BACHELOR OF ARTS

SEMESTER II

ECONOMICS - II
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 CONTENT
Unit 1 - Cost And Revenue Analysis.........................................................................................4

Unit 2 - Market Structure And Perfect Competition Market...................................................52

Unit 3 - Monopoly And Imperfect Competition Market Monopoly........................................96

Unit 4 – Factors Pricing.........................................................................................................150

Unit 5 – Statistics...................................................................................................................190
UNIT 1 - COST AND REVENUE ANALYSIS

STRUCTURE

1.0 Learning Objectives

1.1 Introduction

1.2 Cost of Production

1.3 Meaning and Definition of Cost

1.4 Different Concept of Production Cost

1.4.1 Monetary Cost

1.4.2 Implicit and Explicit Cost

1.4.3 Opportunity Cost

1.5 Inter-Relationship between Average and Marginal cost

1.6 Causes to increase in Marginal and Average cost

1.7 Cost according to Line period (short- long term)

1.8 Revenue Analysis

1.9 Revenue Analysis Concept

1.9.1 Total

1.9.2 Average

1.9.3 Marginal Revenue

1.10 Relationship between Average Revenue and Marginal Revenue

1.11 Concept of Profit

1.11.1 Gross

1.11.2 Net

1.11.3 Normal

1.11.4 Abnormal

1.12 Summary
 1.13 Keywords

1.14 Learning Activity

1.15 Unit End Questions

1.16 References

1.0 LEARNING OBJECTIVES

After studying this unit, you will be able to

 Explain the different concept of production cost.

 Examine the inter-relationship between average and marginal cost.

 Illustrate the revenue analysis concept.

1.1 INTRODUCTION

In production, research, retail, and accounting, a cost is the value of money that has been used
up to produce something or deliver a service, and hence is not available for use anymore. In
business, the cost may be one of acquisition, in which case the amount of money expended to
acquire it is counted as cost. In this case, money is the input that is gone in order to acquire
the thing. This acquisition cost may be the sum of the cost of production as incurred by the
original producer, and further costs of transaction as incurred by the acquirer over and above
the price paid to the producer. Usually, the price also includes a mark-up for profit over the
cost of production.

More generalized in the field of economics, cost is a metric that is totalling up as a result of a

process or as a differential for the result of a decision. Hence cost is the metric used in the
standard modelling paradigm applied to economic processes.

Costs are often further described based on their timing or their applicability. In accounting,
costs are the monetary value of expenditures for supplies, services, labour, products,
equipment and other items purchased for use by a business or other accounting entity. It is the
amount denoted on invoices as the price and recorded in book keeping records as
an expense or asset cost basis.

Opportunity cost, also referred to as economic cost is the value of the best alternative that
was not chosen in order to pursue the current endeavour - i.e., what could have been
accomplished with the resources expended in the undertaking. It represents opportunities
forgone.

In theoretical economics, cost used without qualification often means opportunity cost.

Private costs are the costs that the buyer of a good or service pays the seller. This can also be
described as the costs internal to the firm's production function.

External costs (also called externalities), in contrast, are the costs that people other than the
buyer are forced to pay as a result of the transaction. The bearers of such costs can be either
particular individuals or society at large. Note that external costs are often both non-monetary
and problematic to quantify for comparison with monetary values. They include things like
pollution, things that society will likely have to pay for in some way or at some time in the
future, even so that are not included in transaction prices.

Social costs are the sum of private costs and external costs. For example, the manufacturing
cost of a car (i.e., the costs of buying inputs, land tax rates for the car plant, overhead costs of
running the plant and labour costs) reflects the private cost for the manufacturer (in some
ways, normal profit can also be seen as a cost of production. The polluted waters or polluted
air also created as part of the process of producing the car is an external cost borne by those
who are affected by the pollution or who value unpolluted air or water. Because the
manufacturer does not pay for this external cost (the cost of emitting undesirable waste into
the commons), and does not include this cost in the price of the car (a Kaldor-Hicks
compensation), they are said to be external to the market pricing mechanism. The air
pollution from driving the car is also an externality produced by the car user in the process of
using his good. The driver does not compensate for the environmental damage caused by
using the car.

In accounting, revenue is the income or increase in net assets that an entity has from its

normal activities (in the case of a business, usually from the sale of goods and services to
customers). Commercial revenue may also be referred to as sales or as turnover.
Some companies receive revenue from interest, royalties, or other fees. "Revenue" may refer
to income in general, or it may refer to the amount, in a monetary unit, earned during a period
of time, as in "Last year, Company X had revenue of $42 million". Profits or net
income generally imply total revenue minus total expenses in a given period. In accounting,
in the balance statement, revenue is a subsection of the Equity section and revenue increases
equity, it is often referred to as the "top line" due to its position on the income statement at
the very top. This is to be contrasted with the "bottom line" which denotes net income (gross
revenues minus total expenses).

In general usage, revenue is income received by an organization in the form of cash or cash
equivalents. Sales revenue is income received from selling goods or services over a period of
time. Tax revenue is income that a government receives from taxpayers. Fundraising revenue
is income received by a charity from donors etc. to further its social purposes.

In more formal usage, revenue is a calculation or estimation of periodic income based on a

particular standard accounting practice or the rules established by a government or
government agency. Two common accounting methods, cash basis accounting and accrual
basis accounting, do not use the same process for measuring revenue. Corporations that offer
shares for sale to the public are usually required by law to report revenue based on generally
accepted accounting principles or on International Financial Reporting Standards.

In a double-entry bookkeeping system, revenue accounts are general ledger accounts that are

summarized periodically under the heading "Revenue" or "Revenues" on an income
statement. Revenue account-names describe the type of revenue, such as "Repair service
revenue", "Rent revenue earned" or "Sales".

Service businesses such as law firms and barber shops receive most of their revenue from
rendering services. Lending businesses such as car rentals and banks receive most of their
revenue from fees and interest generated by lending assets to other organizations or
individuals.

1.2 COST OF PRODUCTION

Production costs refer to all the costs incurred by a business from manufacturing a product or
providing a service. Production costs can include a variety of expenses, such as labour, raw
materials, consumable manufacturing supplies, and general overhead.

Production costs, which are also known as product costs, are incurred by a business from
manufacturing a product or providing a service. These costs include a variety of expenses.
For example, manufacturers have production costs related to the raw materials and labour
needed to create the product. Service industries incur production costs related to the labour
required to implement the service and any costs of materials involved in delivering the
service.
Taxes levied by the government or royalties owed by natural resource-extraction
companies also are treated as production costs.

Once a product is finished, the company records the product's value as an asset in its financial
statements until the product is sold. Recording a finished product as an asset serves to fulfil
the company's reporting requirements, as well as inform shareholders.

In the previous chapter, we have discussed the behaviour of the consumers. In this chapter as
well as in the next, we shall examine the behaviour of a producer. Production is the process
by which inputs are transformed into ‘output’. Production is carried out by producers or
firms. A firm acquires different inputs like labour, machines, land, raw materials etc. It uses
these inputs to produce output. This output can be consumed by consumers, or used by other
firms for further production. For example, a tailor uses a sewing machine, cloth, thread and
his own labour to ‘produce’ shirts. A farmer uses his land, labour, a tractor, seed, fertilizer,
water etc to produce wheat. A car manufacturer uses land for a factory, machinery, labour,
and various other inputs (steel, aluminium, rubber etc) to produce cars. A rickshaw puller
uses a rickshaw and his own labour to ‘produce’ rickshaw rides. A domestic helper uses her
labour to produce ‘cleaning services’. We make certain simplifying assumptions to start with.
Production is instantaneous: in our very simple model of production no time elapses between
the combination of the inputs and the production of the output. We also tend to use the terms
production and supply synonymously and often interchangeably. In order to acquire inputs a
firm has to pay for them. This is called the cost of production. Once output has been
produced, the firm sell it in the market and earns revenue. The difference between the
revenue and cost is called the firm’s profit. We assume that the objective of a firm is to earn
the maximum profit that it can. In this chapter, we discuss the relationship between inputs
and output. Then we look at the cost structure of the firm. We do this to be able to identify
the output at which firms’ profits are maximum. The production function of a firm is a
relationship between inputs used and output produced by the firm. For various quantities of
inputs used, it gives the maximum quantity of output that can be produced.

Consider the farmer we mentioned above. For simplicity, we assume that the farmer uses
only two inputs to produce wheat: land and labour. A production function tells us the
maximum amount of wheat he can produce for a given amount of land that he uses, and a
given number of hours of labour that he performs. Suppose that he uses 2 hours of labour/
day and 1 hectare of land to produce a maximum of 2 tonnes of wheat. Then, a function that
describes this relation is called a production function. One possible example of the form this
could take is: q = K × L, Where, q is the amount of wheat produced, K is the area of land in
hectares, L is the number of hours of work done in a day. Describing a production function in
this manner tells us the exact relation between inputs and output. If either K or L increase, q
will also increase. For any L and any K, there will be only one q. Since by definition we are
taking the maximum output for any level of inputs, a production function deals only with the
efficient use of inputs. Efficiency implies that it is not possible to get any more output from
the same level of inputs. A production function is defined for a given technology. It is the
technological knowledge that determines the maximum levels of output that can be produced
using different combinations of inputs. If the technology improves, the maximum levels of
output obtainable for different input combinations increase. We then have a new production
function. The inputs that a firm uses in the production process are called factors of
production. In order to produce output, a firm may require any number of different inputs.
However, for the time being, here we consider a firm that produces output using only two
factors of production – labour and capital. Our production function, therefore, tells us the
maximum quantity of output (q) that can be produced by using different combinations of
these two factors of productions labour (L) and capital (K).

1.3 MEANING AND DEFINITION OF COST

In production, research, retail, and accounting, a cost is the value of money that has been used
up to produce something or deliver a service, and hence is not available for use anymore. In
business, the cost may be one of acquisition, in which case the amount of money expended to
acquire it is counted as cost. In this case, money is the input that is gone in order to acquire
the thing. This acquisition cost may be the sum of the cost of production as incurred by the
original producer, and further costs of transaction as incurred by the acquirer over and above
the price paid to the producer. Usually, the price also includes a mark-up for profit over the
cost of production.

Cost of production refers to the total cost incurred by a business to produce a specific
quantity of a product or offer a service. Production costs may include things such as labour,
raw materials, or consumable supplies. In economics, the cost of production is defined as the
expenditures incurred to obtain the factors of production such as labour, land, and capital,
that are needed in the production process of a product.

For example, the production costs for a motor vehicle tire may include expenses such as
rubber, labour needed to produce the product, and various manufacturing supplies. In the
service industry, the costs of production may entail the material costs of delivering the
service, as well as the labour costs paid to employees tasked with providing the service.

Cost analysis is the life line of modern business. It cannot be ignored at any cost for the
success of any business organisation. On analysis of cost is required. A for the success of any
business organisation. On analysis of cost is required. A producer can supply/produce the
product by organising the factors of production. That means the producer has to hire or
purchase land, labour, capital, etc. by paying price. So, to produce the product the firm or
producer must incur some expenditure and the expenditure so involved is called cost of
production. This lesson is aimed at discussing this aspect of production called cost of
production.

Cost is defined as the expenditure incurred by a firm or producer to purchase or hire factors
of production in order to produce a product. As you know, factors of hire factors of
production in order to produce a product. As you know, factors of production are land,
labour, capital and entrepreneurship. In the production process, the entrepreneur organises
land, labour, capital and raw materials to produce output. As a producer he/she has to pay
rent for land, wages to labour and interest to procure capital. The producer must also be
compensated for his/her services which is called normal profit. Wages, rent, interest, profit
are called factor costs of production. Besides these, the producer also incurs expenditure on
raw costs of production. Besides these, the producer also incurs expenditure on raw materials,
electricity, water, depreciation of capital goods such as machines and indirect taxes etc. The
producer also uses the services of certain factors supplied by his / her own self. The imputed
value of such inputs has formed the part of cost.

1.4 DIFFERENT CONCEPT OF PRODUCTION COST

Production costs refer to all the costs incurred by a business from manufacturing a product or
providing a service. Production costs can include a variety of expenses, such as labour, raw
materials, consumable manufacturing supplies, and general overhead.

1.4.1 Monetary Cost

A firm purchases the services of assets like building, machine etc. It pays hiring charges for
building, normally termed as rent. It employs workers, accountant charges for building,
normally termed as rent. It employs workers, accountant manager etc. and pays wages and
salaries to them. It borrows money and pays interest on it. It purchases raw material, pays
electricity bills and makes such other payments. All such actual payments, on purchasing and
hiring different goods and services used in production are called ‘explicit costs. Normally, in
business, the accountant takes into account only the actual money expenditure as cost. So, in
business the cost is normally the ‘explicit cost’ only.

Fixed costs are expenses that do not change with the amount of output produced. This means
that the costs remain unchanged even when there is zero production or when the business has
reached its maximum production capacity. For example, a restaurant business must pay its
monthly, quarterly, or yearly rent regardless of the number of customers it serves. Other
examples of fixed costs include salaries and equipment leases.

Fixed costs tend to be time-limited, and they are only fixed in relation to the production for a
certain period. In the long term, the costs of producing a product are variable and will change
from one period to another.

Variable costs are costs that change with the changes in the level of production. That is, they
rise as the production volume increases and decrease as the production volume decreases. If
the production volume is zero, then no variable costs are incurred. Examples of variable costs
include sales commissions, utility costs, raw materials, and direct labour costs.

Total cost encompasses both variable and fixed costs. It takes into account all the costs
incurred in the production process or when offering a service. For example, assume that a
textile company incurs a production cost of $9 per shirt, and it produced 1,000 units during
the last month. The company also pays a rent of $1,500 per month. The total cost includes the
variable cost of $9,000 ($9 x 1,000) and a fixed cost of $1,500 per month, bringing the total
cost to $10,500.

For example, in a clothing manufacturing facility, the variable costs may include raw
materials used in the production process and direct labour costs. If the raw materials and
direct labour costs incurred in the production of shirts are $9 per unit and the company
produces 1000 units, then the total variable costs are $9,000.

1.4.2 Implicit and Explicit Cost

An explicit cost is the clearly stated costs that a business incurs. For example, employee
wages, inputs, utility bills, and rent, among others. These are the costs which are stated on the
businesses balance sheet.
By contrast, implicit costs are those which occur, but are not seen. In other words, these are
the costs that are not directly linked to an expenditure. For example, a factory may close
down for the day in order for its machines to be serviced. The explicit cost to repair the
machines is $10,000. However, the factory has lost a whole day’s output which has cost it
$50,000 in lost production. This indirect cost is known as the implicit cost.

Explicit costs are those which are clearly stated on the firm’s balance sheet, whilst implicit
costs are not. Instead, it is the indirect cost of choosing a specific course. When combined
together, explicit and implicit costs make up what is known to be the total economic cost.
This is because the cost of choosing option A has an explicit cost as well as an implicit cost
of what could have been achieved otherwise.

How to Calculate Implicit Cost

Implicit costs are costs that occur due to a specific path or option being chosen. It represents
an opportunity cost when the firm uses resources for one use over another. The implicit cost
is the cost of the action that is foregone. For example, a manager may need to train their staff,
which requires 8 hours of their time. The implicit cost is the cost of their time which could
have been employed doing their other daily tasks. In turn, this costs the firm however much
output that manager would have created had they not needed to train the employees.

Figure 1.1: Implicit Cost

Another example of an implicit cost is that of going to college. The explicit cost may be
$30,000 per year. However, there is also an implicit cost. A student going to college could be
working instead. Even in a minimum wage job, that would be approximately $12,000 per
year – which is the implicit cost. They could be earning $12,000 a year if they didn’t go to
college. So, the total economic cost is the explicit cost of tuition at $30,000 and the implicit
cost of not working which is over $12,000 – meaning a total economic cost of $42,000.

Explicit Cost Examples

An explicit cost is one that is a clear and obvious monetary amount made by the firm. It has a
clear monetary amount which can be seen in the firm’s financial balance sheet. Such
examples include

 Advertising and marketing costs.

 Employee wages, bonuses, commissions, and any other compensation to employees.

 Employee benefits that are not paid directly to the employee, i.e., Healthcare, staff
restaurant, or staff gym.

 Equipment that businesses purchase to make production and output more efficient.

 Rent or other mortgage payments required for the land the firm is using.

 Supplies that the firm requires in order to supply its output to consumers.

 Taxes and legal fees.

 Utilities that are required to keep the firm running such as electricity, water, and
internet service.

Implicit Cost Examples

Whilst explicit costs have a specific value, implicit costs are not always so clear cut. For
example, spending 5 hours playing video games means those 5 hours cannot be used for
studying. The implicit cost is the hours that could have been used for studying instead. The
value by which is not necessary monetarily quantifiable, but is still considered as a cost.

 Lost interest on funds occurs when the firm employs its capital, which means it
foregoes the interest it could have earnt in interest.

 Training a new employee presents an implicit cost in the fact that those seven hours
could have been used doing other work.

 Going to University means that there is an implicit cost which is the money which
could have been earned during that period.

 Maintenance means the firm has to stop production for a time which can lead to a
lower level of output or dissatisfied customers.

Implicit Cost
An implicit cost is any cost that has already occurred but not necessarily shown or reported as
a separate expense. It represents an opportunity cost that arises when a company uses internal
resources toward a project without any explicit compensation for the utilization of resources.
This means when a company allocates its resources, it always forgoes the ability to earn
money off the use of the resources elsewhere, so there's no exchange of cash. Put simply, an
implicit cost comes from the use of an asset, rather than renting or buying it.

Implicit costs are also referred to as imputed, implied, or notional costs. These costs aren't
easy to quantify. That's because businesses don’t necessarily record implicit costs for
accounting purposes as money does not change hands.

These costs represent a loss of potential income, but not of profits. Implicit costs are a type of
opportunity cost, which is the benefit that a company misses out on by choosing one option
or alternative versus another. The implicit cost could be the amount of money a company
misses out on for choosing to use its internal resources versus getting paid for allowing a
third party to use those resources. For example, a company could earn income from renting
out its building versus the revenue earned from using the building for manufacturing and
selling its products.

A company may choose to include implicit costs as the cost of doing business since they
represent possible sources of income. Economists include both implicit costs and the regular
costs of doing business when calculating total economic profit. In other words, economic
profit is the revenue a company generates minus the cost of doing business and any
opportunity costs.

Examples of implicit costs include the loss of interest income on funds and the depreciation
of machinery for a capital project. They may also be intangible costs that are not easily
accounted for, including when an owner allocates time toward the maintenance of a
company, rather than using those hours elsewhere. In most cases, implicit costs are not
recorded for accounting purposes.

When a company hires a new employee, there are implicit costs to train that employee. If a
manager allocates eight hours of an existing employee's day to teach this new team member,
the implicit costs would be the existing employee's hourly wage, multiplied by eight. This is
because the hours could have been allocated toward the employee's current role.
Another example of an implicit cost involves small business owners who may decide to pass
on taking a salary in the early stages of operations to reduce costs and increase revenue. They
provide the business with their skill in lieu of a salary, which becomes an implicit cost.

Explicit Cost

Explicit costs are normal business costs that appear in the general ledger and directly affect a
company's profitability. Explicit costs have clearly defined dollar amounts, which flow
through to the income statement. Examples of explicit costs include wages, lease payments,
utilities, raw materials, and other direct costs.

Explicit costs—also known as accounting costs—are easy to identify and link to a company's
business activities to which the expenses are attributed. They are recorded in a company's
general ledger and flow through to the expenses listed on the income statement. The net
income (NI) of a business reflects the residual income that remains after all explicit costs
have been paid. Explicit costs are the only accounting costs that are necessary to calculate a
profit, as they have a clear impact on a company's bottom line. The explicit-cost metric is
especially helpful for companies' long-term strategic planning.

Implicit Costs vs. Explicit Costs

Implicit costs are technically not incurred and cannot be measured accurately for accounting
purposes. There are no cash exchanges in the realization of implicit costs. But they are an
important consideration because they help managers make effective decisions for the
company.

These expenses are a big contrast to explicit costs, the other broad categorization of business
expenses. Explicit costs represent any costs involved in the payment of cash or another
tangible resource by a company. Rent, salary, and other operating expenses are considered
explicit costs. They are all recorded within a company's financial statements.

The main difference between the two types of costs is that implicit costs are opportunity
costs, while explicit costs are expenses paid with a company's own tangible assets. This
makes implicit costs synonymous with imputed costs, while explicit costs are considered out-
of-pocket expenses. Implicit costs are harder to measure than explicit ones, which makes
implicit costs more subjective. Implicit costs help managers calculate overall economic
profit, while explicit costs are used to calculate accounting profit and economic profit.
Explicit costs, involve tangible assets and monetary transactions and result in real business
opportunities. Explicit costs are easy to identify, record, and audit because of their paper trail.
Expenses relating to advertising, supplies, utilities, inventory, and purchased equipment are
examples of explicit costs. Although the depreciation of an asset is not an activity that can be
tangibly traced, depreciation expense is an explicit cost because it relates to the cost of the
underlying asset owned by the company.

In contrast, implicit or implied costs are not clearly defined, identified, or reported as

expenses. They often deal with intangibles and are described as opportunity costs—the value
of the best alternative not accepted. An example of an implicit cost is time spent on one
activity of a business that could better be spent on a different pursuit. Management will
utilize explicit costs when reviewing a business's operations, including profits; but will
calculate implicit costs only for decision making or choosing between multiple alternatives.

Companies use both explicit and implicit costs when calculating a company's economic profit
- defined as the total return a company receives based on all costs incurred to attain that
revenue. Specifically, economic profit is used extensively to determine whether a business
should enter or exit a market or industry.

1.4.3 Opportunity Cost

Economists define opportunity cost as the value of next best alternative foregone. What does
this mean? It is a common practice that a person makes a list of several. What does this
mean? It is a common practice that a person makes a list of several activities before adopting
a particular one to peruse his / her goal. Similarly, in production a producer leaves some
alternatives before finally choosing to produce the particular output. So, while finally
choosing one, the producer did forego the alternative production. Let us take example of a
farmer. He can produce either rice or wheat on a piece of land. If he has decided to produce
wheat on this piece of land, he has to forego the production of rice for producing wheat. So,
value of rice foregone (next best alternative) is the opportunity cost of producing wheat.

In microeconomic theory, the opportunity cost of an activity or option is the loss of value or

benefit that would be incurred (the cost) by engaging in that activity or choosing that option,
versus/relative to engaging in the alternative activity or choosing the alternative option that
would offer the highest return in value or benefit (the best forgone opportunity).

In basic equation form, opportunity cost can be defined as

Opportunity Cost = FO (returns on best forgone option) − CO (returns on chosen option)

Directly or indirectly, opportunity cost underpins the majority of day-to-day economic
decisions that are made in society. For example, the opportunity cost of mowing one’s
own lawn for a doctor or a lawyer (who might otherwise make $100 an hour if they elected to
work overtime during that time instead) would be higher than for a minimum-wage employee
(who in the United States might earn $7.25 an hour), which would make the former more
likely to hire someone else to mow their lawn for them.

As a representation of the relationship between scarcity and choice, the objective of

opportunity cost is to ensure efficient use of scarce resources. It incorporates all associated
costs of a decision, both explicit and implicit. Opportunity cost also includes the utility or
economic benefit an individual lost, if it is indeed more than the monetary payment or actions
taken. As an example, to go for a walk may not have any financial costs imbedded in to it.
Yet, the opportunity forgone is the time spent walking which could have been used instead
for other purposes such as earning an income.

However, time spent chasing after an income might have health problems like
in presenteeism where instead of taking a sick day one avoids it for a salary or to be seen as
being active.

A production possibility frontier shows the maximum combination of factors that can be
produced. For example, if services were on the x axis of a graph and there were to be an
increase in services from 20 to 25, this would lead to an opportunity cost for the goods that
are on the y axis, as they would drop from 21 to 16. This means that as a result of the increase
in consumption of services, the opportunity cost would be those 5 goods that have decreased.
Regardless of the time of occurrence of an activity, if scarcity was non-existent then all
demands of a person are satiated. It’s only through scarcity that choice becomes essential,
since the use of scarce resources in one way prevents its use in another way, resulting in the
need to make a selection and/or decision.

Sacrifice is a given measurement in opportunity cost of which the decision maker forgoes the
opportunity of the next best alternative. In other words, to disregard the equivalent utility of
the best alternative choice to gain the utility of the best perceived option. If there were
decisions to be made that require no sacrifice then these would be cost free decisions with
zero opportunity cost. Only through the analysis of opportunity cost, the company can choose
the most beneficial project, based on when the actual benefits are greater than the opportunity
cost, so that the limited resources can be optimally allocated to achieve maximum efficiency.
Opportunity costs represent the potential benefits an individual, investor, or business misses
out on when choosing one alternative over another. The idea of opportunity costs is a major
concept in economics.

Because by definition they are unseen, opportunity costs can be easily overlooked if one is
not careful. Understanding the potential missed opportunities foregone by choosing one
investment over another allows for better decision-making.

While financial reports do not show opportunity costs, business owners often use the concept
to make educated decisions when they have multiple options before them. Bottlenecks, for
instance, are often a result of opportunity costs.

A firm incurs an expense in issuing both debt and equity capital to compensate lenders and
shareholders for the risk of investment, yet each also carries an opportunity cost. Funds used
to make payments on loans, for example, cannot be invested in stocks or bonds, which offer
the potential for investment income. The company must decide if the expansion made by
the leveraging power of debt will generate greater profits than it could make through
investments. A firm tries to weight the costs and benefits of issuing debt and stock, including
both monetary and non-monetary considerations, in order to arrive at an optimal balance that
minimizes opportunity costs. Because opportunity cost is a forward-looking consideration,
the actual rate of return for both options is unknown today, making this evaluation in practice
tricky.

Assume the company in the above example foregoes new equipment and instead invests in
the stock market. If the selected securities decrease in value, the company could end up
losing money rather than enjoying the expected 12 percent return.

For the sake of simplicity, assume the investment yields a return of 0%, meaning the
company gets out exactly what it put in. The opportunity cost of choosing this option is 10% -
0%, or 10%. It is equally possible that, had the company chosen new equipment, there would
be no effect on production efficiency, and profits would remain stable. The opportunity cost
of choosing this option is then 12% rather than the expected 2%.

It is important to compare investment options that have a similar risk. Comparing a Treasury
bill, which is virtually risk-free, to investment in a highly volatile stock can cause a
misleading calculation. Both options may have expected returns of 5%, but the U.S.
Government backs the rate of return of the T-bill, while there is no such guarantee in the
stock market. While the opportunity cost of either option is 0 percent, the T-bill is the safer
bet when you consider the relative risk of each investment.

1.5 INTER-RELATIONSHIP BETWEEN AVERAGE AND MARGINAL

COST

The Relation Showing Average with Marginal Cost Curve

The relationship between the marginal cost and average cost is the same as that between any
other marginal-average quantities. When marginal cost is less than average cost, average cost
falls and when marginal cost is greater than average cost, average cost rises.

This marginal-average relationship is a matter of mathematical truism and can be easily

understood by a simple example. Suppose that a cricket player’s batting average is 50. If in
his next innings he scores less than 50, say 45, then his average score will fall because his
marginal (additional) score is less than his average score.

If instead of 45, he scores more than 50, say 55, in his next innings, then his average score
will increase because now the marginal score is greater than his previous average score.
Again, with his present average runs of 50, if he scores 50 also in his next innings, then his
average score will remain the same because now the marginal score is just equal to the
average score.

Likewise, suppose a producer is producing a certain number of units of a product and his
average cost is Rs. 20. Now, if he produces one unit more and his average cost falls, it means
that the additional unit must have cost him less than Rs. 20. On the other hand, if the
production of the additional unit raises his average cast, then the marginal unit must have cost
him more than Rs. 20.

And finally, if as a result of production of an additional unit, the average cost remains the
same, then marginal unit must have cost him exactly Rs. 20, that is, marginal cost and
average cost would be equal in this case.

The relationship between average and marginal cost can be easily remembered with the help
of figure 1.2. It is illustrated in this figure that when marginal cost (MC) is above average
cost (AC), the average cost rises, that is, the marginal cost (MC) pulls the average cost (AC)
upwards.
On the other hand, if the marginal cost (MC) is below the average cost (AC); average cost
falls, that is, the marginal cost pulls the average cost downwards. When marginal cost (MC)
stands equal to the average cost (AC), the average cost remains the same, that is, the marginal
cost pulls the average cost horizontally.

Now, take figure.1.2 where short-run average cost curve AC and marginal cost curve MC are
drawn. As long as short-run marginal cost curve MC lies below short-run average cost curve,
the average cost curve AC is falling. When marginal cost curve MC lies above the average
cost curve AC, the latter is rising.

At the point of intersection L where MC is equal to AC, AC is neither falling nor rising, that
is, at point L, AC has just ceased to fall but has not yet begun to rise. It follows that point L,
at which the MC curve crosses the AC curve to lie above the AC curve is the minimum point
of the AC curve. Thus, marginal cost curve cuts the average cost curve at the latter’s
minimum point.

Figure 1.2: Relation between AC and MC curves

It is important to note that we cannot generalise about the direction in which marginal cost is
moving from the way average cost is changing, that is, when average cost is falling, we
cannot say that marginal cost will be falling too. When average cost is falling, what we can
say definitely is only that the marginal cost will be below it but the marginal cost itself may
be either rising or falling.

Likewise, when average cost is rising, we cannot deduce that marginal cost will be rising too.
When average cost is rising, the marginal cost must be above it but the marginal cost itself
may be either rising or falling. Consider the figure 1.2 where up to the point K, marginal cost
is falling as well as below the average cost.
This point may be known as optimum Point where average cost (AC) and (MC) will be equal
and minimum.

With increase in average cost, marginal cost rise at a faster rates. Beyond OQ level of output
MC curve is above AC curve.

A close study of the above table reveals the following points.

 Where marginal cost is falling total cost will be rising at a declining rate; on the other
hand, where marginal cost is rising, total cost will be rising at an increasing rate.

 When marginal cost is lower than the average cost average cost would be falling. In
other words, when marginal cost is greater than the average cost, the average cost
would be rising.

 If the marginal cost first falls and then rises the marginal cost curve is U-shaped, the
marginal cost will be equal to the average cost at a point where the average cost is the
minimum.

 If the marginal cost is below the average variable cost, the latter must be falling and
vice-versa.

 If the marginal cost first falls and then rises, it will be equal to the average variable
cost at a point where the average variable cost is minimum.

As a result, the average cost is falling. But beyond point K and up to point L marginal cost
curve lies below the average cost curve with the result that the average cost curve is falling.
But it will be seen that between K and L where the marginal cost is rising, the average cost is
falling.

This is because though MC is rising between K and L, it is below AC. It is therefore clear
that when the average cost is falling, marginal cost may be falling or rising. This can also be
easily illustrated by the example of batting average.

1.6 CAUSES TO INCREASE IN MARGINAL AND AVERAGE COST

In economics, the marginal cost is the change in the total cost that arises when the quantity
produced is incremented, the cost of producing additional quantity. In some contexts, it refers
to an increment of one unit of output, and in others it refers to the rate of change of total cost
as output is increased by an infinitesimal amount. As figure 1.2 shows, the marginal cost is
measured in dollars per unit, whereas total cost is in dollars, and the marginal cost is the slope
of the total cost, the rate at which it increases with output. Marginal cost is different
from average cost, which is the total cost divided by the number of units produced.

At each level of production and time period being considered, marginal cost includes all costs
that vary with the level of production, whereas costs that do not vary with production
are fixed. For example, the marginal cost of producing an automobile will include the costs of
labour and parts needed for the additional automobile but not the fixed cost of the factory
building that do not change with output. The marginal cost can be either short-run or long-run
marginal cost, depending on what costs vary with output, since in the long run even building
size is chosen to fit the desired output.

In the simplest case, the total cost function and its derivative are expressed as follows, where
Q represents the production quantity, VC represents variable costs, FC represents fixed
costs and TC represents total costs.

Fixed costs represent the costs that do not change as the production quantity changes. Fixed
costs are costs incurred by things like rent, building space, machines, etc. Variable costs
change as the production quantity changes, and are often associated with labour or materials.
The derivative of fixed cost is zero, and this term drops out of the marginal cost equation: that
is, marginal cost does not depend on fixed costs. This can be compared with average total
cost (ATC), which is the total cost (including fixed costs, denoted C0) divided by the number
of units produced:

For discrete calculation without calculus, marginal cost equals the change in total (or
variable) cost that comes with each additional unit produced. Since fixed cost does not
change in the short run, it has no effect on marginal cost.

For instance, suppose the total cost of making 1 shoe is $30 and the total cost of making 2
shoes is $40. The marginal cost of producing shoes decreases from $30 to $10 with the
production of the second shoe ($40 – $30 = $10).

Marginal cost is not the cost of producing the "next" or "last" unit. The cost of the last unit is
the same as the cost of the first unit and every other unit. In the short run, increasing
production requires using more of the variable input - conventionally assumed to be labour.
Adding more labour to a fixed capital stock reduces the marginal product of labour because
of the diminishing marginal returns. This reduction in productivity is not limited to the
additional labour needed to produce the marginal unit – the productivity of every unit of
labour is reduced. Thus, the cost of producing the marginal unit of output has two
components: the cost associated with producing the marginal unit and the increase in average
costs for all units produced due to the "damage" to the entire productive process. The first
component is the per-unit or average cost. The second component is the small increase in cost
due to the law of diminishing marginal returns which increases the costs of all units sold.

Marginal costs can also be expressed as the cost per unit of labour divided by the marginal
product of labour. Denoting variable cost as VC, the constant wage rate as w, and labour
usage as L, we have

Here MPL is the ratio of increase in the quantity produced per unit increase in labour: i.e.,
ΔQ/ΔL, the marginal product of labour. The last equality holds because ΔL/ΔQ is the change
in quantity of labour that brings about a one-unit change in output. Since the wage rate is
assumed constant, marginal cost and marginal product of labour have an inverse relationship
-if the marginal product of labour is decreasing (or, increasing), then marginal cost is
increasing (decreasing), and AVC = VC/Q=wL/Q = w/(Q/L) = w/APL.

In economics, average cost or unit cost is equal to total cost (TC) divided by the number of

units of a good produced (the output Q).

AC = TC/Q

Average cost has strong implication to how firms will choose to price their commodities.
Firms’ sale of commodities of certain kind is strictly related to the size of the certain market
and how the rivals would choose to act.

Short-run costs are those that vary with almost no time lagging. Labour cost and the cost
of raw materials are short-run costs, but physical capital is not.
An average cost curve can be plotted with cost on the vertical axis and quantity on the
horizontal axis. Marginal costs are often also shown on these graphs, with marginal cost
representing the cost of the last unit produced at each point; marginal costs in the short run
are the slope of the variable cost curve (and hence the first derivative of variable cost).

A typical average cost curve has a U-shape, because fixed costs are all incurred before any
production takes place and marginal costs are typically increasing, because of diminishing
marginal productivity. In this "typical" case, for low levels of production marginal costs are
below average costs, so average costs are decreasing as quantity increases. An increasing
marginal cost curve intersects a U-shaped average cost curve at the latter's minimum, after
which the average cost curve begins to slope upward. For further increases in production
beyond this minimum, marginal cost is above average costs, so average costs are increasing
as quantity increases. For example: for a factory designed to produce a specific quantity
of widgets per period - below a certain production level, average cost is higher due to under-
used equipment, and above that level, production bottlenecks increase average cost.

Long-run average cost is the unit cost of producing a certain output when all inputs,
even physical capital, are variable. The behavioural assumption is that the firm will choose
that combination of inputs that produce the desired quantity at the lowest possible cost.

A long-run average cost curve is typically downward sloping at relatively low levels of
output, and upward or downward sloping at relatively high levels of output. Most commonly,
the long-run average cost curve is U-shaped, by definition reflecting economies of scale
where negatively sloped and diseconomies of scale where positively sloped.

If the firm is a perfect competitor in all input markets, and thus the per-unit prices of all its
inputs are unaffected by how much of the inputs the firm purchases, then it can be shown that
at a particular level of output, the firm has economies of scale (i.e., is operating in a
downward sloping region of the long-run average cost curve) if and only if it has
increasing returns to scale, the latter being exclusively a feature of the production function.
Likewise, it has diseconomies of scale (is operating in an upward sloping region of the long-
run average cost curve) if and only if it has decreasing returns to scale, and has neither
economies nor diseconomies of scale if it has constant returns to scale. With perfect
competition in the output market the long-run market equilibrium will involve all firms
operating at the minimum point of their long-run average cost curves (i.e., at the borderline
between economies and diseconomies of scale).
If, however, the firm is not a perfect competitor in the input markets, then the above
conclusions are modified. For example, if there are increasing returns to scale in some range
of output levels, but the firm is so big in one or more input markets that increasing its
purchases of an input drives up the input's per-unit cost, then the firm could have
diseconomies of scale in that range of output levels. Conversely, if the firm is able to get bulk
discounts of an input, then it could have economies of scale in some range of output levels
even if it has decreasing returns in production in that output range.

In some industries, long-run average cost is always declining (economies of scale exist
indefinitely). This means that the largest firm tends to have a cost advantage, and the industry
tends naturally to become a monopoly, and hence is called a natural monopoly. Natural
monopolies tend to exist in industries with high capital costs in relation to variable costs, such
as water supply and electricity supply.

1.7 COST ACCORDING TO LINE PERIOD (SHORT- LONG TERM)

In economics, the marginal cost is the change in the total cost that arises when the quantity
produced is incremented, the cost of producing additional quantity. In some contexts, it refers
to an increment of one unit of output, and in others it refers to the rate of change of total cost
as output is increased by an infinitesimal amount. As figure 1.2 shows, the marginal cost is
measured in dollars per unit, whereas total cost is in dollars, and the marginal cost is the slope
of the total cost, the rate at which it increases with output. Marginal cost is different
from average cost, which is the total cost divided by the number of units produced.

At each level of production and time period being considered, marginal cost includes all costs
that vary with the level of production, whereas costs that do not vary with production
are fixed. For example, the marginal cost of producing an automobile will include the costs of
labour and parts needed for the additional automobile but not the fixed cost of the factory
building that do not change with output. The marginal cost can be either short-run or long-run
marginal cost, depending on what costs vary with output, since in the long run even building
size is chosen to fit the desired output.

Short run marginal cost is the change in total cost when an additional output is produced in
the short run and some costs are fixed. In the on the right side of the page, the short-run
marginal cost forms a U-shape, with quantity on the x-axis and cost per unit on the y-axis.
On the short run, the firm has some costs that are fixed independently of the quantity of
output (e.g., buildings, machinery). Other costs such as labour and materials vary with output,
and thus show up in marginal cost. The marginal cost may first decline, as in the diagram, if
the additional cost per unit is high if the firm operates at too low a level of output, or it may
start flat or rise immediately. At some point, the marginal cost rises as increases in the
variable inputs such as labour put increasing pressure on the fixed assets such as the size of
the building. In the long run, the firm would increase its fixed assets to correspond to the
desired output; the short run is defined as the period in which those assets cannot be changed.

The long run is defined as the length of time in which no input is fixed. Everything, including
building size and machinery, can be chosen optimally for the quantity of output that is
desired. As a result, even if short-run marginal cost rises because of capacity constraints,
long-run marginal cost can be constant. Or, there may increasing or decreasing returns to
scale if technological or management productivity changes with the quantity. Or, there may
be both, as in the diagram at the right, in which the marginal cost first falls (increasing returns
to scale) and then rises (decreasing returns to scale).

Cost curves form a staple part of the curriculum of undergraduate microeconomics. Their
presentation across textbooks is fairly uniform and has not varied much over the years
presentation across textbooks is fairly uniform and has not varied much over the years since
Marshallian partial equilibrium analysis was first codified in a set of diagrams. The
uniformity and stability of the presentation of the curves belies their controversial beginnings
in the 1920s and 30s, as economists struggled to contain Marshall’s realistic descriptive
insights and biological analogies into a logically coherent static equilibrium model. In the
battle that played out between descriptive realism and neat formalisms, the latter won out for
centre stage in textbook studies of cost. Cost curves are drawn with the quantity of a specific
product along the horizontal axis and money cost on the vertical. They can represent the total
cost of the quantity, the average (per unit) cost, or the marginal cost. For the short-run, total
and average costs can be broken down into the portion reflecting the amount spent on factors
of production whose quantities can be varied, and the portion reflecting the sunk costs of the
fixed factors of production. Further, one can consider long-run cost curves drawn under the
assumption that the quantities of all factors can be varied. Drawn together on one diagram,
cost curves can appear daunting to students of economics, and even their teachers can have
difficulty disentangling them in a comprehensible way. Evidence of the difficulty can be seen
in three pedagogical articles on cost curves that have appeared in the Journal of Economic
Education in recent years.

The short-run cost curves are normally based on a production function with one variable
factor of production that displays first increasing and then decreasing marginal productivity.
Increasing marginal productivity is associated with the negatively sloped portion of the
marginal cost curve, while decreasing marginal productivity is associated with the positively
sloped portion. The average fixed cost (AFC) curve is the cost of the fixed factor of
production divided by the quantity of units of the output, while the average variable cost
(AVC) curve cost traces out the per unit cost of variable factor of production. The U-shaped
average total cost (ATC) curve is derived by adding the average fixed and variable costs. The
marginal cost (MC) intersects both the AVC and ATC curves at their minimum points.
Declining average total costs are explained as the result of spreading the fixed costs over
greater quantities and, at low quantities, the result of the increasing marginal productivity, in
addition. Increasing average costs occur when the effect of declining marginal productivity
overwhelms the effect of spreading the fixed costs.

The long-run cost curves, usually presented in a separate diagram, are also expressed most
commonly in their average, or per unit, form, represented here in figure 1.2. The long-run
average cost (LRAC) curve is shown to be an envelope of the short-run average cost (SRAC)
curves, lying everywhere below or tangent to the short-run curves. The firm is constrained in
the short-run in selecting the optimal mix of factors of production and so will never be able to
find a cheaper mix than can be found in the long-run when there are no constraints. If there
are a discrete number of plant sizes available, the LRAC will be the scalloped curve obtained
by joining those parts of the SRAC curves that represent the lowest cost of production for a
given quantity.

In the case of constant returns to scale, the most common assumption for production
functions, the LRAC curve is horizontal. More generally, the LRAC curve can be drawn as a
U-shape displaying increasing returns at lower levels of output and decreasing returns at
higher levels. The long-run marginal cost curve is usually omitted in introductory treatments.
If it is included, it is drawn so that it lies above the short-run marginal cost curve to the left of
their intersection point, and below to the right. Understanding the relationship between the
short-run and long-run marginal cost curves can be challenging, and may require conjuring
up additional diagrams. Sexton, Graves and Lee (1993) couch their explanation using is costs
and isoquants; whereas Boyd and Boyd (1994) show how the relationship can be explained
using the total cost curves. Keppler and Lallement (2006) trace the cost curve construction
back to Enrico Barone’s 1908 Principi di economia politica. Barone presents a diagram that
contains a total cost curve with costs increasing at a decreasing and then increasing rate -
equivalent to the textbook U-shaped average cost curve. He represents the marginal cost of a
particular quantity as the slope of a tangent to the cost curve at that quantity, and the average
cost of a particular quantity as the slope of a ray from the origin to the relevant point of the
cost curve. Total revenue is represented on the diagram as a line with the slope equivalent to
the price. The construction allows him to identify the profit maximizing quantity as that for
which the price equals marginal cost, and the zero profit long-run equilibrium quantity as that
for which price equals both marginal cost and average total cost .The first U-shaped cost
curve, in which cost is expressed in per unit terms, uncovered by Keppler and Lallement
(2006) appears an article by Edgeworth (1913) on railway rates. Since the discussion was of a
monopoly firm the relationship between price, marginal cost and average cost found in
Barone’s 1908 work is not brought out. The first per unit cost curve construction of a firm in
perfect competition bearing a close resemblance to contemporary textbook treatments, was
presented in paper by Piero Sraffa published in 1925 in an Italian language journal
(reproduced in Keppler and Lallement (2006)). Upon reading the article in Italian, Edgeworth
commissioned Sraffa to write a similar piece for the Economic Journal--which appeared in
1926 but did not contain the diagram. A virtually identical diagram, however, appears in a
related article by Pigou (1928). It is reasonable to suspect that Pigou derived it from Sraffa’s
1925 paper.

1.8 REVENUE ANALYSIS

In accounting, revenue is the income or increase in net assets that an entity has from its

normal activities (in the case of a business, usually from the sale of goods and services to
customers). Commercial revenue may also be referred to as sales or as turnover.
Some companies receive revenue from interest, royalties, or other fees. "Revenue" may refer
to income in general, or it may refer to the amount, in a monetary unit, earned during a period
of time, as in "Last year, Company X had revenue of $42 million". Profits or net
income generally imply total revenue minus total expenses in a given period. In accounting,
in the balance statement, revenue is a subsection of the equity section and revenue increases
equity, it is often referred to as the "top line" due to its position on the income statement at
the very top. This is to be contrasted with the "bottom line" which denotes net income (gross
revenues minus total expenses).

In general usage, revenue is income received by an organization in the form of cash or cash
equivalents. Sales revenue is income received from selling goods or services over a period of
time. Tax revenue is income that a government receives from taxpayers. Fundraising revenue
is income received by a charity from donors etc. to further its social purposes.

In more formal usage, revenue is a calculation or estimation of periodic income based on a

particular standard accounting practice or the rules established by a government or
government agency. Two common accounting methods, cash basis accounting and accrual
basis accounting, do not use the same process for measuring revenue. Corporations that offer
shares for sale to the public are usually required by law to report revenue based on generally
accepted accounting principles or on International Financial Reporting Standards.

In a double-entry bookkeeping system, revenue accounts are general ledger accounts that are

summarized periodically under the heading "Revenue" or "Revenues" on an income
statement. Revenue account-names describe the type of revenue, such as "Repair service
revenue", "Rent revenue earned" or "Sales".

One immediate benefit of the customer revenue analysis is that it allows your business to
recognize the revenue generated rather than the units sold.  This is an important factor to keep
in mind, as you might find some of your customers only purchase products when they’re on
sale, therefore generating far less revenue than sales on products at list price.  The customer
ranking should take into account the customer revenue analysis so that customer profitability
is part of their ranking.  Another way a customer revenue analysis could be used is by
comparing an individual customer to the “average customer,” and average customers within
the same ranking.  This points out which of your customers it pays to give attention.  What is
the average customer?  The average customer in this situation is the mean revenue recognized
from all your customers and from all customers in the same customer ranking. This analysis
allows your business to see the traits and uncover trends of the customers’ revenue generated
in total, by ranking, and for an individual customer.  As the great Peter Drucker once said,
“What gets measured, gets managed.”

A sales revenue analysis is a breakdown that allows your business to see how the business is
performing in comparison to previous years, and estimate how it should perform in the future.
The sales revenue analysis shows which products are generating more revenue for the firm in
any given time frame.   The time frame could use historical data for trend analysis or
projected estimates. These projections can offer your business key insights, including when
it’s generating more revenue in some months than others throughout the year. These trends
could move in cyclical, seasonal or monthly trends, depending on your industry of course.
For example, a tax consultant is likely to generate most of his revenue in the first four months
of the year due to tax season. A tax consultant could still generate revenue during the rest of
the year, but it is a significantly smaller amount than regular tax season.

It is extremely beneficial to pull these trends on an annual, monthly or even daily basis if
possible.  This will greatly assist in reviewing estimated versus actual revenue.  Another
aspect to consider when looking at a sales revenue analysis is recognizing the trend of
specific product sales to help decide which products or services to allocate more funds.  Some
products just sell better at different times of the year, like Christmas socks during December. 
The money allocated to new product sales represents profit that the business can reinvest into
its operations to further increase revenue. This analysis can also assist with inventory
decisions, including whether to increase, reduce or maintain current product inventory levels
- all of which can play a role in increasing revenue.

Putting together a payment trend analysis for customers also has its share of benefits,
including capturing days sales outstanding (DSO) and payment trends. The sales person and
finance department should have this information available to make credit, payment terms, and
order shipping decisions. This analysis could easily highlight a high-volume customer that
usually pays 15 days late. This information could help determine why a customer is in a
lower customer ranking or why the finance department has not increased the credit limit.

One solution to effectively monitor and manage payment trends is the use of an accounts
receivable management and credit collections system. This system should organize,
categorize, and report the data so that tracking DSO, aging invoices, and high-risk clients
is automatic. With a system in place, you can be proactive in your collections process and
improve cash flow. You will no longer need to ask: What invoices are late and how much
money is owed by aging category? How often are customers contacted directly about unpaid
invoices? What percentages of your customers pay on time?

The future belongs to those who can predict it, and according to Mr. Drucker, “the best way
to predict the future is to create it.” When Sir Isaac Newton invented calculus, people thought
he was crazy to talk about capturing instantaneous information on a curve.  He was not only
right, but he gave us the ability to take snapshots of things that people might still not dream
are possible to analyse.  Yet, the software exists today and it is affordable.  The power to
glimpse a customer’s spending patterns and predict their contribution to your business’s
profitability is immense.  Beyond being affordable on the front end, such software solutions
add tremendous revenue down the line for the life of your business.  No one likes to be
written off.  But when they have taken advantage for so long, essentially taking a free ride, it
is time to know when to hold them and when to fold them. Harness the benefits of the
revenue analysis and create the future you want for your business.

1.9 REVENUE ANALYSIS CONCEPT

The amount of money that a producer receives in exchange for the sale of goods is known as
revenue. In short, revenue means sales revenue. It is the amount received by a firm from the
sale of a given quantity of a commodity at the prevailing price in the market. For example, if
a firm sells 10 books at the price of Rs.100 each, the total revenue will be  Rs. 1000.

1.9.1 Total

Total revenue is the amount of income received by the firm from the sale of its products. It is
obtained by multiplying the price of the commodity by the number of units sold.

Figure 1.3: Total revenue

TR=P × Q

where, TR denotes Total Revenue,

P denotes Price and  Q denotes Quantity sold.

For example, a cell-phone company sold 100 cell-phones at the price of  Rs. 500 each.
TR is Rs. 50,000. (TR= 500 × 100 = 50,000).

When price is constant, the behaviour of TR is shown in table 1.1 and figure 1.3, assuming
P=5. When P = 5; TR = PQ

When price is declining with increase in quantity sold. (e.g., Imperfect Competition on the
goods market) the behaviour of TR is shown in table 1.1 and figure 1.4. TR can be obtained
from Demand fiction: If Q = 11–P,

When P = 1, Q = 10

Table 1.1: Total revenue & price declining

Figure 1.4: Total revenue graph

TR = PQ = 1 × 10 = 10.

When P = 3, Q = 8, TR = 24.
When P = 0, Q = 1, TR = 10.

1.9.2 Average

Average revenue is the revenue per unit of the commodity sold. It is calculated by dividing
the Total Revenue(TR) by the number of units sold (Q).

AR = TR /Q; if TR = PQ, AR = PQ/Q = P

AR denotes average revenue; TR denotes total revenue and Q denotes quantity of unit sold.

For example, if the total revenue from the sale of 5 units is Rs 30, the average revenue is
Rs.6. (AR= 30/5 =6). It is to be noted that AR is equal to price.

AR = TR/Q = PQ/Q = P.

Average revenue is the mathematical average of revenue earned per unit or per user. The
average revenue per unit or user (ARPU) allows a company's investors or management team
to analyse revenue generation capability and forecast future growth. ARPU is a macro-level
measurement tool that is useful to analysts and management, but it doesn't provide much
detailed information about the units or user base.

When a company only sells one product at one price, the average revenue of that company's
products is the price of the product. So, in many situations, the terms price and average
revenue are synonyms. However, when a company sells two or more products at two or more
prices, the average revenue is a way to estimate a company's profits. In this situation, ARPU
is essentially the average price of the units or users.

Two other terms closely related to average revenue are total revenue and marginal revenue.
It's good to know the difference between these terms for clarity. Here are their definitions.

1.9.3 Marginal Revenue

Marginal revenue (MR) is the increase in revenue that results from the sale of one additional
unit of output. While marginal revenue can remain constant over a certain level of output, it
follows from the law of diminishing returns and will eventually slow down as the output level
increases. In economic theory, perfectly competitive firms continue producing output until
marginal revenue equals marginal cost.

A company calculates marginal revenue by dividing the change in total revenue by the
change in total output quantity. Therefore, the sale price of a single additional item sold
equals marginal revenue. For example, a company sells its first 100 items for a total of
$1,000. If it sells the next item for $8, the marginal revenue of the 101st item is $8. Marginal
revenue disregards the previous average price of $10, as it only analyses the incremental
change.

Any benefits gained from adding the additional unit of activity are marginal benefits. One
such benefit occurs when marginal revenue exceeds marginal cost, resulting in a profit from
new items sold. A company experiences the best results when production and sales continue
until marginal revenue equals marginal cost. Beyond that point, the cost of producing an
additional unit will exceed the revenue generated. When marginal revenue falls below
marginal cost, firms typically adopt the cost-benefit principle and halt production, as no
further benefits are gathered from additional production.

The formula for marginal revenue can be expressed as

To assist with the calculation of marginal revenue, a revenue schedule outlines the total
revenue earned, as well as the incremental revenue for each unit. The first column of a
revenue schedule lists the projected quantities demanded in increasing order, and the second
column lists the corresponding market price. The product of these two columns results in
projected total revenues, in column three.

The difference between the total projected revenue of one quantity demanded and the total
projected revenue from the line below it is the marginal revenue of producing at the quantity
demanded on the second line. For example, 10 units sell at $9 each, resulting in total
revenues of $90; 11 units sell at $8.50, resulting in total revenues of $93.50. This indicates
the marginal revenue of the 11th unit is $3.50 ($93.50 - $90).

Marginal revenue (MR) is the addition to the total revenue by the sale of an additional unit of
a commodity. MR can be found out by dividing change in total revenue by the change in
quantity sold out. MR = ∆TR / ∆Q where MR denotes Marginal Revenue, ∆TR denotes
change in Total Revenue and ∆Q denotes change in total quantity.

The other method of estimating MR is

MR=TRn –TRn-1 (or) TRn+1 – TRn

where, MR denotes marginal revenue, TRn denotes total revenue of nth item, TRn-1 denotes
total revenue of n -1th item and TRn+1 denotes total revenue of n+1th item.

If TR = PQ MR = dTR/dQ = P, which is equal to AR.

1.10 RELATIONSHIP BETWEEN AVERAGE REVENUE AND

MARGINAL REVENUE

If a firm is able to sell additional units at the same price, then AR and MR will be constant
and equal. If the firm is able to sell additional units only by reducing the price, then both AR
and MR will fall and be different.

Constant AR and MR (at Fixed Price)

When price remains constant or fixed, the MR will be also constant and will coincide with
AR. Under perfect competition as the price is uniform and fixed, AR is equal to MR and their
shape will be a straight line horizontal to X axis. The AR and MR Schedule under constant
price is given in table 1.2 and in the figure 1.5.

Table 1.2: Constant Price

 Figure 1.5: Price and output

Declining AR and MR (at Declining Price)

When a firm sells large quantities at lower prices both AR and MR will fall but the fall in MR
will be steeper than the fall in the AR.

 It is to be noted that MR will be lower than AR. Both AR and MR will be sloping
downwards straight from left to right. The MR curve divides the distance between AR Curve
and Y axis into two equal parts. The decline in AR need not be a straight line or linear. If the
prices are declining with the increase in quantity sold, the AR can be non-linear, taking a
shape of concave or convex to the origin.

Figure 1.6: Price

 Table 1.3:Declining price

Relationship among TR, AR and MR Curves

When marginal revenue is positive, total revenue rises, when MR is zero the total revenue
becomes maximum. When marginal revenue becomes negative total revenue starts falling.
When AR and MR both are falling, then MR falls at a faster rate than AR.

TR, AR, MR and Elasticity of Demand

The relationship among AR, MR and elasticity of demand (e) is stated as follows.

The relationship between the AR curve and MR curve depends upon the elasticity of AR
curve (AR = DD = Price).

 When price elasticity of demand is greater than one, MR is positive and TR is

increasing.

 When price elasticity of demand is less than one, MR is negative and TR is

decreasing.

 When price elasticity of demand is equal to one, MR is equal to zero and TR is

maximum and constant.
It is to be noted that the output range of 1 to 5 units, the price elasticity of demand is greater
than one according to total outlay method. Hence, TR is increasing and MR is positive. At the
output range of 5 to 6 units, the price elasticity of demand is equal to one. Hence TR is
maximum and MR equals to zero.

At the output range of 6 units to 10 units, the price elasticity of demand is less than unity.
Hence, TR is decreasing and MR is negative.

Table 1.4: Elasticity

Figure 1.7: Total Revenue, Price & Quantity

1.11 CONCEPT OF PROFIT

An economic profit is the difference between the revenue a commercial entity has received
from its outputs and the opportunity costs of its inputs. Unlike an accounting profit, an
economic profit takes into account both a firm's implicit and explicit costs, whereas an
accounting profit only relates to the explicit costs which appear on a firm’s financial
statements. Because it includes additional implicit costs, the economic profit usually differs
from the accounting profit.

Economists often view economic profits in conjunction with normal profits, as both consider

a firm's implicit costs. A normal profit is the profit that is necessary to cover both the implicit
and explicit costs of a firm and of the owner-manager or investors who fund it. In the absence
of this profit, these parties would withdraw their time and funds from the firm and use them
to better advantage elsewhere, as to not forgo a better opportunity. In contrast, an economic
profit, sometimes called an excess profit, is the profit remaining after both the implicit and
explicit costs are covered.

The enterprise component of normal profit is the profit that business owners consider

necessary to make running the business worth their time, i.e., it is comparable to the next-best
amount the entrepreneur could earn doing another job. In particular, if enterprise is not
included as a factor of production, it can also be viewed as a return to capital for investors
including the entrepreneur, equivalent to the return the capital owner could have expected (in
a safe investment), plus compensation for risk. Normal profit varies both within and across
industries; it is commensurate with the riskiness associated with each type of investment, per
the risk-return spectrum.

Economic profits arise in markets which are non-competitive and have significant barriers to

entry, such as monopolies and oligopolies. The inefficiencies and lack of competition in these
markets foster an environment where firms can set prices or quantities - instead of
being price-takers, as occurs in a perfectly competitive market. In a perfectly competitive
market when long-run economic equilibrium is reached, an economic profit becomes non-
existent - because there is no incentive for firms either to enter or to leave the industry.

Companies do not make any economic profits in a perfectly competitive market once it has
reached a long run equilibrium. If an economic profit was available, there would be an
incentive for new firms to enter the industry, aided by a lack of barriers to entry, until it no
longer existed. When new firms enter the market, the overall supply increases. Furthermore,
these intruders are forced to offer their product at a lower price to entice consumers to buy
the additional supply they have created and to compete with the incumbent firms. As the
incumbent firms within the industry face losing their existing customers to the new entrants,
they are also forced to reduce their prices.

An individual firm can only produce at its aggregate production function. Which is a
calculation of possible outputs and given inputs; such as capital and labour. New firms will
continue to enter the market until the price of the product is lowered to equal the average cost
of producing the product. Once this has occurred a perfect competition exists and economic
profit is no longer available. When this occurs, economic agents outside the industry find no
advantage to entering the market, as there is no economic profit to be gained. Therefore, the
supply of the product stops increasing, and the price charged for the product stabilizes,
settling into an equilibrium.

The same is likewise true of the long run equilibria of monopolistically competitive
industries, and more generally any market which is held to be contestable. Normally, a firm
that introduces a differentiated product can initially secure temporary market power for
a short while  At this stage, the initial price the consumer must pay for the product is high,
and the demand for, as well as the availability of the product in the market, will be limited. In
the long run however, when the profitability of the product is well established, and because
there are few barriers to entry, the number of firms that produce this product will increase.
Eventually, the supply of the product will become relatively large, and the price of the
product will reduce to the level of the average cost of production. When this finally occurs,
all economic profit associated with producing and selling the product disappears, and the
initial monopoly turns into a competitive industry. In the case of contestable markets, the
cycle is often ended with the departure of the former "hit and run" entrants to the market,
returning the industry to its previous state, just with a lower price and no economic profit for
the incumbent firms.

Economic profit can, however, occur in competitive and contestable markets in the short run,
as a result of firms jostling for market position. Once risk is accounted for, long-lasting
economic profit in a competitive market is thus viewed as the result of constant cost-cutting
and performance improvement ahead of industry competitors, allowing costs to be below the
market-set price.

1.11.1 Gross
Gross profit is the profit a company makes after deducting the costs associated with making
and selling its products, or the costs associated with providing its services. Gross profit will
appear on a company's income statement and can be calculated by subtracting the cost of
goods sold (COGS) from revenue (sales). These figures can be found on a company's income
statement. Gross profit may also be referred to as sales profit or gross income.

Gross profit assesses a company's efficiency at using its labour and supplies in producing
goods or services. The metric mostly considers variable costs—that is, costs that fluctuate
with the level of output, such as

 Materials

 Direct labour, assuming it is hourly or otherwise dependent on output levels.

 Commissions for sales staff

 Credit card fees on customer purchases

 Equipment, perhaps including usage-based depreciation

 Utilities for the production site

 Shipping

The formula for gross profit is

Gross Profit= Revenue − Cost of Goods Sold.

As generally defined, gross profit does not include fixed costs (that is, costs that must be paid
regardless of the level of output). Fixed costs include rent, advertising, insurance, salaries for
employees not directly involved in the production and office supplies.

However, it should be noted that a portion of the fixed cost is assigned to each unit of
production under absorption costing, which is required for external reporting under the
generally accepted accounting principles (GAAP). For example, if a factory produces 10,000
widgets in a given period, and the company pays $30,000 in rent for the building, a cost of $3
would be attributed to each widget under absorption costing.

Gross profit shouldn't be confused with operating profit, also known as earnings before
interest and tax (EBIT), which is a company's profit before interest and taxes are factored in.
Operating profit is calculated by subtracting operating expenses from gross profit.

1.11.2 Net
The net profit margin, or simply net margin, measures how much net income or profit is
generated as a percentage of revenue. It is the ratio of net profits to revenues for a company
or business segment. Net profit margin is typically expressed as a percentage but can also be
represented in decimal form. The net profit margin illustrates how much of each dollar in
revenue collected by a company translates into profit.

Net profit margin is one of the most important indicators of a company's financial health. By
tracking increases and decreases in its net profit margin, a company can assess whether
current practices are working and forecast profits based on revenues. Because companies
express net profit margin as a percentage rather than a dollar amount, it is possible to
compare the profitability of two or more businesses regardless of size.

Investors can assess if a company's management is generating enough profit from its sales
and whether operating costs and overhead costs are being contained. For example, a company
can have growing revenue, but if its operating costs are increasing at a faster rate than
revenue, its net profit margin will shrink. Ideally, investors want to see a track record of
expanding margins, meaning that the net profit margin is rising over time.

Most publicly traded companies report their net profit margins both quarterly
during earnings releases and in their annual reports. Companies that can expand their net
margins over time are generally rewarded with share price growth, as share price growth is
typically highly correlated with earnings growth.

1.11.3 Normal

Normal profit is a profit metric that takes into consideration both explicit and implicit costs. It
may be viewed in conjunction with economic profit. Normal profit occurs when the
difference between a company’s total revenue and combined explicit and implicit costs are
equal to zero. Normal profit is often viewed in conjunction with economic profit. Normal
profit and economic profit are economic considerations while accounting profit refers to the
profit a company reports on its financial statements each period. Normal profit and economic
profit can be metrics an entity may choose to consider when it faces substantial implicit costs.

1.11.4 Abnormal

In economics, abnormal profit, also called excess profit, supernormal profit or pure profit, is

"profit of a firm over and above what provides its owners with a normal (market equilibrium)
return to capital." Normal profit (return) in turn is defined as opportunity cost of the owner's
resources. A related broader term is economic rent, which applies to the owner of a resource,
such as land, rather than to the firm as such.

According to the theoretical model of perfect competition, abnormal profits are unsustainable
because they stimulate new supply, which forces down prices and eliminates the abnormal
profit. Abnormal profit persists in the long run in imperfectly competitive markets where
firms successfully block the entry of new firms. Abnormal profit is usually generated by
an oligopoly or a monopoly; however, firms often try to hide this fact, both from the market
and government, in order to reduce the chance of competition, or government intervention in
the form of an antitrust investigation.

Abnormal profit is when economic profit is positive. Firms earn higher revenues than explicit
costs and implicit costs (or opportunity costs). The economic profit formula is as follows.

Economic profit = Total revenue – Explicit costs – Implicit costs

Explicit costs include total variable costs and total fixed costs. You can find these costs on
the income statement, along with total revenue.

Meanwhile, implicit costs represent the opportunity costs of using the firm’s current
resources. For example, to use a production machine, the company has two best options: buy
it or rent it. If the company chooses to rent a machine, the opportunity cost is the same as the
machine purchase cost. Conversely, if you buy a machine, the rental costs represent implicit
costs.

Of course, you won’t find costs implicit in the income statement.

Revenues from a business's primary activities are reported as sales, sales revenue or net

sales. This includes product returns and discounts for early payment of invoices. Most
businesses also have revenue that is incidental to the business's primary activities, such as
interest earned on deposits in a demand account. This is included in revenue but not included
in net sales. Sales revenue does not include sales tax collected by the business.

Other revenue (or. non-operating revenue) is revenue from peripheral (non-core) operations.

For example, a company that manufactures and sells automobiles would record the revenue
from the sale of an automobile as "regular" revenue. If that same company also rented a
portion of one of its buildings, it would record that revenue as “other revenue” and disclose it
separately on its income statement to show that it is from something other than its core
operations. The combination of all the revenue generating systems of a business is called
its revenue model.

The main source of overall budget revenues is tax revenues; therefore, analysis of tax revenue
components is crucially important. After 2009, based on budget law, there are six types of
taxes: personal income tax, value added tax, excise, import duty and real estate tax. This
research publication analyses dynamics of tax revenues as well as assesses tax burden. Tax
burden is estimated as the ratio of taxes to GDP. Therefore, tax burden implies share of
overall revenues that are paid by taxpayers. As chart 1 represents during 1996-2003 size of
the tax burden was 8.4%-12% of GDP, while during 2004-2009 tax revenues reached 25% of
GDP. After 2009, the size of tax burden stabilize by adoption of organic law of Georgia on
economic freedom imposes fiscal limits.

The microeconomics of strategy is built initially on an understanding of the nature of costs.

The on an understanding of the nature of costs. The links between costs and decision-making
are an essential part of strategy analysis and are central to an understanding of long-run cost
position and competitiveness. The guiding principle is the idea of opportunity cost. This is
defined as The sacrifice of alternatives foregone in producing goods or services. Seldon and
Penance (1965) for example, the cost of capital for project A is the return foregone by taking
project A rather than project B. It is not simply the cash cost of the funds required for project
A. For an individual, the opportunity cost of a new car might be the benefits foregone by not
extending the house. For a company, the opportunity cost of expansion into North America
might be the return foregone by not investing in China. The notion of opportunity cost rests
on the fact of scarcity – resources are limited in relation to the possibilities that exist. Without
scarcity there would be no concept of cost and indeed economics and economic thinking
would be irrelevant. The strength and pervasiveness of the concept of opportunity cost leads
us into an understanding of relevant costs: the costs associated with a decision are those costs
that are directly affected by and are changed by a decision. The significance of this is that
costs are decision specific and therefore are unlikely to be routinely available from those
costs reported in the annual accounts for the purposes of reporting to shareholders.
Accounting costs are typically backward-looking and relate to the firm as a whole whereas,
relevant costs are decisions specific and relate to future costs. Management accounting strives
to bridge this gap by taking a future perspective, although by its nature it cannot in setting
budgets anticipate the characteristics of decisions that are relevant for future costs. Many
costs arise directly from the scale (volume) of operation of a business. The term cost structure
refers to the technical conditions of production in the markets in which A and B operate. The
fundamental issue is the balance of costs between fixed costs, which do not vary with output
(e.g., the cost of machines or buildings or R&D spending) and variable costs, which do (e.g.,
labour costs or raw material costs). Above table sets out the definitions of these different cost
concepts together with an example of the impact of different levels of output. Above figure
depicts a cost function that shows the relationship between average total cost and output. It
shows how average costs vary with output. Note the shape of the average cost relationship.
Average total costs fall and are at the minimum value when output is Q1. The fall in average
total costs occurs (arithmetically) because of the fall in average fixed costs. The shape of cost
curves depends critically on the specification of the relevant time period. Economists make a
simple but very powerful distinction between the short run and the long run. The short run is
the (short) time within which the fixed factors of production cannot be changed. For example,
the nature of a factory and the characteristics of its production lines cannot normally be
changed within a period of weeks or even months. However, over a longer period, say five
years, the factory can be remodelled and the production lines rebuilt to take advantage of new
technology and new working processes. Short-run cost behaviour has two important
characteristics. These are captured in the law of diminishing returns. This says that as
additional amounts of variable factors of production are added to fixed factors (e.g., factory,
production lines), unit costs of output will first decrease up to a point, but will then increase.
The first part of this arises because the fixed costs (associated with the fixed factors of
production) remain constant as output increases. Therefore, unit costs will fall and we see the
importance of attaining the “right” volumes of output where average costs are minimized.

1.12 SUMMARY

 The difference between an opportunity cost and a sunk cost is the difference between
money already spent in the past and potential returns not earned in the future on an
 investment because the capital was invested elsewhere. Buying 1,000 shares of
company A at $10 a share, for instance, represents a sunk cost of $10,000. This is the
amount of money paid out to make an investment, and getting that money back
requires liquidating stock at or above the purchase price. But the opportunity cost
instead asks where could have that $10,000 been put to use in a better way.

 From an accounting perspective, a sunk cost could also refer to the initial outlay to
purchase an expensive piece of heavy equipment, which might be amortized over
time, but which is sunk in the sense that you won't be getting it back. An opportunity
cost would be to consider the forgone returns possibly earned elsewhere when you
buy a piece of heavy equipment with an expected return on investment (ROI) of 5%
vs. one with an ROI of 4%.

 Again, an opportunity cost describes the returns that one could have earned the money
were instead invested in another instrument. Thus, while 1,000 shares in company A
might eventually sell for $12 a share, netting a profit of $2,000, during the same
period, company B increased in value from $10 a share to $15. In this scenario,
investing $10,000 in company A returned $2,000, while the same amount invested in
company B would have returned a larger $5,000. The $3,000 difference is the
opportunity cost of choosing company A over company B.

 As an investor that has already sunk money into investments, you might find another
investment that promises greater returns. The opportunity cost of holding the
underperforming asset may rise to where the rational investment option is to sell and
invest in the more promising investment.

 In economics, risk describes the possibility that an investment's actual and projected

returns are different and that the investor loses some or all of the principal.
Opportunity cost concerns the possibility that the returns of a chosen investment are
lower than the returns of a forgone investment. The key difference is that risk
compares the actual performance of an investment against the projected performance
of the same investment, while opportunity cost compares the actual performance of an
investment against the actual performance of a different investment.

 Still, one could consider opportunity costs when deciding between two risk profiles. If
investment A is risky but has an ROI of 25% while investment B is far less risky but
 only has an ROI of 5%, even though investment A may succeed, it may not. And if it
fails, then the opportunity cost of going with option B will be salient.

 When making big decisions like buying a home or starting a business, you will
probably scrupulously research the pros and cons of your financial decision, but most
day-to-day choices aren't made with a full understanding of the potential opportunity
costs. If they're cautious about a purchase, many people just look at their savings
account and check their balance before spending money. Often, people don't think
about the things they must give up when they make those decisions.

 The problem comes up when you never look at what else you could do with your
money or buy things without considering the lost opportunities. Having takeout for
lunch occasionally can be a wise decision, especially if it gets you out of the office for
a much-needed break.

 However, buying one cheeseburger every day for the next 25 years could lead to
several missed opportunities. Aside from the missed opportunity for better health,
spending that $4.50 on a burger could add up to just over $52,000 in that time frame,
assuming a very achievable 5% rate of return.

 This is a simple example, but the core message holds true for a variety of situations. It
may sound like overkill to think about opportunity costs every time you want to buy a
candy bar or go on vacation. Even clipping coupons versus going to the supermarket
empty-handed is an example of an opportunity cost unless the time used to clip
coupons is better spent working in a more profitable venture than the savings
promised by the coupons. Opportunity costs are everywhere and occur with every
decision made, big or small.

 In economics, there are two main types of costs for a firm. First are explicit costs.
When looking at a firm’s financial statements, these costs are subtracted from the
firm’s revenue to obtain its accounting profit. These explicit costs include employees’
wages, materials, utility bills, and rent.

 Second of all, there are implicit costs, which is a factor in calculating the firm’s
economic profit. This is simply the same as accounting profits, but also subtract the
implicit costs. So, the economic profit is calculated by obtaining the firm’s revenue
and subtracting BOTH explicit and implicit costs.
1.13 KEYWORDS

 Abnormal Cost - An unusual or atypical cost whose occurrence is usually irregular

and unexpected and/or due to some abnormal situation of the production or operation.

 Cost - Is a measurement, in monetary terms, of the amount of resources used for the
purpose of production of goods or rendering services.

 Cost Unit - Cost unit is a form of measurement of volume of production of a product

or a service. Cost unit is generally adopted on the basis of convenience and practice in
the industry concerned.

 Cost of Production - Cost of production of a product or a service consists of cost of

materials consumed, direct employee costs, direct expenses, production overheads,
quality control costs, packing costs, research and development costs and
administrative overheads relating to production.

 Fixed Costs - Fixed costs are costs which do not vary with the change in the volume
of activity. Fixed indirect costs are termed fixed overheads.

1.14 LEARNING ACTIVITY

1. Create a survey on revenue analysis.

___________________________________________________________________________
___________________________________________________________________________

2. Create a session on different concept of production cost.

___________________________________________________________________________
___________________________________________________________________________

1.15 UNIT END QUESTIONS

A. Descriptive Questions

Short Questions

1. What is cost?

2. Define cost of production?

3. Define revenue?
 4. What is profit?

5. What is revenue analysis?

Long Questions

1. Explain the different concept of production cost.

2. Illustrate the concept of monetary cost.

3. Illustrate the concept of implicit and explicit cost.

4. Describe the revenue analysis concept?

5. Examine the concept of profit.

B. Multiple Choice Questions

1. What is Implicit costs?

a. Equal to total fixed costs

b. Comprised entirely of variable costs
c. Payments" for self-employed resources
d. Always greater in the short run than in the long run

2. Which one of the following would be an implicit cost for a firm?

a. Worker wages and salaries for the firm

b. Paid for leasing a building for the firm
c. Paid for production supplies for the firm
d. Of wages foregone by the owner of the firm

3. Which one of the following is true if a firm's revenues just cover all its opportunity
costs?

a. Normal profit is zero

b. Economic profit is zero
c. Total revenues equal its explicit costs
d. Total revenues equal its implicit costs.
 4. Which of the following is the output for the following problem:

With fixed costs of $400, a firm has average total costs of $3 and average variable
costs of $2.50.

a. 200 units
b. 400 units
c. 800 units
d. ,600 units

5. What does it indicate if the short-run average variable costs of production for a firm
are rising?

a. Average total costs are at a maximum

b. Average fixed costs are constant
c. Marginal costs are above average variable costs
d. Average variable costs are below average fixed costs

Answers

1-c, 2-d, 3-b, 4-c, 5-c

1.16 REFERENCES

Reference

 William, Baumol (1968). Entrepreneurship in Economic Theory. American Economic

Review.

 Stephen, Ison & Stuart, Wall. (2007). Economics, Fourth Edition, Harlow. New York:
FT Prentice Hall.

 Israel, Kirzner. (1979). Perception, Opportunity and Profit. Chicago: University of

Chicago Press.

Textbook

 Wolk, Harry I. Dodd, James L. Rozycki, John J. Wolk, Harry I.(2008). Accounting
Theory: Conceptual Issues in a Political and Economic Environment.

 Joseph, V. Carcello. (2008). Financial & Managerial Accounting. McGraw-Hill Irwin.

  Albrecht, William. (1983). Economics. Englewood Cliffs. New Jersey. Prentice-Hall.

Website

 https://en.wikipedia.org/wiki/Profit_(economics)

 https://en.wikipedia.org/wiki/Revenue

 https://www.investopedia.com/terms/o/opportunitycost.asp
UNIT 2 - MARKET STRUCTURE AND PERFECT
COMPETITION MARKET

STRUCTURE

2.0 Learning Objectives

2.1 Introduction

2.2 Market Structure and Perfect Competition Market

2.2.1 Meaning

2.2.2 Definition

2.3 Classification of the Markets

2.3.1 Traditional

2.3.2 Modern

2.4 Perfect Competition Market

2.5 Feature of Perfect Competition

2.6 Meaning of Firm and Industry

2.7 Price Determination under Perfect Competition

2.8 Equilibrium (Short-long run) of Industry and firm

2.9 Summary

2.10 Keywords

2.11 Learning Activity

2.12 Unit End Questions

2.13 References

2.0 LEARNING OBJECTIVES

After studying this unit, you will be able to

 Explain the price determination under perfect competition.

  Illustrate the classification of the markets.

 Examine the equilibrium (short-long run) of industry and firm.

2.1 INTRODUCTION

Market Structure in economics, depicts how firms are differentiated and categorised based on
types of goods they sell (homogeneous / heterogeneous) and how their operations are affected
by external factors and elements. Market structure makes it easier to understand the
characteristics of diverse markets.

Market Structure has been a topic of discussion for many economists like Adam
Smith and Karl Marx who have strong conflicting viewpoints on how the market operates in
presence of political influence. Adam Smith in his writing on economics stressed the
importance of laissez-faire principles outlining the operation of the market in the absence of
dominant political mechanisms of control, while Karl Marx discussed the working of the
market in the presence of a controlled economy sometimes referred to as a command
economy in the literature. Both types of market structure have been in historical evidence
throughout the twentieth century and twenty-first century.

In economics, specifically general equilibrium theory, a perfect market, also known as

an atomistic market, is defined by several idealizing conditions, collectively called perfect
competition, or atomistic competition. In theoretical models where conditions of perfect
competition hold, it has been demonstrated that a market will reach an equilibrium in which
the quantity supplied for every product or service, including labour, equals the
quantity demanded at the current price. This equilibrium would be a Pareto optimum. Perfect
competition provides both allocative efficiency and productive efficiency.

 Such markets are allocatively efficient, as output will always occur where marginal

cost is equal to average revenue i.e., price (MC = AR). In perfect competition,
any profit-maximizing producer faces a market price equal to its marginal cost (P =
MC). This implies that a factor's price equals the factor's marginal revenue product. It
allows for derivation of the supply curve on which the neoclassical approach is based.
This is also the reason why a monopoly does not have a supply curve. The
abandonment of price taking creates considerable difficulties for the demonstration of
a general equilibrium except under other, very specific conditions such as that
of monopolistic competition.
  In the short-run, perfectly competitive markets are not necessarily productively
efficient, as output will not always occur where marginal cost is equal to average
cost (MC = AC). However, in the long-run, productive efficiency occurs as new firms
enter the industry. Competition reduces price and cost to the minimum of the long run
average costs. At this point, price equals both the marginal cost and the average total
cost for each good (P = MC = AC).

The theory of perfect competition has its roots in late-19th century economic thought. Léon
Walras gave the first rigorous definition of perfect competition and derived some of its main
results. In the 1950s, the theory was further formalized by Kenneth Arrow and Gérard
Debreu.

Real markets are never perfect. Those economists who believe in perfect competition as a
useful approximation to real markets may classify those as ranging from close-to-perfect to
very imperfect. The real estate market is an example of a very imperfect market. In such
markets, the theory of the second best proves that if one optimality condition in an economic
model cannot be satisfied, it is possible that the next-best solution involves changing other
variables away from the values that would otherwise be optimal.

Idealizing Conditions of Perfect Competition

There is a set of market conditions which are assumed to prevail in the discussion of what
perfect competition might be if it were theoretically possible to ever obtain such perfect
market conditions. These conditions include

 A large number of buyers and sellers - A large number of consumers with the
willingness and ability to buy the product at a certain price, and a large number of
producers with the willingness and ability to supply the product at a certain price. As
a result, individuals are unable to influence prices more than a little.

 Anti-competitive regulation - It is assumed that a market of perfect competition shall

provide the regulations and protections implicit in the control of and elimination of
anti-competitive activity in the market place.

 Every participant is a price taker - No participant with market power to set prices.

 Homogeneous products - The products are perfect substitutes for each other (i.e., the
qualities and characteristics of a market good or service do not vary between different
suppliers). There are many instances in which there exist "similar" products that
 are close substitutes (such as butter and margarine), which are relatively easily
interchangeable, so that a rise in the price of one good will cause a significant shift to
the consumption of the close substitute. If the cost of changing a firm's manufacturing
process to produce the substitute is also relatively "immaterial" in relationship to the
firm's overall profit and cost, this is sufficient to ensure that an economic situation
isn't significantly different from a perfectly competitive economic market.

 Rational buyers - Buyers make all trades that increase their economic utility and make
no trades that do not.

 No barriers to entry or exit - This implies that both entry and exit must be perfectly
free of sunk costs.

 No externalities - Costs or benefits of an activity do not affect third parties. This

criterion also excludes any government intervention.

 Non-increasing returns to scale and no network effects: The lack of economies of

scale or network effects ensures that there will always be a sufficient number of firms
in the industry.

 Perfect factor mobility - In the long run factors of production are perfectly mobile,

allowing free long term adjustments to changing market conditions. This allows
workers to freely move between firms.

 Perfect information - All consumers and producers know all prices of products and
utilities they would get from owning each product. This prevents firms from obtaining
any information which would give them a competitive edge.

 Profit maximization of sellers - Firms sell where the most profit is generated,
where marginal costs meet marginal revenue.

 Well defined property rights - These determine what may be sold, as well as what
rights are conferred on the buyer.

 Zero transaction costs - Buyers and sellers do not incur costs in making an exchange
of goods.
2.2 MARKET STRUCTURE AND PERFECT COMPETITION MARKET

In this paper we’re going to discuss market structure as one of microeconomics topics,
market structure usually implies the degree of competition or the monopolistic power in the
markets. Market structures in economics have four types with different degrees of
competition from very competitive markets to monopoly (absence of competition), and they
function around the world, each one of them has particular characteristics and features, which
are applied upon the firms functioning in this market. Market structures in economics have
four types with different degrees of competition from very competitive markets to monopoly
(absence of competition), and they function around the world, each one of them has particular
characteristics and features, which are applied upon the firms functioning in this market.
These four types are perfect competition, monopolistic competition, monopoly, and
oligopoly. And studying market structure has a great importance in understanding how firms
behave according to the degree of competitions and the number of buyers and sellers,
therefore we are going to take every and each one of them and show it traits and features and
how firms operate under every structure.

2.1 Meaning

Market structure, in economics, refers to how different industries are classified and
differentiated based on their degree and nature of competition for goods and services. It is
based on the characteristics that influence the behaviour and outcomes of companies working
in a specific market.

Some of the factors that determine a market structure include the number of buyers and
sellers, ability to negotiate, degree of concentration, degree of differentiation of products, and
the ease or difficulty of entering and exiting the market.

Figure 2.1: Market Structure

2.2 Definition

Pure or perfect competition is a theoretical market structure in which the following criteria

are met.

 All firms sell an identical product (the product is a "commodity" or "homogeneous").

 All firms are price takers (they cannot influence the market price of their product).

 Market share has no influence on prices.

 Buyers have complete or "perfect" information—in the past, present and future—

about the product being sold and the prices charged by each firm.

 Resources for such a labour are perfectly mobile.

 Firms can enter or exit the market without cost.

This can be contrasted with the more realistic imperfect competition, which exists whenever a
market, hypothetical or real, violates the abstract tenets of neoclassical pure or perfect
competition.

Since all real markets exist outside of the plane of the perfect competition model, each can be
classified as imperfect. The contemporary theory of imperfect versus perfect
competition stems from the Cambridge tradition of post-classical economic thought.

2.3 CLASSIFICATION OF THE MARKETS

On this day, the world population is 8 billion of which India’s share is second largest namely,
1.234 billion spread over 6,78,999 villages, 5,165 towns, 5,570 tahsils, 595 districts, 7 union
territories and 28 big and small states each having unique features of dynamism. For
marketing people, PEOPLE represent market. These 1.234 billion people depend on
marketing system and engaged in marketing directly or indirectly.

These consumers of the economy represent the consumption wheel; on the other, production
wheel consisting of producers and manufacturers of goods and services rely on marketing to
push their goods and services to those who are needing and willing to pay for.

This is the belt of marketing that connects these wheels of production and consumption for
mutual benefits. That is, industrial and manufacturing activities have no meaning unless their
output is exchanged for money or money’s worth mutually acceptable to both the buyers and
sellers.
That is, manufacturing and producing is one thing and marketing is another. Left to
themselves, they serve no purpose. That is why, marketing is considered much more
important than production as it gives kick-start to the engine of economy.

As an introduction to the topic, there is detailed discussion as topic suggests. The module
ends with Module Based Questions and Module Based Case Studies.

Market, Marketing and Marketing Management

To understand the perfect meaning and status of marketing management in present world,
there is need to understand the meaning and implications of the terms ‘market’ and
‘marketing’. Hence, these three closely related terms are explained below.

Definition – What is Market?

The term ‘market’ originated from Latin word ‘maracatu’s’ having a verb ‘mercari’ implying
‘merchandise’ ‘ware traffic’ or ‘a place where business is conducted’. For a layman, the word
‘market’ stands for a place where goods and persons are physically present. For him, ‘market’
is ‘market’ who speaks of ‘fish market’, ‘mutton market’, ‘meat market’, ‘vegetable market’,
‘fruit market’, ‘grain market’. For him, it is a congregation of buyers and sellers to transact a
deal.

However, for us as the students of marketing, it means much more. In a broader sense, it is
the whole of any region in which buyers and sellers are brought into contact with one another
and by means of which the prices of the goods tend to be equalized easily and quickly.

2.3.1 Traditional

Markets can be classified on different bases of which most common bases are: area, time,
transactions, regulation, and volume of business, nature of goods, and nature of competition,
demand and supply conditions. This classification is off-shoot of traditional approach.

Traditionally, a market was a physical place where buyers and sellers gathered to buy and sell
the goods. Economists describe a market as a collection buyers and sellers who transact over
a particular product or product class.

On the Basis of Area

Using area, there can be local, regional, national and international markets. Local markets
confine to locality mostly dealing in perishable and semi-perishable goods like fish, flowers,
vegetables, eggs, milk, and others.
Regional market covers a wider area may be a district, a state or inter-state dealing in
durables both consumer and non-durables and industrial products, including agricultural
produce.

In case of national markets, the area covered are national boundaries dealing in durable and
non-durable consumer goods, industrial goods, metals, forest products, agricultural produce.
In case of world or international market, the movement of goods is widespread throughout
the world, making it as a single market. It should be noted that due to the latest technologies
in transport, storage and packaging, even the most perishable goods are sold all over the
world, not that only durables.

On the Basis of Time

The time duration is the factor. Accordingly, there can be short period and long period
markets. Short-period markets are for highly perishable goods of all kinds and long-period
markets are for durable goods of different varieties may be produced or manufactured.

On the Basis of Transactions

Taking the nature of transactions, these can be ‘spot’ and ‘future’ markets. In ‘spot’ market,
once the transaction takes place, the delivery takes place, while in case of future markets,
transactions are finalized pending delivery and payment for future dates.

On the Basis of Regulation

Taking regulation, markets can be regulated and non-regulated. A ‘regulated market’ is one
in which business dealings take place as per set rules and regulations regarding, quality,
price, source changes and so on.

These can be in agricultural products or produce and securities. On the other hand,
unregulated market is a free market where there are no rules and regulations; even if they are
there, they are amended as per the requirements of parties of exchange.

On the Basis of Volume of Business

Taking volume of business as a basis, there can be two types of markets namely, “Wholesale”
and “Retail”. Wholesale markets are featured by large volume business and wholesalers.

On the other hand, ‘Retail’ markets are those where quantity bought and sold is on small-
scale. The dealers are retailers who buy from wholesalers and sell back to consumers.

On the Basis of Nature of Goods

Taking the nature of goods, there can be commodity markets, capital markets. ‘Commodity’
markets deal in favour of material, produce, manufactured goods may be consumer and
industrial and bullion market dealing precious metals.

‘Capital’ market is a market for finance. These markets can be subdivided into ‘money’
market dealing in lending, and borrowing of money; ‘Securities’ market or ‘stock’ market
dealing in buying and selling of shares and debentures and ‘foreign exchange’ market where
it is a forex market dealing buying and selling of foreign currencies may be hard or soft.

On the Basis of Nature of Competition

Based on competition or competitive forces, there can be variety of markets for a product or
service. However, only two are the most important namely, perfect and imperfect.

A ‘perfect’ market is one which is characterized by

 Large number of buyers and sellers.

 Prevalence of single lowest price for products those are ‘homogeneous.

 The perfect knowledge on the part of buyers and sellers.

 Free entry and exit of firms in market. These types for markets exist hardly.

The other one is ‘imperfect’ which is featured by

 Products may be similar but not identical.

 Different prices for a class of goods.

 Existence of physical and psychological barriers on movement of goods.

 No perfect knowledge of products and other dimensions on the part of buyers and
sellers.

On the Basis of Demand and Supply

Based on demand and supply conditions or hold of buyers and sellers, there can be seller’s
and buyer’s markets. A seller’s market is one where sellers are in driver’s seat and the buyers
are at the receiving end.

In other words, it is a situation where demand for goods exceeds supply. On the other hand,
buyer’s market is one where buyers are in commanding position. That is, supply is exceeding
the demand for the goods.
2.3.2 Modern

The modern classification is based on the consumer orientation because in modern economic
system consumer is the king-pin and a decisive driving force.

Accordingly, the marketing experts have identified markets based on such broad-based
classification namely, consumer, business, global and, non-profit and government markets.

Consumer Markets

These markets specialize in selling mass consumer durable and nondurable products and
services devote good deal of time in an attempt to establish a superior brand image. These
items may be shoes, apparels, clothing, household items like television, sound system,
washing machines, fans, on one hand and tea, coffee, tea powder, coffee powder, biscuits,
bread spreads, dental cream, personal care beauty-aids, rice, wheat, oat, gourmet mixes and
so on the other.

Much of the brand’s strength rests on developing a superior product and packaging, ensuring
its availability and backing with engaging communications and reliable service. This task of
image building is really ticklish as consumer market goes on changing its colour over the
period of time.

Business Market

This is a market of business buyers and sellers. Business buyers buy goods with a view to
make or resell a product to others at a profit. Therefore, business marketers are to effectively
demonstrate as to how their products will help the buyers in getting higher revenue or lower
costs.

Therefore, companies selling business goods and services often face well-trained and well-
informed professional buyers who are skills in evaluating competitive offerings. These
markets deal in raw-materials, fabricated-parts, appliances, equipment’s, supplies and
services that become the part of end products of the business consumers. Advertising plays its
due role. However, personal selling has the upper hand. Product price, quality and business
suppliers’ reputation have significant role.

Global Markets

Global markets consist of buyers and sellers all over the world. The companies selling goods
and services in the global market place play global gain involving decisions and challenges.
To be successful, they must decide as to which country to enter?
How to enter each country? That is, as an exporter, license partner of a joint venture, contract
manufacturer or only manufacturer, how to adapt their product and source features to each
country? How to price their products in different countries? And how to adapt their
communications to differing cultures of various countries? These decisions are to be made in
the face of differing requirements for buying, negotiating, owning, and disposing of property
under different culture, language, and legal and political systems; and the foreign currency
that is subject to fluctuations having its own implications. It is needless to say that these
goods and services both consumer and industrial or business.

Non-profit and Government Markets

Companies do sell their products and services to non-profit organizations like temples,
churches, universities, charitable institutions and to governmental departments at local, state
and central level. The companies that market their products and services have to consider the
price aspect because these buyers have limited purchasing power.

Again, lower prices badly affect the features and quality of products and services if an
attempt is made to design such an offering.

Hence, these buyers buy through bidding where lowest bid is favoured as there is no
alternative. They also need longer period of credit.

2.4 PERFECT COMPETITION MARKET

A perfect competition market is that type of market in which the number of buyers and sellers
is very large, all are engaged in buying and selling a homogeneous product without any
artificial restrictions and possessing perfect knowledge of the market at a time.

In other words, it can be said—”A market is said to be perfect when all the potential buyers
and sellers are promptly aware of the prices at which the transaction take place. Under such
conditions the price of the commodity will tend to be equal everywhere.”

In this connection Mrs. Joan Robinson has said - ”Perfect competition prevails when the
demand for the output of each producer is perfectly elastic.”

According to Boulding - ”A perfect competition market may be defined as a large number of

buyers and sellers all engaged in the purchase and sale of identically similar commodities,
who are in close contact with one another and who buy and sell freely among themselves.”

Characteristics of Perfect Competition

The following characteristics are essential for the existence of perfect competition.

Large Number of Buyers and Sellers

The first condition is that the number of buyers and sellers must be so large that none of them
individually is in a position to influence the price and output of the industry as a whole. In the
market the position of a purchaser or a seller is just like a drop of water in an ocean.

Homogeneity of the Product

Each firm should produce and sell a homogeneous product so that no buyer has any
preference for the product of any individual seller over others. If goods will be homogeneous
then price will also be uniform everywhere.

Free Entry and Exit of Firms

The firm should be free to enter or leave the firm. If there is hope of profit the firm will enter
in business and if there is profitability of loss, the firm will leave the business.

Perfect Knowledge of the Market

Buyers and sellers must possess complete knowledge about the prices at which goods are
being bought and sold and of the prices at which others are prepared to buy and sell. This will
help in having uniformity in prices.

Perfect Mobility of the Factors of Production and Goods

There should be perfect mobility of goods and factors between industries. Goods should be
free to move to those places where they can fetch the highest price.

Absence of Price Control

There should be complete openness in buying and selling of goods. Here prices are liable to
change freely in response to demand and supply conditions.

Perfect Competition among Buyers and Sellers

In this purchasers and sellers have got complete freedom for bargaining, no restrictions in
charging more or demanding less, competition feeling must be present there.

Absence of Transport Cost

There must be absence of transport cost. In having less or negligible transport cost will help
complete market in maintaining uniformity in price.

One Price of the Commodity

There is always one price of the commodity available in the market.

Independent Relationship between Buyers and Sellers

There should not be any attachment between sellers and purchasers in the market. Here, the
seller should not show pick and choose method in accepting the price of the commodity. If
we will see from the close, we will find that in real life “Perfect competition is a pure myth.”

Perfect Competition and Economic Efficiency

Perfect competition leads to great efficiency in the LR because firms must produce where
price equals the lowest point on their LAC curve. Thus, the output of competitive industries
is equals the lowest point on their LAC curve. Thus, the output of competitive industries is
produced at the lowest possible cost to society. To see this, consider the AC and TC for a
perfectly competitive industry.

Table 2.1: Perfect competition and economic efficiency

Suppose the industry produces 12 million bushels of corn a year. This is accomplished by 120
firms producing 100,000 bushels of corn a year. Suppose the lowest point on the AC curve
firms producing 100,000 bushels of corn a year. Suppose the lowest point on the AC curve
corresponds to the output of 100,000 bushels with an AC of $0.70 per bushel. The lowest cost
way to produce 12 million bushels in the industry is to have 120 farms producing 100,000
bushels each. Total industry cost = AC x industry output, so the total industry cost is lowest
by having each firm produce at the lowest AC possible. Even though each farmer is
concerned with her own profits, the corn industry is guided by producer costs and consumer
demands to produce the amount that society wants at the lowest possible cost.

2.5 FEATURE OF PERFECT COMPETITION

A Perfect Competition market is that type of market in which the number of buyers and
sellers is very large, all are engaged in buying and selling a homogeneous product without
any artificial restrictions and possessing perfect knowledge of the market at a time.
In other words, it can be said—”A market is said to be perfect when all the potential buyers
and sellers are promptly aware of the prices at which the transaction take place. Under such
conditions the price of the commodity will tend to be equal everywhere.”

In this connection Mrs. Joan Robinson has said—”Perfect Competition prevails when the
demand for the output of each producer is perfectly elastic.”

According to Boulding—”A Perfect Competition market may be defined as a large number of

buyers and sellers all engaged in the purchase and sale of identically similar commodities,
who are in close contact with one another and who buy and sell freely among themselves.”

Figure 2.2: Perfect competition

Large Number of Buyers and Sellers

In perfect competition, the buyers and sellers are large enough, that no individual can
influence the price and the output of the industry. An individual customer cannot influence
the price of the product, as he is too small in relation to the whole market. Similarly, a single
seller cannot influence the levels of output, who is too small in relation to the gamut of sellers
operating in the market.

Homogeneous Product

Each competing firm offers the homogeneous product, such that no individual has a
preference for a particular seller over the 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.

Free Entry and Exit

Under the perfect competition, the firms are free to enter or exit the industry. This implies, If
a firm suffers from a huge loss due to the intense competition in the industry, then it is free to
leave that industry and begin its business operations in any of the industry, it wants. Thus,
there is no restriction on the mobility of sellers.

Perfect Knowledge of Prices and Technology

This implies, that both the buyers and sellers have complete knowledge of the market
conditions such as the prices of products and the latest technology being used to produce it.
Hence, they can buy or sell the products anywhere and anytime they want.

No Transportation Cost

There is an absence of transportation cost, i.e., incurred in carrying the goods from one
market to another. This is an essential condition of the perfect competition since the
homogeneous product should have the same price across the market and if the transportation
cost is added to it, then the prices may differ.

Absence of Government and Artificial Restrictions

Under the perfect competition, both the buyers and sellers are free to buy and sell the goods
and services. This means any customer can buy from any seller, and any seller can sell to any
buyer. Thus, no restriction is imposed on either party. Also, the prices are liable to change
freely as per the demand-supply conditions. In such a situation, no big producer and the
government can intervene and control the demand, supply or price of the goods and services.

2.6 MEANING OF FIRM AND INDUSTRY

The decisions of firms depend on consumer demand and production costs. Yet, they also
depend on the behaviour, the number, and the size of other firms in the industry. on the
behaviour, the number, and the size of other firms in the industry. The degree of competition
that firms face can severely limit the choices that firm owners have in setting prices. This can
protect the interests of consumers. For example, the U.S. automakers have faced increasing
competition from Japanese and German automakers. This forced the U.S. firms to produce
cheaper, safer and more reliable cars which benefits consumers. It examines firms under
severe competition and also illustrates monopoly firms that face no competition. Industries
differ dramatically in the number and average sizes of their firms. For example, the fishing
industry contains many small firms, whereas the aircraft and telecommunications industries
are comprised of a few giant firms. Describes perfect competition wherein firms are
numerous and small. First, we will discuss various market forms. Second, we will analyse the
output decisions of perfectly competitive firms. Third, we will consider how developments in
the industry affect individual firms. A firm is a for-profit business organization - such as a
corporation, limited liability company (LLC), or partnership - that provides professional
services. Most firms have just one location. However, a business firm consists of one or more
physical establishments, in which all fall under the same ownership and use the
same employer identification number (EIN).

When used in a title, "firm" is typically associated with businesses that provide professional
law and accounting services, but the term may be used for a wide variety of businesses,
including finance, consulting, marketing, and graphic design firms, among others.

A firm's business activities are typically conducted under the firm's name, but the degree of
legal protection - for employees or owners - depends on the type of ownership structure under
which the firm was created. Some organization types, such as corporations, provide more
legal protection than others. There exists the concept of the mature firm that has been firmly
established. Firms can assume many different types based on their ownership structures.

 A sole proprietorship or sole trader is owned by one person, who is liable for all costs
and obligations, and owns all assets. Although not common under the firm umbrella,
there exists some sole proprietorship businesses that operate as firms.

 A partnership is a business owned by two or more people; there is no limit to the

number of partners that can have a stake in ownership. A partnership's owners each
are liable for all business obligations, and together they own everything that belongs
to the business.

 In a corporation, the businesses' financials are separate from the owners' financials.

Owners of a corporation are not liable for any costs, lawsuits, or other obligations of
the business. A corporation may be owned by individuals or by a government.
Though business entities, corporations can function similarly to individuals. For
 example, they may take out loans, enter into contract agreements, and pay taxes. A
firm that is owned by multiple people is often called a company.

 A financial cooperative is similar to a corporation in that its owners have limited

liability, with the difference that its investors have a say in the company's operations.

An industry is a group of companies that are related based on their primary business

activities. In modern economies, there are dozens of industry classifications. Industry
classifications are typically grouped into larger categories called sectors.

Individual companies are generally classified into an industry based on their largest sources
of revenue. For example, while an automobile manufacturer might have a financing division
that contributes 10% to the firm's overall revenues, the company would be classified in the
automaker industry by most classification systems.

Similar businesses are grouped into industries based on the primary product produced or sold.
This effectively creates industry groups, which can then be used to isolate businesses from
those who participate in different activities. Investors and economists often study industries
to better understand the factors and limitations of corporate profit growth. Companies
operating in the same industry can also be compared to each other to evaluate the relative
attractiveness of a company within that industry.

Stocks within the same industry often rise and fall as a group because the
same macroeconomic factors impact all members of an industry. These macroeconomic
factors can include changes in market sentiment on the part of investors—such as those based
on a response to a particular event or piece of news—as well as changes directed specifically
towards the specific industry, such as new regulations or increased raw material costs.

However, events relating to just one particular business can cause the associated stock to rise
or fall separately from others within the same industry. This can be the result of certain
events, including a differentiating product release, a corporate scandal in the news, or a
change in leadership structures.

2.7 PRICE DETERMINATION UNDER PERFECT COMPETITION

Prof. Marshall compared demand and supply to the two blades of a pair of scissors. A
moment of reflection will show that it is not blade alone that cuts the cloth. Both A moment
of reflection will show that it is not blade alone that cuts the cloth. Both the blades together,
do it. Similarly, it is not demand or supply alone that determines the price of a commodity.
Together through interaction they determine the equilibrium price of a commodity. The
forces of demand and supply determine the price of a commodity. There is a conflict in the
aim of producers and consumers. Producers want to sell the goods at the highest price to
maximize profit and consumers want to buy the goods at the lowest price to maximize
satisfaction. Equilibrium price will be determined where quantity demanded is equal to
quantity supplied in the market. This is called market equilibrium price of the commodity.
You have learnt that the industry under perfect competition is defined as the collection of
Large number of firms producing the homogeneous product. In such a situation no firm
enjoys any power to determine its own price. The price of the commodity is determined at the
level of the industry through the interaction of the forces of demand and supply of the
commodity in the market. Since industry is the price maker, the industry demand curve is
downward sloping. Similarly, the industry supply curve of the product is an upward sloping
curve.

Table 2.2: Determination of equilibrium price of good X

Let us assume that the initial price is 6 per kg and the respective levels of quantity
Determination demanded and supplied are 16 and 24 kg respectively. Obviously, quantity
supplied demanded and supplied are 16 and 24 kg respectively. Obviously, quantity supplied
at this price is exceeding quantity demanded. So, the suppliers or producers will offer a lower
price to the buyers to ensure that their goods do not remain unsold. So, the price gradually
moves from 6 to 5 per kg. At this relatively lower price, demand expands to 18 kg while
supply contracts to 22 kg (in accordance with the respective laws of demand and supply), but
still there is a gap between supply and demand. So, the suppliers still feel that all of their
goods might not sell in the market as quantity demanded is less than quantity supplied. So,
they reduce price further so as to ensure that their goods do not remain unsold. This process
continues till the price level reaches a point where quantity demanded equals quantity
supplied. Thus, when the price falls from 5 to 4, quantity demanded as well as quantity
supplied is equal to 20 kg. Now the suppliers have no reason to reduce their price further.
Hence as long as quantity supplied exceeds the quantity demanded, price of the commodity
keeps falling till both become equal. Note that, when supply exceeds demand, we call it
excess supply that causes price to fall till demand and supply become equal to each other. On
the other hand, at a very low price of 2, quantity demanded in 24 kg which is higher than
quantity supplied of 16 kg. Since demand is higher than supply, price of the commodity
increases to 3. At 3, the quantity demanded is 22 kg which is still higher than the quantity
supplied of 18 kg. It results in increase in price to 4 where we find that quantity demanded
and supplied have become equal at 20 kg. Hence as long as quantity demanded exceeds the
quantity supplied, the price of the commodity keeps increasing till both demand and supply
become equal to each other. Note that when demand exceeds supply, we call it excess
demand that causes price to rise till demand equal’s supply. In the example, at 4, demand and
supply of the commodity are equal and hence there is no reason for the price to fluctuate from
here. Hence 4 is the equilibrium market price. At this price 20 kg is equilibrium quantity. The
process of price determination has also been explained with the help of figure 2.3. In the
figure, DD is the demand curve and SS is the supply curve. The negative slope of demand
curve DD indicates a negative relation between price of the commodity and its quantity
demanded. Similarly, positive slope of the supply curve Similarly, positive slope of the
supply curve SS indicates a positive relation between price of the commodity and its quantity
supplied. Demand curve DD and supply curve SS intersect each other at point E, which is the
point of equilibrium at which equilibrium price is 4 per kg. and equilibrium quantity
demanded and supplied is 20 kg. Equilibrium price is also defined as the price at which
demand curve and supply curve intersect each other.

Price Determination for a Firm under Perfect Competition

Under perfect competition, the industry determines the price following the same route of
adjustment as described above with the help of twin market forces of route of adjustment as
described above with the help of twin market forces of demand and supply. Firms have to
accept the price determined by the industry and offer their output at this price. This can be
shown with the help of the following figure 2.3.
 Figure 2.3: Price determination for a firm under perfect competition

Table 2.3: Price determination under perfect competition

Under perfect competition at price 4 per kg industry demand and industry supply are both
equal to 16 kg and hence the equilibrium price determined by the industry are both equal to
16 kg and hence the equilibrium price determined by the industry is 4 per kg which has to be
followed by all the firms of the industry. The firm may sell any quantity but the price remains
constant at 4 per kg. That is why AR = MR in perfect competition in, and are represented by
a revenue curve which is parallel to x-axis.

Excess Demand
Excess demand is the gap between demand and supply when demand is more than supply. If
at a given price, the quantity demanded of a commodity exceeds its supply. If at a given
price, the quantity demanded of a commodity exceeds its quantity supplied we have excess
demand. For example, in the table 2.3, when price is 2per kg., demand is 24 kg. while supply
is just 16 kg. So, this is a situation of excess demand.

Process of Adjustment

One very interesting and important feature of price mechanism is that any disequilibrium is
self-correcting. Thus, if there is excess demand at any price, price will move in such a way so
as to bring equilibrium between demand and supply. In figure 2.3, when price is ` 2, quantity
demanded is 24 kg but quantity supplied is just 16 kg. So, there is excess demand of 24 – 16
= 8 kg. In this situation, buyers realize that some of them will have to go without the
commodity as supply is less than that of demand. So, they compete to buy the product and, in
the process, offer a higher price. So, effectively price moves from ` 2 to ` 3 per kg. At this
relatively higher price, demand contracts from 24 kg to 22 kg and supply expands from 16 to
18 kg. So, the magnitude of excess demand has diminished from 8 kg to 4 kg, but still there is
a gap and some of the buyers have still to go without the commodity. So, there is still
competition, which raises the price further to ` 4 per kg, where demand contracts further to 20
kg and supply expands to 20 kg. Now, both quantity demanded and quantity supplied are
equal.

Figure 2.4: Quantity demanded and supply

Excess Supply
Excess supply is the gap between demand and supply when supply is more than demand. If at
a given price, the quantity supplied of a commodity exceeds its demand. If at a given price,
the quantity supplied of a commodity exceeds its quantity demanded we have excess supply.
For example, in the table 2.3, when price is ` 6 per kg., demand is 16 kg. while supply is just
24 kg., obviously this is a situation of excess

Supply. Process of Adjustment

When quantity supplied is more than quantity demanded at price of 6 per kg., the suppliers
are now worried as they know that because of excess supply, all of their goods might not be
sold. Every supplier now wants to ensure that his goods are not left unsold. In a bid to ensure
this, the supplier, tries to lure consumers by lowering the price to 5 per kg. But other
suppliers are also doing precisely the same. So, the price effectively falls to 5 per kg. But
even at this relatively lower price, supply still exceeds demand by 4 kg. and so, another cycle
of offering a lower price starts. This continues till the price reaches the level of 4 per kg
where quantity demanded equals quantity supplied. At this price, suppliers have no quantity
demanded equals quantity supplied. At this price, suppliers have no reason to offer a lower
price, as they know that at this price all their goods are going to be sold. So, the equilibrium
in this case has been brought about by decrease in price, which also contracts supply and
expands demand.

Figure 2.5: Quantity demanded and supplied

Effect of Change in Demand on Equilibrium Price and Quantity

As demand and supply are the twin forces determining the equilibrium price of a commodity,
any change in either or both of them is bound to bring in some change commodity, any
change in either or both of them is bound to bring in some change in price. We will study, in
this section, the effect of change in demand, supply held constant.

Effect of Increase in demand When due to any external factor such as rise in population, rise
in income of people, demand for a commodity increases (for every price level), the demand
curve shifts rightwards. As a result, it now intersects the supply curve at a new, higher level,
which causes the price to rise. As shown in the figure below, initial demand curve DD
intersects supply curve.

The equilibrium price is OP and the equilibrium quantity demanded and supplied are OQ.
Now, suppose demand increases and as a result, demand curve shifts are OQ. Now, suppose
demand increases and as a result, demand curve shifts rightwards. This new demand curve
D’D’ intersects the supply curve SS at point ‘e’. So, the new equilibrium price is OP’ which
is higher than the earlier. price OP. It may also be noted that the equilibrium quantity
demanded and supplied have also risen from OQ to OQ’.

Figure 2.6: Price and quantity demanded and supplied.

Effect of Decrease in Demand

When due to any external event such as fall in income level, demand for a commodity falls,
the demand curve shifts leftwards. So, this new demand curve commodity falls, the demand
curve shifts leftwards. So, this new demand curve intersects supply curve at a lower level
which causes the price to fall. In the figure 2.6, initial demand curve DD intersects the supply
curve SS at DD intersects the supply curve SS at point e. The equilibrium price is OP and the
equilibrium, quantity demanded and supplied are OQ. Now, suppose demand decreases and
as a result, demand curve shift leftwards. This new demand curve D’D’ intersects the supply
curve SS at point e’. So, the new equilibrium price is OP’ which is lower than the earlier
price OP. It may also be noted that the equilibrium quantity demanded and supplied have also
decreased from OQ to OQ.

Figure 2.7: Effect of decrease in demand

2.8 EQUILIBRIUM (SHORT-LONG RUN) OF INDUSTRY AND FIRM

It is essential to know the meaning of firm and industry before analysing the two. Firm is an
organization which produces and supplies goods that are demanded by the people with the
goal of maximizing its profits.

According to Prolamellar, “Firm is an organisation that buys and hires resources and sells
goods and services.” To Lipsey, “Firm is the unit that employs factors of production to
produce commodities that it sells to other firms, to households, or to the government.”

Industry is a group of firms producing homogeneous products in a market. According to

Lipsey, “Industry is a group of firms that sells a well-defined product or closely related set of
products.” For example, Raymond, Maffatlal, Arvind, etc., are cloth manufacturing firms,
whereas a group of such firms is called the textile industry.

Conditions of Equilibrium of the Firm and Industry

A firm is in equilibrium when it has no tendency to change its level of output. It needs neither
expansion nor contraction. It wants to earn maximum profits in by equating its marginal cost
with its marginal revenue, i.e., MC = MR.

Diagrammatically, the conditions of equilibrium of the firm are given.

The MC curve must equal the MR curve. This is the first order and necessary condition. But
this is not a sufficient condition which may be fulfilled yet the firm may not be in
equilibrium.

Figure 2.8: Revenue / Cost

The MC curve must cut the MR curve from below and after the point of equilibrium it must
be above the MR. This is the second order condition.’ Under conditions of perfect
competition, the MR curve of a firm coincides with the AR curve. The MR curve is
horizontal to the X- axis. Therefore, the firm is in equilibrium when MC=MR=AR (Price).

In Figure 2.8(A), the MC curve cuts the MR curve first at point A. It satisfies the condition of
MC = MR, but it is not a point of maximum profits because after point A, the MC curve is
below the MR curve. It does not pay the firm to produce the minimum output OM when it
can earn larger profits by producing beyond OM.

Point В is of maximum profits where both the conditions are satisfied. Between points A and
B., it pays the firm to expand its output because it’s MR > MC. It will, however, stop further
production when it reaches the OM1 level of output where the firm satisfies both the
conditions of equilibrium.

If it has any plans to produce more than OM1 it will be incurring losses, for its marginal cost
exceeds its marginal revenue beyond the equilibrium point B. The same conclusions hold
good in the case of a straight-line MC curve as shown in figure 2.8.(B).
An industry is in equilibrium: firstly, when there is no tendency for the firms either to leave
or enter the industry, and secondly, when each firm is also in equilibrium. The first condition
implies that the average cost curves coincide with the average revenue curves of all the firms
in the industry. They are earning only normal profits, which are supposed to be included in
the average cost curves of the firms.

The second condition implies the equality of MC and MR. Under a perfectly competitive
industry these two conditions must be satisfied at the point of equilibrium, i.e.

MC = MR … (1)

AC = AR … (2)

AR = MR

MC = AC = AR

Such a situation represents full equilibrium of the industry.

Short-Run Equilibrium of the Firm

A firm is in equilibrium in the short-run when it has no tendency to expand or contract its
output and wants to earn maximum profit or to incur minimum losses. The short-run is a
period of time in which the firm can vary its output by changing the variable factors of
production. The number of firms in the industry is fixed because neither the existing firms
can leave nor new firms can enter it.

Assumptions

This analysis is based on the following assumptions.

 All firms use homogeneous factors of production.

 Firms are of different efficiency.

 Cost curves of firms vary from each other.

 All firms sell their products at the same price determined by demand and supply of
the industry so that the price of each firm, P (Price) = AR = MR.

 Firms produce and sell different quantities.

The short-run equilibrium of the firm can be explained with the help of marginal analysis and
total cost- total revenue analysis.
Marginal Cost-Marginal Revenue Analysis

During the short run, a firm will produce only if its price equals the average variable cost or
is higher than the average variable cost (AVC). Further, if the price is more than the averages
total costs (SAC or АТС), i.e., P— AR > SAC, the firm will be earning supernormal (or
abnormal) profits.

If price equals the average total costs, i.e., P = AR = SAC, the firm will be earning normal (or
zero) profits or breaks-even. If price equals AVC, the firm will be incurring a loss. If price
falls even a little below AVC, the firm will shut down because in order to produce it must
cover at least its AVC during the short-run.

So, during the short-run under perfect competition, a firm is in equilibrium in all the above
noted situations. We illustrate them diagrammatically as under

Supernormal Profits

The firm will be earning supernormal profits in the short-run when price is higher than the
short-run average cost, as shown in figure 2.9(A). The firm is in equilibrium at point
E1 where SMC=MR and SMC cuts MR from below. OQ, is the equilibrium output and OP
(=Q1E1) is the equilibrium price. Q1S are the short-run average costs.

SE1 (=Q1E1-Q1S) is the profit per unit. TS (equilibrium output) (per unit profit) = TSE1P
area is the supernormal profits.

Normal Profits

The firm may earn normal profits when price equals the short-run average costs as shown in
figure 2.9(B). The firm is in equilibrium at point E2 where SMC =MR and SMC cuts MR
from below. OQ2 is the equilibrium output and OP (=Q2E) is the equilibrium price. The firm
is earning normal profits because Price = AR = MR =SMC= SAC at its minimum point E2.

Minimum Loss

The firm may be in equilibrium and yet incur a loss when price is less than the short-run
average costs, as shown in figure 2.9(C). The firm is in equilibrium at point E3 where SMC =
MR and SMC cuts MR from below. OQ3 is the equilibrium output and OP (=Q3E3) is the
equilibrium price.
Since the average costs Q3B are higher than the price Q3E3, E3B is the loss per unit (Q3B-
Q3E3). The total loss is PE3 x E3B = PE3BA. The firm will continue to produce OQ3 output
so long as it is covering its average variable cost plus some of its fixed cost.

Figure 2.9: Minimum loss

Maximum Loss

If the price fig. 2.9 falls to the level of AVC, the firm will just cover its average variable cost,
as shown in figure 2.9(D). It is indifferent whether to operate or close down because its losses
are the maximum.

It will pay such a firm to continue producing OQ4 output and incur PE4GF losses rather than
close down in the short-run. OQ4 is the shutdown output because if the price falls below OP,
the firm will stop production. E4 is, therefore, the shutdown point.

Shut Down Stage

Figure 2.9 (E) shows a firm which is unable to cover even its AVC at OQ0 level of output
because the price OP is below the AVC curve. It must shut down.

Thus, in the short-run, there are firms which earn normal profits, supernormal profits and
incur losses.
 Figure 2.10: Shut down stage

Total Cost-Total Revenue Analysis

The short-run equilibrium of the firm can also he shown with the help of total cost and total
revenue curves. The firm is able to maximize its profits when the positive difference between
TR and TC is the greatest. This is shown in figure 2.10 where TR is the total revenue curve
and TC the total cost curve.

The total revenue curve is an upward sloping straight line curve starting from O. This is
because the firm sells small or large quantities of its product at a constant price under perfect
competition. If the firm produces nothing, total revenue will be zero The more it produces,
the larger is the increase in total revenue. Hence the TR curve is linear and slopes upward.

The firm will maximize its profits at that level of output where the gap between the TR curve
and the TC curve is the maximum. Geometrically, it is that level at which the slope of a
tangent drawn to the total cost curve equals the slope of the total revenue curve. In figure
2.10, the maximum amount of profit is measured by TP at OQ output.

At outputs smaller or larger than OQ between A and B points, the firm’s profits shrink. If the
firm produces OQ1 output, its losses are the maximum because the TC curve is above the TR
curve. At Q1 its profits are zero.

This is the break-even point of the firm. It starts earning profits when it produces beyond
OQ1 output level. At OQ2 level, its profits are again zero. If it produces beyond this level, it
incurs losses because TC > TR.

Short-Run Equilibrium of the Industry

An industry is in equilibrium in the short-run when its total output remains steady, there
being no tendency to expand or contract its output. If all firms are in equilibrium, the industry
is also in equilibrium. For full equilibrium of the industry in the short-run, all firms must be
earning only normal profits.

The condition for this is SMC = MR = AR = SAC. But full equilibrium of the industry is by
sheer accident because in the short- run some firms may he earning supernormal profits and
some incurring losses. Even then, the industry is in short-run equilibrium when its quantity
demanded and quantities supplied are equal at the price which clears the market.

This is illustrated in figure 2.11 where in Panel (A), the industry is in equilibrium at point E
where its demand curve D and supply curve S intersect which determine OP price at which its
total output OQ is cleared. But at the prevailing price OP, some firms are earning
supernormal profits PE1ST, as shown in Panel (B), while some other firms are incurring
FGE2P losses, as shown in Panel (C) of the figure 2.11.

Figure 2.11: Short-run equilibrium of the industry

Long-Run Equilibrium of the Firm

The long run is a period of time in which the firm can change its plant and scale of
operations. Thus, in the long-run all costs are variable and there are no fixed costs. The firm
is in the long-run equilibrium under perfect competition when it does not want to change its
equilibrium output.

It is earning normal profits. If some firms are earning supernormal profits, new firms will
enter the industry and supernormal profits will be competed away. If some firms are incurring
losses, some of the firms will leave the industry till all earn normal profits.
Thus, there is no tendency for firms to enter or leave the industry because every firm must
earn normal profits. “In the long-run, firms are in equilibrium when they have adjusted their
plant so as to produce at the minimum point of their long-run AC curve, which is tangent (at
this point) to the demand (AR) curve defined by the market price” so that they earn normal
profits.

Assumptions

This analysis is based on the following assumptions.

 Firms are free to enter into or leave the industry.

 All firms are of equal efficiency.

 All factors are homogenous. They can be obtained at constant and uniform prices.
SMC.

 Cost curves of firms are uniform.

 The plants of firms are equal, having given technology.

 All firms have perfect knowledge about price and output.

Given these assumptions, each firm of the industry will be in long-run equilibrium when it
fulfils the following two conditions.

1. In equilibrium, its short-run marginal cost (SMC) must equal to its long-run marginal
cost (LMC) as well as its short-run average cost (SAC) and its long-run average cost
(LAC) and both should equal MR=AR=P.

Thus, the first equilibrium condition is

SMC = LMC = MR = AR = P = SAC = LAC at its minimum point, and

2. LMC curve must cut MR curve from below: Both these conditions of equilibrium are
satisfied at point E in figure 2.12 where SMC and LMC curves cut from below SAC
and LAC curves at their minimum point E and SMC and LMC curves cut AR = MR
curve from below. All curves meet at this point E and the firm produces OQ optimum
output and sells it at OP price.
 Figure 2.12: Price and Output

Since we assume equal costs of all the firms of industry, all firms will be in equilibrium in the
long-run. At OP price a firm will have neither a tendency to neither leave nor enter the
industry and all firms will earn normal profits.

Long-Run Equilibrium of the Industry

The industry is in equilibrium in the long-run when all firms earn normal profits. There is no
incentive for firms to leave the industry or for new firms to enter it. With all factors
homogeneous and given their prices and the same technology, each firm and industry as a
whole are in full equilibrium where LMC = MR = AR (-P) = LAC at its minimum.

Such an equilibrium position is attained when the long-run price for the industry is
determined by the equality of total demand and supply of the industry.

Figure 2.13: Long-run equilibrium of the industry

The long-run equilibrium of the industry is illustrated in figure 2.13 where the long-run price
OP is determined by the intersection of the demand curve D and the supply curve S at point E
and the industry is producing OM output. At this price OP, the firms are in equilibrium at
point A in Panel (B) at OQ level of output where LMC = SMC = MR =P ( = AR) = SAC =
LAC at its minimum.

At this level, the firms are earning normal profits and have no incentive to enter or leave the
industry. It follows that when the industry is in long-run equilibrium, each firm in the
industry is also in long-run equilibrium. If both the industry and the firms are in long-run
equilibrium, they are also in short-run equilibrium.

Perfect competition market has many characteristics.

It's called a perfect competition market when it's available on very large number of buyers
and sellers and all of them that engaged in selling and buying products without any invented
restrictions and having a quite good knowledge of markets. So, the perfect competitive
market is the market with absent of monopolistic elements, in this market structure the prices
are determined by the market demand and supply forces and they are absolutely free to enter
this industry or exit from it as well. So, the perfect competitive market is the market with
absent of monopolistic elements, in this market structure the prices are determined by the
market demand and supply forces and they are absolutely free to enter this industry or exit
from it as well.

Large Number of Sellers and Buyers

If the number of buyers and sellers are very small, they will be in a position that they can
make an effect on all the price and output of the industry so there must be a huge number of
buyers and sellers in the market, thus the supply of individual seller is very small that will not
make changes in total price. When this happens the buyer or seller has no power by himself
to make changes in the prices, the price is fixed for all industry, so he must accept it. When
this happens the buyer or seller has no power by himself to make changes in the prices, the
price is fixed for all industry, so he must accept it.

No Barriers of Entry or Exit

To achieve perfect comparative market the firms should be free to leave the industry if they
don’t make a profit or want to quit, as well as entering the industry if they want, this means
that anyone has the right to enter or exit the industry with no barriers. Thus, each seller has
full freedom to enter or exit the market.
Identical Product

All the firms produce a homogeneous product and sell it so that the buyer can choose any
product from any seller, the individual can buy any product he prefers from many firms.

Absence of Artificial Restrictions

There’s no discrimination among the sellers and buyers, each one of them is totally free to
sell or buy from whoever he wants to, and there’s no restrictions forced by the producers or
government to control the prices, supply or demand; thus, the prices movement is
unrestricted.

Maximization of Profit

The main goal of any firm that maximize its profits, to maximize the profit the firms set
(MR=MC) marginal revenue equal marginal cost.

In the short run the firms can make economic profits, economic loss or zero, when the price is
less than the average this mean the firm making loss but when the price greater than the
average firm is making a profit, in the perfect competitive market are able to reach super-
normal profits as shown in the figure 2.14.

Figure 2.14: Profit in the perfect competitive market

But In the long run as the firms that make a profits, more firms want to enter the market and
when this happens it will make the industry supply curve shifts to the right and the
equilibrium price will fall, the profits will decrease until it reaches zero.
When the prices go down and become lower than average price, the firms will start losing
which will make this firms leave the market, thus more firms leave the market, and it will
make change on supply curve and shift it to the lift, prices will rise up and firms’ profit will
increase until no firms gain losses and it reach zero.

In sum, the perfect competitive market in the long run do not have any economic profit.

Pricing Decision

The price in this market is determined by the markets power, therefore the seller in this
market is price taker, not price maker, they have to accept the market price.

When any firm rise the price of its product, the buyer will simply stop buying from this
particular seller and buy the product from other sellers with low price so the firms can't have
an independent price.

It means that firms can sell its products at the ruling market price only because the number of
products and sellers a very large.

Perfect Knowledge of Market Conditions

Buyers and sellers should have full information about market conditions, and the prices of
products in thus market, this knowledge forces the firms to commit to the market price.

Absence of Transport Costs

Because of the difference in the distances of the places of sale If there is a transportation cost
of product from one place to another, this will make a huge different between prices from
place to another, so that should not be any cost for transport.

The goods should be free to move to those places where they can get the highest price.

Absence of Selling Costs

In the perfect competitive market there’s no selling costs, no need to add any advertisement
or any other types of selling cost because all firms industry are homogeneous and there’s a
full knowledge and well-informed customer.

Advantages of perfect competition are listed below.

 First and foremost, advantage of perfect competition is that chances of consumer

exploitation are very low in case of this type of market structure because in perfect
competition sellers do not have any monopoly pricing power and hence they cannot
 influence the price of the product or charge higher than the normal price from
consumers.

 Another advantage of perfect competition is that consumer get standardized product

irrespective of the place of purchase of product, so for example if a consumer is living
in city A and he or she travels to city B and he or she requires soap which normally
has perfect competition then consumer does not have to worry about quality of
product because product will remain same whether consumer purchase it from city A
or city B.

 Perfect competition is consumer-oriented market implying that consumer is king in

case of this type of market structure and sellers cannot displease the consumer
because consumer will quickly shift from one seller to another, hence as far as
consumers are concerned perfect competition market structure gives them pleasure of
shifting from one seller to another if they are not satisfied from the product or sellers
services.

 Another advantage of perfect competition is that it has very little or no advertisement

expense because products are homogeneous and if the firm keeps the price as decided
by market forces, then sales will automatically happen without the company incurring
huge publicity and advertisement expense.

Disadvantages of perfect competition are

 The biggest disadvantage of this type of market structure is that there is no incentive
for sellers to innovate or add more features to the product because in case of perfect
competition profit margin is fixed and seller cannot charge higher than normal price
which is prevailing in the market because consumer will move to other sellers hence
sellers keep selling standardized product at price fixed by market forces of demand
and supply.

 Another disadvantage of perfect competition is that there are very few barriers to

entry implying that any firm can enter the market and start selling the product, hence
old firms cannot afford to be complacent because chances of losing market share to
new firms always loom over them.

 In the case of perfect competition firm which has the best location is likely to generate
more sales then firm which is not located on prime location and hence location
 playing its part rather than customer service of the seller or product features is a
limitation in perfect competition.

As one can see from the above that perfect competition has both advantages and
disadvantages, however in real life this type of market structure seldom exists because all
products cannot be homogeneous and there is slight difference even between perfect
homogeneous products which give sellers opportunity to charge differential price from
customers, hence in real-world perfect competition is rarely found.

Economic profit does not occur in perfect competition in long run equilibrium; if it did, there
would be an incentive for new firms to enter the industry, aided by a lack of barriers to
entry until there was no longer any economic profit. As new firms enter the industry, they
increase the supply of the product available in the market, and these new firms are forced to
charge a lower price to entice consumers to buy the additional supply these new firms are
supplying as the firms all compete for customers. Incumbent firms within the industry face
losing their existing customers to the new firms entering the industry, and are therefore
forced to lower their prices to match the lower prices set by the new firms. New firms will
continue to enter the industry until the price of the product is lowered to the point that it is the
same as the average cost of producing the product, and all of the economic profit
disappears. When this happens, economic agents outside of the industry find no advantage to
forming new firms that enter into the industry, the supply of the product stops increasing, and
the price charged for the product stabilizes, settling into an equilibrium.

The same is likewise true of the long run equilibria of monopolistically competitive industries

and, more generally, any market which is held to be contestable. Normally, a firm that
introduces a differentiated product can initially secure a temporary market power for a short
while  At this stage, the initial price the consumer must pay for the product is high, and the
demand for, as well as the availability of the product in the market, will be limited. In the
long run, however, when the profitability of the product is well established, and because there
are few barriers to entry, the number of firms that produce this product will increase until the
available supply of the product eventually becomes relatively large, the price of the product
shrinks down to the level of the average cost of producing the product. When this finally
occurs, all monopoly profit associated with producing and selling the product disappears, and
the initial monopoly turns into a competitive industry. In the case of contestable markets, the
cycle is often ended with the departure of the former "hit and run" entrants to the market,
returning the industry to its previous state, just with a lower price and no economic profit for
the incumbent firms.

Profit can, however, occur in competitive and contestable markets in the short run, as firms
jostle for market position. Once risk is accounted for, long-lasting economic profit in a
competitive market is thus viewed as the result of constant cost-cutting and performance
improvement ahead of industry competitors, allowing costs to be below the market-set price.
In the short run, a firm operating at a loss [R < TC (revenue less than total cost) or P < ATC
(price less than unit cost)] must decide whether to continue to operate or temporarily shut
down. The shutdown rule states "in the short run a firm should continue to operate if price
exceeds average variable costs". Restated, the rule is that for a firm to continue producing in
the short run it must earn sufficient revenue to cover its variable costs. The rationale for the
rule is straightforward: By shutting down a firm avoids all variable costs. However, the firm
must still pay fixed costs. Because fixed costs must be paid regardless of whether a firm
operates, they should not be considered in deciding whether to produce or shut down. Thus,
for determining whether to shut down a firm should compare total revenue to total variable
costs (VC) rather than total costs (FC + VC). If the revenue the firm is receiving is greater
than its total variable cost (R > VC), then the firm is covering all variable costs and there is
additional revenue ("contribution"), which can be applied to fixed costs. (The size of the
fixed costs is irrelevant as it is a sunk cost. The same consideration is used whether fixed
costs are one dollar or one million dollars.) On the other hand, if VC > R then the firm is not
covering its production costs and it should immediately shut down. The rule is conventionally
stated in terms of price (average revenue) and average variable costs. The rules are equivalent
(if one divides both sides of inequality TR > TVC by Q gives P > AVC). If the firm decides
to operate, the firm will continue to produce where marginal revenue equals marginal costs
because these conditions insure not only profit maximization (loss minimization) but also
maximum contribution.

Another way to state the rule is that a firm should compare the profits from operating to those
realized if it shut down and select the option that produces the greater profit. A firm that is
shut down is generating zero revenue and incurring no variable costs. However, the firm still
has to pay fixed cost. So, the firm's profit equals fixed costs or −FC. An operating firm is
generating revenue, incurring variable costs and paying fixed costs. The operating firm's
profit is R − VC − FC. The firm should continue to operate if R − VC − FC ≥ −FC, which
simplified is R ≥ VC. The difference between revenue, R, and variable costs, VC, is the
contribution to fixed costs and any contribution is better than none. Thus, if R ≥ VC then firm
should operate. If R < VC the firm should shut down.

A decision to shut down means that the firm is temporarily suspending production. It does not
mean that the firm is going out of business (exiting the industry). If market conditions
improve, and prices increase, the firm can resume production. Shutting down is a short-run
decision. A firm that has shut down is not producing. The firm still retains its capital assets;
however, the firm cannot leave the industry or avoid its fixed costs in the short run. Exit is a
long-term decision. A firm that has existed an industry has avoided all commitments and
freed all capital for use in more profitable enterprises.

However, a firm cannot continue to incur losses indefinitely. In the long run, the firm will
have to earn sufficient revenue to cover all its expenses and must decide whether to continue
in business or to leave the industry and pursue profits elsewhere. The long-run decision is
based on the relationship of the price and long-run average costs. If P ≥ AC then the firm will
not exit the industry. If P < AC, then the firm will exit the industry. These comparisons will
be made after the firm has made the necessary and feasible long-term adjustments. In the long
run a firm operates where marginal revenue equals long-run marginal costs.

2.9 SUMMARY

 In conclusion, the concept of market structure is central to both economics and

marketing. Besides, there are difference feature in these four common types of market
structure which is perfect competition, monopolistic competition, oligopoly and
monopoly.

 Perfect Competition which is many sellers of a standardized product, Monopolistic

Competition which has many sellers of a differentiated product, Oligopoly has few
sellers of a standardized or a differentiated product, and Monopoly which is a single
seller of a product for which there is no close substitute.

 These four market structures each represent an abstract (generic) characterization of a

type of real market. Market structure is important in that it affects market outcomes
through its impact on the motivations, opportunities and decisions of economic actors
participating in the market.

 In conclusion, after complete these two tasks, I gained extra knowledge about the
detail of monopoly and it’s characteristic. In a monopoly market only has one seller
 running the business in entire market. Therefore, there is no competition with others.
A monopolistic also needs to ensure no barriers to entry of other companies.

 In addition, free market structure is the competition that comes from allowing anyone
who needs to sell a particular service or item to do so. Under market structure there
have four common types which are perfect competition, monopolistic competition,
oligopoly and monopoly. There is different market with different characteristics and
examples.

 Marketing is the most exciting of all business sports. It is the heartbeat of every
successful business. It is continually changing in response to the explosion of
information, the expansion of technology, and the aggressiveness of competition, at
all levels and everywhere.

 All business strategy is marketing strategy. Your ability to think clearly and well
about the very best marketing strategies, and to continually change and upgrade your
activities, is the key to the future of your business. Fortunately, like all business skills,
marketing can be learned by practice, experimentation, and continually making
mistakes.

 This chapter explained generic business-level strategies that executives must choose
between to keep their firms competitive. Executives must identify their firm’s source
of competitive advantage by choosing to compete based on low-cost versus (often)
more expensive features that differentiate their firm from competitors. In addition,
targeting either a narrow or broad market helps firms further understand their
customer base.

 Based on these choices, firms will follow cost leadership, differentiation, focused cost
leadership, or focused differentiation strategies. Another potentially viable business
strategy, best cost, exists when firms offer relatively low prices while still managing
to differentiate their goods or services on some important value-added aspects.

 One predictor of long(er)-term business success is the firm’s ability to stick to

strategy.  Low-cost firms that venture into additional features or services often find
that they have to increase prices to pay for these additional features, decreasing their
ability for cost leadership.
  Similarly, firms that differentiate need to invest sufficiently in R&D to ensure the
element of differentiation remains both current and desirable. Whatever their strategy,
all firms can fall victim to being “stuck in the middle” by not offering sufficiently
unique features or competitive prices.

 Smaller manufacturers play an important role in the competitiveness of American

industry. They comprise the bulk of manufacturing establishments, are integral parts
of the supply chain for both commercial and defence products, and provide the vast
majority of manufacturing employment.

2.10 KEYWORDS

 Market Structure - The conditions in an industry, such as number of sellers, how

easy or difficult it is for a new firm to enter, and the type of products that are sold.

 Marginal Revenue - The additional revenue gained from selling one more unit.

 Perfect Competition - Each firm faces many competitors that sell identical products.

 Shutdown Point - Level of output where the marginal cost curve intersects the
average variable cost curve at the minimum point of AVC; if the price is below this
point, the firm should shut down immediately.

 Long-Run Equilibrium - Where all firms earn zero economic profits producing the
output level where P = MR = MC and P = AC.

2.11 LEARNING ACTIVITY

1. Create a survey on perfect competition market.

___________________________________________________________________________
___________________________________________________________________________

2. Create a session on price determination under perfect competition.

___________________________________________________________________________
___________________________________________________________________________

2.12 UNIT END QUESTIONS

A. Descriptive Questions
Short Questions

1. What is price determination?

2. Define market?

3. What is perfect competition market?

4. Write the main feature of perfect competition?

5. Define perfect competition market?

Long Questions

1. Explain the market structure and perfect competition market.

2. Examine the classification of the markets.

3. Describe the feature of perfect competition?

4. Explain the price determination under perfect competition.

5. Examine the equilibrium (short-long run) of industry and firm.

B. Multiple Choice Questions

1. Which one the following is Perfect competition is an industry?

a. A few firms producing identical goods

b. Many firms producing goods that differ somewhat.
c. A few firms producing goods that differ somewhat in quality
d. Many firms producing identical goods

2. Which among the following is a perfectly competitive industry?

a. Many buyers and many sellers

b. Many sellers, but there might be only one or two buyers
c. Many buyers, but there might be only one or two sellers
d. One firm that sets the price for the others to follow.

3. Which among the following, in perfect competition, is the product of a single firm?

a. Is sold to different customers at different prices

 b. Have many perfect complements produced by other firms?
c. Have many perfect substitutes produced by other firms?
d. Is sold under many differing brand names

4. Which is a perfect competition?

a. There are significant restrictions on entry

b. Each firm can influence the price of the good
c. There are few buyers
d. All firms in the market sell their product at the same price

5. What is the price elasticity of demand for any particular perfectly competitive firm's
output known as?

a. Perfect complement to wheat from farm B

b. Perfect substitute for wheat from farm B
c. Normal good
d. Inferior good.

Answers

1-d, 2-a, 3-c, 4-d, 5-b

2.13 REFERENCES

Reference

 Mirman, Leonard J. Salgueiro, Egas & Santugini, Marc (2015). "Learning in a

Perfectly Competitive Market". Rochester, NY.

 Bykadorov, I.A.. Kokovin, S.G. & Zhelobod’ko, E.V. Product diversity in a vertical
distribution channel under monopolistic competition.

  Cominetti, Roberto. Correa, José R & Stier-Moses, Nicolás E. (2009). "The Impact of
Oligopolistic Competition in Networks".

Textbook

 Franklin, Fisher. (1991). Industrial Organization, Antitrust, and the Law. Cambridge,
MA, MIT Press.
  Manning, Alan. (2003). Monopsony in motion : imperfect competition in labour
markets. Princeton.

 Body of Knowledge on Infrastructure Regulation “Market Structure: Introduction”.

Website

 https://en.wikipedia.org/wiki/Market_structure

 https://www.investopedia.com/terms/f/firm.asp

 https://www.investopedia.com/terms/p/perfectcompetition.asp
UNIT 3 - MONOPOLY AND IMPERFECT
COMPETITION MARKET MONOPOLY

STRUCTURE

3.0 Learning Objectives

3.1 Introduction

3.2 Definition of Monopoly

3.3 Characteristics of Monopoly

3.4 Types of Monopoly

3.4.1 Natural Monopoly

3.4.2 Social Monopoly

3.4.3 Legal Monopoly

3.4.4 Fiscal Monopoly

3.4.5 Simple Monopoly

3.4.6 Discriminating Monopoly

3.4.7 Chosen Monopoly

3.5 Price Determination Under Monopoly

3.6 Monopoly Control

3.7 Monopoly and Anti-Trust Policy

3.8 Monopolistic Competition

3.8.1 Definition

3.8.2 Characteristics

3.8.3 Price Determination under Monopolistic Competition

3.9 Product Differentiation Oligopoly

3.9.1 Definition

3.9.2 Characteristics
 3.9.3 Price Leadership

3.10 Price Discrimination Under Monopoly

3.11 Summary

3.12 Keywords

3.13 Learning Activity

3.14 Unit End Questions

3.15 References

3.0 LEARNING OBJECTIVES

After studying this unit, you will be able to

 Illustrate the types of monopoly.

 Explain the characteristics of monopoly.

 Examine the price determination under monopoly.

3.1 INTRODUCTION

A monopoly exists when a specific person or enterprise is the only supplier of a particular
commodity. This contrasts with a monopsony which relates to a single entity's control of
a market to purchase a good or service, and with oligopoly and duopoly which consists of a
few sellers dominating a market. Monopolies are thus characterized by a lack of economic
competition to produce the good or service, a lack of viable substitute goods, and the
possibility of a high monopoly price well above the seller's marginal cost that leads to a
high monopoly profit. The verb monopolize refers to the process by which a company gains
the ability to raise prices or exclude competitors. In economics, a monopoly is a single seller.
In law, a monopoly is a business entity that has significant market power, that is, the power to
charge overly high prices, which is associated with a decrease in social surplus. Although
monopolies may be big businesses, size is not a characteristic of a monopoly. A small
business may still have the power to raise prices in a small industry (or market).

A monopoly may also have monopsony control of a sector of a market. Likewise, a

monopoly should be distinguished from a cartel (a form of oligopoly), in which several
providers act together to coordinate services, prices or sale of goods. Monopolies,
monopsonies and oligopolies are all situations in which one or a few entities have market
power and therefore interact with their customers (monopoly or oligopoly), or suppliers
(monopsony) in ways that distort the market.

Monopolies can be established by a government, form naturally, or form by integration. In

many jurisdictions, competition laws restrict monopolies due to government concerns over
potential adverse effects. Holding a dominant position or a monopoly in a market is often not
illegal in itself, however certain categories of behaviour can be considered abusive and
therefore incur legal sanctions when business is dominant. A government-granted
monopoly or legal monopoly, by contrast, is sanctioned by the state, often to provide an
incentive to invest in a risky venture or enrich a domestic interest group. Patents, copyrights,
and trademarks are sometimes used as examples of government-granted monopolies. The
government may also reserve the venture for itself, thus forming a government monopoly, for
example with a state-owned company.

Monopolies may be naturally occurring due to limited competition because the industry is

resource intensive and requires substantial costs to operate (e.g., certain railroad systems). In
economics, the idea of monopolies is important in the study of management structures, which
directly concerns normative aspects of economic competition, and provides the basis for
topics such as industrial organization and economics of regulation. There are four basic types
of market structures in traditional economic analysis: perfect competition, monopolistic
competition, oligopoly and monopoly. A monopoly is a structure in which a single supplier
produces and sells a given product or service. If there is a single seller in a certain market and
there are no close substitutes for the product, then the market structure is that of a "pure
monopoly". Sometimes, there are many sellers in an industry or there exist many close
substitutes for the goods being produced, but nevertheless companies retain some market
power. This is termed "monopolistic competition", whereas in an oligopoly, the companies
interact strategically.

In general, the main results from this theory compare the price-fixing methods across market
structures, analyse the effect of a certain structure on welfare, and vary technological or
demand assumptions in order to assess the consequences for an abstract model of society.
Most economic textbooks follow the practice of carefully explaining the "perfect
competition" model, mainly because this helps to understand departures from it (the so-called
"imperfect competition" models).
The boundaries of what constitutes a market and what does not are relevant distinctions to
make in economic analysis. In a general equilibrium context, a good is a specific concept
including geographical and time-related characteristics. Most studies of market structure
relax a little their definition of a good, allowing for more flexibility in the identification of
substitute goods.

3.2 DEFINITION OF MONOPOLY

Monopoly is one of the extreme imperfect markets amongst Monopoly, Monopolistic

Competition and Oligopoly as it lacks several characteristics of perfect competition and it
exists where a single firm rules the industry.

The word Monopoly is a combination of two words in which “mono” implies “single” and
“poly” means “seller”. Therefore, the market controlled by a sole trader is said to a Monopoly
market.

A monopoly refers to when a company and its product offerings dominate a sector or
industry. The term monopoly is often used to describe an entity that has total or near-total
control of a market.

Monopolies can result from extreme free-market capitalism, in that absent any restriction or
restraints, a single company or group becomes large enough to own all or nearly all of the
market (including by acquiring competitors) for a particular type of product or service.

On the other hand, monopolies can also arise and be sustained by government-enforced
barriers to entry or regulations that limit competition (e.g., in the case of utilities). A
monopoly is characterized by the absence of competition, which can lead to high costs for
consumers, inferior products and services, and corrupt behaviour. A company that dominates
a business sector or industry can use that dominance to its advantage, and at the expense of
others. It can create artificial scarcities, fix prices, and circumvent natural laws of supply and
demand. It can impede new entrants to the field and inhibit experimentation or new product
development, while the public - robbed of the recourse of choosing a competitor—is at its
mercy. A monopolized market often becomes unfair, unequal, and inefficient.

Mergers and acquisitions among companies in the same business are highly regulated and
researched for this reason. Firms are typically forced to divest assets if federal authorities
believe a proposed merger or takeover will violate anti-monopoly laws. By divesting assets, it
allows competitors to enter the market by those assets, which can include property, plant, and
equipment (PP&E) and customers.

Monopolies typically have an unfair advantage over their competition because they are either
the only provider of a product or control most of the market share or customers for their
product. Although monopolies might differ from industry to industry, they tend to share
similar characteristics, which include

 High barriers of entry - Competitors are not able to enter the market, and the
monopoly can easily prevent its competition from securing its foothold in an industry
by acquiring it.

 Single seller - There is only one seller in the market, meaning the company becomes
the entire industry it serves.

 Price maker - The company that operates the monopoly decides the price of the
product that it will sell without any competition keeping its prices in check. As a
result, monopolies can raise prices at will.

 Economies of scale - A monopoly often can produce at a lower cost than smaller
companies. Monopolies can buy huge quantities of inventory at a volume discount,
for example. As a result, a monopoly can lower its prices so much that smaller
competitors can't survive. Essentially, monopolies can engage in price wars due to the
scale of their manufacturing and distribution networks such as warehousing and
shipping, which they can handle at lower costs than their competitors can.

A company with a pure monopoly means that a company is the only seller in a market with
no other close substitutes. For many years, Microsoft Corporation had a monopoly on
computer software and operating systems. Also, with pure monopolies (as opposed
to oligopolies, for example), there are high barriers to entry, such as significant start-up costs
that prevent competitors from entering the market.

When there are multiple sellers in an industry with many similar substitutes for the goods
produced and companies retain some power in the market, it's referred to as monopolistic
competition. In this scenario, an industry has many businesses that offer similar products or
services, but their offerings are not perfect substitutes. In some cases, this can lead
to duopolies.
In a monopolistic competitive industry, barriers to entry and exit are typically low, and
companies try to differentiate themselves through price cuts and marketing efforts. However,
because the products offered by various competitors are so similar, it's difficult for consumers
to tell which product is better. Some examples of monopolistic competition include retail
stores, restaurants, and hair salons.

A natural monopoly can develop when a company becomes a monopoly due to its industry's

high fixed or start-up costs. Also, natural monopolies can arise in industries that require
unique raw materials or technology, or it's a specialized industry in which only one company
can meet the industry's customers' needs.

Companies that have patents on their products, which prevent competition from developing
the same product in a specific field, can have a natural monopoly. Patents allow the company
to earn a profit for several years without fear of competition to help recoup the investment as
well as the high start-up and research and development (R&D) costs that the company
incurred. Pharmaceutical or drug companies are often allowed patents and a natural
monopoly to promote innovation and research.

There are also public monopolies set up by governments to provide essential services and
goods, such as the U.S. Postal Service (though of course, the USPS has less of a monopoly on
mail delivery since the advent of private carriers such as United Parcel Service and FedEx).
In the utilities industry, natural or government-allowed monopolies flourish. Usually, there is
only one major (private) company supplying energy or water in a region or municipality. The
monopoly is allowed because these suppliers incur large costs in producing power or water
and providing these essentials to each local household and business, and it is considered more
efficient for there to be a sole provider of these services.

Imagine what a neighbourhood would look like if there were more than one electric company
serving an area. The streets would be overrun with utility poles and electrical wires as the
different companies compete to sign up customers, hooking up their power lines to houses.
Although natural monopolies are allowed in the utility industry, the trade-off is that the
government heavily regulates and monitors these companies. Regulations can control the
rates that utilities charge their customers and the timing of any rate increases.
3.3 CHARACTERISTICS OF MONOPOLY

A monopoly refers to when a company and its product offerings dominate a sector or
industry. The term monopoly is often used to describe an entity that has total or near-total
control of a market.

Monopolies can result from extreme free-market capitalism, in that absent any restriction or
restraints, a single company or group becomes large enough to own all or nearly all of the
market (including by acquiring competitors) for a particular type of product or service.

On the other hand, monopolies can also arise and be sustained by government-
enforced barriers to entry or regulations that limit competition (e.g., in the case of utilities).

 A monopoly refers to when a company and its product offerings dominate one sector
or industry.

 Monopolies can be considered an extreme result of free-market capitalism and are

often used to describe an entity that has total or near-total control of a market.

 Natural monopolies can exist when there are high barriers to entry; a company has a
patent on their products or is allowed by governments to provide essential services.

The following are some of the characteristics of monopoly.

Figure 3.1: Characteristics of monopoly

  Sole firm / trader - Monopoly market is solely captured by an individual seller or firm
of a particular commodity having no competitors in the market, the whole output of
such commodity depends upon that firm or trader; thus, they form industry with a
monopoly.

 Cost determiner: - As the monopolist is the sole king of that industry, he also
determines the cost of the commodity produced, and there is no one in the market as a
competitor who can challenge his price and the value decided by him becomes the
final price of that product to sell in the market.

 Price bias - As the monopolist is a sole trader of that commodity in the whole market,
he may be biased amidst customers, i.e., can charge more from rich and low from
poor customers.

 Optimum production - Production in the monopoly market should be in optimum

scale as supply rise may bring fall in the price of the product.

 No substitute products - The monopoly firm or trader captures an entire market of the
product as they have the patent of that product; thus, no substitute products can be
produced and sold in the market by other firms.

 Entry constraints - Entering in the monopoly market is restricted for the firms as the
monopolist has captured the market with his specialities, hence other firms cannot
compete with them, and for the Monopoly firm it is obligatory to have a patent for
surviving in the market.

 Stability of production elements - All the elements of the production are not always
movable, which becomes one of the essential components behind the monopolist
command on such resources. No one can copy such factors or combination for the
production, and hence chances of deposing monopolist become negligible.

 Precise knowledge and profit maximization - The monopolist learns perfectly about
the market conditions to avoid the uncertainties of the future, and their main aim is to
maximize the profits of the firm.

Examples

There are various firms in the monopolistic market; some of the examples of such monopoly
firms are as follows:
De Beers (Raw Diamond Company)

They owned most of the diamond mines all over the world covering most of the African
mines since 19th century, and they had become a single raw diamond seller since late 19th
century to almost the beginning of the 21st century.

They maintained their position as the largest owner of the raw diamonds through their various
business strategies, and that is how they ended up being the single largest seller of raw
diamond and able to attain Monopoly status in the market for raw diamonds.

Microsoft

When Microsoft came up with an exceptionally user-friendly operating system during a time
when very few user-friendly operating systems are available in the market, as a result of
which they become a significant holder of this key resource.

However, there are various operating systems available in the market such as Linux, Unix,
but they are not as much user friendly as windows.

Thus, windows cover almost 90% of the market, which made the Microsoft Monopoly player
in the market for operating systems.

Pharmaceutical Company

As pharmaceutical company invests a lot of money in research to come up with new drug
formulas or new compositions, as they are spending a lot of money for it and the end result
may or may not bring any results to them which creates a vast sunk cost for the company.

To overcome the fear of loss, patent laws are followed, which gives protection to such
pharmaceutical companies that if they come up with a very useful composition, they will get
a Monopoly power for that composition for some time.

3.4 TYPES OF MONOPOLY

Monopoly is made of two words - ’Mono’ and ‘Poly’. ‘Mono’ means single and ‘Poly’ means
seller. Thus, ‘Monopoly refers to a market situation where one firm or a group of firms which
are combined to have a control over the supply of the product. ”

In other words, monopoly is a market situation in which there is only one seller of a product
with barriers to entry of others.
The product has no close substitutes. The cross elasticity of demand with every other product
is very low. This means that no other firms produce a similar product. Thus, the Monopoly
firm is itself an industry and the monopolistic faces the industry demand curve.

Figure 3.2: Types of monopoly

3.4.1 Natural Monopoly

It depends upon the natural factors of the area such as Karnataka has a monopoly of the
coffee market as the climate of Karnataka suits best for coffee cultivation. It depends upon
the natural factors of the area such as Karnataka has a monopoly of the coffee market as the
climate of Karnataka suits best for coffee cultivation.

When a monopoly is established due to natural causes then it is called natural monopoly. To-
day India has got monopoly in mica production and Canada has got monopoly in nickel
production. These monopoly natures have provided to these countries.

3.4.2 Social Monopoly

When the government controls the production for public welfare, it is said to be a social
monopoly.

It may have been a rocky/big screen kind of start for The Facebook, but it didn’t take long for
Zucks to figure out he was playing a game of monopoly. Now he’s either buying up all the
hottest properties on the board or taking them without asking.
When this whole social media game kicked off, there was a fight over one thing - attention. It
didn’t matter what kind, all that mattered was that you chose Facebook over Myspace. Now
after a decade or so, the fight for attention has become far more complex. Rather than
spending 20 minutes a day on social media we average more than two hours. We no longer
just look to social media to connect with old friends we use it as our source of news,
motivation, information, entertainment, friendships, more than friendships, politics, we buy,
we sell, we market and we share our most intimate sides with others. With such a broad range
of services to fulfil it seems that several more platforms were required to satisfy all our social
needs.

3.4.3 Legal Monopoly

It is a monopoly which arises because of legal barriers or provisions such as copyrights; the
law prohibits an action of replicating any design registered under a particular brand name.
When anybody receives or acquires monopoly due to legal provisions in the country.

For example:

When legal monopolies emerge on account of legal provisions like patents, trade-marks,
copyrights etc. The law forbids the potential competitors to imitate the design and form of
products registered under the given brand names, patent or trade-marks. This is done to
safeguard the interests of those who have done much research and undertaken risks of
innovating a particular product.

A legal monopoly, also known as a statutory monopoly, is a firm that is protected by law
from competitors. In other words, a legal monopoly is a firm that receives a government
mandate to operate as a monopoly.

Legal monopolies can be established through

 A public franchise

 A government licenses

 A patent or copyright

3.4.4 Fiscal Monopoly

The government governs this monopoly for printing currency and the minting of coins, etc.
Fiscal monopolies are public enterprises which have been granted a legal monopoly over the
production or distribution of a particular kind of good or service in order to raise revenue and
not in order to further the interests of public economic or social policy.

3.4.5 Simple Monopoly

In this type of monopoly, uniform charges are charged by the traders to all the buyers for its
products.

A simple monopoly firm charges a uniform price for its output sold to all the buyers. While a
discriminating monopoly firm charges different prices for the same product to different
buyers. A simple monopoly operates in a single market a discriminating monopoly operates
in more than one market.

A monopoly market is a situation when a service or a product may be brought only from a
single supplier. This situation is the defining characteristic of a specific market. A monopoly
situation usually arises in cases when there is an absence of economic competition. This
absence of competitors to manufacture the product or service needed by the consumers is a
simple monopoly. It is also a requirement that the product or service is un-substitutable or
irreplaceable in nature.

3.4.6 Discriminating Monopoly

A discriminating monopoly is a single entity that charges different prices - typically, those
that are not associated with the cost to provide the product or service - for its products or
services for different consumers. Non-discriminating monopolies, on the other hand, do not
engage in such a practice.

A company that operates as a discriminating monopoly by using its market-controlling

position can do this as long as there are differences in price elasticity of demand between
consumers or markets and barriers to prevent consumers from making an arbitrage profit by
selling among themselves. By catering to each type of customer, the monopoly makes more
profit.

It discriminates amongst the buyers for selling similar products, different prices are charged
on divergent buyers such as lawyer charges different fees from his every client. Chosen
Monopoly This type of monopoly comes into existence to avoid the throat-cutting
competition in the market and creates a group of monopolists to escalate their profits.

A discriminating monopoly can operate in a variety of ways. A retailer, for example, might

set different prices for products it sells based on the demographics and location of its
customer base. For instance, a store that operates in an affluent neighbourhood might charge
a higher rate compared with selling the product in a lower income area.

The variances in pricing may also be found at the city, state, or regional level. The cost of a
slice of pizza at a major metropolitan location might be set to scale with the expected income
levels within that city.

Pricing for some service companies may change based on external events such as holidays or
the hosting of concerts or major sporting events. For example, car services and hotels may
raise their rates on dates when conferences are being held in town because of the increased
demand with the influx of visitors.

Housing and rental prices can also fall under the effects of a discriminating monopoly.
Apartments with the same square footage and comparable amenities may come with
drastically different pricing based on where they are located. The property owner, who may
maintain a portfolio of several properties, could set a higher rental price for units that are
closer to popular downtown areas or near companies that pay substantial salaries to their
employees. The expectation is that renters with higher income will be willing to pay larger
rental fees compared with less desirable locations.

3.4.7 Chosen Monopoly

This type of monopoly comes into existence to avoid the throat-cutting competition in the
market and creates a group of monopolists to escalate their profits.

3.5 PRICE DETERMINATION UNDER MONOPOLY

A firm under monopoly faces a downward sloping demand curve or average revenue
curve. Further, in monopoly, since average revenue falls as more units of output are sold, the
marginal revenue is less than the average revenue. In other words, under monopoly the MR
curve lies below the AR curve.

 The Equilibrium level in monopoly is that level of output in which marginal revenue equals
marginal cost. The producer will continue producer as long as marginal revenue exceeds the
marginal cost. At the point where MR is equal to MC the profit will be maximum and beyond
this point the producer will stop producing marginal cost, but beyond OM the marginal
revenue is less than marginal cost. Therefore, the monopolist will be in equilibrium at output
OM where marginal revenue is equal to marginal cost and the profits are the greatest. The
corresponding price in the diagram is MP’ or OP. It can be seen from the diagram at output
OM, while MP’ is the average revenue, ML is the average cost, therefore, P’L is the profit
per unit. Now the total profit is equal to P’L (profit per unit) multiply by OM (total output).
In the short run, the monopolist has to keep an eye on the variable cost, otherwise he will stop
producing. In the long run, the monopolist can change the size of plant in response to a
change in demand. In the long run, he will make adjustment in the amount of the factors,
fixed and variable, so that MR equals not only to short run MC but also long run MC.

Monopoly is that market form in which a single produce controls the whole supply of a single
commodity which has no close substitutes. a single commodity which has no close
substitutes. Thus, there are two essential conditions to constitute a monopoly.

 There must be a single producer or seller. He may be an individual or a firm of

partners or f joint-stock company. This condition-is essential to eliminate competition.

 The commodity dealt in should have no closely competing substitutes. That is, there
should be no other firm or firms producing similar products, otherwise there will be
competition. These two conditions ensure that the monopolist can set the price of his
commodity, i.e., he can pursue an independent price-output policy. Power to influence
price is the essence of monopoly.

Under monopoly conditions, too, there is bound to be interaction between the forces of
demand and supply. But there is this difference that the-supply is not free to adjust of demand
and supply. But there is this difference that the-supply is not free to adjust itself to demand. It
is under the control of the monopolist. A monopolist is the sole producer of his product which
has no closely competing substitutes. In other words, the cross-elasticity of demand between
the product of the monopolist and the product of the closest rival must be very low, i.e., the
product of a rival cannot take the place of the monopolized product. Monopolist is a sole
producer of the commodity and he can easily influence the price by changing his supply.
Under perfect competition, because there is a large number of producers, the supply of each
producer constitutes only a small proportion of the total supply Hence, under perfect
competition, no one seller can influence the price by changing his own supply. On the other
hand, the monopolist can influence the price. On the other hand, the monopolist can influence
the price. In fact, he sets the price. There is another difference between monopoly and
competition. When there is perfect competition, the demand for the product of an individual
producer is perfectly elastic at the ruling price. He can sell any amount at the prevailing price.
Such demand is represented by a horizontal straight line parallel to the X-axis. Also, marginal
revenue (MR) = Price, i.e., average revenue (AR). These two curves MR and AR coincide.
This is not so in monopoly; the demand for the monopolized product is not perfectly elastic
(there being practically no substitutes); hence demand price or curve AR falls to the right and
MR curve is always below it. Being in control of the supply, the monopolist can (a) either fix
the price and offer to supply the quantity demanded at that price; or (b) he can fix the supply,
and then let price be determined by demand in relation to the supply fixed by him. But he
cannot fix both the price and also force the people to buy a pre-determined quantity at that
price. He can only do one of these two things, i.e., either fix the price or fix the supply.

Equalising Marginal Revenue and Marginal Cost

The aim of the monopolist, like every other producer, is to maximize his total money profits.
Therefore, he will produce to a point and charge a price which gives him the profits.
Therefore, he will produce to a point and charge a price which gives him the maximum
money profits. In other words, he will be in equilibrium at the price-output level at which his
profits are maximum. He will go on producing so long as additional units add more to
revenue than to cost. He will stop at that point beyond which additional units of production
add more to cost than to revenue. In other words, the monopolist will be in equilibrium
position at that level of output at which marginal revenue equals marginal cost. He will
continue expanding output so long as marginal revenue exceeds marginal cost. He does so
because profits will go on increasing as long as marginal revenue exceeds marginal cost. At
the point where marginal revenue is equal to marginal cost, the profits will be maximized. If
the production is carried beyond this point, the profits will start decreasing.

The price-output equilibrium of the monopolist can be easily understood with the help of
figure 3.3. AR is the demand curve or average revenue curve facing of figure. 3.3. AR is the
demand curve or average revenue curve facing the monopolist. MR is the marginal revenue
curve, which lies below the average revenue curve AR. AC is the average cost curve and MC
is the marginal cost curve. It can be seen from the diagram that until OM output, the marginal
revenue is greater than marginal cost, but beyond OM the marginal revenue is less than
marginal cost. Therefore, the monopolist will be in equilibrium at output OM, where
marginal revenue is equal to marginal cost and profits are the maximum. The price at which
output OM is sold in the market can be known from looking at demand curve or average
revenue curve AR. It can be seen from figure.3.3 that corresponding to equilibrium output
OM, the price or the demand or average revenue is MP’ ( = OP). Thus, it is clear that given
the cost-revenue situation as presented in the diagram, a monopolistic firm will be in
equilibrium at output OM and will be charging price equal to MP’ (= OP).

Figure 3.3: Equalising marginal revenue and marginal cost

Monopoly price is not necessarily a high price. It may sometimes be even lower than ‘the
price under competition, because the monopolist is spared the expenses of ‘the price under
competition, because the monopolist is spared the expenses of advertisement. Besides, he
gains from the usual economies, resulting from large-scale production. It is also not necessary
that the monopolist should always charge the highest possible price. He is afraid of public
opinion, of Government interference and of substitutes being adopted for the commodity he
produces. Thus, the monopoly price is not necessarily a high price. But it generally is the
monopolist cannot help exploiting his monopolistic position and charging a high price.

In the long period the monopolist introduces changes in his equipment’s and techniques of
production. During this period in order to gain excess profit, he will change efficiency and
capacity of his resources according to his need. But the determination of the quantity of
production follows, the same line as under short period.
 Figure 3.4: Production

In this figure 3.4 LMC and LMR intersect each other at the point E and after that LMC goes
on rising. Thus, OQ production is determined and OP is the price. But average cost is SQ. So,
profit per unit is RS and at OQ output the total profit is PTSR.

Under Price Competition AR =MR, where-as under Monopoly MR <AR.

Under perfect competition price is determined by the interaction of total demand and supply.
This price is acceptable to all the firms in the industry. No firm can change this price. So,
average revenue and marginal revenue, at every level of production, will be constant and
equal. Their curves are parallel to X-axis.

Under Monopoly, to sell every additional unit of the commodity price will have to be lower.
In this way, with the sale of every additional unit, average and marginal income goes on
falling. But the decrease in average revenue is relatively less sharp than the decrease in
marginal revenue, It is because marginal revenue is limited to one unit, whereas in case of
average revenue, the decrease price is divided by the number of units. Therefore, the fall in
average revenue has relatively less slope. That is the reason why marginal revenue is less
than average revenue.

3.6 MONOPOLY CONTROL

As was illustrated, monopoly in a market can result in an economy not achieving a Paretian
optimum. A Kaldor-Hicks’s loss occurs because in order to maximize its profit at a Paretian
optimum. A Kaldor-Hicks’s loss occurs because in order to maximize its profit a monopolist
raises the price of its product above its marginal cost of production. A monopolist fosters
scarcity of the monopolized good in order to increase its profit. Consumers (buyers) are
economically disadvantaged as a result. Economists have traditionally argued that economic
scarcity will be greater under monopoly than if greater market competition is present. More
specifically, it is often argued that monopoly will result in greater economic scarcity than if
perfect competition prevails. But as will be seen in this chapter, monopoly may be superior to
perfect competition in stimulating economic growth and thereby reducing scarcity. Also, a
monopoly may be advantageous when decreasing costs of production occur. In this case,
demand for the product could be met at least cost by one supplier. Just as perfect competition
is an ideal or abstract market type, so too is monopoly. The difficulties of defining monopoly
and measuring monopoly power and the pitfalls of various measures are discussed in this
chapter. The traditional profit-maximizing model of monopoly, assuming the absence of
entry, is outlined first and the consequences of a monopolist's behaviour for consumers'
surplus are explored. The extent of losses in consumers' surplus as a result of monopoly
compared to the alternative of perfect competition is shown in a static setting to depend on
the inelasticity of the demand for the monopolized product and on the inelasticity of marginal
cost. This leads on to a discussion of the relative benefits of monopoly and perfect
competition in a dynamic setting involving technological change and to a consideration of 'X-
inefficiency' under monopoly and the possible social costs of this compared to 'allocative'
inefficiency. The possibility of non-profit-maximizing behaviour on the part of a monopolist
is then allowed for, and some of the effects and welfare consequences of this are analysed.
Entry conditions are extremely important in determining whether and for how long a
monopoly lasts and these conditions influence the behaviour of 'incumbent' monopolists.
Consequently, in any discussion of monopoly behaviour, it is important to take potential
entry into account. In this chapter, account is taken of barriers to entry such as absolute cost
barriers (for instance arising from patenting and learning differences between businesses),
legal barriers, and economies of scale such as those stemming from features of technology or
advertising and marketing. Once models of monopoly behaviour have been outlined and
explored in this chapter, the discussion considers government regulation of monopolies,
government action to prevent the formation of monopolies, and the seemingly inconsistent
policy of public encouragement of the formation of monopolies, for instance by fostering
mergers of firms. Issues discussed the formation of monopolies, for instance by fostering
mergers of firms. Issues discussed include the following: are public monopolies the answer to
problems and difficulties of regulating or preventing private monopolies? What patterns of
behaviour can be expected from bureaucrats managing public monopolies and how are
politicians likely to influence the behaviour of such enterprises? Is there a significant
separation of ownership and control or management of public enterprises? What
consequences does this have? Is government failure to be expected in operating public
monopolies and how does this compare with likely private market failure? Subsequently, this
chapter assembles empirical evidence on the size of the deadweight loss due to monopoly,
and the consequences of monopoly for the amount of research and development, patenting,
and invention and advertising. This is followed by an analysis of aspects of price
discrimination, bundling and full-line forcing practices which imply a degree of market
power.

3.7 MONOPOLY AND ANTI-TRUST POLICY

The previous chapters on the theory of the firm identified three important lessons: First, that
competition, by providing consumers with lower prices and a variety of innovative products,
is a good thing; second, that large-scale production can dramatically lower average costs; and
third, that markets in the real world are rarely perfectly competitive. As a consequence,
government policymakers must determine how much to intervene to balance the potential
benefits of large-scale production against the potential loss of competition that can occur
when businesses grow in size, especially through mergers.

For example, in 2006, AT&T and BellSouth, two telecommunications companies, wished to
merge into a single firm. In the year before the merger, AT&T was the 121st largest company
in the country when ranked by sales, with $44 billion in revenues and 190,000 employees.
BellSouth was the 314th largest company in the country, with $21 billion in revenues and
63,000 employees.

The two companies argued that the merger would benefit consumers, who would be able to
purchase better telecommunications services at a cheaper price because the newly created
firm would be able to produce more efficiently by taking advantage of economies of scale
and eliminating duplicate investments. However, a number of activist groups like the
Consumer Federation of America and Public Knowledge expressed fears that the merger
would reduce competition and lead to higher prices for consumers for decades to come. In
December 2006, the federal government allowed the merger to proceed. By 2009, the new
post-merger AT&T was the eighth largest company by revenues in the United States, and by
that measure the largest telecommunications company in the world. Economists have spent -
and will still spend - years trying to determine whether the merger of AT&T and BellSouth,
as well as other smaller mergers of telecommunications companies at about this same time,
helped consumers, hurt them, or did not make much difference.

This chapter discusses public policy issues about competition. How can economists and
governments determine when mergers of large companies like AT&T and BellSouth should
be allowed and when they should be blocked? The government also plays a role in policing
anticompetitive behaviour other than mergers, like prohibiting certain kinds of contracts that
might restrict competition. In the case of natural monopoly, however, trying to preserve
competition probably will not work very well, and so government will often resort to
regulation of price and/or quantity of output. In recent decades, there has been a global trend
toward less government intervention in the price and output decisions of businesses.

Since a merger combines two firms into one, it can reduce the extent of competition between
firms. Therefore, when two U.S. firms announce a merger or acquisition where at least one of
the firms is above a minimum size of sales (a threshold that moves up gradually over time,
and was at $70.9 million in 2013), or certain other conditions are met, they are required under
law to notify the U.S. Federal Trade Commission (FTC). The left-hand panel of shows the
number of mergers submitted for review to the FTC each year from 1999 to 2012. Mergers
were very high in the late 1990s, diminished in the early 2000s, and then rebounded
somewhat in a cyclical fashion. The right-hand panel of shows the distribution of those
mergers submitted for review in 2012 as measured by the size of the transaction. It is
important to remember that this total leaves out many small mergers under $50 million,
which only need to be reported in certain limited circumstances. About a quarter of all
reported merger and acquisition transactions in 2012 exceeded $500 million, while about 11
percent exceeded $1 billion.

In the closing decades of the 1800s, many industries in the U.S. economy were dominated by
a single firm that had most of the sales for the entire country. Supporters of these large firms
argued that they could take advantage of economies of scale and careful planning to provide
consumers with products at low prices. However, critics pointed out that when competition
was reduced, these firms were free to charge more and make permanently higher profits, and
that without the goading of competition, it was not clear that they were as efficient or
innovative as they could be.
In many cases, these large firms were organized in the legal form of a “trust,” in which a
group of formerly independent firms were consolidated together by mergers and purchases,
and a group of “trustees” then ran the companies as if they were a single firm. Thus, when the
U.S. government passed the Sherman Antitrust Act in 1890 to limit the power of these trusts,
it was called an antitrust law. In an early demonstration of the law’s power, the U.S. Supreme
Court in 1911 upheld the government’s right to break up Standard Oil, which had controlled
about 90% of the country’s oil refining, into 34 independent firms, including Exxon, Mobil,
Amoco, and Chevron. In 1914, the Clayton Antitrust Act outlawed mergers and acquisitions
(where the outcome would be to “substantially lessen competition” in an industry), price
discrimination (where different customers are charged different prices for the same product),
and tied sales (where purchase of one product commits the buyer to purchase some other
product). Also in 1914, the Federal Trade Commission (FTC) was created to define more
specifically what competition was unfair. In 1950, the Celler-Kefauver Act extended the
Clayton Act by restricting vertical and conglomerate mergers. In the twenty-first century, the
FTC and the U.S. Department of Justice continue to enforce antitrust laws.

Both the four-firm concentration ratio and the Herfindahl-Hirschman index share some
weaknesses. First, they begin from the assumption that the “market” under discussion is well-
defined, and the only question is measuring how sales are divided in that market. Second,
they are based on an implicit assumption that competitive conditions across industries are
similar enough that a broad measure of concentration in the market is enough to make a
decision about the effects of a merger. These assumptions, however, are not always correct.
In response to these two problems, the antitrust regulators have been changing their approach
in the last decade or two.

Defining a market is often controversial. For example, Microsoft in the early 2000s had a
dominant share of the software for computer operating systems. However, in the total market
for all computer software and services, including everything from games to scientific
programs, the Microsoft share was only about 16% in 2000. A narrowly defined market will
tend to make concentration appear higher, while a broadly defined market will tend to make it
appear smaller.

There are two especially important shifts affecting how markets are defined in recent
decades: one centres on technology and the other centres on globalization. In addition, these
two shifts are interconnected. With the vast improvement in communications technologies,
including the development of the Internet, a consumer can order books or pet supplies from
all over the country or the world. As a result, the degree of competition many local retail
businesses face has increased. The same effect may operate even more strongly in markets
for business supplies, where so-called “business-to-business” websites can allow buyers and
suppliers from anywhere in the world to find each other.

Globalization has changed the boundaries of markets. As recently as the 1970s, it was
common for measurements of concentration ratios and HHIs to stop at national borders. Now,
many industries find that their competition comes from the global market. A few decades
ago, three companies, General Motors, Ford, and Chrysler, dominated the U.S. auto market.
By 2007, however, these three firms were making less than half of U.S. auto sales, and facing
competition from well-known car manufacturers such as Toyota, Honda, Nissan,
Volkswagen, Mitsubishi, and Mazda. When HHIs are calculated with a global perspective,
concentration in most major industries - including cars - is lower than in a purely domestic
context.

Because attempting to define a particular market can be difficult and controversial, the
Federal Trade Commission has begun to look less at market share and more at the data on
actual competition between businesses. For example, in February 2007, Whole Foods Market
and Wild Oats Market announced that they wished to merge. These were the two largest
companies in the market that the government defined as “premium natural and organic
supermarket chains.” However, one could also argue that they were two relatively small
companies in the broader market for all stores that sell groceries or specialty food products.
Rather than relying on a market definition, the government antitrust regulators looked at
detailed evidence on profits and prices for specific stores in different cities, both before and
after other competitive stores entered or exited. Based on that evidence, the Federal Trade
Commission decided to block the merger. After two years of legal battles, the merger was
eventually allowed in 2009 under the conditions that Whole Foods sell off the Wild Oats
brand name and a number of individual stores, to preserve competition in certain local
markets.

This new approach to antitrust regulation involves detailed analysis of specific markets and
companies, instead of defining a market and counting up total sales. A common starting point
is for antitrust regulators to use statistical tools and real-world evidence to estimate
the demand curves and supply curves faced by the firms that are proposing the merger. A
second step is to specify how competition occurs in this specific industry. Some possibilities
include competing to cut prices, to raise output, to build a brand name through advertising,
and to build a reputation for good service or high quality. With these pieces of the puzzle in
place, it is then possible to build a statistical model that estimates the likely outcome for
consumers if the two firms are allowed to merge. Of course, these models do require some
degree of subjective judgment, and so they can become the subject of legal disputes between
the antitrust authorities and the companies that wish to merge.

Most true monopolies today in the U.S. are regulated, natural monopolies. A natural
monopoly poses a difficult challenge for competition policy, because the structure of costs
and demand seems to make competition unlikely or costly. A natural monopoly arises when
average costs are declining over the range of production that satisfies market demand. This
typically happens when fixed costs are large relative to variable costs. As a result, one firm is
able to supply the total quantity demanded in the market at lower cost than two or more firms
- so splitting up the natural monopoly would raise the average cost of production and force
customers to pay more.

Public utilities, the companies that have traditionally provided water and electrical service
across much of the United States, are leading examples of natural monopoly. It would make
little sense to argue that a local water company should be broken up into several competing
companies, each with its own separate set of pipes and water supplies. Installing four or five
identical sets of pipes under a city, one for each water company, so that each household could
choose its own water provider, would be terribly costly. The same argument applies to the
idea of having many competing companies for delivering electricity to homes, each with its
own set of wires. Before the advent of wireless phones, the argument also applied to the idea
of many different phone companies, each with its own set of phone wires running through the
neighbourhood.

Regulating Anticompetitive Behaviour

The U.S. antitrust laws reach beyond blocking mergers that would reduce competition to
include a wide array of anticompetitive practices. For example, it is illegal for competitors to
form a cartel to collude to make pricing and output decisions, as if they were a monopoly
firm. The Federal Trade Commission and the U.S. Department of Justice prohibit firms from
agreeing to fix prices or output, rigging bids, or sharing or dividing markets by allocating
customers, suppliers, territories, or lines of commerce.

In the late 1990s, for example, the antitrust regulators prosecuted an international cartel of
vitamin manufacturers, including the Swiss firm Hoffman-La Roche, the German firm BASF,
and the French firm Rhone-Poulenc. These firms reached agreements on how much to
produce, how much to charge, and which firm would sell to which customers. The high-
priced vitamins were then bought by firms like General Mills, Kellogg, Purina-Mills, and
Proctor and Gamble, which pushed up the prices more. Hoffman-La Roche pleaded guilty in
May 1999 and agreed both to pay a fine of $500 million and to have at least one top
executive serve four months of jail time.

Under U.S. antitrust laws, monopoly itself is not illegal. If a firm has a monopoly because of
a newly patented invention, for example, the law explicitly allows a firm to earn higher-than-
normal profits for a time as a reward for innovation. If a firm achieves a large share of the
market by producing a better product at a lower price, such behaviour is not prohibited by
antitrust law.

Restrictive Practices

Antitrust law includes rules against restrictive practices - practices that do not involve
outright agreements to raise price or to reduce the quantity produced, but that might have the
effect of reducing competition. Antitrust cases involving restrictive practices are often
controversial, because they delve into specific contracts or agreements between firms that are
allowed in some cases but not in others.

For example, if a product manufacturer is selling to a group of dealers who then sell to the
general public it is illegal for the manufacturer to demand a minimum resale price
maintenance agreement, which would require the dealers to sell for at least a certain
minimum price. A minimum price contract is illegal because it would restrict competition
among dealers. However, the manufacturer is legally allowed to “suggest” minimum prices
and to stop selling to dealers who regularly undercut the suggested price. If you think this
rule sounds like a fairly subtle distinction, you are right.

An exclusive dealing agreement between a manufacturer and a dealer can be legal or illegal.

It is legal if the purpose of the contract is to encourage competition between dealers. For
example, it is legal for the Ford Motor Company to sell its cars to only Ford dealers, for
General Motors to sell to only GM dealers, and so on. However, exclusive deals may also
limit competition. If one large retailer obtained the exclusive rights to be the sole distributor
of televisions, computers, and audio equipment made by a number of companies, then this
exclusive contract would have an anticompetitive effect on other retailers.
Tie-in sales happen when a customer is allowed to buy one product only if the customer also
buys a second product. Tie-in sales may sometimes be illegal. Suppose that to purchase a
popular DVD, the store required that you also purchase two other DVDs of your choice. That
would be a violation of the tie-in sales regulations. A related, but not identical, concept is
called bundling, where two or more products are sold as one. For example, a cell phone that
takes pictures forces a customer to buy a camera along with the phone.

In some cases, tie-ins and bundling can be viewed as anticompetitive. However, in other
cases they may be legal and even common. It is common for people to purchase season
tickets to a sports team or a set of concerts so that they can be guaranteed tickets to the few
contests or shows that are most popular and likely to sell out. Computer software
manufacturers may often bundle together a number of different programs, even when the
buyer wants only a few of the programs. Think about the software that is included in a new
computer purchase, for example.

Predatory pricing occurs when the existing firm (or firms) reacts to a new firm by dropping
prices very low, until the new firm is driven out of the market, at which point the existing
firm raises prices again. This pattern of pricing is aimed at deterring the entry of new firms
into the market. But in practice, it can be hard to figure out when pricing should be
considered predatory. Say that American Airlines is flying between two cities, and a new
airline starts flying between the same two cities, at a lower price. If American Airlines cuts its
price to match the new entrant, is this predatory pricing? Or is it just market competition at
work? A commonly proposed rule is that if a firm is selling for less than its average variable
cost - that is, at a price where it should be shutting down - then there is evidence for predatory
pricing. But calculating in the real world what costs are variable and what costs are fixed is
often not obvious, either.

The Microsoft antitrust case embodies many of these Gray areas in restrictive practices.

Did Microsoft Engage in Anticompetitive and Restrictive Practices?

The most famous restrictive practices case of recent years was a series of lawsuits by the U.S.
government against Microsoft - lawsuits that were encouraged by some of Microsoft’s
competitors. All sides admitted that Microsoft’s Windows program had a near-monopoly
position in the market for the software used in general computer operating systems. All sides
agreed that the software had many satisfied customers. All sides agreed that the capabilities
of computer software that was compatible with Windows—both software produced by
Microsoft and that produced by other companies - had expanded dramatically in the 1990s.
Having a monopoly or a near-monopoly is not necessarily illegal in and of itself, but in cases
where one company controls a great deal of the market, antitrust regulators look at any
allegations of restrictive practices with special care.

The antitrust regulators argued that Microsoft had gone beyond profiting from its software
innovations and its dominant position in the software market for operating systems, and had
tried to use its market power in operating systems software to take over other parts of the
software industry. For example, the government argued that Microsoft had engaged in an
anticompetitive form of exclusive dealing by threatening computer makers that, if they did
not leave another firm’s software off their machines (specifically, Netscape’s Internet
browser), then Microsoft would not sell them its operating system software. Microsoft was
accused by the government antitrust regulators of tying together its Windows operating
software, where it had a monopoly, with its Internet Explorer browser software, where it did
not have a monopoly, and thus using this bundling as an anticompetitive tool. Microsoft was
also accused of a form of predatory pricing; namely, giving away certain additional software
products for free as part of Windows, as a way of driving out the competition from other
makers of software.

In April 2000, a federal court held that Microsoft’s behaviour had crossed the line into unfair
competition, and recommended that the company be broken into two competing firms.
However, that penalty was overturned on appeal, and in November 2002 Microsoft reached a
settlement with the government that it would end its restrictive practices.

The concept of restrictive practices is continually evolving, as firms seek new ways to earn
profits and government regulators define what is permissible and what is not. A situation
where the law is evolving and changing is always somewhat troublesome, since laws are
most useful and fair when firms know what they are in advance. In addition, since the law is
open to interpretation, competitors who are losing out in the market can accuse successful
firms of anticompetitive restrictive practices, and try to win through government regulation
what they have failed to accomplish in the market. Officials at the Federal Trade Commission
and the Department of Justice are, of course, aware of these issues, but there is no easy way
to resolve them.
3.8 MONOPOLISTIC COMPETITION

Monopolistic competition characterizes an industry in which many firms offer products or

services that are similar, but not perfect substitutes. Barriers to entry and exit in a
monopolistic competitive industry are low, and the decisions of any one firm do not directly
affect those of its competitors. Monopolistic competition is closely related to the business
strategy of brand differentiation.

Monopolistic competition is a middle ground between monopoly and perfect competition (a

purely theoretical state), and combines elements of each. All firms in monopolistic
competition have the same, relatively low degree of market power; they are all price makers.
In the long run, demand is highly elastic, meaning that it is sensitive to price changes. In the
short run, economic profit is positive, but it approaches zero in the long run. Firms in
monopolistic competition tend to advertise heavily.

Monopolistic competition is a form of competition that characterizes a number of industries

that are familiar to consumers in their day-to-day lives. Examples include restaurants, hair
salons, clothing, and consumer electronics. To illustrate the characteristics of monopolistic
competition, we'll use the example of household cleaning products.

Because the products all serve the same purpose, there are relatively few options for sellers to
differentiate their offerings from other firms'. There might be "discount" varieties that are of
lower quality, but it is difficult to tell whether the higher-priced options are in fact any better.
This uncertainty results from imperfect information: the average consumer does not know the
precise differences between the various products, or what the fair price for any of them is.

Monopolistic competition tends to lead to heavy marketing, because different firms need to
distinguish broadly similar products. One company might opt to lower the price of their
cleaning product, sacrificing a higher profit margin in exchange – ideally - for higher sales.
Another might take the opposite route, raising the price and using packaging that suggests
quality and sophistication. A third might sell itself as more eco-friendly, using "green"
imagery and displaying a stamp of approval from an environmental watchdog. In reality,
every one of the brands might be equally effective.

Economists who study monopolistic competition often highlight the social cost of this type of
market structure. Firms in monopolistic competition expend large amounts real resources on
advertising and other forms of marketing. When there is a real difference between the
products of different firms, which the consume might not be aware of, these expenditures can
be useful. However, if it is instead the case that the products are near perfect substitutes,
which is likely in monopolistic competition, then real resources spent on advertising and
marketing represent a kind of wasteful rent-seeking behaviour, which produces a deadweight
loss to society.

Monopolistic competition is a type of imperfect competition such that there are many

producers competing against each other, but selling products that are differentiated from one
another (e.g. by branding or quality) and hence are not perfect substitutes. In monopolistic
competition, a firm takes the prices charged by its rivals as given and ignores the impact of its
own prices on the prices of other firms. If this happens in the presence of coercive
government, monopolistic competition will fall into government-granted monopoly.
Unlike perfect competition, the firm maintains spare capacity. Models of monopolistic
competition are often used to model industries. Textbook examples of industries with market
structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and
service industries in large cities. The "founding father" of the theory of monopolistic
competition is Edward Hastings Chamberlin, who wrote a pioneering book on the
subject, Theory of Monopolistic Competition (1933). Joan Robinson published a book The
Economics of Imperfect Competition with a comparable theme of distinguishing perfect from
imperfect competition.

3.8.1 Definition

Monopolistic competition is a type of market structure where there are many firms in the
market, but each offers a slightly different product. It is characterised by low barriers to entry
and exit, which creates fierce competition.

As a result of low barriers to entry, new competitors constantly enter the market to prevent
existing firms from making super-normal profits. One example of monopolistic competition
is hairdressing. There are many firms which offer a slightly differentiated service, whilst
competition is equally strong.

A market that has a Monopolistic structure can be seen as a mixture between

a monopoly and perfect competition. Whilst monopoly and perfect competition are at
completely different ends of the spectrum; monopolistic competition is somewhere in
between. It is similar to a monopoly in the fact a firm can make supernormal profits in the
short-term. Yet at the same time, there is easy market entry and exit, with few barriers to
entry: similar to perfect competition.

In short, monopolistic competition is a market structure where many competitors sell slightly
different products. In turn, they compete on factors other than price; such as quality, and
reliability.

3.8.2 Characteristics

Monopolistic Competition-Monopolistic Competition is that condition of market in which

there are many sellers of any commodity but commodity of every seller is different from
commodities of other sellers in any way. Therefore, product differentiation is main quality of
monopolistic competition.

Following are the main characteristics of monopolistic competition are

 Large number of firms and buyers - Firm producing differentiated product and sellers
are large in numbers in monopolistic competition.

 Product differentiation - Product differentiation is the main feature of monopolistic

competition. Product differentiation means that product of different types, brands, and
qualities will be available to customers in a fixed time period. Product differentiation
occurs when buyer of product can differentiate between two products. In this, firms
are in large number but their products are different from each other in anyway, but
these products are close substitutes of each other. Product differentiation is obtained
due to characteristic of product like shape, measurement, colour, durability, quality
etc. There are many examples of product differentiation like bath soaps Lux, Godrej,
Camay, Rexona, etc.

 Freedom of entry and exit of firms - In the situation of monopolistic competition there
is freedom of entry and exit of firms in the industry like perfect competition. It should
be noticed that Chamberlin has used group at the place of industry for group of firms
which produce differentiated products under the monopolistic competition.

 Selling cost - An important characteristic of monopolistic competition is that every

firm spends more money in promoting its product under it. Firm gives advertisements
in newspapers, cinemas, magazines, radio, T.V. etc. for selling its product in the
maximum amount. The investment done on all these is called as Selling Costs.
  Price control - Every firm has limited control on the cost of product. Average income
and limit end income curve of a firm fall down like monopoly in monopolistic
competition. It means that in this situation, firm can slow down the price for selling
more products and raise price for fewer products. In monopolistic competition, a firm
has control on cost of its production due to the product differentiation. But due to the
availability of close substitute of opposite product firms do not have full control on
cost in monopolistic competition. The cost of every firm is affected by cost policy of
its competitors in market up to the certain limit.

 Limited mobility - In monopolistic competition, sources of production and products

and do not have mobility in services.

 Imperfect knowledge - In the situation of monopolistic competition, buyers, sellers of

products, and owners of sources do not have knowledge of different prices of product.
The reason is that comparison between productions of different firms is not possible
due to product differentiation. Customers are fond of the production of any one
specific firm. They only buy the production of that firm even if it costs higher than
others. In this way even sources of production are not able to know fully that how
much the different firms are costing to the sources of services.

 Non-price competition - The main characteristic of monopolistic competition is that

under its different firms without changing the costs of products compete with each
other like the example of companies producing ‘Surf’ and ‘Ariel’. If you take a box of
‘Surf’, you will get a glass utensil similarly, with the box of ‘Ariel’ you will get the
steel spoon. In this way, firms, by providing different types of facilities and products
etc. to customers to attracts them toward their products. This type of competition is
called as Non-Price Competition.

3.8.3 Price Determination under Monopolistic Competition

Imperfect competition covers all situations where there is neither pure competition nor pure
monopoly. Both perfect competition and pure monopoly are very unlikely to be found in the
real world. In the real world, it is the imperfect competition lying between perfect
competition and pure monopoly. The fundamental distinguishing characteristic of imperfect
competition is that average revenue curve slopes downwards throughout its length, but it
slopes downwards at different rates in different categories of imperfect competition. The
monopolistic competition is one form of imperfect competition.
Features of Monopolistic Competition

Monopolistic competition refers to the market situation in which many producers produce
goods which are close substitutes of one another. Two important distinguishing features of
monopolistic competition are

Product differentiation, and

 Existence of many firms supplying the market.

  Product Differentiation

In contrary to perfect competition where there is only one homogeneous commodity, in

monopolistic competition there is differentiation of products. In monopolistic competition,
products are not homogenous nor are they only remote substitutes. These are the products
produced by competing monopolists that have separate identity, brand, logos, patents, quality
and such other product features. Product differentiation does not mean that goods are
completely different. Rather it means that products are different in some ways, but not
altogether so. These imaginary differences are created through advertising, marketing,
packaging and the use of trademarks and brand names.

Existence of Many Firms

Under monopolistic competition, there is fairly large number of sellers, let say 25 to 70. Each
individual firm has relatively small part of the total market so that each has a very limited
control over the price of the product. And each firm determines its own price-output policy
without considering the reactions of rival firms.

Because of consumers’ attachment to a particular brand, the seller acquires a monopolistic

influence on the market. Thus, the demand curve facing a firm under monopolistic
competition is a downward sloping curve, i.e., if he wants to sell more, he has to lower his
price. The demand curve or AR curve under monopoly also slopes downwards, but there is a
difference between demand curves facing under monopolistic competition and pure
monopoly. The demand curve faced by a ‘competing monopolist’ is more elastic than the
demand curve faced by the ‘monopolist’, because there are no close substitutes available for
the monopolist commodity.

Under monopolistic competition, the firm will be in equilibrium position when marginal
revenue is equal to marginal cost. So long the marginal revenue is greater than marginal cost,
the seller will find it profitable to expand his output, and if the MR is less than MC, it is
obvious he will reduce his output where the MR is equal to MC. In short run, therefore, the
firm will be in equilibrium when it is maximising profits, i.e., when MR = MC.

Short Run Equilibrium

Short run equilibrium is illustrated in the following diagram.

Figure 3.5: Monopolistic competition short run equilibrium

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 AC curve, therefore, the profit is shown as PT. PT is the
supernormal profit per unit of output. Total supernormal profit will be measured by
multiplying the supernormal profit to the total output, i.e., PT × OM or PTT’P’ as shown in
figure 3.5.

 The firm may also incur losses in the short run if it is facing AR curve below the AC
curve in figure 3.5.

 MP is less than MT and TP are the loss per unit of output. Total loss will be measured
by multiplying loss per unit of output to the total output, i.e., TP × OM or TPP’T’.

Long Run Equilibrium

Under monopolistic competition, the supernormal profit in the long run is disappeared as new
firms are entered into the industry. As the new firms are entered into the industry, the demand
curve or AR curve will shift to the left, and therefore, the supernormal profit will be
competed away and the firms will be earning normal profits. If in the short run firms are
suffering from losses, then in the long run some firms will leave the industry so that
remaining firms are earning normal profits.
The AR curve in the long run will be more elastic, since a large number of substitutes will be
available in the long run. Therefore, in the long run, equilibrium is established when firms are
earning only normal profits. Now profits are normal only when AR = AC. It is further
illustrated in the following diagram.

Figure 3.6: Long run equilibrium in monopolistic competition

3.9 PRODUCT DIFFERENTIATION OLIGOPOLY

In a differentiated-product oligopoly, a firm’s profits will depend on the type of product it

chooses to offer, as well depend on the type of product it chooses to offer, as well as the entry
and product-type decisions of its competitors. Price competition may be tougher if the market
contains more operating firms. Firms can soften the price competition found in less
concentrated markets, however, by offering differentiated products. Given market demand,
quantity will also depend on firms’ relative locations in product space. Using data from a
large cross section of motel oligopolies, in which firms are differentiated according to the
quality of services they offer, this empirical analysis measures the impact of both market
concentration and product differentiation on competitive outcomes. The empirical work
extends a long line of research on the relationship between market structure and the
profitability of firms. Such studies have primarily examined homogeneous product markets;
by analysing data from a product differentiated industry, can explicitly measure how the
effects of competitors differ according to their relative product-space locations. The results
demonstrate that competitors have a less harmful effect when products are differentiated. In
the case of motels, duopoly prices are about 5% lower than the monopoly price when the two
competitors offer similar-quality lodging services. If the quality of the two firms is different,
however, there is no price effect associated with the second firm. The paper also proposes an
econometric methodology to address the endogeneity problem that confronts empirical work
on the relationship between outcomes and market structure. Firms anticipate the competitive
effects of market structure when making their entry and product-type decisions. The market
structure variables used to explain the observed outcomes, therefore, derive from the related
entry and product choice stage of the game. As a result, it is crucial to allow for correlation
between unobserved factors that affect the entry and product-type decisions of firms and
unobservable in the outcome regressions. To correct for the potential bias caused by this
correlation, an econometric model of equilibrium market structure is employed as a selection
equation in a two-step estimation procedure. The second-step outcome regressions are
modified to reflect the market structure selection. This alternative approach emphasizes the
logical relationship among firms’ entry and product choice behaviour, market structure, and
price competition. Following this introduction, provide some background for the analysis of
competitive outcomes in motel oligopolies. Section III presents the two-step estimation
procedure developed to measure the effects of concentration and differentiation on outcomes.
This procedure is used to analyse the observed outcomes of motels located along interstate
highways; the data are outlined in section IV. In section V, I present the estimation results.
Evidence from the analysis of these outcomes help demonstrate why motel firms find
differentiation a profitable product choice strategy. Section VI provides some concluding
remarks.

Analyses relating profits and market concentration were a fundamental part of the structure-
conduct-performance paradigm fundamental part of the structure-conduct-performance
paradigm in industrial organization. Regressions that reported a positive correlation were
treated as support for the hypothesis that firms would earn higher profits if they faced fewer
competitors. Demsetz (1974) critiqued this literature by pointing out that even if a positive
correlation between economic profits and concentration could be established, the direction of
causation would remain in doubt. For example, if firms have different capabilities, some are
apt to be more profitable (they may have lower costs) than others—these firms ought to
outperform less capable counterparts. If the number of firms possessing superior capabilities
is small, only a few will survive. In this scenario, a positive correlation between profits and
market concentration occurs because the small number of highly profitable firms translates
into a concentrated market, not because concentration somehow enables firms to earn higher
profits. This argument casts fundamental doubt on non-structural methods for examining the
relationship between profits and market structure. Nonetheless, some authors proceeded to
make improvements on these early regressions. Weiss (1989) responded with a compendium
of studies that explored the relationship between market structure and prices, rather than
profits. He contended that since prices are determined in the market, they would not reflect
the technical superiority of operating firms, as profits might. Weiss’s book summarized a
collection of more than 100 empirical analyses - the typical study regressed price (controlling
for variables related to market level costs) on some measure of concentration for a collection
of markets in a homogeneous product industry - and concluded: “our evidence that
concentration is correlated with price is overwhelming.” The price and market structure
regressions leave a further econometric difficulty unaddressed. Because of the relationship
between price competition and market structure determination, it is likely that underlying
shocks (to demand, for example) will affect both. Market concentration measures used to
explain price may be correlated with unobservable in the price regression, causing bias in its
estimated parameters. To date, remedies for this endogeneity problem have had limited
success. An effective two-stage least-squares procedure relies on instruments that affect
market structure but not prices, which are typically difficult to isolate. Reiss and Spiller
(1989) employ a promising approach that embeds price and quantity determination, along
with some assumptions about the nature of price competition, directly within a model of
entry. This empirical strategy captures the effect of market structure on both outcomes and
entry at once. While applying their model is limited by the difficulty of solving for all the
equilibrium price and quantity strategies when several firms are operating, it does
demonstrate the gains to be made from an integrated analysis of market structure
determination and price competition. The estimation procedure proposed in the following
section extends the empirical literature on the effects of market concentration in two
important ways. First estimate a much richer set of competitive effects. Since theory suggests
that the impact of additional competitors ought to vary with product type.

Data for the empirical analysis comes from the motel segment of the lodging industry, which
caters to highway segment of the lodging industry, which caters to highway travellers and
represents nearly half of the estimated 48,000 hotel properties in the United States. Motels
began to prosper during the first half of the twentieth century: as Americans purchased
automobiles in larger numbers, it became popular to criss-cross the country on vacations and
to travel from town to town for business. The industry was buoyed further by the National
System of Interstate and Défense Highways, a 42,500-mile network of freeways established
in 1956 and constructed in the years since. Business establishments providing services for
travellers have flourished along interstate highways, even in remote areas where little demand
for such services would otherwise exist. While all motels provide the same basic services,
they differ in the level of quality associated with these services. Industry observers have
traditionally applied a single-index representation of differentiation based on quality to
categorize roadside motel establishments. Travel organizations like the American Automobile
Association (AAA) have established rating systems to provide consumers with accurate
information about the quality of motel services. Using AAA’s rating for each motel have
divided the motels in my sample into two product types: low and high quality. Further details
on the data set are presented in section IV. Though franchising and chain affiliation are
widespread in the motel industry, independent entrepreneurs still make decisions for each
individual property. This is crucially important for the empirical work, which assumes that
the quality type of each establishment represents the choice that maximizes profits for that
establishment. The individual franchisees and independent motel proprietors represented in
my data set almost certainly behave in this manner. This assumption is particularly
appropriate for smaller rural markets, where franchisees choose their quality by selecting
which chain to represent and independent motels remain quite common.

3.9.1 Definition

The term ‘Oligopoly’ is coined from two Greek words ‘Oligoi meaning ‘a few’ and ‘pollen
means ‘to sell’.

It occurs when an industry is made up of a few firms producing either an identical product or
differentiated product.

In simple words, “Oligopoly is a situation in which there are so few sellers that each of them
is conscious of the results upon the price of the supply which he individually places upon the
market”-The number of sellers is greater than one, yet not big enough to render negligible the
influence of any one upon the market price.

“Oligopoly is that situation in which a firm bases its markets policy in part on the expected
behaviour of a few close rivals.” – J. Stigier
“An oligopoly is a market of only a few sellers, offering either homogeneous or differentiated
products. There are so few sellers that they recognize their mutual dependence.” – PC.
Dooley

“Oligopoly is a market structure characterized by a small number of firms and a great deal of
interdependence.” -Mansfield

“An oligopoly is a market situation in which each of a small number of interdependent,

competing producer’s influences but does not control the market.” – Grinols

“Oligopoly is a market situation in which number of firms in an industry is so small that each
must consider the reaction of rivals in formulating its price policy.” – McConnel

3.9.2 Characteristics

Oligopoly is a market situation in which there are only a few sellers of a commodity. Under
this, each seller can influence its price-output policy. It is because the number of sellers is not
very large and each seller controls a big portion of total supply.

Price-output policy of a firm does affect the rivals. The price which is fixed under oligopoly
without product differentiation is indeterminate. In case of differentiated products, monopoly
agreements are even less possible.

Monopoly Power

There is an element of monopoly power in oligopoly. Since there are only a few firms and
each firm has a large share of the market. In its share of the market, it controls the price and
output. Thus, an oligopoly has some monopoly power.

Interdependence of Firms

Under perfect competition there are so many small firms and no single firm is strong enough
to influence price or output. So, the firms do not care about the actions and reactions of other
firms. Under monopoly, the question of interdependence of firms does not arise because there
is one single firm in the market.

Under oligopoly, there are only a few firms, each producing a homogeneous or slightly
differentiated product. Since the number of firms is small, each firm enjoys a large share of
the market and has a significant influence on the price and output decisions. Thus, there is
interdependence of firms. No firm can ignore the actions and reactions of rival firms under
oligopoly.
Conflicting Attitude of Firms

Under oligopoly, two types of conflicting attitudes are found in the firms. On the one hand,
firms realize the disadvantages of mutual competition and desire to combine to maximize
their joint profits. This tendency leads to the formation of collusion. On the other hand, the
desire to maximize one’s individual profit may lead to conflict and antagonism, the firms
come into clash with one another on the question of distribution of profits and allocation of
markets. Thus, there is an existence of two opposing attitudes among the firms.

Few Firms

For example, the market for automobiles in India exhibits oligopolistic structure as there are
only few producers of automobiles. If there are only two firms, it is called ‘duopoly’.

Nature of Product

If the firm’s product homogeneous product, it becomes pure oligopoly. The firms with
product differentiation constitute impure oligopoly.

Interdependence Among Firms

In oligopoly market, each firm treats the other as its rival firm. It is for this reason that each
firm while determining price of its product, takes into account the reaction of the other firms
to its own action.

Large Number of Consumers

In this market, there are large numbers of consumers to demand the product.

Indeterminate Demand

The demand curve under oligopoly is indeterminate because any step taken by his rivals may
change the demand curve.

Basis of Product Differentiation

On the basis of product differentiation, oligopoly may be classified as pure or perfect

oligopoly and imperfect or differentiated oligopoly. In the case of pure oligopoly, the product
of different firms in the industry is identical or homogeneous while in the case of
differentiated oligopoly, the products of different firms are not identical but rather
differentiated products. Thus, differentiated oligopoly will exist where the competing firms
produce products which are close substitutes but not perfect substitutes.
The distinction between pure oligopoly and differentiated oligopoly does not play a
significant role in the analysis. In real situation, firms in most oligopolistic industries produce
differentiated products. But theoretically we may determine price and output in both kinds of
oligopoly.

Basis of Entry of Firms

On the basis of the possibility of entry of new firms into the industry, oligopoly may be
classified as open oligopoly and closed oligopoly. An open oligopoly provides full freedom
to new firms to enter into the industry. In the situation of open oligopoly there is no
restriction of any kind for the desiring firms to enter into the market. A closed oligopoly, on
the other hand, refers to that market situation where only the few firms control the entire
market and new firms are not allowed to enter the industry.

Basis of Price Leadership

On the basis of presence or absence of price leadership, oligopoly may be classified as partial
oligopoly and full oligopoly. Partial oligopoly refers to that market situation where the
industry is dominated by one large firm (known as the leader) and the other firms (known as
the followers) of the industry follow the price policy determined by their leader. Full
oligopoly, on the other hand, refers to that market situation where there is no leader and no
followers.

Basis of Agreement

On the basis of agreement, oligopoly is classified as collusive oligopoly and non-collusive

oligopoly. A collusive oligopoly refers to that market situation where the firms of the
industry follow a common policy of pricing. In other words, they combine together to avoid
competition among themselves regarding the price and output of the industry. A non-
collusive oligopoly refers to that market situation where there is no agreement among the
firms regarding the price and output of the entire market. In other words, the firms under non-
collusive oligopoly act independently.

3.9.3 Price Leadership

Price leadership refers to a situation where prices and price changes established by a
dominant firm, or a firm are accepted by others as the leader, and which other firms in the
industry adopt and follow. When price leadership is adopted to facilitate collusion, the price
leader will generally tend to set a price high enough that the least efficient firm in the market
may earn some return above the competitive level.

Price leadership occurs when a leading firm in a given industry is able to exert enough
influence in the sector that it can effectively determine the price of goods or services for the
entire market. This type of firm is sometimes referred to as the price leader.

This phenomenon is common in industries that have oligopolistic market conditions, such as
the airline industry. This level of influence often times leaves the rivals of the price leader
with little choice but to follow its lead and match the prices if they are to hold onto
their market share. In the airline industry, a dominant company typically sets the prices and
other airlines feel compelled to adjust their prices to match the prices of the leading firm.

There are certain economic conditions that make the emergence of price leadership more
likely to occur within an industry: the number of companies involved is small; entry to the
industry is restricted; products are homogeneous; demand is inelastic, or less elastic;
organizations have a similar long-run average total cost (LRATC). LRATC is an economics
metric that is used to determine the minimum (or lowest) average total cost at which a firm
can produce any given level of output in the long run (when all inputs are variable).

The proliferation of price leadership tends to occur more often in sectors that produce goods
and services that offer little differentiation from one producer to another.

Price leadership also tends to emerge when there is a high level of consumer demand for a
specific product; this results in consumers being drawn away from any competing products.
Thus, the price of the specific product that is experiencing high levels of consumer demand
becomes the market leader.

Types of Price Leadership

There are three primary models of price leadership: barometric, collusive, and dominant.

Barometric

The barometric price leadership model occurs when a particular firm is more adept than
others at identifying shifts in applicable market forces, such as a change in production costs.
This allows the firm to respond to market forces more efficiently. For instance, the firm may
initiate a price change.

It is possible for a firm with a small market share to act as a barometric price leader if it's a
good producer and if the firm is attuned to trends in its market. Other producers may follow
its lead, assuming that the price leader is aware of something that they have yet to realize.
However, because a barometric leader has very little power to impose its decisions on other
firms in the industry, its leadership might be short-lived.

Collusive

The collusive price leadership model may emerge within markets that have oligopolistic
conditions. Collusive price leadership occurs as a result of an explicit or implicit agreement
among a handful of dominant firms to keep their prices in mutual alignment.

Smaller firms within the market are effectively forced into following the price change
initiated by the dominant firms. This practice is most common in industries where the cost of
entry is high, and the costs of production are known.

These agreements between firms–either explicit or implicit–may be considered illegal if the

effort is designed to defraud the public. There is a fine line between price leadership and
illegal acts of collusion. Price leadership is more likely to be considered collusive–and
potentially illegal–if the changes in the price of a good are not related to changes in the
operating costs of the firm.

Dominant

The dominant price leadership model occurs when one firm controls the vast majority of the
market share in its industry. Within the industry, there are other, smaller firms that provide
the same products or services as the leading firm. However, in this model, these smaller firms
cannot influence prices.

A dominant price leadership model is sometimes referred to as a partial monopoly. In this

type of model, the price leader might engage in predatory pricing, which refers to the practice
of lowering prices to levels that make it impossible for smaller, competing firms to remain in
business. In most countries, business decisions that enact predatory pricing and are aimed at
hurting smaller companies are illegal.

Advantages and Disadvantages of Price Leadership

There are many potential advantages for firms that emerge as price leaders within an
industry. In some instances, other firms within an industry may also benefit from the
emergence of a price leader. For example, if companies in a particular market follow a price
leader by setting higher prices, then all producers in that market stand to profit, as long as
demand remains steady.
Price leadership also has the potential to eliminate (or reduce) price wars. If a market is
completely comprised of companies of a similar size, in the absence of price leadership, price
wars could ensue as each competitor tries to increase its share of the market.

One side effect of price leadership may be better-quality products as a result of an increase in
profits. Increased profits often mean more revenue for companies to invest in research and
development (R&D), and thus, an increase in their ability to design new products and deliver
more value to customers.

The dynamics of price leadership may also create a system of interdependence rather than
rivalry. When firms in the same market choose a parallel pricing structure–instead of
undercutting each other–it fosters a positive environment conducive to growth for all
companies.

There are also many potential disadvantages to the emergence of price leadership within an
industry. In general, price leadership is only advantageous to businesses (in terms of their
profits and performance). Price leadership where prices are increased does not convey any
material advantages to consumers - however in the case where the price leader lowers prices
consumers may benefit with less expensive goods and services.

In every price leadership model–barometric, collusive, dominant–it is the sellers that benefit
from increased revenues, not the consumers. Customers will need to pay more for items that
they were used to getting for less (before the sellers conspired to raise prices).

Consumers, however, may benefit in the short run if a price leader lowers prices. This
assumes the price leader is not using predatory pricing to drive firms not able to respond out
of business and later on exert monopoly pressure and raise prices.

Price leadership can also be unfair to smaller firms because small firms who attempt to match
a leader's prices may not have the same economies of scale as the leaders. This can make it
hard for them to sustain consistent price declines (and, in the long-term, to remain in
business).

Price leadership can also result in malpractices on the part of competing firms that make the
decision not to follow the leader's prices. Instead, they may engage in aggressive promotion
strategies, such as rebates, money-back guarantees, free delivery services, and instalment
payment plans.
Finally, in a price leadership model, there is an inevitable discrepancy between the benefits
conferred to the price leader versus the benefit conferred to other firms operating in the same
industry. For example, if it costs the price leader less capital to produce the same product than
it costs another firm, then the leader will set lower prices. This will result in a loss for any
firm that has higher costs than the price leader.

Sources of Monopoly Power

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

 Economic barriers - Economic barriers include economies of scale, capital

requirements, cost advantages and technological superiority.

 Economies of scale - Decreasing unit costs for larger volumes of

production. Decreasing costs coupled with large initial costs, If for example the
industry is large enough to support one company of minimum efficient scale then
other companies entering the industry will operate at a size that is less than MES, and
so cannot produce at an average cost that is competitive with the dominant company.
And if the long-term average cost of the dominant company is constantly decreasing,
then that company will continue to have the least cost method to provide a good or
service.

 Capital requirements - Production processes that require large investments of capital,

perhaps in the form of large research and development costs or substantial sunk costs,
limit the number of companies in an industry: this is an example of economies of
scale.

 Technological superiority - A monopoly may be better able to acquire, integrate and

use the best possible technology in producing its goods while entrants either do not
have the expertise or are unable to meet the large fixed costs needed for the most
efficient technology. Thus one large company can often produce goods cheaper than
several small companies.

 No substitute goods - A monopoly sells a good for which there is no close substitute.

The absence of substitutes makes the demand for that good relatively inelastic,
enabling monopolies to extract positive profits.
  Control of natural resources - A prime source of monopoly power is the control of
resources (such as raw materials) that are critical to the production of a final good.

 Network externalities - The use of a product by a person can affect the value of that
product to other people. This is the network effect. There is a direct relationship
between the proportion of people using a product and the demand for that product. In
other words, the more people who are using a product, the greater the probability that
another individual will start to use the product. This reflects fads, fashion
trends, social networks etc. It also can play a crucial role in the development or
acquisition of market power. The most famous current example is the market
dominance of the Microsoft office suite and operating system in personal computers.

 Legal barriers - Legal rights can provide opportunity to monopolise the market in a
good. Intellectual property rights, including patents and copyrights, give a monopolist
exclusive control of the production and selling of certain goods. Property rights may
give a company exclusive control of the materials necessary to produce a good.

 Advertising - Advertising is most important to sell the product because of the single
user, they have to do it their own.

 Manipulation - A company wanting to monopolise a market may engage in various

types of deliberate action to exclude competitors or eliminate competition. Such
actions include collusion, lobbying governmental authorities, and force.

Monopoly versus Competitive Markets

While monopoly and perfect competition mark the extremes of market structures there is
some similarity. The cost functions are the same. Both monopolies and perfectly competitive
(PC) companies minimize cost and maximize profit. The shutdown decisions are the same.
Both are assumed to have perfectly competitive factors markets. There are distinctions, some
of the most important distinctions are as follows.

 Marginal revenue and price - In a perfectly competitive market, price equals marginal
cost. In a monopolistic market, however, price is set above marginal cost.

 Product differentiation - There is no product differentiation in a perfectly competitive

market. Every product is perfectly homogeneous and a perfect substitute for any
other. With a monopoly, there is great to absolute product differentiation in the sense
that there is no available substitute for a monopolized good. The monopolist is the
 sole supplier of the good in question. A customer either buys from the monopolizing
entity on its terms or does without.

 Number of competitors - PC markets are populated by an infinite number of buyers

and sellers. A monopoly involves a single seller.

 Barriers to entry - Barriers to entry are factors and circumstances that prevent entry
into market by would-be competitors and limit new companies from operating and
expanding within the market. PC markets have free entry and exit. There are no
barriers to entry, or exit competition. Monopolies have relatively high barriers to
entry. The barriers must be strong enough to prevent or discourage any potential
competitor from entering the market.

 Elasticity of demand - The price elasticity of demand is the percentage change of

demand caused by a one percent change of relative price. A successful monopoly
would have a relatively inelastic demand curve. A low coefficient of elasticity is
indicative of effective barriers to entry. A PC company has a perfectly elastic demand
curve. The coefficient of elasticity for a perfectly competitive demand curve is
infinite.

 Excess profits - Excess or positive profits are profit more than the normal expected
return on investment. A PC company can make excess profits in the short term but
excess profits attract competitors, which can enter the market freely and decrease
prices, eventually reducing excess profits to zero. A monopoly can preserve excess
profits because barriers to entry prevent competitors from entering the market.

 Profit maximization - A PC company maximizes profits by producing such that price

equals marginal costs. A monopoly maximises profits by producing where marginal
revenue equals marginal costs. The rules are not equivalent. The demand curve for a
PC company is perfectly elastic – flat. The demand curve is identical to the average
revenue curve and the price line. Since the average revenue curve is constant the
marginal revenue curve is also constant and equals the demand curve, Average
revenue is the same as price (AR = TR/Q = P x Q/Q = P). Thus, the price line is also
identical to the demand curve. In sum, D = AR = MR = P.

 P-Max quantity, price and profit -If a monopolist obtains control of a formerly
perfectly competitive industry, the monopolist would increase prices, reduce
production, and realise positive economic profits.
  Supply curve - in a perfectly competitive market there is a well-defined supply
function with a one-to-one relationship between price and quantity supplied. In a
monopolistic market no such supply relationship exists. A monopolist cannot trace a
short-term supply curve because for a given price there is not a unique quantity
supplied. As Pin Dyck and Ruben Feld note, a change in demand "can lead to changes
in prices with no change in output, changes in output with no change in price or both".

 Monopolies produce where marginal revenue equals marginal costs. For a specific
demand curve, the supply "curve" would be the price-quantity combination at the
point where marginal revenue equals marginal cost. If the demand curve shifted the
marginal revenue curve would shift as well and a new equilibrium and supply "point"
would be established. The locus of these points would not be a supply curve in any
conventional sense.

The most significant distinction between a PC company and a monopoly is that the monopoly
has a downward-sloping demand curve rather than the "perceived" perfectly elastic curve of
the PC Company. Practically all the variations mentioned above relate to this fact. If there is a
downward-sloping demand curve then by necessity there is a distinct marginal revenue curve.
The implications of this fact are best made manifest with a linear demand curve. Assume that
the inverse demand curve is of the form x = a − by. Then the total revenue curve is TR = ay −
by2 and the marginal revenue curve is thus MR = a − 2by. From this several things are
evident. First, the marginal revenue curve has the same y intercept as the inverse demand
curve. Second, the slope of the marginal revenue curve is twice that of the inverse demand
curve. Third, the x intercept of the marginal revenue curve is half that of the inverse demand
curve. What is not quite so evident is that the marginal revenue curve is below the inverse
demand curve at all points. Since all companies maximise profits by equating MR and MC it
must be the case that at the profit-maximizing quantity MR and MC are less than price, which
further implies that a monopoly produces less quantity at a higher price than if the market
were perfectly competitive.

The fact that a monopoly has a downward-sloping demand curve means that the relationship
between total revenue and output for a monopoly is much different than that of competitive
companies. Total revenue equals price times quantity. A competitive company has a perfectly
elastic demand curve meaning that total revenue is proportional to output. Thus the total
revenue curve for a competitive company is a ray with a slope equal to the market price. A
competitive company can sell all the output it desires at the market price. For a monopoly to
increase sales it must reduce price. Thus, the total revenue curve for a monopoly is a parabola
that begins at the origin and reaches a maximum value then continuously decreases until total
revenue is again zero. Total revenue has its maximum value when the slope of the total
revenue function is zero. The slope of the total revenue function is marginal revenue. So, the
revenue maximizing quantity and price occur when MR = 0. For example, assume that the
monopoly's demand function is P = 50 − 2Q. The total revenue function would be TR = 50Q
− 2Q2 and marginal revenue would be 50 − 4Q. Setting marginal revenue equal to zero we
have

So, the revenue maximizing quantity for the monopoly is 12.5 units and the revenue
maximizing price is 25.

A company with a monopoly does not experience price pressure from competitors, although
it may experience pricing pressure from potential competition. If a company increases prices
too much, then others may enter the market if they are able to provide the same good, or a
substitute, at a lesser price. The idea that monopolies in markets with easy entry need not be
regulated against is known as the "revolution in monopoly theory".

A monopolist can extract only one premium, and getting into complementary markets does
not pay. That is, the total profits a monopolist could earn if it sought to leverage its monopoly
in one market by monopolizing a complementary market are equal to the extra profits it could
earn anyway by charging more for the monopoly product itself. However, the one monopoly
profit theorem is not true if customers in the monopoly good are stranded or poorly informed,
or if the tied good has high fixed costs.

A pure monopoly has the same economic rationality of perfectly competitive companies, i.e.,
to optimise a profit function given some constraints. By the assumptions of increasing
marginal costs, exogenous inputs' prices, and control concentrated on a single agent or
entrepreneur, the optimal decision is to equate the marginal cost and marginal revenue of
production. Nonetheless, a pure monopoly can – unlike a competitive company – alter the
market price for its own convenience: a decrease of production results in a higher price. In
the economics' jargon, it is said that pure monopolies have "a downward-sloping demand".
An important consequence of such behaviour is that typically a monopoly selects a higher
price and lesser quantity of output than a price-taking company; again, less is available at a
higher price.

3.10 PRICE DISCRIMINATION UNDER MONOPOLY

In monopoly, there is a single seller of a product called monopolist. The monopolist has
control over pricing, demand, and supply decisions, thus, sets prices in a way, so that
maximum profit can be earned.

The monopolist often charges different prices from different consumers for the same product.
This practice of charging different prices for identical product is called price discrimination.
According to Robinson, “Price discrimination is charging different prices for the same
product or same price for the differentiated product.”

According to Stigler, “Price discrimination is the sale of various products at prices which are
not proportional to their marginal costs.”

In the words of Dooley, “Discriminatory monopoly means charging different rates from
different customers for the same good or service.”

According to J.S. Bains, “Price discrimination refers strictly to the practice by a seller to
charging different prices from different buyers for the same good.”

Types of Price Discrimination

Price discrimination is a common pricing strategy’ used by a monopolist having discretionary

pricing power. This strategy is practiced by the monopolist to gain market advantage or to
capture market position.

The different types of price discrimination are explained as follows:

 Personal - Refers to price discrimination when different prices are charged from
different individuals. The different prices are charged according to the level of income
of consumers as well as their willingness to purchase a product. For example, a doctor
charges different fees from poor and rich patients.

 Geographical - Refers to price discrimination when the monopolist charges different

prices at different places for the same product. This type of discrimination is also
called dumping.
  On the basis of use - Occurs when different prices are charged according to the use of
a product. For instance, an electricity supply board charges lower rates for domestic
consumption of electricity and higher rates for commercial consumption.

 Degrees of Price Discrimination - Price discrimination has become widespread in

almost every market. In economic jargon, price discrimination is also called
monopoly price discrimination or yield management. The degree of price
discrimination vanes in different markets.

These three degrees of price discrimination are explained as follows:

1. First-degree price discrimination - Refers to a price discrimination in which a

monopolist charges the maximum price that each buyer is willing to pay. This is also
known as perfect price discrimination as it involves maximum exploitation of
consumers. In this, consumers fail to enjoy any consumer surplus. First degree is
practiced by lawyers and doctors.

2. Second-degree price discrimination - Refers to a price discrimination in which buyers

are divided into different groups and different prices are charged from these groups
depending upon what they are willing to pay. Railways and airlines practice this type
of price discrimination.

3. Third-degree price discrimination - Refers to a price discrimination in which the

monopolist divides the entire market into submarkets and different prices are charged
in each submarket. Therefore, third-degree price discrimination is also termed as
market segmentation.

In this type of price discrimination, the monopolist is required to segment market in a

manner, so that products sold in one market cannot be resold in another market. Moreover,
he/she should identify the price elasticity of demand of different submarkets. The groups are
divided according to age, sex, and location. For instance, railways charge lower fares from
senior citizens. Students get discount in cinemas, museums, and historical monuments.

3.11 SUMMARY

 When it comes to economics, free markets tend to exist in four kinds of states: ideal
competition, monopolistic competition, oligopoly, and monopoly. All markets all over
the world are subject to these four conditions. Of course, there is bound to be overlap
 and coexistence, but these are the main kinds of competitive markets we see.
However, in this article, we will study what a monopoly market is.

 A monopoly happens in markets when there is no competition. In markets like this,

the pricing power lies in the hands of a few - meaning the people, whether a group or
organization, who are the sole suppliers of the product, set the price.

 Price takers can never rise to the level of price makers in this sort of economy without
the help of externalities. In this article, we show you how to take the market price
back.

 This chapter concludes by pointing to a number of key implications, take ways, and
open questions that have emerged throughout this book. It highlights in particular the
conclusions that the book derived from the application of the natural monopoly
framework to digital platform markets; the competition policy implications that
emerge from the economic literature on multisided markets; the role of breakup
policies in digital markets; the intuitional refinements that may be desirable for a
contestability and Schumpeterian-based policy approach; and some of the political
economy implications that may derive from the emergence of different standards of
regulatory intervention and enforcement across jurisdictions.

 This chapter has discussed the behaviour of firms that have control over the prices
they charge. We have seen that these firms behave very differently from the
competitive firms studied in the previous chapter. Table 2 summarizes some of the
key similarities and differences between competitive and monopoly markets.

 From the standpoint of public policy, a crucial result is that monopolists produce less
than the socially efficient quantity and charge prices above marginal cost. As a result,
they cause deadweight losses. In some cases, these inefficiencies can be mitigated
through price discrimination by the monopolist, but other times, they call for
policymakers to take an active role. How ‘prevalent are the problems of monopoly?
There are two answers to this question.

 In one sense, monopolies are common: Most firms have some control over’ the prices
they charge. They are charge the market price for their goods because their goods are.
not exactly the same as those offered by other firms. A Fortuitous is .not the same as a
Toyota Camry. Ben and Jerry’s ice cream is not ‘the same as Breyer).Each of these
 ‘downward sloping demand curve, which gives each producer some degree of
monopoly power.

 Yet firms with substantial monopoly power are rare. Few goods are truly unique.
Most have substitutes that, even if not exactly the same, are similar. Bernard Jerry can
raise the price of their ice cream a little without losing all their sales, but if they raise
it very much, sales will fall substantially as their customers switch to another brand.

3.12 KEYWORDS

 Allocative Efficiency:- Producing the optimal quantity of some output; the quantity
where the marginal benefit to society of one more unit just equals the marginal cost.

 Legal Monopoly:- Legal prohibitions against competition, such as regulated

monopolies and intellectual property protection.

 Monopoly:- A situation in which one firm produces all of the output in a market.

 Deregulation:- Removing government controls over setting prices and quantities in

certain industries.

 Natural Monopoly:- Economic conditions in the industry, for example, economies of

scale or control of a critical resource, that limit effective competition.

3.13 LEARNING ACTIVITY

1. Create a session on monopoly and anti-trust policy.

___________________________________________________________________________
___________________________________________________________________________

2. Create a survey on product differentiation oligopoly.

___________________________________________________________________________
___________________________________________________________________________

3.14 UNIT END QUESTIONS

A. Descriptive Questions

Short Questions

1. What is monopoly?
 2. Define monopoly control?

3. Write the main nature of natural monopoly?

4. Define monopolistic competition?

5. What is price leadership?

Long Questions

1. Explain the price determination under monopoly.

2. Examine the monopolistic competition.

3. Illustrate the product differentiation oligopoly.

4. Illustrate the monopoly and anti-trust policy.

5. Describe the characteristics of monopoly?

B. Multiple Choice Questions

1. Which of the following is a unregulated monopolies?

a. Cannot change the market quantity

b. Can influence the market quantity and price.
c. Cannot incorporate
d. Take the market price as given

2. Which of the following is not a key feature of a monopoly?

a. Diseconomies of scale
b. No close substitutes
c. Influence over price
d. Barriers to entry

3. Which one of the following is not true statements about a monopoly?

a. A monopoly is the only supplier of the good

b. Monopolies have no barriers to entry or exit
c. The good produced by a monopoly has no close substitutes
 d. None of the above; that is, all of the above answers are true statements about a
monopoly

4. What is an industry in which one firm can supply the entire market at a lower price
than two or more firms called as?

a. Legal monopoly
b. Single-price monopoly
c. Natural monopoly
d. Price-discriminating monopoly

5. Which one of the following is true of a natural monopoly?

a. The firm can supply the entire market at a lower cost than could two or more
firms
b. Its average total cost curve slopes upward as it intersects the demand curve
c. The firm is not protected by any barrier to entry
d. Economies of scale exist to only a very low level of output

Answers

1-b, 2-a, 3-b, 4-c, 5-a

3.15 REFERENCES

Reference

  Goodwin, N. Nelson. J. Ackerman, F. & Weisskopf, T. (2009). Microeconomics in

Context.

 Samuelson, William F & Marks, Stephen, G. (2003). Managerial Economics.

 Nicholson, Walter & Snyder, Christopher. (2007). Intermediate Microeconomics.

Textbook

  The New Palgrave Dictionary of Economics. (2008.). Basingstoke, Hampshire:

Palgrave Macmillan.
  Riggs, Thomas & Bonk, Mary. (2008). Government-Granted Monopoly. Everyday
Finance: Economics, Personal Money Management, and Entrepreneurship. Detroit:
Gale Cengage Learning. 

 Frank, Robert H. (2008). Microeconomics and Behaviour 

Website

 https://en.wikipedia.org/wiki/Monopoly

 https://stats.oecd.org/glossary/detail.asp?ID=3285

 https://economicskey.com/conclusion-the-prevalence-of-monopoly-6262
UNIT 4 – FACTORS PRICING

STRUCTURE

4.0 Learning Objectives

4.1 Introduction

4.2 Factors of Production

4.2.1 Land

4.2.2 Labour

4.2.3 Capital

4.2.4 Organization

4.3 Theories of Distribution

4.4 Marginal Productivity

4.5 Modern Theory of Distribution

4.6 Theories of Rent: Ricardo and Modern Theory of Rent

4.7 Theories of Wages: Modern Theory of Wages

4.7.1 Wages Determination Under Imperfect Competition

4.8 Theories of Interest

4.8.1 Loanable Fund and Keynes Liquidity Preference Theory of Interest

4.9 Theories of Profit

4.9.1 Uncertainty Theory of Profit

4.9.2 Dynamic Theory of Profit

4.9.3 Innovation Theory of Profit

4.10 Summary

4.11 Keywords

4.12 Learning Activity

4.13 Unit End Questions

 4.14 References

4.0 LEARNING OBJECTIVES

After studying this unit, you will be able to:

 Explain the theories of distribution.

 Examine the modern theory of distribution.

 Illustrate the theories of profit.

4.1 INTRODUCTION

In economic theory, a factor price is the unit cost of using a factor of production, such
as labour or physical capital.

Classical and Marxist economists argue that factor prices decided the value of a product and
therefore the value is intrinsic within the product. For this reason, the term 'natural price' is
often used instead.

Marginalist economists argue that the factor price is a function of the demand for the final
product, and so they are imputed from the finished product. The theory of imputation was
first expounded by the Austrian economist Friedrich von Weiser.

It follows from the definition just stated that prices perform an economic function of major
significance. So long as they are not artificially controlled, prices provide an economic
mechanism by which goods and services are distributed among the large number of people
desiring them. They also act as indicators of the strength of demand for different products and
enable producers to respond accordingly. This system is known as the price mechanism and
is based on the principle that only by allowing prices to move freely will the supply of any
given commodity match demand. If supply is excessive, prices will be low and production
will be reduced; this will cause prices to rise until there is a balance of demand and supply. In
the same way, if supply is inadequate, prices will be high, leading to an increase in
production that in turn will lead to a reduction in prices until both supply and demand are in
equilibrium. In fact, this function of prices may be analysed into three separate functions.
First, prices determine what goods are to be produced and in what quantities; second, they
determine how the goods are to be produced; and third, they determine who will get the
goods. The goods so produced and distributed may be consumer items, services, labour, or
other saleable commodities. In each case, an increase in demand will lead to the price being
bid up, which will induce producers to supply more; a decrease in demand will have the
reverse effect. The price system provides a simple scale by which competing demands may
be weighed by every consumer or producer.

Of course, a totally free and unfettered price mechanism does not exist in practice. Even in
the relatively free market economies of the developed Western world there are all kinds of
distortions—arising out of monopolies, government interference, and other conditions - the
effect of which reduces the efficiency of price as a determinant of supply and demand. In
centrally planned economies, the price mechanism may be supplanted by centralized
governmental control for political and social reasons. Attempts to operate an economy
without a price mechanism usually result in surpluses of unwanted goods, shortages of
desired products, black markets, and slow, erratic, or no economic growth.

Factors of production can be defined as inputs used for producing goods or services with the
aim to make economic profit.

In economics, there are four main factors of production, namely land, labour, capital, and
enterprise. The price that an entrepreneur pays for availing the services of these factors is
called factor pricing.

An entrepreneur pays rent, wages, interest, and profit for availing the services of land, labour,
capital, and enterprise respectively. The theory of factor pricing deals with the price
determination of different factors of production.

The determination of factor prices is always assumed to be similar to the determination of

product prices. This is because in both the cases, the prices are determined with the help of
demand and supply forces. Moreover, the demand for factors of production is similar to the
demand for products.

However, there are two main differences on the supply side of factors of production and
products. Firstly, in product market, the supply of a product is determined by its marginal
cost of production. On the other hand, in factor market, it is not possible to determine the
supply of factors on the basis of marginal cost.

For example, it is difficult to ascertain the exact cost of production for factors, such as land
and capital. Secondly, the supply of factors of production cannot be readily adjusted as in the
case of products. For instance, if the demand for a land increases, then it is not possible to
increase its supply immediately.
4.2 FACTORS OF PRODUCTION

Factor pricing is associated with the prices that an entrepreneur pays to avail the services
rendered by the factors of production. For example, an entrepreneur needs to pay wages to
labour, rents for availing land, and interests for capital so that he/she can earn maximum
profit. These factors of production directly affect the production process of an organization.

In context of an economy, these four factors of production when combined together produce
a net aggregate of products, which is termed as national income. Therefore, it is important to
determine the prices of these four factors of production. The theory of factor pricing deals
with the determination of the share prices of four factors of production, namely land, labour,
capital and enterprise.

In other words, the theory of factor pricing is concerned with the principles according to
which the price of each factor of production is determined and distributed. Therefore, the
theory of factor pricing is also known as theory of distribution. According to Chapman, the
theory of distribution, “accounts for the sharing of the wealth produced by a community
among the agents, or the owners of the agents, which have been active in its production.”

There are two aspects of each factor of production, which are as follows:

 Price aspect - Refers to the aspect in which an organization pays a certain amount to
avail the services of factors of production. For example, wages, rents, and interests
constitute the price of factors of production.

 Income aspect - Refers to another aspect in which a certain amount is received by a

factor of production. For instance, rents received by a landlord and wages received by
labour constitute the income generated from the factors of production.

Generally, it is assumed that factor pricing theory is similar to product pricing theory.
However, there are certain differences between the two theories. Both the theories assume the
determination of prices by the interaction of two market forces, namely demand and supply.
However, there are differences in the nature of demand and supply of factors of production
with respect to that of products. The demand for factors of production is derived demand,
while demand for products is direct demand. Moreover, the demand for the factors of
production is joint demand.

This is because a product cannot be produced using a single factor of production. On the
other hand, the supply of products is closely related with the cost of production, whereas
there is no cost of production for factors. For example, there is no cost of production for land,
labour, and capital. Therefore, the factor pricing is separated from product pricing.

The theory of factor pricing is concerned with the principles according to which the price of
each factor of production is determined and distributed. The distribution of factors of
production can be of two types, namely personal and functional. Personal distribution is
concerned with the distribution of income among different individuals.

It is associated with the amount of income generated not with the source of income. For
example, an individual earns Rs. 20,000 per month; this income can be earned by him/her by
wages, rents, or dividends. On the other hand, functional distribution is associated with the
distribution of income among different factors of production as per their functions.

It is concerned with the source of income, such as wages, rents, interests, and profits. In
regard of distribution of factors of production, there are two theories, namely marginal
productivity theory and modern theory of factor pricing.

4.2.1 Land

Land, as ordinarily understood, refers to earth’s surface. But in economics, the term land is
used in a very wider sense. Marshall defined land as “the term land is used in a very wider
sense. Marshall defined land as “the materials and forces which nature gives freely for man’s
aid in land and water, in air and light and heat”. Land refers to those natural resources that are
useful and scarce. In other words, land stands for all natural resources, which yield an income
or have an exchange value.

Characteristics Features of Land

Land as a factor of production has the following characteristic features.

 Land is fixed in quantity. It is said that land has no supply price. That is, price of land
prevailing in the market cannot affect its supply; the price may be high or low, its
supply remains the same.

 Land has original and indestructible properties.

 Land lacks mobility in the geographical sense.

 Land differs in fertility.

4.2.2 Labour
Labour would mean any work, manual or mental, which is done for a reward. Marshall
defined labour as “any exertion of mind or body undergone partly or Marshall defined labour
as “any exertion of mind or body undergone partly or wholly with a view to some good other
than the pleasure derived directly from the work”. A person who is working in his rose-
garden as a hobby is not a labourer. But, if he works in rose garden, which is cultivated for
sales, then he is a labourer.

Characteristics of Labour

 Labour cannot be separated from the labourer. Hence, a labourer has to sell his labour
in person. sell his labour in person.

 Labour is highly perishable. A labourer cannot preserve his labour and deliver it in
the future. A day without work in a worker’s life is lost forever.

 Labourer has a weak bargaining power. As labour is perishable, it has no reserve

price. Hence, labourers have to accept low wages rather than being idle or
unemployed.

 The supply of labour changes slowly. Supply of labour cannot be curtailed

immediately, even if wages fall. This is due to the fact that labourers must earn their
subsistence, somehow. Conversely, increase in labour supply depends on new births
and a long period of training.

 Labour is not so mobile as capital due to differences in language, environment, habits,

etc in different localities.

4.2.3 Capital

When economists refer to capital, they are referring to the assets–physical tools, plants, and
equipment–that allow for increased work productivity. Capital comprises one of the four
major factors of production, the others being land, labour, and entrepreneurship. Common
examples of capital include hammers, tractors, assembly belts, computers, trucks, and
railroads. Economic capital is distinguished from financial capital, which includes the debt
and equity accumulated by businesses to operate and expand.

Capital is unlike land or labour in that it is artificial; it must be created by human hands and
designed for human purposes. This means time must be invested before capital can become
economically useful. For example, the fisherman who fashions himself a rod must first divert
time from other activities to do so.
In this sense, capital goods are the foundation of human civilization. Buildings need to be
built, tools crafted, and processes improved. By increasing productivity through improved
capital equipment, more goods can be produced and the standard of living can rise. Capital
goods are also sometimes referred to as the means of production because these physical and
non-financial inputs create objects that can eventually be bestowed with economic value. The
economist Adam Smith defines capital as, "that part of man's stock which he expects to
afford him revenue.

Ever-improving capital is important because of what follows its production: cheaper and
more bounteous goods. Note that money is not included among the factors of production.
While money facilitates trade and is an effective measure of a good's value, individuals
cannot eat, wear, or be sheltered by money itself. The ultimate aim of economic activity,
work, and trade is to acquire goods, not money. Money is a means to afford goods. Better
capital goods allow people to travel farther, communicate faster, eat better foods, and save
enough time from labour to enjoy leisure. Many countries have printed and inflated their way
into poverty by losing focus on savings, investment, and capital equipment in favour of
increasing their money supply by printing more of their currency.

Before a factory can be built or a car can be manufactured, someone must have saved enough
resources to be able to survive the production process. This involves forgoing present
consumption in favour of greater future consumption.

Every capital production process starts with savings. Savings help by generating investments.
Investments eventually lead to finished goods and services. Traditionally, it is the role of the
capitalist to first save and then assume risk by employing people in production processes
before revenue is generated from the finished goods. All of the factors of production interact
with one another. Natural resources are transformed into capital goods by human labour and
subjected to market risk through entrepreneurial activity.

Each factor of production is able to contribute to production processes and earn an income

based on its use. The income for land is usually called rent. Labour receives wages.
Employed capital goods and equipment receive interest, normally through their investment.
Successful entrepreneurs receive profits.

Capital is the man-made physical goods used to produce other goods and services. In the
ordinary language, capital means money. In Economics, capital refers to that part of man-
made wealth which is used for the further production of wealth. According to Marshall,
'Capital consists of those kinds of wealth other than free gifts of nature, which yield income.
Money is regarded as capital because it can be used to buy raw materials, tools, implements
and machinery for production. The terms capital and wealth are not synonymous. Capital is
that part of wealth which is used for the further production of wealth. Thus, all wealth is not
capital but all capital is wealth.

4.2.4 Organization

An entrepreneur is a person who combines the different factors of production (land, labour
and capital), in the right proportion and initiates the process of production and also bears the
risk involved in it. The entrepreneur is also called 'organiser'. Entrepreneurship is risk taking,
managerial, and organizational skills needed to produce goods and services in order to gain a
profit. In modern times, an entrepreneur is called 'the changing agent of the society'. He is not
only responsible for producing the socially desirable output but also to increase the social
welfare.

Functions of an Entrepreneur

 Identifying profitable investible opportunities:- Conceiving a new and most promising

and profitable idea or capturing a new idea available in the market is the foremost
function of an entrepreneur. This is known as identifying profitable investible
opportunities.

 Deciding the size of unit of production:- An entrepreneur has to decide the size of the
unit - whether big or small depending upon the nature of the product and the level of
competition in the market.

 Deciding the location of the production unit:- A rational entrepreneur will always
locate his unit of production nearer to both factor market and the end-use market. This
is to be done in order to bring down the delay in production and distribution of
products and to reduce the storage and transportation cost.

4.3 THEORIES OF DISTRIBUTION

Distribution is the species of Exchange by which produce is divided between the parties who
have contributed to its production. Exchange being divided according as both, or one only, or
neither of contributed to its production. Exchange being divided according as both, or one
only, or neither of the parties have competitors, Distribution is similarly divided. The case in
which both parties have competitors will here be first and principally considered. The
simplest type of this distributive exchange would be of a kind which is effected once for all,
without reference to a series of future productions and exchanges. For example, to adapt an
illustration used by Mr. Henry George, let it be supposed that on a particular occasion each
out of a number of white men hires one or more black men to assist in catching seals, on the
agreement that each white man shall give his black assistants a certain proportion of the take,
the terms having been settled in an open market in which any one white is free to bid against
any other white and any one black against any other black. A conception more appropriate to
existing industry is that each white agrees to pay in exchange for a certain amount of service
a definite quantity of produce, not in general limited to the result of a particular operation. On
a particular day less, seal may be taken than the employer has agreed to give the employee for
the day. In this case, even if payment is not made till the end of the day, the employer must
pay for help on a particular day in part with seal caught on a previous day. He must pay
altogether out of past accumulations when payment is made before the work is done. When
the employer agrees to pay a definite amount, he cannot expect to gain on each day’s
transaction, but on an average of days. This example is suited to illustrate some general
properties of Exchange which attach to Distribution as a species of Exchange. Such are the
laws which connect a change in the supply or demand upon one side of the market with a
change in the advantage resulting from the transaction to the parties on either side. Thus,
competition on both sides being presupposed, a decrease of supply in a technical sense of the
term on the one side is, ceteris paribus, universally attended with detriment to the other side,
but is not universally attended with detriment to the side on which the supply is decreased.
Accordingly, a limitation of supply on one side may be advantageous to that side, though not
to both sides. The case of Distribution compared with Exchange in general in respect to such
limitation of supply has only this peculiarity - that the danger of this policy defeating itself is
in the case of Distribution specially visible and threatening. There is an evident limit to what
the black man dealing with the white man can get in exchange for a certain amount of his
service; namely, the total product which that service utilised by the white man will on an
average produce. To be sure, there is here but a case of the general principle that no one will
give more for a thing, whether article of consumption or factor of production, than the
equivalent of its total utility to him, which total diminishes as the quantity of the Commodity
is reduced. But this limit is less liable to escape attention when it is fixed by the material
conditions of production rather than by the desires of consumers. Conspicuous warning is
given to parties in the position of our black men not to attempt to benefit themselves by a
considerable reduction in their supply of service; for, though to attempt to benefit themselves
by a considerable reduction in their supply of service; for, though they might possibly obtain
a larger proportion, they would probably obtain a smaller portion, of the average product. The
laws which have been stated and other general laws of Exchange are equally true in more
complicated cases of Distribution. So far, we have supposed only a single factor—the service
of the black man, or, more generally, the factor ß - offered by the competitors, say, B1, B2,
etc., in exchange for some of the produce an offered by the competitors, say, A1, A2, etc. Let
us now introduce other kinds of factors, , , etc. And let us no longer suppose payment to be
made by parties of the type A, in the kind of commodity which is produced, namely, a. A
more concrete conception is that, besides the group A, B, C, D, there is another and another
group, - A, B, C, D; A'', B”, C, D;- where each capital letter typifies a set of competing
individuals. It may be supposed that each A purchases out of the finished product that he
turns out - namely, a - portions of the products a, a, etc., which he distributes according to the
law of supply and demand among parties of the type B, C, D. In fine, each A may pay for the
factors of production altogether in some one product, a” - “numeraire,” as happily conceived
by M. Walras, or, less generally, money, - which the purveyors of the factors can exchange
for the articles which they want. These articles need not be all commodities ready for
consumption: some of the parties may care to purchase factors of production wherewith to
play the role which has been assigned to A. Having now obtained a general idea of the
machinery by which distribution in a regime of competition is effected, let us go on to
consider in more detail the parts of the mechanism. And, first, of the party that takes factors
of production in exchange for products or the means of purchasing the same, the party above
represented by the white man and labelled A. The functions of this party may be investigated
by an ancient method which Sidgwick has proposed to rehabilitate for the purposes of
modern economics, - the search for a definition. What is an entrepreneur? Amid the
diversified combinations of attributes which the industrial world presents - innumerable as
the varieties in which vegetable nature riots - we ought to fix certain characters agreeably to
the rule laid down by Mill under the head of definition by type. “Our conception of the class”
should be “the image in our minds which is that of a specimen complete in all the
characteristics.” Four such type specimens may be distinguished, ranged in a descending
order according to the extent of functions ascribed to the entrepreneur. There is, first, the
party whom the classical writers designate as the Capitalist, “who from funds in his
possession pays the wages of the labourers, or supports them during the work; who supplies
the requisite buildings, materials, and tools, or machinery; and to whom, by the usual terms
of the contract, the produce belongs to be disposed of at his pleasure.” This party will here be
considered as devoting his care and savings to a single business.

It might seem, indeed, as if this class did not call for special treatment, as differing only in the
amount, not in the kind of remuneration. A fig tree which bears no fruit is not therefore a tree
of a distinct species. The horse which the Scotchman its owner had just trained to live upon a
minimum, when the animal unfortunately died, was not therefore a new variety of the equine
genus, requiring mention in a treatise on Natural History. However, as imposing theories
have been connected with this last category, it comes within the scope of the present inquiry.
As our aim in comparing definitions should be, as Sidgwick says, “far less to decide which
we ought to adopt than to apprehend the grounds on which each has commended itself to
reflective minds,” - the hunt for a definition being followed not so much for the sake of the
quarry as of the views which are incidentally presented, - let us go on to consider the
principal propositions which the several conceptions are adapted to bring under our notice. In
this inquiry much assistance will be obtained from a series of articles on cognate subjects in
the Quarterly Journal of Economics, which forms a sort of economic symposium. The first
definition is particularly suited to inquiries in which the parties who are in the habit of saving
are contrasted as to their actions and interests with the parties who do not save,
approximately, the working classes. Specimens of such inquiry may be found in the fifth
chapter of Mills first book, and in Professor Taussig’s important article on “The Employers
Place in Distribution.” It sounds paradoxical to add that the classical conception is not
particularly adapted to illustrate the Ricardian theory of rent. But the definition of the
capitalist above given is not easily reconciled with the received representation, that the
capitalist’s remuneration is equal to the number of doses which he lays out, multiplied by the
remuneration of the last dose, the ordinary rate of profit. For, as Sidgwick argues, there is no
adequate reason for expecting that “remuneration for management” as well as interest should
tend to be at the same rate for capitals of different sizes. Doubtless, the proposition is
accurate enough to support the practical consequences which have been deduced from it.

4.4 MARGINAL PRODUCTIVITY

The marginal productivity theory of distribution, as developed by J. B. Clark, at the end of

the 19th century, provides a general explanation of how the price (of the earnings) of the 19th
century, provides a general explanation of how the price (of the earnings) of a factor of
production is determined. In other words, it suggests some broad principles regarding the
distribution of the national income among the four factors of production. According to this
theory, the price (or the earnings) of a factor tends to equal the value of its marginal product.
Thus, rent is equal to the value of the marginal product (VMP) of land; wages are equal to the
VMP of labour and so on. The neo-classical economists have applied the same principle of
profit maximisation (MC = MR) to determine the factor price. Just as an entrepreneur
maximises his total profits by equating MC and MR, he also maximises profits by equating
the marginal product of each factor with its marginal cost.

Assumptions of the Theory

The marginal productivity theory of distribution is based on the following seven assumptions.

 Perfect competition in both product and factor markets - Firstly, the theory assumes
the perfect competition in both product and factor markets. Firstly, the theory assumes
the perfect competition in both product and factor markets. It means that both the
price of the product and the price of the factor (say, labour) remains unchanged.

 Operation of the law of diminishing returns - Secondly, the theory assumes that the
marginal product of a factor would diminish as additional units of the factor are
employed while keeping other factors constant.

 Homogeneity and divisibility of the factor - Thirdly, all the units of a factor are
assumed to be divisible and homogeneous. It means that a factor can be divided into
small units and each unit of it will be of the same kind and of the same quality.

 Operation of the law of substitution - Fourthly, the theory assumes the possibility of
the substitution of different factors. It means that the factors like labour, capital and
others can be freely and easily substituted for one another. For example, land can be
substituted by labour and labour by capital.

 Profit maximisation - Fifthly, the employer is assumed to employ the different factors
in such a way and in such a proportion that he gets the maximum profits. This can be
achieved by employing each factor up to that level at which the price of each is equal
to the value of its marginal product.

 Full employment of factors - Sixthly, the theory assumes full employment for factors.
Otherwise, each factor cannot be paid in accordance with its marginal product. If
some units of a particular factor remain unemployed, they would be then willing to
accept the employment at a price less than the value of their marginal product.
  Exhaustion of the total product - Finally, the theory assumes that the payment to each
factor according to its marginal productivity completely exhausts the total product,
leaving neither a surplus nor a deficit at the end.

The Essence of the Theory: The theory states that the firm employs each factor up to that
number where its price is The theory states that the firm employs each factor up to that
number where its price is equal to its VMP. Thus, wages tend to be equal to the VMP of
labour; interest is equal to VMP of capital and so on. By equating VMP of each factor with
its cost a profit- seeking firm maximises its total profits. Let us illustrate the theory with
reference to the determination of the price of labour, i.e., wages. Let us suppose that the price
of the product is Rs. 5 (constant) and the wages per unit of labour are Rs. 200 (constant). As
the number of factors other than labour remain unchanged, wages represent the marginal cost
(MC). Table 12.1: Calculation of MPP, VMP and MRP of a Variable Factor (Labour)

The VMP or MRP of labour is greater than wages; so, the firm can earn more profits by
employing an additional labour. But at 5 or wages; so, the firm can earn more profits by
employing an additional labour. But at 5 or 6 labourers, the VMP or MRP of labour is less
than wages, so it would reduce the number of labourers. But when it employs 4 labourers, the
wage rate (Rs. 20) becomes equal to the VMP or MRP of labour (also Rs. 20). Here the firm
gets the maximum profits because its marginal cost of labour (or marginal wage Rs. 12) is
equal to its marginal revenue (VMP or MRP, Rs. 20). Thus, under the assumption of perfect
competition a firm employs a factor up to that number at which the price of the factor is just
equal to the value of the marginal product (=MRP of the factor). In the same way it can be
shown that rent is equal to the VMP of land, interest is equal to the VMP of capital, and so
forth. The theory may now be illustrated diagrammatically. See figure.4.1. Here WW is the
wage line indicating the constant rate of wages at each level of employment (AW = MW.
Here AW is average wage and MW is marginal wage). The VMP line shows the value of
marginal product curve of labour, and it goes downwards from left to right indicating
diminishing MPP of labour. Shows that the firm employs OL number of labourers, because
by doing so it equates the MRP of labour with the wage ratio, and makes optimum purchase
of labour.
 Figure 4.1: Wage determination

Criticisms of the theory - The marginal productivity theory of distribution has been subjected
to a The marginal productivity theory of distribution has been subjected to a number of
criticisms: In determination of marginal product: Firstly, main product is a joint product—
produced by all the factors jointly. Hence the marginal product of any particular factor (say,
land or labour) cannot be separately determined. As William Petty pointed out as early in
1662. Labour is the father and active principle of wealth, as lands are the mother.

 Unrealistic - It is also shown that the employment of one additional unit of a factor
may cause an improvement in the whole of organisation in which case the MPP of the
variable factors may increase. In such circumstances, if the factor is paid in
accordance with the VMP, the total product will get exhausted before the distribution
is completed. This is absurd. We cannot think of such a situation in reality.

 Market imperfection - The theory assumes the existence of perfect competition, which
is rarely found in the real world. But E. Chamberlin has shown that the theory can
also be applied in the case of monopoly and imperfect competition, where the
marginal price of a factor would be equal to its MRP (not to its VMP).

 Full employment -Again, the assumption of full employment is also unrealistic. Full
employment is also a myth, not a reflection of reality.

 Difficulties of factor substitution - W. W. Leontief, the Nobel economist, denies the

possibility of free substitution of the factors always owing to the technical conditions
 of production. In some products process, one factor cannot be substituted by another.
Moreover, organisation or entrepreneurship is a specific factor which cannot be
substituted by any other factor.

 Emphasis on the demand side only - The theory is one-sided as it ignores the supply
side of a factor; it has emphasised only the demand side i.e., the employer’s side, hi
the opinion of Samuelson, the marginal productivity theory is simply a theory of one
aspect of the demand for productive services by the firm.

 Inhuman theory - Finally, the theory is often described as ‘inhuman’ as it treats

human and non-human factors in the same way for the determination of factor prices.

4.5 MODERN THEORY OF DISTRIBUTION

The modern theory of factor pricing provides a satisfactory explanation of the problem of
distribution. It is known as the demand and supply theory of distribution. According to the
modem theory of factor pricing, the equilibrium factor prices can be explained by the forces
of demand and supply.

Prices paid for productive services are like any other price and they are basically determined
by demand and supply conditions. Incomes are received as payments for the services of
factors of production. Wages are payments for the services rendered by labour.

Rents are payments for the services of land and interest is payment for the services of capital.
In this way most incomes are remunerations or prices paid for services rendered by factors of
production in the process of production. This theory is superior to the marginal productivity
theory, because it takes into account both the forces of demand and supply in the
determination of factor prices. Marshall held the view that no separate theory is required to
explain factor prices. The principles which govern commodity pricing also govern factor-
pricing. The following paragraphs touch upon the salient aspects of the theory.

“The theory of factor prices is just a special case of the theory of price. We first develop a
theory of the demand for factors, then a theory of the supply of factors and finally combine
them into a theory of determination of equilibrium price and quantities.” Lipsey and Stonier

Assumptions

 Every producer tries to get maximum profit.

 Producers have perfect knowledge of the MRP.

  Active competition exists in the factor market.

 There is active competition among the different units of factors.

 The state does not intervene to equate the prices of the factor service.

Demand for Factors of Production

The demand for factors of production is different from that of the demand for goods. The
demand for goods is direct while the demand for factors of production is derived demand.
The factors of production are demanded because they assist the process of production.
Productivity of a factor refers to the contribution made by it in the process of production. If
the demand for goods which the factor produces is more, its own demand will also be high
and vice-versa. The elasticity of demand for industry with identical costs will be high. It
means that the total demand of a factor unit at OP price level is OM i.e., OX’ x 200. Further,
at price level OP’, the demand is OM’ = (OX” X 200) and so on. Now, by taking all the
possible combinations of factors price and the total demand for it we can draw the demand
curve DD for the whole industry. In Figure, the factor price is determined by the quantity of
the factor, possibility of substitutes, and elasticity of demand for final product. Thus, the
demand for the factor is determined by its marginal revenue productivity.

Figure 4.2: Demand for factors of production

4.6 THEORIES OF RENT: RICARDO AND MODERN THEORY OF
RENT

The quantity of land is limited, and so is its productiveness, and it is not uniform in quality. If
the superior land will not support the population, recourse must be made to inferior lands and
the produce is, thus, raised at different costs. The differential advantage of the superior land
over the inferior gives rise to economic rent. It is plain that the farmer may just as well pay
for the superior land as get the inferior land rent free.

Thus, rent arises out of the difference existing in the productiveness of different soils under
cultivation at the time for the purpose of supplying the same market, and the amount of rent is
determined by the degree of those differences. This is known as Ricardo’s Theory of Rent.

According to Ricardo, rent is that portion of the produce of the earth, which is paid to the
landlord for the original and indestructible powers of the soil. It is a surplus enjoyed by the
super marginal land over the marginal land arising due to the operation of the law of
diminishing returns.

Productiveness depends on fertility and convenience of situation. Therefore, economic rent in

its simplest form is the differential profit that arises in the case of production, owing to
differences in natural conditions due to

 Fertility of the soil

 Advantages of situation

Take, for simplicity, a new country dependent on its own supplies and occupied by a body of
settlers. At first we may suppose that there is an abundance of the best land and that it is
practically free. In this case only the best land will be used, and the produce will sell so as to
just cover (with current wages and profits) the expenses of production. So far, there is no
differential profit and, thus, no economic rent.

As population increases the yield from the best land (the methods of cultivation remain the
same) will not meet the demand. The relative scarcity raises price, and at this higher price it
pays to resort to inferior land. How the same amount of capital yields different amounts of
produce on the two qualities of land; but since all the produce must sell at the same price, a
differential profit emerges from the better land.
This constitutes economic rent and the amount of rent is equal to the difference between the
value of its produce, and the produce of the second quality with the same expenditure of
labour and capital. Thus, economic rent exists, if a gift of nature is limited and appropriate
and differential profit arises by its use.

The laws of supply and demand, however, explain the operation by which such rent is fixed,
for just as the competition of farmers will enable landlords to claim that portion in excess of
ordinary profits, so, on the other hand, the competition of landlords renders the exaction of
more than this impracticable.

The land margin is made the central point in the Ricardian theory of rent. In Ricardo’s law of
rent, we have two margins.

The land of the second quality is now said to be land on the margin of cultivation. Land on
the margin just pays for the expenses of cultivation, viz., wages and profit on capital, and it
yields on surplus for rent. Rent is measured from this point for rent is always the difference
between the produce obtained by the employment of the two equal portions of capital and
labour upon the land. Of course, cost of transportation must be first deducted. The margin of
cultivation is determined by the price of agricultural produce. As the price of this rises, lands
of inferior quality will pay for cultivation and, similarly, if the price falls, those lands will fall
out of cultivation.

We observe that E land is cultivated, but that the return in sufficient only to pay for the labour
and capital costs involved. Hence, there is no marginal product attributable to land E and no
income for the owner. When returns to producers who use land are sufficient to pay only for
labour and capital costs, the land is called marginal or no-rent land. If land is so poor that it
will not even pay labour and capital costs, like the F land in our illustration, it is called sub-
marginal land. Such land will not be used at all.

An increase in population causes rent to rise for two reasons—firstly, the increased demand
for food raises the price of agricultural produce and, secondly, more land must be cultivated
to supply the needs of the people. Both causes operate to lower the margin of cultivation and,
thus, increase rent.

This is partly counteracted by the importation of supplies at a cheap rate and by agricultural
improvements which increase the supply without extending the area of cultivation. We shall
better understand the modern theory of rent if we first know the implications of and objection
to the Ricardian Theory.
4.7 THEORIES OF WAGES: MODERN THEORY OF WAGES

Modern theory of wages regards wages as a price of labour. A labour sells his services, which
is utilized as a factor in the process of production. As we know, prices of all commodities are
determined by their usual supply and demand in the market. According to this approach also
wages are determined by the interaction of market forces of demand and supply of labour. To
further understand this theory, we need to explain the demand and supply of labour and the
nature of their curves. Demand for labour: The demand for labour comes from the
entrepreneurs as it is used for the production of goods and services. Thus, the demand for
labour depends upon the productivity of labour i.e., higher the productivity of labour, the
greater will be its demand from employers. Thus, demand for labour depends upon the
marginal productivity of labour; since the marginal productivity curve of labour slopes
downwards after a stage, the demand curve of labour will also slope downward.

Number of labour has been measured on OX-axis and the wage rate on Y-axis. DD is the
industry’s demand curve. It slopes downward from left to right indicating that when wages
are low, demand for labour increases and when the wage rate tends to increase, demand for
labour decreases. Thus, there is inverse relationship between wage rate and demand for
labour.

Intersection of the demand and supply curve and wage determination - In any industry wage
is determined. At that point the demand curve for labour cuts the supply curve of labour. At
this point demand for labour is equal to supply of labour. In the figure 4.3 at OW2 wage rate
supply and demand of labour are equal where the supply and demand curve of labour
intersect each other at point E, so the wage is determined at this point. However, when the
wage rate decreases to OW1 then the demand of labour W1A is less than the supply of labour
W1B. This will lead to labour shortage which will force wage rate to increase. On the other
hand, when the wage rate increases to OW3 then supply of labour W3C is greater than
demand of labour W3T. This will lead to surplus availability of labour which will force the
wage rate to decrease. Hence, it is only the OW2 wage rate which is the equilibrium wage
rate prevalent in the wage market. In the equilibrium state, wage rate always tends to be equal
to the marginal productivity of labour, though, in practical life it may be more or less than the
marginal productivity.

Wage determination by an individual firm under perfect competition or relationship between

wages and marginal productivity.
As we know, that a firm under perfect competition accepts the price fixed by the industry.
Similarly, a firm will accept the wage rate fixed by the industry as a firm utilises only a small
portion of total supply of labour so it is not in a position to influence the wage rate.
Therefore, the wage line of a firm is a horizontal straight line or the average wage (AW) of a
firm = the marginal wage of the firm (MW) as shown in the figure 4.3. In the diagram, OW is
the wage rate fixed by the industry which is accepted by all the firms. A firm is in
equilibrium (and earns maximum profit) at the point E1 in diagram, where its marginal
revenue product (MRP) is equal to its marginal cost or marginal wage (MW). Hence, at
equilibrium: Wage=AW=MW=MRP. This is an indispensable condition of equilibrium of a
firm. Here, at point E, the firm pays OW wages and employs OL quantity of labour. Thus, we
may conclude by saying that modern demand and supply theory of wages is a more
comprehensive theory then the classical theory of wages as it considers both the demand and
supply of labour for determination of wages.

4.7.1 Wages Determination Under Imperfect Competition

Economists, such as Joan Robinson and Pigou, have contributed a lot in determining wages in
imperfect competition.

There can be various forms of an imperfect market, including monopolistic competitive

market, oligopoly, and monopoly. Here, we will focus our discussion of wage determination
in context of monopsony. In case of monopsony, there is only one buyer of a factor of
production, which is labour in this case. This single buyer has no competitor in the market.

Therefore, the position of the buyer is very strong as compared to labour. Monopsony can
also take place when a single employer employs a huge labour force for a particular job type.
In this case, the employer would have a control on setting the wages for that particular job.

Figure 4.3: Determination of wage rate under imperfect competition

In figure 4.3, AW (average wage curve) is representing the supply curve of labour, while
MRP represents the demand curve of labour. AW is showing an upward slope. This implies
that employer needs to pay higher wages if he / she wants to hire more labour. MW
represents the marginal wage curve. MW intersects MRP at point E, which is the equilibrium
point. At point E, MW gets equal to MRP when the number of labour is equal to ON with the
wage rate of OW (=NH). The wage rate OW is lower than the MRP wage rate that is NE.
Therefore, the labour is getting wage rate lower by EH from the actual MRP rate that they
deserve.

EH represents the level of wage rate at which labour is exploited in monopsony condition. It
is also termed as monopolistic exploitation. Therefore, in case of monopsony, the wage rate
and number of employees is low as compared to perfect competition. In case of perfect
competition, the equilibrium point would be at C. At point C, wage rate would be OW (=NC)
and number of labour is ON that is higher as compared to the case of monopsony.

Under perfect competition, equilibrium wage rate is determined where demand for labour is
equal to supply of labour. In other words, under perfect competition, a labourer will get wage
equal to its marginal revenue productivity in the long run.

In figure.4.3 units of labour have been measured on X-axis and wages on Y-axis. DD and SS
are the demand and Supply curves of labourers respectively. Both the curves intersect each
other at point E which determines wage rate OP in the market.

At this level of wages, ON units of labourers will get employment. Now suppose, wages go
up to OP1. At this price, demand is ON1 and supply ON2. Since, the supply is more than
demand; it will lead to competition among labourers to get employment which in turn results
in a decrease in wage rate. On the other hand, if w age rate falls to OP2, demand will be more
than the supply. This results in competition among the producers to get the services of labour
which in turn leads to an increase in wage rate. Therefore, we may observe that equilibrium
will be restored at that point where demand curve of labourers intersects the supply curve of
labourers.

4.8 THEORIES OF INTEREST

The time preference theory of interest, also known as the agio theory of interest or the
Austrian theory of interest, explains interest rates in terms of people's preference to spend in
the present over the future.
This theory was developed by economist Irving Fisher in "The Theory of Interest, as
Determined by Impatience to Spend Income and Opportunity to Invest It." He described
interest as the price of time, and "an index of community’s preference for a dollar of present
over a dollar of future income."

 The time preference theory of interest, also referred to as the agio theory of interest,
helps explain the time value of money.

 This theory argues that people prefer to spend today and save for later, so that interest
rates will always be positive - meaning that a dollar today is more valuable than one
in the future.

 Other theories explain interest rates, such as the classical theory, in different terms.

Other theories, besides the time preference theory of interest, have been developed to explain
interest rates. The classical theory explains interest in terms of the supply and demand of
capital. Demand for capital is driven by investment and the supply of capital is driven by
savings. Interest rates fluctuate, eventually reaching a level at which the supply of capital
meets the demand for capital.

Liquidity preference theory, on the other hand, posits that people prefer liquidity and must be
induced to give it up. The rate of interest is intended to entice people to give up some
liquidity. The longer that they are required to give it up, the higher the interest rate must be.
Hence, interest rates on 10-year bonds, for example, are typically higher than on two-year
bonds.

Irving Fisher’s neoclassical views on the time-preference theory of interest state that time
preference relates to an individual’s utility function, or the extent to which one measures the
worth or value of goods, and how that individual weighs the trade-off in utility between
present consumption and future consumption. Fisher believes that this is a subjective and
exogenous function. Consumers who are choosing between spending and saving respond to
the difference between their own subjective sense of impatience to spend, or their subjective
rate of time preference, and the market interest rate, and adjust their spending and saving
behaviours accordingly.

According to Fisher, subjective rate of time preference depends on an individual’s values and
situation; a low-income person may have a greater time preference, preferring to spend now
since they know that future needs will make saving difficult; meanwhile, a spendthrift may
have a lower time preference, preferring to save now since there is less concern about future
needs.

Austrian economist Eugen von Böhm-Bawerk, who expounded on the theory in his

book Capital and Interest, believes that the value of goods decreases as the length of time
needed for their completion increases, even when their quantity, quality, and nature remain
the same. Böhm-Bawerk names three reasons for the inherent difference in value between
present and future goods: the tendency, in a healthy economy, for the supply of goods to
grow over time; the tendency of consumers to underestimate their future needs; and the
preference of entrepreneurs to initiate production with materials presently available, rather
than waiting for future goods to appear.

4.8.1 Loanable Fund and Keynes Liquidity Preference Theory of Interest

The loanable funds doctrine extends the classical theory, which determined the interest rate
solely by saving and investment, in that it adds bank credit. The total amount of credit
available in an economy can exceed private saving because the bank system is in a position to
create credit out of thin air. Hence, the equilibrium (or market) interest rate is not only
influenced by the propensities to save and invest but also by the creation or destruction of fiat
money and credit.

If the bank system enhances credit, it will at least temporarily diminish the market interest
rate below the natural rate. Wicksell had defined the natural rate as that interest rate which is
compatible with a stable price level. Credit creation and credit destruction induce changes in
the price level and in the level of economic activity. This is referred to as Wicksell's
cumulative process.

According to Ohlin), one cannot say "that the rate of interest equalises planned savings and
planned investment, for it obviously does not do that. How, then, is the height of the interest
rate determined? The answer is that the rate of interest is simply the price of credit, and that it
is therefore governed by the supply of and demand for credit. The banking system – through
its ability to give credit – can influence, and to some extent does affect, the interest level."

The loanable funds doctrine, by contrast, does not equate saving and investment, both
understood in an ex-ante sense, but integrates bank credit creation into this equilibrium
condition. According to Ohlin: "There is a credit market ... but there is no such market for
savings and no price of savings". An extension of bank credit reduces the interest rate in the
same way as an increase in saving.

During the 1930s, and again during the 1950s, the relationship between the loanable fund’s
doctrine and the liquidity preference theory was discussed at length. Some authors considered
the two approaches as largely equivalent but this issue is still unresolved.

4.9 THEORIES OF PROFIT

This theory was first propounded by the American Economist Walker. It is based on the ideas
of Senior and J.S. Mill. According to Mill, “the extra gains which any producer obtains
through superior talents for business or superior business arrangements are very much of a
kind similar to rent. Walker says that “Profits are of the same genus as rent”. His theory of
profits states that profit is the rent of superior entrepreneur over marginal of less efficient
entrepreneur.

According to these economists, there was a good deal of similarity between rent and profit.
Rent was the reward for the use of land while a profit was the reward for the ability of the
entrepreneur. Just as land differs from one another in fertility, entrepreneurs differ from one
another in ability. Rent of superior land is determined by the difference in productivity of the
marginal and super marginal land; similarly, the profits of the marginal and super marginal
entrepreneurs.

In short it is the intra-marginal lands that earn a surplus over marginal lands. So also, intra
marginal entrepreneurs earn a surplus over marginal entrepreneur. Just as there is the
marginal land, there is the marginal entrepreneur. The marginal land yields no rent; so also,
marginal entrepreneur is a no profit entrepreneur.

The marginal entrepreneur sells his produce at cost price and gets no profit. He secures only
the wages of management not profit. Thus, profit does not enter into cost of production. Like
rent, profit also does not enter into price. Profit is thus a surplus.

 According to critics there cannot be perfect similarity between rent and profit. Rent is
generally positive and in rare cases it may be zero. But rent can never be negative.
When entrepreneur suffers losses profit can be negative.

 The theory explains profit as the differential surplus rather than a reward for an
entrepreneur.
  Profit is not always the reward for business ability. Profit can be due to monopoly or
it can arise due to favourable chance to the entrepreneur.

 This theory maintains that there is no profit entrepreneur just as no rent land. But in
practical life there is no such entrepreneur because whether the entrepreneur has
ability or not be gets profit as his reward.

 The system of joint stock enterprise has become more important in the modern
economy. The manner in which dividends are distributed among the shareholders is
not at all related to latter’s ability. Both dull and intelligent shareholders enjoy the
same dividends. In fact, the less able may secure more dividends if they possess more
shares.

 This theory assumes that profit does not enter into price. But this is unrealistic
because profit as a part of the cost of production does enter into price.

 Rent is a known and expected surplus. It is also a contractual payment. Profit is

unknown.

 Walker has analysed only surplus profit. But profit can be several other types.’

 Walker failed to understand the true nature of profit. According to Walker, profit
arose on account of the ability of the entrepreneur to undertake risk. Critics point out
that profit is not the reward for undertaking risk but it is the reward for the avoidance
of risk.

This theory was propounded by Taussig, the American economist. According to this theory,
profit is also a type of wage which is given to the entrepreneur for the services rendered by
him. In the words of Taussig, “profit is the wage of the entrepreneur which accrues to him on
account of his ability”.

Just as a labourer receives wages for his services, the entrepreneur works hard gets profit for
the part played by him in the production. The only difference is that while labourer renders
physical services, entrepreneur puts in mental work. Thus, an entrepreneur is not different
from a doctor, lawyer, teacher, etc., who do mental work. Profit is thus a form of wage.

This theory is associated with American economist Hawley. According to him profit is the
reward for risk-taking in business. Risk-taking is supposed to be the most important function
of an entrepreneur. Every production that is undertaken in anticipation of demand involves
risk. According to Drucker there are four kinds of risk. They are replacement, obsolescence,
risk proper and uncertainty.

The first two are calculated and therefore they are insured. But the other two are unknown
and unforeseen risks. It is for bearing such risk profit is paid to entrepreneur. No entrepreneur
will be willing to undertake risks if he gets only the normal return.

Therefore, the reward for risk-taking must be higher than the actual value of the risk. If the
entrepreneur does not receive the reward, he will not be prepared to undertake the risk. Thus,
higher the risk greater is the possibility of profit.

According to Hawley the entrepreneur can avoid certain risks for a fixed payment to the
insurance company. But he cannot get rid of all risks by means of insurance. If he does so he
is not an entrepreneur and would earn only wages of management and not profit.

 Risk-taking is not the only entrepreneurial function which leads to emergence of

profits. Profits are also due to the organizational and coordinating ability of the
entrepreneur. It is also reward for innovation.

 According to Carver profit is paid to an entrepreneur not for beaming the risk but for
minimizing and avoiding risk.

 This theory assumes that profit is proportional to risk undertaken by entrepreneurs.

But this is not true in practical life because even entrepreneurs who do not take any
risk are paid profit.

 Knight says that it is not every risk that gives profit. It is unforeseen and non-insured
risks that account for profit. According to Knight risks are of two types viz.,
foreseeable risk and unforeseeable risk. The risk of fire in a factory is a foreseeable
risk and can be covered through insurance. The premium paid for the fire insurance
can be included in the cost of production. The entrepreneur can foresee such a risk
and insures it. An insurable risk in reality is no risk and profit cannot arise due to
insurable risk.

 There is little empirical evidence to prove that entrepreneurs earn more in risky
enterprises. In a way all enterprises are risky, for an element of uncertainty is present
in them and every entrepreneur aims at making large profits.
Prof. J.B. Clark propounded the dynamic theory of profit in the year 1900. To him profit is
the difference between the price and the cost of production of the commodity. Profit is the
result of progressive change in an organized society.

The progressive change is possible only in a dynamic state. According to Clark the whole
economic society is divided into organized and unorganized society. The organized society is
further divided into static and dynamic state. Only in dynamic state profit arises.

In a static state, the five generic changes such as the size of the population, technical
knowledge, the amount of capital, method of production of the firms and the size of the
industry and the wants of the people do not take place; everything is stagnant and there is no
change at all. The element of time is non-existent and there is no uncertainty. The same
economic features are repeated year after year.

Therefore, there is not risk of any kind to the entrepreneur. The price of the good will be
equal to the cost of production. Hence profit does not arise at all. The entrepreneur would get
wages for his labour and interest on his capital. If the price of the commodity is higher than
the cost of production, competition would reduce the price again to the level of the cost of
production so that profit is eliminated.

The presence of perfect competition makes the price equal to the cost of production which
eliminates the super normal profit. Thus, Knight observes, “Since costs and selling prices are
always equal, there can be no profit beyond wages for the routine work of supervision”.

It is well known that the society has always been dynamic. Several changes are taking place
in a dynamic society.

4.9.1 Uncertainty Theory of Profit

This theory is propounded by Knight. According to this theory, profit is reward for bearing
uncertainty. Uncertainty is due to unforeseeable or non-insurable risk. According to knight,
there are two types of risk. They are foreseeable and unforeseeable. The possible losses due
to foreseeable risk is avoidable with insurance. Therefore, the risks are insurable risk but
possible loss due to unforeseeable risk is not avoidable with insurance. Therefore, the risks
are non-foreseeable risk. There are mainly four types of non-insurable risk. They are

Profit has been defined in several ways by different economists. Some have defined it as the
percentage returns on investment of capital while others have defined it as the reward of
ownership of business. Some have referred it as the reward for risk taking in business while
others have called it as a reward for entrepreneurship. There are still some other Economists
who have defined profit as the residual income which results to a businessman after he has
made payment to all the other factors of production. Though different economists have
interpreted the term profit in different ways but we may safely conclude and define profit as
the excess of an entrepreneur’s receipts over his total cost of production which includes both
explicit as well as implicit costs. In general, it is Gross profit which is referred to as profit.
Gross profit includes Net profit and Gross profit = Total Receipts (from sales of a product) –
Total Expenditure (in producing a product). Profit is the only reward of a factor of production
which can be negative , where it is called ‘loss’ while rewards of other factor of production
like rent, wages and interest are always positive.

This theory was propounded by an American economist Prof. Frank H. Knight. This theory,
starts on the foundation of Hawley’s risk bearing theory. Prof. Knight agrees with Hawley
that profit is a reward for risk-taking. There are two types of risks viz. foreseeable risk and
unforeseeable risk. According to Knight unforeseeable risk is called uncertainty bearing.
Prof. Knight regards profit as the reward for bearing non-insurable risks and uncertainties. He
distinguishes between insurable and non-insurable risks. Certain risks are measurable, the
probability of their occurrence can be statistically calculated. The risks of fire, theft, flood
and death by accidents are insurable. These risks are borne by the insurance company. The
premium paid for insurance is included in the cost of production. According to Knight these
foreseen risks are not genuine economic risks eligible for any remuneration of profit. In other
words, insurable risk does not give rise to profit.

Prof. Knight calls these risks as ‘uncertainties’ and ‘it is uncertainties in this sense which
explains profit in the proper use of the term’. These risks cannot be foreseen and measured,
they become non- insurable and the uncertainties have to be borne by the entrepreneur.
According to this theory there is a direct relationship between profit and uncertainty bearing.
Greater the uncertainty bearing the higher the level of profit. Uncertainty beaming has
become so important in business enterprise in modern days, it has come to be considered as a
separate factor of production. Like other factors it has a supply price and entrepreneurs
undertake uncertainty bearing in the expectation of earning certain level of profit. Profit is
thus the reward for assuming uncertainty. In the modern days production has to take place in
advance of consumption. The producers have to face their rival producers and the future is
uncertain and unknown. These are uncertainties. Some entrepreneurs are able to see it more
clearly than others and therefore they are able to earn 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. Simply, 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 the
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.

While the 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 a 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.

Knight believes that profit might arise out of the decisions made concerning the state of the
market, such as decisions with respect to increasing the degree of monopoly in the market,
decisions regarding holding stocks that might result in the windfall gains, decisions taken to
introduce new product and technique, etc.

The major criticism of the knight’s theory of profit is, the total profit of an entrepreneur
cannot be completely attributed to uncertainty alone. There are several functions that also
contribute to the total profit such as innovation, bargaining, coordination of business
activities, etc.

4.9.2 Dynamic Theory of Profit

Clark’s Dynamic Theory of Profit was propounded by J.B. Clark, who believed that profits
arise in the dynamic economy and not in the static economy.

Definition

Clark’s Dynamic Theory of Profit was propounded by J.B. Clark, who believed that profits
arise in the dynamic economy and not in the static economy. The static economy is one in
which the things do not change significantly or remains unchanged. Such as, the population
and capital remain stationary, goods continue to be homogeneous, production process
remains unchanged, and the factors of production has enjoyed freedom but does not move
because the marginal product in each industry remains the same. Also, there is no uncertainty
and risk.

On the contrary, the dynamic economy is characterized by the generic changes such as an

increase in population, improvement in production techniques, change and increase in the
consumer demands, changes in the organizational forms, increase in capital. The major
function of an entrepreneur is to work in a dynamic economy to take the advantage of these
changes and promote his business, reduce costs, and expand sales.

Clark believed that those entrepreneurs who successfully takes the advantage of these
changes in the dynamic economy make the pure profit, which is in addition to the normal
profit. Pure profits are short lived because, in the long run, the competitors imitate the
changes initiated by the leader. As a result, the demand for the factors of production
increases, thereby increasing the factor prices and the overall cost of production. On the other
hand, with an increase in the output, the price of a product declines for a given level of
demand as a result of which the pure profits disappear.

Thus, according to Clark, the profit is an elusive amount which can be grasped, but cannot be
held by an entrepreneur as it slips through the fingers and bestows itself to all the society
members. Clark’s dynamic theory of profit should not be misinterpreted as, the profits in the
dynamic economy remain for a short period of time and then disappears forever. But,
however, generic changes take place frequently, and the manager or entrepreneur through his
foresight must capitalize on it and continue to make a profit in excess of the normal profit. It
can be concluded that Clark’s dynamic theory of profit is based on a notion that emergence,
disappearance, and re-emergence of profits is a continuous process.

The Dynamic Theory of Profits was introduced by J. B Clark. According to him profits come
only in dynamic economy but not in static economy. Dynamic economy means the economy
in which frequent changes will occur. In static economy there is no possibility of coming
changes. In static economy there will not be any change both in demand and supply. So,
profits cannot arise. According to Clark the following things exist in a static economy.

In such society the demand for goods can be estimated easily. There is no risk and
uncertainty. Supply will be always equal to demand estimated. The price will be always equal
to the cost of production, because there is perfect competition.
In static society the reward is just equal to the marginal productivity of the factors of
production and so there cannot be profits. But we are not living in a static society. Ours is a
dynamic world, where some changes are constantly taking place.

According to J. B. Clark, five main changes are constantly taking place in dynamic society.
They are

 Changes in the number of human wants

 Changes in the methods of production

 Changes in the capital formation in the economy

 Changes in the method of organization of the business

 Changes in the size of population and incomes of the people

According to Clark, profit arises in a dynamic society on account of these changes. These
changes affect the demand for and supply of commodities and thus lead to the emergency of
profit. These are general dynamic changes. But sometimes dynamic changes may be
introduced deliberately by the firms themselves. For example, a firm may succeed in cutting
down its cost by improving its production techniques and thereby increasing its profit. In
short, it is the operation of dynamic changes which leads to the emergency of profit.
According to Clark, profit belongs to economic dynamics but not economic statics.

Criticism of Dynamic Theory of Profits

 Types of risks -According to Knight all types of dynamic changes do not yield profit.
According to him two types of changes takes place in society. a) Foreseeable changes.
b) Unforeseeable changes. According to him only unforeseeable changes brings
profits.

 Risk in undertaken by entrepreneur - According to Clark, risk is undertaken by

capitalist but not entrepreneur, But it is not correct. If the capitalist is a risk taker,
entrepreneur lose all his importance and become a salaried employee.

 Determination of profit - The theory does not explain how the rate of profits can be
determined.

 Distinction between profits and wages - According to Prof. Taussig, dynamic theory

has created an unnecessary and artificial wages of management.
  Losses - According to Clark, whenever there is a change in the economy, it brings
profit. But in reality it is not correct. Sometimes they may cause losses also.

 Profit in the reward - This theory states that profits arise due to dynamic changes. It
does not recognize that profits are the reward for entrepreneurs.

4.9.3 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, innovation theory of profit posits that 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.
Thus, 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 goods, the emergence
or opening of a new market, finding new sources of raw material, a new variety or a design of
the product, etc.

The innovation theory of profit posits 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 innovation to be new or novice. Earlier, the entrepreneur was
enjoying a monopoly position in the market as innovation was confined to himself and was
earning larger profits. But after some time, with the others imitating the innovation, the
profits started disappearing.

An entrepreneur can earn larger profits for a longer duration if the law allows him to patent
his innovation. Such as a design of a product is patented to discourage others to imitate it.
Over the time, the supply of factors remaining the same, the factor prices tend to rise as a
result of which the cost of production also increases. On the other hand, with the firms
adopting innovations the supply of goods and services increases and their prices fall. Thus, on
one hand the output per unit cost increases while on the other hand the per unit revenue
decreases.

There is a point of time when the difference between the costs and receipts gets disappear.
Thus, the profit in excess of the normal profit disappears. This innovation process continues
and also the profits continue to appear or disappear.

In this article we will discuss about the innovation theory of profit. Although profits arise due
to frictions (i.e., time lags in market adjustments) and monopoly positions, the innovation
theory, advanced by Schumpeter, goes one step ahead to suggest that profit is the reward for
innovation. Profit is a necessary reward for inducing individuals to undertake the risks
associated with developing new products, new production techniques, or new marketing
strategies. These individuals earn higher than normal profits. But, such profits are of a
transitory nature. Such profits will gradually disappear unless strong barriers’ can be created.
Innovation refers to a number of things such as the development or discovery of new markets
or new products, improved consumer acceptance because of successful product
differentiation programmes, or successful market segmentation. The growth and development
of USA Federal Express is an obvious example of innovation through market segmentation.
The success of Federal Express in providing overnight delivery to a segment of the
communications market is an innovation that spawned an entire industry and thousands of
new jobs by providing a needed service.

Thus, the key ingredient to the innovation theory of profit is the dynamic and ever-changing
nature of demand that supports and rewards successful innovators. Innovation — trying
something new — is vitally necessary for economic growth. Successful innovation provides a
great stimulus to new investment, and may well lead to the growth of large-scale industries.
Various types of risks are associated with the running of a business. Some risks such as the
risk of loss due to flood, fire or burglary, or injuries to employees, are insurable. It is so
because the laws of probability can be applied to such events and insurance companies can
calculate the degree of risk involved and fix premium on the basis of such calculation.

But, no one can calculate the numerical probability that a firm, or a group of firms, will make
profits or losses in future. In a dynamic world characterized by constant changes in tastes and
preference of buyers and technological progress or frequent changes in government policy the
success or failure of a particular enterprise in the past is no good guides as to the likely
success or failure of a similar enterprise in the future. Thus, profits are to be treated as the
reward for taking non-insurable risks.

J. A. Schumpeter has, of course, emphasized the role of profit as a necessary incentive for
innovation. Innovation refers to the introduction of a new product or a new method of
producing an old product, or opening up a new market. No doubt, all enterprises in a
capitalist economy involve a high degree of risk, but innovations of the type mentioned above
carry a much higher degree of risk. Innovators are encouraged by the prospects of large
profits. Such profits often accrue to the pioneer—one who is the first in the field.

In the dynamic changes, which give rise to profits according to the dynamic theory of profits,
Joseph Schumpeter has singled out for special treatment the part played by innovations. The
daring and the dynamic entrepreneurs continue to hit at one innovation or another. keeping
their business ahead of others and thus make a handsome profits. According to Schum peter,
the principal function of the entrepreneur is to make innovations and profits are a reward
for performing this important function. Schumpeter has given the term innovation very wide
meaning. Discovery of a new material or a new technique of production resulting in the
lowering of the cost of production or improving the quality of the product is an
innovation. Any new measure or new policy initiated by the entrepreneur comes under
innovation as Schumpeter uses the term.

Success of any of these innovations brings a handsome increase in profits. Profits increase

because either the cost of production is lowered or the product fetches a higher price. It may
be pointed out, however, that profits owing to innovations are only temporary and tend to
be competed away. Soon the innovations come to be imitated by the rivals and they cease to
be innovations or lose their novelty. Only when the innovation is got patented can the
originating entrepreneur continue to enjoy it. But in a dynamic world and
progressive economy, the superior entrepreneurs continue to make innovations and enjoy the
profits thereof. As Stigler observes, ‘These profits may exist for a considerable time because
of the ignorance of other firms of their (innovations) existence or because of the time
required for the entry of new firms. More important, the successful innovator Clll
continuously seeks new disequilibrium profits since the horizon of conceivable innovations is
unlimited.” S We may also remember that profits are both the cause and effect of
innovations.
Profits serve as a necessary incentive for making innovations; hence profits are a cause of
innovations. But since innovations result in profits, profits are the effect of
innovations. Criticism. Schumpeter’s innovation theory can be criticised on the same ground
as Clark’s dynamic theory:

i. Schumpeter also like Clark ignores uncertainty as a source of profit.

ii. He also denies that risk-bearing plays any role in the determination of profit.

Risk-bearing theory of profits Most people do mind the risk which makes • them hesitate to
take a plunge in business. The greater the risk the higher must be the expected profit in order
to induce them to start the business. All businesses are more or less speculative, and
unless the risk-taker is going to be amply rewarded, business will not be started. As risk acts
as a great deterrent, the supply of entrepreneurs is kept down, and those who do take the ‘risk
much more than the normal return on capital. Hence, profits are regarded as a reward for risk-
taking or risk-bearing. This theory of profit is associated with F. B. Hawley’s name. 6 He
says profits is the reward for risks and responsibilities that the undertaker .subjects himself to.
Drucker mentions four kinds of risks: replacement, risk proper, uncertainty and obsolescence.
Replacement generally known as depreciation, is calculable and is counted as
cost. Obsolescence is the least calculable but is also an item in the cost Risk proper (i.e., risk
of marketability of the product) and uncertainty are not costs in the conventional sense, but
are charges against profits. They may be called costs of staying in business. Physical risks
like fire, accident, etc., can be provided against by insurance, and are, therefore, included in
costs.

As against this, there is the view that though profits do contain some remuneration for risk
taking, yet the high profits made by entrepreneurs cannot in their entirely be attributed to the
element of risk. They are not, at any rate, in proportion to the risk undertaken. On the
contrary, it is pointed out by Carver that profits arise not because ‘risks are borne, but
because the superior entrepreneurs are able to reduce them. We might say-though it may
seem paradoxical- that profits are made not because risks are borne but because they are
avoided. Still, it cannot be denied that a great deal of pure profit is the reward for risk-
bearing.
4.10 SUMMARY

 The term “distribution” was introduced as a generalization of a mass density that can
be represented by a function. Such a distribution on the x-axis can be, for example, a
unit mass at the origin and zero density at all other points of a line. The total mass of
any segment, including the origin, is one. The total mass of any segment that does not
contain the origin is zero.

 The generalized functions are defined as the closure of the space of ordinary functions
in a way that is quite analogous to the Cantor definition of the real numbers as regular
sequences of rational numbers. In this respect, one surprising result obtained by L.
Schwartz is equivalent to the statement that any continuous weak function is a weak
derivative of a function in the ordinary sense, and the latter class of functions can be
restricted to continuous functions. The theory can be developed formally as the set of
continuous linear functionals consisting of continuous functions and their derivatives
defined by integration by parts.

 For roughly the past quarter of a century the majority of the world economy has
operated under a policy consensus that has been advocated by politicians (of left and
right), supra-national authorities, economic commentators and academic economists
alike. Workers should be ‘flexible’ so that they tolerate relatively low wages, spells of
unemployment and general uncertainty. Governments should be fiscally responsible
and restrict their borrowing.

 Above all, the setting of monetary policy should be independent from government and
aimed at low inflation (though policy aimed at this goal has operated by variously
targeting the money supply, exchange rates and consumer price inflation). From a
global perspective, finance capital or wealth should be ‘free’ so that it can be invested
in whatever country its owners choose; and exchange rates should be set by markets,
not managed by financial authorities.

 The equilibrium between these four variables together determines the rate of interest
as well as the equilibrium level of income. According to Hansen, “An equilibrium
condition is reached, when the desired volume of cash balances equals the quantity of
money, when the marginal efficiency of capital is equal to the rate of interest and
 finally, when the volume of investment is equal to the normal or desired volume of
saving. And these factors are integrated.

 The main weakness of the other theories of interest is that they assume the level of
income as constant and do not take into consideration its influence on the rate of
interest. The loanable funds theory does not tell us what the rate of interest will be,
but gives us the IS curve. IS curve being a negatively sloping curve showing different
levels of income at different rates of interest.

 We have discussed above the various theories of profits. The question arises: which
theory shall we accept? How do profits arise? Here we are thinking of not gross profit
but net profit. The fact is that in the real world there are several causes which give rise
to profit, but the principle cause is uncertainty. This uncertainty is due to the dynamic
nature of the world. In this real world of ours, some or the other change is always
taking place. But such changes only are causes of profits as cannot be foreseen as we
have read in K6  Enterprise and the Productive Process 1907 Night’s theory.

 However, in a static world, profits can arise in one way, viz., owing to monopoly. The
monopoly profits arise in the dynamic world also. Decides monopoly profits can arise
also from any other position of advantage.

4.11 KEYWORDS

 Capital - Any asset that can enhance one's power to perform economically useful
work. Capital goods, real capital, or capital assets are already-produced, durable
goods or any non-financial asset that is used in production of goods or services.

 Capital Cost - A fixed, one-time expense incurred on the purchase of land, buildings,

construction, and equipment used in the production of goods or in the rendering of
services. In other words, it is the total cost needed to bring a project to a commercially
operable status. Whether a particular cost is capital or not depends on many factors,
such as accounting, tax laws, and materiality.

 Uncertainty - Uncertainty as used here means the range of possible values within

which the true value of the measurement lies. This definition changes the usage of
some other commonly used terms. For example, the term accuracy is often used
to mean the difference between a measured result and the actual or true value.
  Loanable Fund - Loanable funds is the sum total of all the money people and entities
in an economy have decided to save and lend out to borrowers as an investment rather
than use for personal consumption. ... One way to make an investment is to
lend money to borrowers at a rate of interest.

 Innovation - Innovation is a process by which a domain, a product, or a service is

renewed and brought up to date by applying new processes, introducing new
techniques, or establishing successful ideas to create new value.

4.12 LEARNING ACTIVITY

1. Create a session on marginal productivity.

___________________________________________________________________________
___________________________________________________________________________

2. Create a survey on loanable fund and Keynes liquidity preference theory of interest.

___________________________________________________________________________
___________________________________________________________________________

4.13 UNIT END QUESTIONS

A. Descriptive Questions

Short Questions

1. What is production?

2. Define capital?

3. Write the main theories of wages?

4. Write the main theories of profit?

5. Describe the main criticism of theories of wages?

Long Questions

1. Explain the theories of distribution.

2. Explain the theories of interest.

3. Illustrate the uncertainty theory of profit.

4. Discuss the concept of dynamic theory of profit.

 5. Illustrate the wages determination under imperfect competition.

B. Multiple Choice Questions

1. In the simple Keynesian model consumption is a function of which one the following?

a. Rate of interest
b. Level of income
c. Price level
d. All of these

2. What is Keynesian analysis known as?

a. A short run analysis

b. Long run analysis
c. Both short and long run analysis
d. Medium run analysis

3. Which one the following is used for the value of marginal product is calculated for
multiplying.

a. Marginal product; price of the product

b. Wage; price of the product
c. Quantity of labour; wage rate
d. Total product; wage rate

4. Which among the following is the right option where a profit-maximizing firm hires
labour up to the point?

a. The wage times the quantity of labour equals the marginal product
b. Price equals the wage
c. Price equals the quantity of labour
d. The wage equals value of marginal product
 5. Which among the following is the right option for the return to a factor of production
which is fixed in supply in the short period is called as?

a. Scarcity rent
b. Economic rent
c. Quasi-rent
d. Contractual rent

Answers

1-b, 2-a, 3-b, 4-d, 5-c

4.14 REFERENCES

Reference

 Ohlin, Bertil. (1937). "Some Notes on the Stockholm Theory of Savings and
Investment”.

 Ohlin, Bertil. Robertson, D. H & Hawtrey, R. G. (1937). "Alternative Theories of the

Rate of Interest: Three Rejoinders".

 Patinkin, Don. (1958). "Liquidity Preference and Loanable Funds: Stock and Flow
Analysis".

Textbook

 Robertson, D. H. (1934). "Industrial Fluctuation and the Natural Rate of Interest".

 Ohlin, Bertil. (1937). "Some Notes on the Stockholm Theory of Savings and
Investment.

 Tsiang, S. C. (1956). "Liquidity Preference and Loanable Funds Theories, Multiplier

and Velocity Analysis: A Synthesis".

Website

 https://en.wikipedia.org/wiki/Loanable_funds

 https://www.knowledgiate.com/clarks-dynamic-theory-profit/

 https://economicskey.com/innovations-theory-profits-8720
UNIT 5 – STATISTICS

STRUCTURE

5.0 Learning Objectives

5.1 Introduction

5.2 Nature and Scope of Statistics

5.3 Relationship of Economics to statistics

5.4 Statistical Averages

5.4.1 Mean

5.4.2 Median

5.4.3 Mode

5.4.4 Geometric Mean

5.4.5 Harmonic Mean

5.5 Merits of Statistics Averages

5.6 Demerits of Statistics Averages

5.7 Theory and Applicable Simple Problems

5.8 Summary

5.9 Keywords

5.10 Learning Activity

5.11 Unit End Questions

5.12 References

5.0 LEARNING OBJECTIVES

After studying this unit, you will be able to:

 Explain the Nature and Scope of Statistics

 Examine the Relationship of Economics to statistics

  Illustrate the Merits of Statistics

5.1 INTRODUCTION

Statistics is the discipline that concerns the collection, organization, analysis, interpretation,
and presentation of data. In applying statistics to a scientific, industrial, or social problem, it
is conventional to begin with a statistical population or a statistical model to be studied.
Populations can be diverse groups of people or objects such as "all people living in a country"
or "every atom composing a crystal". Statistics deals with every aspect of data, including the
planning of data collection in terms of the design of surveys and experiments.

When census data cannot be collected, statisticians collect data by developing specific

experiment designs and survey samples. Representative sampling assures that inferences and
conclusions can reasonably extend from the sample to the population as a whole.
An experimental study involves taking measurements of the system under study,
manipulating the system, and then taking additional measurements using the same procedure
to determine if the manipulation has modified the values of the measurements. In contrast,
an observational study does not involve experimental manipulation.

Two main statistical methods are used in data analysis: descriptive statistics, which
summarize data from a sample using indexes such as the mean or standard deviation,
and inferential statistics, which draw conclusions from data that are subject to random
variation (e.g., observational errors, sampling variation). Descriptive statistics are most often
concerned with two sets of properties of a distribution (sample or population): central
tendency (or location) seeks to characterize the distribution's central or typical value,
while dispersion (or variability) characterizes the extent to which members of the distribution
depart from its centre and each other. Inferences on mathematical statistics are made under
the framework of probability theory, which deals with the analysis of random phenomena.

A standard statistical procedure involves the collection of data leading to test of the
relationship between two statistical data sets, or a data set and synthetic data drawn from an
idealized model. A hypothesis is proposed for the statistical relationship between the two data
sets, and this is compared as an alternative to an idealized null hypothesis of no relationship
between two data sets. Rejecting or disproving the null hypothesis is done using statistical
tests that quantify the sense in which the null can be proven false, given the data that are used
in the test. Working from a null hypothesis, two basic forms of error are recognized: Type I
errors (null hypothesis is falsely rejected giving a "false positive") and Type II errors (null
hypothesis fails to be rejected and an actual relationship between populations is missed
giving a "false negative").Multiple problems have come to be associated with this framework,
ranging from obtaining a sufficient sample size to specifying an adequate null hypothesis.
Measurement processes that generate statistical data are also subject to error. Many of these
errors are classified as random (noise) or systematic (bias), but other types of errors (e.g.,
blunder, such as when an analyst reports incorrect units) can also occur. The presence
of missing data or censoring may result in biased estimates and specific techniques have been
developed to address these problems.

Statistics is a mathematical body of science that pertains to the collection, analysis,

interpretation or explanation, and presentation of data, or as a branch of mathematics. Some
consider statistics to be a distinct mathematical science rather than a branch of mathematics.
While many scientific investigations make use of data, statistics is concerned with the use of
data in the context of uncertainty and decision making in the face of uncertainty.

In applying statistics to a problem, it is common practice to start with a population or process

to be studied. Populations can be diverse topics such as "all people living in a country" or
"every atom composing a crystal". Ideally, statisticians compile data about the entire
population (an operation called census). This may be organized by governmental statistical
institutes. Descriptive statistics can be used to summarize the population data. Numerical
descriptors include mean and standard deviation for continuous data (like income), while
frequency and percentage are more useful in terms of describing categorical data (like
education).

When a census is not feasible, a chosen subset of the population called a sample is studied.
Once a sample that is representative of the population is determined, data is collected for the
sample members in an observational or experimental setting. Again, descriptive statistics can
be used to summarize the sample data. However, drawing the sample contains an element of
randomness; hence, the numerical descriptors from the sample are also prone to uncertainty.
To draw meaningful conclusions about the entire population, inferential statistics is needed. It
uses patterns in the sample data to draw inferences about the population represented while
accounting for randomness. These inferences may take the form of answering yes/no
questions about the data (hypothesis testing), estimating numerical characteristics of the data
(estimation), describing associations within the data (correlation), and modelling
relationships within the data (for example, using regression analysis). Inference can extend to
forecasting, prediction, and estimation of unobserved values either in or associated with the
population being studied. It can include extrapolation and interpolation of time series or
spatial data, and data mining.

The early writings on statistical inference date back to Arab mathematicians and
cryptographers, during the Islamic Golden Age between the 8th and 13th centuries. Al-
Khalil (717–786) wrote the Book of Cryptographic Messages, which contains the first use of
permutations and combinations, to list all possible Arabic words with and without vowels. In
his book, Manuscript on Deciphering Cryptographic Messages, Al-Kindi gave a detailed
description of how to use frequency analysis to decipher encrypted messages. Al-Kindi also
made the earliest known use of statistical inference, while he and later Arab cryptographers
developed the early statistical methods for decoding encrypted messages. Ibn Adlan (1187–
1268) later made an important contribution, on the use of sample size in frequency analysis.
The earliest European writing on statistics dates back to 1663, with the publication of Natural
and Political Observations upon the Bills of Mortality by John Graunt. Early applications of
statistical thinking revolved around the needs of states to base policy on demographic and
economic data, hence its stat- etymology. The scope of the discipline of statistics broadened
in the early 19th century to include the collection and analysis of data in general. Today,
statistics is widely employed in government, business, and natural and social sciences.

The mathematical foundations of modern statistics were laid in the 17th century with the
development of the probability theory by Gerolamo Cardano, Blaise Pascal and Pierre de
Fermat. Mathematical probability theory arose from the study of games of chance, although
the concept of probability was already examined in medieval law and by philosophers such
as Juan Caramuel. The method of least squares was first described by Adrien-Marie
Legendre in 1805.

The modern field of statistics emerged in the late 19th and early 20th century in three
stages. The first wave, at the turn of the century, was led by the work of Francis
Galton and Karl Pearson, who transformed statistics into a rigorous mathematical discipline
used for analysis, not just in science, but in industry and politics as well. Galton's
contributions included introducing the concepts of standard deviation, correlation, regression
analysis and the application of these methods to the study of the variety of human
characteristics—height, weight, eyelash length among others. Pearson developed the Pearson
product-moment correlation coefficient, defined as a product-moment, the method of
moments for the fitting of distributions to samples and the Pearson distribution, among many
other things. Galton and Pearson founded Biometrika as the first journal of mathematical
statistics and biostatistics (then called biometry), and the latter founded the world's first
university statistics department at University College London.

Ronald Fisher coined the term null hypothesis during the Lady tasting tea experiment, which

"is never proved or established, but is possibly disproved, in the course of experimentation".
The second wave of the 1910s and 20s was initiated by William Sealy Gosset, and reached its
culmination in the insights of Ronald Fisher, who wrote the textbooks that were to define the
academic discipline in universities around the world. Fisher's most important publications
were his 1918 seminal paper The Correlation between Relatives on the Supposition of
Mendelian Inheritance (which was the first to use the statistical term, variance), his classic
1925 work Statistical Methods for Research Workers and his 1935 The Design of
Experiments, where he developed rigorous design of experiments models. He originated the
concepts of sufficiency, ancillary statistics, Fisher's linear discriminator and Fisher
information. In his 1930 book The Genetical Theory of Natural Selection, he applied
statistics to various biological concepts such as Fisher's principle (which A. W. F.
Edwards called "probably the most celebrated argument in evolutionary biology")
and Fisherian runaway, a concept in sexual selection about a positive feedback runaway
affect found in evolution.

The final wave, which mainly saw the refinement and expansion of earlier developments,
emerged from the collaborative work between Egon Pearson and Jerzy Neyman in the 1930s.
They introduced the concepts of "Type II" error, power of a test and confidence intervals.
Jerzy Neyman in 1934 showed that stratified random sampling was in general a better method
of estimation than purposive (quota) sampling.

Today, statistical methods are applied in all fields that involve decision making, for making
accurate inferences from a collated body of data and for making decisions in the face of
uncertainty based on statistical methodology. The use of modern computers has expedited
large-scale statistical computations and has also made possible new methods that are
impractical to perform manually. Statistics continues to be an area of active research for
example on the problem of how to analyse big data.
5.2 NATURE AND SCOPE OF STATISTICS

Statistics has been defined differently by different authors and each author has assigned new
limits to the field which should be included in its scope. We can do no better than give
selected definitions of statistics by some authors and then come to the conclusion about the
scope of the subject. A.L. Bowley defines, “Statistics may be called the science of counting”.
At another place he defines, “Statistics may be called the science of averages”. Both these
definitions are narrow and throw light only on one aspect of Statistics. According to King,
“The science of statistics is the method of judging collective, natural or social, phenomenon
from the results obtained from the analysis or enumeration or collection of estimates”. Many
a time counting is not possible and estimates are required to be made. Therefore, Boddington
defines it as “the science of estimates and probabilities”. But this definition also does not
cover the entire scope of statistics. The statistical methods are methods for the collection,
analysis and interpretation of numerical data and form a basis for the analysis and comparison
of the observed phenomena. In the words of Croxton &Cowden, “Statistics may be defined as
the collection, presentation, analysis and interpretation of numerical data”. Horace Secrist has
given an exhaustive definition of the term statistics in the plural sense.

Need for Statistical Data

Statistics plays a very important role in the field of economics. There is need of statistical
data in every walk of life. No field of study is complete without the supporting quantitative
information about that field. Some of the ways in which statistics is widely used in economics
are as follows:

 In construction of economic theories - An economic theory is first developed on the

basis of what we observe in real life. It is then approved or disapproved by the
analysis of statistical data relevant to the observation. For example, it is observed that
consumers demand less at higher prices. This observation takes the shape of a theory
when it is confirmed from actual statistical data that consumers really demand less at
higher prices.

 In economic planning - Statistics is an important tool of economic planning. Planners

use statistical data to formulate policies for economic development. For example,
India is an over populated country. However, the extent of overpopulation can be
revealed by data on population and resources available to support the population.
 Effective policies to control population can be framed only after we know how much
over-populated India is.

 In evaluation of policies of the government - It is not only enough to implement

policies but also necessary to know whether the implementation has been proper or
not. Statistical data helps us to evaluate the policies of the government. For example,
how much revenue did the government get through higher taxes? It is through
statistical investigations that the Finance Minister gets feedback on the taxes paid by
the people and the revenue accrued to the government.

 To reveal the structure of an economy - We study the structure of an economy with

the help of data on population, natural resources, employment, national income,
production, exports, imports etc. The statistical knowledge about these helps us to
know about the structure of the economy and the changes in the structure of the
economy.

Scope of Statistics

In ancient times, statistics was used by the state for the purpose of administration. But now a
days, it is widely used as a tool of all sciences. There is hardly any field whether it be
biology, botany, astronomy, physics, chemistry, sociology, or psychology where statistical
tools are not used. The word statistics is used in two senses.

i. The plural sense and

ii. The singular sense

In a plural sense it refers to quantitative information or simply statistical data. In singular

sense, it refers to method or methods used in arriving at the quantitative information or
dealing with it. We can explain the difference between the two with the help of following
example.
 Table 5.1: Growth of population in India

The above table 5.1 records population of India in different years. Here we are referring only
to the quantitative information about population. We are using the word statistics in the plural
sense in this case. When we say that population of India was estimated through the census
method; that the figures are presented in the tabular form; that population of India is
continuously rising and that it is rising on account of fall in death rate, we are referring to the
methods of collection, presentation, interpretation of trend in data and analysis of data
respectively. All these steps are statistical methods. Here we are using the word statistics in
the singular sense.

Importance of Statistics in Economics

There are number of economic laws which have evolved due to statistical analysis in the field
of economics, e.g., Engel's law of family expenditure, Malthus theory of population etc. Let
us understand the importance of statistics keeping in view the various parts of economics.

 Statistics and the study of consumption - Every individual needs a certain number of
things. He spends first on necessities, then on comforts and luxuries, which depend on
his income. We discover how different groups spend their income on different items
of consumption with the help of statistics.

 Statistics and the study of production - The progress of production every year can
easily be measured by statistics. The comparative study of productivity of various
elements of production (e.g., land, labour, capital and entrepreneurship) is also done
with the help of statistics. The statistics of production are very helpful for adjustment
of demand and supply.
  Statistics and the study of exchange - Production is based on national and
international demand. A producer needs statistics for deciding the cost of production
and selling price so that he can study competition and demand of commodity in a
market. The law of price determination and cost price which are bared on the various
market conditions and demand and supply can be studied with the help of statistics.

 Statistics and the study of distribution - Statistics are helpful in calculation of national
income in the field of distribution statistical methods are used in solving the problem
of the distribution of national income. Various problems arise due to unequal
distribution of wealth and national income and are solved with the help of statistical
data.

5.3 RELATIONSHIP OF ECONOMICS TO STATISTICS

Economic statistics is a topic in applied statistics that concerns the collection, processing,

compilation, dissemination, and analysis of economic data. It is also common to call the data
themselves 'economic statistics', but for this usage see economic data. The data of concern to
economic statistics may include those of an economy within a region, country, or group of
countries. Economic statistics may also refer to a subtopic of official statistics for data
produced by official organizations (e.g. national statistical services, intergovernmental
organizations such as United Nations, European Union or OECD, central banks, ministries,
etc.). Analyses within economic statistics both make use of and provide the empirical data
needed in economic research, whether descriptive or econometric. They are a key input for
decision making as to economic policy.

Economics is the study of various factors that affect both nations and individuals. To avoid
the bland use of economic theory in their explanations, economists mix in mathematics and
statistics in their studies. This compilation of research techniques leads to econometrics, with
a distinct link between statistics and econometrics as economists explain the likelihood that
something will occur. Econometrics also makes heavy use of case models, which are often
the base for specific studies on a given topic. Researchers gather copious amounts of
information and use econometrics and statistics to explain any relationships between
hypotheses.

All major economic studies require the use of variables and one or more hypotheses; in some
cases, a literature review testing other studies may be possible. Many people with upper-level
degrees - primarily at the doctorate level, though some with master’s degrees as well - teach
the use of statistics for research and studies. In short, economic researchers look to define
relationships between variables that may drive the economy. Statistics and econometrics are
linked as researchers need information on the strength between relationships and the
correlations between gathered data. Common statistical measurements include standard
deviation, ANOVA, and regression, among others.

Not all studies conducted with the use of statistics and econometrics use the same techniques.
For example, businesses may need information on the likelihood that an event will occur in a
specific time period. The use of an economics consulting firm may help a company determine
equilibrium points for products, marginal costs, marginal revenue, and other economic
measurements. Statistics can help a company determine the probability of these events
occurring. Again, these studies cannot be complete without the use of econometrics and
statistics being involved.

The most common way for either type of study to start - whether for a national study or an
individual company - is with a simple question or the discovery of a problem. An economic
model may then be put in place to help answer the question or complete the study. In short,
these models can test economic parameters, review elasticities, predict economic outcomes,
or test a hypothesis based on assumptions initially made during the early stages of the study.
Statistics and econometrics are necessary to properly define how to use these models and
solve economic problems. Other analyses will test the economic consequences of actions, as
in what happens when a company makes a poor decision.

Data analysis is a core function of both of these professions. The interpretation of data differs
because economists are primarily interested in how the data applies to consumers while
statisticians are primarily interested in tailoring the collection of data to specific questions.
Statisticians and economists may work together on projects where the economist develops the
question about a market trend and the statistician develops the survey to be distributed for
data collection. Once the data is collected for such a project, the statistician would analyse the
data for accuracy and the economist would develop a report about the economic impact of the
trend.

Economists can analyse market data for a variety of sectors, such as mining, manufacturing,
services, technology, or government. Types of data collected include the price of market
items, employment statistics, and consumer demand for specific products. Economists use
market data to predict trends, detail how laws might affect the economy, or make
recommendations to a company about profits. The analyses provided by economists are used
by the federal government to assess the overall health of the U.S. economy and set interest
rates. Many economists study a specialized subset of the economy, such as labour and
employment trends, anti-trust laws, or welfare policies.

Job responsibilities of an economist include

 Compiling data into computer software programs that generate graphs

 Researching historical trends in consumer behaviour

 Designing policies to maximize the economic benefit of specific trends

 Presenting research findings to other economists at professional meetings

Statisticians design ways to collect data for a specific purpose. The U.S. Census was designed
by statisticians to collect basic demographic data about the population of the entire country.
Other surveys may focus on a smaller question, such as the effectiveness of a particular drug
in treating a disease. Regardless of the reason for the data collection, it is the job of a
statistician to make sure the data collection method accurately reflects the population being
sampled and that the data is valid. The final analysis report from a statistician includes
information qualifying the data collected based on significant differences observed and the
specific conditions for which the data may be used. Applications of statistical analysis can
range from sports statistics and opinion polls to endangered species surveys and levels of
environmental pollution.

Job responsibilities of a statistician include

 Using computer software to identify relationships in data.

 Modelling data trends based upon different sampling methods.

 Improving data collection methods based upon probability theory.

 Manipulating raw data into graphs and charts to display relationship.

5.4 STATISTICAL AVERAGES

After the data have been properly checked for its quality, the first and foremost analysis is
usually for the descriptive statistics. The general aim is to summarize the data, iron out any
peculiarities and perhaps get ideas for a more sophisticated analysis. The data summary may
help to suggest a suitable model which in turn suggests an appropriate inferential procedure.
The first phase of the analysis will be described as the initial examination of the data or initial
data analysis. It has many things in common with explanatory data analysis which includes a
variety of graphical and numerical techniques for exploring data. Thus, explanatory data
analysis is an essential part of nearly every analysis. It provides a reasonably systematic way
of digesting and summarizing the data with its exact form naturally varies widely from
problem to problem. In general, under initial and exploratory data analysis, the following are
given due importance.

Statistical averages are important in the measurement of quantities that are obscured by
random variations. As an example, to motivate the discussion, consider the problem of
measuring a voltage level with a noisy instrument. Suppose that the unknown voltage has
value a and that the instrument has an uncertainty x. The observed value may be y = a + x.
Suppose that an independent measurements are made under identical conditions, meaning
that neither the unknown value of the voltage nor the statistics of the instrument noise change
during the process. Let us call the n measurements yi, 1 ≤ i ≤ n. Under our model of the
process, it must be the case that yi = a + xi. Now form the quantity

This is the empirical average of the observed values. It is important to note that y(n) is a
random variable because it is a numerical value that is the outcome of a random experiment.
That means that it will not have a single certain value. We expect to obtain a different value if
we repeat the experiment and obtain n new measurements. We also expect that the result
depends upon the value of n, and have the sense that larger values of n should give better
results. This intuition is basically correct. The purpose of this analysis is to refine what we
understand intuitively and to identify the ways in which our intuition can be fooled. If we
substitute yi = a + xi into the above expression we find
The summation represents the empirical average x(n). Hence, we have arrived at a result y(n)
= a + x(n). We cannot actually observe x(n) because it is the result of the unknown
measurement noise. So, we are led to wonder how y(n) = a + x(n) tells us more about the
value of a than what y = a + x tells us. The answer is that the variance of y(n) can be much
smaller than the variance of y. We have not yet defined the term variance but we will shortly.
It is a measure of our uncertainty. If the noise on each measurement is independent, then the
variance decreases as 1/n. By making n sufficiently large it can be made as small as we wish.
Let us now turn to setting up the machinery. The approach will be to bring in the probability
distributions for the unknown quantities.

5.4.1 Mean

A mean is the simple mathematical average of a set of two or more numbers. The mean for a
given set of numbers can be computed in more than one way, including the arithmetic
mean method, which uses the sum of the numbers in the series, and the geometric
mean method, which is the average of a set of products. However, all of the primary methods
of computing a simple average produce the same approximate result most of the time.

 The mean is the mathematical average of a set of two or more numbers.

 The arithmetic mean and the geometric mean are two types of mean that can be
calculated.

 Summing the numbers in a set and dividing by the total number gives you the
arithmetic mean.

 The geometric mean is more complicated and involves multiplication of the numbers
taking the nth root.

 The mean helps to assess the performance of an investment or company over a period
of time, and many other uses.

The mean is a statistical indicator that can be used to gauge the performance of a company’s
stock price over a period of days, months, or years, a company through its earnings over a
number of years, a firm by assessing its fundamentals such as price-to-earnings ratio, free
cash flow, and liabilities on the balance sheet, and a portfolio by estimating its average
returns over a certain period.

An analyst who wants to measure the trajectory of a company’s stock value in the last, say 10
days, would sum up the closing price of the stock in each of the 10 days. The sum total would
then be divided by the number of days to get the arithmetic mean. The geometric mean will
be calculated by multiplying all of the values together. The nth root of the product total is
then taken, in this case, the 10th root, to get the mean.

Mean is an essential concept in mathematics and statistics. The mean is the average or the
most common value in a collection of numbers. In statistics, it is a measure of central
tendency of a probability distribution along median and mode. It is also referred to as an
expected value.

It is a statistical concept that carries a major significance in finance. The concept is used in

various financial fields, including but not limited to portfolio management and business
valuation.

5.4.2 Median

In statistics and probability theory, the median is the value separating the higher half from the
lower half of a data sample, a population, or a probability distribution. For a data set, it may
be thought of as "the middle" value. The basic feature of the median in describing data
compared to the mean (often simply described as the "average") is that it is not skewed by a
small proportion of extremely large or small values, and therefore provides a better
representation of a "typical" value. Median income, for example, may be a better way to
suggest what a "typical" income is, because income distribution can be very skewed. The
median is of central importance in robust statistics, as it is the most resistant statistic, having
a breakdown point of 50%: so long as no more than half the data are contaminated, the
median is not an arbitrarily large or small result.

Formally, a median of a population is any value such that at most half of the population is
less than the proposed median and at most half is greater than the proposed median. As seen
above, medians may not be unique. If each set contains less than half the population, then
some of the population is exactly equal to the unique median.

The median is well-defined for any ordered (one-dimensional) data, and is independent of

any distance metric. The median can thus be applied to classes which are ranked but not
numerical (e.g., working out a median grade when students are graded from A to F), although
the result might be halfway between classes if there is an even number of cases.

A geometric median, on the other hand, is defined in any number of dimensions. A related
concept, in which the outcome is forced to correspond to a member of the sample, is
the medoid.
There is no widely accepted standard notation for the median, but some authors represent the
median of a variable x either as x͂ or as μ1/2 sometimes also M. In any of these cases, the use
of these or other symbols for the median needs to be explicitly defined when they are
introduced.

The median is a special case of other ways of summarising the typical values associated with
a statistical distribution: it is the 2nd quartile, 5th decile, and 50th percentile.

The median can be used as a measure of location when one attaches reduced importance to
extreme values, typically because a distribution is skewed, extreme values are not known,
or outliers are untrustworthy, i.e., may be measurement/transcription errors.

For example, consider the multiset

1, 2, 2, 2, 3, 14.

The median is 2 in this case, (as is the mode), and it might be seen as a better indication of
the centre than the arithmetic mean of 4, which is larger than all-but-one of the values.
However, the widely cited empirical relationship that the mean is shifted "further into the
tail" of a distribution than the median is not generally true. At most, one can say that the two
statistics cannot be "too far" apart. Inequality is relating means and medians below.

As a median is based on the middle data in a set, it is not necessary to know the value of
extreme results in order to calculate it. For example, in a psychology test investigating the
time needed to solve a problem, if a small number of people failed to solve the problem at all
in the given time a median can still be calculated.

Because the median is simple to understand and easy to calculate, while also a robust
approximation to the mean, the median is a popular summary statistic in descriptive statistics.
In this context, there are several choices for a measure of variability: the range,
the interquartile range, the mean absolute deviation, and the median absolute deviation.

For practical purposes, different measures of location and dispersion are often compared on
the basis of how well the corresponding population values can be estimated from a sample of
data. The median, estimated using the sample median, has good properties in this regard.
While it is not usually optimal if a given population distribution is assumed, its properties are
always reasonably good. For example, a comparison of the efficiency of candidate estimators
shows that the sample mean is more statistically efficient when — and only when — data is
uncontaminated by data from heavy-tailed distributions or from mixtures of
distributions. Even then, the median has a 64% efficiency compared to the minimum-variance
mean (for large normal samples), which is to say the variance of the median will be ~50%
greater than the variance of the mean.

The median is the middle number in a sorted, ascending or descending, list of numbers and
can be more descriptive of that data set than the average.

 The median is the middle number in a sorted, ascending or descending, list of

numbers and can be more descriptive of that data set than the average.

 The median is sometimes used as opposed to the mean when there are outliers in the
sequence that might skew the average of the values.

 If there is an odd amount of numbers, the median value is the number that is in the
middle, with the same amount of numbers below and above.

 If there is an even amount of numbers in the list, the middle pair must be determined,
added together, and divided by two to find the median value.

Median is the middle number in a sorted list of numbers. To determine the median value in a
sequence of numbers, the numbers must first be sorted, or arranged, in value order from
lowest to highest or highest to lowest. The median can be used to determine an approximate
average, or mean, but is not to be confused with the actual mean.

 If there is an odd amount of numbers, the median value is the number that is in the
middle, with the same amount of numbers below and above.

 If there is an even amount of numbers in the list, the middle pair must be determined,
added together, and divided by two to find the median value.

The median is sometimes used as opposed to the mean when there are outliers in the
sequence that might skew the average of the values. The median of a sequence can be less
affected by outliers than the mean.

5.4.3 Mode

The mode is the value that appears most often in a set of data values. If X is a discrete
random variable, the mode is the value x (i.e., X = x) at which the probability mass
function takes its maximum value. In other words, it is the value that is most likely to be
sampled.
Like the statistical mean and median, the mode is a way of expressing, in a (usually) single
number, important information about a random variable or a population. The numerical value
of the mode is the same as that of the mean and median in a normal distribution, and it may
be very different in highly skewed distributions.

The mode is not necessarily unique to a given discrete distribution, since the probability mass
function may take the same maximum value at several points x1, x2, etc. The most extreme
case occurs in uniform distributions, where all values occur equally frequently.

When the probability density function of a continuous distribution has multiple local

maxima it is common to refer to all of the local maxima as modes of the distribution. Such a
continuous distribution is called multimodal (as opposed to unimodal). A mode of
a continuous probability distribution is often considered to be any value x at which
its probability density function has a locally maximum value, so any peak is a mode.

In symmetric unimodal distributions, such as the normal distribution, the mean (if defined),

median and mode all coincide. For samples, if it is known that they are drawn from a
symmetric unimodal distribution, the sample mean can be used as an estimate of the
population mode.

The mode of a sample is the element that occurs most often in the collection. For example,
the mode of the sample [1, 3, 6, 6, 6, 6, 7, 7, 12, 12, 17] is 6. Given the list of data [1, 1, 2, 4,
4] its mode is not unique. A dataset, in such a case, is said to be bimodal, while a set with
more than two modes may be described as multimodal.

For a sample from a continuous distribution, such as [0.935..., 1.211..., 2.430..., 3.668...,
3.874...], the concept is unusable in its raw form, since no two values will be exactly the
same, so each value will occur precisely once. In order to estimate the mode of the underlying
distribution, the usual practice is to discretize the data by assigning frequency values
to intervals of equal distance, as for making a histogram, effectively replacing the values by
the midpoints of the intervals they are assigned to. The mode is then the value where the
histogram reaches its peak. For small or middle-sized samples, the outcome of this procedure
is sensitive to the choice of interval width if chosen too narrow or too wide; typically, one
should have a sizable fraction of the data concentrated in a relatively small number of
intervals (5 to 10), while the fraction of the data falling outside these intervals is also sizable.
An alternate approach is kernel density estimation, which essentially blurs point samples to
produce a continuous estimate of the probability density function which can provide an
estimate of the mode.

The following MATLAB (or Octave) code example computes the mode of a sample: Unlike

mean and median, the concept of mode also makes sense for "nominal data" (i.e., not
consisting of numerical values in the case of mean, or even of ordered values in the case of
median). For example, taking a sample of Korean family names, one might find that "Kim"
occurs more often than any other name. Then "Kim" would be the mode of the sample. In any
voting system where a plurality determines victory, a single modal value determines the
victor, while a multi-modal outcome would require some tie-breaking procedure to take
place.

Unlike median, the concept of mode makes sense for any random variable assuming values
from a vector space, including the real numbers (a one-dimensional vector space) and
the integers (which can be considered embedded in the reals). For example, a distribution of
points in the plane will typically have a mean and a mode, but the concept of median does not
apply. The median makes sense when there is a linear order on the possible values.
Generalizations of the concept of median to higher-dimensional spaces are the geometric
median and the centre point.

 All three measures have the following property: If the random variable (or each value
from the sample) is subjected to the linear or affine transformation, which
replaces X by a + b, so are the mean, median and mode.

 Except for extremely small samples, the mode is insensitive to "outliers" (such as
occasional, rare, false experimental readings). The median is also very robust in the
presence of outliers, while the mean is rather sensitive.

 In continuous unimodal distributions the median often lies between the mean and the
mode, about one third of the way going from mean to mode. In a formula, median ≈
(2 × mean + mode)/3. This rule, due to Karl Pearson, often applies to slightly non-
symmetric distributions that resemble a normal distribution, but it is not always true
and in general the three statistics can appear in any order.

 For unimodal distributions, the mode is within √3 standard deviations of the mean,

and the root mean square deviation about the mode is between the standard deviation
and twice the standard deviation.
The mode is the value that appears most frequently in a data set. A set of data may have one
mode, more than one mode, or no mode at all. Other popular measures of central tendency
include the mean, or the average of a set, and the median, the middle value in a set.

In statistics, data can be distributed in various ways. The most often cited distribution is the
classic normal (bell-curve) distribution. In this, and some other distributions, the mean
(average) value falls at the mid-point, which is also the peak frequency of observed values.
For such a distribution, the mean, median, and mode are all the same value. This means that
this value is the average value, the middle value, also the mode—the most frequently
occurring value in the data.

Mode is most useful as a measure of central tendency when examining categorical data, such
as models of cars or flavours of soda, for which a mathematical average median value based
on ordering cannot be calculated.

 In statistics, the mode is the most commonly observed value in a set of data.

 For the normal distribution, the mode is also the same value as the mean and median.

 In many cases, the modal value will differ from the average value in the data.

Advantages and Disadvantages of the Mode

Mode is the most frequently occurring value in a dataset. Along with mean and median, mode
is a statistical measure of central tendency in a dataset. Unlike the other measures of central
tendency that are unique to a particular dataset, there may be several modes in a dataset.

Corporate Finance Institute reviews some of these statistical measures in our Math for
Corporate Finance course.

Advantages of Mode

 The mode is easy to understand and calculate.

 The mode is not affected by extreme values.

 The mode is easy to identify in a data set and in a discrete frequency distribution.

 The mode is useful for qualitative data.

 The mode can be computed in an open-ended frequency table.

 The mode can be located graphically.

Disadvantages of Mode

 The mode is not defined when there are no repeats in a data set.

 The mode is not based on all values.

 The mode is unstable when the data consist of a small number of values.

 Sometimes data have one mode, more than one mode, or no mode at all.

5.4.4 Geometric Mean

The geometric mean is the average of a set of products, the calculation of which is commonly
used to determine the performance results of an investment or portfolio. It is technically
defined as "the nth root product of n numbers." The geometric mean must be used when
working with percentages, which are derived from values, while the standard arithmetic
mean works with the values themselves.

The geometric mean is an important tool for calculating portfolio performance for many

reasons, but one of the most significant is it takes into account the effects of compounding.

 The geometric mean is the average rate of return of a set of values calculated using
the products of the terms.

 Geometric mean is most appropriate for series that exhibit serial correlation—this is
especially true for investment portfolios.

 Most returns in finance are correlated, including yields on bonds, stock returns, and
market risk premiums.

 For volatile numbers, the geometric average provides a far more accurate
measurement of the true return by taking into account year-over-year compounding
that smooths the average.
The geometric mean, sometimes referred to as compounded annual growth rate or time-
weighted rate of return, is the average rate of return of a set of values calculated using the
products of the terms. What does that mean? Geometric mean takes several values and
multiplies them together and sets them to the 1/nth power.

For example, the geometric mean calculation can be easily understood with simple numbers,
such as 2 and 8. If you multiply 2 and 8, then take the square root (the ½ power since there
are only 2 numbers), the answer is 4. However, when there are many numbers, it is more
difficult to calculate unless a calculator or computer program is used.

The main benefit of using the geometric mean is the actual amounts invested do not need to
be known; the calculation focuses entirely on the return figures themselves and presents an
"apples-to-apples" comparison when looking at two investment options over more than one
time period. Geometric means will always be slightly smaller than the arithmetic mean,
which is a simple average.

Example of Geometric Mean

If you have $10,000 and get paid 10% interest on that $10,000 every year for 25 years, the
amount of interest is $1,000 every year for 25 years, or $25,000. However, this does not take
the interest into consideration. That is, the calculation assumes you only get paid interest on
the original $10,000, not the $1,000 added to it every year. If the investor gets paid interest
on the interest, it is referred to as compounding interest, which is calculated using the
geometric mean.

Using the geometric mean allows analysts to calculate the return on an investment that gets
paid interest on interest. This is one reason portfolio managers advise clients to reinvest
dividends and earnings.

The geometric mean is also used for present value and future value cash flow formulas. The
geometric mean return is specifically used for investments that offer a compounding return.
Going back to the example above, instead of only making $25,000 on a simple interest
investment, the investor makes $108,347.06 on a compounding interest investment.

Simple interest or return is represented by the arithmetic mean, while compounding interest
or return is represented by the geometric mean.

The geometric mean is the average growth of an investment computed by

multiplying n variables and then taking the nth –root.  In other words, it is the average return
of an investment over time, a metric used to evaluate the performance of a single investment
or an investment portfolio.

Why use Geometric Mean?

The arithmetic mean is the calculated average of the middle value of a data series. It is
accurate to take an average of independent data, but weakness exists in a continuous data
series calculation.

Example: An investor has annual return of 5%, 10%, 20%, -50%, and 20%.

Using the arithmetic mean, the investor’s total return is (5%+10%+20%-50%+20%)/5 = 1%

By comparing the result with the actual data shown on the table, the investor will find a 1%
return is misleading.

5.4.5 Harmonic Mean

The harmonic mean is a type of numerical average. It is calculated by dividing the number of
observations by the reciprocal of each number in the series. Thus, the harmonic mean is the
reciprocal of the arithmetic mean of the reciprocals.

The harmonic mean helps to find multiplicative or divisor relationships between fractions
without worrying about common denominators. Harmonic means are often used in averaging
things like rates (e.g., the average travel speed given a duration of several trips).

The weighted harmonic mean is used in finance to average multiples like the price-earnings
ratio because it gives equal weight to each data point. Using a weighted arithmetic means to
average these ratios would give greater weight to high data points than low data points
because price-earnings ratios aren't price-normalized while the earnings are equalized. The
harmonic mean is the weighted harmonic mean, where the weights are equal to 1. The
weighted harmonic means of x1, x2, x3 with the corresponding weights w1, w2, w3 is given
as
  The harmonic mean is the reciprocal of the arithmetic mean of the reciprocals.

 Harmonic means are used in finance to average data like price multiples.

 Harmonic means can also be used by market technicians to identify patterns such as
Fibonacci sequences.

Other ways to calculate averages include the simple arithmetic mean and the geometric mean.
An arithmetic average is the sum of a series of numbers divided by the count of that series of
numbers. If you were asked to find the class (arithmetic) average of test scores, you would
simply add up all the test scores of the students, and then divide that sum by the number of
students. For example, if five students took an exam and their scores were 60%, 70%, 80%,
90%, and 100%, the arithmetic class average would be 80%.

The geometric mean is the average of a set of products, the calculation of which is commonly
used to determine the performance results of an investment or portfolio. It is technically
defined as "the nth root product of n numbers." The geometric mean must be used when
working with percentages, which are derived from values, while the standard arithmetic
mean works with the values themselves.

As an example, take two firms. One has a market capitalization of $100 billion and earnings
of $4 billion (P/E of 25) and one with a market capitalization of $1 billion and earnings of $4
million (P/E of 250). In an index made of the two stocks, with 10% invested in the first and
90% invested in the second, the P/E ratio of the index is

Using the WAM: P/E = 0.1×25+0.9×250 = 227.5

Using the WHM: P/E = 250.1 + 2500.90.1 + 0.9 ≈ 131.6

Where: WAM = weighted arithmetic mean

P/E = price-to-earnings ratio

WHM = weighted harmonic mean.
5.5 MERITS OF STATISTICS AVERAGE

The word ‘Statistics’ is derived from the Latin word ‘statis’ or the Italian word ‘statists’ or
German word ‘statistic.’ All these words mean a political state. In the olden days statistics
was necessary for the proper functioning of the affairs of a state. Thus, in those days Statistics
was called as ‘science of state’ or ‘science of kings’ as it was mainly used by the state or
kings. Today statistics is defined as a field of study relating to the collection analysis,
interpretation and presentation of data. In this lesson you will learn about the meaning of
statistics and its scope and its need in economics

The main advantage of statistics is that information is presented in a way that is easy to
analyse, which makes its conclusions easily accessible. Comparative statistical analysis
allows people to identify the strengths and weaknesses of different strategies, programs,
policies or products across multiple demographics, making it an indispensable tool for
decision makers.

Statistics are gathered anonymously, which reduces the reluctance of individuals to volunteer
information. This allows researchers to gather data that is otherwise inaccessible.
Furthermore, statistical methods are standardized, which makes them easy to replicate and
guarantees consistent quality over time. Statistics provides hard data on performance and
output, creating an excellent benchmark by which to measure efficiency and productivity.

Statistics and the Study of Consumption

Every individual needs a certain number of things. He spends first on necessities, then on
comforts and luxuries, which depend on his income. We discover how different groups spend
their income on different items of consumption with the help of statistics.

Statistics and the Study of Production

The progress of production every year can easily be measured by statistics. The comparative
study of productivity of various elements of production (e.g., land, labour, capital and
entrepreneurship) is also done with the help of statistics. The statistics of production are very
helpful for adjustment of demand and supply.

Statistics and the Study of Exchange

Production is based on national and international demand. A producer needs statistics for
deciding the cost of production and selling price so that he can study competition and demand
of commodity in a market. The law of price determination and cost price which are bared on
the various market conditions and demand and supply can be studied with the help of
statistics.

Statistics and the Study of Distribution

Statistics are helpful in calculation of national income in the field of distribution statistical
methods are used in solving the problem of the distribution of national income. Various
problems arise due to unequal distribution of wealth and national income and are solved with
the help of statistical data.

5.6 DEMERITS OF STATISTICS AVERAGE

Statistics is the science of collecting, analysing, presenting, and interpreting data.

Governmental needs for census data as well as information about a variety of economic
activities provided much of the early impetus for the field of statistics. Currently the need to
turn the large amounts of data available in many applied fields into useful information has
stimulated both theoretical and practical developments in statistics.

Qualitative Aspect Ignored

The statistical methods don’t study the nature of phenomenon which cannot be expressed in
quantitative terms.

Such phenomena cannot be a part of the study of statistics. These include health, riches,
intelligence etc. It needs conversion of qualitative data into quantitative data. So, experiments
are being undertaken to measure the reactions of a man through data. Now a days statistics is
used in all the aspects of the life as well as universal activities.

It does not Deal with Individual Items

It is clear from the definition given by Prof. Horace Sacrist, “By statistics we mean
aggregates of facts…. and placed in relation to each other”, that statistics deals with only
aggregates of facts or items and it does not recognize any individual item. Thus, individual
terms as death of 6 persons in an accident, 85% results of a class of a school in a particular
year, will not amount to statistics as they are not placed in a group of similar items. It does
not deal with the individual items, however, important they may be.

It does not Depict Entire Story of Phenomenon

When even phenomena happen, that is due to many causes, but all these causes cannot be
expressed in terms of data. So, we cannot reach at the correct conclusions. Development of a
group depends upon many social factors like, parents’ economic condition, education,
culture, region, administration by government etc. But all these factors cannot be placed in
data. So, we analyse only that data we find quantitatively and not qualitatively. So, results or
conclusion are not 100% correct because many aspects are ignored.

It is Liable to be Miscued

As W.I. King points out, “One of the short-comings of statistics is that do not bear on their
face the label of their quality.” So, we can say that we can check the data and procedures of
its approaching to conclusions. But these data may have been collected by inexperienced
persons or they may have been dishonest or biased. As it is a delicate science and can be
easily misused by an unscrupulous person. So, data must be used with a caution. Otherwise,
results may prove to be disastrous.

Laws are not Exact

As far as two fundamental laws are concerned with statistics.

i. Law of inertia of large numbers and

ii. (Law of statistical regularity, are not as good as their science laws.

They are based on probability. So, these results will not always be as good as of scientific
laws. On the basis of probability or interpolation, we can only estimate the production of
paddy in 2008 but cannot make a claim that it would be exactly 100 %. Here only
approximations are made.

Results are True only on Average

As discussed above, here the results are interpolated for which time series or regression or
probability can be used. These are not absolutely true. If average of two sections of students
in statistics is same, it does not mean that all the 50 students is section A has got same marks
as in B. There may be much variation between the two. So, we get average results.

“Statistics largely deals with averages and these averages may be made up of individual items
radically different from each other.” —W.L King

To Many Methods to Study Problems

In this subject we use so many methods to find a single result. Variation can be found by
quartile deviation, mean deviation or standard deviations and results vary in each case. “It
must not be assumed that the statistics is the only method to use in research, neither should
this method of considered the best attack for the problem.” - Croxten and Cowden.

Statistical Results are not Always Beyond Doubt

“Statistics deals only with measurable aspects of things and therefore, can seldom give the
complete solution to problem. They provide a basis for judgement but not the whole
judgment.” - Prof. L.R. Connor.

Although we use many laws and formulae in statistics but still the results achieved are not
final and conclusive. As they are unable to give complete solution to a problem, the result
must be taken and used with much wisdom.

Other advantages and disadvantages of statistics are

 They are familiar to library staff and managers.

 They can be analysed relatively quickly.

 They can be analysed relatively quickly.

 Information is collected in a standardised way.

 They are usually straightforward to analyse.

 They overcome the difficulties of encouraging participation by users.

 They are often required and respected by decision-makers within the institution and
beyond e.g., funders, government.

 They support qualitative data obtained from questionnaires, interviews etc with 'hard
facts.

 They are useful for benchmarking purposes.

 Presenting facts in a definite form.

 Simplifying mass of figure- condensation into few significant figures.

 Facilitating comparison.

 Helping in formulating and testing of hypothesis and developing new theories.

  Helping in predictions.

 Helping in formulation of suitable policies.

 It helps to present bulk data in a precise and definite form.

 Statistics helps to compare data and draw conclusions.

 Statistics helps in forecasting trends.

 Statistical data provides a base for decision making and formulating policies.

 Does not deal with individual measurement.

 Deals only with quantities characteristics.

 Result is true only on an average.

 It is only one of the methods of studying a problem.

 Statistics can be measured. It requires skills to use it effectively, otherwise

misinterpretation is possible.

 It is only a tool or means to an end and not the end itself which has to be intelligently
identified using this tool.

 Statistics studies numerical facts only, it is not suited for qualitative study such as
honesty, friendship etc.

 Data must be homogenous and uniform otherwise comparison may not be possible.

 Statistical methods can be used by experts only or they may give rise to errors or
distrust in the data.

 Statistical data can be prone to misuse.

5.7 THEORY AND APPLICABLE SIMPLE PROBLEMS

The human beings are in their lives every day confronted with the situations that are for them
contradictory, containing obstructions that have to be overcome in order to achieve the aim,
or the human beings experience various difficulties. To cope with these situations, it is
desirable to apply the thought processes enabling generating of knowledge necessary for a
successful solving or removing of the above-mentioned obstructions. Those situations, raising
the inevitably thought processes, are, according to A. M. Matyushkin (1973), in psychology
called as the problem situations and the relevant tasks as the problem tasks. The definition of
the term problem is presented differently, therefore it is desirable to analyse it in detail and
define it. Theoretically, a problem is understood as a difficulty of theoretical or practical
nature that causes an inquiring attitude of a subject and leads him/her to the enrichment of
his/her knowledge This term is in the fields of education similarly understood by a Polish
scientist, W. Okoń, who defines a didactic problem as a practical or theoretical difficulty that
a pupil has to solve independently by his own active research. Usually, the base of this
difficulty is a systematic and deliberately organized situation, in which the pupil aspires to
overcome the difficulties in accordance to the specific needs and by this he/she gains new
knowledge and experience. The analysis of this particular situation leads to the formulation of
a problem – to the verbal definition of the occurred difficulty.

Appropriate conditions enable the formation of a problematic situation, in which the

individual finds him/herself and that surrounds him/her. According to suitable statement of
Cz. Kupisiewicz (1964), this situation embarrasses the individual which causes a feeling of a
difficulty superimposed by curiosity and strives to satisfy him/her. Acquired forms of
behaviour of the individual find themselves in a conflict with the given situation, the
individual is forced to adapt to those new situations, to create the new ways of behaviour by
which a new balance of the forces is developed therefore the conflict is overcome
(comparison to Linhart, 1982). The problematic situation cannot be confused with a problem;
this term will be defined later. By studying of the scientific publications, we draw a
conclusion that the most suitable definition is made by J. Linhart, who defines the
problematic situation as a totality of conditions that determine the formation and specifics of
the problem. It is impossible to be fully identified with another definition made by I. J. Lerner
(1986). He defines a problematic situation as a barrier that subject is clearly or indefinitely
aware of and to its overcoming he/she needs a creative search of the new knowledge, new
ways and activities. However, the barrier is not the only element of the problematic situation
- this role is played by the other factors as well. Analysing the different problematic
situations, we draw a conclusion that they are characterized by diversity and it is possible to
divide them in the groups based on the similar signs. Considering the understanding and
subsequent problem solving, as the simplest situations occur those where necessary pieces of
information are apparent and where no unnecessary data, that would have to be filtered out
and analysed by concluding operations, are presented. The problem is clear and, basically, it
is only a matter of finding its solution. All substantial circumstances are clearly specified: the
current state, the target state and the available operators. These situations can be described as
the specific problematic situations and as the examples can be named different types of brain
teasers. It is possible to meet this kind of problematic situations very often in the field of
school education, to which refer Mayer and Wittrock (2006). They state that educational
materials very often prioritize well-defined problems; however, the most of the real-life
problems are defined wrongly. As found, an ease of preparation of those problematic
situations from side of the teacher, high number of students and to that related level of the
problematic situations contribute to that. Further problems may cause the relative time
consuming which is advantageous mainly because of the length of the standardized teaching
unit. The opposite situations that can be called as uncertain problematic situations are
characteristic by the lack of information which has to be firstly gained. Often it is not obvious
which information will be needed for problem solution and the problem is not obvious as
well as it has to be firstly identified, prepared and defined and later solved. The objective
uncertainty is outside the individual who finds himself in the problematic situation. Funke
and French (1995) refer to those problematic situations as “non-transparent”. The problematic
situations are possible to be assessed in terms of statics, or dynamics, which is defined e.g.,
by the authors Blech and Funke (2010), Klieme (2004), Wirth and Klieme (2004). The
changeability of the complex of the conditions, that determine the creation and specifics of
the problem in time, is determinable. For the problem solving is more advantageous when the
conditions are stable and no changes are happening – in these cases is the problematic
situation called static problematic situation. An example of static problematic situation can
be, again, a brain teaser. On the other hand, for the dynamic problematic situations is the
change of conditions, that determine creation and specifics of the problem in time,
characteristic. The conditions can change because of various influences, whose creation and
effect can the individual not affect. The on-going consideration of the influences acting in
time and their control is an assumption for successful problem-solving process in those
situations. The dynamics does not have to be in the context of problem solving understood as
negative, it can operate also positively, and e.g., previously unsolvable problem suddenly
becomes solvable.

As it was already discussed above, the thinking of an individual begins with the awareness of
the problematic situation. In this case, the problematic situation has a potential to grow into a
problem that deserves a solution. Every problem is bound to the problematic situation,
however, not every problematic situation turns into the problem because this reality depends
on the individual. A person, who finds him/herself in a problematic situation and is aware of
its existence, does not have to “see” the problem until the ability of the problem awareness is
developed. The individual, who is aware of the problem, is able to specify the difficulty or
the source of the conflict which causes the problematic situation, is capable to deal with the
problem. Contrary to that, the individual who is not able to be aware of the problem, is albeit
experiencing the feeling superimposed by curiosity, however, does not realise what causes
the difficulty, which obstacle that causes the conflict has to be removed, and, therefore, he is
not able to remove it. A lot of factors affect the problem awareness and those can appear
inside the problematic situation, e.g.: the inappropriate verbal utterances that should induce
the situation or the lack of knowledge. They can also appear outside the problematic
situation, i.e., noise, improper lighting or a visual impairment. Taking this into account, we
can mention also so-called perceptibility of the problem. The threshold of the perceptibility is
different amongst the individuals which is mainly conspicuous when more people find
themselves in problematic situations of the same parameters. The exterior conditions of the
individual are the same, the conditions directly connected to the individual are different. If
the individual is perceiving the problem, the willingness to deal with the problem is very
essential. This is a state when the individual approaches the evaluation of the circumstances
of the problem and character of the problematic situation. He/she evaluates the particular
circumstances and he / she attaches a particular importance to them. One of the opinions is
that he/she is not willing to deal with the problem in the current situation or to proceed to its
solution. This is very important in the educational field because the problems that are given to
the pupils should be the ones that the pupils accept willingly and if not, the pupils should be
motivated. The reluctance to deal with the problem is going to be obvious mainly in the
situations that allow an escape because the feeling of difficulties is not pleasant for every
individual. If the individual is willing to deal with the problem, it does not mean that he/she is
going to be willing to solve it. If he/she e.g., does not have the initial data for seeking the
ways of overcoming the obstacles and there are no obvious possibilities to gain the data, then
the situation is not accepted by him/her, therefore it will not be reflected in his/her thinking.
In this case there is no will connected to the effort to solve the problem going to appear. The
willingness to solve the problem, similarly as the willingness to deal with the problem, cannot
be assumed automatically, therefore it is desirable to induce it with the help of the appropriate
resources and ways, and to motivate the individual. R. E. Mayer states that the willingness is
affected by motivational and emotional factors such as the interest, the conviction (self-
confidence) and the conception of own abilities (1998). In the motivation of the individual
can appear interests, habits, ideals or external stimuli, and others, depending on the nature of
the problem. The willingness to solve the problem negatively affect three factors that cannot
be neglected. M. Nakonecny (1998) states that for the individual´s willingness to solve the
problem and deal with it is essential the probability that he/she achieves his aim. The value of
the aim, which should be achieved by solving or the subject´s expectations of possible
consequences, play an important role as well. Only two ways of being excited by motives to
solve the problem are meaningful in the educational field. First case is to create a situation
that excites the pupil, energizes him/her, and i.e., induces a state in which the pupil
experiences the impulse or forcing to the interest about the problem and its solution. The
teacher has to lead the pupil to the experience of wanting to be active. The interest about the
problem solving has to be aroused, which enables to satisfy the need resulting from the
unfamiliarity, we can speak about so-called cognitive need. M. Nakonecny (Zak lady
psychology, 1998) states that this state is characterised by a particular tension and motive
(compulsion), and for that is important to understand the problem and to perceive the obstacle
that prevents the achievement of the aim. A problem always contains a conflict or a
difficulty, which has to be overcome during the solution process. However, the obstacle has
to be conspicuous to the individual so that the conflict or a difficulty are feelable. The
mentioned state can be characterised as a disequilibrium and the individual is motivated to
balance it which leads to his/her satisfaction. The need is satisfied by solving the problem and
gaining the needed knowledge. The second way is the application of external stimuli that
cause inner motives and that are resources of satisfying the individual´s inner needs. Instead
of desire to solve the problem and satisfaction of the needs regarding its solution the
individual him/herself orients to the effective solution of the problem. The purpose stays in
this case outside the problem itself because the problem plays only a vicarious role. The pupil
solves the problem in order to achieve the aim and the problem solving becomes only a
resource. This is in terms of educational results not as beneficial as when the interest in the
problem itself appears. It is typical for the school environment to apply the stimuli that are
not natural, e.g., the pupil does not encounter grades in normal life. The problem solving can
be according to R. E. Mayer (1990) defined as a summary of the cognitive processes focused
on the change of the given state to the final state where the solution procedure is not obvious.
The given characteristics is among the experts of problem solving usually accepted (Klieme
2004; Mayer and Wittrock, 2006; Reef et al., 2006). The problem solving and its cause is
defined in the work of Funke (2010) who stated that the person’s initial knowledge of the
problem are the conditions (the given state). The operations are permissible activities that can
be performed in order to achieve the required final state (result) with the help of available
instruments. On the way to the aim are standing obstacles that have to be overcome (e.g., the
lack of knowledge or the directly obvious strategies). The process of overcoming of the
obstacles can include not only cognitive but also motivational and emotional aspects. The
solution of the didactic problem begins with the awareness of the existence of the problematic
situation followed by understanding of its essence. During the problem solving the human
being faces many obstacles and meets different possible solutions among which he/she has to
choose. His/her personality itself is a very complicated system of characteristics and roles -
their interaction is often contradictory. Fight between the motives is conditioned by that, it is
characteristic for the active behaviour: attitude and emotionally substantiated wishes of the
subject very often collide with the surrounding world (compar. Linhart, 1982). The problem
solving is a personal and aimed process. That means that the activities done by an individual
during the problem-solving process are led to his/her personal aim (Mayer and Wittrock,
2006).

Mean

The arithmetic mean of a given data is the sum of all observations divided by the number of
observations.

For example: A cricketer's scores in five ODI matches are as follows: 12, 34, 45, 50, 24. To
find his average score in a match, we calculate the arithmetic mean of data using the mean
formula.

Mean is denoted by x (pronounced as x bar).

Median

The value of the middlemost observation, obtained after arranging the data in ascending
order, is called the median of the data.
For example, consider the data: 4, 4, 6, 3, 2.

Let's arrange this data in ascending order: 2, 3, 4, 4, 6. There are 5 observations.

Thus, median = middle value i.e., 4.

We can see here: 2, 3, 4, 4 , 6  (Thus, 4 is the median).

Figure 5.1: Median

Example 1

Let's consider the data: 56, 67, 54, 34, 78, 43, 23.What is the median?

Solution

Arranging in ascending order, we get: 23, 34, 43, 54, 56, 67, 78.

Here, n (no.of observations) = 7

So,

Mode
The value which appears most often in the given data i.e., the observation with the highest
frequency is called a mode of data.

Example 1:

Find the mode of the given data.

Solution:

The highest frequency == 12, so the modal class is 40-60.

L = l = lower limit of modal class = 40

Fm = fm = frequency of modal class =12

f1 = f1 = frequency of class preceding modal class = 10

f2 = f2 = frequency of class succeeding modal class = 6

h = h = class width = 20

Using the mode formula,

Statistical Data

When full census data cannot be collected, statisticians collect sample data by developing
specific experiment designs and survey samples. Statistics itself also provides tools for
prediction and forecasting through statistical models.

To use a sample as a guide to an entire population, it is important that it truly represents the
overall population. Representative sampling assures that inferences and conclusions can
safely extend from the sample to the population as a whole. A major problem lies in
determining the extent that the sample chosen is actually representative. Statistics offers
methods to estimate and correct for any bias within the sample and data collection
procedures. There are also methods of experimental design for experiments that can lessen
these issues at the outset of a study, strengthening its capability to discern truths about the
population.

Sampling theory is part of the mathematical discipline of probability theory. Probability is

used in mathematical statistics to study the sampling distributions of sample statistics and,
more generally, the properties of statistical procedures. The use of any statistical method is
valid when the system or population under consideration satisfies the assumptions of the
method. The difference in point of view between classic probability theory and sampling
theory is, roughly, that probability theory starts from the given parameters of a total
population to deduce probabilities that pertain to samples. Statistical inference, however,
moves in the opposite direction - inductively inferring from samples to the parameters of a
larger or total population.

A common goal for a statistical research project is to investigate causality, and in particular to
draw a conclusion on the effect of changes in the values of predictors or independent
variables on dependent variables. There are two major types of causal statistical studies:
experimental studies and observational studies. In both types of studies, the effect of
differences of an independent variable (or variables) on the behaviour of the dependent
variable are observed. The difference between the two types lies in how the study is actually
conducted. Each can be very effective. An experimental study involves taking measurements
of the system under study, manipulating the system, and then taking additional measurements
using the same procedure to determine if the manipulation has modified the values of the
measurements. In contrast, an observational study does not involve experimental
manipulation. Instead, data are gathered and correlations between predictors and response are
investigated. While the tools of data analysis work best on data from randomized studies,
they are also applied to other kinds of data - like natural experiments and observational
studies—for which a statistician would use a modified, more structured estimation method
(e.g., Difference in differences estimation and instrumental variables, among many others)
that produce consistent estimators.

 Planning the research, including finding the number of replicates of the study, using
the following information: preliminary estimates regarding the size of treatment
 effects, alternative hypotheses, and the estimated experimental variability.
Consideration of the selection of experimental subjects and the ethics of research is
necessary. Statisticians recommend that experiments compare (at least) one new
treatment with a standard treatment or control, to allow an unbiased estimate of the
difference in treatment effects.

 Design of experiments, using blocking to reduce the influence of confounding

variables, and randomized assignment of treatments to subjects to allow unbiased
estimates of treatment effects and experimental error. At this stage, the experimenters
and statisticians write the experimental protocol that will guide the performance of the
experiment and which specifies the primary analysis of the experimental data.

 Performing the experiment following the experimental protocol and analysing the

data following the experimental protocol.

 Further examining the data set in secondary analyses, to suggest new hypotheses for
future study.

 Documenting and presenting the results of the study.

Experiments on human behaviour have special concerns. The famous Hawthorne study
examined changes to the working environment at the Hawthorne plant of the Western
Electric Company. The researchers were interested in determining whether increased
illumination would increase the productivity of the assembly line workers. The researchers
first measured the productivity in the plant, then modified the illumination in an area of the
plant and checked if the changes in illumination affected productivity. It turned out that
productivity indeed improved (under the experimental conditions). However, the study is
heavily criticized today for errors in experimental procedures, specifically for the lack of a
control group and blindness. The Hawthorne effect refers to finding that an outcome (in this
case, worker productivity) changed due to observation itself.

Types of Data

Various attempts have been made to produce a taxonomy of levels of measurement. The
psychophysicist Stanley Smith Stevens defined nominal, ordinal, interval, and ratio scales.
Nominal measurements do not have meaningful rank order among values, and permit any
one-to-one (injective) transformation. Ordinal measurements have imprecise differences
between consecutive values, but have a meaningful order to those values, and permit any
order-preserving transformation.

Because variables conforming only to nominal or ordinal measurements cannot be reasonably

measured numerically, sometimes they are grouped together as categorical variables, whereas
ratio and interval measurements are grouped together as quantitative variables, which can be
either discrete or continuous, due to their numerical nature. Such distinctions can often be
loosely correlated with data type in computer science, in that dichotomous categorical
variables may be represented with the Boolean data type, polytomous categorical variables
with arbitrarily assigned integers in the integral data type, and continuous variables with
the real data type involving floating point computation. But the mapping of computer science
data types to statistical data types depends on which categorization of the latter is being
implemented.

Other categorizations have been proposed. For example, Mos teller and Tukey (1977)
distinguished grades, ranks, counted fractions, counts, amounts, and balances. Nelder (1990)
described continuous counts, continuous ratios, count ratios, and categorical modes of data.
The issue of whether or not it is appropriate to apply different kinds of statistical methods to
data obtained from different kinds of measurement procedures is complicated by issues
concerning the transformation of variables and the precise interpretation of research
questions. "The relationship between the data and what they describe merely reflects the fact
that certain kinds of statistical statements may have truth values which are not invariant under
some transformations. Whether or not a transformation is sensible to contemplate depends on
the question one is trying to answer.

Descriptive Statistics

A descriptive statistic is a summary statistic that quantitatively describes or summarizes

features of a collection of information, while descriptive statistics in the mass noun sense is
the process of using and analysing those statistics. Descriptive statistics is distinguished
from inferential statistics (or inductive statistics), in that descriptive statistics aims to
summarize a sample, rather than use the data to learn about the population that the sample of
data is thought to represent.

Descriptive statistics mostly focus on the central tendency, variability, and distribution of
sample data. Central tendency means the estimate of the characteristics, a typical element of a
sample or population, and includes descriptive statistics such as mean, median,
and mode. Variability refers to a set of statistics that show how much difference there is
among the elements of a sample or population along the characteristics measured, and
includes metrics such as range, variance, and standard deviation.

The distribution refers to the overall "shape" of the data, which can be depicted on a chart
such as a histogram or dot plot, and includes properties such as the probability distribution
function, skewness, and kurtosis. Descriptive statistics can also describe differences between
observed characteristics of the elements of a data set. Descriptive statistics help us understand
the collective properties of the elements of a data sample and form the basis for testing
hypotheses and making predictions using inferential statistics.

Inferential Statistics

Statistical inference is the process of using data analysis to deduce properties of an

underlying probability distribution. Inferential statistical analysis infers properties of
a population, for example by testing hypotheses and deriving estimates. It is assumed that the
observed data set is sampled from a larger population. Inferential statistics can be contrasted
with descriptive statistics. Descriptive statistics is solely concerned with properties of the
observed data, and it does not rest on the assumption that the data come from a larger
population.

Inferential statistics are tools that statisticians use to draw conclusions about the
characteristics of a population from the characteristics of a sample and to decide how certain
they can be of the reliability of those conclusions. Based on the sample size and distribution
of the sample data statisticians can calculate the probability that statistics, which measure the
central tendency, variability, distribution, and relationships between characteristics within a
data sample, provide an accurate picture of the corresponding parameters of the whole
population from which the sample is drawn.

Inferential statistics are used to make generalizations about large groups, such as estimating
average demand for a product by surveying a sample of consumers' buying habits, or to
attempt to predict future events, such as projecting the future return of a security or asset
class based on returns in a sample period.

Regression analysis is a common method of statistical inference that attempts to determine

the strength and character of the relationship (or correlation) between one dependent variable
(usually denoted by Y) and a series of other variables (known as independent variables). The
output of a regression model can be analysed for statistical significance, which refers to the
claim that a result from findings generated by testing or experimentation is not likely to have
occurred randomly or by chance but are instead likely to be attributable to a specific cause
elucidated by the data. Having statistical significance is important for academic disciplines or
practitioners that rely heavily on analysing data and research.

Statistics, Estimators and Pivotal Quantities

Consider independent identically distributed (IID) random variables with a given probability

distribution: standard statistical inference and estimation theory defines a random sample as
the random vector given by the column vector of these IID variables. The population being
examined is described by a probability distribution that may have unknown parameters.

A statistic is a random variable that is a function of the random sample, but not a function of
unknown parameters. The probability distribution of the statistic, though, may have unknown
parameters. Consider now a function of the unknown parameter: an estimator is a statistic
used to estimate such function. Commonly used estimators include sample mean,
unbiased sample variance and sample covariance.

A random variable that is a function of the random sample and of the unknown parameter,
but whose probability distribution does not depend on the unknown parameter is called
a pivotal quantity or pivot. Widely used pivots include the z-score, the chi square statistic and
Student's t-value.

Between two estimators of a given parameter, the one with lower mean squared error is said
to be more efficient. Furthermore, an estimator is said to be unbiased if its expected value is
equal to the true value of the unknown parameter being estimated, and asymptotically
unbiased if its expected value converges at the limit to the true value of such parameter.

Other desirable properties for estimators include: UMVUE estimators that have the lowest
variance for all possible values of the parameter to be estimated (this is usually an easier
property to verify than efficiency) and consistent estimators which converges in probability to
the true value of such parameter.

This still leaves the question of how to obtain estimators in a given situation and carry the
computation, several methods have been proposed: the method of moments, the maximum
likelihood method, the least squares method and the more recent method of estimating
equations.

Null Hypothesis and Alternative Hypothesis

Interpretation of statistical information can often involve the development of a null
hypothesis which is usually (but not necessarily) that no relationship exists among variables
or that no change occurred over time.

The best illustration for a novice is the predicament encountered by a criminal trial. The null
hypothesis, H0, asserts that the defendant is innocent, whereas the alternative hypothesis, H1,
asserts that the defendant is guilty. The indictment comes because of suspicion of the guilt.
The H0 (status quo) stands in opposition to H1 and is maintained unless H1 is supported by
evidence "beyond a reasonable doubt". However, "failure to reject H0" in this case does not
imply innocence, but merely that the evidence was insufficient to convict. So, the jury does
not necessarily accept H0 but fails to reject H0. While one cannot "prove" a null hypothesis,
one can test how close it is to being true with a power test, which tests for type II errors.

Error

Working from a null hypothesis, two broad categories of error are recognized.

 Type I errors where the null hypothesis is falsely rejected, giving a "false positive".

 Type II errors where the null hypothesis fails to be rejected and an actual difference
between populations is missed, giving a "false negative".

Standard deviation refers to the extent to which individual observations in a sample differ

from a central value, such as the sample or population mean, while Standard error refers to an
estimate of difference between sample mean and population mean.

A statistical error is the amount by which an observation differs from its expected value,
a residual is the amount an observation differs from the value the estimator of the expected
value assumes on a given sample (also called prediction).

Mean squared error is used for obtaining efficient estimators, a widely used class of
estimators. Root mean square error is simply the square root of mean squared error. Many
statistical methods seek to minimize the residual sum of squares, and these are called
"methods of least squares" in contrast to least absolute deviations. The latter gives equal
weight to small and big errors, while the former gives more weight to large errors. Residual
sum of squares is also differentiable, which provides a handy property for doing regression.
Least squares applied to linear regression is called ordinary least squares method and least
squares applied to nonlinear regression is called non-linear least squares. Also, in a linear
regression model the non-deterministic part of the model is called error term, disturbance or
more simply noise. Both linear regression and non-linear regression are addressed
in polynomial least squares, which also describes the variance in a prediction of the
dependent variable (y axis) as a function of the independent variable (x axis) and the
deviations (errors, noise, disturbances) from the estimated (fitted) curve.

Measurement processes that generate statistical data are also subject to error. Many of these
errors are classified as random (noise) or systematic (bias), but other types of errors (e.g.,
blunder, such as when an analyst reports incorrect units) can also be important. The presence
of missing data or censoring may result in biased estimates and specific techniques have been
developed to address these problems.

Interval Estimation

Most studies only sample part of a population, so results don't fully represent the whole
population. Any estimates obtained from the sample only approximate the population
value. Confidence intervals allow statisticians to express how closely the sample estimate
matches the true value in the whole population. Often they are expressed as 95% confidence
intervals. Formally, a 95% confidence interval for a value is a range where, if the sampling
and analysis were repeated under the same conditions (yielding a different dataset), the
interval would include the true (population) value in 95% of all possible cases. This
does not imply that the probability that the true value is in the confidence interval is 95%.
From the frequentist perspective, such a claim does not even make sense, as the true value is
not a random variable. Either the true value is or is not within the given interval. However, it
is true that, before any data are sampled and given a plan for how to construct the confidence
interval, the probability is 95% that the yet-to-be-calculated interval will cover the true value:
at this point, the limits of the interval are yet-to-be-observed random variables. One approach
that does yield an interval that can be interpreted as having a given probability of containing
the true value is to use a credible interval from Bayesian statistics: this approach depends on a
different way of interpreting what is meant by "probability", that is as a Bayesian probability.
In principle confidence intervals can be symmetrical or asymmetrical. An interval can be
asymmetrical because it works as lower or upper bound for a parameter (left-sided interval or
right sided interval), but it can also be asymmetrical because the two-sided interval is built
violating symmetry around the estimate. Sometimes the bounds for a confidence interval are
reached asymptotically and these are used to approximate the true bounds.

Significance
Statistics rarely give a simple Yes/No type answer to the question under analysis.
Interpretation often comes down to the level of statistical significance applied to the numbers
and often refers to the probability of a value accurately rejecting the null hypothesis
(sometimes referred to as the p-value).

The standard approach is to test a null hypothesis against an alternative hypothesis. A critical
region is the set of values of the estimator that leads to refuting the null hypothesis. The
probability of type I error is therefore the probability that the estimator belongs to the critical
region given that null hypothesis is true (statistical significance) and the probability of type II
error is the probability that the estimator doesn't belong to the critical region given that the
alternative hypothesis is true. The statistical power of a test is the probability that it correctly
rejects the null hypothesis when the null hypothesis is false.
 Figure 5.2: Set of possible results

Referring to statistical significance does not necessarily mean that the overall result is
significant in real world terms. For example, in a large study of a drug it may be shown that
the drug has a statistically significant but very small beneficial effect, such that the drug is
unlikely to help the patient noticeably.

Although in principle the acceptable level of statistical significance may be subject to debate,

the significance level is the largest p-value that allows the test to reject the null hypothesis.
This test is logically equivalent to saying that the p-value is the probability, assuming the null
hypothesis is true, of observing a result at least as extreme as the test statistic. Therefore, the
smaller the significance level, the lower the probability of committing type I error.

Some problems are usually associated with this framework.

 A difference that is highly statistically significant can still be of no practical

significance, but it is possible to properly formulate tests to account for this. One
response involves going beyond reporting only the significance level to include the p-
value when reporting whether a hypothesis is rejected or accepted. The p-value,
however, does not indicate the size or importance of the observed effect and can also
seem to exaggerate the importance of minor differences in large studies. A better and
increasingly common approach is to report confidence intervals. Although these are
produced from the same calculations as those of hypothesis tests or p-values, they
describe both the size of the effect and the uncertainty surrounding it.

 Fallacy of the transposed conditional, aka prosecutor's fallacy: criticisms arise

because the hypothesis testing approach forces one hypothesis (the null hypothesis) to
be favoured, since what is being evaluated is the probability of the observed result
given the null hypothesis and not probability of the null hypothesis given the observed
result. An alternative to this approach is offered by Bayesian inference, although it
requires establishing a prior probability.

 Rejecting the null hypothesis does not automatically prove the alternative hypothesis.

 As everything in inferential statistics it relies on sample size, and therefore under fat

tails p-values may be seriously mis-computed.

Statistics is a branch of applied mathematics that involves the collection, description,

analysis, and inference of conclusions from quantitative data. The mathematical theories
behind statistics rely heavily on differential and integral calculus, linear algebra, and
probability theory. Statisticians, people who do statistics, are particularly concerned with
determining how to draw reliable conclusions about large groups and general phenomena
from the observable characteristics of small samples that represent only a small portion of the
large group or a limited number of instances of a general phenomenon.

The two major areas of statistics are known as descriptive statistics, which describes the
properties of sample and population data, and inferential statistics, which uses those
properties to test hypotheses and draw conclusions.

Statistics are used in virtually all scientific disciplines such as the physical and social
sciences, as well as in business, the humanities, government, and manufacturing. Statistics is
fundamentally a branch of applied mathematics that developed from the application of
mathematical tools including calculus and linear algebra to probability theory.

In practice, statistics is the idea we can learn about the properties of large sets of objects or
events (a population) by studying the characteristics of a smaller number of similar objects or
events (a sample). Because in many cases gathering comprehensive data about an entire
population is too costly, difficult, or flat out impossible, statistics start with a sample that can
conveniently or affordably be observed.

Two types of statistical methods are used in analysing data: descriptive statistics and

inferential statistics. Statistician’s measure and gather data about the individuals or elements
of a sample, then analyse this data to generate descriptive statistics. They can then use these
observed characteristics of the sample data, which are properly called "statistics," to make
inferences or educated guesses about the unmeasured (or unmeasured) characteristics of the
broader population, known as the parameters.

Statistics in Singular Sense

In the singular sense, statistics means science of statistics or statistical methods. If refers to
techniques or methods relating to collection, classification, presentation, analysis and
interpretation of quantitative data. These are the stages through which every statistical
enquiry has to pass through. We shall discuss these stages one by one.

Collection of Data

Collection of data is the first step of a statistical enquiry. Statistical data are mainly classified
into primary and secondary data. Primary data are data collected directly through survey,
directly from first hand sources by means of surveys, observations or experimentations.
These are data that has not been previously published. Secondary data are data collected from
other sources including published and online resources. For example, Reserve Bank of India
Bulletin and National Accounts Statistics are published data i.e., Secondary data. You will
read more about primary and secondary data in the next lesson.

Organisation of Data

Organisation of the data refers to the arrangement of data in such a form that comparison of
the mass of similar data may be facilitated and further analysis may be possible. An important
method of organization of data is to distribute data into different classes or sub-classes on the
basis of their characteristics. This process is called classification of data.

Presentation of Data

The presentation of data means exhibition of the data in such a clear and attractive manner
that these are easily understood and analysed. There are many forms of presentation of data
of which the following three are well known: textual or descriptive presentation, tabular
presentation and diagrammatic presentation. You will study more about this in the next
lesson.

Analysis of Data

After the data have been collected, organized and presented, they need to be analysed.
Analysis of data is a technique through which significant facts from the numerical data are
extracted. One of the most important objects of statistical analysis is to get one single value
that describes the characteristic of the whole data. Analysis of an economic or other problems
is not possible without the use of certain statistical tools such as measures of central tendency
like mean, median or mode.

Interpretation of Data

Interpretation of data is the last stage of a statistical enquiry. After making analysis with the
help of statistical tools, we interpret the data to derive some conclusions in order to formulate
certain policies. Interpretation must be done carefully, as wrong interpretation will lead to
formulation of wrong policies and hence do more harm than good.
5.8 SUMMARY

 The ultimate goal of research is to produce dependable knowledge or to provide the

evidence that may guide practical decisions. Statistical conclusion validity (SCV)
holds when the conclusions of a research study are founded on an adequate analysis of
the data, generally meaning that adequate statistical methods are used whose small-
sample behaviour is accurate, besides being logically capable of providing an answer
to the research question. Compared to the three other traditional aspects of research
validity (external validity, internal validity, and construct validity), interest in SCV
has recently grown on evidence that inadequate data analyses are sometimes carried
out which yield conclusions that a proper analysis of the data would not have
supported.

 This paper discusses evidence of three common threats to SCV that arise from
widespread recommendations or practices in data analysis, namely, the use of
repeated testing and optional stopping without control of Type-I error rates, the
recommendation to check the assumptions of statistical tests, and the use of regression
whenever a bivariate relation or the equivalence between two variables is studied. For
each of these threats, examples are presented and alternative practices that safeguard
SCV are discussed. Educational and editorial changes that may improve the SCV of
published research are also discussed.

 Psychologists are well aware of the traditional aspects of research validity introduced
by Campbell and Stanley (1966) and further subdivided and discussed by Cook and
Campbell (1979). Despite initial criticisms of the practically oriented and somewhat
fuzzy distinctions among the various aspects, the four facets of research validity have
gained recognition and they are currently covered in many textbooks on research
methods in psychology (e.g., Beins, 2009; Goodwin, 2010; Girden and Kabacoff,
2011).

 Methods and strategies aimed at securing research validity are also discussed in these
and other sources. To simplify the description, construct validity is sought by using
well-established definitions and measurement procedures for variables, internal
validity is sought by ensuring that extraneous variables have been controlled and
confounds have been eliminated, and external validity is sought by observing and
measuring dependent variables under natural conditions or under an appropriate
 representation of them. The fourth aspect of research validity, which Cook and
Campbell called statistical conclusion validity (SCV), is the subject of this paper.

 Statistical conclusion validity is the degree to which conclusions about the

relationship among variables based on the data are correct or "reasonable". This began
as being solely about whether the statistical conclusion about the relationship of the
variables was correct, but now there is a movement towards moving to "reasonable"
conclusions that use: quantitative, statistical, and qualitative data. Fundamentally, two
types of errors can occur: type I (finding a difference or correlation when none exists)
and type II (finding no difference or correlation when one exists).

 Statistical conclusion validity concerns the qualities of the study that make these types
of errors more likely. Statistical conclusion validity involves ensuring the use of
adequate sampling procedures, appropriate statistical tests, and reliable measurement
procedures.

 Beware false confidence - You may soon develop a smug sense of satisfaction
that your work doesn’t screw up like everyone else’s. But I have not given you a
thorough introduction to the mathematics of data analysis. There are many ways to
foul up statistics beyond these simple conceptual errors.

 Errors will occur often, because somehow, few undergraduate science degrees or
medical schools require courses in statistics and experimental design – and some
introductory statistics courses skip over issues of statistical power and multiple
inference.

 This is seen as acceptable despite the paramount role of data and statistical analysis in
the pursuit of modern science; we wouldn’t accept doctors who have no experience
with prescription medication, so why do we accept scientists with no training in
statistics? Scientists need formal statistical training and advice.

 Data are collected with the help of statistical methods, they are made simple and
informative, and with the help of proper conclusions are obtained. There are many
methods to get help to collect data and make them eligible for use. These methods are
called statistical methods.
  If science is knowledge then art is action i.e., art refers to the branch of knowledge
which changes the best methods for solving various problems and the measures for
achieving the facts are also suggested.

5.9 KEYWORDS

 Mean - The mean is the average or the most common value in a collection of

numbers. In statistics, it is a measure of central tendency of a probability distribution
along median and mode. It is also referred to as an expected value.

 Median - The median is the middle number in a sorted, ascending or descending, list
of numbers and can be more descriptive of that data set than the average. The median
is sometimes used as opposed to the mean when there are outliers in the sequence that
might skew the average of the values.

 Mode - The mode is the value that appears most frequently in a data set. A set of data
may have one mode, more than one mode, or no mode at all. ... The mode can be the
same value as the mean and/or median, but this is usually not the case.

 Arithmetic Mean - The arithmetic mean is the simplest and most widely used
measure of a mean, or average. It simply involves taking the sum of a group of
numbers, then dividing that sum by the count of the numbers used in the series.

 Harmonic Mean - The harmonic mean is a type of numerical average. It is calculated

by dividing the number of observations by the reciprocal of each number in the series.
Thus, the harmonic mean is the reciprocal of the arithmetic mean of the reciprocals.

5.10 LEARNING ACTIVITY

1. Create a session on nature and scope of statistics.

___________________________________________________________________________
___________________________________________________________________________

2. Create a survey on relationship of economics to statistics.

___________________________________________________________________________
___________________________________________________________________________
5.11 UNIT END QUESTIONS

A. Descriptive Questions

Short Questions

1. What is median?

2. What is mode?

3. Define mean.

4. Define arithmetic mean?

5. Write the formula of harmonic mean?

Long Questions

1. Explain about nature and scope of statistics.

2. Illustrate the relationship of economics to statistics.

3. Discuss the merits of statistics.

4. Illustrate the geometric mean.

5. Examine the relationship of economics to statistics.

B. Multiple Choice Questions

1. Which among the following values is used as a summary measure for a sample, such
as a sample mean?

a. Population parameter
b. Sample parameter
c. Sample statistic
d. Population mean

2. Which one of the following is a branch of statistics?

a. Descriptive statistics
b. Inferential statistics
c. Industry statistics
 d. Both A and B

3. Which is the category under which the control charts and procedures of descriptive
statistics which are used to enhance a procedure can be classified into?

a. Behavioural tools
b. Serial tools
c. Industry statistics
d. Statistical tools

4. Which among the following options do individual respondents, focus groups, and
panels of respondents belong to?

a. Primary data sources

b. Secondary data sources
c. Itemized data sources
d. Pointed data sources

5. Which one of the following are the variables whose calculation is done according to
the weight, height, and length known as?

a. Flowchart variables
b. Discrete variables
c. Continuous variables
d. Measuring variables

Answers

1-c, 2-d, 3-d, 4-a, 5-c

5.12 REFERENCES

Reference

 Chance, Beth L.& Rossman, Allan J. (2005)."Preface" (PDF). Investigating Statistical

Concepts, Applications, and Methods.
  Lakshmikanthan, D. Kannan, V. (2002). Handbook of stochastic analysis and
applications.

 Schervish, Mark, J. (1995). Theory of statistics. Second edition.

Textbook

 Helen, Mary, Walker. (1975). Studies in the history of statistical method.

 Galton, F (1877). "Typical laws of heredity". Nature. 15 (388)

 Stigler, S.M. (1989). "Francis Galton's Account of the Invention of Correlation".

Website

 https://en.wikipedia.org/wiki/Statistics

 https://www.investopedia.com/terms/m/mean.asp

 http://statisticalconcepts.blogspot.com/2010/04/averages.html