly elastic at OR2 rate of interest. So when the supply of
money increases to Q3M3 the rate of interest remains stationary at OR2
corresponding to equilibrium E3.
Criticisms to Liquidity Preference Theory of Interest
The Keynesian theory of interest has been severely criticized by several economists
such as Hansen, Robertson, Knight, Hutt and others. The criticism to this theory were
account of the following:
a. College Bursar’s theory: one of the fallacies or misconception about this theory is
that the demand for money is mostly associated with liquidity preference for the
speculative motive to which the rate of interest is brought directly into touch. The
theory presumes the existence of number of wealthy and shrewd people who will
hold money by selling bonds when the rate of interest falls and hold less cash but
more bonds in the case of rise in the interest rate. But Robertson does not regard
bonds as the only alternative to money as a use for resource both by the individual
and entrepreneur. Thus his theory which insists on working everything through
bond market is a College Bursar’s theory and seems to be lacking in realism and
comprehensiveness.
b. Inadequate and misleading: the theory does not explain as to what determines
the normal rate and therefore, given the degree of divergence (deviation) the
actual rate of interest. The actual rate of interest cannot be described consistently
as measuring the cost of the uncertainty or risk involved in holding bonds rather
than money. If there is no uncertainty at all, actual rate would simply stand at
certain definite level below the normal rate. Hence, this theory is regarded as at
the best inadequate and at the worst misleading.
c. Methodological Fallacy: just as the rate of interest is explained as the price for
parting with liquidity, similarly the price of sugar or any other commodity can be
explained by the relative preference for them. But there is vital difference; a
change in the quantity of money would tend to change the price of the good in
the same proportion, but not the price of bonds beyond a temporary level.
Actually, there is no functional relationship between price level and ant rate of

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 interest while discussing the influence of speculation on the interest rate on loans.
Hence, no monetary change has any direct or permanent effect on the rate of
interest. Thus there is a methodological fallacy in this theory of assuming a
definite relationship between the quantity of money and the rate of interest.
d. Inconsistent: according to this theory, the rate of interest should be highest at the
bottom of depression because the liquidity preference is strongest at that time
due to falling prices; hence a large reward will have to be paid to wealth holders
to part with their cash by offering higher interest. But in reality the facts are just
opposite. As per this theory short term interest rates should be lowest during the
peak of boom because people would be investing their money rather than holding
cash. The liquidity preference thus is lowest and a very small reward would be
required to induce people to part with cash. But in reality, the rate of interest is
at the highest peak during boom period. Thus, this theory is inconsistent with
facts.
e. Saving Essential for Liquidity: this theory regards rate of interest as the reward for
parting with liquidity and not a return merely of saving. However, saving is
essential for accumulating funds for investing at interest. Therefore, without
saving there cannot be any liquidity to surrender. The rate of interest is the return
for saving without liquidity.
f. Liquidity not essential for rate of interest: the term liquidity preference used in
this theory is not helpful in explaining the nature of interest. It is more confusing,
vague and self- contradictory. For instance, if a person is holding funds in the form
of fixed deposits, he is getting interest for keeping such deposits i.e. he is getting
rewarded for holding the money as against the concept of this theory which states
that interest is the reward for parting with liquidity.
g. Confusion regarding relation between interest rate and quantity of money: the
theory on one hand states that demand for money is inversely dependent on the
rate of interest and on the other that the equilibrium rate on interest is inversely
dependent upon the amount of money. There is no distinction made between the
two propositions and are often used in an identical manner, thus creating
confusion.
Superiority over Loanable Funds Theory of Interest
Despite criticisms the liquidity preference theory of interest is considered superior
over the loanable funds theory on account of the following:
a. This theory is a statement about stock or quantity of money at a point of time,
while the loanable fund theory is a statement about certain flows or quantities of
money per time period. As the quantity of money is fixed at a point of time,

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 economists prefer the stock approach of liquidity preference theory of interest
over the loanable funds theory.
b. The liquidity preference theory of interest is more realistic than the loanable
funds theory because it is more similar to the behavior of interest rate in the
business world. It explains various motives of holding money and the relation
between business expectations and rate of interest.
c. All the variables in the loanable funds theory like savings, investment, hoarding,
dishoarding are in terms of partial equilibrium analysis while demand for and
supply of money in the liquidity preference theory of interest is treated as part of
the general determinate system. So the loanable funds theory fails to fit in a
general determinate system.
Production Function
The production function is purely a technical relation which connects factor inputs
and output. Production function is defined by Prof. Watson as “the relation between
a firm’s physical production (output) and the material factors of production (inputs)”.
Production function thus reflects how much output can be expected with a given
quantum of material, labor, capital, etc. Thus production function is an indicator of
the physical relationship between the inputs and output of a firm.
When a firm produces 50 steel tables a day, its production function would contain
the minimum quantities of steel, color, welding rods, labor, machine type, electricity
and other inputs that are necessary to produce 50 tables. In simple words the
production function in this case consists of maximum number of tables that can be
produced with the given quantities of inputs. Like a demand function, production
function is expressed in relation to a particular time period. It denotes the flow of
inputs resulting in the flow of outputs during a particular period of time.
The production function of a firm depends on the state of technology. With every
development in technology the production function of the firm undergoes a change.
Whenever technology improves a new production function comes into existence.
Therefore, the output of the modern firm depends not only on the traditional
productive resources like land, labor, capital and management but also on the level
of technology. There exists a functional relationship between these inputs and
resulting outputs of the firm. Such relationship is called production function.
Symbolically, the production function of a firm may be expressed as follows:
Q = f ( Ld, L, C, M, T)
where, Q stands for Output,
f = function, Ld = Land, L =Labor, C= Capital, M= Management and T = technology.
Production function is of great help to the managers and executives in the decision
making process at the firm level. It helps in computing the least cost input
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combination for a given output or maximum output-input combination for given
cost. It is useful in arriving at optimum and economic combination of inputs for
getting a certain level of output. The value or utility of employing a variable factor in
the production can be better judged with the help of the production function.
Additional employment of the variable inputs is desirable only when the marginal
revenue productivity of a variable factor is more than its price. It is feasible to stop
the additional employment of the variable factor at a point where the marginal
revenue productivity equals its price.
The production function is differently defined in the short run and in the long run.
The distinction is based on the nature of factor inputs. Those inputs that vary directly
with the output are called variable factors. These are the factors that can be changed.
Variable factors exist in both the short run and the long run. Examples of variable
factors include daily wage labor, raw materials, etc. On the other hand, those factors
that cannot be changed or varied as the output changes are called fixed factors.
These factors are normally characteristic of the short run or short period of time only.
Fixed factors do not exist in the long run.
Thus, the production function may be broadly classified and defined into two:
a. Short run production function which is studied through Law of Variable
Proportions; and
b. Long run production function which is explained by Return to Scale

Short Run Production Function – The Law of Variable Proportions

The law examines the relationship between one variable factor and output keeping
the quantities of other factors fixed. As per the law of Variable Proportions, 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.
Assumptions of the law - the law is based on the following assumptions:
a. Only one factor is made variable and other factors are kept constant.
b. This law does not apply in case all factors are proportionately varied i.e. where
the factors must be used in rigidly fixed proportions to yield a product.
c. The variable factor units are homogenous i.e. all the units of variable factors are
of equal efficiency.
d. Input prices remain unchanged.
e. The state of technology does not change or remains the same at a given point of
time.
f. The entire production operation is only for short run, as in case of long run all
inputs are variable.

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Three stages of Law: The behavior of the output when the varying quantity of one
factor is combined with a fixed quantity of the other can be divided into following
three stages:
1. Stage of Increasing Returns – during this stage, the total product, the average
product and the marginal product are increasing. It is notable that the marginal
product in this stage increases but in a later part it starts declining. Though
marginal product starts declining, it is greater than the average product so that
the average product continues to rise. This stage ends when the average product
reaches its highest (maximum) point.
2. Stage of Decreasing Returns – in the second stage, the total product continues to
increase but at a diminishing rate. The marginal product and the average product
are declining but are positive. At the end of this stage, the total product is
maximum and the marginal product is zero.
3. Stage of Negative Returns – in this third stage, the marginal product becomes
negative. The total product and the average product are declining.
Long Run Production Function – Returns to Scale
In the long run, all factors can be changed. Returns to scale studies the changes in
output when all factors or inputs are changed. An increase in scale means that all
inputs or factors are increased in the same proportion.
Three phases of Returns to Scale - the change in output as a result of changes in the
scale can be studied in three phases as mentioned below:
1. Increasing Returns to Scale – if the increase in all factors leads to a more than
proportionate increase in output, it is called increasing returns to scale. For e.g. if
all inputs are increased by 5% and the output increases by more than 5% i.e. 10%,
then in this case the marginal product can be said to be rising.
2. Constant Returns to Scale – if all the factors are increased in a given proportion,
the output will increase in the same proportion. For e.g. if a 5% increase in all the
factors results in an equal proportion of 5% in the output then in this case the
marginal product is said to be constant.
3. Decreasing Returns to Scale – if the increase in all factors leads to a less than
proportionate increase in output it is called decreasing returns to scale. For e.g. if
all the factors are increased by 5% and the output increases by less than 5% i.e.
3%, then in this case the marginal product can be said to be decreasing.

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 Unit IV – Market Structure

Market Structure
The term “market structure” refers to the characteristics of the market either
organizational or competitive, that describes the nature of competition and the
pricing policy followed in the market. Thus market structure can be defined as the
number of firms producing the identical goods and services in the market whose
structure is determined on the basis of the competition prevailing in the market.
The term “market” refers to a place where sellers and buyers meet and facilitate the
selling and buying of goods and services. However, in economics the term market has
much wider meaning than just a place; it extents to all buyers and sellers who are
spread out to perform the marketing activities.
Types of Market Structure
There are four different types of Market Structure which are as mentioned below:
a. Perfect Competition ( Competitive) Market Structure
b. Monopolistic Competition (Competitive) Market Structure
c. Monopoly Market Structure
d. Oligopoly Market Structure

Perfect Competition (Competitive) Market

A perfect competitive market is the one which has large number of buyers
(consumers) and sellers (producers / suppliers) of a homogeneous product. Perfect
competitive prevails when the demand for the output of each producer is perfectly
elastic. In a competitive market, the market mechanisms imply the relationship
between buyers and sellers, thereby determining the price of goods and services.
More specifically, in a competitive market, there are a great number of buyers and
sellers for buying and selling homogenous products with very less or no barriers for
entry and exit. Perfect competition is also referred as pure competition when there
is no direct competition between the rivals and all sell identically the same product
at a single price.
Characteristics/ Features of Perfect Competition (Competitive) Market
1. Large number of buyers and sellers: in a perfect competitive market there are
large number of buyers and sellers. Due to the presence of large buyers and
sellers, no individual can influence the market price, demand or supply of a
commodity. An individual buyers or seller is too small in relation to the whole
market, hence he cannot influence the market in any way.

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2. Homogeneous Product: each competing firm in the market offers homogeneous
i.e. identical product that are perfect substitute of one another. As a result of this
no individual has a preference for a particular seller over others. Salt, wheat, coal,
etc. are some of the homogeneous products for which customers are indifferent
and buy these from the one who charges a less price. Thus, an increase in the price
would let the customer go to some other supplier.
3. Free Entry and Exit: under perfect competitive market, the firms are free to enter
or exit. Thus, if a firm suffers from loss due to intense competition, then it is free
to leave at any point of time. Similarly, any new firm who wants to join the market
can freely enter as per their wish.
4. Perfect knowledge of prices and technology: in a perfect competitive market,
both the buyers and sellers have complete knowledge of market conditions such
as the price, demand, supply of products and the latest technology being used to
produce the product. Hence, they can buy or sell the products anywhere and
anytime they want.
5. Single Price: all homogeneous products bought and sold in the perfectly
competitive market have a single price i.e. prices of all identical products shall
remain uniform or same price across the market. A seller in this market is a price
taker and not a price maker.
6. No transportation cost: it is assumed that there will not be any transportation
costs in perfectly competitive market as all the firms are close to one another, as
well as they are near to the market. This is so because, the prices of products shall
differ firm wise on account of additional transportation costs and for a perfectly
competitive market it is important that prices of homogeneous products remain
uniform across the market
7. No Government and artificial restrictions: in perfectly competitive market, both
the buyers and sellers are free to buy and sell the goods and services i.e. any
customer can buy from any seller and any seller can sell to any buyer. There are
no restrictions imposed on either party. Thus the prices are liable to change freely
as per the prevailing demand – supply situation. No government, statutory or non-
statutory body can intervene and control the demand, supply or price of the
goods and services.
Price Determination under Perfect Competition (Competitive) Market
Equilibrium Price: equilibrium price is that price at which the quantity demanded is
equal to quantity supplied. The price of a product under perfect competitive market

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is influenced by both buyers and sellers and equilibrium price is determined by the
interaction of demand and supply forces.
According to Marshall, demand and supply are like two blades of a pair of scissors.
Just as cutting paper or cloth is not possible by making use of one blade, the
equilibrium price of a commodity cannot be determined either by the forces of
demand or by supply alone. Both demand and supply determine the price. This is
explained in the following illustration along with table and graph.
Price per unit Quantity Demanded Quantity Supplied
(Rs.) (units) (units)
5 100 500
4 200 400
3 300 300
2 400 200
1 500 100

The above table, shows the effect of price on market demand and supply. It can be
seen that when the price of the commodity was Rs.5, quantity demanded is 100 units
and quantity supplied is 500 units. As the supply of commodity is more than its
demand, the price falls to Rs.4 and Rs.3; the demand starts rising to 200 and 300
units, while the supply declines to 400 and 300 units, respectively. It is also seen that
both quantity supplied and demanded are equal at the price of Rs.3. Thus, Rs.3 will
be called as equilibrium price.
If the price falls further to Rs 2 and Rs 1, the quantity demanded shall rise to 400 and
500 units, while the supply will decline to 200 and 100 units respectively. As the
demand for commodity is more than supply in this case, the price will rise upto Rs2
and Rs.3.
E - Equilibrium point, OP – Equilibrium Price
OQ - Equilibrium Quantity Demand/ Supply
In the adjacent graph, the demand curve DD
is seen to be sloping downward indicating an
inverse relation between price and quantity
demanded. Supply curve SS shows an upward
curve indicating direct relation between price
and quantity supplied. Both curve intersect at
equilibrium point E.

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Monopolistic Competition (Competitive) Market Structure
In a monopolistic competitive market there are large number of firms that produce
differentiated products which are close substitutes for each other. In other words,
large sellers selling the products that are similar but not identical or homogeneous
and compete with each other on other factors besides price.
Characteristics/ Features of Monopolistic Competition (Competitive) Market
1. Product Differentiation: this is one of the major feature of the firms operating in
monopolistic competitive market that, produce the product which is not identical
or homogeneous but is slightly different from one another. As the products are
slightly different from each other they remain close substitute of each other and
hence cannot be priced very differently from each other.
2. Large number of firms: a large number of firms operate under monopolistic
competitive market and there is stiff competition between the existing firms.
Unlike perfect competitive market the firms produce the differentiated products
which are substitutes for each other, thus creating competition among the firms.
3. Free Entry and Exit: any firm incurring loss due to intense competition can move
out of the market at any time. Similarly, new firms can enter the market freely,
provided it is able to withstand the competition from existing firms and survive in
the market.
4. Some Control over Price: as the products are close substitutes for each other, if a
firm lowers the price of the product, then customers of other products will switch
over to it. Conversely, with increase in price of product, it will lose its customers
to others. Thus in monopolistic competitive market an individual firm is not a price
taker but has some influence over the price of its product.
5. Heavy Expenditure on Advertisement and Selling Costs: the firms in monopolistic
competitive market incur a huge amount of sum on advertisements and other
selling costs to promote the sale of their products. As the products made by the
firms are different and close substitutes for each other, the firm needs to
undertake promotional activities to capture large market share.
6. Product Variation: there is a variation in the products offered by different firms in
monopolistic competitive market. To meet the needs and requirements of the
customers each firm tries to adjust its product accordingly. Such changes could be
in the form of new design, better quality, new packaging, etc. Thus the quantum
of product a firm is selling in the market depends on the uniqueness of its product
and the extent to which it differs from other products.

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The monopolistic competition is also called as imperfect competition because this
market structure lies between pure monopoly and pure competition.
Price Determination under Monopolistic Competition (Competitive) Market
In monopolistic competitive market, the firm will be in equilibrium position when
marginal revenue is equal to marginal cost. So long as the marginal revenue is greater
than marginal cost, the seller will find it profitable to expand his output and if the
marginal revenue is less than marginal cost he will reduce his output where marginal
revenue is equal to marginal cost. Therefore, in short run the firm will be in
equilibrium when it is maximizing profits i.e. Marginal Revenue = Marginal Cost.
Short Run Equilibrium: the diagram below illustrates the short run equilibrium

(a) Short run Equilibrium with Profit (b) Short run Equilibrium with Loss
In the above diagram, the short run average cost is MT and short run average
revenue is MP. Since the AR curve is above the SAC curve, there is profit shown as
PT. PT is the super normal profit per unit of output. The total super normal profit will
be measured by multiplying the super normal profit to the total output i.e. PT X OM
or the area PTT1P1 as shown in fig. (a).
The firm may also incur loss in the short run if the AR curve is below the SAC curve.
In fig. (b) MP is seen to be less than MT and TP is the loss per unit of output. The total
loss will be measured by multiplying loss per unit of output to total output i.e. TP X
OM or TPP1T1.
Long Run Equilibrium: under monopolistic competition, the supernormal profit
earned in short run starts fading away or disappearing in the long run as new firms
enter the market. With the entry of new firms, the supply shall increase and the
demand curve or AR curve will shift to the left thereby reducing the supernormal
profit of the firm to normal profit due to competition. If in the short run firms are
suffering from losses, then in the long run some firms of these firms will leave the

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market, thus reducing the supply of products and help the remaining firms in earning
normal profits.
The AR Curve in the long run will be more elastic,
since large number of substitutes will be available
in the long run. Hence in the long run, equilibrium
is established when firms are earning only normal
profits. The profits are normal only when AR=AC.
In the adjacent fig. P is the point at which the AR
curve touches the average cost curve (LAC) as a
tangent. P is regarded as the equilibrium point at
which the price level is MP and output is OM.
Monopoly Market Structure
The word monopoly suggests, “mono” meaning single and “poly” meaning seller.
Hence monopoly market structure is characterized by a single seller selling unique
product with the restriction for a new firm to enter the market. In simple words,
monopoly is a form of market where there are no close substitutes.
Characteristics/ Features of Monopoly Market Structure
1. Full Control of the firm: Under monopoly, the firm has full control over the supply
of a product. The elasticity of demand is zero for the products.
2. Single Seller: under monopoly, there is a single seller or a producer of a particular
product and there is no difference between the firm and the industry. The firm is
itself an industry.
3. Pricing: the firms in monopoly market can influence the price of a product and
hence, these firms are price makers and not price takers.
4. Restrictions on Entry: in a monopoly market, there are barriers and restrictions
for entry of new firms.
5. No Substitutes: the products offered by firms in a monopoly market are unique
and are totally different from one another. Therefore, these products are neither
identical, homogeneous, close substitutes nor alternative to one another.
Oligopoly Market Structure
The Oligopoly market is a place where few sellers are selling homogeneous or
differentiated products. In simple words, the oligopoly market structure lies between
pure monopoly and monopolistic competition, where few sellers dominate the
market and have control over the price of the product.
Under oligopoly market structure the firm either produces:

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Homogeneous products: the firms producing homogeneous products are called Pure
or Perfect Oligopoly. Producers of industrial products such as copper, steel, iron etc.
are some examples of these.
Heterogeneous Products: the firms producing heterogeneous products are called as
Imperfect or Differentiated Oligopoly. Such type of oligopoly is found in producers of
consumer products such as soaps, detergents, televisions, etc.
Characteristics/ Features of Oligopoly Market Structure
1. Few Sellers: under oligopoly market, the sellers are few and customers are many.
Few firms dominating the market enjoy a considerable control over the price of
the product.
2. Interdependence: one of the main feature of an oligopoly market is that the seller
has to always be cautious with respect to actions taken by the competing firms.
As there are few sellers in the market, if any firm changes the price or introduces
any promotional scheme, all other firms need to be alert to comply with it to
remain in competition. Thus there is complete interdependency among the sellers
with respect to their price –output policies.
3. Advertising: under oligopoly market, every firm advertises their products on
frequent basis, with an intention to reach out to more customers and increase
their customer base. Hence, in order to be in race each firm spends large amount
of money on advertisement and promotion of its products.
4. Competition: it is genuine that with a few players in the market, there will be
intense competition among the sellers. Any move taken by the firm will have
considerable impact on its rivals. Thus, every seller keeps an eye over its rival and
is always ready with the counterattack.
5. Entry and Exit Barriers: the firms can easily exit whenever it wants but has to face
certain barriers with entering into the market. These barriers could be in the form
of Government licenses, patents, high capital requirement, complex technology,
etc. Also sometimes the government regulations favor the existing large firms,
which act as a barrier for new entrants.
6. Lack of Uniformity: there is a total lack of uniformity among firms in terms of their
size, some may be large scale while some could just be a small scale firm.

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