MICRO ECONOMICS

-: Chapter 1:-
INTRODUCTION
Economics
It is a social science of human behavior which deals with the allocation of resources in
such a manner that consumers can maximise their satisfaction, producers can maximise
their profit and society can maximise its welfare. Economic is both a science as it talks
about objective and standardized concepts, and also it is a social science as it talks about
the theories of different individuals.
OR
It refers to the rational management of scarce resources such that economic gains are
maximised at the micro and macro level.
Economy
It is a framework within which all the economic activities are carried out. It shows how
people of the concerned area earn their livings.
OR
It is a system by which people can earn a living .
Economic activities
It means that activity which is based on or related to the use of scarce resources for the
satisfaction of human wants. For example- Consumption
OR Activities which are done for exchange of money.
Economic Problem (Problem of Choice)
It is a problem of choice or in other words, it's concerned with the use of scarce resources
among alternative human wants and using their resources towards the end of satisfying
wants as fully as possible. Economic problem leads to humans making a choice, as they
have limited resources in hand.
Problem of choice for producer- as the producers have limited factors of production
(inputs), they have to make a choice among which commodity to produce.
Problem of choice for consumer- as the consumers have limited amount of money, they
have to make a choice among which commodity to purchase.
Resources- a stock of capital, humans, materials and other assets that can be used in
effective functioning and production. (factors of production-land, labour, capital,
entrepreneurship, raw material, fuel and power)
Causes of an Economic problem
An economic problem or problem of choice arises due to the following reasons:
1. Scarcity of resources (Demand > supply)
Scarcity is the prime cause of all economic problems i.e. problem of choice mainly
arises due to scarcity.
As the resources in any economy are limited in nature, problem of choice arises. The
supply of the commodities is fixed and limited, but there is unlimited demand for those
resources.
2. Human wants are unlimited and recurring in nature.
 No man can satisfy all his wants.
 As one want is satisfied, many other come up.
Therefore, we can say that satisfaction of all wants is not possible and problem of choice
arises.
3. Alternative use of resources
Resources can be put to various alternative uses. For example, a piece of land may be
used to grow wheat, rice or may be used for construction of building. Here we face the
problem of choice.

Difference between positive and normative economics-

Positive economics Normative economics
 Its objective is to determine the facts  Its aim is to determine the norms or
and reality. aims.
 Questions arising in positive  Questions arising is normative
economics are what is, what was and economics is what ought to be or
what would be. what should be.
 It focuses on the actual economic  Normative statements offer value
situation judgments (opinions about right and
wrong of a policy)
 ECONOMICS (subject matter)

MICRO ECONOMICS MACRO ECONOMICS

Micro-Economics
(i) Unit of study:- It studies the economic behavior of individual economic units or is
concerned with study of individuals.
(ii) Scope :- It has a narrow scope.
(iii) Alternative name :- Price theory
Macro Economics
(i) Unit of study :- It is concerned with the behavior of the economy as a whole or deals
with aggregate of economy.
(ii) Scope :- It has a wide scope.
(iii) Alternative name :- Income – employment theory.
Difference between micro and macro economics-
Micro Economics Macro Economics
1 It is a branch of economics which deals It is a branch of economics which deals
with the study of individuals. with the study of aggregates (total or
averages of total)
2 Problem of allocation of resources is to Problem of how to achieve fuller and
be studied under micro economics. how to achieve growth is studied under
macro economics.
3 It is concerned with the pricing It is concerned with income theories.
theories.
4 MICROECONOMIC VARIABLES MACROECONOMIC VARIABLES
- Demand of a consumer - National Income
- Supply by a producer - Aggregate supply in the economy
- Cost of a product - Budget of a government
- Revenue - Money and Banking
- Textile industry -All the industries in the market
Types Of Economies
MARKET ECONOMY/ PLANNED MIXED ECONOMY
CAPITALIST ECONOMY/
ECONOMY SOCIALIST
ECONOMY
1. Objective: Profit Objective: Social
Maximization Welfare
2. It is an economy where It is an economy where It is an economy where
all the resources are all the resources are resources are owned and
managed and owned by owned and managed by managed by both private
private sector. the government. and public sector.

3. Problems are solved by Problems are solved by Both price mechanism

price mechanism central planning and central planning
(through forces of authority. authority solve the
demand & supply) Eg : China, Russia economic problems.
Eg: USA, UK Eg: India

CENTRAL PROBLEMS OF AN ECONOMY :

Allocation of resources How to achieve fuller How to achieve growth of

utilisation of resources resource.
(how to allot the available
resources)

- What to produce ? (how to fully utilize or (how to have increment in

- How to produce ? exhaust the available the existing resources)
resources.)
- For whom to produce ?
NOTE : Above 3 problems are known as central problem of an economy because these are
faced by all types of economies (capitalist / socialist). Allocation of resources, is a
problem dealt in micro economics.

Allocation of resources
1. What to Produce and in what quantity
A major problem is to decide what commodities should be produced and in what
quantities with the limited resources.
It is the problem of choice among different types of goods.
a) Consumer Goods ( choice between them)
 b) Choice between Necessary Goods and Luxury Goods
Necessary goods :- bread clothes, houses etc.
Luxury goods :- car, gold ornaments etc.
c) Choice between Private goods (sofa, fridge)
and Public Goods (parks, bridges)
d) Choice between Civil Goods (shoes, bags) and War Time Goods (explosives, gun)
- This problem arises due to Scarcity of Resources.
- It is on the basis of these choices, a country decides the allocations of scarce
resources for the production of various commodities.
2. How to produce?
- It is related with the Problem of Choice of Technique used for production.
- This problem is concerned with more production at lower cost or efficient use of
resources.
There are two types of technique :
a) Labour Intensive Technique
It is the technique in which proportionate use of labour is greater than
proportionate use of Capital. This technique leads to a greater employment and
thus growth in national income.
b) Capital Intensive Technique
It is the technique in which proportionate use of Capital is greater than
proportionate use of Labour. This technique leads to quality-efficient, less time
consuming and cost-efficient production.
(The technique with maximum productivity and least cost is chosen.)
3. For whom to produce?
It is problem of distribution of final goods and services i.e. the problem of distribution.
The problem has two aspects
1. Personal distribution – ( Distribution of outputs)
It states that how should production/output be distributed among different individuals and
households of society.
2. Functional distribution – (Distribution of income)
It means how should the income generated from the sale of the production be distributed
among different factors of production viz Land, labour, Capital, and the Entrepreneur as
their reward. Also called factorial distribution, where land gets rent, labour gets wages,
capital gets interest and entrepreneur gets profit from the revenue of the production.
 PRODUCTION POSSIBILITY CURVE
[Production Possibility Boundary / Production Possibility Frontier / Transformation
Curve / Transformation Line ]
It is that graphical presentation which shows various possible combinations of two goods
that can be produced within given resources, assuming that all the techniques being
constant and resources are fully utilised.
It is a graphical showcase of different combinations of maximum units of X and Y that a
producer can produce, using all the resources he/she has.
- ASSUMPTIONS OF PPC
(i) Two commodities
(ii) Resources are fixed
(iii) Fuller utilization of resources – No resources are equally efficient in the production
of all the goods .
(iv) State of technology is constant
- SCHEDULE AND DIAGRAM
Δ in loss of Y
X Y MOC =
Δ in gain of X
A 0 100 - increasing
MOC –
B 1 90 10
(concave to
C 2 70 20 the origin)
D 3 40 30
E 4 0 40
- FEATURES OF PPC
1. PPC is downward sloping curve from left to right.
Because PPC represents combination of two goods which is to be produced within
fixed resources and constant technology, therefore when producer increases the
production of one good, he has to sacrifice the production of another good.
2. PPC is concave to the Origin
To produce additional units of X, the producer has to sacrifice more and more units of Y.
The rate at which, production of one good is sacrificed, for the production of an additional
unit of another good is known as MOC.
Because of increasing MOC, PPC is concave to the origin. This means that the producer
has to lose more and more units of Y commodity, to produce one more unit of X
commodity, as we move downwards along the PPC.
This is because it becomes difficult to substitute resources, specialized in production of one
good to suit the production of other good.
Marginal Opportunity cost (MOC) refers to the ratio of change in loss of Y commodity to
change in gain of X commodity. [For a rational producer, PPC is always CONCAVE]
Δ in loss of Y
MOC =
Δ in gain of X
Note 1: PPC can be a straight line when MOC is constant.
X Y MOC
1 80 20
2 60 20
3 40 20
4 20 20
5 0 20

Note 2: PPC may be CONVEX to the origin when MOC is diminishing.

X Y MOC
1 60 40
2 30 30
3 10 20
4 0 10

MARGINAL RATE OF TRANSFORMATON

MRT is the rate at which resources are being shifted from the production of one good to
production of other good (MOC = MRT)
Δ in loss of Y
MOC =
Δ in gain of X

OPPORTUNITY COST

Opportunity cost refers to the sacrifice for the next best alternative use of resource.
Or
Opportunity cost is the cost one has to bear for a better opportunity.
Opportunity cost concept ensures that producer will shift to the next best alternative
assignment, if a producer is getting more than what he/she is losing, within the same
resources.
It is what a person loses or what he/she gives up.
For eg. The opportunity cost of opting for higher studies rather than a job is the amount of
wages or salary that the person would have earned in a job.

ATTAINABLE AND UNATTAINABLE COMBINATION OF GOODS

(combinations, a producer can and cannot produce)

 A, B & E attainable (it shows efficient use of the resources and technology)
 D is unattainable. (as the producer doesn‟t have enough resources to produce this
combination).
  C is also attainable combination. (it shows inefficient use of the resources and
technology)
With the help of PPC the following situations are shown :
1. Fuller utilisation of resources.
2. Under utilisation of resources.
3. Growth of resources.

A & B : Fuller utilisation of resources and the use of Efficient technology

C : Under utilization of resources and the use of inefficient technology.
G : Growth of resources.
– Examples of growth of resources:
(i) Availability of new equipment
(ii) Increase in skilled labour through population growth. (also true for unskilled labour)
(iii) Discovery of new resources.
(iv) Repair of technology / equipment.

SHIFTING OF PPC
1. PPC shifts from left to right:
It shows that the producer can produce more of both the commodities.
This can be due to-
(i) Improvement in technology of producing both the goods.
(ii) Increment in resources (physical, financial, human.)

2. PPC shifts from right to left:

It shows that the producer can produce less of both the commodities.

This can be due to-

(i) Destruction of resources.
(ii) Obsolesce of technology of producing both the goods.

ROTATION OF PPC-
CASE I
This shows that the producer can produce more of X commodity and the same
quantity of Y commodity.
As-
 When technology of producing X commodity improves
 Resources of good X increases.

CASE II
This shows that the producer can produce more of Y commodity and the same
quantity of X commodity.
 As-
 Improvement in technology of producing Y commodity
 Resources of good Y increases
- Following situations of ROTATION OF PPC are also possible :
CASE III CASE IV
This shows that the producer can This shows that the producer can
produce more of X commodity produce more of Y commodity
with the same quantity of Y with the same quantity of X
commodity. commodity.

As- As-
 Obsolesce of Technology of  Obsolesce of technology of
producing X commodity. producing Y commodities.
 Destruction of resources,
 Destruction of resources
required for X commodity
required for Y commodity.
*HOTS*
1. Why is MOC always increasing?
It increases because no resource is equally efficient in production of all goods. As the
resources are transferred from one good to another good, MOC increases because less
and less efficient resources are transferred each time.
2. An economy always produces on its PPC? Defend or refute.
No, an economy tries to do so, however efficient and fuller utilisation of resources is
not possible.
3. Which of the following statements are true or false ? Give reasons.
(i) An economy always produces on but not inside the PP curve .
(ii) Massive unemployment shifts the PP curve to the left .
(iii)An economy cannot operate on any point outside the PP curve .
(i) False . When there is underutilization or inefficient utilization of resources ,
The economy will produce at a point inside the PPC .
(ii)False . Massive unemployment does not cause a shift in the PPC
but causes the economy to operate at a point inside the PPC .
(iii)True . A PPC is drawn assuming given resources and constant technology .
With these assumptions , the economy can operate at a point on PPC but not
beyond it
5. What is the slope of PPC? What does it show?
MOC is the slope of PPC and due to increasing MOC, PPC is concave to the origin. It
shows increasing slope i.e. more and more of commodity Y is to be sacrificed for every
additional unit of commodity X produced.
6. "Scarcity and choice are inseparable." – Comment
It can be explained with the help of following points .
i) AT CONSUMER'S LEVEL
Scarcity means limited income and choice means allocation of income to the extent that
different goods and services can be purchased in such a manner that he/she can
maximize his/her SATISFACTION.
ii) AT PRODUCER'S LEVEL
Scarcity means limited resources (inputs) and choice means allocation of resources for
production of goods and services in such a manner that he/she can maximize his/her
PROFITS.
iii) AT National LEVEL(Society Level)
Scarcity means limited national resources and choice means use these of resources in
such a manner that social welfare can be maximized.
7. Why does the need for economizing the resources arise?
Economizing resources means not wasting the resources, and not overspending the
resources unnecessarily. This need arises because the resources are limited and scarce
in nature.
8. In case of technology being constant, what option do we have to raise the level of
output?
If technology is constant, in order to increase the output, we can fully utilize the
available resources and exhaust them in the best possible way, so that they work on
their fullest potential, and subsequently output increases. Also, we can make the
resources more efficient by spreading education and skill-training, so that the resources
increase, and we can produce more of output.
9. Labour absorbing technology is given up in preference to capital intensive
technology. State its economic value in the context of production possibility
frontier for the domestic economy.
If labour absorbing technology is given up, that means that lesser labour is employed in
the production process which leads to unemployment. This means that there is less
income generation leading to fall in the national income. The production will be inside
the PPC as the human resources are not fully utilized.
10. What does concavity of PPC implies?
It implies that the slope of PPC, i.e MOC, is increasing.
11. The nation has two alternatives of producing 100X + 200Y or 102X + 196Y
from its given resources. The nation chooses the second. What is the MOC of
producing X?
2Y, is the MOC of producing X as MOC =
Δ in loss of Y
Δ in gain of X
12. If a person has Rs.200, with which he can either eat in a restaurant or buy a
book. He buys the book, what is the opportunity cost of buying that book?
Eating Rs.200 of food in the restaurant is the opportunity cost.
Economic changes and PPC-
Case Impact on Reason
PPC of India
1. Establishment Outward shift Skill development will improve, which would
of large number (shifts to the result in increase the production potential of the
of institutions of right) country.
science.
2. Floods Inward shift Reduction in resources due to destruction by
(shifts to the floods leading to fall in production potential.
left)
3. Swachh Bharat Outward shift Cleanliness reduces chances of people falling ill
Mission (shifts to the and thus insures better health. This reduces the
right) labour being absent from the work. This in turn,
improves the efficiency level and increases the
production potential of the country
4. Outflow of Inward shift Reduction in resources
foreign capital (shifts to the
left)
5. „Make in India‟ Outward shift More foreign investment, leading to increase in
appeal to (shifts to the resources.
foreign right)
investors
6. Education Outward shift Education raises efficiency by making the
campaign (shifts to the people skilled, increasing production potential.
right)
8. Economic No effect on PPC shows what a country can potentially
slowdown PPC produce, not what it actually produces.
Slowdown will bring down the output and the
production will be inside the PPC.
9. Efforts towards No effect on Help in reaching the fullest potential. There is no
reducing PPC increase in the resources. Just the existing
unemployment resources are put to use.
 -:Chapter 2:-
CONSUMER EQUILIBRIUM
CONSUMER
Consumer is an economic agent who purchases goods and services to satisfy his/her
wants directly.
EQUILIBRIUM
It's a state of BALANCE
Or
It's a state of rest position where two forces become equal and where there is no tendency
to change (rest position)
OBJECTIVE OF CONSUMER EQUILIBRIUM -
Consumer equilibrium is a DECISION MAKING CONCEPT. With the help of this
approach a consumer decides rationally whether a product should be purchased or not.
A consumer is supposed to be in equilibrium when :
Price = Satisfaction in terms of money.
OR
Whatever amount consumer
= whatever amount consumer is willing to pay
actually does pay
- It is a situation when the consumer attains the maximum satisfaction possible from the
consumption of commodity/commodities, within the amount he is spending on the
commodity/commodities.
- To understand CONSUMER EQUILIBRIUM, we have to study two approaches:

MARSHALL APPROACH HICKS & ALLEN

CARDINAL APPROACH/ APPROACH / ORDINAL
UTILITY APPROACH APPROACH/
INDIFFERENCE CURVE
APPROACH
 MARSHALL'S APPROACH

Single commodity model Several commodity model

- Marshall used a term UTILITY, to define satisfaction-

UTILITY
- It refers to the want satisfying power of a commodity or it refers to satisfaction
derived from commodity.
It's a psychological concept but Marshall considered following assumptions/ Hypothesis :
1. Utility can be measured in cardinal numbers (like 1,2,3................)
2. Utility can be measured in a hypothetical unit: utils.
3. Each and every unit of commodity has its independent utility.
TYPES OF UTILITY
1. MARGINAL UTILITY
It refers to change in total utility due to consumption of an additional unit of commodity.
or
It refers to satisfaction derived from each individual unit of a commodity. It is the
amount of satisfaction received from consuming a particular unit of a commodity. Eg.-
when a consumer consumed 4th apple, she received 10 utils of satisfaction from that 4th
apple and thus MU=10.
MU = TUn – TUn-1
Or
ΔTU
MU =
Δ units consumed
2. TOTAL UTILITY
It refers to the total satisfaction derived by consuming all the units of a commodity.
Or
It refers to the sum total of SATISFACTION derived from consuming all the units of a
commodity. Eg.- when the consumer consumed 4 units of apple, she received 370 utils of
satisfaction till the 4th apple, thus TU= 370
TU = ΣMU
 Units consumed Satisfaction TU MU
0 0 0 0
1st 200 200 200
nd
2 120 320 120
3rd 40 360 40
4th 10 370 10
th
5 0 370 0
6th -40 330 -40

# RELATIONSHIP B/W TOTAL UTILITY AND MARGINAL UTILITY

 When MU falls but above zero or remains Positive, TU rises.

 When MU becomes zero, TU at its MAXIMUM (such point is known as point of
satiety or full satisfaction)
 When MU becomes negative, TU falls
NOTE 1: Shape of TU curve is Inverse 'U' shape.
NOTE 2: Shape of MU curve is Downward Sloping from left to right.

LAW OF DIMINISHING MARGINAL UTILITY

 INTRODUCTION
The law of Diminishing Marginal Utility was initially propounded by a German
economist H.H. Gossen but was given a systematic formulation by Alfred Marshall. It
is also known as “the first law of Gossen”.
 MEANING
 This law states that when a consumer consumes an adequate quantity of a commodity
continuously , satisfaction derived from each individual unit keeps on diminishing.
 In other words, this law states that marginal utility from each successive unit keeps on
diminishing as the consumer increases its consumption continuously.
 Thus, more the consumption, the less will be MU, and less the consumption, the more
will be MU.
 ASSUMPTIONS OF THE LAW :
a. All the units of commodity must be same (adequate and suitable) in all respects
(size, colour , quantity , quality ,etc)
b. Consumption of commodity must be continuous without time interval .
c. There should be no change in taste and preferences of a consumer .
Schedule :
Units Consumed Marginal Utility
0 0
1 400
2 200
3 120
4 40
5 10
6 0
7 -40
point of satity
Diagram :

point of satity
- Exceptions of LDMU (situations or commodities where satisfaction doesn‟t
decrease, with continuous consumption.)
i) Inadequate quantity
ii) Time gap
iii) Liquor consumption
iv) Jewellery
v) Cash (in case of poor)
 vi) Rare commodities (antiques and monuments)
vii) If substitutes are readily available
Conclusion
Law of Diminishing Marginal Utility is considered as the “Fundamental Law of
Satisfaction” or “Fundamental Psychological Law” because it has universal
applicability .

Determination of consumer equilibrium in case of single commodity:

Here Marshall wants to show, how many units of a commodity a rational consumer
should consume, so that he/she can achieve maximum level of satisfaction, if he/she is
purchasing a single commodity.
- Meaning
Consumer equilibrium refers to a situation when consumer can maximize his satisfaction
within his given level of income without making any change in his existing expenditure.
- Assumptions : (LDMU C2 3 constant)
1. Law of diminishing marginal utility should be applicable /applied.
2. Consumer is a rational being.
3. Cardinal measurability of utility.
4. Taste and preference should be constant.
5. Price of commodity should be constant.
6. Marginal utility of money (Additional utility in terms of money on account of
expenditure of the last rupee on the available goods & services OR It is worth of a
rupee ) should be constant.
- Condition of equilibrium condition-
Consumer equilibrium is attained when :

= Px or = MU

Schedule
Consumer equilibrium in a single commodity model case is illustrated by numerical
example in the given table . Suppose the consumer wants to buy X commodity .
Units MUx MUm Px +/-
Consumed (x)
0 0 4 2 - -
st
1 20 Utils 4 Utils Rs 2 Rs 5 +3 Consumer surplus
2nd 16 ” 4 ” Rs 2 Rs 4 +2
3rd 12 ” 4 ” Rs 2 Rs 3 +1
4th 8 ” 4 ” Rs 2 Rs 2 0 Consumer equilibrium
5th 4 ” 4 ” Rs 2 Rs 1 -1 Consumer deficit
6th 0 ” 4 ” Rs 2 Rs 0 -2

From the above schedule and diagram it can be concluded that:

 A rational consumer will purchase till 4th unit or until consumer equilibrium is
reached i.e. will purchase 4 units of X commodity where-

= Px (Consumer equilibrium is attained)

 From the first three units consumer is getting a surplus of Rs. 6 (3+2+1)
> Px (Consumer surplus)

This shows that a consumer should consume more units of the commodity.

 A rational consumer would not purchase beyond 4th unit because consumer is in
deficit where

< Px (Consumer deficit)

This shows that the consumer should consume less units of the commodity.

Determination of consumer equilibrium in case of several

commodities: (Two commodities Model).
When the consumer is buying two commodities, Marshall explained, how many units of
one commodity and how many units of another commodity, should a rational consumer
buy, to attain the maximum level of satisfaction, within his/her income, from those two
commodities.
- Base
 a. When a consumer wants to buy two or more commodities , his equilibrium will be
determined by the Law of Equi-Marginal Utility’. In this case he will distribute his
money income among those goods in such a way that he gets equal marginal utility
from all the goods .
b. The „Law of Equi-Marginal Utility‟ states that a consumer will attain the
equilibrium when the marginal utilities of the various commodities that he
consumes are equal .
c. „Law of Diminishing Marginal Utility‟ also applies in the two commodity case

- Conditions of equilibrium
a. In case of two commodities a consumer gets maximum satisfaction when a rupee
worth of marginal utility is same for both the commodities .
In other words , ratio of marginal utility to price in case of each good is same
= = MUm
(Note : Derivation of this condition
If = MUm and = MUm
Then , = = MUm )

b. Consumer has to spend his entire income , in other words , at equilibrium point the
money is spent is just equal to income. (expenditure = income).
( Px x Qx ) + ( Py x Qy ) = M (income)

- Tabular presentation
This Model can be explained with the help of following schedule :
Px = Rs 8 / unit Y = Rs 38 Py = Rs 2/ unit Mum = 8 utils
Units consumed MUx MUy MUx MUy
Px Py
0 - - - -
1 80 40 10 20
2 72 36 9 18
3 64 32 8 16
4 56 28 7 14
5 48 24 6 12
6 40 20 5 10
7 32 16 4 8
8 24 12 3 6
9 16 8 2 4
10 8 4 1 2
From the above schedule, it can be concluded that following bundles must be taken into
consideration (as in these bundles = )

(1x,6y) 1x8+6x2 = Rs. 20

(3x,7y) 3x8+7x2 = Rs. 38
(5x,8y) 5x8+8x2 = Rs. 56
(7x,9y) 7x8+9x2 = Rs. 74
(9x,10y) 9x8+10x2 = Rs. 92
Out of the above combinations consumer equilibrium will be established at (ii) 3x + 7y
a. The consumer will allocate his income of Rs. 38 among two commodities in such a
way that the ratio of marginal utilities to the respective prices of both the commodities
are equal among these bundles .
= = MUm
8 = 8 = 8
b. In order to be in equilibrium consumer will buy 3 units of X commodity and 7 units of
Y commodity .
c. At the equilibrium point consumer has to spend his entire income .
( Px x Qx ) + ( Py x Qy ) = M
3x8 + 7x2 = Rs. 38
- Diagrammatic presentation

- Explanation
 It is clear from the diagram that consumer will get maximum satisfaction if he buys
only that quantity of each good that gives him same utility from the last rupee spent
on each good . In other words , must be equal to .
  If is not equal to then the consumer is not in equilibrium. If >
then per rupee MUx > per rupee MUy . He will buy more of X and less of Y good .
This will reduce MUx and increase in MUy . These changes will continue till =
and he will be in equilibrium.

CONSUMER EQUILIBRIUM BY HICKS AND ALLEN APPROACH

The indifference curve approach was fully developed by JR HICKS and DAVID ALLEN .
Indifference curve analysis is based on the idea of ordinal utility or ordinal approach .
Ordinal utility means the consumer can rank the preference where one commodity is
preferred over another .
According to this approach consumer equilibrium can be determined with the help of
Indifference map and budget line .
INDIFFERENCE CURVE:
Meaning
- It is that graphical presentation which shows various possible combinations of two
goods which gives same level of satisfaction.
- Thus, the consumer is indifferent between the various combinations on a given
indifference curve.
- IC shows the points depicting certain quantity of X commodity and certain quantity
of Y commodity, and each point gives equal satisfaction to the consumer.
(Combinations- certain units of X commodity, certain units of Y commodity.)
Indifference Schedule
It is a tabular statement showing different combination of two goods which presents equal
satisfaction to consumer .
Combinations X (Apples) Y (Orange) Satisfaction
A 1 15 100
B 2 10 100
C 3 6 100
D 4 3 100
E 5 1 100
Diagrammatic presentation
 In the diagram , A , B , C ,D and E are the five different combinations or bundles of X
and Y commodities
 By joining these combinations we get indifference curve (IC) , which gives equal
satisfaction to the consumer .
 IC is also known as „Iso-Utility Curve‟
FEATURES / CHARACTERISTICS OF INDIFFERENCE CURVE (IC)
1. It is downward sloping curve from left to right(shape)
This is because it represents combination of two goods which gives the same level of
satisfaction . In order to maintain same level of satisfaction , when consumer increases the
consumption of one good he has to sacrifice the consumption of the other good. As any
curve is downward sloping, when there is an inverse relationship between items on X-axis
and Y-axis.

2. Indifference Curve is Convex to the origin (Slope)

This is because of diminishing marginal rate of substitution of x for y. (MRSxy).
MRSxy is the rate at which one product can be substituted by another,(how much of good
Y is being sacrificed, so that more of good X is gained).
Δ change in loss of Y
MRSxy =
Δ change in gain of X
This implies that in order to get one unit of a commodity the consumer will give up
progressively less and less units of the other commodity under a given price income
situation. As consumer is a rational being, he/she wants to loss less and less, with each
progressive combination.
- IC would have been convex to the origin, if MRS was increasing.
- IC would have been straight line, if MRS was constant.

3. Ic never touches x and y axis

This is because it represents combination of two goods and to attain the same level of
satisfaction therefore one of any goods cannot be zero. So IC never touches any of the axis.
4. Higher the indifference curve
represents higher the level of
satisfaction:
A combination on a higher IC will give
more satisfaction than on a lower IC,
because higher IC will represent more
amount of either one or both the
commodities. As more the units consumer
has, more satisfaction he/she attains.
5. Two indifference curves can never intersect each other:
 Each indifference curve represents a different level of satisfaction but each
point on the indifference curve shows a level of equal satisfaction.

 As we know that every point on an IC gives same level of satisfaction-

- On IC1 - A=B
- On IC2 - A=C
Therefore, by transitive property of equality,
B=C. (i)
 But we also know that higher the IC, higher will be the level of satisfaction, as
higher combination shows more units of the commodities. And it is clear from the
above diagram that B is higher than C.
- Thus, B>C (ii)
 Thus, because of this paradox [ (i) and (ii)], two indifference can never intersect
each other.
Indifference Map
When more than one indifference curve is
shown in one diagram then such diagram is
termed as indifference map or in other
words family of IC is also termed as IC
map .
In the diagram there are three indifference
curves i.e. IC1 , IC2 , IC3. Each IC
represents different level of satisfaction . It is clear from the diagram that IC2 shows
satisfaction more than IC1and IC3 shows satisfaction more than IC2.
Marginal Rate of Substitution (MRS)
 Meaning
 MRS is the rate at which the consumer is willing to substitute one good for another ,
without changing the level of satisfaction .
 In other words MRSxy is defined as the amount of Y commodity , the consumer is
willing to give up to get one additional unit of X commodity, so that the same level
of satisfaction is maintained .
 MRSxy is the quantity of Y commodity forgone for getting one additional unit of X
commodity .
 The slope of the indifference curve shows the MRSxy because it indicates the rates
at which the consumer is willing to substitute one good with the other .
 MRS – Schedule

Combinations X Y Satisfaction MRSxy

commodity commodity
A 1 30 100 -
B 2 25 100 5:1
C 3 21 100 4:1
D 4 18 100 3:1
E 5 16 100 2:1
 It is clear from the schedule that , when consumer moves from combination A to B ,
he is willing to give up 5 units of commodity Y for 1 unit of X i.e. MRS of X for Y
is 5 : 1 . In the same way from B to C , MRSxy is 4 : 1 . It is clear from the table
that MRS of Y for X is diminishing .
  Why does MRS decrease ?
There are the following reasons for this :
1. When a consumer has more of a commodity, his intensity of want for it
decreases. Initially he gains greater satisfaction from the consumption of X
commodity and so he is willing to substitute more units of Y, for gaining X. But
slowly, with continuous consumption, his satisfaction from X decreases and so
he is willing to substitute less and less of Y, for more of X.
Thus, when the consumer has more units of X commodity, with each of next
combination, his intensity or desire for additional units of X decreases.
2. Most of the goods are imperfect substitutes of one another and give different
levels of satisfaction to the consumer. If they could substitute one another
perfectly, MRS would remain constant.
3. Monotonic preferences- this is the preference of a consumer where he/she is
inclined towards that bundle which has more units of the commodity. And due to
this, the consumer wants to loss less and less and keep more with him/herself.
And thus MRSxy decreases.
4. Consumers capacity to sacrifice units of a good is greater when it is plentiful
and it is less when it is scarce.
BUDGET LINE
It is that graphical presentation which shows various possible combinations of two goods
that can be purchased within given monetary income, assuming that prices of two goods
are constant. This graph shows the ability of the consumer to buy the commodities, in
terms of his/her income. It shows different combinations of certain units of X and certain
units of Y, that the consumer can purchase
This concept can be explained with the help of following example:
Example : let suppose Income be (Y) = Rs. 100
Price of x commodity = Rs. 10/unit
 Price of y commodity = Rs 20/unit
Comb. x y Slope = or (MRE =
)

A 0 5 -
B 2 4 ½ = 0.5
C 4 3 0.5
D 6 2 0.5
E 8 1 0.5
F 10 0 0.5
A,B,C,D and E are the possible combinations of X and Y commodity, that the consumer
can purchase, with the income he/she has in hand.
Representation of these possible combinations on a graph, is known as budget line.
- Budget line Equation :
Px Qx + Py Qy = Y
(expenditure on X and Y = income of the consumer)
- Budget Line Constraint (it depicts the limit or the constraint of the consumer)
PxQx + PyQy ≤ Y
(expenditure can be either less or equal to the income{money in hand}, not more)
- Properties of budget line-
1. It is downward sloping-
As the budget line shows the possible combinations of two goods which can be purchased
within the fixed amount of income, if the consumer wants to increase the consumption of
one good, he/she has to sacrifice certain units of another good.
2. It is a straight line curve
Budget line is a straight line curve because its slope is constant.
Marginal Rate of exchange: (slope of Budget Line)
It is the rate at which one product can be exchanged by other.
Δ in loss of y
MRE =
Δ in gain of x

Slope of Budget line = Price ratio i.e. , this slope remains constant, leading to a

Straight line budget line.

 - Attainable and Unattainable combinations

 A, B and C are attainable combinations because they are on the budget line, thus the
consumer has the ability to buy these combinations and it depicts that the whole income
is spent.
 H is also attainable combination because it is inside the budget line, thus the consumer
has the ability to buy this combination as well, and it depicts that whole of the income
is not spent .
 L is unattainable combination because it is outside the budget line and the consumer
doesn‟t have the ability to buy this combination within the income level.
- Shifting of Budget Line
Case 1 : Shifts from left to right (the consumer can purchase more of both the
commodities).

Reason : • Monetary Income increases or

• prices of both the goods
decreases.
Case 2 : Shifts from right to left (the consumer
can buy less of both the commodities).

Reason : • Monetary Income decreases OR

• Price of both the goods increases.
# Rotation of Budget Line -
Case 1 : The consumer can buy more of only X commodity

Reason : • Price of only x commodity decreases but monetary income is constant.

Case 2 : The consumer can buy more of only Y commodity

Reason : • Price of only y commodity decreases but monetary income is constant.

Consumer equilibrium determination (Hicks and Allen approach ) :

Given the indifference map of the consumer and budget line, we can find out the
combination (bundle) which gives maximum satisfaction to the consumer i.e. equilibrium
point.
According to this approach, consumer equilibrium will be determined where the following
conditions are fulfilled :-
 Conditions of consumer equilibrium
The conditions of consumer‟s equilibrium where
he would maximise his
satisfaction are as follows :
1. The budget line should be tangent to the
Indifference curve.
( the amount the consumer is paying =
satisfaction the consumer gets in return)
Or
 MRS xy = MRE
Or

MRSxy=

2. Expenditure = Income (Y)

(the consumer is getting the maximum quantity of both the commodities, possible
within his/her income. As this depicts maximum satisfaction the consumer can
attain within his/her income level).
PxQx + Py Qy = Y
 In the diagram , MN is the budget line . IC3 and IC4 indifference curves have
become irrelevant to a consumer because both lie outside the price space of the
consumer . IC1 and IC2 are only relevant indifference curves in the budget space .
 Both the conditions of consumer equilibrium are fulfilled at both point E and point
A. but we know that higher the IC higher will be the satisfaction. IC2 is higher than
IC1, and thus point E will give more satisfaction, within the same income.
 A consumer will maximise his total satisfaction at point E where slope of IC2 is
equal to the slop of MN budget line (MRS xy = MRE) and also, whole of the income
is spent on this combination (PxQx + Py Qy = Y).
 A consumer would get maximum satisfaction by buying OX1 units of X
commodity and OY1 units of Y commodity .
 All the conditions of equilibrium are fulfilled at point E . They are not fulfilled at
point A and B .
 Consumer equilibrium in terms of Price ratio and MRS :
 MRSxy is the no. of units of Y commodity which the consumer is willing to
sacrifice to obtain one extra unit of X commodity without affecting the level of
satisfaction .
 The ratio of prices in which also equals the ratio of the no. of units of Y
required to be sacrificed to obtain one extra unit of X in the market .
1. MRSxy >

 Initially when the consumer starts purchasing , MRSxy > . It means that to
obtain one extra unit of X commodity the consumer is willing to sacrifice
more than what he has to sacrifice actually .
 The consumer gains as he goes on obtaining more and more units of X , MU
of X commodity goes on declining . Therefore , the consumer is willing to
sacrifice less and less of Y each time for one extra unit of X .
  As a result , MRSxy falls an ultimately becomes equal to at some
combination of X and Y (at E point). At this combination , the consumer is in
equilibrium .
2. MRSxy <
 If the consumer attempts to obtain more units of X beyond the equilibrium
level then MRSxy will become less than and he will start loosing . So ,
The consumer will not try to obtain more units of X commodity.
As, We know that MRSxy =
Δ in loss of y
Δ in gain of x

MRSxy Equilibrium Changes Reason

Or Dis-
equilibrium
5:1 2:1 As 5>1, in this
4:1 2:1 Consumption situation, a rational
MRSxy > consumer will buy
3:1 2:1 of X will ↑
more of X and less
of Y, which will
lower the ratio of
MRSxy, by which
ultimately
MRSxy =

2:1 2:1 MRSxy = Equilibrium

point

As 1<2, in this
1:1 2:1 Consumption situation, a rational
MRSxy < consumer will buy
of X will ↓
less of X and more
of Y, which will
increase the ratio of
MRSxy, by which
ultimately
MRSxy =
* HOTS *
Q. 1 Define MUm.?
Ans Marginal utility of money refers to worth of a rupee to a consumer. If a
consumer is spending Rs. 1, on any commodity available in the market, MUm is the
amount of satisfaction that a consumer thinks he deserve in return of that Rs.1. Thus,
MUm of a rich person is low, while of a poor person is high.
Q. 2 Define law of Equi-marginal utility.
Ans It states that a consumer will attain the equilibrium when the marginal
utilities of the two commodities that he consumes, are equal. Thus equilibrium is
attained without any biasness between x and y commodity.
Q. 3 Why does MRSxy always diminish ?
Ans
combinations shirt trousers MRS
A 1 20 -
B 2 16 4
C 3 13 3
D 4 11 2
E 5 10 1
Consumers capacity to sacrifice units of a good is greater when it is plentiful and it is
less when it is scarce. And also, the consumer is more excited to consume the new
commodity(shirt) in the start, and gets bored subsequently, with continuous
consumption. Initially at combination A, consumer had 1 unit of shirt and 20 units of
trousers . Here consumer‟s capacity to sacrifice or forego trousers is greater, and the
consumer is willing to lose more as he gains more satisfaction from the new commodity
(shirt).Therefore, he can sacrifice a larger quantity of trousers (4 units) in favour of a
smaller quantity of shirt. Here , shirt is important than trousers .
But if we compare it with a movement from D to E where trousers now become
relatively important than the shirts (because of scarcity of trousers ) and satisfaction
received from shirts also decreases, consumer is willing to give up only small number of
trousers (only 1 unit ) for an additional unit of shirt . Therefore, MRS diminishes as the
stock of trousers decreases .
Q. 4 Define "monotonic preferences"
a. Monotonic preference means that the consumer always prefer that combination
which has either more of both the goods or more of at least one good and no less of
other good as compared to another bundle .
b. For example there are two commodities – X and Y
(a). if two bundles of X and Y commodities are (a) (20X , 20Y) and
 (b) (10X ,10Y)
The consumer will prefer (a) because it contains more of both X and Y
commodities.
Q. 5 What is a bundle ?
Ans A combination of two goods consumed by an household is called a bundle. A
bundle contains certain quantity of X commodity and certain quantity of Y
commodity.
Q. 6 Define budget set.
Ans A budget set is the collection of all bundles of two goods that a consumer can
buy within his given level of income at the prevailing market prices.
Q. 7 Define MRSxy.
Ans MRSxy is the rate at which one product can be substituted by another product
without changing level of satisfaction.
Change in loss of good Y
MRSxy =
Change in gain of good X
Good X Good Y MRSxy
1 30 -
2 25 5
3 4 4
4 18 3
5 16 2

Q8. If a consumer is indifferent to the bundles (5,6) and (6,6), does he

have monotonic preferences?
Ans. No, the consumer does not have monotonic preferences, as the persons
having such preference would be different between the above-mentioned
combinations and would choose (6,6).
Q9. What does the horizontal intercept on the budget line shows?
Ans. It shows that whole of the income of the consumer is spent on the
consumption of X commodity. And no units of Y commodity is consumed.
Q10. If the consumer consumes 2 goods X and Y, and is in equilibrium,
what will be the effect on the consumption of the goods, if price of Y
commodity falls?
Ans. The consumer equilibrium condition is-
=
 If price of Y falls, then-
<
To attain equilibrium, the consumer will increase the consumption of Y
commodity, so that MUy falls {as more the consumption, less the satisfaction
(LDMU)}. and decrease the consumption of X commodity so that MUx rises
{as less the consumption, more the satisfaction (LDMU)}.

Q11. For a consumer total utility from the consumption of 5 units of a

commodity is 75 units. Total utility rises to 99 units when 8 units of the
commodity are consumed. Calculate marginal utility.
Ans.
ΔTU
MU =
Δ units consumed
MU = 99-75
8-5
MU = 24
3
MU = 8 utils.
Q12. A consumer wants to consume two goods whose prices are Rs. 4 and
Rs. 5 respectively. The consumer’s income is Rs. 120.
a. Construct the budget line of the consumer.
b. What is the slope of the budget line and how does it behave?
c. If the consumer consumes 5 units of X and 7 units of Y, what will be
the effect on the budget line?
d. What will be the effect on the budget line if price of Y commodity
falls to Rs. 4?
Ans.
a.
X Y
A 0 24
B 5 20
C 10 16
D 15 12
E 20 8
F 25 4
G 30 0

b. Slope of budget line is MRE (marginal rate of exchange), which is the rate
at which one commodity is exchanged for another commodity. Typically, MRE
remains constant, that means that a consumer has to exchange equal amount of Y
commodity to gain more of X commodity, and that is why budget line is a straight
line. Here, the slope of the budget line is 0.8, as MRE =
Δ in loss of y
Δ in gain of x

c. If a consumer consumes 5 units of X and 7 units of , that means the expenditure of

the consumer is total of 20 + 35 = Rs.55, while the income is Rs.120. This means,
PxQx + Py Qy < Y, whole of the income is not spent.
And thus, the consumption will be inside the budget line.
d If the price of X commodity falls to Rs 4, that means, with the same amount of income,
the consumer can buy more units of X commodity. And so, there will be rotation in the
budget line.

Q13. Ice cream sell for Rs. 30. Laxmi has eaten 2 ice creams. Her marginal
utility from eating 2 ice creams is 120. If for her, marginal utility of one
rupee is 3, should she eat more ice-cream?
Ans. Consumer equilibrium condition, one commodity model is-

= Px *(marginal utility of one rupee = marginal utility of money)

Putting the values, should be equal to 30, which is not true as

40 > 30

And thus, > Px

In such a situation, the consumer is in surplus, and thus Laxmi should buy more units of
ice-cream, to attain consumer‟s equilibrium.
O14. If the consumer consumes X commodity and is in equilibrium at a particular
unit of that commodity, how will the consumption be affected if, MUm increases?
Ans. Consumer equilibrium condition, one commodity model is-

= Px

If the MUm increases, then,

< Px

Thus the consumer is in deficit, and to attain consumer equilibrium, he should decrease
the consumption of X commodity. As with less consumption MUx will rise, and
will become equal to PX, (due to applicability of law of diminishing marginal utility).
Q15. What is the rate at which TU increases, when MU falls but above zero?
Ans. TU increases at diminishing rate as the rate of TU is MU, which is diminishing.
 Chapter 3
THEORY OF DEMAND
 DESIRE is the wish for consumption of a commodity (goods and services) of a
consumer.
 An effective DESIRE can be converted into DEMAND if the following two
conditions are satisfied-
1. Desired product should be available in the market.
2. Willingness and ability of consumer to buy the product at a particular time and
particular price.
 QUANTITY DEMANDED
Quantity Demanded refers to the quantity of a commodity which a consumer is able
and willing to buy at a particular time and particular price.
It is the amount of a commodity that a consumer wants to buy at a given price and
time.
Px Dx
10 100
 DEMAND
Demand refers to the quantities of a commodity which a consumer is able and
willing to buy during a period of time at various prices.
It the different amounts of a commodity that a consumer wants to buy at different
prices and different time.
Px Dx
10 100
8 120
12 60

 DEMAND SCHEDULE
It is a tabular presentation which shows different quantity demanded at different
prices.

Px Dx
10 100
8 120
12 60
When demand is represented in a table, it is known as demand schedule.
  DEMAND CURVE
It is a graphical presentation which shows different quantity demanded at different
price.

When demand is represented on a graph, it is known as demand curve.

 Demand Function
Demand Function shows the functional relationship between quantity demanded for a
commodity and factors affecting demand. Demand function can be expressed as :
Dx = f (Px , Pr ,Y, T, W, G, Sp, E)
f = function of (depends on)
(it shows that the amount of demand of a commodity depends on the factors affecting
the demand)

 FACTORS AFFECTING DEMAND/ DETERMINANTS OF

DEMAND
1. Price of the commodity - Main factor

2. Price of related goods

3. Income of the consumer
4. Change in taste, preference and fashion - other factors
5. Change in weather and climate
6. Expected change in future prices
7. Government policies
 CETERIS PARIBUS
" When other things being equal". Here, other things, refers to the factors other than
price of a commodity. When price of the commodity works, other factors are assumed to
be constant. It means that when price of the commodity affects the quantity demanded for a
commodity, other factors cannot influence the demand for that commodity.
1. PRICE OF A COMMODITY
It is the main factor which affects Demand for a commodity.
 When other things being equal, If Price of a commodity DECREASES Quantity
Demanded EXTENDS.
 When other things being equal, If price of a commodity INCREASES Quantity
Demanded CONTRACTS.
This concept can be explained with the help of following schedule and diagram.
P D
10 100
8 120
12 60

On the basis of above schedule and Diagram, it can be concluded that Price and Quantity
Demanded have INVERSE relationship or price effect is negative.
The less the price of the commodity, the more is demanded, and more the price of the
commodity, the less is demanded.
Note- When other factors work, price of the commodity is constant.
2. PRICE OF RELATED GOODS:
The related goods are of two types.

SUBSTITUTE GOODS COMPLEMENTARY GOODS

(a) SUBSTITUTE GOODS

Those goods which can be used in place of each other are called substitute goods. In
case of Substitute goods, cross price effect is positive
 Which simply means that, price of main commodity being constant, when price of
substitute goods increases, demand for main good also increases. As the substitute
good becomes comparatively expensive, the consumers shift to the consumption of
main good, and thus its demand increases.
Similarly, when price of substitute goods decreases, demand for main good
decreases. As the substitute good becomes comparatively cheaper, the consumers
shift from the consumption of main good, and thus its demand decreases.
Eg: Pepsi and Coke
Tea and Coffee

(b) COMPLEMENTARY GOODS

Those goods which are complementary to each other. In case of complementary
goods, Demand of one good is NEGATIVELY related to price of other.
Eg: Car and Petrol
A.C and electricity
In case of complementary goods, cross price effect is negative
Which simply means that if price of main commodity being constant when price of
complimentary good (Petrol) increases, Demand for main commodity (car)
decreases. As using the main good also become expensive with increase in price of
the complementary good.
Similarly, when price of complementary good decreases, price of main good being
constant, demand for the main good increases. This is because, consuming the main
good has become cheaper.
NOTE: Examples of Joint Goods which are not complementary are as follows:
 Tea and sugar
 Pen and Notebook etc.
Where if Px decreases Demand for Y does not increase
3. INCOME OF THE CONSUMER
(Here we talk about the monetary income of the consumer, that is the
income in terms of money and not the purchasing power.)
A. INFERIOR GOODS
These goods are the cheaper and poor quality goods. These are those goods where
income effect is negative which simply means that when income of consumer
increases, demand for inferior goods decreases and vice versa.
With increase in income of the consumer, he/she has the ability to afford a better
quality good, and thus leaves the consumption of inferior good, and thus demand for
inferior goods decreases.
Similarly, when income of the consumer decreases, the consumer shifts towards the
consumption of inferior goods, as they are unable to afford the more expensive goods,
and thus demand for inferior goods increases. Eg. – bajra and jowar.
A good whose demand by a consumer falls with the rise in income of that consumer is
called an inferior good . For example , if a consumer reduces the consumption of toned
milk when his income rises , then toned milk is an inferior good for that consumer .
Remember , toned milk is not always an inferior good . At lower income levels it may
be a normal good . Like this , no good is either always normal or always inferior . It is
the income level of the individual consumer that makes a good normal or inferior for
him . Demand for an inferior good rises with the fall in income .
B. NORMAL GOODS/ LUXURIES AND COMFORT GOODS
Normal goods are those goods where income effect is positive. These are the better
quality and comparatively expensive goods. It simply means that when Income of a
consumer increases, Demand for normal goods also increases and when income of a
consumer decreases, the Demand for normal goods, also decreases.
With more income, the consumer can afford a better quality good, and thus demand
for such good increases. And with decrease in income, the consumers are unable to
afford the normal goods, thus its demand decreases. Eg. – wheat and rice.

4. Tastes and Preferences

a. Tastes and preferences of buyer depend upon individual likes and dislikes, trends
and fashion , social environment.
b. There are two types of changes in tastes and preferences of the consumer:
(i) Favourable change (ii) Unfavourable change.

(i) Favourable change

A positive or favourable change in tastes and preferences of the consumer
shall lead to increase in demand as he buys more of a commodity even when
its price continue to be the same. (eg.- if hats are in fashion, it will be a
favourable change for hats, and its demand will increase.)
 (ii) Unfavourable change
A negative or unfavourable change in tastes and preferences of the
consumer shall lead to decrease in demand as he buys less of a commodity
even when its price continue to be the same. (eg.- if hats are out of fashion,
then it is an unfavourable change for hats, and its demand will decrease.)
5. Expectations of future prices
a. If the consumer expects that the price in future will rise then he will buy more
quantity in present at the existing price, as prices are comparatively cheaper from
the future and thus demand increases.
b. Similarly, if the consumer expects that the prices in future will fall then, he will
buy less quantity in present at the existing price as the prices in the future will be
comparatively cheaper from existing price and thus demand decreases.
6. Population
a. Increase in population means increase in number of buyers which directly means
an increase in demand.
b. Decrease in population means that there are less number of buyers and thus there is
decrease in demand.
7. Weather and Climate
Due to favourable change in weather and climate, demand curve shifts rightward
(increase in demand) and due to unfavourable change in weather and climate demand
curve shifts leftward (decrease in demand).
For eg.- Demand for sweaters increase during winters, as it is a favourable change in
climate for sweaters. Similarly, demand for sweaters decrease during summers, as it is
an unfavourable change in climate for sweaters.
DIAGRAM FOR REMAINING FACTORS
  CHANGE IN QUANTITY DEMANDED (Movement along the
same curve)
It refers to a situation when other things being equal, quantity demanded extends and
contracts with the decrease and increase in price of a commodity respectively.
In other words, it refers to a situation when there is downward and upward movement
along the demand curve due to change in price of commodity, keeping other factors
constant. Then such situation is said to be movement along the same curve.
Change in quantity demanded has two parts:
(i) EXTENSION/ EXPANSION CONTRACTION
(ii) When other things being equal, When other thing being equal, Quantity
Quantity Demand extends with Demanded Contracts With increase in
decrease in the price of the commodity the price of the commodity such
such situation is said to be extension of situation is said to be contraction of
demand demand
(iii) Schedule Schedule
Px Dx Px Dx
10 100 10 100
8 120 12 60

Diagram: Diagram:

(iv) In case of extension of Demand, there is In case of contraction, there is

DOWNWARD MOVEMENT along the UPWARD MOVEMENT along the
same curve (A-B as shown in diagram) same curve (A-C Shown in diagram)
 CHANGE IN DEMAND (shifting of the curve)
 Change in demand refers to increase or decrease in demand for a commodity in
response to change in other determinants other than the price of the same
commodity.
 It is a shift formation of a new demand curve due to change in other factors when
price of the product remains constant.
Change in demand has two parts:
INCREASE IN DEMAND DECREASE IN DEMAND
1. It refers to a situation when price of a It refers to a situation when price of a
commodity being constant, demand of a commodity being constant, demand of
commodity increases due to favourable a commodity decreases due to
change in other things. unfavourable change in other things.
2. Schedule Schedule
Px Dx Px Dx
10 100 10 100
10 120 10 80

3. In case of increase in demand, Demand In case of Decrease in demand,

curve shifts from left to right which is Demand curve shifts from right to left
shown in the above diagram (A-B) which is shown in the above diagram
(A-C)
4. Causes of increase in Demand- Causes of Decrease in Demand-

Due to increase in price of substitute Due to decrease in price of substitute

goods. goods
Due to decrease in price of complementary Due to increase in price of
goods complementary goods
Due to increase in Income of a Consumer Due to decrease in Income of
(in case of luxurious and normal goods) consumer (in case of luxurious and
normal goods)
Due to decrease in Income of a consumer Due to increase in Income of
(Inferior goods) consumer (Inferior goods)
 Due to favorable taste and preference and Due to unfavorable taste and
fashion. preference and fashion.
Due to increase in size of population Due to decrease in size of population
Expected rise in future price Expected fall in future Price

 INDIVIDUAL DEMAND AND MARKET DEMAND

 INDIVIDUAL DEMAND
It refers to the quantity of a commodity demanded by an individual consumer at a given
time and given prices. It shows how many units of a commodity is demanded by a
single consumer.
 INDIVIDUAL DEMAND SCHEDULE
It is a tabular presentation which shows different quantity demanded by an individual
consumer at different price
Px Dx (Rohan)
10 100
12 80
15 50

 INDIVIDUAL DEMAND CURVE

It is a graphical presentation which shows different quantity demanded by an individual
consumer at different prices.

 MARKET DEMAND
It refers to the total quantity of a commodity demanded by all the consumers in the
market at a given time and given price. In other words, it is horizontal summation of
individual demand at a given time and given price. It shows how many units of a
commodity is demanded by all the consumers in the market, of that commodity.
 MARKET DEMAND SCHEDULE
It is a tabular presentation which shows sum total of quantity demanded by all the
consumers in a market at different price.
 {If there are two consumers (A and B) in the market, of x commodity}
Px A B M.D. (A+ B)
10 100 50 150
12 80 100 180
15 50 50 100

 MARKET DEMAND CURVE

It is a graphical presentation which shows sum total of different quantities demanded by
all the consumer in a market at different prices.

 LAW OF DEMAND
 Statement of the law
It states that, "When other things being equal, Quantity Demand extends with the
decrease in price of commodity and Quantity Demanded contracts with increase in
price of commodity."
 Law of Demand establishes inverse relationship between price and quantity
demand or price effect is negative.
 And thus, price effect is negative.
 In law of demand, price is the independent factor and quantity demanded is the
dependent factor. So, quantity demanded changes due to change in the price.
 Due to this inverse relationship, demand curve is downward sloping.
 Law of Demand is a QUALITATIVE STATEMENT It expresses consumer
behavior or rationality of a consumer. It expresses the quality of Quantity demanded
of responding negatively to the price. It doesn‟t express the quantity of change in
quantity demanded.
 Assumptions of law of demand
 No change in price of related goods.
 No change in income of a consumer.
 No change in taste, preference and fashion.
 No change in weather and climate.
 No change in size of population.
 No change in expected future prices
 Law of Demand can be explained with the help of following schedule and diagram-
Px Dx
10 100
12 80
5 150

 Exceptions of law of demand

There are certain cases when law of demand does not operate. This means that in below
mentioned goods or situations, even with rise in price, quantity demanded doesn‟t
contract. In exceptions, the demand curve is positively sloped (where quantity
demanded is directly related with price ).

1. ARTICLE OF DISTINCTION/ VEBLEN EFFECT (SNOB EFFECT)

This concept was introduced by Veblen. According to him, article of distinction or
status symbol products have more demand only if their prices are high because
these goods are distinct from the rest and that makes them valuable. Veblen termed
these as “Conspicuous goods”
Eg: Diamond Jewellery, expensive carpets etc.
2. IGNORANCE OF THE CONSUMER
Sometimes, out of ignorance the consumer feels that a good is worthless if its price
is low. So they buy less goods at a low price. More is purchased only if its price is
high.
3. GIFFEN GOODS (Given by-Sir Robert Giffen)
Those inferior goods where price effect is positive and income effect is negative.
Eg: Meat and Bread.
4. HABITUAL
Law of demand does not operate in case of habitual goods because the consumer is
ready to pay more price to get that good as he/she has become habitual of or is
addicted. Eg.- alchohol,tea.
5. EMERGENCY
In case of emergency law of demand does not operate. If the consumption of a
commodity is urgent and unavoidable, then it is demanded even at a high price. Eg.-
medicines, injections.
6. NECESSITY GOODS
Consumption of certain necessity goods is important and cannot be avoided. Thus
goods like school uniform, books, food grains and vegetables are demanded even at
a high price.

 OPERATION OF LAW OF DEMAND

When price rises, quantity demanded contracts and when price falls, quantity
demanded extends due to the following reasons-
(other factors does not change)

Important Questions:-
Q. Why does Law of Demand operate?
or
Why does Inverse relationship exist between price and quantity demanded?
or
Why does demand curve slope Downwards?
or
Why does consumer buy more at less price?
or
Why does consumer buy less at high price?
1) Law of diminishing marginal utility
- LDMU states that with consumption of an additional unit of a commodity, marginal
utility derived from successive units goes on declining.
- A consumer will buy more and more units of a commodity only when he has to pay
less and less price for each additional unit. The fallen Marginal Utility (satisfaction)
with continuous consumption can be compensated with the fallen price. More the
consumption, less the satisfaction and less the consumption, more the satisfaction.
- A consumer is in equilibrium when marginal utility is equal to price of the product
(Mux= Px), (consumer equilibrium condition, single commodity model by Marshall).
- As, if price falls then, MUx > Px, and to attain equilibrium the consumer will
increase the consumption, so that the value of MU falls (LDMU), and thus quantity
demand extends with decrease in price.
- Also, if price increases then, MUx < Px, and to attain equilibrium the consumer will
decrease the consumption, so that the value of MU rises (LDMU), and thus quanity
demand contracts with increase in price.
2) Income Effect (real income effect)
Real income is the purchasing power of the commodity. It showcases ho much units
of the commodity, the consumer can buy, with the amount of income in hand.
A change in the price of a commodity causes a change in real income of the consumer.
With a fall in price, real income (Purchasing Power) increases and thus demand rises
and vice - versa
P ↓→ Real income ↑→ Demand ↑
P ↑→ Real income ↓→ Demand ↓
Eg- Income Price Quantity Demanded
Rs.100 Rs.10 10
Rs.100 Rs. 5 20
Rs.100 Rs.20 5
Within the same income in hand, the consumer can buy more units of a commodity,
when the price of the commodity falls, and thus quantity demanded extends.
Similarly, with the same amount of income, the consumer is able to buy less of a
commodity, due to increase in its price, and thus quantity demanded contracts.
3) Substitution Effect
It is the effect of a change in relative price of substitute good on the quantity demanded
of the product .
When the price of a commodity falls and the price of its substitute remain constant ,
the main good becomes relatively cheaper in comparison to the other substitute
commodity and consumer leaves the consumption of the substitute goods and shifts
towards the main good, and thus quantity demanded extends.
In other words , its substitute become relatively costlier thus the demand for the
relatively cheaper commodity increases .
Similarly, when the price of the main good rises, substitute good become relatively
cheaper, and consumer shifts to the consumption from the main good to the substitute
good and thus quantity demanded of the main commodity contracts.
4) Change in number of buyers
When price of a commodity falls some new consumers start purchasing it as they
are able to afford it due to fallen price, consequently the demand for that commodity
increases.
When price of a commodity rises existing consumers leave the consumption, as they
are no longer able to afford it, and thus quantity demanded contracts.
 5) Various uses of a commodity
A commodity like milk, steel, electricity etc can be put to several uses. When the
price of a commodity increases the consumers reduce the use of that commodity, so
demand reduces. Or when price of commodity decreases, consumers increase the
use of that commodity thus demand increases.

 TYPES OF GOODS
1. NORMAL GOODS
Those goods where price effect is negative and income effect is positive. Here law of
demand operates.
2. SUBSTITUTE GOODS
Those goods which can be used in place of each other. Cross price effect is positive.
(Eg. Pepsi & coke)
3. COMPLEMENTARY GOODS
Those goods which are complementary for each other or goods where demand for one
good is negatively related with the price of other good and cross price effect is negative.
(Eg. Car and petrol)
4. INFERIOR GOODS
Those goods where there is an inverse or negative relationship between income and
demand for a good are called inferior goods or in other words where Income Effect is
negative. These are low price and low quality good used by people with low income.
5. GIFFEN GOODS
These goods were introduced by Sir Robert Giffen. These are those inferior goods
where income effect is negative but price effect is positive.
Sir Robert Giffen, an economist, was surprised to find out that during inflation in the
economy, as the price of bread increased , the British workers purchased more bread and
not less of it . This was something against the law of demand. As, inflation caused such a
large decline in the purchasing power of the poor people that they were forced to cut down
the consumption of meat and other more expensive foods. Since bread even when its price
was higher than before was still the cheapest food article, people consumed more of it not
less when its price went up. Bread was demanded even at a higher price because it was
comparatively cheaper from the rest of the food items.
Note: In case of Giffen goods law of demand does not operate.
Note: All Giffen goods are inferior goods but all inferior goods are not giffen goods.
Note: Giffen goods demand curve is an upward sloping curve.
TYPES OF DEMANDS
1. JOINT DEMAND
When two goods are jointly demanded to fulfill a particular want, it is
termed as Joint Demand.
Eg: Pen and Ink | Fan and electricity etc.
2. COMPOSITE DEMAND
Demand for such a commodity which can be put in several uses such
demand is termed as composite demand.
Eg: Demand for electricity
3. AUTONOMOUS DEMAND/ DERIVED DEMAND
DIRECT DEMAND
Demand for final products to satisfy Demand for factors of production
human wants directly is termed as (raw material/ fuel/Power etc) which
direct demand is derived to produce final goods is
Eg: requirement of house derived demand Eg: Requirement of
steel/bricks/ cement to build a house.
 Chapter 4 - ELASTICITY OF DEMAND
Elasticity of demand refers to the degree of responsiveness of demand due to change in
any one of the factors affecting demand.

Elasticity of Demand

Price elasticity Income Elasticity Cross Elasticity

PRICE ELASTICITY OF DEMAND
It refers to the degree of responsiveness of quantity demanded due to change in price of a
commodity. It is the extent to which quantity demanded responds to the change in price.
Elasticity of demand depicts how much quantity demanded is going to change when there
is a particular amount of change in the price of the commodity.

 We measure the change of Q.D and price in terms of percentage so that both the
items have a common measure of value.
 Price elasticity of demand is a QUANTITATIVE STATEMENT as it measures the
quantity of change in QD due to a change in price.
 The more elastic the demand for a commodity, the more volatile is the demand.
This means more the elasticity, the more will be the change in Q.D, as compared to the
change in price.
 Ed / Ep = price elasticity of demand.

 DEGREES OF PRICE ELASTICITY OF DEMAND

 PERFECTLY ELASTIC (Ep= ∞)
 PERFECTLY INELASTIC(Ep= 0)
 UNIT/ UNITARY ELASTIC (Ep= 1)
 MORE THAN UNITARY ELASTIC/ HIGHLY ELASTIC/ ELASTIC (Ep >1)
 LESS THAN UNITARY ELASTIC/ RELATIVELY INELASTIC/
INELASTIC(Ep <1)
These can be explained as follows:-
1. PERFECTLY ELASTIC (Ep= )
It refers to a situation where quantity demanded keeps on changing continuously
without any change in price of the commodity.
Px Dx
10 100
10 120
10 150
10 60

(Ep= )
Demand curve is parallel to x-axis

2. PERFECTLY INELASTIC (Ep= 0)

It refers to a situation where quantity demanded does not change with a continuous change
in the price of a commodity.
Px Dx
10 100
5 100
15 100

(Ep= 0)
Demand curve is parallel to Y-axis
3. UNIT/ UNITARY ELASTIC (Ep= 1)
It refers to a situation where percentage change in quantity demanded is equal to
percentage change in price. Such demand is said to be unitary elastic demand.
Px Dx
10 100
8 120
 Ep= 1
Rectangular hyperbola curve is formed. Rectangular hyperbola is a curve, under which
every rectangle drawn has the same area. Rectangles drawn under Unitary elastic
demand curve will be equal as percentage fall on one axis is equal to percentage rise on
another axis.
4. MORE THAN UNIT ELASTIC/ HIGHLY ELASTIC/ELASTIC (Ep >1)
It refers to a situation where percentage change in quantity demand is greater than
percentage change in price such demand is said to be elastic.
Px Dx
10 100
8 150

(Ep >1)
Demand Curve will be flatter.
5. LESS THAN UNIT ELASTIC/RELATIVELY INELASTIC/INELASTIC (Ep <1)
It refers to a situation where percentage change in quantity demanded is less than
percentage change in price. Such demand is said to be inelastic.
Px Dx
10 100
6 120

(Ep <1)
Demand curve will be steeper.
COMBINED DIAGRAM
METHOD OF CALCULATING PRICE ELASTICITY OF DEMAND
 Percentage Method/ Proportionate Method
Under this method, Ep can be calculated as follows:

Here, Q= Change in Quantity demand

P = Change in Price
Q= Original Quantity
P= Original Price
While solving numerical problems by percentage method (plus or minus) sign will be
ignored but inverse relationship between demand and price will be taken into consideration
if minus sign is given in the question.
Elasticity of Demand for two Intersecting Demand Curve
If two negatively sloped demand curves intersect each other then, at the point of
intersection, flatter demand curve (DD) is more elastic then the steeper one (D1D1).

We know that in an elastic demand curve, percentage change in Q.D is greater than
percentage change in price, which will be flatter. And in an inelastic demand curve
percentage change Q.D is less than percentage change in price, which is steeper.
On both the demand curves, an equal change in price (PP1) is made. Due to this, in DD
there is a change in the quantity demanded – QQ2 , and in D1D1 – QQ2.
It is clear from the diagram that the change in demand QQ2 (DD curve) is more than
change in demand QQ1 (D1D1 Curve), with the same change in price (PP1). Therefore, DD
is more elastic then D1D1.
Slope of demand curve-
- Slope of demand curve = change in price
Change in Q.D
i.e

- Slope of demand curve measures the rate of change in quantity demanded, with
respect to change in price of the commodity.
- The slope of demand curve is based on absolute change in price and quantity,
whereas the price elasticity of demand is concerned with relative change in price
and quantity.
- Slope of the demand curve (linear demand curve) is constant throughout its length,
whereas the price elasticity of demand varies between infinity and 0 on its different
points.
- ….slope of demand curve

- Ed = × ….price elasticity of demand

- Ed =
×
- Linear demand curve equation-
D(p) = a – bp
Where,
D = demand of a commodity
b=

p = price of the commodity

a = value on y intercept
 FACTORS AFFECTING PRICE ELASTICITY OF DEMAND:
Price elasticity of a commodity is elastic or inelastic, depends on the following aspects-

1- Availability of substitutes

Many substitutes Less/no substitutes

(Elastic) (Inelastic)
(Ed>1) (Ed<1)

- When there are a lot of substitutes for a particular good, and price of such
goodschanges, the consumer has the privilege of shifting to its substitutes. If price
of the commodity rises, it is very convenient for the consumers to shift to the
consumption of another good. And so even with a small rise in price, quantity
demanded decreases to a greater rate, and thus, the elasticity is highly elastic (%
change in Q.D > % change in price).
- If there are no substitutes for a commodity, then even when the price of the
commodity rises, the consumers do not have the privilege to shift towards the
consumption of another commodity. And so, fall in quantity demanded is much less
than the rise in price and thus the elasticity is inelastic (% change in Q.D < %
change in price).
2- Nature of the commodity

Basic Necessity Luxuries and comforts

(Inelastic) Elastic
(Ed<1) (Ed>1)

- When a commodity is a basic necessity to the consumer, such as books, school

uniform, food grains, then the consumption of such commodity cannot be avoided,
and when price of such commodities rises, quantity demanded doesn‟t fall to that
extent, so the elasticity is inelastic (% change in Q.D < % change in price).
- But the consumption of luxury and comfort goods, like vacation, room heater, is
not necessary and can be avoided. So when price of such commodities rises,
quantity demanded falls with a greater degree, thus elasticity is highly elastic (%
change in Q.D > % change in price).
 3- Uses of the commodity

Limited uses Multiple uses

Inelastic Elastic

- If the commodity has multiple uses like electricity, which are put into a number of
uses, like for running A.C, microwave, vacuum cleaner, mixer grinder. If price of
electricity increases then the demand is decreased from all the consumptions, and so
elasticity is elastic (% change in Q.D > % change in price).
- On the other hand, if the commodity has a single or limited use like sofa, school
uniform, then when price rises, quantity demanded will be decreased from only that
limited use and thus elasticity is inelastic (% change in Q.D < % change in price).

4- Price range

Very high/very low Moderate to high

Inelastic Elastic

- In case of very high and very low price of commodity like toothbrush, soap,
pencil, the demand is inelastic because even if their prices rise in case of very low-
priced commodity, then it doesn‟t affect the consumer much and doesn‟t add too
much of burden to the consumer and quantity demanded doesn‟t decrease much
with rise in price. Also, commodities that are very highly priced like antiques and
luxury cars, are consumed by that section of rich people, for whom price doesn‟t
matter. If they are buying an already very expensive commodity, they not decrease
the consumption much due to a higher price. And so elasticity is inelastic (%
change in Q.D < % change in price).
- On the other hand, with increase in price of medium to high price ranged
commodities like clothes, scooter, when price rises, it adds a greater burden to the
consumer and so the quantity demanded is decreased much more than the change in
price, and so elasticity is inelastic (% change in Q.D > % change in price).
 5- Proportion of consumer's budget

Small Proportion Large Proportion

Inelastic Elastic

- Goods on which consumers spend a small proportion of their income (toothpaste ,

needles , etc) , will have an inelastic demand, as when price of such commodities rises,
it still doesn‟t add burden on the budget of the consumer. Eg.- the consumer is earning
Rs. 20,000 per month, and if he buys toothbrush from that money every month. If the
price of toothbrush rises from Rs.5 to Rs.7, it will not affect the consumer much, and
he/she would not decrease the quantity demanded a lot, and so the elasticity is inelastic
and so elasticity is inelastic (% change in Q.D < % change in price).
- On the other hand, goods on which the consumers spend a large proportion of their
income (car, rent on the house), then with rise in price of such commodities, adds high
burden on the budget of the consumer. If the consumer is earning Rs. 20,000 per month,
and he has to pay on the clothes and shoes, from that income every month, then if the
price of the clothes and shoes rises from Rs. 10,000 to Rs. 15,000, it will be highly
affected on the consumer, and he/she will reduce the consumption much more than the
rise in price, and thus elasticity is elastic (% change in Q.D > % change in price).
6- Time period

Short term Long term

Inelastic Elastic
In case of short period demand is inelastic as In case of long period, demand is
consumption of such commodity cannot be elastic because in the long run a
postponed and so the consumer doesn‟t get consumer can change his
the time to adjust to the change in price and is consumption habits more
unable to change the preferences. And so, the conveniently than in the short run and
quantity demanded is not reduced much even gets the ability to defer to the
when price rises, thus inelastic (% change in consumption and so quantity
Q.D > % change in price). demanded is reduced to a greater rate
than the rise in price, and thus the
elasticity is elastic (% change in
Q.D > % change in price).
 HOTS
1. The Demand function of commodity X is
Dx=100-10p
Find out the price of 'X' commodity when demand is=
i) 10 units
ii) 5 units
iii) 0 units
Ans. i) Dx = 100-10p
10=100-10p
10p=100-10=90

P=Rs 9

Ans. ii) Dx = 100-10p

5=100-10p
10p=95 P=Rs 9.5

Ans. iii) Dx = 100-10p

P=10
2. Draw a diagram showing:
i) All 5 degrees of elasticity in ONE diagram
Ans. 2
i) All 5 degrees in one diagram (percentage method)
3. How x and y goods are related when with a fall in the price of X, demand for Y.
i) Increase
ii) Decrease
Ans. 3
i) Complementary goods
ii) Substitute goods.
4. From the following cases identify the expansion of demand and increase in demand.
i) Rise in demand of car due to fall in its prices.
Expansion of demand
ii) Rise in demand of car during festival season
Increase in demand
iii) Rise in demand of umbrella during rainy season
Increase in demand
iv) Rise in demand of sprite due to rise in price of Pepsi
Increase in demand

5. Which of the following commodities have elastic or inelastic demand:

Salt, mobile phone, school uniform, needles, cigarettes, cars, medicines, electricity.
Ans.
Elastic : : Mobile Phone, Cars, Electricity
Inelastic : Salt, Uniform, Needles, Medicines
6. Distinguish between elasticity of demand and law of demand.
Ans. Law of demand shows negative qualitative relationship between price and quantity
demanded for a commodity where as elasticity of demand measures quantitative
relationship.
7. Distinguish between:
NORMAL GOODS GIFFEN GOOD
Those goods where price effect is Those goods where price effect is
Negative and Income effect is Positive. Positive and Income effect is Negative
Law of Demand operates Law of demand doesn't operate
In case of normal goods, demand curve Demand curve slopes upward with
slopes DOWNWARD with respect to respect to price
 price

8. Suppose there was a 4% decrease in the price of a good and as a result the
expenditure on the good increased by 2% what can you say about elasticity of
demand?
Ans. Ed>1 (elastic)
Because due to fall in price , total expenditure increases.
9. Are slope of demand curve and elasticity of demand the same thing?
Ans. No,
Slope = Change in P
Change in Q
Whereas elasticity = (-) ×P/Q

10. What is giffen paradox? What does it imply?

Ans. It means that giffen goods are an exception to law of demand, where price and
quanity demanded has positive relationship, unlike the rest of the commodities. It implies
that the demand curve in case of giffen goods are upward sloping.
11. A consumer buys 10 units of a good at the price of Rs.5 per unit. Slope of the
demand curve of that good is –(2). Calculate the price elasticity of demand.
- Ans. Ed =
×

= ×

=1/4
= 0.25
Ed = 0.25 (inelastic demand)
12. What does the negative sign in price elasticity of demand depicts?
Ans. It depicts the negative relationship between price and quantity demanded, and so if
price increases, Q.D falls and vice-a-versa. That is why price elasticity of demand has a
negative sign.
13. Arrange the following price elasticities in ascending order (from less elastic to
more elastic).
(-3), (-0.4),(0),(∞),(-3.1)
Ans. (0),(-0.4),(-3),(3.1), (∞)

14. Consider the demand curve D(p) = 10 – 3p. what is the elasticity at price 5/3.
Ans. D = 10 – 3 (5/3), as p = 5/3.
Thus D = 5
We know that D(p) = a – bp
Where,
D = demand of a commodity
b=

p = price of the commodity

thus b = =3

price elasticity of demand = ×

putting the values = 3 ×

= 3 × 1/3
=1
elasticity is unitary elastic, ed = 1.
15. Can the same commodity be an inferior good for one and luxury good for
another?
Ans. Yes, a commodity can be inferior for a high income earning person and that same
commodity can be a normal good (luxury) for a low income earning person. Thus, the
interpretation of the nature of the commodity dependes upon the income level of a
consumer. Wearing clothes from a brand XYZ, can be a luxury for a poor person, while
that same brand can be an inferior good for a very rich person.
16. A consumer spends Rs.1000 on a good priced at Rs. 8 per unit. When price falls by
25 percent, the consumer continuous to spend Rs. 1000 on the good. Calculate price
elasticity of demand by percent method.

Ans. Percentage change = × 100

New price = 25% = × 100

= change in P = 2
New price = 8 + 2 = 10
Total expenditure = price × quantity demanded
price Q.D Total expenditure
8 125 1000
10 100 1000

Ed = ×

Ed = ×
Ed = - 0.2 (highly inelastic)

18. The demand function of X commodity is given as Q = 60 – 3P. Calculate price

elasticity of demand when price rises from Rs. 5 to Rs.8 per unit.
Ans. Q.D (before the change in price) = Q = 60 – 3(5)
Q = 45
Q.D (after the change in price) = Q = 60 – 3(8)
Q = 36

Ed = × (change in Q = 45-36 = 9)

Ed = ×

Ed = - 0.33 (highly inelastic)

 -:Chapter - 5:-
SUPPLY
 STOCK
In refers to the number of units lying or available with the producer at a given time.
It is the quantity of a commodity that is ready to be sold, by a producer, at a point of
time.
 QUANTITY SUPPLIED
It refers to the quantity of a commodity which a producer is ready to sell at a
particular time and at particular price.
Thus, it is that amount of a commodity from the stock that a producer is willing to sell
in the market, at a given time and price.
Px Qs
10 100
 SUPPLY
It refers to the quantities of a commodity which a producer is ready to sell during a
period of time at various prices.
It is the different amounts of a commodity, that producer wants to sell, at different
prices, over a stretch of time.
Px Qs
10 100
15 500
8 50

 SUPPLY SCHEDULE
It is a tabular presentation which shows different quantity supplied at different prices.
when supply is represented in a table, it is known as supply schedule.
When we represent supply in a table, it is supply schedule.
Px Qs
10 100
15 500
8 50
 SUPPLY CURVE
It is a graphical presentation which shows different quantity supplied at different
prices.
When supply is represented on a graph, it is known as supply curve.

 FACTORS AFFECTING SUPPLY/DETERMINANTS OF

SUPPLY
(The units of a commodity, that a producer will supply, depends on the following
factors)
1. Price of a commodity Main Factor
2. Price of Factors of production
3. State of technology
4. No. of firms Other Factor
5. Government policy
6. Price of related goods
- CETERIS PERIBUS
" When other things being equal". Here, other things refer of the factors other than price
of a commodity. This means that when price of the commodity is working, other factors
are assumed to be constant. This simply means that when price is affecting the quantity
supplied, the other factors cannot influence the supply, at that time.
1. Price of a commodity
When other factors being constant, price of a commodity increase, then quantity
supplied extends/rises and when price of a commodity decrease, quantity supplied
contracts/falls. There is a direct or positive relationship between price and quantity
supplied.
 Px Qs
10 100
12 150
8 60

2. Price of factors of production (Price of inputs)

Expenditure incurred on hiring or buying the inputs is termed as cost of production.
When price of factors of production increases, cost of production also increase
leading to fall in profit margins and supply of a commodity accordingly decreases at a
given price.
On the other hand, when the price of factors of production decrease, cost of
production also decrease and profit margins increases so supply of a commodity
accordingly increases at a given price.
Price of Inputs – Cost of production  – Profit – supply
If Price of Inputs – Cost of production  – Profit – supply

Price Price of inputs Cost Profit Supply

10 8 8 2 100
10 9 9 1 60
10 7 7 3 120

Px Sx
15 100
15 200
15 60
3. STATE OF TECHNOLOGY
It is another important factor which effects supply of a commodity. It means the
technique, that the producer is using for production. If the producer uses improved
technology then cost of production decrease and production level increase with the
same resources, supply of a commodity accordingly increases at given price. On the
other hand, when technology becomes obsolete, cost of production increases due to
which supply for commodity accordingly decreases.
Use of obsolete (deteriorated) technique – Cost of production  – Profit –
supply
If use of better technique – Cost of production  – Profit – supply

Px Sx
12 100
12 150
12 40

4. GOVERNMENT POLICY
It is another important factor which affects supply of a commodity. When government
imposes taxes, cost of production increases due to which supply of a commodity
accordingly decreases and if government reduces the taxes or provides subsidies to
the producers, cost of production reduces and supply of a commodity accordingly
increases, at a given price.

Px Sx
12 150
12 100
12 60
 5. NUMBER OF FIRMS
When number of firms increase in the market, supply of a commodity increases at a
given price as there are more producers in the market leading to more production and
consequently increase in supply of that commodity. And if number of firms
decreases, due to less production of the commodity, supply of a commodity also
decreases at a given price.

Px Sx
12 100
12 150
12 40

6. PRICE OF RELATED GOODS (SUBSTITUTE GOODS)

It also affects supply of a commodity. In this case, when price of substitute increases,
price of main good being constant, supply of main commodity decreases as the
production of the substitute good is more beneficial for the producer, and so he/she
shifts his/her resources to the production of substitute good. And also, when price of
substitute good decreases, price of main good being constant, production of main
good becomes more beneficial and the producer shifts his/her resources from the
production of substitute good to the main good, and thus the demand for main good
increases.

Px Sx
12 150
12 100
12 60

SUPPLY FUNCTION:
It is a function which establishes functional relationship between supply of a commodity
and factors affecting it. It depicts the maximum possible supply from the function of the
factors affecting it.
S = f (Px, Pfop, ST, GP, NF, PR)
S = supply
f = function of
 CHANGE IN QUANTITY SUPPLIED (MOVEMENT IN
SUPPLY CURVE)
It refers to a situation when other things being equal, quantity supplied extends and
contracts with an increase and decrease in prices of a commodity respectively.
In other words, upward and downward movement in a supply curve takes place due to
change in price of a commodity, keeping other factors constant.

Px Sx
10 100
12 150
8 60

Movement in supply curve has two parts:

Extension of supply Contraction of supply
1. When other things being equal, price of a 1. When other things being equal,
commodity increases, quantity supplied price of a commodity decreases,
extends. Such a situation as known as quantity supplied contracts.
extension of supply. Such a situation is known as
contraction of supply.
2.

2. Px Sx/Qs Px Sx/Qs
10 100 10 100
12 150 8 60

3.
3.

4. In case of extension of supply, there is 4. In Case of contraction of

upward movement along the supply supply, there is downward
curve from AB movement along the supply
curve from AC.
  CHANGE IN SUPPLY (SHIFTING OF SUPPLY CURVE)
It refers to a situation where supply of a commodity increases and decreases at a given
price due to change in factors other than price of a commodity.
In other words, when supply curve shifts rightward and leftward at a given price due to
change in factors other than price of a commodity, then that situation is referred as shifting
of supply curve.

Px Sx/Qs
10 100
10 150
10 60

Shifting of supply curve has two parts which are as follows:

Increase in supply Decrease in supply
1. It refers to a situation where supply of 1. It refers to a situation where
a commodity increases at a given price supply of a commodity
due to favorable change in factors decreases at a given price
due to unfavorable change
other than price of a commodity
in factors other than price of
a commodity.
2.
2. PX Sx/ PX Sx/
Qs Qs
10 100 10 100
10 150 10 60
3.

3.

4. In case of increase in supply, there is 4.In case of decrease in supply,

rightward shift of the supply curve there is leftward shift of the
from AB supply curve from AC
5. Causes of Increase in supply: 5. Causes of Decrease in supply:
Due to increase in price of factors of
Due to decrease in price of factors of
production
production
Due to obsolesce of technology
Due to improvement in technology
Due to increase in excise duty (tax)
Due to decrease in excise duty (tax)
Due to decrease in number of firms
Due to increase in number of firms
Due to increase in price of substitute
Due to decrease in price of substitute
goods.
goods.

LAW OF SUPPLY
It states that, "when other things being equal, Quantity supplied extends with increase in
the price of the commodity and quantity supplied contracts with decrease in the price of the
commodity."
Law of supply establishes direct/positive relationship between price of a commodity
and quantity supplied. This leads to an upward sloping supply curve. This concept can be
explained with the help of following schedule and diagram:
Px Sx/Qs
10 100
15 200
8 60

ASSUMPTIONS OF LAW OF SUPPLY:

1. No change in price of factors of production.
2. No change in state of technology
3. No change in government policy
4. No change in number of firms
5. No change in price of related goods.
Exceptions of Law of Supply
There are certain cases when the law of supply does not operate . In exceptions , the supply
curve is negatively sloped , where quantity supplied is inversely related with price .
a. Agricultural products
The law of supply does not apply strictly to agricultural products , the supply of which
is governed by natural factors. Eg.- Even at a higher price, supply of rice cannot be
increased, if there is a low rainfall.
b. Future expectations
If the producer expects higher price of the commodity in future, then he would sell
lesser amount of goods even at a high price at present to earn a greater amount of profit.

c. Perishable goods
The seller may be willing to sell more units of perishable goods although their price
may be falling. As if the stock is retained at a low price, the commodity will become
stale and unsellable. Example – vegetables.
d. Sale of old stock
When a firm want to sell its old stock then it sells more goods at reduced prices because
the motive behind such a sale is to clear the old stock and make space for the new
stock.
e. Status symbol products
Supply of these products remain limited even if their price rises, as value of these goods
are maintained only because it is not distributed to a larger mass.
f. Artistic goods
The law of supply does not operate in case of high-quality artistic goods like painting
and craft work, to sustain their value.

Q. Why does the law of supply operate?

Ans. Law of supply operates and there is a positive relationship between price and quantity
supplied because-
a. Level of Profit
The main aim of the producer in the market, is to maximise his/her profit. Increase
in the price of commodity causes a rise in profits as a result the producers are
induced to produce and supply more quantity of the commodity to increase their
amount of profit. Similarly, if price of the commodity falls, the producer gets less
profits, and so to avoid that, they reduce their supply.
Price↑→ Profit↑→ Supply↑
Price↓→ Profit↓→ Supply↓
b. Change in stock
When there are higher prices, to attain more profits, producers bring out their stock
for sale, which implies increase in supply. If price of the commodity falls, to escape
the low levels of profit, the producer retain the stock with themselves, and
consequently supply decreases.
 Price↑→ Stock↓→ Supply↑
Price ↓→Stock ↑→Supply↓
c. Due to rising MC. (it is the rising part of MC curve, that ensures profits)

INDIVIDUAL SUPPLY AND MARKET SUPPLY

Individual supply – It refers to the quantity of a commodity which a producer or a firm
is willing to sale in the market at a particular price and particular time. It showcases the
supply by an individual producer or an individual firm.
Individual supply schedule – It is a tabular presentation showing amounts of a product
that a single producer for a firm is ready to sale at various prices during a period of time .
Px Qs
10 100
15 200
8 60
Individual supply curve – It is a Graphical presentation which shows different quantity
supplied by a firm at different prices.

Market supply – It refers to the total quantity of a commodity which is supplied by all the
producers in the market at a particular price and particular time. It showcase the supply by
the total off all the producers or firms, in the market, of a particular commodity.
Market supply schedule – It is a tabular presentation which shows total quantity supplied
by all the firms in the market at different prices. If there are 2 firms A and B in the market,
selling x commodity-
Px Qs(A) QS (B) Market supply(A+B)
2 10 20 30
3 20 30 50
4 30 40 70
5 40 50 90
Market supply curve – It is a graphical presentation which shows total quantity supplied
by all the firms in the market at different prices.
Market supply curve is the horizontal summation of individual supply curve .
 CHAPTER- 6
PRICE ELASTICITY OF SUPPLY
It refers to the degree of responsiveness of quantity supplied due to change in the price of
the commodity. It is extent at which quantity supplied is going to change due to a particular
change in price of the commodity.
 Method Of calculating elasticity of supply:

Percentage Method
Under this method ES (elasticity of supply) can be calculated as follows:

ES = (% change = × 100)


= 


=


Where, Q= change in quantity supplied

P= Change in Price, P= Original (base) Price
Q=Original (base) Quantity
DEGREES OF ELASTICITY OF SUPPLY
(1) Perfectly Elastic (Es = )
It refers to a situation when quantity supplied keeps on changing continuously without any
change in price of commodity. Such situation is said to be perfectly elastic.
Px Sx/Qs
10 100
10 120
10 135
10 150

ES=
Supply curve is parallel to X axis.
(2) Perfectly Inelastic (Es = 0)
It refers to situations where quantity supplied does not change with continuous change in
price of the commodity. Such situation is said to be perfectly inelastic.
 Px Sx/Qs
10 100
5 100
15 100

ES=0
Supply curve is parallel to Y axis
(3) Unit/Unitary Elastic (Es = 1)
It refers to a situation where: Percentage change in Quantity supplied is equal to Percentage
change in price.
Px Sx/Qs
10 100
15 150

ES=1
Supply curve is a straight line curve.
(4) More than unitary elastic/highly elastic/Elastic (Es > 1)
It refers to a situation where percentage change in quantity supplied is greater than
percentage change in price, such supply is said to be more than unit/unitary elastic. A small
change in price leads to greater amount of change in the Q.S of the commodity.

Px Sx/Qs
10 100
12 150 Flatter Curve

ES > 1
(5) Less than unitary elastic /inelastic/ relatively inelastic (Es < 1)
It refers to a situation where Percentage change in Quantity supplied is less than Percentage
change in price. Then such supply is relatively inelastic.
Px Sx/Qs
10 100
15 120 Steeper curve

ES < 1

 Elasticity of supply for two intersecting supply curve

a. If two positively sloped supply curves intersect each other , then at a point of
intersection , flatter supply curve (SS) is more elastic than the steeper one (S1S1).
b. Flatter supply curve (SS) and the steeper curve (S1S1) both intersect at point E . The
price is OP and the quantity Supplied is OQ at point E . When price increases from OP
to OP1 (in both the curves), quantity supplied increases from OQ to OQ1 for S1S1 supply
curve and from OQ to OQ2 for SS supply curve
c. It is clear from the diagram the change in supply QQ2 (SS curve) is more than change in
supply QQ1 (S1S1 curve) , with the same change in price (P1P1). Therefore , SS is more
elastic then S1S1. As more the change in quantity supplied, more elastic the supply of
the commodity.

 Factors Affecting Elasticity of Supply:

(The commodity would be elastic or inelastic, depends on the following determinants).

1. Nature of commodity
-If the commodity is non-perishable (durable), then it can be easily stored with a
producer, for a long time. Thus, elasticity of such commodities is elastic, as the
producer can decrease the supply in a greater amount, even if there is a small fall in
 price, as they will not go stale, (% change in Q.S > % change in price). Eg.- plastic
goods, clothes.
- Similarly, if the commodity is non-durable, it cannot be stored for a long time, and
thus if price falls, the producer is unable decrease the supply a lot, thus elasticity is
inelastic. (% change in Q.S < % change in price) Eg.- eggs, vegetables.

Durable Non- Durable

Elastic Inelastic
ES>1 Es<1

2. Nature of Input Used

- If the inputs, required for the production, are easily available in the market, then the
producer has the ability to produce the commodity in a large quantity easily, as soon as the
price of the commodity rises. And thus, the elasticity is elastic, (% change in Q.S > %
change in price).
- Similarly, if the inputs required for the production of the commodity are not easily
available, then the producer is unable to increase the supply a lot, when there is a rise in the
price of the commodity. And thus the elasticity is inelastic, (% change in Q.S < % change
in price).
Easily Not
available Easily Available

Elastic Inelastic
Es>1 Es<1

3. Time Period
- In very short run, all the inputs remain constant, and so, even when price of the
commodities rises, the producer is unable to change his/her supply at all. Thus the
elasticity is perfectly inelastic (no change in Q.S, with change in price).
- In short run, some inputs can be increased, and some cannot be. Thus, when price of
the commodity rises, the producer is able to increase a little amount of supply, and
thus the elasticity is inelastic (% change in Q.S < % change in price).
- If the producer is in long run, then he/she can increase all his/her inputs. Thus, when
price of the commodity increases, the producer is able to increase the supply at
 much higher degree. Thus, the elasticity is elastic (% change in Q.S > % change in
price).
Very short Short Long Period
period/market Period
Period

Perfectly Inelastic Inelastic Elastic

Es=0 Es<1 Es>1

4. Risk Taking
- If the producer is taking high risk, in the business, then he/she has put high level of
investment. Due to this, he/she has the ability to increase supply of a commodity,
using greater amount of resources, even with a small increase in price. And thus, the
elasticity is said to be elastic (% change in Q.S > % change in price).
- If the producer has taken low risk, this means he/she has put low investment in the
business. Due to this, when the price of the commodity increases, the producer
cannot increase the supply much. Thus the elasticity is said to be inelastic (%
change in Q.S < % change in price).

High Risk Low Risk

Elastic Inelastic
Es>1 Es<1

5. Technique of Production
- If the producer is using a simple technique for production, then it will be convenient
and hassle free for him/her, to increase the supply. That is why, when price
increases the producer easily increases the supply, to a much greater rate, and thus
the elasticity is elastic (% change in Q.S > % change in price).
- But if a complex technique is used for production of a commodity, then it is
burdensome and difficult for the producer, to increase the supply. Thus, when price
of such commodities increases, the producer is unable to increase the supply at a
high rate. Thus, the elasticity is inelastic (% change in Q.S < % change in price).

Simple Complex
Elastic Inelastic
Es>1 Es<1
Q1. Differentiate b/w stock and supply.
Ans.
STOCK SUPPLY
1) Not related to price . 1)Related to price.
2)Any quantity measured at a 2)Quantities of a commodity that a
particular time. producer is able & willing to sell
3) It is a stock concept. during a period of time at various
prices.
3)It is flow concept.

Q2. Commodities X and Y have equal price elasticity of supply. The supply of X
rises from 400 units to 500 units due to 20% rise in its price. Calculate the
percentage fall in supply of Y if its price falls by 8%
Ans. EX = EY

EX = (% change = × 100)


= × 100 )

= 1.25
EX = EY = 1.25

EY =


1.25 =

% change in Q.S = 10%

Q.3 The price elasticity of supply of commodity Y is half the price elasticity of
supply of X. 16% rise in the price of X results in 40% rise in supply. If the price of
Y falls by 8%, calculate the percentage fall in its supply.

Ans. EX = E Y

EX =


= 2.5

EX = EY = 1.25
 
EY =


1.25 =

% change in Q.S = 10%

Q.4 Total revenue at price Rs. 4 per unit of a commodity is Rs. 480. Total
revenue increases by Rs. 240 when its price rises by 25 percent. Calculate its
price elasticity of supply.
Ans. New price-
% change = × 100

25% = × 100

Change in Price = Rs. 1

New price =4+1=5
Total revenue = Quantity supplied × Price
T.R Q.S PRICE
480 120 4
720 144 5


Es=


=0.8
 -:Chapter-7:-
Product: Returns to a factor
Product
 In this chapter, we have to study physical (no. of units) inputs and physical output
relationship which is termed as PRODUCTION FUNCTION.
 Output is same as product, which is the goods and services produced, in the
production process.
 Factors of production/inputs-They are essential elements which cooperate with each
other in the production process. These are of two types.

PRIMARY (factor inputs) SECONDARY (non-factor inputs)

 Land  Raw Material
 Labour  Fuel
 Capital  Power
 Entrepreneurship
 Qx = f { }
(Output) - (Input) function

But to understand this chapter, Factors of production must be classified as follows:

1. FIXED FACTORS:
 Fixed factors refer to those factors of production which cannot be changed during
short run.
 These are used in a fixed quantity in the short run.
 These factors can be changed only in the long run.
 Example- land, plant and machinery, factory building etc.
2. VARIABLE FACTORS
Variable factor refers to those factors of production which can be changed during short
period.
The quantity of variable inputs varies according to the level of output.
Example- labour, raw material etc.
When a producer initiates a business, such business may pass through three runs (phases)
which can be stated as follows:
 RUN

VERY SHOR RUN/ SHORT RUN LONG RUN

MARKET PERIOD
Is a run where all factors of It is a run where there It is a run where all factors are
production are assumed to be is a combination of assumed to be variable, and
fixed. So, production cannot fixed and variable thus every input can be
be increased at all. None of factors. Where certain changed.
the factor can be changed in factors (fixed) cannot
this run. be changed, while the
others (variable), can
be changed.

SHORT RUN V/S LONG RUN

1. It is a run where there is a It is a run where all factors are
combination of fixed and variable variable in nature.
factors.
2. Variable proportion of production Constant proportion of production
function applies. function applies
3. It states that, keeping fixed factors It states that, if all factors increases in
constant, variable factors are increased, same proportion, scale of production
output tends to change. tends to change.
4. Factor-ratio (ratio between the factors Factor ratio (ratio between the factors
of production) keeps on changing, as of production) does not change, as
one factor is constant, while other every factor is increased in the same
varies. proportion.
5. Eg: Land Labour Factor Eg: Land Labour Factor
Ratio Ratio
1 1 1:1 1 1 1:1
1 2 1:2 2 2 1:1
1 3 1:3 3 3 1:1
6. In short run, scale of production does Scale of production changes with
not change with continuous change in continuous change in Variable factor.
Variable Factor.
PRODUCTION FUNCTION
It is a function which establishes a functional relationship between physical input and
physical output of a commodity.
Or
In other words, Production function is a technological relationship that shows the
maximum output producible from various combinations of inputs.
A simple production function can be expressed as follows:
QX=f(x1,x2,x3,……….xn)
QX → Output of commodity X
f → function or depends upon
x1,x2,x3,………xn → physical quantities of various input
Note:- Production function never establishes any economic relationship between input and
output ( only technical or physical relationship) .
TYPES OF PRODUCTIONS FUNCTION

VARIABLE PROPORTION CONSTANT PROPORTION

PRODUCTION FUNCTION PRODUCTION FUNCTION
 It is a function which establishes a  It is a function which establishes a
functional relationship between functional relationship between
maximum possible output of a maximum possible output of a
commodity and input which are of commodity and factor are of variable
fixed and variable nature. nature.
Q= f{x1,x2} Q= f{x1, x2}
Q= Maximum possible output Q= Maximum possible output
x1= Variable factor required (no. of x1= amount of factor 1 (variable
variable factors) nature)
x2= Fixed factor (amount of factors which x2= Amount of factor 2 (variable)
is constant)
Example:- Example:-
50 x = f {5, 4} 50x = f {5, 4}
60 x = f {6, 4} 60x = f {10, 8}
It is also called short run production It is also called long run production
function function
BASIC CONCEPTS OF PRODUCTION- TOTAL, AVERAGE AND MARGINAL
PHYSICAL PRODUCTS (PRODUCT AND ITS TYPES)
In this chapter, product can be classified as follows:
1. TOTAL PRODUCT/TOTAL PHYSICAL PRODUCT (TP/TPP)
It refers to the total volume of output produced at a given factor ratio.
In other words, total product is the total units or the total quantity of commodity produced
by a firm with the use of all the units of variable factor keeping fixed input constant. It is
total output that is produced by all the variable factors combined, at a particular factor
ratio.
TP = (AP) X (Variable factor)
TP = ∑
2. AVERAGE PRODUCT(AP/APP)
It refers to the production per unit of the variable factors. It is the output produced by a
single variable factor, at a particular factor ratio.

AP=

3. MARGINAL PRODUCT (MP/MPP)

It refers to the change in total product due to introduction of one more or less variable
factor.
Marginal product is an addition to the total product when an additional unit of variable
factor (labour) is employed. It showcase the rate of total product.

MP = or MP=TPn – TPn-1


Above 3 concepts can be explained with the help of following schedule.

Land Labour T.P. A.P. M.P.
1 0 0 0 0
1 1 10 10 10
1 2 28 14 18
1 3 45 15 17
1 4 52 13 7
1 5 52 10.4 0
1 6 48 8 -4
  RETURNS TO A FACTOR

 LAW OF VARIABLE PROPORTIONS

This law was propounded by Alfred Marshall. It exhibits 'Short run production function'
in which one factor is variable and other is fixed. It is the modern version of returns to
factor. This law states that, by keeping fixed factors constant, increase in one variable
factor in short run: Initially, TP increases at increasing rate (%  in TP > %  in variable
factors) but eventually, TP increases at diminishing rate (%is TP< %is variable
factors) and finally, it falls.
In other words, this law states that as there is an increase in variable factor, keeping fixed
factors constant. Initially, MP Increases but eventually, MP diminishes and finally, MP
becomes negative.
Explanation of the law
Tabular Presentation
Land (L1) Labour TP MP Stages of
Fixed Factor (L2) Units) Units Returns to production
Variable variable factor
Factor
1 1 5 5 TP↑at↑rate Stage I
1 2 15 10 MP↑ Stage of increasing
1 3 30 15 returns

1 4 40 10 TP↑at↓rate Stage II
1 5 45 5 MP↓(Positive) Stage of decreasing
1 6 45 0 returns

1 7 40 -5 TP↓ Stage III

1 8 30 -10 MP↓(Negative) Stage of Negative
returns
 Diagrammatic presentation

NOTE: -
- MP is itself rate of TP.
- 'J' shape TP: increasing returns
- 'A' shape TP: decreasing returns
- TP increasing at increasing rate- this means that the producer is required to
increase less units of variable factors and there is a more level of increase in total
output produced, out of it. The variable factors are increasing slowly (in less
quantity), while total output is increasing faster (in more quantity). % increase in
TP > % increase in variable factor.
- TP increasing at diminishing rate- this means that the producer is required to
increase more units of variable factors and there is a low level of increase in total
output produced, out of it. The variable factors are increasing faster (in more
quantity), while total output is increasing slower (in less quantity). % increase in
TP < % increase in variable factor.
- TP is falling- this means that even when the producer is increasing variable input,
less and less units of total output is being produced.

Law of variable proportions exhibits three stages:

1. Law of Increasing returns:-
In short run, by keeping fixed factors constant, increase in variable factor, initially MP
increases and TP increases with an increasing rate, such phase is termed as increasing
returns to a factor because there is underutilization of the fixed input.
2. Law of diminishing returns:-
In this stage, as variable factors increases continuously by keeping fixed factors constant,
MP diminishes and TP increases with diminishing rate because there is pressure on fixed
input.
3. Law of negative returns:-
In this stage, when variable factor increases continuously by keeping fixed factors constant,
MP becomes negative and TP starts diminishing because there is too much of variable
input in relation to the fixed in relation to the fixed input.
 ASSUMPTIONS OF THE LAW
1. In short run, there should be combination of fixed and variable factors.
2. State of technology is assumed to be constant.
3. Variable factor (Labour) should be homogeneous.
 Rational stage of operation
Technically, producer will find his equilibrium only in second stage of production when
MP is decreasing but still remains positive and TP is maximum. So stage of diminishing
returns is the most relevant stage of operation for a producer.
 Postponement of the Law
Postponement of the law of variable proportions (the situation of diminishing MP) is
possible under two situations, as under:
(1) When there is improvement in technology used in the process of production. So
that greater output is achieved with the same inputs.
(2) When some substitute of the fixed factor is discovered. So that the constraint of
fixity of the factor is removed. However, such a situation is very rare, if not
impossible.

CAUSES OF INCREASING RETURNS TO FACTOR

1. Fuller utilisation of fixed factor
In the initial stages, fixed factor remains underutilised. The producer has the ability to fully
exhaust the fixed factor, in the initial stage, as it is not used before and holds the capacity
to be fully used which leads to greater increase in the total output. Its fuller utilisation calls
for greater application of variable factor. Hence initially, additional units of variable factor
add more and more to total output or marginal product of variable factor tends to rise.
2. Division of labour and specialization
With more units of variable factor (labour), it is possible to divide the work among the
labourers according to their skill, experience and knowledge. This division of labour results
in specialization which insures better efficiency in production leading to increasing return.
3. Better coordination between factors
Initially, as long as the fixed factors remains underutilised additional application of factors
tends to improve the degree of coordination between fixed and variable factors. As variable
factor is increased, they work better and more effectively with the fixed input. As a result,
total output increases at an increasing rate.
4. Volume discount
When a firm purchases raw material etc. in bulk, it may get some type of discount on price.
Volume discounts also lead to increasing returns due to cost reduction.

CAUSES OF DIMINISHING RETURNS TO FACTOR

1. Fixity of the factors (use beyond optimum capacity)
As more and more units of variable factor continue to be combined with fixed factor the
fixed factor (which cannot be increased) gets over-utilised and exhausted. It loses its
capacity to produce efficiently Hence, rate of increase in total production falls, leading to
diminishing returns.
2. Lack of perfect substitution between factors upto a certain limit.
Factors of production are imperfect substitutes for each other, as fixed factors become
exhausted, variable factor is used as a substitute of it. The variable factor cannot produce
with same level of efficiency as fixed factor. Eg. -More and more of labour cannot be used
in place of additional capital. Hence, diminishing returns comes in.
3. Poor co-ordination between factors
Continuous increasing application of variable factor along with fixed factor beyond a point
cross the limit of ideal factor ratio, which disturbs the co-ordination between fixed and
variable factors. Continuous increase in variable factor working with the constant fixed
factor leads to overcrowding. Hence, law of diminishing return set in.
4. Management problem
Use of too much of variable factor (labour) creates the problem for effective management.
Issues of conflicts and demands arise, which negatively impacts the production.
 Relationship between TP and MP
1) When MP increases, TP increase at an increasing rate.
2) When MP diminishes but above zero, TP increases with diminishing rate.
3) When MP becomes Zero, TP at its maximum.
4) When MP becomes negative TP starts falling.
Note:- MP can be negative but TP can never be negative.
 Relationship between MP and AP-
(We understand the effect on average product, due to the positioning of average product
with marginal product)
1) When MP is greater than AP, then AP rises
2) When MP is equal to AP then AP at its maximum
3) When MP is less than AP, AP falls

-: HOTS:-
Q.1 Can the law of diminishing returns be postponed?
Ans. Yes,
i) The law can be postponed by using improved technique of production
ii) If some substitute of the fixed factor is discovered the law can be postponed.
Q. 2 Why MP curve cuts AP from its top?
Ans. This is because when AP rises, MP is greater than AP, when AP falls MP is less than
AP. Implying that MP curve cuts AP from its top. So AP‟S maximum point is when MP
cuts it, as before that it is continuously rising (because AP is less than MP) and as after that
AP is falling (because it becomes more than MP).
Q. 3 AP may continue to rise even MP starts declining. Why?
Ans. This happens as long as declining MP is greater than existing AP.
Q.4 There is always an ideal factors ratio. What happens if this ideal ratio is crossed?
Ans. If the ideal factor ratio is crossed, diminishing returns to a factor set in. MP of the
Variable factors starts declining. TP increases only at a decreasing rate.
Q.5 Do you agree that TP must decrease in a situation of diminishing returns?
Ans. No. TP should not be decreasing in a situation of diminishing returns. In a situations
of diminishing returns, MP decreases. It means less and less units of output are added to
TP. Nevertheless, TP must be rising. TP decreases only in a situation of negative returns.
Q.6 Should both TP and MP be declining in a situation of diminishing returns?
Ans. No. In a situation of diminishing returns, only MP should be declining. And when MP
is decreasing, TP should be increasing, though at a diminishing rate.
 -:Chapter- 8:-
Cost
 It refers to the monetary expenditure incurred on factors of production/inputs for
producing a commodity.
 It is also known as 'nominal' or 'money' cost.
 In the short run a firm employs two types of factors of production i.e. fixed factors
and variable factors.
 Corresponding to fixed and variable factors, cost is also of two types.
Types of short run cost
FIXED COST VARIABLE COST
It is also known as overhead cost, It is also known as direct cost, avoidable
unavoidable cost or supplementary cost or prime cost.
cost.
1) This cost is related to initiation of This cost is related to initiation of
business. production.
2) It is the cost incurred on fixed factors It is the cost incurred on variable factors
of production. of production.
3) Can be incurred when output is zero. Always zero when output is zero.
4) It remains same whether output is It keeps on changing as output changes.
zero or more.
5) Eg. Rent of premises, salary to Eg. Expenditure on fuel, raw materials
permanent staff, minimum telephone wages to causal workers etc.
bill, minimum electricity bill,
insurance premium, Interest on
Capital, License fees, Normal profit
etc.
Short Run Cost Curves

Total Cost curves Average Cost curves Marginal Cost curve

(MC)

TFC TVC TC AFC AVC AC/ATC

 TOTAL COST CURVES-
Output TFC TVC TC
0 12 0 12
1 12 9 21
2 12 16 28
3 12 18 30
4 12 22 34
5 12 30 42
6 12 42 54

{AB=PQ=TFC}

1. TFC CURVE-
- In short period, total cost incurred on fixed factors is termed as total fixed cost
(TFC). This cost does not change with the change in level of output (as fixed factor
remains constant) and it incurs even when no output is produced and so TFC curve
starts above the origin. When the output is zero or maximum TFC remains the same.
- Since TFC is constant at all levels, total fixed cost curve is a horizontal straight line
parallel to x-axis.
- TFC = AFC × output
- TFC= TC- TVC
2. TVC CURVE
- In the short run the total cost incurred on variable factors is termed as total
variable cost (TVC)
 - Total Variable cost changes directly with the level of output, rising as more is
produced and falling as less produced. When output in zero, this cost is also zero,
and so TVC curve starts from the origin.
- TVC = AVC× output
- TVC= TC-TFC
- Shape of TVC:
(i) Initially in short run, TVC increases with a diminishing rate because of law of
increasing returns.
(ii) Then after reaching a point it increases with an increasing rate because of law of
diminishing returns.

3. TC CURVE
- It refers to the total expenditure of producing any given amount of output or
summation of TFC and TVC at any given level of output.
- Thus, TC curve starts from TFC curve (at zero level of output), as TC consists of
both TFC and TVC, and TVC is zero at zero level of output.
- TC is then parallel to TVC as gap between TC and TVC curve is TFC (which
remains constant) (AB=PQ-See diagram).
- The difference between TC and TVC is TFC which is always constant. As the
difference between them is of TFC, which is constant.
- TC changes just like TVC changes as TC consists of TVC and TFC, and TFC has
no change.
- TC = AC × output
- TC = TFC + TVC
- Shape of TC:
(i) Initially in short run, TC increases with a diminishing rate because of law of
increasing returns.
(ii) Then after reaching a point it increases with an increasing rate because of law of
diminishing returns.
Relationship between TFC, TVC and TC
 TC curve can be obtained by adding TFC and TVC curve vertically at each point.
 TC and TVC curve have the similar shapes , the only difference is that TVC starts from
origin while TC starts above the origin. They have similar shape because TC will
change exactly as TVC will change because any change in TC is due to TVC, as TFC is
constant.
 At O level of output, TC is equal to TFC in short run (because there is no TVC at zero
level of output) so TC and TFC curves start from the same point which is somewhere
above the origin.
 The vertical difference between TC and TFC curves represents the TVC.
 The vertical difference between TC and TVC curve represents the TFC. TC and TVC
remain parallel all the same, as the difference between TC and TVC (which is TFC)
remains constant.

AVERAGE COST CURVES

1. AVERAGE COST/AVERAGE TOTAL COST (AC/ATC)
 Average cost (AC) is the cost per unit of output produced. AC can be obtained by
dividing the total cost by the quantity of output.
AC =
 Diagrammatically the vertical summation of average fixed cost (AFC and average
variable cost (AVC) gives the AC or ATC curve.
ATC or AC = AFC + AVC

(i) In short run, AC curve is U-shaped

(ii) Initially, AC diminishes because law of increasing return.
(iii) Then AC rises due to law of diminishing returns.

2. AVERAGE FIXED COST (AFC)

 Average Fixed cost is the per unit fixed cost of production. It is the per unit
expenditure on fixed factors.
 AFC can be obtained by dividing TFC by the quantity of output.
 AFC =
 AFC = AC-AVC (TFC = AFC X Q)
 AFC can never be zero as TFC can never be zero.
 AFC curve is downward sloping from left to right because, AFC = TFC
(numerator) remains constant and output (denominator) keeps on increasing.
 It never touches x & y axis as it can never be zero because TFC (numerator) remains
constant and is never zero.
  It is a rectangular hyperbola curve which means any rectangle drawn below it will
have equal area because TFC is constant.

3. AVERAGE VARIABLE COSTS (AVC)

Average variable cost is per unit cost on the variable factors of production.
 AVC can be obtained by dividing TVC by the quantity of output.
AVC = = (TVC = AVC X Q)
 AVC = AC-AFC

 In short run, AVC curve is U-shaped

 Initially, AVC diminishes because law of increasing return, when TVC increases
with diminishing rate.
 Then AVC rises due to law of diminishing returns, when TVC increases at
increasing rate.
A. MARGINAL COST (MC)
 Marginal cost (MC) is the change in total cost by producing one more or one less
unit of output.
  In other words, MC is the addition to total cost as one more unit of output is
produced.
It is closely associated to TVC
 MC = TCn - TCn-1 or TVCn - TVCn-1
 MC = or
 ΣMC = TVC

Marginal cost is not affected by fixed cost

MC is independent of fixed cost. MC represents the change and there is no change in total
fixed cost, as it remains constant with change in output.
It is only the variable cost which changes with the change in the level of output in the short
run. In other words, a change in TC is only caused by a change in TVC and MC measures
the change in TC, which is only due to TVC.
MC can be estimated from total variable cost (TVC) also and is directly related with it.
Therefore, MC is the change in TVC as one more unit of output is produced.

- It is half u-shaped curve, as it initially falls due to increasing returns to factor and
then it rises due to diminishing returns to factor.
- The area under MC curve represents TVC.
 COMBINED DIAGRAM OF AFC, MC, ATC AND AVC.

- The distance between AC and AVC keeps on decreasing as the distance between
them is of AFC, which keeps on decreasing, as AC = AFC + AVC.
- The AC and AVC curves never intersect each other because there is a gap between
them, of AFC, which never becomes zero.
- AFC can never intersect AC, as AFC can never be equal to AC, because of the
difference between them of AVC.
- MC intersects AVC, before it intersects AC, because AVC rises earlier than AC.
This is because AC consists of AFC, which is falling. Thus AC is more consistent
than AVC.
RELATIONSHIP BETWEEN MC & AC

(i) MC is less than AC, AC falls

(ii) MC is equal to AC, AC is at its minimum
(iii) MC is greater than AC, AC rises
 RELATIONSHIP BETWEEN MC & AVC

(i) MC is less than AVC, AVC falls

(ii) MC equals to AVC, AVC is at its minimum
(iii) MC is greater than AVC, AVC rises

RELATIONSHIP BETWEEN TC & MC

 When TC rises at diminishing rate (up to point A), MC decreases (till point E).
 When TC rises at an increasing rate (beyond point A), MC increases (beyond point E).
 When rate of increase in TC stops diminishing, MC is at its minimums point (at point
E).
 Relationship between Variable Short Run Costs
Output TFC TVC TC AFC AVC ATC MC
(units)
0 12 0 12 ∞ - 0 -
1 12 9 21 12 9 21 9
2 12 15 27 6 7.5 13.5 6
3 12 18 30 4 6 10 2
4 12 22 34 3 5.5 8.5 4
5 12 30 42 2.4 6 8.4 8
6 12 42 54 2 7 9 12

B. Other types of costs

1. Explicit cost Implicit Cost
1. It refers to the expenditure 1. Cost which is incurred on self-
incurred on those factors which owned resources used in
are purchased from market or the production process or the cost in
which payment is not made to
cost in which payment is made
the outsiders.
to outsiders for buying or hiring
of inputs.
2. Examples:
2. Examples:
Salary for own services, rent of own
Expenses on raw materials, fuel
premises etc.
purchases from market
NOTE- While calculating TC, implicit cost also should be taken into consideration:
II) Money cost and real cost
C. MONEY COST
The amount spent in terms of money by a firm for production and sale of a commodity.
(production cost). It is the monetary expenses that the producer bear.
Eg: Interest, Wages etc.
 REAL COST
It refers to the efforts, sacrifices, discomforts and pain suffered by the person while
rendering factor services.it is physical expenses that the producer bear.
Real cost is a subjective concept that makes it difficult to calculate.
Eg: Worker works 8 hours for Rs. 100. Then 8 hours is real cost.
III) Private and social cost
 PRIVATE COST
It refers to cost of production incurred by an individual firm to produce a commodity. For
an individual firm, private cost includes both explicit and implicit cost.
 SOCIAL COST
It refers to the cost or disadvantages that the society has to bear on account of production
of the commodity. Eg: Water pollution, Air pollution etc. cause health hazards and thereby
involves cost of the entire society.
IV) Opportunity Cost
It refers to the sacrifice for the next best alternative use or opportunity cost is opportunity
Lost.
V) Normal Profit
It is the minimum amount which is required by entrepreneur to be sustained in business.
TC=Explicit Cost+ Implicit Cost+ Normal Profit.

-:HOTS:-
Q.1 As output increase, AC tends to be closer to AVC, Why?
Ans. AC=AFC+AVC. As output increases, AFC must fall as TFC is constant.
Consequently, component of AFC in AC tends to shrink. This brings AC closer to
AVC. The difference between AC and AVC is represented by AFC, which is falling
and the gap is falling and so AC and AVC tend to come closer.
Q.2 AC may continue to decline even when MC is rising. Why?
Ans. Even when MC is rising, AC will continue to fall as long as MC is less than AC.
Q.3 The average cost of producing 5 units of a product is Rs. 5 and that of producing
6 units is Rs. 6 What is the marginal cost.
Ans. OUTPUT AC TC (AC×OUTPUT)
5 5 25
6 6 36
MC = TCn - TCn-1
= 36 – 25
= Rs. 11
Q.4 Give reasons and state whether the following are true or false.
(i) Average cost falls only when marginal cost falls.
(ii) When marginal cost rises, average cost will also rise.
(iii) As output is increased, the difference between Average Total Cost (ATC) and
average Variable Cost (AVC) falls ultimately and becomes zero.
(iv) The gap between AC and AVC keeps on decreasing with rise in output.
Ans. (i) False: AC still falls even when MC rises, till AC > MC.
(ii) False: When MC rises, AC may fall or remain constant and or may rise. AC rises
when AC < MC.
(iii) False: Because the different between ATC and AVC falls but never becomes zero
because AFC always remains positive. AC = AVC + AFC.
(iv) True: Because the difference between AC and AVC is AFC, which falls with
increase in output.
 -:Chapter- 9:-
REVENUE
Meaning of Revenue
It refers to the amount of money mobilized or obtained by a firm due to its sales or the
revenue of a firm refer to its sales receipts or money receipts from the sale of its output. It
is the money that the producer receives, when output is sold.
TYPES OF REVENUE-
TOTAL REVENUE (TR)
It refers to the total amount of money mobilised by a firm due to its sales of a particular
level of output or Total revenue refers to the total amount of money that a firm receives
from selling a given amount of output.
TR = Quantity sold x price per unit (AR)
( TR = P x Q )

AVERAGE REVENUE (AR)

It refers to revenue per unit of output or price per unit is also known as AR

- AR is the same thing as price (AR=Price)

AR means per unit revenue received by the firm from the sale of the product. Price means
per unit payment made by the consumer to buy per unit of the product.
Average revenue from seller‟s point of view, is equal to the price from buyer‟s point of
view. Therefore, AR and price are one and the same thing.
AR curve and demand curve for the firm‟s products are also one and the same. AR curve is
called demand curve since it indicates quantity demanded by the buyers at different prices.
- AR curve is equal to demand curve(AR=Demand Curve)
 AR curve also acts as the demand curve of the firm.
 The demand curve of the firm shows the quantity of the commodity demanded by
all the consumers, from that firm, at different prices.
  Firm‟s demand curve is different from the individual demand curve as individual
demand curve shows the quantity of a commodity demanded by a particular
consumer, from any or many firms, at different prices.
 The firm‟s demand curve is same as the AR curve, as AR curve shows the revenue
per unit of output sold which is same as firm‟s demand curve as the per unit revenue
is same as the price of the commodity, and the output sold for the producer is same
as the quantity demanded by the consumers.

MARGINAL REVENUE (MR)

It refers to change is TR due to sale of an additional unit of output.


MR = TRn – TRn-1
Above three aspects can be explained with the help of the following schedule:
Q. Sold Price TR AR MR
0 - 0 - -
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
 :-Chapter 10:-
MAIN MARKET FORMS
 MARKET
 Ordinarily „Market‟ refers to a physical place or an area where commodities are
bought and sold.
 In Economics. „Market is the mechanism or arrangement by which buyers and sellers of
a commodity are in close contact for sale and purchases and are able to strike a deal
about the price and the quantity to be bought and sold.
 In other words. „Market refers to a structure in which buyers and sellers of a commodity
remain in close contact, where a consumers tries to maximise their satisfaction, while
producers tries to maximise their profit.
 In other words, Market is a place where prospective buyer and prospective seller come
in contract with each other for buying and selling of produce.
 Market is a mechanism that facilitates contract between the buyer and sellers for sale
and purchase of goods and services to satisfy their needs.
 FORMS OF MARKETS
Market may be classified into four types

Perfect Competition Monopoly Imperfect Competition

mpetition Monopolistic Oligopoly

 BASIS OF CLASSIFICATION
1) Numbers of buyers and sellers
2) Nature of product
3) Freedom (of entry and exit)
4) Price
5) Position of AR and MR
6) Price elasticity of demand
7) Price Taker/ Maker
8) Selling Cost
9) Knowledge of the Product
BASIS OF PERFECT MONOPOLY MONOPOLISTIC OLIGOPOLY
CLASSIFICATION COMPETITION COMPETITION

Number of buyers Large Buyers Single Seller Large Buyer Few Sellers
and sellers and large
Large Sellers Large Buyers Large Sellers
buyers

Nature of Product Homogeneous Product Product Homogeneous

(Identical in price, Specialization differentiation or or
color, brand, (No close heterogeneous Differentiated
quantity, quality, substitute product (Close
shape, size, available) substitutes
packaging etc) available)

Price Uniform Price Price Price

discrimination discrimination discrimination

Price Taker or Firms are Price Firm- Price Sellers have partial Price maker
Maker Taker Maker control over price

Knowledge about Perfect knowledge Imperfect Imperfect Imperfect

market conditions knowledge knowledge because knowledge
because of of product
price differentiation
discrimination

Freedom Free entry and free Restricted Free entry and free Entry barriers
exit entry exit

Price Elasticity Ep= Ep<1 No Ep>1 Close Indeterminate

close substitutes (Elastic) demand curve
(because
substitutes (due to inter
(Inelastic) dependence)

AR and MR AR=MR AR>MR AR>MR AR>MR

Selling Cost No Selling cost Low High High( loss of

social welfare
and wastage)
 PERFECT COMPETITION
Perfect competition is a market in which there are large number of buyers and sellers of
a homogenous product. Price of the product is determined by the industry so a uniform
price prevails in the market. No firm can influence that price.
FEATURES OF PERFECT COMPETITION-
1) Large number of buyers and sellers-
There are many sellers in the market selling the commodity, and there are many
consumers of the commodity, buying it. Due to this-
Each buyer and seller is so small a part of the market as compared to the whole
market, that he/she can't influence the market price. Each seller produces such a small
quantity of the total market supply that he can't influence the market price.
Also, a single buyer is also too small a part of the market to influence the price of the
commodity.
As a result, the prices are decided by the industry which is taken by the firm.
Hence, an individual firm is a price taker in this market.
Implications- (this feature leads to)
i) Firm is a price taker.
ii)Seller can sell any amount of goods at given price.
iii)Demand is perfectly elastic.

As a single buyer or seller doesn‟t have the ability to influence the price, the price is
decided by the whole industry by the forces of market demand and market supply.
Every firm takes that price, and can sell any quantity of the commodity at that given
price.
2) Homogeneous Product
Under perfect competition all the firms produce homogenous or perfectly standardized
product.
The products produced by the firm are identical in all respects like quality, colour, size,
weight, design etc.
The buyers do not distinguish the output of one firm from that of the other. And so, they
will pay same price of product to all the firms in the industry. Thus, every firm function on
a uniform price, decided by the industry.
Implications-
i)Uniform price .
ii)Goods are perfect substitutes.
iii)Prevalence of minimum price.
iv)No consumer exploitation.

3) Uniform Price (Same price)

Product homogeneity and large number of buyer and sellers implies that all sellers sell their
products at a uniform price.
Any firm in this market can sell any quantity of the commodity, at a given price.
If any firm tries to raise its price, it will lose its sales, as it is very convenient for the
consumer to shift to a different firm (due to large sellers and homogenous product). So,
firms sell their products at a constant price.
Implication
i)Minimum reserve price

4) Free entry and exit

Any firm can enter and exit industry with utmost freedom. There is no legal restriction
to the entry, as every firm is selling homogenous commodities. Entry and exit of the
firms depend on super normal profit and super normal loss in short run.
If there is super normal profit in the industry in short run, new firms will get attracted
and will enter into the market. More the firms in the industry, more is the supply. With
increase in supply, equilibrium prices falls and with fallen price, the firms starts earning
less profits. Thus, due to free entry of the firms in the market, only normal profits
prevail in the market. None of the firm earn super normal profit in perfect
competition, in long run.
Firms are earning super normal profit  Entry of new firms  Market Supply
() Price () Profit ()  Normal Profit in long run.
And if there are losses in the short run, the existing firm will start exiting the market to
avoid the losses. The less the firm in the market, the less the supply. And due to
decrease in supply, equilibrium price increases. With the risen price, the firms in the
market starts earning normal profit and stop bearing losses. Thus, only normal profits
exists in perfect competition in long run.
Firms are incurring losses  Firms start exiting  Market Supply ()  Price
() Profit () Normal Profit
Implication
(i). Only normal profits in the long run.
5) Perfect knowledge
Buyers and sellers are fully aware about the price prevailing in market because
homogeneous product is being sold in the market. Thus, any seller does not sell the
commodity below or above the market price. Also, any buyer will not buy at a higher
price as they are also fully aware.
Also buyers and sellers have complete knowledge about the demand and supply of the
commodity and so the sellers can restrict the supply accordingly.
Every producer also holds perfect awareness about the availability of inputs and
technology and everyone has equal access. It helps in reducing cost of production.
6) Selling cost
Selling cost means the expenditure on advertisement and publicity of the product.
As the commodity sold in the market is homogenous, and all the firms are selling
perfect substitutes, none of the firm requires to spend money on the selling cost. So, no
selling cost is incurred by any firm, in this market.
A firm under perfect competition faces a horizontal straight-line demand curve which
means market price remains constant irrespective of the number of units sold by a firm.
7) Elasticity of Demand (Ep=∞)
AR curve plays the role of demand curve. It is perfectly elastic, Ed = ∞ (continuous
change in quantity demanded, without any change in price).
AR curve also represents price line. In perfect competition price remains constant, (due
to large sellers in the market and homogenous products) and so the AR and demand
curve will be parallel to X-axis.
- In perfect competition, the firm can sell any amount of the commodity at the
prevailing price. The firm's demand curve is indicated by a straight horizontal line. A
firm under perfect competition is a price taker and faces a perfectly elastic demand
curve.
8) TR, AR and MR under Perfect Competition (Schedule and diagram)
Quantity Price TR AR MR
sold
0 - - - -
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
6 10 60 10 10
 AR curve remains constant, parallel to X-axis, as AR= price of the commodity, and
in perfect competition, price remains unchanged.
MR curve overlaps AR curve as MR represents the change in the total revenue, which
is also constant. And so, AR=MR.
TR curve increases at a constant rate because of constant MR (MR is the rate of TR).
It is an upward sloping straight line curve.

 MONOPOLY
Meaning – It refers to a market structure in which there is only a single seller and large
number of buyers of a commodity with no close substitutes of the commodity,
available. The word monopoly is derived from the Greek word „monos‟, meaning
„single‟ and „polein‟ meaning „seller‟. For example- Indian railways.
FEATURES OR CHARACTERISTICS OF MONOPOLY MARKET
1) Single seller and large number of buyers
There is only one seller or producer of a commodity in the monopoly market. The
monopoly firm has full control over the supply and the price of the commodity. Any
change in the amount of output produced by the monopolist would have significant
influence over the market price. As there is one seller, he/she has the power to influence
the price of the commodity.
The number of buyers of the product is large. Therefore, no buyer can influence the
price of the product.
Implications-
i) Firm is the Price maker
ii) Consumer exploitation
ii) Product specialization
The products sold by the monopolist have no close substitutes in the market. As a
result, the consumer will have to purchase the commodity from the monopolist only. In
other words, a monopolist does not face competition. Eg. There is no close substitute of
Indian railways as a bulk carrier in Indian economy.
The monopolist is selling such a commodity, which is not sold by any other seller, and
so the monopolist holds the ability to be the price maker of that commodity.
Implications-
i) No competition among the firms
ii) Firm is the price maker
iii) Restricted Entry
Under monopoly, there are some restrictions or barriers on the entry of new firm
due to natural, legal or man-made restrictions in the forms of patent rights, copy right,
government laws, exclusive control over technique or raw material etc.
Due to restricted entry, no new firm can enter in the market easiliy and thus there is no
increase in the supply in the market. So there is no competition for the monopolist.
Monopoly firm earns abnormal or super normal profits in the long run due to the
limited supply by only the monopoly firm.
Implications-
i) Legal, technical or natural barriers to the entry of new firms.
ii) Firm earns super-normal profit in the long run.
iv) Price discrimination
It refers to the act of a seller (monopolist) of charging different prices from different
buyers for the same product. In monopoly, there is a possibility of price discrimination.
As the monopolist is the sole seller, he/she can charge different prices from two buyers,
for the same commodity.
Implications-
i) Consumer exploitation
ii) High profits
v) Price maker
This means that a monopolist can fix whatever price he wishes to fix for his product, as
he is a single seller of the product which has no substitutes, because there are legal,
natural and technical barriers to entry of new firms.
He is important enough part of the market to influence the price of the commodity.
Implications-
i) No close substitutes of the commodity
ii) Single seller
ii) Barriers to entry & exit

vi) Elasticity of demand (Ed<1)- (Negatively sloped steeper demand curve)

The demand curve (AR) faced by the monopolist is downward sloping which indicates
that a monopolist can sell more only by lowering the price, as more is demanded at less
price, due to law of demand.
Also, demand curve in the monopoly market is inelastic (steeper), as there are no close
substitutes available in the market, due to which even when the price of the commodity
is increased, quantity demanded is fallen at a very small degree.

Steeper demand curve

vii) Shape of TR, AR and MR under MONOPOLY (Schedule and diagram)

Q. sold Price TR AR MR
0 - - - -
1 10 10 10 10
2 9.5 19 9.5 9
3 9 27 9 8
4 8.5 34 8.5 7
5 8 40 8 6
6 7.5 45 7.5 5
7 7 49 7 4
8 6.5 52 6.5 3
9 6 54 6 2
10 5.5 55 5.5 1
11 5 55 5 0
12 4.5 54 4.5 -1
In monopoly, AR is greater than MR (AR>MR), as MR is the change in total revenue,
which falls faster than the per unit revenue (AR).

Also, both AR and MR curve are downward sloping steeper, due to law of demand
and lack of close substitutes respectively. (AR = demand curve).

Structure of Monopoly (Why is there only a single seller in the monopoly market?)

This is due to the restricted entry of any other seller in the market. A new firm is unable
to enter, due to either of the following restrictions-

 Government License

The government gives license to only one company for providing a particular product
or service in a given locality.
Eg. Till 2002, BSNL had the Monopoly of providing international telecom services.
 Patent rights

Big private companies engage in research and discoveries and come out with new
inventions or a new technique of production or new commodity. To encourage this
research, development, innovation and discovery and reward their risk and investment
in research, the government provides them with patent right which is the official
recognition that they are the original creators of the product and no one can use the product
or technique without obtaining a license from them.
Patent life is the amount of years till which this right is given to the inventors, by the
government.
 Cartel formation (collision against competition)

In order to maximize their profit and create a single united power, sometimes producers of
a particular product, retaining their identities, come together and form an organization
called a cartel.
Eg. : OPEC
 Natural Occurrence
Monopoly may exist as a natural phenomenon. This is known as natural monopoly.
Any other producer is unable to enter the market because they don‟t have the availability of
raw material required for the commodity or the commodity itself, due to natural
restrictions.
Eg.: The only spring of water in an island maybe under the control of one person.
The only marble quarry in the market, is owned by a person, then that person
becomes the monopolist of marble and no one else is able to sell the same commodity
in the market.

MONOPOLISTIC COMPETITION
(Competitive behavior)
Meaning – It refers to the market in which there are large number of sellers selling closely
related differentiated products to a larger number of buyer. Each firm has a partial control
over the price of the product. Eg. (FMCG products like Toothpaste, Shampoo etc.)
FEATURES OR CHARACTERISTICS OF MONOPOLISTIC MARKET
1) Large number of buyers and sellers
In imperfect competition, there are large number of firms selling closely related products.
Each firm produces only a very small part of the market supply. So, firms under
monopolistic competition are not completely price makers.
 In monopolistic competition, the number of buyers is very large so no individual buyer
can influence the price of the product by changing his demand.
Also, there is high competition among the sellers due to the large number of firms,
trying to sell their commodity and earn more profits.
Implication
i) Choice of products ensures quality
ii) High competition among the sellers
iii) Partial control over price by the firms
2) Product differentiation
Product differentiation means that the commodity, sold by different sellers in the
market, has variations in them. This means, that close substitutes of the commodity
are available in the market.
In monopolistic competition, the number of firms is large but their products differ from
one another. Product differentiation can be brought by changing the quality, colour,
shape, brand, durability of product, by advertisement and publicity, patent rights,
packing and trademarks, by providing supplementary and other services along with the
sale of the product to the consumer etc.
Because of product differentiation, each firm can decide its price policy, independently
and they are not completely price takers. So, each firm has a partial control over
price of its product.
Partial control over price by the sellers means that the producer can influence the price,
due to product differentiation. But only till an extent, because there are large sellers in
the market, which creates high competition.
So, a particular seller can increase the price on the basis of a distinct product, but it
cannot be increased a lot, otherwise the buyer will shift to another seller.
Implications
i)Consumer welfare and exploitation both
ii)Misleading
iii)Partial control over price by the firms
iv)Ed > 1

3) Freedom of entry and exit of firms

Firms are free to enter into or exit from the industry. There is freedom of entry in the
sense that new firms are free to produce.
On the other hand, there are no restrictions on the firm deciding to leave the industry.
- Whoever has the ability to compete and sustain in the market can enter and exit. This
implies that the firms will earn normal profits in the long run.
4) Selling Cost
The expenses or cost which are incurred by the firm on advertisement and publicity to
promote its sales are called the selling cost.
Each firm has to spend huge amount of expenditure on the advertisement of its
product due to high degree of competition among the sellers.
In order to sell more units of the product, each firm gives wide publicity of its product
in newspapers, cinema, magazine, TV, radio etc.
Implication
i)Brand loyalty (leads to partial control of price)
5) Lack of perfect knowledge
- Sellers and buyers of product and owners of factors of production do not have
perfect knowledge about the prices of the products and factor services and the
market conditions of demand and supply, due to large number of buyers and
sellers.
- Due to product differentiation, it is very difficult for a consumer to compare the
prices of different products.
Implications
i) Consumer exploitation
6) Elasticity of Demand (Ed > 1) (Flatter Curve)
 - Demand curve is downward sloping as more is demanded at a lowered price,
because law of demand operates.
- Demand curve in monopolistic market, is elastic in nature (Ep>1) and so flatter
demand curve, indicating a slight change in price will have a greater effect on
demand. This is because, there are close substitutes available in the market, and as
soon as a seller increases the price of the commodity, the buyers has the privilege to
shift to another seller.
7) Shape of TR, MR and AR under monopolistic market:-

8) AR is greater than MR (AR>MR), as MR is the change in total revenue, which falls

faster than the per unit revenue (AR).

- Both AR and MR are downward sloping, as AR acts as the demand curve, and
more is demanded at a lower price.
- Also, AR and MR are flatter because the demand curve is highly elastic, due to
easy availability of substitutes of the commodity in the market.
 Relationship between TR and MR under imperfect competition: -
  When MR increases, TR increases at increasing rate.
 When MR diminishes, TR increases at a diminishing rate.
 When MR is Zero, TR at its Maximum.
 When MR becomes Negative, TR starts falling.
Note:- MR is the rate of change in TR
 Relationship between AR and MR

 When MR>AR, AR increases.

 When MR=AR, AR at its maximum.
 When MR<AR, AR falls
OLIGOPOLY
It is a market situation in which an industry has only few big firms mutually dependent for
taking decisions about price and output.
In other words, oligopoly is a market situation where a few big firms produce and compete
for their homogenous or differentiated products. There is interdependence of firms with
regards to price, output and advertisement.

 TYPE OF OLIGOPOLY:
- Perfect oligopoly and imperfect oligopoly-
(i) Perfect Oligopoly
This oligopoly market is that market where there are few firms producing
homogeneous products in the market.
(ii) Imperfect oligopoly
It is called imperfect oligopoly when there are few firms in the market, selling
differentiated products.
 - Non-Collusive and Collusive Oligopoly
(i) Non-Collusive or Non-Cooperative Oligopoly
If in an Oligopoly market, the few firms present, compete with each other and
maintains a non-cooperative nature, then it is called non-collusive oligopoly. Here
firms try to introduce policies which clashes with other firm‟s, and try to cut each
other‟s sale.
(ii) Collusive Oligopoly or Cooperative Oligopoly
If the few firms in the market, cooperate with each other in determining price or
output or both, it is called collusive oligopoly. Here, the firms form cartels and
introduces policies that doesn‟t clash with each other‟s. eg- OPEC
FEATURES OR CHARACTERISTICS OF OLIGOPOLY
1. Few Firms
- Oligopoly market structure is that where there are a few big firms producing most
of the output of industry. The exact number of firms is not defined. The few firms
capture the whole market of the commodity.
- The word 'few' signifies that the number of firms is manageable enough to make a
guess of the likely reactions of a rival by a firm.
Implications-
i) Extra –normal profits
ii) Firms are Price makers
iii)Underutilization of resources
2. Firms are interdependent in taking price and output decision
- When there are few firms, it is likely that the rival firms have knowledge as to how
each firm operates. The policy of one firm directly effects every other firm because
the products are substitutes of one another and they are very few sellers of that
product.
- If one firm does something about price and output policy, the rivals are likely to
take quick note of it and react by changing their own price and output plans. Thus,
every firm is quick to react to any change in a firm‟s price policy.
- Therefore, the given firm, expecting reactions from its rivals, considers such
possible reactions, before taking any decision about price and output of product.
- Hence, it makes each firm dependent on each other. There is cut throat
competition existing among the firms.
-
 Implications
i) Cut- throat competition
ii) Consumer welfare
3. Barriers to entry of firms
- Patent rights, control over the raw material, government license prevent new
firms from entering into industry. Only those firms which are able to cross the
barriers are able to enter.
- The few firms present in the market are so big, that a large amount of investment
and risk is required for a new seller, to stand among the existing firms. Thus, only
those few firms can enter in the market who has the ability to match up with the
current firms.
- Also, a lot of times, the firms form cartels or cooperative groups and prevents any
new firm from entering in that cartel.
Implication
i) Extra normal profits in the long run

4. Non- Price competition

- Each firm holds knowledge about each other‟s price policy. Firms try to avoid price
competition for the fear of price war. If one firm changes the price, the other does
too. This doesn‟t help in increasing demand, but leads to clashes among the firm.
- They use other methods like advertising, better services to customer, providing gifts,
guarantee and warranty coupons, to compete with each other instead of using price.
5. Price rigidity
- In oligopoly market, price remains stable over a period of time. This is known as
price rigidity.
- When an oligopolistic firm changes its price, its rival firms will react and change
their prices which in turn would affect the stability and create uncertainty.
Therefore, through negotiations, the firms decide over a price, which remains stable
over long stretches.
Implications
i)Consumer exploitation
ii)Unnecessary production
iii) Artificial superiority of the product
6. Indeterminate demand curve
 - The demand curve faced by an oligopolistic is indeterminate. An oligopoly firm
can never predict its sales correctly.
- Generally, a firm decreases the price, so that the consumers get attracted to their
product, and shift from the consumption from another firm, to that firm.
- But in oligopoly market, the firms are so interdependent, that they keep complete
knowledge about each-others price policy. The firms are quick to react to that
policy. And so, when a firm decreases its price, the other firms also do so. This
makes it impossible to predict sales of a firm.
- Because of high degree of interdependence and price rigidity, the demand curve in
this market in unable to be determined.
Implication
i) Decision making not possible

Note:
(i) AR plays role of demand curve in every market.
(ii) Selling Cost is the expenditure incurred on advertisement by the firm to persuade
buyer to buy the product.
(iii) Price Discrimination:- Different prices charged by the seller from different users for
same product.
(iv) Product discrimination – Variations present in the commodity sold by different
firms, in the market, on the basis on shape, size, colour, quality etc.
QUESTIONS
Q1. Why does an oligopoly emerge?
Ans. i) High investment and selling cost
ii) Government licensing
iii) Patent Right
Q2. Why Firms are Price Taker under PERFECT COMPETITION ?
Ans.– i) Homogenous produce.
ii) Large number of buyers and sellers.
iii) Perfect knowledge among buyers and sellers.
Q3. What are the main features of Perfect Competition?
Ans. i) Demand is perfectly elastic.
ii)Normal profit in the long run.
 iii)Firm is a price taker.
iv) Firm can sell any quantity of a commodity at a given price.

Q4. What happens under Perfect Competition?

Ans. i) Output is maximum.
ii) Cost is minimum.
iii) Only normal profit in the long run.
iv) No selling cost.
Q5. Why is a firm under monopoly of price makers?
Ans. i)Single seller
ii)Specialized products
iii)Barriers to entry and exit.
Q6. What are the MERITS OF MONOPOLY?
i) High skill and efficiency
ii)Promoter research and development
Q7. What are the DEMERITS OF MONOPOLY
i)Less output
ii)High price
iii)Economic concentration
 -:Chapter 11:-
Producer Equilibrium
 PRODUCER-

Producer is an economic agent who produces goods and services for sale, generally
with the objective of maximizing his profit.

 EQUILIBRIUM-

It is a state of balance or rest position where two forces become equal and where there
is no tendency to change.

 PRODUCER EQUILIBRIUM

It refers to a situation where producer can maximize his/her profit at a given level of
output.

OR

It is a decision-making concept with the help of this approach a producer decide

rationally how much level of output should be produced so that profits are maximized.

 Determination of Producer equilibrium (Approaches)

TR and TC approach MR and MC approach

 Total revenue and total cost approach (TR and TC approach)

(Non evaluative topic)

- According to this approach, producer equilibrium will be determined where

this condition of equilibrium :

PROFIT (Max) = TR (Max) - TC (Min)

- According to this approach, producer equilibrium will be determined at that point

where TC is at its minimum, by which profit is maximized.
1. Perfect competition

According to TR and TC approach, a firm or a producer is in equilibrium at OQ output,

where the difference between TR and TC is maximum.
2. Imperfect competition

According to TR and TC approach, a firm or a producer is in equilibrium at OQ output,

where the difference between TR and TC is maximum.
Note- Break-even point (BEP):-
Point at which TR=TC. Here firm earns no profit, no loss but normal profit (because it‟s a
part of TC) is earned.

MR -MC APPROACH
- Marginal revenue (MR) and Marginal cost (MC) approach is another way of
identifying Producer‟s equilibrium. It is derived from TR and TC approach.
- Marginal cost is the change in total cost due to additional unit of output produced.
Marginal revenue is the change in total revenue due to additional unit output sold.
- Marginal cost represents the change in expenditure of the producer, on producing
the output, while marginal revenue represents change in the money that the
producer receives, on selling the output.
- If marginal revenue is greater than marginal cost, this means that the producer
earning more money from selling the output, then he/she is spending on the
production of that output and hence is earning profits.
- While, if marginal revenue is less than marginal cost, the producer is spending more
money on the production of the output, then he is earning from selling the output
and thus the producer is incurring losses.
- According to this approach producer equilibrium will be determined where
following conditions are fulfilled-
(i) MR= MC
- MR=MC is the only state where the producer can achieve equilibrium as :
- If MR > MC, additional revenue per unit (MR) is greater than additional cost
incurred (MC), due to which a producer should increase production, as he is gaining
profits. Thus, equilibrium is not attained yet, as there are chances to earn more
profits, and so balance (equilibrium) has not yet been achieved.
- If MR < MC, additional cost per unit produced is greater than additional revenue
incurred; hence a producer must decrease the production as the consumer is bearing
losses. It is not an ideal equilibrium situation.
- So the left condition, MR = MC, is the equilibrium condition because here there is
neither chance to earn more profit nor the producer is facing losses, and so balance
is achieved.
(ii) MC should cut MR from below
OR
MC should rise after intersection
- Again, it is the only ideal situations as:
 - If MC is falling after equilibrium, it means that the producer is in stage of
increasing returns, where ideally the production shouldn‟t be stopped. His
equilibrium in a stage of diminishing returns.
- Also, rising MC assures, that if the producer doesn‟t stop the production, MC will
become greater than MR, and he will have to bear loses.
- MR can become equal to MC, at more than one situation, but rising MC after that
point insures that the producer doesn‟t have chances to earn more profit.
 Producer Equilibrium under perfect competition by MR and MC approach:-
Output Price TR TC Profit/Loss MR MC
+/-
1 10 10 8 2 10 8
Equilibirum 2 10 20 18 2 10 10
3 10 30 26 4 10 8
4 10 40 36 4 10 10
5 10 50 48 2 10 12

 In the above table MR=MC condition is satisfied both at output level 2 units and
output level 4 units (MR=MC i.e. Rs. 10) But the second condition – “MC becomes
greater than MR”- in satisfied only at 4 unit of output.
 Therefore, producer‟s equilibrium output is 4 units.
Diagrammatic Presentation

 When a producer is free to sell any quantity at a given price (perfect competition-
price remains constant), the MR curve is perfectly elastic, straight line parallel to the
X-axis and MR = AR.
 MC curve is half „U‟ shaped curve.
 Graphically the two condition of producer‟s equilibrium become:
 (i) MC curve intersects MR curve (MR = MC) and
(ii) MC is rising after the intersection.
 At point K the producer is not attaining equilibrium as he has chances of earning
profit, till point E.
 The second condition is satisfied only at E point.
 After E, MC becomes greater than MR.
 Therefore, the Producer‟s equilibrium level or output is OQ2.
 Producer Equilibrium under Monopoly by MR and MC approach:-

Here producer is in equilibrium at point E where all the conditions of equilibrium are
fulfilled. So, producer is in equilibrium at OQ1 level of output.
 Producer Equilibrium under Monopolistic competition by MR and MC approach:-
Here producer is in equilibrium at point E where all the conditions of equilibrium are
fulfilled. So, producer is in equilibrium at OQ1 level of output.
 SHUT DOWN POINT
Fixed costs, once incurred, cannot be recovered even if the firm shuts down. Therefore, the
decision to shut down is determined by variable costs alone.
It occurs when a firm is just covering its variable cost.

 BREAK EVEN POINT

A firm breaks even when at the equilibrium level of output, its average revenue (AR)
equals to its average cost (AC).
A point where a firm is just covering all its cost. ( Only normal profits are incurred)
TR=TC
So, break even is struck at E where AR=AC suggesting no profit, no loss but just earning
normal profits.
 SUPER NORMAL PROFIT (Abnormal / Extra normal Profit)
A firm would earn profits if at the equilibrium level of output, its average revenue (AR) is
more than its average cost (AC).
Its refers to a situation where
TR>TC

It would be seen as follows:

- Equilibrium point : E (MR=MC)
- Equilibrium output: OQ
- Average Revenue : QE
- Average Cost : QD
- Profit per unit : QE-QD = ED
- Total Profit : ED x OQ = Area EDCP
 SUPER NORMAL LOSS
A firm suffers losses, if at the equilibrium level of output, its average revenue (AR) is less
than its average cost (AC).
Its refers to a situation where
TR<TC
Area EBCP = Super Normal Loss
It would be seen as follows:
 Equilibrium point : E (MR=MC)
 Equilibrium output: OQ
 Average Revenue : QE
 Average Cost : QB
 Loss per unit : QB-QE = EB
 Total Loss : EB x OQ = Area EBCP
 -:HOTS:-
Q.1 If MC is higher than MR at a particular level of output, what will a producer do to
maximize his profit?

Ans. Producer will reduce the production to maximize the profit.

Q.2 If MC is less than MR at a particular level of output, what will a producer do to

maximize his profit?

Ans. Producer will increase the production to maximize the profits.

Q.3 Giving reasons, state whether the following statements are true or false:

(i) A producer is in equilibrium when total cost and total revenue are equal.

(ii) MC should be rising at the point of producer‟s equilibrium.

(iii) A producer gets maximum profits only when difference between average revenue and
average cost is maximum.

(iv) A firm is in equilibrium when marginal revenue curve cuts marginal cost curve from
below.

Ans. (i) False: A producer is in equilibrium when difference between total revenue and
total cost is maximum.

(ii) True: If MC falls at the point of equilibrium then it means that it is possible to increase
profits by producing more. So, MC should be rising at the producer‟s equilibrium.

(iii) False: A producer gets maximum profits when difference between total revenue and
total cost is maximum.

(iv) False: A firm is in equilibrium when MC curve cuts MR curve from below.
 -:Chapter:-

PRICE DETERMINATION UNDER PERFECT COMPETITION

 Market Equilibrium

- Under perfect competition, price is determined by "price mechanism" (on the basis of
forces of demand and supply) i.e. Market demand and market supply works together.

- Market equilibrium is a state where the market for a commodity achieves balance. This
condition is attained when the market demand for the commodity is equal to market
supply.

- Price is determined at that point where Market Demand (MD)= Market Supply
(MS).

- Market demand is the total quantity of a commodity demanded by all the consumers in
the market.

- Market supply is the total quantity of a commodity supplied by all the producers in the
market.

- As price and demand have inverse relationship, demand curve sloped Downward and
on the other hand, price and supply have direct/positive relationship, supply curve
slopes Upward.

 Equilibrium Price

- The price at which the quantity demanded of a commodity (market demand) is equal to
the quantity supplied (market supply) is known as equilibrium price. In other words the
price at which market equilibrium is reached is called equilibrium price.

- Under Perfect competition when these two forces intersect each other, equilibrium is
attained or price of a commodity is determined under perfect competition which is
termed as Equilibrium price.

 Equilibrium Quantity

- When at an equilibrium price, quantity demanded of a commodity (market demand) is

equal to quantity supplied (market supply) is known as equilibrium quantity.
- The quantity of a commodity which is bought and sold at an equilibrium price is called
equilibrium quantity.

 Determination of Market Equilibrium

In a perfectly competitive market, equilibrium price of a commodity is determined by

interaction of market forces of demand and supply by the industry. Equilibrium is
determined where the quantity demanded of a commodity become equal to the quantity
supplied in the market. D = S

In other words, market demand of the commodity equals to market supply. This point is
called market equilibrium because there is neither excess demand nor excess supply in
the market. At this point the price which is determined is called equilibrium price and
the quantity is termed as equilibrium quantity.

This can be explained with the help of following schedule and diagram.
  In the above diagram, MS is the market supply while MD is the market demand.
 The equilibrium is achieved at point E.
 Equilibrium price is P and equilibrium quantity is Q.
 This equilibrium price is decided by the industry, and is given to each firm, in
perfect competition.

Problem of Excess demand and excess supply

Equilibrium price is considered to be ideal for both consumer and producer. But, when
there is no such equilibrium and market price is either below or above the equilibrium then
the problem of excess demand and excess supply arises.
1. Excess demand (Scarcity) (D>S)
 Meaning
 Excess demand for a product means that at a given price the market demand of
a commodity is more than the market supply or the consumers demand more
than what the producers are willing to supply.
 In other words, at a given price the amount by which the quantity demanded of a
commodity exceeds the quantity supplied, is called excess demand.
 Any price below the equilibrium price leads to a condition of excess demand.
The consumers are demanding more, at a low price but the producers are not
supplying that much at that low price.
 Thus, market price is less than the equilibrium price.
 Impact (How is equilibrium achieved?)
 A chain of effects takes place under the condition of excess demand.
 In such a situation, market price is less than the equilibrium price. Excess
demand of a commodity will create competition among buyers.
 This will lead to rise in the price, as the consumers become ready to buy the
scarce commodity at a higher price.
 Higher price inspires sellers to sell more, and so the market supply of the
commodity increases.
 These changes will take place until the market reaches the equilibrium point or
the market demand becomes equal to the market supply.
D>S → Scarcity →P↑→ D↓→S↑→(D=S)
2. Excess supply (surplus) (S>D)
 Meaning
 Excess supply for a product means that at a given price, the market supply of a
commodity, is more than the market demand or producers supply more than
what the consumers demand.
 Any price above the equilibrium price leads to a condition of excess supply. The
consumers are demanding less, at a high price but the producers are supplying
more at that high price.
 In such a situation, the market price is more than the equilibrium price.
 Impact (How is equilibrium achieved)
 Excess supply of a commodity to will create competition among the sellers.
 This will lead to fall in the price, as the sellers become ready to sell the surplus
stock of commodity at a less price.
 Which in turn will lead to rise in demand of the commodity.
 These changes will take place until the market reaches the equilibrium point
or the market supply become equal to the market demand.
Explanation box
S>D → Surplus →P↓→ D↑→S↓→(D=S)
Example
Price Market Market supply Trend Pressure on price
demand
2 10 2
D>S P↑
4 8 4
6 6 6 D=S Equilibrium Price
8 4 8
D<S P↓
10 2 10
 Diagram

Effects of Change in demand and change in supply on Market

equilibrium.
-Now, we will study the effects of Shift in demand curve and supply curve.
-Shifting in demand and supply is caused due to other factors, other than price of the
commodity.
- Increase in demand or supply leads to a rightward shift and decrease in demand or
supply leads to a leftward shift.
- We have to study the change caused by change in demand and supply on the
equilibrium price and equilibrium quantity.
SITUATION I : When there is change in demand, and no change in supply
There can be 2 types of change in demand-
i. Increase in demand
ii. Decrease in demand
 CASE I – INCREASE IN DEMAND

Explanation
 DD is the original demand curve.
 SS is the original supply curve.
 Both the curves intersect at point E.
 Point E is the original or initial equilibrium point.
 OP is the equilibrium price.
 OQ is the equilibrium quantity.
 Due to an increase in demand, the demand curve shifts rightward from DD to D1D1.
 New demand curve D1D1 and the supply curve intersect at point E1.
 The new equilibrium point will occur at point E1.
 As a result, the equilibrium price rises from OP to OP1 and equilibrium quantity
rises from OQ to OQ1.
 CASE II – DECREASE IN DEMAND

Explanation
 DD is the original demand curve.
 SS is the original supply curve.
 Both the curves intersect at point E.
 Point E is the original or initial equilibrium point.
 OP is the equilibrium price.
 OQ is the equilibrium quantity.
 Due to a decrease in demand, the demand curve shifts leftward from DD to D1D1.
 New demand curve D1D1 and the supply curve intersect at point E1.
 The new equilibrium point will occur at point E1.
 As a result, the equilibrium price decreases from OP to OP1 and equilibrium
quantity decreases from OQ to OQ1.
SITUATION II : When there is change in supply, and no change in demand
There can be 2 types of change in supply-
i. Increase in supply
ii. Decrease in supply
 CASE I – INCREASE IN SUPPLY

Explanation
 DD is the original demand curve.
 SS is the original supply curve.
 Both the curves intersect at point E.
 Point E is the original or initial equilibrium point.
 OP is the equilibrium price.
 OQ is the equilibrium quantity.
 Due to an increase in supply, the supply curve shifts rightward from SS to S1S1.
 New supply curve S1S1 and the demand curve intersect at point E1.
 The new equilibrium point will occur at point E1.
 As a result, the equilibrium price decreases from OP to OP1 and equilibrium
quantity rises from OQ to OQ1.
 CASE II – DECREASE IN SUPPLY

Explanation
 DD is the original demand curve.
 SS is the original supply curve.
 Both the curves intersect at point E.
 Point E is the original or initial equilibrium point.
 OP is the equilibrium price.
 OQ is the equilibrium quantity.
 Due to a decrease in supply, the supply curve shifts leftward from SS to S1S1.
 New supply curve S1S1 and the demand curve intersect at point E1.
 The new equilibrium point will occur at point E1.
 As a result, the equilibrium price increases from OP to OP1 and equilibrium quantity
decreases from OQ to OQ1.
SITUATION III : When there is simultaneous change in demand and supply
(Both demand and supply are changing at the same time)
There can be 2 types of changes
i. Simultaneous Increase
-When increase in demand is greater than increase in supply
-When increase in supply is greater than increase in demand
-Increase in demand is equals to increase in supply.
ii. Simultaneous decrease
- When decrease in demand is greater than decrease in supply
- When decrease in supply is greater than decrease in demand
- Decrease in demand is equals to decrease in supply.
 i. Simultaneous Increase in demand and supply -

Case : I When increase in demand is greater than increase in supply.

Explanation
 DD is the original demand curve.
 SS is the original supply curve.
 Both the curves intersect at point E.
 Point E is the original or initial equilibrium point.
 OP is the equilibrium price.
 OQ is the equilibrium quantity.
 Due to an increase in supply, the supply curve shifts rightward from SS to S1S1.
 Due to an increase in demand, the demand curve shifts rightward from DD to D1D1.
 New supply curve S1S1 and the demand curve D1D1 intersect at point E1.
 The new equilibrium point will occur at point E1.
 As a result, the equilibrium price increases from OP to OP1 and equilibrium
quantity rises from OQ to OQ1.
 Case :- II When increase in demand is less than increase in supply.

Explanation
 DD is the original demand curve.
 SS is the original supply curve.
 Both the curves intersect at point E.
 Point E is the original or initial equilibrium point.
 OP is the equilibrium price.
 OQ is the equilibrium quantity.
 Due to an increase in supply, the supply curve shifts rightward from SS to S2S2.
 Due to an increase in demand, the demand curve shifts rightward from DD to D2D2.
 New supply curve S2S2 and the demand curve D2D2 intersect at point E2.
 The new equilibrium point will occur at point E2.
 As a result, the equilibrium price decreases from OP to OP2 and equilibrium
quantity rises from OQ to OQ2.
 Case :- III When increase in demand is equal to increase in supply.

Explanation
 DD is the original demand curve.
 SS is the original supply curve.
 Both the curves intersect at point E.
 Point E is the original or initial equilibrium point.
 OP is the equilibrium price.
 OQ is the equilibrium quantity.
 Due to an increase in supply, the supply curve shifts rightward from SS to S1S1.
 Due to an increase in demand, the demand curve shifts rightward from DD to D1D1.
 New supply curve S1S1 and the demand curve D1D1 intersect at point E1.
 The new equilibrium point will occur at point E1.
 As a result, there is no change in equilibrium price but equilibrium quantity rises
from OQ to OQ1.
 ii. Simultaneous decrease in demand and supply
Case :- 1 When decrease in demand is greater than decrease in supply.

Case :- 2 When decrease in demand is less than decrease in supply.

Case :- 3 When decrease in demand is equal to decrease in supply.

Specific cases:-
1. When supply is perfectly elastic and there is increase/decrease in demand.

2. When supply is perfectly inelastic and these is increase/decrease in demand.

3. When demand is perfectly elastic, there is increase and decrees in supply:-

4. When demand is perfectly inelastic and there is increase and decrease in supply.

Note:- Explain all the above diagrams according to the changes on equilibrium,
equilibrium price and equilibrium quantity.
APPLICATION OF TOOLS OF DEMAND AND SUPPLY
(GOVT'S INTERFERENCE)
 Not only is market equilibrium affected by the sources of demand and supply
shifted considered earlier, it is influenced by various government policies as well.
 There are two specific situations to show the impact of govt. regulations on market
equilibrium:
(A) Price ceiling(maximum/control price)
 When price is set below equilibrium price
 Situation of excess demand
 The government imposing upper limit (maximum selling price) on the price of a
good or service, it is called price ceiling. In terms of demand and supply curves,
price ceiling is fixing price by the government below the equilibrium price when the
equilibrium price is perceived to be too high.
 Price ceiling is generally imposed by the govt. on necessary items like wheat, rice,
kerosene, sugar, medicines during in times of „shortages‟. No producer can the
commodity at a higher price than the ceiled price.
Consequences- The producer becomes discouraged to sell the commodity at a lower
price and thus such problems arises-
 Black marketing
 Rationing of goods
 Shortage of the commodity
 Problem of distribution
(B) Price floor (Minimum price/Support Price)
 When price is set above equilibrium price
 Situation of excess supply
 When the government imposes lower limit (minimum selling price) on the price of
the commodity above the equilibrium price, it is known as price flooring.
 Most well-known examples of imposition of price floor are agricultural price
support programme and the minimum wage legislation, where a minimum support
price is assured to the producer.
 These programes are meant to insulate farmers and labours from income fluctuation
resulting from price variations in the free market.
 No producer can sell the commodity, at a price lower than the floored price.

Consequences- Due to high prices, the consumers are discouraged to buy the
commodity. This leads to-
 Surplus stock of the commodity
 Buffer stock
 Subsidy
 Minimum reserve price

VIABLE INDUSTRY NON-VIABLE INDUSTRY

- The supply and demand curve - The supply and demand curve
intersect at a point. do not intersect each other at any
positive quantity.

Eg.- Manufacturing sector , service Eg. - Cement industry, if entry tax is

sector raised, Aircraft industry

- HOTS –
Q.1 When there is simultaneous increase in demand and supply, under which
condition the equilibrium price remains constant?
Ans. When the increase in demand is equals to increase in supply, there is no change in
the equilibrium price of the commodity.
Explanation
 DD is the original demand curve.
 SS is the original supply curve.
 Both the curves intersect at point E.
 Point E is the original or initial equilibrium point.
 OP is the equilibrium price.
 OQ is the equilibrium quantity.
 Due to an increase in supply, the supply curve shifts rightward from SS to S1S1.
 Due to an increase in demand, the demand curve shifts rightward from DD to D1D1.
 New supply curve S1S1 and the demand curve D1D1 intersect at point E1.
 The new equilibrium point will occur at point E1.
 As a result, there is no change in equilibrium price but equilibrium quantity rises
from OQ to OQ1.
Q2. When there is increase in the price of tea, how will it affect the equilibrium
price of coffee?
Ans. Tea and coffee are substitute goods, and so the cross price effect is positive.
So, if price of tea increases, the demand for coffee will also increase.
When there is increase in demand for a commodity, the equilibrium price rises.
Q3. An industry has a market supply function as QS = 900 + 2P and demand
function is QD = 1200 – P. Determine equilibrium price and quantiy.
Ans. . Equilibrium is achieved when demand = supply
QD = Q S
1200 – P = 900 + 2P
1200 – 900 = 2P + P
300 = 3P
P = Rs.100
Q = (substituting the value of P)
1200 – 100 = 900 + 2(100)
= 1100 units