GEC S1 01

Introduction to Economic Theory-I

SEMESTER - I

ECONOMICS
BLOCK - 1

KRISHNA KANTA HANDIQUI STATE OPEN UNIVERSITY

Subject Experts

Professor Madhurjya P. Bezbaruah, Dept. of Economics, Gauhati University

Professor Nissar A. Barua, Dept. of Economics, Gauhati University
Dr. Gautam Mazumdar, Dept. of Economics, Cotton College

Course Co-ordinator : Dr. Chandrama Goswami, KKHSOU

SLM Preparation Team

UNITS CONTRIBUTORS

1 Dr. Swabera Islam , K. C. Das Commerce College (Retd.)

2 Subhashish Gogoi, Former Faculty, KKHSOU
3, 4 & 5 Professor Nissar A. Barua , Gauhati University
Bhaskar Sarmah, KKHSOU
6 Bhaskar Sarmah, KKHSOU
7&8 Dr. Ratul Mahanta, Gauhati University

Editorial Team

Content : Professor K. Alam (Retd.) Gauhati University

Dr. Chandrama Goswami, KKHSOU
Language : Professor Robin Goswami , Former Sr. Academic Consultant
KKHSOU
Structure, Format & Graphics : Bhaskar Sarmah, KKHSOU

First Edition: May, 2017, Reprint May 2018

This Self Learning Material (SLM) of the Krishna Kanta Handiqui State University is
made available under a Creative Commons Attribution-Non Commercial-ShareAlike4.0 License
(International): http.//creativecommons.org/licenses/by-nc-sa/4.0.
Printed and published by Registrar on behalf of the Krishna Kanta Handiqui State Open University.

The university acknowledges with thanks the financial support provided by the
Distance Education Bureau, UGC, for the preparation of this study material.

Headquarters : Patgaon, Rani Gate, Guwahati-781 017

City Office : Housefed Complex, Dispur, Guwahati-781 006; Web: www.kkhsou.in
 CONTENTS

UNIT 1: Introduction to Economics Pages: 5-21

Basic Concepts in Economics: Subject Matter of Economics– What
Economics is about? Nature and Scope of Economics, Choice as an
Economic Problem, Stock and Flow Variables; Micro Economic Approaches:
Scope and Subject Matter of Micro Economic Approaches; Macro Economic
Approaches: Scope and Subject Matter of Macro Economic Approaches

UNIT 2: The Market Mechanism Pages: 22-37

Demand Supply Framework: Meaning of Demand. Law of Demand, Meaning
of Supply, Law of Supply; Concept of Equilibrium; Market Equilibrium; Static
Analysis; Comparative Static Analysis; Dynamic Analysis

UNIT 3: Demand Analysis Pages: 38-57

The Idea of Demand and the Demand Curve; Movement Along a Demand
Curve; Shift in the Demand Curve; Exceptions to the Law of Demand; Elasticity
of Demand: Price Elasticity of Demand, Income Elasticity of Demand, Cross
Elasticity of Demand

UNIT 4: Consumer Behaviour: Cardinal Approach Pages: 58-71

Cardinal and Ordinal Approach to Utility: Basic Concepts: Measurement of
Utility, Concepts of Total Utility and Marginal Utility, Law of Diminishing Marginal
Utility; Consumer’s Equilibrium: Law of equi-marginal utility; Consumers
Surplus

UNIT 5: Consumer Behaviour: Ordinal Approach Pages: 72-94

The Indiference Curve Technique: Basic Concepts: Assumptions of the
Indifference Curve Technique, Indifference Schedule and Indifference Curve,
Indifference Map, Properties of Indifference Curves; Consumer Equilibrium
through Indifference Curve Approach; Price Effect, Substitution Effect and
the Income Effect
UNIT 6: Concepts of Revenue Pages: 101-114
Concepts of Total Revenue, Average Revenue and Marginal Revenue;
Relationship between Total Revenue, Average Revenue and Marginal Revene
Curves; Relationship between Total Revenue, Average Revenue, Marginal
Revenue and Price Elasticity of Demand

UNIT 7: Theory of Production Pages: 115-141

Production Decisions; Law of Variable Proportions; Returns to Scale; Concepts
in Production: Production Function, Iso-quant, Isoquant Map, Marginal Rate of
Technical Substitution (MRTS) (Factor Substitution); Equilibrium of a Firm;
Expansion path

UNIT 8: Cost of Production and Cost Curves Pages: 142-157

Different Concepts of Costs; Nature of Cost Curves in the Short-run: Total Variable
Cost and Total Fixed Cost, Average Cost Curves, Marginal Cost Curve; Long-
run Cost Curves of a Firm: Long-run Average Cost Curve, Long-run Marginal
Cost Curve

4 Introduction to Economic Theory-I

COURSE INTRODUCTION

This course introduces a learner to the field of Economics. Economics, according to the Oxford
English Dictionary is “the branch of knowledge concerned with the production, consumption and transfer
of wealth”. Economics can be broadly subdivided into two categories– Microeconomics and
Macroeconomics. Microeconomics is the branch of economics which studies the implications of individual
human action, especially about how these decisions affect the utilization and distribution of scarce
resources. Macroeconomics studies how the aggregate economy behaves. In macroeconomics, a
variety of economy-wide phenomena is examined– such as National Income, Gross Domestic Product,
changes in employment, etc.

This course comprises 15 units and has been divided in three blocks of five units each.

BLOCK INTRODUCTION

This first block of the paper ‘Introduction to Economic Theory I’ comprises five units. Unit I
describes the subject matter of Economics and its division into Micro and Macro. It also deals with the
concepts of stock and flow variables. Unit II deals with the concept of equilibrium and describes static
analysis, comparative static analysis and dynamic analysis. Unit III introduces the concept of demand
as understood in economics. The derivation of the demand curve is explained and situations of movement
along the curve and shift in the curve are also dealt with. The learner is introduced to the concept of
elasticity in this unit. Unit IV deals with the cardinal approach of Consumer Behaviour. Here the Law of
Diminishing Marginal Utility is explained along with the Law of Equi Marginal Utility. The learners also
come to know about the concept of Consumer’s Surplus in this Unit. Unit V explains the Ordinal Approach
to Consumer Behaviour. Here Indifference Curves and their properties are explained along with the
Budget Line. The Price, Income and Substitution Effect of a change in price is explained diagrammatically.

This block includes some along-side boxes to help you know some of the difficult, unseen
terms. Some “ACTIVITY’ have been included to help you apply your own thoughts. And, at the end of
each section, you will get “CHECK YOUR PROGRESS” questions. These have been designed to self-
check your progress of study. It will be better if you solve the problems put in these boxes immediately
after you go through the sections of the units and then match your answers with “ANSWERS TO
CHECK YOUR PROGRESS” given at the end of each unit.

Introduction to Economic Theory-I 5

6 Introduction to Economic Theory-I
UNIT 1: INTRODUCTION TO ECONOMICS
UNIT STRUCTURE

1.1 Learning Objectives

1.2 Introduction
1.3 Basic Concepts in Economics
1.3.1 Subject Matter of Economics– What Economics is about?
1.3.2 Nature and Scope of Economics
1.3.3 Choice as an Economic Problem
1.3.4 Stock and Flow Variables
1.4 Micro Economic Approaches
1.4.1 Scope and Subject Matter of Micro Economic Approaches
1.5 Macro Economic Approaches
1.5.1 Scope and Subject Matter of Macro Economic Approaches
1.6 Let Us Sum Up
1.7 Further Reading
1.8 Answers to Check Your Progress
1.9 Model Questions

1.1 LEARNING OBJECTIVES

After going through this unit, you will be able to -

 identify the basic concepts and need to study Economics
 discuss the subject matter, nature and scope of Economics
 elaborate the concept of choice as an economic problem
 identify stock and flow variables
 give the meaning of microeconomic approaches
 explain the scope and subject matter of microeconomic approaches
 give the meaning of macro economic approaches
 explain the scope and subject matter of macroeconomic
approaches.

Introduction to Economic Theory-I 7

Unit 1 Introduction to Economics

1.2 INTRODUCTION

This Unit is concerned with familiarising you with some of the

important concepts in Economics. They include nature and scope of
Economics, the central problems of an economy, choice as an economic
problem; stock and flow variables; meaning, scope and subject matter of
micro and macro economic approaches.
We shall begin with a few basic concepts in Economics, which
includes subject matter of Economics, its nature and scope, choice as an
economic problem, stock and flow concepts thereby moving towards two
major branch of economics as Microeconomics and Macroeconomics.

1.3 BASIC CONCEPTS IN ECONOMICS

This section deals with a few basic concepts in Economics. This

section has been divided into four major sub-sections as follows:

1.3.1 Subject Matter of Economics– What Economics is

about?

To know the subject matter of economics, we have to study

the various notable definitions and their illustrations. Over these
years, different economists have tried to define the subject in various
contexts. We will study four Major definitions put forward by:
 Adam Smith
 Alfred Marshall
 Lionnel Robinns and
 P. A. Samuelson.
To know more about Adam Smith’s definition: Adam Smith, author of The Wealth of
Adam Smith, please
Nations (1776), is generally regarded as the Father of modern
refer to Appendix-B at
the end of the block. Economics. In this work, Smith describes the subject in these terms:
Political economy, considered as a branch of the science of a
statesman or legislator, proposes two distinct objects: first, to
supply a plentiful revenue or product for the people, or, more
properly, to enable them to provide such a revenue or
8 Introduction to Economic Theory-I
Introduction to Economics Unit 1

subsistence for themselves; and secondly, to supply the state

or commonwealth with a revenue sufficient for the public
services, it proposes to enrich both the people and the
sovereign.
Smith referred to the subject as ‘Political Economy’, but that
was gradually replaced in general usage by the term `Economics’
after 1870.
The above definition put forward by Smith has been criticised
on many grounds. First, Smith had laid primary emphasis on wealth.
It has been criticised that wealth can never be of prime importance
in human life in a modern society. Wealth may be one of the means
to fulfill some of the human wants, but, inheritance of wealth alone
can never be the sole objective of human lives. Thus, the prime
importance should be on human being or human life, and not on
wealth. Second, all kinds of wealth does not increase human welfare.
Third, Adam Smith’s definition does not make any reference to To know more about
Alfred Marshall,
scarcity of resources which is the main cause of all economic
please refer to
problems. Appendix-B at the end
Alfred Marshall’s Definition: In his book, Principles of Economics, of the third block.
published in 1890, Marshall states:
Economics examines that part of social and individual action
which is most closely connected with the attainment and with Robinson Crusoe:
the use of material requisites of well-being. Thus, it is on the refers to the character
one side, a study of wealth and on the other and more important Daniel Defoe’s famous
novel of the same
side, a part of the study of man.
name. The character
Clearly Marshall’s definition underlines, the importance of
of the novel, Robinson
material goods which are related to human welfare. Another Crusoe leads an
important aspect of Marshall’s definition is that it has considered isolated life in an
Economics as a social science. Thus, according to this definition, uninhabited island.
Hence, here it means
Economics is a social science and not one which studies isolated
an individual or a
individuals or Robinson Crusoes. human being living in
Although Marshall’s definition is superior to Adam Smith’s separation from the
definition, yet it has been criticised on the following grounds. First, society.
Introduction to Economic Theory-I 9
Unit 1 Introduction to Economics

according to this definition the subject matter of Economics is the

increase in material welfare. Even when Marshall has acknowledged
the prevalence of both material and immaterial wealth, yet his
definition has completely ignored the role of non-material welfare
in human lives. Secondly, the shift of emphasis from wealth to
welfare is a welcome step, but it is difficult to measure welfare,
since it is a subjective concept relating to the state of mind.
Moreover, Marshall too has failed to address the most important
problem of Economics i.e. the issue of scarcity of resources.
To know more about Lionel Robbins’ definition: In his book, Nature and Significance
Lionel Robins, please of Economic Science, Robbins defines Economics as follows:
refer to Appendix B at
“Economics is the science which studies human behaviour as a
the end of the block.
relation between ends and scarce means which has alternative
uses.’’
This definition emphasizes three important points:
 Here, ‘ends’ refer to wants. Human wants are unlimited in
number. If one want is satisfied, another crops up.
 Contrary to the unlimited number of wants, the means of
satisfying these wants are strictly limited.
 The limited means we have in our hands to fulfil our wants
have alternative uses.
These three statements together give rise to the economic
problem of choice. The study of the economic problem or the
problem of choice is, thus, the subject matter of Economics.
Criticisms of Robbins’ Definition: Like the earlier ones, Robbins’
definition too has been criticised. The main criticisms are:
 The definition is too wide. It has made the subject matter of
Economics more abstract and complex.
 The definition put forward by Robbins does not incorporate the
‘growth’ aspect of an economy.
 The definition ignores some of the fundamental problems of
under-developed and developed nations like poverty and
unemployment.
10 Introduction to Economic Theory-I
Introduction to Economics Unit 1

 According to Professor Cairncross, choices only in the social

context are relevant for study; individual choices can never be
a subject matter of Economics.
 According to Samuelson and Nordhaus, Economics is also
related to the concept of efficiency. Robbins has not paid
attention to that.
Paul A. Samuelson’s Definition: Paul A. Samuelson has defined To know more about
Economics on the basis of the modern concept of growth. According Paul A. Samuelson
to him, please refer to
Appendix-B at the end
Economics is a study of how men and society ‘choose’ with or
of the block.
without the use of money, to employ scarce productive resource
which could have alternative uses, to produce various
commodities over time and distribute them for consumption,
now and in the future among the various people and groups of
society.
Samuelson’s defintion takes into account men, money,
scarce resources and production aspects. However; critics point
out that his definition has not paid due attention to the aspect of
human well-being, which is a very important in our lives. Again, the
role played by the service sector in contemporary society has not
been paid due attention.

1.3.2 Nature and Scope of Economics

The nature and scope of Economics are related to the basic

question: What Economics is about? A study of the definitions as
given in the earlier section helps us to understand the nature of
Economics and to address the question: ‘Is Economics the study
of wealth or scarce economic resources or of human behaviour?
From the discussion of the definitions of Economics we can
say that Economics studies how man and society try to utilise the
limited resources which have alternative uses to solve the various
problems. Again, how an economy or the economies should follow
the different developmental policies and strategies in the interest
Introduction to Economic Theory-I 11
Unit 1 Introduction to Economics

of the present and future generations is also the subject matter of

Economics.
The scope of Economics is very wide. It includes the subject
matter of Economics, whether it is a science or an art, and whether
it is a positive science or a normative science. Economics is a social
science that studies the production, distribution, and consumption
of resources. By extension, Economics also studies economies,
the creation and distribution of wealth, the abundance and scarcity
of resource, and human welfare. The term Economics has come
from the Greek words oikos (house) and nomos (custom or law),
hence it means “rules of the house (hold)’’.
It is a general fact that production of something will not
automatically lead to its consumption. The goods produced will be
exchanged at the personal, national and international level. The
scope of Economics, thus, includes irternal trade and international
trade under its purview. Thus, the study of money, personal income,
national income, monetary policy, fiscal policy, pubfic finance,
Government’s role in the economic development of countries,
Economics of environment and Economics of weifare are all integral
parts of the scope and nature of Economics.
The Scope of Economics also includes the two approaches
to economic theory given below:
 Microeconomics is the branch of Economics that examines
the behaviour of individual decision-making units– that is,
business firms and households.
 Macroeconomics is the branch of Economics that examines
To know more about
Ragnar Frisch please the behaviour of economic aggregates – income, output,
refer to Appendix-B at employment, and so on – on a national scale. It is to be noted
the end of the block. that the terms ‘micro’ and ‘macro’ were coined by Ragnar Frisch.
Economics may also be discussed as Positive or Normative.
 Positive Economics studies economic behaviour without
making judgments. It describes what exists and how it works.

12 Introduction to Economic Theory-I

Introduction to Economics Unit 1

 Normative Economics, also called ‘Policy Economics’,

analyzes the outcomes of economic behaviour, evaluates them
as good or bad, and may prescribe courses of action.
One of the uses of Economics is to explain how economies
work as economic systems and what relations are there between
economic players (agents) in the larger society. Method of economic
analysis have been increasingly applied to fields that involve people
(officials included) making choices in a social context, such as crime,
education, the family, health, law, politics, religion, social institutions
and war.

CHECK YOUR PROGRESS

Q.1: State whether the following statements are

true or false:
a) Economics is the social science that studies the
production, distribution, and consumption of resources.
(True/False)
b) Robbin’s definition is scarcity based. (True/False)
c) Production automatically leads to consumption.
Q.2: Who coined the terms ‘Micro’ and ‘Macro’?
Q.3: Fill in the blanks:
a) Economics is the science which studies ....................
as a relation between .................... and scarce means
which has alternative uses.
b) Oikos means .................. and nomos means ...................
c) The Wealth of Nations was written in the year ..................
Q.4: Match the following set A with set B:
Set A Set B
i) Adam Smith a) Principles of Economics
ii) Alfred Marshall b) Wealth of Nations
iii) Lionnel Robbins c) Nature and Significance
of Economic Science

Introduction to Economic Theory-I 13

Unit 1 Introduction to Economics

Q.5: How has Lionnel Robbins defined Economics? Mention the

important aspects of his definition. (Answer in about 50 words)
............................................................................................
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............................................................................................

1.3.3 Choice as an Economic Problem

Every nation’s resources are insufficient to produce the

quantities of goods and services that would be required to satisfy
all the wants of the citizens. This is known as the problem of scarcity
and this can be overcome by exercising choice.
Scarcity and Choice: Because of scarcity of resources an individual
has many decisions or choices to make, like:
 Whether to go to college after school or start earning?
 Whether to buy a motor cycle or a small car?
 Whether to marry or remain single?
In fact our whole life is a multiple-choice problem. Similarly
firms also have to make many choices, like:
 Whether to expand output or improve quality?
 Whether to close down a factory or run at a loss?
 Whether to produce output in the same state or in a neighbouring
state?
All economic choices involve the allocation of scarce
resources. Choices are dictated by scarcity of resources at our
command.
Faced with the problem of scarcity, all societies are faced
with various basic economic problems which must be solved. These
problems are also called central problems of an economy.
These problems are:
 What to produce? It refers to which goods and services a society
chooses to produce and in what quantites to produce them.
14 Introduction to Economic Theory-I
Introduction to Economics Unit 1

 How to produce? It refers to the way in which resources or

inputs are organised to produce the goods and services.
 How much to produce? How much to produce is an important
aspect for the economy. We must judiciously utilise the available
resources to meet the present demands, as well as to conserve
such resources for meeting the future demands.
 For whom to produce? For whom to produce deals with the
way that the output is distributed among the members of the
society.

1.3.4 Stock and Flow Variables

Economics distinguish between quantities that are stocks

and those that are flows. Stock variables refers to the state of affairs
at a point of time. Whereas flow refers to the rate at which something
happens over a peroid of time. You can easily understand both by
thinking stock as water of a pond and flow as water of a river. For
example, the money supply, price level, assets of a firm or level of
employment are stock concepts; whereas the national income,
profits of a firm, the level of industrial production are flow concepts.

CHECK YOUR PROGRESS

Q.6: State whether the following statements are

true or false:
a) The study of the economic problem or the problem of
choice is the subject matter of Economics.
b) Because of scarcity of resources an individual has many
decisions or choices to make.
Q.7: Define stock and flow variables with appropriate examples.
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Introduction to Economic Theory-I 15
Unit 1 Introduction to Economics

Q.8: What are the central problems of an economy? (Answer in

about 50 words)
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............................................................................................
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............................................................................................

1.4 MICRO ECONOMIC APPROACHES

Microeconomics is a special sub branch of Economics. Here ‘Micro’

is a Greek word which means small. It is concerned with individual firm
and individuals rather than the whole economy and in that sense it is ‘micro’
in nature. To be very precise, it is a branch of economics that studies the
behaviour of individuals and firms in making decisions regarding the
allocation of limited resources. It refers to markets where goods or services
are bought and sold. Microeconomics deals in how these decisions and
behaviours affect the supply and demand for goods and services, which
determines prices. And later, prices determine the quantity supplied and
quantity demanded. According to Prof. K. E. Boulding, “Micro Economics
is the study of a particular firm, particular household, individual prices,
wages, incomes, individual industries and particular commodities.”

1.4.1 Scope and Subject Matter of Micro Economic

Approaches

Micro economic approach is generally concerned with the

following topics which can be discussed as the scope of
microeconomics.
Commodity Pricing: Pricing of goods and services constitute the
subject matter in micro economic analysis. Prices of individual
comodities are determined by the individual forces of demand and
supply. So micro economic analysis makes demand analysis
(individual consumer behaviour) and supply analysis (individual
producer behaviour).
16 Introduction to Economic Theory-I
Introduction to Economics Unit 1

Factor Pricing: You know that there are four factors of production
namely land, labour, capital and organisation. These four factors
contribute towards the production process. So they get rewards in
the form of rent, wages, interest and profit respectively. Micro
economics deals with the determination of such rewards. This is
called factor pricing. It is an important scope of microeconomics.
So microeconomics is also called as ‘Price Theory’ or ‘Value Theory’.
Welfare Theory: Microeconomics also has its scope in welfare
aspects. It deals with the optimum allocation of available resources
to maximise social or public welfare. It provides answers of the
very crucial questions of economics viz. ‘What to produce?’, ‘How
to produce?’, ‘For whom it is to be produced?’. So we can say that
microeconomics as a branch of economics gives guidance for
utilising scarce resources of economy to maximise public welfare.

1.5 MACRO ECONOMIC APPROACHES

Macroeconomics by its very name indicates that it is concerned

with ‘Macro’ concepts which means large in contrast to ‘Microeconomics’.
The word ‘Macro’ is derived from the Greek word ‘Makros’ meaning large
or aggregate(total). It is therefore the study of aggregates covering the
entire economy such as total employment, national income, national output,
total investment, total savings, total consumption, aggregate supply,
aggregate demand, general price level etc. It is therefore aggregate
economics as it studies the economy as a whole. Prof. J. L. Hansen says,
“Macroeconomics is that branch of economics which considers the
relationship between large aggregates such as the volume of employment,
total amount of savings, investment, national income etc.”

1.5.1 Scope and Subject Matter of Macro Economic

Approcahes

Macroeconomics, as a study of aggregates, tries to examine

the interrelations among various economic aggregates, their

Introduction to Economic Theory-I 17

Unit 1 Introduction to Economics

determination and causes of fluctuations in them. It is therefore the

study of aggregates covering the entire economy such as total
employment, national income, national output, total investment, total
savings, total consumption, aggregate supply, aggregate demand,
general price level etc. The subject matter and scope of
macroeconomics can be discussed as under–
 Theory of Income and Employment: Macro-economic analysis
explains what determines the level of national income and
employment, and what causes fluctuations in the level of
income, output and employment. To understand how the level
of income and employment is determined, we have to study
the determinants of aggregate supply and aggregate demand
and further we have to study consumption function and
investment function. The analysis of consumption function and
investment function are important subject matter of Macro-
Economic Theory.
Theory of Business Cycles is also a part and parcel of the
theory of income.
This theory also examines inter-relation between income
and employment, and suggests policies to solve the problems
related to these variables.
 Theory of General Price Level and Inflation: Macro-economic
analysis shows how the general level of prices is determined
and further explains what causes fluctuations in it.
The study of general level of prices is significant on account
of the problems created by inflation and depression. The
problems of inflation and depression are the serious economic
problems faced these days by most of the countries in the world.
 Theory of Growth and Development: Another important
subject matter of Macro-Economics is the theory of economic
growth and development. It studies the causes of under
development and poverty in poor countries and suggests
strategies for accelerating growth and development in them.
18 Introduction to Economic Theory-I
Introduction to Economics Unit 1

Growth Theory also deals with the problems of full utilization of

increasing productive capacity in developed countries and
explains how the higher rate of growth with stability, can be
achieved in these countries.
 Macro Theory of Distribution: Still another important subject
matter of Macro-Economics is, to explain what determines the
relative shares from the total national income of the various classes,
especially as workers and capitalist. Ricardo and Karl Marx
propounded theories, explaining the determination of relative
shares of various social classes in the total national income.
Afterwards, Kalecki and Kaldor also explained determination
of relative shares of wages and profits in the national income.
Macro theory of distribution thus deals with the relative shares
of rent, wages, interest and profits in the total national income.
In addition to this, study of public finance, international trade,
monetary and fiscal policies are also the subject matter of Macro-
Economics.

CHECK YOUR PROGRESS

Q.9: Give the definition of microeconomics.

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Q.10: Mention briefly the scope and subject matter of
microeconomics.
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Q.11: What is meant by macroeconomics?
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Introduction to Economic Theory-I 19
Unit 1 Introduction to Economics

Q.12: What do the theories of macroeconomics generally deal with?

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1.6 LET US SUM UP

 We have discussed above the central problems of an economy,

that is, what to produce, for whom to produce, how much to produce
and how to produce.
 Every nation’s resources are insufficient to produce the quantities
of goods and services that would be required to satisfy all the wants
of the citizens. This is known as the problem of scarcity and this
can be overcome by exercising choice.
 Economics distinguish between quantities that are stocks and those
that are flows. Stock variables refers to the state of affairs at a
point of time. Whereas flow refers to the rate at which something
happens over a peroid of time.
 Microeconomics is a branch of economics that studies the behaviour
of individuals and firms in making decisions regarding the allocation
of limited resources.
 The scope and subject matter of microeconomic approach is
generally concerned with commodity pricing, factor pricing and
welfare theory.
 Macroeconomics is the study of aggregates covering the entire
economy such as total employment, national income, national
output, total investment, total savings, total consumption, aggregate
supply, aggregate demand, general price level etc.
 The scope and subject matter of macroeconomics is concerned
with theory of income and employment, theory of general price
level and inflation, theory of growth and development, macro
theories of distribution etc.

20 Introduction to Economic Theory-I

Introduction to Economics Unit 1

1.7 FURTHER READING

1) Ahuja, H.L. (2006); Modern Economics; New Delhi: S. Chand & Co.
Ltd.
2) Dewett, K.K. (2005); Modern Economic Theory; New Delhi: S. Chand
& Co. Ltd.
3) Koutsoyiannis, A. (1979); Modern Microeconomics; New Delhi:
Macmillan.
4) Sundharam, K.P.M. & Vaish, M.C. (1997); Microeconomic Theory;
New Delhi: S.Chand & Co. Ltd.

1.8 ANSWERS TO CHECK YOUR PROGRESS

Ans. to Q. No. 1: a) True, b) True, c) False

Ans. to Q. No. 2: Ragnar Frisch.
Ans. to Q. No. 3: a) Economics is the science which studies human
behaviour as a relation between ends and scarce means which
has alternative uses.
b) Oikos means house and nomos means custom or law.
c) The Wealth of Nations was written in 1776.
Ans. to Q. No. 4: i) Adam Smith b) Wealth of Nations
ii) Alfred Marshall a) Principles of Economics
iii) Lionnel Robbins c) Nature and Significance of
Economic Science
Ans. to Q. No. 5: According to Lionel Robbins, “Economics is the science
which studies human behaviour as a relationship between ends
and scarce means which have alternative uses.” Robins’ definition
emphasises the following:
i) ‘Ends’ refers to unlimited human wants.
ii) Resources for satisfying human wants are limited.
iii) Scarce resources can be put to alternative uses.

Introduction to Economic Theory-I 21

Unit 1 Introduction to Economics

Ans. to Q. No. 6: a) True, b) True

Ans. to Q. No. 7: Stock variables refers to the state of affairs at a point
of time. Whereas flow refers to the rate at which something happens
over a peroid of time. For example, the money supply, price level,
assets of a firm or level of employment are stock concepts; whereas
the national income, profits of a firm, the level of industrial production
are flow concepts.
Ans. to Q. No. 8: The central problem of an economy arise due to
scarcity of resources. Again, these limited economic resources have
altemative uses. These limited economic resources create problems
of choice as what to produce, how to produce, how much to produce
for whom to produce, etc. These are the certral problems of an
economy.
Ans. to Q. No. 9: Microeconomics is a branch of economics that studies
the behaviour of individuals and firms in making decisions regarding
the allocation of limited resources.
Ans. to Q. No. 10: The scope and subject matter of microeconomic
approach is generally concerned with comodity pricing, factor pricing
and welfare theory.
Ans. to Q. No. 11: Macroeconomics is the study of aggregates covering
the entire economy such as total employment, national income,
national output, total investment, total savings, total consumption,
aggregate supply, aggregate demand, general price level etc. It is
therefore aggregate economics as it studies the economy as a
whole.
Ans. to Q. No. 12: Macroeconomics generally deals with the theories of
income and employment; theroy of general price level and inflation;
theory of growth and development and macro theories of
distribution.

22 Introduction to Economic Theory-I

Introduction to Economics Unit 1

1.9 MODEL QUESTIONS

A) Very Short Questions (Answer each question in about 75 words):

Q.1: Who authored the book Wealth of Nations, and in which year was
it published? Why this book is remarkable?
Q.2: Define scarcity.
Q.3: What is meant by problem of choice in economics?
B) Short Questions (Answer each question in about 100-150 words):
Q.1: Discuss the subject matter of Economics.
Q.2: Discuss the scope of Economics.
Q.3: Discuss choice as an economic problem.
Q.4: How far is Marshall’s definition of Economics an improvement over
Smith’s definition?
Q.5: What are the fundamental propositions of the Robbins’ definition
of Economics?
Q.6: What are the two broad approaches to the study of Economics?
C) Essay-Type Questions (Answer each question in about 300-500 words):
Q.1: Discuss briefly the subject matter of economics.
Q.2: Discuss the nature and scope of economics.
Q.3: Distinguish between microeconomic and macroeconomic
approaches. Discuss their scope and subject matter in a brief
manner.

*** ***** ***

Introduction to Economic Theory-I 23

 UNIT 2: THE MARKET MECHANISM
UNIT STRUCTURE
2.1 Learning Objectives
2.2 Introduction
2.3 Demand Supply Framework
2.3.1 Meaning of Demand
2.3.2 Law of Demand
2.3.3 Meaning of Supply
2.3.4 Law of Supply
2.4 Concept of Equilibrium
2.5 Market Equilibrium
2.6 Static Analysis
2.7 Comparative Static Analysis
2.8 Dynamic Analysis
2.9 Let Us Sum Up
2.10 Further Reading
2.11 Answers to Check Your Progress
2.12 Model Questions

2.1 LEARNING OBJECTIVES

After going through this unit, you will be able to:

 illustrate the demand supply framework
 give the concept of equilibrium
 discuss market equilibrium
 define static analysis
 define comparative static analysis
 define dynamic analysis.

2.2 INTRODUCTION

This Unit is concerned with familiarising you with some of the

important concepts in Economics like demand supply framework and market
equilibrium, static, comparative static and dynamic analysis etc.
24 Introduction to Economic Theory-I
The Market Mechanism Unit 2

By the term ‘demand’ we mean the desire to purchase a good or

service that is backed by the purchasing power. The term ‘supply’ refers to
the amount of goods and services that are offered for sale at a price.
Having knowledge about the price mechanism makes it easy for us to
discuss the concept of market equilibrium.

2.3 DEMAND SUPPLY FRAMEWORK

Meaning of Demand: The demand for a commodity is essentially

consumers’ attitude and reactions towards that commodity. Precisely stated,
the demand for a commodity is the amount of it that a consumer will
purchase or will be ready to take off from the market at the given prices in
a given period of time. Thus, demand in Ecomomics implies both the desire
to purchase and the ability to pay for the commodity. It is to be noted that
mere desire for a commodity does not constitute demand for it, if it is not
backed by the ability to pay or the purchasing power.

LET US KNOW

Demand for a good is determined by several factors,

such as price of the good itself, tastes and habits of
the consumer for a commodity, income of the consumer, the prices
of related goods, prices of substitutes or complements. When there
is change in any of these factors, demand of the consumer for that
good also changes.

Law of Demand: The law of demand expresses the functional

relationship between the price and the quantity of the commodity
demanded. The law of demand or the functional relationship between price
and commodity demanded is one of the best known and most important
laws of economic theory. According to the law of demand, other things
being equal, if the price of a commodity falls, the quantity demanded of it
will rise and if the price of the commodity rises, its quantity demanded will
decline. Thus, according to the law of demand, there is an inverse
relationship between price and quantity demanded, other things remaining
Introduction to Economic Theory-I 25
Unit 2 The Market Mechanism

the same. These other things which are assumed to be constant are: the
tastes or preferences of the consumer; the income of the consumer and
the prices of the related goods. This law of demand ensures the downward
slope of the demand curve. The figure 2.1 exhibits a typical downward
sloping demand curve for an individual consumer.
Fig. 1.1: Demand Curve of an Individual Consumer
Y

14
D
12
Price per Unit (Rs.)

10
8
6
4
2
D
0 10 20 30 40 50 60 X
Quantity (in units)
In the above figure 2.1, quantity demaned is measured along the
X-axis and price of the commodity is measured along the Y-axis. From the
figure it can be seen that when price of the commodity was Rs 12, the
demand for the commodity was 4 units only. When price fell to Rs 10,
demand for the commodity increased to 8 units. And finally, when price of
the commodity declined to Rs 4, demand for the commodity increased to
20 units. Thus, by plotting the various price-quantity combinations, a
negatively (or downward) sloped demand curve DD is obtained. The
downward slope of the demand curve indicates that when price rises, less
units are demanded and when the price falls, more quantity is demanded.
This negative slope arises basically because of the law of diminishing
marginal utility which states that as a person takes more and more of a
commodity, the utility derived from the subsequent unit falls.
Meaning of Supply: Supply is a fundamental economic concept
that describes the total amount of a specific good or service that is available
to consumers. Supply can relate to the amount available at a specific price
or the amount available across a range of prices if displayed on a graph. It
26 Introduction to Economic Theory-I
The Market Mechanism Unit 2

is the relation between the price of a good and the quantity available for
sale from suppliers (such as producers) at that price. Producers are
hypothesized to be profit-maximizers, meaning that they attempt to produce
the amount of goods that will bring them the highest profit.
Law of Supply: The law of supply states that supply shows a direct,
proportional relation between price and quantity supplied (other things
unchanged). In other words, the higher the price at which the good can be
sold, the more of it producers will supply. The higher price makes it profitable
to increase production. At a price below equilibrium, there is a shortage of
quantity supplied compared to the quantity demanded.
The supply schedule is the relationship between the quantity of
goods supplied by the producers of a good and the current market price. It is
graphically represented by the supply curve. It is commonly represented as
directly proportional to price. This has been shown in the following figure 2.2.

Fig. 1.2: Supply Curve

Y
S
Price per Unit (Rs.)

30

20

10

0 50 100 150
Quantity (in units)
The above figure depicts a normal supply curve. From the figure
we can see that when price of the commodity was Rs. 10, supply of the
good was 50 units. When price increased to Rs. 20, supply of the good
also increased to 100. Further increase of the price to Rs. 30 resulted in
the increase in the supply of the commodity to 150 units. Thus, we can see
that in case of a nomal good, the supply curve slopes upwards to the right.
This is because with a rise in the price of the good in question, more supply
of the good is available for sale.
Introduction to Economic Theory-I 27
Unit 2 The Market Mechanism

ACTIVITY 2.1

A fall in price always leads to rise in demand. Justify

the statement with the help of an example.

CHECK YOUR PROGRESS

Q.1: State whether the following statements are

True or False:
a) Every want is a demand.
b) The relationship between demand and price is positive.
c) A normal supply curve slopes upwards to the right.
Q.2: Explain the concept of demand. (Answer in about 40 words)
............................................................................................
............................................................................................
............................................................................................
............................................................................................
Q.3: How is the quantity of supply of a commodity related to its
price? (Answer in about 30 words)
............................................................................................
............................................................................................
............................................................................................

2.4 CONCEPT OF EQUILIBRIUM

In Economics, ‘equilibrium’ is a term used to describe a situation

where economic agents or agregates of economic agents such as markets
have no incentive to change their economic behaviour.
Applied to an individual agent, such as a consumer or a firm, it
denotes a situation in which the agent is under no pressure or has no
incentive to alter the current levels or states of economic action, because
he finds that he cannot improve his position in terms of any economic
criteria. When applied to markets, equilibrium denotes a situation in which

28 Introduction to Economic Theory-I

The Market Mechanism Unit 2

the aggregate buyers and sellers are satisfied with the current combination
of prices and the quantities of goods bought or sold, and so there is no
incentive to change their present actions.

2.5 MARKET EQUILIBRIUM

At every moment, some people are buying while others are selling.
Foreign companies are opening production units in India while Indian
companies are selling their products abroad. In the midst of all this turmoil,
markets are constantly solving the problems of what to produce, how much
to produce, how to produce and for whom to produce. As they balance all
the forces operating in the economy, markets are finding a market
equilibrium of supply and demand.
Thus, the term ‘market equilibrium’ represents a ba!ance among
the different buyers and sellers. According to G. J. Stigler, “An equilibrium To know more about G.
is a position from which there is no tendency to move.”Equilibrium describes J. Stigler, please refer
to Appendix-B at the
a situation where economic agents or aggregates of economic agents such
end of the third block
as markets have no incentive to change their economic behaviour.
Depending upon the price, households and firms all want to sell or
buy different quantities. The market finds the equilibrium price that
simultaneously meets the desires of buyers and sellers. Too high a price
would mean a glut of goods with too much output; too low a price will on Glut: An excessively
the other hand lead to a deficiency of goods. Those prices for which buyers alrendant supply of
desire to buy exactly the quantity that sellers desire to sell yield an something.

equilibrium of supply and demand.

Thus, we have discussed that the word “equilibrium” denotes a
state of rest from where there is no tendency to change. In the following
figure 2.3 the point ‘e’ describes a position of equilibrium because this is a
point where all buyers and all sellers are satisfied.

Introduction to Economic Theory-I 29

Unit 2 The Market Mechanism

Fig. 1.3: Equilibrium of a Firm

From figure 2.3 it can be seen that the price P* is determined by

the intersection of the market demand (DD) and market supply curve (SS)
and is called the equilibrium price. Corresponding to this equilibrium price,
the quantity transacted Q* is called the equilibrium quantity.
If the price is higher than P* say P1, then the buyers can buy what
they want to buy at that price, but the seller cannot sell all they want to sell.
Demand will be low. This is a situation of excess supply or surplus in the
market. The suppliers are dissatisfied. This situation cannot be sustained
and the market price has to come down.
Again, If the price is lower than P*, say P 2, then the sellers can sell
what they want to sell at that price, but buyers cannot buy all they want to
buy because supply of the good will be low. This is a situation of excess
demand or shortage of supply in the market. The buyers are dissatisfied.
This situation cannot, be sustained and the market price has to go up.
Thus, we have seen that when prices are above or below P*, the
market is in disequilibrium. The market is in equilibrium when demand is
equal to supply and in the figure given above the point of equilibrium is at
point e where equilibrium price is OP* and equilibrium quantity is 0Q*.
The laws of supply and demand state that the equilibrium market
price and quantity of a commodity is the intersection point of consumer’s
demand and producer’s supply. Here the quantity supplied equals the
30 Introduction to Economic Theory-I
The Market Mechanism Unit 2

quantity demanded; that is, equilibrium is reached. Equilibrium implies that

price and quantity will be steady.
According to the law of supply and the law of demand, a market will
move from a disequilibrium point where the quantity demanded is not equal
to the quantity supplied, to an equilibrium point. This is called stable
equilibrium. Not all economic equilibria are stable. For an equilibrium to be
stable, a small deviation from equilibrium leads to economic forces that
returns an economic sub-system toward the original equillibrium.
When the price is above the equilibrium point there is a surplus of
supply; and when the price is below the equilibrium point there is a shortage
in supply. Different supply curves and different demand curves have
different points of economic equilibrium. In most simple microeconomic
analysis of supply and demand in a market, a static equilibrium is observed.
Static equilibrium occurs in a stationary economy where population,
technology, resources, tastes and preferences do not change. When
changes take place in such a system, the rate of change remains the
same. However, economic equilibrium can be dynamic when the factors
mentioned above such as population, technology and so on change over
time. Equilibrium may also be multi-market or general, as opposed to the
partial equilibrium of a single market.

CHECK YOUR PROGRESS

Q.4: Who are the economic agents? (Answers

in about 30 words)
............................................................................................
............................................................................................
............................................................................................
Q.5: State whether the following statements are True or False:
a) In Economic theory, all equilibria are not stable,
b) In most of the cases of simple Microeconomic analysis,
dynamic equilibria are used.

Introduction to Economic Theory-I 31

Unit 2 The Market Mechanism

c) Static equilibrium occurs in a society where population,

technology, resources, tastes and preferences do not
change.
Q.6 What is meant by stable equilibrium? (Answer in about 40
words)
............................................................................................
............................................................................................
............................................................................................
............................................................................................

2.6 STATIC ANALYSIS

Static analysis ocupies an important place in economic theory and

analysis. A greater part of economic theory has been formulated with the
aid of the technique of economic statics. The task of economic theory is to
explain the functional relationships between systems of economic variables.
If a functional relationship is established between two variables whose
values relate to the same point of time or to the same period of time, the
analysis is said to be static analysis.
In other words, the static analysis or static theory is the study of
static relationship between relevant variables. A functional relationship
between variables is said to be static if values of the economic variables
relate to the same point of time or to the same period of time. We can give
various examples of the static relationship between economic variables
and various economic laws based upon them. For example, we can refer
to the law of demand. This law tries to establish the functional relationship
between quantity demanded of a good and price of that good at a given
moment or period of time. This law states that, other things remaining the
same, the quantity demanded varies inversely with price at a given point
or period of time. Similarly, the static relationship has been established
between quantity supplied and price of goods, both variables relating to
the same point of time. Therefore, the analysis of this relationship is a
static analysis.

32 Introduction to Economic Theory-I

The Market Mechanism Unit 2

Till recently, the whole price theory in which we explain the

determination of equilibrium prices of products and factors in different
market categories were mainly static analysis, for the values of the various
variables, such as demand, supply, and price were taken to be relating to
the same point or period of time.
Importance of Static Analysis: The method of economic statics is
very important and a large part of economic theory has been developed
using the technique of economic statics. It is widely used because it makes
the analysis simple and easier to handle. According to Prof. Robert Dorfman,
“statics is much more important than dynamics, partly because it is the
ultimate destination that counts in most human affairs, and partly because
the ultimate equilibrium strongly influences the time paths that are taken to
reach it, whereas the reverse influence is much weaker”.

2.7 COMPARATIVE STATIC ANALYSIS

Comparative static analysis is an important tool to study and analyse

economic theory and problems. Most of economic theory consists of
comparative statics analysis. Comparative Statics is the determination of
the changes in the endogenous variables of a model that will result from a
change in the exogenous variables or parameters of that model. It is a
method of study which focusses on the external force that make the
equilibrium in the model change. The external force here refer to exogenous
variables. You know that in economics we have two types of variables:
endogenous and exogenous variables. Endogenous means any variable
defined within the model whereas the exogenous variable refers to constant
term or parameter where its value is defined outside the model. There are
various examples of comparative static analysis. For example, we can refer
to the Keynsain model of IS-LM which represents both equilibrium in goods
market and money market.
Comparative statics is commonly used to study changes in supply
and demand when analyzing a single market, and to study changes in
monetary or fiscal policy when analyzing the whole economy. The term
'comparative statics' is more commonly used in relation to microeconomics
Introduction to Economic Theory-I 33
Unit 2 The Market Mechanism

(including general equilibrium analysis) than to macroeconomics.

Comparative statics was formalized by John R. Hicks (1939) and Paul A.
Samuelson (1947).

2.8 DYNAMIC ANALYSIS

Dynamic analysis is very popular in contemporary economics.

Economic dynamics is a more realistic method of analysing the behaviour
of the economy or certain economic variables through time. It considers
the relationship between relevant variables whose values belong to different
points of time. Professor Ragnar Frisch who is one of the pioneers in the
use of the technique of dynamic analysis in economics defines economic
dynamics as follows: “A system is dynamical if its behaviour over time is
determined by functional equations in which variables at different points of
time are involved in an essential way.” He further elaborates, “We consider
not only a set of magnitudes in a given point of time and study the
interrelations between them, but we consider the magnitudes of certain
variables in different points of time, and we introduce certain equations
which embrace at the same time several of those magnitudes belonging
to different instants. This is the essential characteristic of a dynamic theory.
Only by a theory of this type we can explain how one situation grows out of
the foregoing.” We can give various examples of dynamic analysis from
the field of micro and macroeconomics. For example, in microeconomics,
if one assumes that, the supply (S) for a good in the market in the given
time (t) depends upon the price that prevails in the preceding period (that
is, t – 1) the relationship between supply and price is said to be dynamic.
Similarly in the macroeconomics field if it is assumed that the consumption
of the economy in a given period depends upon the income in the preceding
period (t – 1) we shall be conceiving a dynamic relation.
Importance of Dynamic Analysis: The importance of economic
dynamics or dynamic analysis can be explained as follows–
To make the economic analysis realistic we have to incorporate the
impacts of changing time in the variables. That is why, economic dynamics
is very important for realistic economic analysis. In the real world, various
34 Introduction to Economic Theory-I
The Market Mechanism Unit 2

key variables such as prices of goods, output of goods, income of the

people, investment and consumption, etc. are changing over time.
Some variables take time to respond to the change in other variable.
In other words, there is a time lag in them. For example, changes in income
in one period makes its influence on consumption in the next period. These
can be analysed only through dynamic analysis.
The values of certain variables depend upon the rate of growth of
other variables. For example, we have seen in Harrod’s dynamic model of
a growing economy that investment depends upon expected rate of growth
in output.
In some cases where certain variables depend upon the rate of
change in other variables, application of both the period analysis and the
rate of change analysis of dynamic economics become essential.
Dynamic analysis becomes very necessary in case of growth
studies. It helps in building dynamic models of optimum growth both for
developed and developing countries of the world.

CHECK YOUR PROGRESS

Q.7: Define static analysis. W hat are its

importance?
............................................................................................
............................................................................................
............................................................................................
............................................................................................
Q.8: What is meant by comparative static analysis?
............................................................................................
............................................................................................
............................................................................................
Q.9: Define Economic dynamics.
............................................................................................
............................................................................................
............................................................................................
............................................................................................
Introduction to Economic Theory-I 35
Unit 2 The Market Mechanism

Q.10: Distinguish between static and dynamic analysis.

............................................................................................
............................................................................................
............................................................................................
............................................................................................
............................................................................................

2.9 LET US SUM UP

 The law of demand is one of the most important laws of economic

theory. It establishes an inverse relationship between price and
quantity demanded of a commodity.
 Mere desire for a commodity does not constitute demand for it, if it
is not backed by purchasing power.
 The higher the price at which the good can be sold, the more of it
producers will supply. On account of this, a normal supply curve
slopes upwards to the right.
 A market equilibrium represents a balance among all the different
buyers and sellers.
 The word “equilibrium” denotes a state of rest from where there is
no tendency to change because this is a point where all buyers
and all sellers are satisfied.
 Not all economic equilibria are stable.
 If a functional relationship is established between two variables
whose values relate to the same point of time or to the same period
of time, the analysis is said to be static analysis.
 The method of economic statics is very important and a large part
of economic theory has been developed using the technique of
economic statics.
 Comparative Statics is the determination of the changes in the
endogenous variables of a model that will result from a change in
the exogenous variables or parameters of that model.

36 Introduction to Economic Theory-I

The Market Mechanism Unit 2

 Comparative statics is commonly used to study changes in supply

and demand when analyzing a single market, and to study changes
in monetary or fiscal policy when analyzing the whole economy.
 Dynamic analysis considers the relationship between relevant
variables whose values belong to different points of time.
 Economic dynamics is very important for realistic economic analysis.
In the real world, various key variables such as prices of goods,
output of goods, income of the people, investment and consumption,
etc. are changing over time.

2.10 FURTHER READING

1) Ahuja, H.L. (2006); Modern Economics; New Delhi: S. Chand & Co.
Ltd.
2) Dewett, K.K. (2005); Modern Economic Theory; New Delhi: S. Chand
& Co. Ltd.
3) Koutsoyiannis, A. (1979); Modern Microeconomics; New Delhi:
Macmillan.
4) Sundharam, K.P.M. & Vaish, M.C. (1997); Microeconomic Theory;
New Delhi: S.Chand & Co. Ltd.

2.11 ANSWERS TO CHECK YOUR PROGRESS

Ans. to Q. No. 1: a) False, b) False, c) True

Ans. to Q. No. 2: Demand can be defined as a desire for a commodity
or service which is backed by the ability to pay. The need for a
commodity, doesn’t mean its demand. It is called demand only when
the consumer has sufficient purchasing power to pay for it.
Ans. to Q. No. 3: The quantity of supply of a commodity is positively
related to its price. This means that as price increases, quanity
supplied of the commodity concerned also increases and vice-versa.

Introduction to Economic Theory-I 37

Unit 2 The Market Mechanism

Ans. to Q. No. 4: Economic agents can be any individual, firm, a seller

or an industry that undertakes economic activity, viz, production,
investment, saving, consumption etc.
Ans. to Q. No. 5: a) True, b) False, c) True
Ans. to Q. No. 6: Acccording to the law of supply and the law of demand,
market will move from a disequilibrium point, where the quantity
demanded is not equal to the quantity supplied, to an equilibrium
point. This is called stable equilibrium.
Ans. to Q. No. 7: If a functional relationship is established between two
variables whose values relate to the same point of time or to the
same period of time, the analysis is said to be static analysis.
The method of economic statics is very important and a large
part of economic theory has been developed using the technique
of economic statics. It is widely used because it makes the analysis
simple and easier to handle.
Ans. to Q. No. 8: Comparative Statics is the determination of the
changes in the endogenous variables of a model that will reusult
from a change in the exogenous variables or parameters of that
model.
Ans. to Q. No. 9: Economic dynamics is a more realistic method of
analysing the behaviour of the economy or certain economic
variables through time. It considers the relationship between relevant
variables whose values belong to different points of time.
Ans. to Q. No. 10: There are some basic difference between static
analysis and dynamic analysis. As the name suggests, they are
opposite to each other. The main point of difference between static
and dynamic analysis is that- while static analysis analyzes the
relationship between two variables at a particular point of time while
dynamic analysis analyzes the relationship between two variables
through different point of time.
In practice, dynamic analysis is more realistic and practical than
the static analysis; but static analysis is easier to use for its simplicity.

38 Introduction to Economic Theory-I

The Market Mechanism Unit 2

2.12 MODEL QUESTIONS

A) Very Short Questions (Answer each question in about 75 words):

Q.1: State the law between the price and the quantity demanded of a
product.
Q.2: Mention the law of supply in a few lines.
Q.3: Give the definition of statics, comparative statics and dynamic
analysis.
B) Short Questions (Answer each question in about 100-150 words):
Q.1: Discuss the role of market mechanism in Economics.
Q.2: Give the concept of equilibrium and write a brief note on market
equilibrium.
Q.3: What are the basic difference between economic statics and
economic dynamics?
C) Essay-Type Questions (Answer each question in about 300-500 words):
Q.1: State and explain the laws of demand and supply with the help of
suitable figures.
Q.2: What is meant by equilibrium? What are the basic conditions for
market equilibrium? How is equilibrium reached? Explain with the
help of suitable figure.

*** ***** ***

Introduction to Economic Theory-I 39

 UNIT 3: DEMAND ANALYSIS
UNIT STRUCTURE
3.1 Learning Objectives
3.2 Introduction
3.3 The Idea of Demand and the Demand Curve
3.4 Movement Along a Demand Curve
3.5 Shift in the Demand Curve
3.6 Exceptions to the Law of Demand
3.7 Elasticity of Demand
3.7.1 Price Elasticity of Demand
3.7.2 Income Elasticity of Demand
3.7.3 Cross Elasticity of Demand
3.8 Let Us Sum Up
3.9 Further Reading
3.10 Answers to Check Your Progress
3.11 Model Questions

3.1 LEARNING OBJECTIVES

After going through this unit, you will be able to:

 give the definition of demand
 derive a demand curve
 explain the movement along a demand curve
 illustrate the shift in the demand curve
 state the three variants of elasticity of demand, i.e. price elasticity,
income elasticity, and cross elasticity.

3.2 INTRODUCTION

The theory of demand studies the various factors that determine

demand. It is traditionally accepted that four factors affect the demand for
a commodity, namely:
 its own price
 consumer’s income
40 Introduction to Economic Theory-I
Demand Analysis Unit 3

 prices of other commodities, and

 taste of the consumers.
The basic idea of demand is the willingness to buy a commodity or
to enjoy a service. But to be effective, it should be backed by purchasing
power. Other things remaining constant, there exists an inverse relationship
between price and quantity demanded which is stated as law of demand.
The degree of responsiveness of quantity demanded of a good
due to a change in its price/income of the consumer/prices of related
commodities are indicated by price/income/cross elasticity of demand
respectiveiy.

3.3 THE IDEA OF DEMAND AND THE DEMAND CURVE

Demand is the amount of particular goods or services that a

consumer or group of consumers will want to purchase at a given price.
But as said above, merely the want of something will not constitute demand.
It should be backed by purchasing power to be effective demand. Usually
demand in Economics means ‘effective demand’. For example, you may
dream of having an aeroplane of your own; but if you don’t have the
purchasing power to buy it, it will not be considered as demand. On the
other hand, if you have 100 rupees is your hand than you can demand the
goods and services worth 100 rupees.
Demand is invariably related to price. There is an inverse relationship
between price and quantity demanded known as law of demand. The law
of demand expresses the functional relationship between quantity
demanded of a commodity and its price. According to the law of demand,
other things being equal, the quantity demanded will rise with a fall in its
price. This implies that there is an inverse relationship between the quantity
demanded and the price, given that other things remain the same. The
other things that are assumed to remain unchanged consist of income of
the consumer, prices of related goods, and the taste of the consumer.
The law of demand can be illustrated by a demand schedule. And
the demand schedules constitute the basis on which the demand curve is
constructed. Table 3.1 shows a hypothetical demand schedule of a
Introduction to Economic Theory-I 41
Unit 3 Demand Analysis

consumer. The table shows the various quantities demanded at different

prices by the consumer. Thus, at price Rs. 6, the quantity demanded is 10
units. As the price falls successively by Re. 1, the quantity demanded
correspondingly increases by 10 units for every decrease in the price.
Table 3.1: A Hypothetical Demand Schedule
Price (Rs) Quantity Demanded Price/Demand Combinations
(1) (2) (3)
6 10 a
5 20 b
4 30 c
3 40 d
2 50 e
1 60 f
Now, let us plot the various price and quantity demanded
combinations of table 3.1 in the following figure 3.1.
Fig. 3.1: Demand Curve of a Comsumer

Y
D

6 a
b
5 
c
4 

d
Price

3
2 e

1 f
D
X
0 10 20 30 40 50 60
Commodity

By plotting the various price-quantity demanded combinations from

table 3.1, we derive the demand curve DD in figure 3.1. Thus, the demand
curve is a graphic representation of the demand schedule and it indicates
the various quantities demanded for a commodity at various prices.
42 Introduction to Economic Theory-I
Demand Analysis Unit 3

The demand curve slopes downward towards the right. This is

because as prices fall, the quantity demanded goes on increasing. Thus, it
shows that there exists an inverse relationship between the price of a
commodity and the quantity demanded for it.
Individual Demand and Market Demand: It is to be noted that
demand may be distinguished as individual consumer’s demand and
market demand. Market demand for a good is the sum total of the demands
of the individual consumers who purchase the commodity in the market.
By definition, individual demand indicates the quantities of a good
or service which the household is willing and able to purchase at various
prices, holding other things constant. Although for some purposes it is
useful to examine an individual consumer’s demand, it is frequently
necessary to analyse demand for an entire market made up of many
consumers. We will now show how we derive the market demand curve
from individual demand curves. Let us assume that there are only two
consumers in the market. Their demands and the market demand are given
below and the individual demand curves and the market demand curve
are shown in figure 3.2 (a), (b) and (c).

Table 3.2: Demand Schedules for two Customers and the Market
Demand Schedule
Price Quantity Demanded (in Kgs)
(In Rs) Consumer 1 Consumer 2 Market Demand
(1) (2) (3) (4)
12 4 6 4 + 6 = 10
10 5 8 5 + 8 = 13
8 6 10 6 + 10 = 16
6 7 12 7 + 12 = 19
4 8 14 8 + 14 = 22
2 9 16 9 + 16 = 25

The market demand is in fact the summation of the demand

schedules of the two individual consumers. These demand schedules have
been shown with the help of the figures 3.2 (a), (b) and (c)
Introduction to Economic Theory-I 43
Unit 3 Demand Analysis

Fig. 3.2 (a): Demand Curve of Customer 1 Fig. 3.2 (a): Demand Curve of Customer 2

D1 D2
12  12 

10  10 
Demand
Curve of Demand Curve of Consumer 2
8  Consumer 1 8 
Price

6  6 

4  4 

2 2 
D1 D2
0 4 6 8 10 0 4 6 8 10 12 14 16
Quantity

Fig. 3.2 (c): Market Demand Curve

Y

D
12 

10 

8 

6 
Price

4 
D
2 

0 10 12 14 16 18 20 22 24 26 X
Quantity

In the above, figure 3.2 (a) represents the individual demand

schedule of consumer 1, figure 3.2 (b) represents the individual demand
schedule of consumer 2, while figure 3.2 (c) represents the market demand
schedule. Thus, D D represents the demand curve of consumer 1, D D
1 1 2 2
represents the demand curve of consumer 2 and DD represents the market
demand curve.
Assumptions of the Law of Demand: The working of the law of
demand rests on the following assumptions:
44 Introduction to Economic Theory-I
Demand Analysis Unit 3

 The habits and tastes of the consumer remain the same.

 There is no change in income of the consumer.
 The prices of other related goods remain the same.
It is to be noted that while the law of demand is universally
applicable, it may not hold good in certain cases. We shall discuss this in
the next section.

CHECK YOUR PROGRESS

Q.1: State whether the following statements are

True or False:
a) Other things remaining the same, there exists an inverse
relationship between the quantity demanded and its
price.
b) Change in demand occurs due to a change in the price
of a commodity.
c) Market demand is the summation of individual demands
of all the consumers in the market.
Q.2: Fill in the blanks:
a) By definition, other things remaining the same, ................
indicates the quantities of goods or services which the
household is willing to and able to purchase at various
prices.
b) The demand curve slopes .................... towards the right.
c) .................... for a good is the sum total of the demand
of the individual consumers who purchase the
commodity in the market.
Q.3: How would you derive a market demand curve from
individual demand curves? (Answer in about 30 words)
............................................................................................
............................................................................................
............................................................................................
............................................................................................

Introduction to Economic Theory-I 45

Unit 3 Demand Analysis

3.4 MOVEMENT ALONG A DEMAND CURVE

Movement along a demand curve means change in the quantity

demanded in response to the change in price. This movement is in the
same demand curve. This situation can be illustrated with the same diagram
of 3.1 or 3.2(c) where the general demand curve and market demand
curve has been portrayed. Here movement along different points of the
demand curve corresponding to the different combination of price and
quantity demanded will clearly show you the movement along a demand
curve.

3.5 SHIFT IN THE DEMAND CURVE

Movement along a demand curve can show changes in quantity

demanded corresponding to various price level of a particular good or
service. But for change in demand, we have to show the shift in demand
curve. A shift to the left of the original demand curve will show decrease in
demand and shift to the right will show increase in demand. This can be
shown with the help of the following diagram:
Fig. 3.3: Shift in the Demand Curve
Y
D1
D
D2
Price

D1
D
D2
0 X
Quantity

In the above figure 3.3, shift in the demand curve has been shown.
DD is the original demand curve. A decrease in demand is shown by
downward shift in the demand curve to the left (D 2D2), and an increase in
demand is shown by an upward shift in demand curve to D 1D1. This shift in
46 Introduction to Economic Theory-I
Demand Analysis Unit 3

demand may be caused by some factors other than price. This change
can be due to the taste and preference of the consumer, new innovation
and technology etc.

3.6 EXCEPTIONS TO THE LAW OF DEMAND

For certain commodities the law of demand does not hold, and
they exhibit a direct relationship between the price and quantity demanded.
The commodities that violates the ‘law of demand’ are mentioned
below:
 Giffen Goods: Giffen Goods are special categories of inferior goods
which do not follow the ‘law of demand’. Thus, a fall in the price of
such a good will result in a decrease in the quantity demanded and
vice versa. Robert Giffen studied this paradox. This happens To know more about
because the income effect of the price change of a Giffen good is Robert Giffen please
refer to Appendix-‘B’.
positive and is greater than the negative substitution effect. This
results in a price effect which is positive, resulting in the price and
quantity demanded changing in the same direction.
Besides Giffen Goods, the law of demand may not operate in the
case of the following goods:
 ‘Status Symbol’ Goods: These goods are bought because they
confer a social prestige to the buyer. According to Torstein Veblen, To know more about
a fall in their prices will result in the curtailment in the quantity Torstein Veblem
demanded, resulting in the violation of the law of demand. This please refer to
Appendix-‘B’.
generally happens in case of luxury goods.
 Speculative Consumption: Speculation of further rise in prices of
the very essential products may induce consumers to purchase
more of a commodity as its price increases, resulting in a temporary
failure of the law of demand. Suppose, the price of a very important
drug/medicine has started to increase very sharply. In such a
situation, in anticipation of further increase in prices in the coming
days, the consumers may find it more beneficial to purchase more
quantity of the drug than actually required.

Introduction to Economic Theory-I 47

Unit 3 Demand Analysis

CHECK YOUR PROGRESS

Q.4: State whether the following statements are

True or False:
a) According to the law of demand, there exists an inverse
relationship between the price of a commodity and its
demand.
b) The law of demand does not hold good in case of Giffen
goods.
Q.5: Fill in the blanks:
a) In case of normal goods, substitution effect is ..................
b) The relative strength of the two components of the price
effect determines the relationship between the price of
a commodity and ..................... for it.
Q.6: Define the term Giffen good? (Answer in about 40 words)
............................................................................................
............................................................................................
............................................................................................
............................................................................................
Q.7: Why is the law of demand violated in case of specultive
consumption? (Answer in about 50 words).
............................................................................................
............................................................................................
............................................................................................
............................................................................................
Q.8: Distinguish between change in quantity demanded and
change in demand. (Answer in about 50 words)
............................................................................................
............................................................................................
............................................................................................
............................................................................................
............................................................................................

48 Introduction to Economic Theory-I

Demand Analysis Unit 3

3.7 ELASTICITY OF DEMAND

Elasticity of demand relates to the degree of responsiveness of

quantity demanded of a good to a change in :
 its price, or
 the consumer’s income, or
 the prices of related goods.
Thus, change in quantity demanded as a response to the the above
three variable gives us three different concepts of elasticity of demand,
namely:
 price elasticity of demand (resulting due to a change in price)
 income elasticity of demand (resulting due to a change in income)
 cross elasticity of demand (resulting due to a change in the prices
of related goods).

3.7.1 Price Elasticity of Demand

Price elasticity of demand measures the responsiveness of

quantity demanded of a good to changes in its price, other things
remaining the same. Price elasticity of demand can be expressed
by two related measures, viz.:
 Point Elasticity of Demand, and
 Arc Elasticity of Demand.
Now, let us explain these two concepts in some detail.
 Point Elasticity of Demand: Point elasticity of demand
technique is used to measure the price elasticity of demand of
a good if the change in its price is very small.
Hence, the point elasticity of demand is defined as the
proportionate change in the quantity demanded of the product
due to a very small proportionate change in price. Thus,
Proportionate change in quantity demanded
Point Elasticity of demand 
Proportionate change in price

Q
Q P  Q
Thus, ep= P  x
Q P
P
Introduction to Economic Theory-I 49
Unit 3 Demand Analysis

wheres, ep means price elesticity, P means price, Q means quantity,

and  means infinitesimal (very very small) change in the variable
concerned.
The price elasticity of demand is always negative due to
the inverse relationship between price and quantity demanded.
However, in general the negative sign is ignored in the formula.
Graphically, the point elasticity of demand in a linear demand
curve is shown by the ratio of segments of the line to the right and
to the left of any particular point. This has been shown in figure 3.4.
Fig. 3.4: Point Elasticity in a Linear Demand Curve
Y
D

F
Price

D/
X
0 Q Quantity

Thus, in figure 3.4 point elasticity of demand on point F of

the linear demand curve DD’ is measured as :

Lower segment FD


Upper segment FD

Now given this graphical measurement of point elasticity, it

is obvious that a linear demand curve like the one in figure 3.4, the
mid-point will represent unitary elasticity of demand. This has been
shown in figure 3.5.

50 Introduction to Economic Theory-I

Demand Analysis Unit 3

Fig. 3.5 : Elasticities on Different Points of a Linear Demand Curve

Y

D E= 
a
E>1
b
E=1
Price

c
E<1
d
e E=0
X
0 D/ Quantity

From figure 3.5, it can be seen that at point c of the demand

curve DD/, DC = D/C (i.e. the lower segment of the demand curve
equals the upper segment). Thus, elasticity of demand at this point
c is 1. Points above ‘c’ and below ‘a’ of the demand curve have
elasticities greater than 1. Similarly, below the point ‘c’ and above
point ‘e’ where the demand curve touches the horizontal axis,
elasticities at various points (say at point ‘d’) will be less than 1.
Elasticities at two extreme points of the demand curve, i.e., at points
a and e will be infinite and zero respectively.
Thus, we find that the point elasticity of demand ranges
between 0 and  ,i,e,
0 < ep< 

Now,
a) If ep = 0, the demand is perfectly inelastic.
b) If ep = 1, the demand is perfectly elastic.
c) If ep < 1, the demand is relatively elastic.
Now, let us explain these situations in some detail.
a) If ep=0, the demand is perfectly inelastic. This implies that any
proportionate change in price will have no effect on the quantity
demanded. A perfectly inelastic demand is indicated in figure
3.6, which is a straight perpendicular on the horizontal axis.

Introduction to Economic Theory-I 51

Unit 3 Demand Analysis

Fig. 3.6: Vertical Demand Curve : Perfectly Inelastic

Y
D

Price
0 Quantity X
D
b) If ep=  the demand is perfectly elastic. this implies that for a
small change in price there would be a infinitely large change
in quantity demanded. This gives us a demand curve which is
parallel to the horizontal axis as has been shown in the following
figure 3.7.
Fig. 3.7: Horizontal Demand Curve : Perfectly Elastic

D
Price

0 Quantity X

c) If ep=1, the demand is unitarily elastic. Here, a proportionate

change in the price will result in the same proportionate change
in the quantity demanded. The demand curve passes through
the origin as has been shown in figure 3.8.
Fig. 3.8: Proportionate change : Unitary Elastic

Y
D

P2
Price


P1

D
0 Q2  Q1 Quantity X

52 Introduction to Economic Theory-I

Demand Analysis Unit 3

 Arc Elasticity of Demand: The arc elasticity of demand

measures the price elasticity of demand when the change in
price is somewhat large. In terms of demand curve, the arc
elasticity measures the price elasticity of demand over an arc
between two points on the demand curve. In fact, it is a measure
of the average elasticity, and represents the elasticity of the
mid-point of the chord that joins the two points (say, A and B)
on the demand curve. The two points are defined by the initial
and the final prices.
Thus, the arc elasticity of demand is:
Q P1 + P2
ep  x
P Q1 + Q 2
Where, ep=arc elasticity,  Q = Q1 – Q2,  P = P1 – P2, Q1 and Q2
are the two quantities at the two prices P 1 and P2 respectively.
The concept of Arc elasticity of demand has been explained
with the help of figure 3.9.
Fig. 3.9: Arc Elasticity of Demand
Y
D

P1 A

ΔP
{
Price

P2 B

D
ΔQ
}

X
0 Q1 Q2 Quantity
In figure 3.9, the elasticity of demand in the AB segment of
the demand curve DD is indicated by the arc elasticity of demand.
Thus, the arc elasticity of demand is average elasticity of the
segment AB and is represented by the midpoint of the chord AB
joining the two points A and B of the demand curve DD.
Introduction to Economic Theory-I 53
Unit 3 Demand Analysis

3.7.2 The Income Elasticity of Demand

The income elasticity of demand is defined as the

proportionate change in the quantity demanded due to a
proportionate change in income. Thus,
Q
Y Q Q
Thus, ey  x =
Y Q Y
Y
Where ey means income elasticity, Y means income, Q means
quantity,  means infinitesimal change.
For example, suppose income of Mr. X has increased from
Rs. 5,000 to Rs. 6,000 per month, i.e., by 20 percent. As a result,
expenditure of consumption of his fruit basket increases from 10
kg to 12 kg, i.e., by 20 percent. Thus, income elasticity of demand
in this case will be 20/20 or 1.
The income elasticity of demand had been used by some
economists to classify goods as luxuries, necessities and inferior
goods. Thus:
ey = 0 means: the commodity is a necessity
ey > 0 means: the commodity is luxury, and
ey < 0 means: the commodity is inferior.

ACTIVITY 3.1

Calculate the income elasticity of demand and indicate

the range of income over which acommodity x is a
luxury, a necessity or an inferior goods.
Sl Income Quantity Q x Y ey Types of
No. (in Rs.) (Y) (Qx) (in%) (in%) Goods
1 8,000 5
2 12,000 10 100 50 2 Luxury
3 16,000 – – – – –
4 20,000 18 – – – –
5 24,000 20 – – – –
6 28,000 19 – – – –
7 32,000 18 – – – –

54 Introduction to Economic Theory-I

Demand Analysis Unit 3

3.7.3 The Cross Elasticity of Demand

When two goods are related to each other, then the change
in demand for one good in response to a change in the price of the
second good is indicated by the cross elasticity of demand. The
cross elasticity of demand is defined as the proportionate change
in the quantity demanded of x in response to a proportionate change
in the price of y.

Q x
Qx P Q x
Thus, exy  = y x
P

y Q x  Py
Py

Where, exy means cross elasticity of demand, Q x means Quantity

of the commodity X,  Qx means change in quantity of X, P y means
Price of the commodity Y, and  Py means Change in price of Y..
Now, exy < 0 means: x and y are complimentary goods, and
exy > 0 means: x and y are substitutes.

CHECK YOUR PROGRESS

Q.9: What is meant by elasticity of demand?

(Answer in about 40 words)
............................................................................................
............................................................................................
............................................................................................
............................................................................................
............................................................................................
Q.10: How will you graphically measure the point elasticity of
demand of a linear demand curve? (Answer in about 40 words)
............................................................................................
............................................................................................
............................................................................................
............................................................................................
............................................................................................

Introduction to Economic Theory-I 55

Unit 3 Demand Analysis

Q.11: Mention some of the applications of the concept of income

elasticity of demand. (Answer in about 40 words)
............................................................................................
............................................................................................
............................................................................................
............................................................................................
............................................................................................

3.8 LET US SUM UP

 The theory of demand studies the various factors that determine

demand.
 The law of demand states that, other things remaining same, there
exists an inverse relationship between quantity demanded and the
price.
 “Change in Demand” and the “Change in Quantity Demanded” are
not the same thing.
 Demand may be distinguished as individual consumer’s demand
and market demand. Market demand for a good is the sum total of
the demands of the individual consumers who purchase the
commodity in the market.
 For certain commodities, the law of demand does not hold good.
 Income effect of a price change of a Giffen good is positive and is
greater than the negative substitution effect.
 Besides Giffen Goods, the law of demand may also not operate in
the case of status symbol goods and in case of speculative
consumption.
 Elasticity of demand relates to the degree of responsiveness of
quantity demanded of a good to a change in–
 Its price (price elasticity)
 The consumer’s income (income elasticity)
 The prices of related goods (cross elasticity)
56 Introduction to Economic Theory-I
Demand Analysis Unit 3

 Price Elasticity of demand can be further classified as point elasticity

of demand and arc elasticity of demand.

3.9 FURTHER READING

1) Ahuja, H.L. (2006); Modern Economics; New Delhi: S. Chand & Co.
Ltd.
2) Jhingan, M.L. (1986); Micro Economic Theory; New Delhi: Konark
Publications.
3) Koutsoyiannis, A. (1979); Modern Microeconomics; New Delhi:
Macmillan.

3.10 ANSWERS TO CHECK YOUR PROGRESS

Ans. to Q. No. 1: a) True, b) False, c) True

Ans. to Q. No. 2: a) By definition, other things remaining same, the
individual demand schedule indicates the quantities of goods
and services which the household is willing to and able to
purchase at various prices.
b) The demand curve slopes downward towards the right.
c) Market demand for a good is the sum total of the demand of the
individual consumers who purchase the commodity in the market.
Ans. to Q. No. 3: The market demand curve can be derived from the
demand curves of the individual. This is done by adding the
quantities demanded by all the consumers, at each price. Thus,
we get the aggregate demand curve for the market as a whole.
Ans. to Q. No. 4: a) True, b) True
Ans. to Q. No. 5: a) Price effect is the summation of substitution effect
and the income effect.
b) In case of Giffen goods, substitution effect is negative.
c) The relative strength of the two components of the price effect
determines the relationship between the price of a commodity
and the demand for it.
Introduction to Economic Theory-I 57
Unit 3 Demand Analysis

Ans. to Q. No. 6: A Giffen Good is a special type of inferior good which

does not follow the “law of demand”. Thus, a fall in the price of
such a good will result in a decrease in the quantity demanded
whereas a rise in its price would induce an increase in the quantity
demanded.
Ans. to Q. No. 7: The law of demand is violated in case of speculative
consumption because, speculation of further rise in pricces may
induce consumers to consume more of a commodity as its price
increases, resulting in a temporary failure of the law of demand.
Ans. to Q. No. 8: A change in “quantity demanded” is an out come of a
change in price, as other things remain constant. On the other hand,
a change in “demand” may occur with prices remaining constant,
while other factors such as income of the consumer, prices of related
goods and taste of the consumer changes.
Thus, change in quantity demanded is represented by a
movement along the same demand curve, while the change in
demand results in an upward or downward shift in the demand curve.
Ans. to Q. No. 9: Elasticity of demand means the degree of responsive-
ness of quantity demanded of a good to a change in:
 its price, or
 the consumer’s income, or
 the price of related goods.
Ans. to Q. No. 10: Point elasticity of demand in a linear demand curve
can be shown graphically by taking the ratio of segments of the line
to the right and to the left of any particular point. Thus, point elasticity
of demand on a linear demand curve can be measured by:
Lower segment FD 
=
Upper segment FD

on any point of the demand curve.

Ans. to Q. No. 11: The income elasticity of demand can be used to
classify goods as luxuries, necessities and inferior goods. Thus,
ey= 0 means: the commodity is a necessity.
ey > 0 means: the commodity is luxury, and
ey < 0 means: the commodity is inferior.
58 Introduction to Economic Theory-I
Demand Analysis Unit 3

3.11 MODEL QUESTIONS

A) Very Short Questions (Answer each question in about 75 words):

Q.1: Define the term elasticity of demand. What are the different types
of the price elasticity of demand?
Q.2: Deduce the demand curve when the price elasticity of demand of
product is zero.
Q.3: What is Point elasticity of demand? Derive the elasticities of demand
on the different parts of demand curve.
B) Short Questions (Answer each question in about 100-150 words):
Q.1: Differentiate between individual demand and market demand. How
can you derive the market demand curve from individual demand
schedules of two consumers?
Q.2: Briefly explain how the relationship between the substitution effect
and the income effect help us to derive the relationship between
the price of a commodity and its demand?
Q.3: What is an Engel curve? What is its significance with regards to
indicating of necessities and inferior goods?
C) Essay-Type Questions (Answer each question in about 300-500 words):
Q.1: Define “price elasticity of demand”. Distinguish between “price
elasticity” and “arc elasticity”. How would you measure the two?
Q.2: State the law of demand? On its basis construct a demand schedule
and derive the demand curve.
Q.3: Discuss under what conditions, the law of demand is violated. What
is the consequences?

*** ***** ***

Introduction to Economic Theory-I 59

 UNIT 4: CONSUMER BEHAVIOUR-CARDINAL
APPROACH
UNIT STRUCTURE

4.1 Learning Objectives

4.2 Introduction
4.3 Cardinal and Ordinal Approach to Utility: Basic Concepts
4.3.1 Measurement of Utility
4.3.2 Concepts of Total Utility and Marginal Utility
4.3.3 Law of Diminishing Marginal Utility
4.4 Consumer’s Equilibrium: Law of equi-marginal utility
4.5 Consumer’s Surplus
4.6 Let Us Sum Up
4.7 Further Reading
4.8 Answers to Check your Progress
4.9 Model Questions

4.1 LEARNING OBJECTIVES

After going through this unit, you will be able to:

 appreciate the diffecence between cardinal and ordinal utility
 describe the concepts of total utility and marginal utility
 illustrate the law of diminishing marginal utility
 describe the law of equi-marginal utility
 give the concept of consumer surplus.

4.2 INTRODUCTION

The Theory of Consumer Behavior studies how a consumer spends

his income so as to attain the highest satisfaction or utility. This utility
maximisation behaviour of the consumer is subject to the constraint
imposed by his limited income and the prices of the various commodities
he desires to consume. The consumer compares the different “bundles of
goods” that he can consume given his income and the price of the goods
60 Introduction to Economic Theory-I
Consumer Behaviour-Cardinal Approach Unit 4

in the bundles. And in the process, he attempts to determine the bundle

that will give him the maximum satisfaction. This unit, thus, deliberates on
the study of consumer behaviour. In the study of consumer behaviour,
utility plays an important part. It begins with the discussion of two
approaches to the study of utility, viz., cardinal utility and ordinal utility. The
attainment of a consumer’s equilibrium through the use of both these
approaches have also been discussed. Finally, the concept of price effect
and its breaking up into the substitution effect and income effect have also
been discussed.

4.3 CARDINAL AND ORDINAL APPROACHES TO

UTILITY : BASIC CONCEPTS

Let us ponder for a few minutes over this question : why do we buy
goods and services from the market? Well, the answer is obvious : they
satisfy our wants. Thus, in this sense, goods and services have want-
satisfying power. In Economics, we name this want-sarisfying power as
‘utility’. Thus, utility may be defined as the power of a commodity or a
service to satisfy the wants of a consumer. Alternatively, utility may also be
defined as the satisfaction that a consumer derives by consuming a
commodity or a service. Utility is a subjective concept and it is formed in
the mind of a consumer. It is important to note that the concept of utility is
not related to the concepts of morality or ethics. Let us take an example :
a drug addict person consumes drugs. In Economics paralance, the drug
addict is a consumer of drugs and drugs have utility for the person. While
dealing with the issue of utility, It is not considered if consumption of drugs
will have any harmful effects on the health of the drug addict. Another
important aspect of utility is that being a subjective concept, the level of
satisfaction from the consumption of goods and services varies among
different individuals. Suppose, you and one of your friends have gone to a
tea stall. You may like to take a hot samosa and tea, while your friend may
not like them so much. Thus, the satisfaction you will derive from the hot
samosa and the cup of tea will differ from what your friend will derive from

Introduction to Economic Theory-I 61

Unit 4 Consumer Behaviour-Cardinal Approach

the items. In fact, the extent of desire for a commodity by an individual

depends on the utility that he associates it with.

4.3.1 Measurement of Utility

Having said that utility is an important concept, the next

obvious question that comes to one’s mind is how to measure it. In
the study of utility, two prominent schools of thought exist, viz., the
cardinal and the ordinal school. The cardinal utility theory was
developed over the years with significant contributions from Gossen,
Jevons, Walras and finally Marshall. The cardinal school of thought
assumed that utility can be measured and quantified. It means, it is
possible to express utility that an individual derives from consuming
a commodity or service in quantitative terms. Thus, a person may
express the utility he derives from consuming an apple as 10 utils
or 20 utils. Moreover, it allows consumers to compare and define
the difference in utilities perceived in two commodities. Thus, it
allows an individual to state that commodity A (accuring an utility of
20 utils) gives double the utility of commodity B (accruing an utility
of 10 utils). Another assumption of the cardinalist school of thought
is that total utility is a function of the individual utilities derived from
each individual unit of the commodity. In an earlier version of the
theory, it was assumed that utilities were additive. This meant that
an individual was able to add the utilities he/she derived from the
consumption of the successive units of a commodity to derive the
total utility of consumption. However, additivity of utility was later
on relaxed.
The assumption of the cardinalist school of thought on
measurement of utilities was challenged later by ordinalist school
of thought. Rather, they pointed out that utility actually should be
arranged in an order of preference. Thus, according to them, utility
is ordinal, and not cardinal. We begin our discussion on the cardinal
approach, then will move towards the ordinal approach to utility in
the next unit.
62 Introduction to Economic Theory-I
Consumer Behaviour-Cardinal Approach Unit 4

4.3.2 Concepts of Total Utility and Marginal Utility

Let us now take a hypothetical example to derive the

relationship between total utility and marginal utility as discussed
in the cardinal approach. Our hypothetical consumer likes to
consume mangoes. Thus, the Total utility (TU) from the consumption
of mangoes is the aggregate utility derived by the consumer after
consuming all the available units of the commodity, i.e. mangoes.
Thus, it is the sum of all the utilities accruing from each individual
unit of the commodity.
Marginal utility (MU), on the other hand, is the utility derived
from an aditional unit of the commodity, over and above what had
been consumed. This relation can be better understood from the
following table 4.1 and the figure 4.1.

Table 4.1 : A Hypothetical Utility Schedule

Number of Mangoes Total Utility Marginal Utility
1 10 10
2 22 12
3 32 10
4 40 8
5 45 5
6 46 1
7 43 -3
8 38 -5

Graphically, this relation between marginal utility and total

utility has been shown in figure 4.1.
Now, from the table 4.1 and the figure 4.1, we can see that
total utility rises upto a certain limit (upto consumption of the 6 th
mango). Then it tends to diminish. The marginal utility, on the other
hand first increases till second unit and then keeps on declining.
And after the consumption of the 6 th apple, the marginal utility of
the consumer in fact becomes negative.

Introduction to Economic Theory-I 63

Unit 4 Consumer Behaviour-Cardinal Approach

Fig. 4.1 : Total Utility & Marginal Utility Curves

Total Utility
Total Utility
Curve
Marginal Utility

Marginal
Utility Curve

Quantity Consumed

4.3.3 Law of Diminishing Marginal Utility

An important aspect of the law of marginal utility as

discussed in the cardinal utility approach is its nature. According to
the cardinal utility approach, marginal utility of a good diminishes
as more and more units of the good is consumed. Marshall has
described this law in these words, “The additional benefit which a
person derives from a given increase of his stock of a thing
diminishes with every increase in the stock that he already has.”
The law of diminishing marginal utility may be illustrated
with the help of the above hypothetical utility schedule 4.1. From
the schedule it can be seen that from the consumption of the first
unit of the good, the consumer derives 10 utils of utility. From the
64 Introduction to Economic Theory-I
Consumer Behaviour-Cardinal Approach Unit 4

next unit, he derives 12 utils. Again, from the consumption of the

third unit of the good, the consumer derives 10 utils of utility.
Similarly, from the consumption of the fourth and the fifth unit, the
consumer attains 8 and 5 utils of marginal utility respectively. Thus,
the marginal utility derived from each successive unit of the good
though initially increases exhibits a declining trend as the consumer
goes on to consume the successive units of the good. Total utility,
on the other hand, keeps on increasing. However, the rate of
increase in total utility decreases with the consumption of successive
units of the good.
This law of diminishing marginal utility rests on an important
practical fact. Even when a consumer may have unlimited wants,
but after a certain stage each particular want is satiable. Therefore,
as the consumer consumes successive units of the same good,
intensity of satisfaction from each additional unit goes on
diminishing, and a point is reached when the consumer is no more
interested in the consumption of the same good. Let us take an
example. How many sweets can a person continuously take? It
can be easily said that after a few initial units (one or two), the
person will not derive the same satisfaction. However, after the
consumption of a few units of the same variety of sweets, the
consumer may become disinterested to consume any more sweets.
Thus, the level of zero utility or even negative utility is reached.
The theory of diminishing marginal utility works under the
following conditions : first, there is no time-gap in the consumption
process. This means that consumption is a continuous process
and no leisure is there in the consumption of the successive units.
Secondly, tastes and preferences of the consumer remain
unchanged during the period. And third, all the units of consumption
are homogeneous in terms of size, quality and other attributes.
The principle of diminishing marginal utility however fails to
work under certain circumstances. Exceptions are there when the
law fails to operate. For example, the law tends to fail in case of
Introduction to Economic Theory-I 65
Unit 4 Consumer Behaviour-Cardinal Approach

consumption of liquor. A drinker may tend to drink more and more

(at least as compared to the consumption of sweets or any other
thing), and thus exhibit a case of positive relationship between
marginal utlity and the quantity of liquor consumed. However, even
when a drinker of liquor exhibits such a positive relationship between
quantity of liquor and the level of satisfaction, there is however, a
limit to this habit as well. After a certain stage, the drinker of liquor
has to stop consuming more liquor. Another example frequently
cited as an exception to the law of diminishing marginal utility is in
Philately is the case of habits like philately or numismatics. People with such
collection or study of habits will like to own/study about more and more items. As such, it
stamps and postal
seems that the law of diminishing marginal utility does not operate.
history and other
related items. However, it should be noted that the person with such habits tends

Numismatics is the
to collect/ study varieties of such items, rather than a number of
study or collection of copies of the same item. The person, thus, finds it more pleasurable
currency, including to own different varieties of the product at their kitty. The law seems
coins, tokens, paper
to fail to operate in case of luxury and esteemed goods as well. For
money and related
example, rich and affluent people tend to prefer a diamond jewellery
objects.
of higher prices, rather than the lower one.

CHECK YOUR PROGRESS

Q.1: State whether the following statements are

True (T) or False (F):
a) Utility can be measured in proper mathematical terms.
b) Gossen amd Marshall were great contributors to the
cardinal approach to utility.
Q.2: Fill in the blanks:
a) .................... utility is the utility flowing from an additional
unit of the commodity.
b) According to the cardinal utility approach, marginal utility
of a good .................... as more and more units of the
good is consumed.

66 Introduction to Economic Theory-I

Consumer Behaviour-Cardinal Approach Unit 4

c) .................... utility is the result of utilities derived from

each additional unit of the commodity.
Q.3: Define total utility. (Answer in about 30 words)
............................................................................................
............................................................................................
............................................................................................
Q.4: Define Marginal Utility. (Answer in about 30 words)
............................................................................................
............................................................................................

4.4 CONSUMER’S EQUILIBRIUM: THE LAW OF EQUI

MARGINAL UTILITY

Before discussing how the consumer attains equilibrium, let us

discuss the assumptions on which the theory rests. The assumptions of
the theory are:
 The consumer is rational in the sense that given his income
constraints, he would always attempt to maximise his utility.
 Utility is a cardinal concept and it can be measured and expressed
in quantitative terms. For convenience, it is expressed in terms of
the monetary units that a consumer is willing to pay for the marginal
unit of the commodity.
 The law of diminishing marginal utility operates. This implies that
as a consumer increases his/her consumption of a commodity, the
utility accruing from successive units of the commodity decreases.
In other words, the marginal utility of a commodity will keep on
falling as a consumer goes on increasing its consumption (this is
what we have already discussed in Table 4.1 and the subsequent
figure 4.1).
 Marginal utility of Money is constant. That is, as one acquires more
and more money, the marginal utility of money will remain
unchanged. This assumption is critical because money is used as
a standard unit of measurement of utility, and, hence, cannot be
elastic.
Introduction to Economic Theory-I 67
Unit 4 Consumer Behaviour-Cardinal Approach

 The total utility of a ‘bundle’ of goods depends on the quantities of

the individual commodities. Thus: U = f(x , x , ..., ..., ..., x ) where U
1 2 n
means total utility x , x , ..., ..., ..., x are the quantities of n number
1 2 n
of commodities.
It is to be noted that in the earlier version of the theory, utilities
were considered to be additive. However, in the later version of the theory,
this assumption has been dropped, without any effect on its basic argument.
Now, let us discuss how the consumer attains equilibrium.
Consumer’s equilibrium in the cardinal approach to utility may be derived
with the help of the law of equi-marginal utility. Initially we derive the
equilibrium of the consumer when he/she spends his/her money income
M on a single commodity X. Here, the consumer will be at equilibrium
when the marginal utility of X is equal to its market price.
Symbolically: MU = P , where MU stands for marginal utility of the
x x x
commodity X and P stands for price of the concerned commodity X.
x
Now: if
i) MU > P , then the consumer can increase his/her welfare by
x x
consuming more of X. He/she will continue to do that until his/her
marginal utility for X falls sufficiently, to be equal with its price.
ii) MU < P , then the consumer can enhance his/her welfare by cutting
x x
down on his/her consumption of X. He/she will be persisting on
doing this, until X falls sufficiently, to be equal with its price P .
x
If more commodities are introduced into the model, then the
consumer will attain equalibrium when the ratios of the marginal utilities of
the individual commodities to their respective price are equal for all
commodities. That is:
MU MU MU
x  y z  MU
 .......... .
P P P M
x y z
where, x, y, ..., ..., ..., z are different commodities; and
MU = marginal utility of money income.
M
This statement is defined by the “law of equi-marginal utility”, which
states that a consumer will distribute his/her money income among different
commodities in such a way that the utility derived from the last rupee spent
on each commodity is equal.
68 Introduction to Economic Theory-I
Consumer Behaviour-Cardinal Approach Unit 4

Now if :

MU MU
x  y
i) P P , then the consumer will start substituting commodity Y
x y

with commodity X, causing MU to fall and MU to rise. This he/she

x y

MU MU
y x
will continue untill P equals P .
y x

MU MU
x  y
ii) Conversely, if P P , then the consumer will substitute
x y

commodity X with commodity Y until the equilibrium is restored.

Limitations of the Theory: The theory of equi marginal utility has
been criticised on the ground of the following basic limitations :
 Utility cannot be cardinally measured. Hence, the assumption that
utility derived from the consumption of various commodities can be
measured and expressed in quantitative terms is very unrealistic.
 As income increases the marginal utility of money changes. Hence
the assumption of constant marginal utility of money is not realistic.
Once we consider that trhe marginal utility of money changes, the
whole theory breaks down, as the unit of measurement itself
changes.
 Finally, the law of diminishing marginal utility is a psychological law,
which cannot be empirically established and has to be taken for
granted.

4.5 CONSUMER’S SURPLUS

The terms ‘surplus’ is used in Economics in various contexts. The

consumer’s surplus is the amount that consumers benefit by being able to
purchase a product for a price that is less than they would be willing to pay.
In other words, consumer’s surplus is the difference between the price the
consumer is willing to pay (also called as ‘reservation price’) and the actual
price he actually pays. If someone is willing to pay more than the actual
price, their benefit in a transaction is how much they saved when they
Introduction to Economic Theory-I 69
Unit 4 Consumer Behaviour-Cardinal Approach

didn’t pay that price. For example, a person is looking for a rented house.
He is ready to pay a monthly rent of Rs. 2,000/- for it. However due to
competition in the market, the person gets the house at a rent of Rs. 1,500/
- per month. Thus, Rs. 500/- (the difference between the reservation price
of the consumer and what he actually pays) is the consumer’s surplus in
this case.
Fig. 4.2: Consumer’s Surplus

Consumer’s
Surplus

Supply Curve
Price

Demand Curve
Producer’s
Surplus

Quantity

In the above figure 4.2, AD represents the demand curve, CS

represents the supply curve. The equilibrium price is OB or QE. In the
figure, portion ABE represents consumer’s surplus. It is to be noted that
ABE is the consumer’s surplus because, the consumer was ready to pay
OAEQ for OQ amount of quantities at OB price; but he actually pays OBEQ.
Thus ABE (OAEQ – OBEQ) is the consumer’s surplus.

CHECK YOUR PROGRESS

Q.5: State Whether the following statements are

True (T) or False (F):
a) According to the cardinal utility approach, marginal utility
of money does not remain constant.
b) According to the cardinal utility approach, utility can be
measured in monetary terms.

70 Introduction to Economic Theory-I

Consumer Behaviour-Cardinal Approach Unit 4

Q.6: Fill in the blanks:

a) According to the critics of the cardinal utility approach,
utility cannot be .................... measured.
b) Critics of the cardinal utility appraoch point out that as
.................. increases, marginal utility of money changes.
c) According to the law of .................... a consumer will
distribute his money income among different
commodities in such a way that the utility derived from
the last rupee spent on each commodity is equal.

4.6 LET US SUM UP

 Theory of consumer behaviour studies how a consumer spends

his income so as to attain the highest satisfaction or utility.
 Utility is a subjective concept and its perception varies among
different individuals.
 The cardinalist school asserts that utility can be measured and
quantified, while the ordinalist school asserts that utility cannot be
measured in quantitative terms.
 The law of equi-marginal utility states that a consumer will attain
equilibrium when the ratios of the marginal utilities of the individual
commodities to their respective prices are equal for all commodities.
 The theory has been criticised on the ground that utility cannot be
measured cardinally and utility of money does not remain constant.
The law of diminishing marginal utility is also unrealistic as this is a
psychological law, and cannot be established empirically.
 Consumer’s surplus is the difference between the price the
consumer is willing to pay (also called as ‘reservation price’) and
the actual price he actually pays.

Introduction to Economic Theory-I 71

Unit 4 Consumer Behaviour-Cardinal Approach

4.7 FURTHER READING

1) Ahuja, H.L. (2006); Modern Economics; New Delhi: S. Chand & Co.
Ltd.
2) Chopra, P.N. (2008); Micro Economics; New Delhi: Kalyani
Publishers.
3) Dewett, K.K. (2005); Modern Economic Theory; New Delhi: S. Chand
& Co. Ltd.
4) Koutsoyiannis, A. (1979); Modern Microeconomics; New Delhi:
Macmillan.
5) Sundharam, K.P.M. & Vaish, M.C. (1997); Microeconomic Theory;
New Delhi: S.Chand & Co. Ltd.

4.8 ANSWERS TO CHECK YOUR PROGRESS

Ans. to Q. No. 1: a) False, b)True

Ans. to Q. No. 2: a) Marginal utility is the utility flowing from an additional
unit of the commodity.
b) According to the cardinal utility approach, marginal utility of a
good diminishes as more and more units of the good are
consumed.
c) Total utility is the result of utilities derived from each additional
unit of the commodity.
Ans. to Q. No. 3: Total utility (TU) is the aggregate utility derived by a
consumer after consuming all the available units of a commodity.
Thus, it is the sum of all the utilities accruing from each individual
unit of the commodity.
Ans. to Q. No. 4: Marginal utility (MU) is the utility flowing from an
additional unit of a commodity, over and above what had been
consumed.
Ans. to Q. No. 5: a) False, b)True

72 Introduction to Economic Theory-I

Consumer Behaviour-Cardinal Approach Unit 4

Ans. to Q. No. 6 : a) According to the critics of the cardinal utility approach,

utility cannot be cardinally measured.
b) Critics of the cardinal utility approach point out that as income
increases, marginal utility of money changes.
c) According to the law of equi-marginal utility, a consumer will
distribute his money income among different commodities in
such a way that the utility derived from the last rupee spent on
each commodity is equal.

4.9 MODEL QUESTIONS

A) Very Short Questions (Answer each question in about 75 words):

Q.1: Dislinguish between cardinal and ordinal utility. Which one of these
two concepts is more realistic and why?
Q.2: What is cardinal utility?
Q.3: Define the term marginal utility.
Q.4: What do you mean by the term total utility?
Q.5: State any two situations where the law of diminishing marginal utility
fails to operate.
B) Short Questions (Answer each question in about 100-150 words):
Q.1: Write a short note on the concept of diminishing marginal utility.
Under what conditions does this law operate?
Q.2: Discuss the assumptions of the cardinalist approach to utility. What
criticisms have been raised on the assumptions of this approach?
C) Essay-Type Questions (Answer each question in about 300-500 words):
Q.1: State the law of Equi-marginal utility. How does it explain consumer’s
equilibrium?
Q.2: Discuss the law of diminishing marginal utility with suitable diagram.
Write down its assumptions and exceptions.

*** ***** ***

Introduction to Economic Theory-I 73

 UNIT 5: CONSUMER BEHAVIOUR-ORDINAL
APPROACH
UNIT STRUCTURE

5.1 Learning Objectives

5.2 Introduction
5.3 The Indiference Curve Technique: Basic Concepts
5.3.1 Assumptions of the Indifference Curve Technique
5.3.2 Indifference Schedule and Indifference Curve
5.3.3 Indifference Map
5.3.4 Properties of Indifference Curves
5.4 Consumer Equilibrium through Indifference Curve Approach
5.5 Price Effect, Substitution Effect and the Income Effect
5.6 Let Us Sum Up
5.7 Further Reading
5.8 Answers to Check your Progress
5.9 Model Questions

5.1 LEARNING OBJECTIVE

After going through this unit, you will be able to:

 explain the basic concepts of indifference curve and the budget
line
 derive the equilibrium of the consumer using the ordinal/indifference
curve approach
 explain the price effect and split it up into substitution effect and
income effect
 give the concept of giffen goods.

5.2 INTRODUCTION

This unit deliberates on the study of consumer behaviour through

ordinal approach. This approach states that utility is not measureable in a
cardinal way. A consumer can only give rank to his preferences or order
74 Introduction to Economic Theory-I
Consumer Behaviour-Ordinal Approach Unit 5

them. In this unit the attainment of a consumer’s equilibrium ordinally

through the use of indifference curve approach has been discussed. At
first, the basic concepts related to indifference curve approach has been
given. Finally, the concept of price effect and its breaking up into the
substitution effect and income effect have also been discussed along with
the idea of Giffen Goods.

5.3 THE INDIFFERENCE CURVE TECHNIQUE: BASIC

CONCEPTS

The indifference curve technique was conceived as an alternative

to the cardinal utility approach of the theory of consumer behaviour. A
number of economist have contributed to this techique as it has evolved
over the years, with the latest reflnements attributed to Slutsky, J.R. Hicks
and R.G.D. Allen.
The indifference curve technique rejects the concept of cardinal
utility and asserts that utility cannot be measured in quantitative terms.
Instead, it adopts the principle of ordinal utility which states that, while the
consumer may not be able to indicate exactly the amount of utility that he
derives from the consumption of a commodity or a combination of
commodities, he is perfectly capable of comparing and ranking the different
levels of satisfactions that he derives from them. For example, in case of
different varieties of rice, Mrs Saikia may prefer (in terms of satisfaction
derived from) to consume a joha variety of rice over aijung variety of rice,
and aijung variety of rice over parimal variety of rice. Interestingly, this
much of information(i.e., information about the order of ranking among the
different varieties of rice) is sufficient to derive the demand schedule and
hence the demand curve of an individual consumer. Therefore, the
questionnable assumption that consumers possess a cardinal measure of
satisfaction can be dropped. Thus, the basic distinction between the two
schools of thought is that the cardinal approach to the measurement of
utility believes that the utility derived from the consumption of commodity
can be expressed in quantitative terms. The ordinal approach, on the other
hand, rejects this and states that the consumer at best can rank the various
Introduction to Economic Theory-I 75
Unit 5 Consumer Behaviour-Ordinal Approach

commodities (or combination of them) in accordance with the satisfaction

that he/she expects from their consumption.
Now, let us discuss some of the key concepts used in the
indifference curve analysis, viz. indifference curve, indifference map and
the budget line. Let us begin with the assumptions on which the theory of
indifference curve rests.

5.3.1 Assumptions of the Indifference Curve Technique

The indiference curve technique is based on the following

assumptions.
 Utility can be Ordinally Measured: The consumer can rank
various commodities or combination of commodities in
accordance with the satisfaction that the consumer derives from
them.
 The Consumer is Rational: Given the market prices and the
money income, a consumer will attempt to maximise his/her
satisfaction when he/she undertakes consumption.
 Additive Utilities: The quantities of the commodities that is
consumed determines the total utility of the consumer.
 Consistency of Choices: The choice of the consumer is
consistent in the sense that if he/she chooses combination A
over B in one peried, he/she will not choose B over A in another
period. Symbolically : If A > B, then B < A.
 Transitivity of Consumer Choice : If a consumer prefers
combination A to B, and prefers B to C, then, it can be concluded
that he/she prefers A to C.
Symbolically : If A > B, and B > C, then A > C.

5.3.2 Indifference Schedule and Indifference Curve

An indfference curve is defined as the locus of the various

combinations of two commodities that yield the same satisfaction
to the consumer, so that the consumer is indifferent to any one
particular combination. In other words, all combinations of the two
76 Introduction to Economic Theory-I
Consumer Behaviour-Ordinal Approach Unit 5

commodities in the indifference curve are equally desired by the

consumer.
An indifference curve is based on the indifference schedule,
which represents the various combinations of two commodities that
give the consumer the same level of satisfaction. Given below is
an indifference schedule representing various combination of
commodity X and Y that gives the consumer the same amount of
satisfaction.
Table 5.1 : Indifference Curve Schedule
Combination X Y MRSxy
1st 1 20 –
2nd 2 15 5
3rd 3 11 4
4th 4 8 3
5th 5 6 2
6th 6 5 1
Putting the various combinations of the indifference
schedule from the above table 5.1, we obtain the IC, indifference
curve as shown in figure 5.1.

Fig. 5.1 : Indifference Curve

y
20 (x = 1, y = 20)

15 (x = 2, y = 15)
Commodity Y

10 (x = 3, y = 11)

(x = 4, y = 8)
(x = 5, y = 6)
5
(x = 6, y = 5)
IC1

0 1 2 3 4 5 6 x
Commodity X
Introduction to Economic Theory-I 77
Unit 5 Consumer Behaviour-Ordinal Approach

In figure 5.1, the slope of the indifference curve is indicated

by the “marginal rate of substitution’. The marginal rate of substitution
of X for Y is defined as the numbers of Y that has to be given up by the
consumer to get an additional unit of X, so that his/her satisfaction
remains unchanged. Thus, [slope of the indifference curve] = MRSxy.
It can be seen from table 5.1 that as the consumer gets
more and more of X, the number of X he is willing to give up for an
additional unit of X successively falls. This is known as the “principle
of diminishing marginal rate of substitution” which states that the
marginal rate of X for Y falls as more and more of X is substituted
for Y. This implies that the indifference curve always slopes
downwards to the right and is convex to the origin.

5.3.3 Indifference Map

An indifference map, on the other hand, shows all the

indifference curves which rank the preference of the consumer.
While the combinations of commodities on the same indifference
curve yield the same satisfaction, combinations on a higher
indifference curve yield higher levels of satisfaction and
combinations on a lower curve yield lower levels of satisfaction. In
figure 5.2, an indifference map has been shown.
Fig. 5.2: An Indifference Map
y

20

16
Commodity Y

12

IC3
8
IC2
IC1
4
0 1 2 3 4 5 6 7 x
Commodity X
78 Introduction to Economic Theory-I
Consumer Behaviour-Ordinal Approach Unit 5

In the above figure, we see an indifference map of a

consumer. It is needless to say that the rational consumer would
prefer to be on a higher indifference curve (i.e. he would prefer to
be on IC2 than being IC1 and on IC3 than on IC1 and IC2) rather than
on the indifference cure which is positioned lower (IC 2 or IC1).

5.3.4 Properties of Indifference Curves

Let us now discuss the properties of the indifference curves.

The important properties of the indifference curves are as follows:
 Indifference Curves are Downward Sloping towards the
Right: The first important property of an indifference curve is
that it slopes downward from left to right. This is also called as
indifference curves are negatively sloped towards right. The
basic reason for the downward slope is that as the consumer
chooses to move along an indifference curve, he/she has to
sacrifice some units of one good to obtain an additional unit of
the other good. The sacrifices of a few units of one good for
obtaining an additional unit of the other good becomes
necessary so that the consumer remains in the same level of
satisfaction as he/she moves along an indifference curve. Thus,
we get the indifference curve of the shape as has been shown
in the previous figure 5.1 or 5.2.
 Indifference Curves are Convex to the Origin : Another
important property of an indifference curve is that an indifference
curves is convex to the origin. The convexity of an indifference
curve is basically due to the working of the principle of
diminishing marginal rate of substitution. While discussing the
concept of an indifferene curve, we have mentioned that as the
consumer consumes more and more units of X, the number of
units of Y he is willing to give up for an additonal unit of X begins
to fall. A relook at the table 5.1 as has already been discussed
would clarify this point. From the table, it can be seen that as
the consumer increases consumption of X by an additional unit,
Introduction to Economic Theory-I 79
Unit 5 Consumer Behaviour-Ordinal Approach

he tends to give up smaller units of Y for each additional unit of

X. The indifference curve representing the table 5.1 (i.e., figure
5.1) is reprodued here.
Fig. 5.1: Indifference Curve (Reproduced)

y
20 (x = 1, y = 20)

15 (x = 2, y = 15)
Commodity Y

10 (x = 3, y = 11)

(x = 4, y = 8)
(x = 5, y = 6)
5
(x = 6, y = 5)

IC1

0 1 2 3 4 5 6 x
Commodity X

 Indifference Curves cannot Intersect: Another important

property of an indifference curve is that no two indifference
curves can intersect. This means that only one indifference curve
can pass through a point in an indifference map. Figure 5.3 will
make this point clear.
From the figure shown in the next page it can be seen that
the indifference curve IC2 allows the consumer to choose the
combination A. Again IC1 is another indifference curuve in his
indifference map. Now, let us suppose that the consumer
chooses combination B in the indifference cuve IC1. It is obvious
from the above figure that combination A would give the
consumer higher level of satisfaction as it offers the consumer
higher quantities of both the goods X and Y. Now, let us consider
point C. This point is common to both the indifference curves.
Thus, combinations A and C would give the consumer the same
level of satisfaction, as both the points lie on the same
80 Introduction to Economic Theory-I
Consumer Behaviour-Ordinal Approach Unit 5

indifference curve IC2. Again for combinations B and C also the

consumer will derive the same level of satisfaction as both of
them are on the same indifference curve IC1. What it means is
that combinations A and B will derive the same level of
satisfaction. This is not at all logical to accept. Thus, two
indifference curves can never intersect.
Fig. 5.3: No two Indifference Curves can intersect

A

B

Commodity Y

15

10 C
IC1
5
IC2
0 1 2 3 4 5 6 7 8 9 X
Commodity X

The same thing may happen if two indifference cuves touch

a single common point in an indifference map as has been shown
in the next figure 5.4.
Fig. 5.4: No two Indifference Curves can touch each other

A
Commodity Y


B

C
 IC2

IC1
0 Commodity X x

Introduction to Economic Theory-I 81

Unit 5 Consumer Behaviour-Ordinal Approach

CHECK YOUR PROGRESS

Q.1: State whether the following statements are

True (T) or False (F):
a) According to the indifference curve analysis, consistency
of consumer choices states that if a consumer prefers
combination A to B, and prefers B to C, then it implies
that the consumer prefers A to C.
b) According to the indifference curve approach, utility
cannot be cardinally measured, they can only be
ordinally arranged.
Q.2: Fill in the blanks :
a) The slope of the indifference curve is indicated by
.....................
b) Two .................... cannot intersect.
c) An indifference curve is defined as the .................... of
various combinations of two commodities that yield the
.................... level of satisfaction to the consumer.
Q.3: What is meant by ‘consistency of consumer choices’ and
‘transitivity of consumer choices’ as discussed in the
indifference curve analysis? (Answer in about 50 words).
............................................................................................
............................................................................................
............................................................................................
............................................................................................
............................................................................................
Q.4: What does an indifference schedule exhibit? (Answer in
about 30 words)
............................................................................................
............................................................................................
............................................................................................
............................................................................................

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Consumer Behaviour-Ordinal Approach Unit 5

Q.5: Can an indifference curve be upward rising? Justify your

view in about 60 words.
............................................................................................
............................................................................................
............................................................................................
............................................................................................
............................................................................................

5.4 EQUILIBRIUM OF A CONSUMER USING THE

INDIFFERENCE CURVE APPROACH

The equilibrium of a consumer under the indifference curve

approach can be derived using the budget line and the indifference curve
of the consumer. Therefore, before discussing the equilibrium of the
consumer, let us first discuss the concept of the budget line.
Concept of the Budget Line: The budget line is an important
concept in the indifference curve technique. It is defined as the various
combination of the two commodities (X and Y) that a consumer can
consume, given his income(M) and the price of the two commodities (P x
and Py).
The Budget line can be algebraically expressed as: M = P xX + PyY.
where X and Y indicate the quantities of X and Y respectively.
Now, let us suppose, M = 100, P x = 10 and Py = 20, then
a) If the consumer spends all his income on X, then he can consume:

X  M  100 10
Px 10
b) and if he spends all his income on Y, then the number of units of y
that he can consume is:

Y  M  100  5
Py 20
Thus, 10x and 5y are the two extreme limits of the consumer’s
expenditures. However, he usually prefers a combination of the two
commodities within these two limits. In fact, the budget line joins the two
extreme consumption limits of the consumer, and the points within those
Introduction to Economic Theory-I 83
Unit 5 Consumer Behaviour-Ordinal Approach

two limits indicate the combinations available to the consumer, given his
income and the prices of the two commodities.
The concept of budget line has been shown with the help of figure
5.5.
Fig. 5.5: Budget Line
y
A
Commodity Y 5

1 B
0 2 4 6 8 x
10
Commodity X
In the above figure 5.5, AB indicates the budget line. In this budget
line AB, the consumer has the option of consuming 10x(0B) or 5y(0A) or
some combination of the two.
The slope of the budget line is the ratio of the prices of the two
commodities. Geometrically,
M
Py
[Slope of the Budget Line] = M  Px
Py
Px

Consumer’s Equilibrium: Given his budget line, a consumer would

like to maximise his satisfaction by climbing on to the highest indifference
curve. This has been shown in the following figure 5.6.
From the figure 5.6 it can be seen that the consumer is at equilibrium
at point b, where his budget line is tangent to the indifference curve IC2.
He has the option of consuming at ‘a’ and ‘c’, but those combinations are
rejected as they would place him on a lower indifference curve IC 1. The
consumer would like to be on the indifference curve IC 3, but his budget
line does not allow him to do that. From figure 5.6, it can be seen that at
equilibrium the consumer consumes 0x amount of X and 0y amount of Y.

84 Introduction to Economic Theory-I

Consumer Behaviour-Ordinal Approach Unit 5

Fig. 5.6: Equilibrium of the Consumer

Y

a
Commodity Y

y b

IC3
c IC2

IC1
X
0 X B Commodity X
Thus, at equlibrium,
[slope of the indifference curve] = [slope of the budget line]
Symbolically, it can be expressed as :
Px
MRS xy 
Py
Indifference Curve Technique vs Cardinal UtilityAnalysis: The
indifference curve technique is considered to be surperior to the cardinal
utility approach on the following grounds:
 It avoids the unrealistic assumption of cardinal utility and instead
adopts the concept of ordinal utility.
 It can be used to split the price effect into substitution effect and
income effect.
 It is not based on the unrealistic assumption of constant marginal
utility of money.
Limitations of the Indiference Curve Technique: The indifference
curve technique has been crticised on the following grounds:
 The indifference curve technique does not tell us anything new,
and it is only “old wine in new bottle”.
 It assumes that the consumer is very familiar with his entire
preference schedule, which is not the case in actual life.
Introduction to Economic Theory-I 85
Unit 5 Consumer Behaviour-Ordinal Approach

 The technique can be efficiently applied only to two commodities.

Once more than two commodities are introduced, the analyais
become very complicated to illustrate.

CHECK YOUR PROGRESS

Q.6: State whether the following statements are

True (T) or False (F):
a) The indifference curve approach avoids the unrealistic
assumption of constant marginal utility of money.
b) The budget line of the consumers are the same.
Q.7: Mention any two superiorities of the ordinal approach over
the cardinal aproach. (Answer in about 50 words).
............................................................................................
............................................................................................
............................................................................................
............................................................................................
............................................................................................
Q.8: What is a budget line? Derive the algebraic expression of
the budget line. (Answer in about 50 words).
............................................................................................
............................................................................................
............................................................................................
............................................................................................
............................................................................................

5.5 PRICE EFFECT, SUBSTITUTION EFFECT AND THE

INCOME EFFECT

While discussing the law of demand, we have seen that as the

price of good changes, quantity demanded for that good also changes in
the opposite direction. Thus, if the price of a good rises, quantity demanded
of that good falls, and vice versa.

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Let us consider this question: why it so happens? Two factors may

be held responsible for this. First, suppose our hypothetical consumer
consumes two commodities, kachori and tea. Now, let us further suppose
that the price of kachori increases, while price of tea remains constant.
Thus, in such a situation, the real income of the consumer decreases. Real Income: Income
Thus, the purchasing power of the consumer decreases, and as such, which is available for
spending after tax and
even when the income of the consumer has not changed, his budget for
other contribution have
consumption has decreased. This is similar to the situation, when the
been deducted
income of the consumer decreases. Thus, the response of the consumer corrected for inflation.
to the change in the prices, i.e., his response as a matter of decline in his
purchasing powers is referred to as the income effect.
The second factor is that, when the price of kachori increases, and
purchasing power of the consumer remaining the same, amount of tea
that the consumer must give up for obtaining an extra unit of kachori
increases. Let us take this example. Suppose, the price of a kachori is Rs.
4/- while the price of a cup of tea is Rs. 2/-. Thus, a cup of tea is relatively
cheaper (or less expensive) compared to the other good, i.e., kachori.
This means that to obtain a kachori, the consumer has to give up 2 cups of
tea. Or, to obtain a cup of tea, the consumer has to give up half of one
kachori. Thus, the relative price of a good shows its cost in terms of the
other good in question.
Now, suppose the price of tea increases to Rs. 4/-. The consumer
must now give up one kachori for a cup of tea. Thus, compared to the
earlier case, tea has become more expensive. Please note that the
consumer had to give up only half of a kachori to obtain a cup of tea, but
now he needs to give up a full piece of kachori for the same cup of tea.
Again, to obtain a kachori, the consumer has to give up one cup of tea.
Thus, compared to the earlier case, kachori has become relatively cheaper.
Please note that earlier, the consumer had to give up two cups of tea for
one kachori, but now, he needs to give up only one cup of tea. Thus, the
response of the consumer in making choices between the two goods while
taking into consideration the changes in their relative prices is known as
the substitution effect. These two effects viz., the income effect and the
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Unit 5 Consumer Behaviour-Ordinal Approach

substitution effect can be summed up together, and is termed as the price

effect. Thus, the price effect reveals how a consumer reacts to his buying
habits as a result of a change in the prices of one of the two commodities.
The price effect and its two components, i.e., the substitution effect
and the income effect can be explained with the help of the indifference
cuve analysis. Let us first discuss the price effect. Then we shall explain
how to decompose the price effect into substitution effect and income effect.
Price Effect : We have already discussed the concept of the
indifference curve and the budget line and we have seen how given his/
her money income (shown by the budget line), a consumer attains his/her
equilibrium in terms of the combination of the two commodities, viz., X and
Y. Thus, as the price of X increases (price of Y and income of the consumer
remaining the same) the budget constraint rotates clockwise about the Y
axis, i.e., on the X axis, the budget line will move towards the origin point
(or towards the left). This has been shown with the help of figure 5.7.
Fig. 5.7: Price Effect
Y

A
Commodity Y

y2 e2
e1
y1
IC1

IC2

0 x2 B2 x1 Commodity X B1 X

From Figure 5.7 it can be seen that the consumer originally faces
the indifference curve IC1. His/her level of income has been depicted by
the budget line AB1. Thus, given this budget line, the consumer attains
equilibrium at point e 1, where the budget ine AB 1 is tangent to the
indifference curve IC1. In this point of equilibrium, the consumer consumes
0X1 of commodity X and 0Y1 of commodity Y. Now let us suppose, the
price of X increases. As a result, the real income of the consumer will be
88 Introduction to Economic Theory-I
Consumer Behaviour-Ordinal Approach Unit 5

adversely affected. As a result, the budget line of the consumer shifts

clockwise about Y axis, i.e., it moves towards the left of origin of the axes
(towards point 0). The new budget line of the consumer is AB 2. In this
changing situation, the consumer no more remains on the same indifference
curve. The new indifference curve of the consumer is IC2. Thus, given the
budget line AB2, the consumer attains equilibrium at point e2. The movement
from e1 to e2 represents the price effect.
Now, let us explain how this price effect can be decomposed as
the substitution effect and the income effect. We shall first discuss the
substitution effect.
Substitution Effect: The substitution effect seeks to reply to the
theoretical question. “What will happen if the consumer only faced the
new relative price but could still attain the old level of utility. How would the
consumer switch between the two goods?” The substitution effect replies
to this question. The substitution effect has been explained with the help
of figure 5.8.
Fig. 5.8: Substitution Effect
Y

A
IA’

y3 Ie3
Ie2
Commodity Y

y1 Ie1

IIC1

IIC2

0 x3 B2 x1 B3 B1 X
Commodity X
Please note that here we are trying to analyse what will happen if
the consumer is allowed to close combinations of commodities in his initial
indifference curve IC1, if we take into consideration the changing budget
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Unit 5 Consumer Behaviour-Ordinal Approach

situation (or the changing relative prices of the two commodities). Thus,
we want to analyse given the new budget constraint AB 2, how the consumer
will behave if he is allowed to choose combinations of the two commodities
in his initial indifference curve IC1. In such situations, the budget line will
shift in parrellel to the new budget line AB 2. In figure, this has been shown
by the budget line A/B3 (the dark dotted line). This budget line A’B3 is tangent
to the original indifference curve IC1 at point e3. Thus, at this equilibrium
point e3, the consumer buys less of the commodity which is relatively
expensive (OX3 instead of OX1) and more of the commodity which is
relatively cheaper (OY3 instead of OY1). Thus, this shows that due a change
in the price, the consumers tends to sustitute relatively more expensive
commodity for the relatively cheaper commodity. This is the substitution
effect.
Income Effect: The income effect reveals how the consumer will
react to a change in his purchasing power given the new relative prices.
For analysing the income effect, we assume that the substitution effect
has already taken place. Thus, here we take into consideration the
behaviour of the consumer, when given the new relative prices, the
consumer faces a lower indiference curve (as his realincome has been
adversely affected, he no more remains on the same indifference curve).
In such a situation, given the new budget line and the lower indifference
curve, the consumer reacts by choosing less of both the commodities, as
compared to when he is allowed to remain in the same indifference curve
even when taking into consideration the new relative prices (this is what
we have considered in case of the substitution effect). This has been
explained with the help of figure 5.9.
From figure 5.9, it can be seen that with the subsitution effect already
in action the consumer buys less of both the commodities X and Y. The
income effect has been shown by the movement of the consumer from e 3
to e2.

90 Introduction to Economic Theory-I

Consumer Behaviour-Ordinal Approach Unit 5

Fig. 5.9: Income Effect

Y

A A1

y3 e3
Commodity Y

y2 e2

IC1

IC2

0 x2 x3 B2 B3 B1 X
Commodity X

We can now summarise the whole process in a single figure. This

has been shown with the help of figure 5.10.
Fig. 5.10: Price Effect and its Two Components

A A1

y3 e3
Su
Commodity Y

Income
bs
titu

y2
e2
ati

e1
on

y1

IC1

IC2

0 x2 x3 B2 x1 B3 B1 X
Commodity X

In figure 5.10, the overall behaviour of the consumer as a response

to the change in the price of one commodity has been shown. As the price
of the X commodity increases, on overall, the consumer moves from point
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Unit 5 Consumer Behaviour-Ordinal Approach

e1 to point the point e2. This is the price effect. However, we can break up
this overall price effect into two components, viz., the substitution effect
and the income effect. The substitution effect is considered first. The
substitution effect has been shown by the movement of the consumer
from point e1 to point e3. The income effect is allowed, keeping in mind that
the substitution effect has already taken place. The income effect has
been shown with the help of movement of the consumer from point e 3 to
point e2.
Thus, on the overall, we can summarise that as the price of one
good increases, the real income of the consumer is adveresely affected.
Or, in other words, the budget line of the consumer is adveresely affected.
As a result, the consumer no more remains on the same indifference curve.
After the price effect is allowed to happen, and given his new budget line,
the consumer attains equilibrium on a lower indiference curve. In attaining
this new equilibrium, the consumer consumes less of the commodity which
is relatively expensive (in our case, commodity X) and more of the
commodity which is relatively cheaper (commodity Y).

CHECK YOUR PROGRESS

Q.9: Fill in the blanks:

a) Price effect has .................... components.
b) The increase in the consumption of a commodity due to
a fall in its price is called .....................
c) To discuss the price effect, the .................... was used by
Hicks, while the cost-difference method was used by
.....................
Q.10: What is meant by the price effect? (Answer in about 50
words).
............................................................................................
............................................................................................
............................................................................................
............................................................................................

92 Introduction to Economic Theory-I

Consumer Behaviour-Ordinal Approach Unit 5

Q.11: Explain the concept of substitution effect? (Answer in about

50 words).
............................................................................................
............................................................................................
............................................................................................
............................................................................................
............................................................................................
............................................................................................

5.6 LET US SUM UP

 Theory of consumer behaviour studies how a consumer spends

his income so as to attain the highest satisfaction or utility.
 An indifference curve is the locus of the various combination of two
commodities that yield the same satisfaction to the consumer, so
that he is indifferent to any one particular combination.
 An indifference map shows all the indifference curves which rank
the preference of the consumer. While combinations of commodities
on the same indifference curve yield the same satisfaction,
combinations on a higher indifference curve yield greater
satisfaction and combinations on a lower curve yield less
satisfaction.
 A consumer is in equilibrium at the point where his budget line is
P
tangent to the indifference curve. Symbolically: MRS xy  x P
y

 The substitution effect and the income effect are the two
components of the price effect.
 These two components can be derived using either the Hicksian
compensating variation method or the Slutsky’s cost - difference
method.

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Unit 5 Consumer Behaviour-Ordinal Approach

5.7 FURTHER READING

1) Ahuja, H.L. (2006); Modern Economics; New Delhi: S. Chand & Co.
Ltd.
2) Chopra, P.N. (2008); Micro Economics; New Delhi: Kalyani
Publishers.
3) Dewett, K.K. (2005); Modern Economic Theory; New Delhi: S. Chand
& Co. Ltd.
4) Koutsoyiannis, A. (1979); Modern Microeconomics; New Delhi:
Macmillan.
5) Sundharam, K.P.M. & Vaish, M.C. (1997); Microeconomic Theory;
New Delhi: S.Chand & Co. Ltd.

5.8 ANSWERS TO CHECK YOUR PROGRESS

Ans. to Q. No. 1: a) False, b) True

Ans. to Q. No. 2: a) The slope of the indifference curve is indicated by
marginal rate of substitution.
b) Two indifference curves cannot intersect.
c) An indifference curve is defined as the locus of various
combinations of two commodities that yield the same level of
satisfaction to the consumer.
Ans. to Q. No. 3: Consistency of choices means that the choice of the
consumer is consistent in the sense that if he chooses combination
A over B in one period, he will not choose B over A in another period.
Again, transitivity of consumer choice means that if a consumer
prefers combination A to B, and prefers B to C, then, it can be
concluded that he prefers A to C.
Ans. to Q. No. 4: An indifference schedule represents the various
combinations of two commodities that give the consumer the same
level of satisfaction. An indifference curve is drawn based on an
indifference schedule.
94 Introduction to Economic Theory-I
Consumer Behaviour-Ordinal Approach Unit 5

Ans. to Q. No. 5: An indifference curve cannot be upward rising,

because in such an indifference curve, as the counsumer will move
upward the curve, he will be able to choose more quantities of both
the goods. As such, he will not remain indifferent among the different
bundles of goods available to him. This is clearly a violation of the
very definition of an indiffernce curve.
Ans. to Q. No. 6 : a) True, b) True
Ans. to Q. No. 7 : Two important superiorities of the indifference curve
approach over the cardinal utility approach are:
 Indifference curve approach avoids the unrealistic assumption
of cardinal utility and instead adopts the concept of ordinal utility.
 It can be used to split the price effect into substitution effect
and income effect.
Ans. to Q. No. 8: A budget line is defined as the various combinations
of two commodities (say, X and Y) that a consumer can consume,
given his income (M) and the price of the two commodities (Px and Py).
Thus, a Budget line can be algebraically expressed as:
M = PxX + PyY.
Where X and Y indicates the quantities of x and y respectively.
Ans. to Q. No. 9: a) Price effect has two components.
b) The increase in the consumption of a commodity due to a fall in
its price is called as price effect.
c) To discuss the price effect, the compensating variation method
was used by Hicks, while the cost-difference method was used
by Slutsky.
Ans. to Q. No. 10: If a consumer consumes two commodities X and Y,
and given the price of Y, the price of X falls then the real income of
the consumer increases. This is because he can now consume more
of X with his given income. The increase in the consumption of a
commodity due to a fall in its price is referred to as the ‘Price Effect’.
Ans. to Q. No. 11: The increase in the consumption of X is brought about
by substituting the relatively cheaper X for Y. It is referred to as the
substitution effect. Hence, the ‘substitution effect’ takes place when
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the relative prices of the two commodities change is such a manner

that the consumer concerned is neither better nor worse of than he
was before, but is obliged to rearrange his purchases in accordance
with the new relative prices.

5.9 MODEL QUESTIONS

A) Very Short Questions (Answer each question in about 75 words):

Q.1: Dislinguish between cardinal and ordinal utility. Which one of these
two concepts is more realistic and why?
Q.2: What is meant by cardinal utility?
Q.3: Define the term marginal utility.
Q.4: Explain the term total utility?
Q.5: State any two situations where the law of diminishing marginal utility
fails to operate.
B) Short Questions (Answer each question in about 100-150 words):
Q.1: Write a short note on the concept of diminishing marginal utility.
Under what conditions does this law operate?
Q.2: Discuss the assumptions of the cardinalist approach to utility. What
criticisms have been raised on the assumptions of this approach?
Q.3: What is meant by an indifference map? Why does an indifference
curve take the shape of a downward sloping convex curve?
Q.4: With the help of a suitable figure discuss the concept of a budget
line.
C) Essay-Type Questions (Answer each question in about 300-500 words):
Q.1: State the law of Equi-marginal utility. How does it explain consumer’s
equilibrium?
Q.2: What is meant by an indifference curve? Discuss the properties of
indifference cuves.
Q.3: Derive the consumer’s equilibrium using the indifference map and
the budget line as your tools.
Q.4: Derive the “Price Effect” of a price fall. Distintegrate the price effect
into substitution effect and income effect.
*** ***** ***
96 Introduction to Economic Theory-I
UNIT 6: CONCEPTS OF REVENUE
UNIT STRUCTURE

6.1 Learning Objectives

6.2 Introduction
6.3 Concepts of Total Revenue, Average Revenue and Marginal
Revenue
6.4 Relationship between Total Revenue, Average Revenue and
Marginal Revene Curves
6.5 Relationship between Total Revenue, Average Revenue, Marginal
Revenue and Price Elasticity of Demand
6.6 Let Us Sum Up
6.7 Further Reading
6.8 Answers to Check Your Progress
6.9 Model Questions

6.1 LEARNING OBJECTIVES

After going through this unit, you will be able to:

 discuss the concepts of total revenue, average revenue and marginal
revenue
 derive the relationships between average revenue and marginal
revenue curves
 explain the relationship between total revenue, average revenue,
marginal revenue and price elasticity of demand.

6.2 INTRODUCTION

In the previous block of the first semester, we have already discussed

the nature of demand from the viewpoint of an individual consumer. In that
context, we discussed that consumers demand goods and services as
they provide certain utility to the consumer. This means that a product
available in the market for sale bought by a consumer has a demand. Let us
now consider the matter from the viewpoint of a seller. A
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Unit 6 Concepts of Revenue

seller will be very much concerned with the nature of demand for his product.
This is because the monetary value of demand of a consumer for the product
constitutes his revenue. Thus, the more the demand, the greater will be the
volume of revenue earned by the seller. The concept of revenue when viewed
from the viewpoint of a seller is classified into three types: average revenue,
marginal revenue and total revenue. In this unit, we shall discuss these
three concepts and their inter-relationships. Apart from this, we shall also
relate these concepts with the concept of price elasticity we have already
discussed in the previous block.

6.3 CONCEPTS OF TOTAL REVENUE, AVERAGE

REVENUE AND MARGINAL REVENUE

We have already mentioned, the price paid by a consumer for a

product constitutes revenue for the seller. It is, therefore, quite obvious that
the more the seller sells, the greater will be the volume of his revenue. As
such, the total revenue of a seller depends on two basic things; first, the
price of a unit of the product, and the sales volume. The price per unit earned
gives us average revenue. And the revenue earned by selling an additional
unit is called the marginal revenue. Let us discuss these concepts in detail.
Total Revenue: The whole amount of money received by a seller
from selling a given amount of the product is called total revenue. Let us
suppose, if a seller sells 150 units of pens and each unit of pen is sold at a
market prices at Rs. 12/-. The total revenue earned by the seller is Rs.
1800/- (Rs.12 x 150 units). Thus, by definition,
Total Revenue = Market price X total quantity sold.
Symbolically, TR = P X Q.
where, TR stands for total revenue, P stands for market price and Q
stands for total quantity sold.
Average Revenue: Average revenue is defined as the average value
of total revenue with respect ot the number of units sold. Average revenue
can be obtained by dividing total revenue by the number of units sold. Thus,
Total revenue
Average Revenue = Total quantity sold

98 Introduction to Economic Theory-I

Concepts of Revenue Unit 6

TR
Symbolically, AR =
Q
where, AR stands for average revenue, TR stands for total revenue
and Q stands for quantity.
With reference to the previous example, the average revenue of Rs.
12/- is obtained by dividing total revenue (Rs. 1800/-) by total quantity sold
(150 units).
From the above discussion, it seems that average revenue and price
are the same concepts. It may be, or it may not be. If the seller sells each
unit of the product at the same price, average revenue and price will be the
same. If on the other hand, the seller sells the different units of the product
at different prices, average revenue will not be equal to price. Let us consider
an example. Suppose our hypothetical seller sells two units of the product
to two different consumers, viz., consumer A and consumer B. Let us further
suppose that the seller sells one unit of the product to consumer A at Rs.12
while he sells the other unit of product to consumer B at Rs.10. Thus, the
average revenue earned by the seller comes out to be Rs.(12 + 10)/2 =
Rs.11/- while prices of the two units of the product were Rs.12/- and Rs.10/
- respectively.
In practice, we find that the seller sells the individual unit of the
product at the same price at a particular point of time. This is because, if an
individual seller tends to charge higher prices for the product, consumers
will move away from him and will purchase the product from other seller
who sells at a lower price. As against this, he cannot lower the price of the
product at his will. This is because, if the seller tries to sell the product at a
lower price, the other sellers will follow him and he will face competition in
the market. Ultimately, a single price will prevail in the market. As such, in
economics average revenue is taken as equivalent to the price of the product
except when we discuss the case of price discrimination. We shall discuss
this in detail later in the next block.
Another important point to be noted here is that as we have already
mentioned, the money value of demand of the consumer constitutes

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Unit 6 Concepts of Revenue

revenue for the seller. As such, the demand curve of the consumer is same
as the total revenue curve of the seller.
Marginal Revenue: Marginal revenue is the net revenue earned by
selling an additional unit of the product. Thus, marginal revenue is obtained
when we calculate the changes in total revenue caused by the sale of an
additional unit of the product.
Thus, marginal revenue is represented as:
Change in total revenue
Marginal Revenue = Change in total units sold

TR
Symbolically, it is represented as: MR =
Q
where, MR stands for marginal revenue, TR stands for total revenue,
Q stands for total units sold, and  stands for change in.
Let us consider the case of marginal revenue in the context of our
hypothetical seller who sells all units of pens at Rs.12/-. Suppose the seller
increase his sales from 150 units to 151 units. In this case, the total revenue
earning of the sellers will be Rs.1812/-. Thus, marginal revenue will be (Rs.
1812 – 1800) = Rs.12/-; this is same as average revenue.
However, if price charged in the extra unit of the product is different
from the price charged in the earlier units, marginal revenue will be different
from average revenue. For example, let us suppose that our hypothetical
seller sales the 151st unit at Rs.11.50/- while he sold all the previous units at
Rs. 12/-. Thus, the total revenue earned by the seller is Rs.1811.50/- and
marginal revenue is (Rs.1811.50 – 1800) = Rs.11.50/-.

6.4 RELATIONSHIP BETWEEN TOTAL REVENUE,

AVERAGE REVENUE AND MARGINAL REVNUE
CURVES

From the above discussion, we are already familiar with the concepts
of average revenue, marginal revenue and total revenue. In this section, we
shall discuss the inter-relationships between these revenue concepts in
more detail. In doing this, we shall first have to deduce the graphical shapes
of the average revenue, marginal revenue and total revenue curves.

100 Introduction to Economic Theory-I

Concepts of Revenue Unit 6

Before going to discuss the relationship between these revenue

concepts, let us make a point clear here. These revenue concepts have a
direct relation with the market structure under which the firm is operating in.
Thus, the structure of the market affects the shapes of the revenue curves.
We shall discuss the different forms of market structures later. For the time
being, let us consider that there are two broad classifications of markets,
viz., perfect competition and imperfect competition. Perfect competition is
described as the market where there are large number of buyers and sellers
and no individual participant is large enough to have the market power to
set the price of a homogeneous product. As such, the seller can supply any
amount of the product at the existing market price and the buyer also can
buy any amount of the product. However, no seller/buyer can individually
influence the market price. Again, the products of the different sellers are
homogeneous; no differences among the products exist. The absence of
perfect competition implies that the market is imperfect. In an imperfectly
competitive market, the seller may have control over the market price. Thus,
a seller under imperfect competition may have absolute control over the
market price or a limited control over it only. However, there exists many
forms of imperfect competition, and the degree of control of the seller over
the market price depends on the form of the market the seller operates in.
Let us now analyse the shapes of the Total Revenue, Average
Revenue and the Marginal Revenue Curves under the two broad market
forms of perfect competition and imperfect competition.
Total Revenue, Average Revenue and Marginal Revenue
Curves of a Firm under Perfect Competition: As we have already
mentioned, a firm under perfect competition has to accept the prevailing
market price and can sell any amount of output in the market at that price
(we shall discuss perfect competition in detail later). Thus, a firm under
perfect competition will earn AR, TR and MR similar to the following table
6.1.

Introduction to Economic Theory-I 101

Unit 6 Concepts of Revenue

Table 6.1: Total, Average and Marginal Revenue Schedules under

perfect competition
(Revenue figures in Rs.)
No. of units sold (Q) Price (AR) TR(AR x Q) MR
1 14 14 14
2 14 28 14
3 14 42 14
4 14 56 14
5 14 70 14

Based on the above schedule 6.1, the shapes of TR, AR and MR

curves of a perfect competitive firm have been shown in the following sections.
Total Revenue Curve: The following figure 6.1 portrays the shape
of the Total Revenue Curve of a firm under perfect competition.
Fig. 6.1: Total Revenue Curve of a Firm under Perfect Competition
y
TR Curve
70
60
50
Revemie

40
30

20

10
0 1 2 3 4 5 Quantity x

From the figure it is obvious that the total revenue curve of the firm is
an upward rising straight line. This curve, in fact represents the supply curve
of a firm.
Average Revenue and Marginal Revenue Curves: We have
already mentioned that under perfect competition, the market price for the
product is fixed and the seller has no influence to alter the same. Again, the
seller can supply any amount of the commodity at the prevailing market
price. Thus, the prevalent market price also becomes the average revenue
and marginal revenue of the firm. This is clear from the above table 6.1.
From the table it is clear that the prevalent market price, i.e., Rs.14 is also
102 Introduction to Economic Theory-I
Concepts of Revenue Unit 6

the average revenue and marginal revenue of the firm. Thus, the shape of
average revenue curve and the marginal revenue curve will be the same.
This has been shown with the help of the following figure 6.2.
Fig. 6.2: Average Revenue and Marginal Revenue Curve under
Perfect Competition

AR = MR = Price
Revemie

Quantity

It can be seen from figure 6.2 that the firm’s AR and MR curves are
the same. The slope of the curves is horizontal.
AR and MR and TR Curves of a Firm under Imperfect
Competition: Unlike perfect competition, a firm under imperfect competition
does not have to sell its entire amount of the product at a fixed market price.
This means that the firm can sell more units of the product as its price falls.
We have shown a hypothetical schedule of AR, TR and MR in table 6.2.
Table 6.2: Total, Average and Marginal Revenue Schedules of a
Firm under Imperfect Competition
(Revenue figures in Rs.)
Number of Price or Average Total Revenue Marginal
units sold (Q) Revenue (AR) (AR x Q) Revenue
1 20 20 20
2 19 38 18
3 18 54 16
4 17 68 14
5 16 80 12
6 15 90 10
7 14 98 8
8 13 104 6

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Unit 6 Concepts of Revenue

9 12 108 4
10 11 110 2
11 10 110 0
12 9 108 –2
13 8 104 –4

From the above table it can be seen that as AR declines by one

rupee with the number of units sold being raised by one unit, MR declines by
Rs. 2/-. Again, TR is the maximum when MR equals 0. After that MR becomes
negative, and TR tends to decline. This has been shown in figure 6.3.
Fig. 6.3: AR, MR and TR curves of a Firm under imperfect competition
20
19
18
17
16 A C B
15
14
13
12
11
10
9
8
7
6
5 AR
4
AR, MR, TR 

3
2
1
0 1 2 3 4 5 6 7 8 9 10 11 12 13 Output 
–1
–2
–3
–4
110 MR
100
90 TR
80
70
60
50
40
30
20
10
0 1 2 3 4 5 6 7 8 9 10 11 12 13

From figure 6.3 it can be seen that unlike perfect competition, firm’s
AR and MR curves under imperfect competition are not the same. However,
both the curves are downward sloping. Again, the slope of the marginal
104 Introduction to Economic Theory-I
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revenue curve is twice as much steeper as that of the average revenue

curve. This is because it can be seen from the above table 6.2 that as sale
increases by one unit, average revenue falls by one rupee while marginal
revenue falls by two rupees. Thus if we draw a perpendicular line on the y- A line is said to be
axis from any point of the AR curve, say AB as shown in the figure, the MR perpendicular to
another line if the two
curve will cut it in the middle. Thus, AC = half of AB.
lines intersect at a
Again, it can be seen that total revenue (TR) continues to rise until
right angle, i.e., if the
MR equals zero. Thereafter, as MR tends to become negative, TR tends to two lines create a 900
decline. Thus, the shape of the TR curve under imperfect completion is angle.
different from that of perfect competition.

CHECK YOUR PROGRESS

Q.1: Why are the AR and MR curves same under

perfect competition? (Answer in about 40 words)
............................................................................................
............................................................................................
............................................................................................
............................................................................................
............................................................................................
Q.2: Is the shape of the total revenue curve same in case of both
perfect competition and imperfect competition? (Justify your
view in about 40 words)
............................................................................................
............................................................................................
............................................................................................
............................................................................................
............................................................................................
Q.3: How will you derive average revenue from total revenue?
............................................................................................
............................................................................................
............................................................................................
............................................................................................

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Unit 6 Concepts of Revenue

6.5 RELATIONSHIP BETWEEN TR, AR, MR AND

PRICE ELASTICITY OF DEMAND

We had already discussed that price elasticity of demand in a

horizontal demand curve (which is found in case of perfect competition) is
infinite. Again, we also discussed that the price elasticity of demand varies
at different point in a linear demand curve. The linear demand curve (which
is found in case of imperfect competition) can be utilized in deriving a
relationship between the shapes of the AR, MR and TR curves and price
elasticity of demand.
The relationship between price elasticity of demand and the revenue
concepts, viz., AR, MR is expressed as:

 e  1
MR  AR  
 e 
where, MR = marginal revenue, AR = average revenue and e = price
elasticity of demand.
Thus, from this formula we can know what would be the marginal
revenue if elasticity and AR are given to us.
Let us take the case when price elasticity of demand is 1.

1  1
Thus, MR  AR  
 1 
Thus, MR = AR X 0 = 0.
Again, from this formula we can find:
If e > 1, MR is positive, and MR<AR
If e < 1, MR is negative, and MR>AR.
This relationship among AR, MR, TR and price elasticity of demand
can also be shown graphically in figure 6.4.
From figure 6.4 it can be seen that C is the middle point of the average
revenue curve DD. At this point C price elasticity of demand is equal to one
. Corresponding to this point C of the DD curve, we can find that MR is
equal to zero (this is because, corresponding to C of the DD curve, the MR
curve cuts the x-axis at point N). Thus, at quantity 0N, price elasticity of
demand is 1, while MR is zero. At a quantity less than 0N, price elasticity of
106 Introduction to Economic Theory-I
Concepts of Revenue Unit 6

demand is greater than 1 (or positive) and at a quantity less than 0N, price
elasticity of demand is less than 1 (or negative). It has also be seen that
when the marginal revenue is positive, price elasticity of demand is also
positive and when marginal revenue is negative, price elasticity of demand
also becomes negative.
Fig. 6.4: Relationship between AR,MR, TR and price elasticity
of Demand

AR, MR

Output

MR

TR

TR

Output

Again, from the bottom panel of the figure it can be seen that total
revenue is maximum when price elasticity of demand equals one. It can be
further noticed that when the price elasticity of demand is greater than one
(or positive), TR tends to increase and when the price elasticity of demand
is less than one (or negative), TR tends to diminish.

Introduction to Economic Theory-I 107

Unit 6 Concepts of Revenue

CHECK YOUR PROGRESS

Q.4: What is the price elasticity of demand in

case of a horizontal demand curve?
............................................................................................
............................................................................................
Q.5: What happens to marginal revenue when price elasticity of
demand equals one?
............................................................................................
............................................................................................
Q.6: What happens to total revenue when price elasticity of
demand is less than one?
............................................................................................
............................................................................................

6.6 LET US SUM UP

 The whole income received by a seller from selling a given amount

of the product is called total revenue.
 Average revenue can be obtained by dividing total revenue by the
number of units sold.
 Marginal revenue is the net revenue earned by selling an additional
unit of the product.
 In case of perfect competition, the shape of average revenue curve
and the marginal revenue curve are the same.
 Unlike perfect competition, firm’s AR and MR curves under imperfect
competition are not the same.
 Under imperfect competition, the slope of the marginal revenue curve
is twice as much steeper as that of the average revenue curve.
 Price elasticity of demand in terms of the revenue concepts, viz.,
 e  1
AR, MR is given as: MR  AR  
 e 

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Concepts of Revenue Unit 6

where, MR = marginal revenue, AR = average revenue and e= price

elasticity of demand.
 If e = 1, MR is zero.
If e > 1, MR is positive, and
If e < 1, MR is negative.
 Total revenue is maximum when price elasticity of demand equals
one.
 When the price elasticity of demand is greater than one (or positive),
TR tends to increase and when the price elasticity of demand is
less than one (or negative), TR tends to diminish.

6.7 FURTHER READING

1) Ahuja, H.L. (2006); Modern Economics; New Delhi: S. Chand & Co.
Ltd.
2) Dewett, K.K. (2005); Modern Economic Theory; New Delhi: S. Chand
& Co. Ltd.
3) Koutsoyiannis, A. (1979); Modern Microeconomics; New Delhi:
Macmillan.
4) Sundharam, K.P.M. & Vaish, M.C. (1997); Microeconomic Theory;
New Delhi: S.Chand & Co. Ltd.

6.8 ANSWERS TO CHECK YOUR PROGRESS

Ans. to Q. No. 1: Under perfect competition, the market price for the
product is fixed and the seller has no influence to alter the same.
However, the seller can supply any amount of the commodity at the
prevailing market price. As a result, the prevalent market price also
represents the average revenue curve and marginal revenue of the
firm. Hence, both the curves are same.
Ans. to Q. No. 2: The shape of the total revenue curve is not same in perfect
competition and imperfect competition. This is because price
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Unit 6 Concepts of Revenue

of a product remains fixed under perfect competition, while under imperfect

competition, price of a product may change.
Ans. to Q. No. 3: Average revenue can be derived from total revenue by
dividing it by the number of units sold. Thus, average revenue = total
revenue / no. of units sold.
Ans. to Q. No. 4: Price elasticity of demand in case of a horizontal demand
curve is infinite.
Ans. to Q. No. 5: Marginal revenue becomes zero when price elasticity
demand equals one.
Ans. to Q. No. 6: When price elasticity is less than one, total revenue tends
to diminish from its maximum point.

6.9 MODEL QUESTIONS

A) Very Short Questions (Answer each question in about 75 words):

Q.1: Define the following terms:
a) Marginal Revenue b) Average revenue c) Total revenue
Q.2: How would you derive marginal revenue from total revenue?
Q.3: Why under imperfect competition, the MR curve is twice as much
steeper than the AR curve?
B) Short Questions (Answer each question in about 100-150 words):
Q.1: Derive the total revenue curve of a firm in a perfectly competitive
market.
Q.2: Show the relationship between average revenue and marginal
revenue under imperfect competition.
C) Essay-Type Questions (Answer each question in about 300-500 words):
Q.1: Show the relationship between average revenue, marginal revenue
and total revenue in a perfectly competitive market. Based on the
relationship, derive the AR, MR and TR curves.
Q.2: Derive the relationship between AR,MR, TR and the price elasticity
of demand under imperfect competition.

*** ***** ***

110 Introduction to Economic Theory-I
UNIT 7: THEORY OF PRODUCTION
UNIT STRUCTURE

7.1 Learning Objectives

7.2 Introduction
7.3 Production Decisions
7.4 Concepts in Production
7.4.1 Production Function
7.4.2 Iso-quant
7.4.3 Isoquant Map
7.4.4 Marginal Rate of Technical Substitution (MRTS)
(Factor Substitution)
7.5 Law of Variable Proportions
7.6 Returns to Scale
7.7 Equilibrium of a Firm
7.8 Expansion path
7.9 Let Us Sum Up
7.10 Further Reading
7.11 Answers to Check Your Progress
7.12 Model Questions

7.1 LEARNING OBJECTIVES

After going through this unit, you will be able to:

 know about production and production decisions
 what is iso-quant and how to construct it
 understand what is factor substitution
 explain the law of variable proportions
 compare the laws of returns to scale with law of variable proportions
 determine the equilibrium condition of the firm and derive the
expansion path.

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Unit 7 Theory of Production

7.2 INTRODUCTION

While studying consumer behaviour, we have found that a consumer

always tries to maximize his utility given his budget constraint. There are
strong similarities between the behaviour of a producer and a consumer. In
this unit, we will discuss the behaviour of a producer. With a given production
function, a producer always tries to reach the optimum output. The process
of transformation of inputs into output is called production and the physical
relation between inputs and output is called production function. A particular
level of output can be produced by using inputs in various combinations. An
iso-quant shows all possible combinations of inputs that yield the same
output. Then the behaviour of production function keeping all inputs constant
except one is studied with the help of the law of variable proportions. Returns
to scale has also been studied by varying all inputs. The condition of
equilibrium of a firm to reach the optimum output has also been discussed
here. When a firm increases output, it moves from one equilibrium position
to another. Finally, we study the expansion path which shows the movement
of equilibrium condition from one position to another.

7.3 PRODUCTION DECISIONS

Just as a consumer has to take certain decision regarding the basket

of consumption, time, and use of resources etc., a producer or a firm also
has to undertaken certain decisions. Production decision of a firm relates to
four basic questions the firm faces: what to produce, how to produce, how
much to produce and for whom to produce.
 What to produce? A firm will produce according to its perception
of the customer demand. It can either produce consumer goods like
food, clothing etc. (which are for consumption purpose) or it can
produce capital goods like machinery etc. (which are for investment
purposes).
 How to produce? After a firm decides what it will produce, the next
question it faces is how to produce. We have already discussed
that there are four factors of production, viz., land, labour, capital
112 Introduction to Economic Theory-I
Theory of Production Unit 7

and entrepreneurship. Of these four factors, supply of land may be

considered given. The role of entreperneurship is undertaken by the
firm itself. As such, out of the four factors, labour and capital are of
special interest for the firm. Thus, the firm has the option of producing
goods by labour intensive technique and capital intensive technique.
Labour intensive technique is the one in which manual labour is used
to produce goods. Capital intensive technique is the one in which
machineries are used to produce goods.
 How much to produce? The firm has also to decide its production
capacity and its production volume.
 For whom to produce? A firm has to decide its target population
(i.e. to whom they will serve products and/or services). Example, it
will not be viable to produce luxurious goods for middle income or
low income group if they can’t afford it and produce basic necessity
goods for rich class if they don’t need it. Therefore, a firm needs to
match its produce according to the target population it is serving.

7.4 CONCEPTS IN PRODUCTION

We have already mentioned that a firm has to take several decisions

while producing a commodity. A commodity may be produced by various
methods of production. Among the set of technically efficient processes,
the choice of a particular technique is a purely economic decision. The
decision is based on price of factors. Another decision to be taken is to
determine the range of output where marginal products of factors are positive
but declining.

7.4.1 Production Function

A production function is a relation between inputs to the

production process and the resulting output. A production function
shows the highest output that a firm can produce for every specified
combination of inputs. Let us assume that there are two inputs
(factors of production) labour and capital. Now the production function
can be written as:
Introduction to Economic Theory-I 113
Unit 7 Theory of Production

Q = f (L, K)
where, Q is a dependent variable which represents output; and both
labour (L) and capital (K) are independent variables.
This relation simply states that output depends on inputs. To
get output Q, inputs can be combined in various proportions. But as
technology improves the same inputs can give more and more output
and the same output can be obtained by less and less input. In our
production function, there are only two variables. But there may be
other variables in the production function.

7.4.2 Iso-quant

An iso-quant or equal product line is a curve showing all

possible combinations of inputs that yield the same level of output.
This concept is analogous to consumer’s indifference curve.
Therefore, it is also known as producer’s indifference curve. Let us
explain the concept with the help of a production function which uses
both labour and capital and produces 50 units.
Table 7.1: Combination of Labour and Capital to Produce Output
Combination Units of Units of Output
of Labour and Capital Labour Capital
1 1 13 50
2 2 9 50
3 3 6 50
4 4 4 50
5 5 3 50
In this example, the producer can produce 50 units of output
with 1 unit of labour + 13 units of capital, 2 units of labour + 9 units of
capital, 3 units of labour+ 6 units of capital, 4 units of labour + 4 units
of capital or 5 units of labour + 3 units of capital. When these points
are plotted on graph paper and joined, they form an iso-quant. In
other words, an iso-quant is a locus of points showing alternative
combinations of labour and capital which produce same level of
output.
114 Introduction to Economic Theory-I
Theory of Production Unit 7

The above table has been shown graphically in the following

figure 7.1. In the figure IQ1 represents the Iso-quant curve. Capital
has been depicted in the y-axis while the labour has been shown in
the x-axis. Point 1 on the IQ curve represents the capital-labour
1
combination 1, which represents 13 units of capital and 1 unit of
labour. Other combinations 2,3,4 and 5 thus represent different units
of capital labour of the iso-quant.
Fig. 7.1: Iso-quant
Y

1
2
Capital

4
5

0 Labour X

7.4.3 Iso-Product Map or Isoquant Map

The Iso-Product Map, like the Indifference Curve Map shows

a set of iso-product curves. A higher iso product curve shows a
higher level of output and a lower iso-product curve represents a
lower level of output. Figure 7.2 is an isoquant map. The points on
the same IQ shows an equal level of output whereas an IQ to the
right represents a larger amount of output.
Figure 7.2: Isoquant Map
Y
Capital

IQ 4
IQ 3
IQ 2
IQ 1

0 Labour X
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Unit 7 Theory of Production

7.4.4 Marginal Rate of Technical Substitution

The concept of Marginal Rate of Technical Substitution

(MRTSLK) between labour and capital can be explained with the help
of the following schedule.
Table 7.2: Combinations of Labour and Capital
Combinations Units of Units of Output MRTSlk
of labour labour (L) capital (K)
and capital
A 1 15 50 –
B 2 11 50 4
C 3 8 50 3
D 4 6 50 2
E 5 5 50 1
As can be seen from the table (Table 7.2), 50 units of output can be
produced by using 1 unit of labour and 15 units of capital. The same output
can be produced by combination of B which uses 2 units of labour and 11
units of capital. Same amount of output can be produced by combination of
C, D and E which uses more and more units of labour but lesser and lesser
units of capital. That is, in the different combinations of inputs labour can be
substituted for capital and yet we have the same amount of output. The
rate at which one additional unit of a factor of production can be subsituted
for the other to obtain the same amount of output is known as the ‘marginal
rate of technical substitution’ (MRTS). In other words, MRTS of labour for
capital is the number of units of capital which can be replaced by one unit of
labour, the quantity of output remaining the same. MRTS is the slope of the
isoquant or the amount of one input (K) that a firm is able to give up in return
for an additional unit of another input (L) with no change in total output.
Another characteristics of MRTSLK is that MRTS has a diminishing tendency.
In other words, as the amount of labour units is increasing in the succeeding
combinations, less and less units of capital are sacrificed to obtain the same
output.

116 Introduction to Economic Theory-I

Theory of Production Unit 7

Fig. 7.3: Marginal Rate of Technical Substitution

Y
A

B
Capital

C
D
E

IQ1 = 50
0 Labour X

The above figure 7.3 shows that iso-quant IQ 1 represents output

level 50. As we move downward from A to B, AB1 units of capital is substituted
by BB1 units of labour. Similarly, B to C, BC1 units of capital is substituted
by CC1. Again if we come down from point C to D, CD 1 units of capital is
foregone to obtain EE1 units of capital. It is clear that for the same quantity
of labour (represented by BB1= CC1=DD1=EE1), we are sacrificing less
and less of capital (represented by AB1> BC1>CD1> DE1). When more units
of labour are used to compensate for the loss of the units of capital to maintain
constant output, the marginal physical productivity of labour diminishes Marginal Physical
and the marginal physical productivity of capital increases. Therefore, MRTS Productivity of
diminishes as labour is substituted for capital. It makes the iso-quant convex Labour and Capital: it
is the additional output
to the origin.
obtained from an
Elasticity of Substitution: The degree of substitutability between
additional unit of
two inputs is measured by elasticity of substitution. It is the proportionate labour or capital i.e.
change in the ratio of the factors divided by proportionate change in the the additional output
MRTS. per unit of labour or
capital.
Therefore :
proportionate change in the ratio of the factors
Es =
proportionate change in the MRTS

Es (Elasticity of substitution) varies between zero and infinity. When

two factors can not be substituted at all, Es is zero and elasticity of
substitution is infinite when the factors are perfect substitutes i. e, E is 1.
s
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Unit 7 Theory of Production

7.4.5 Properties of Iso-quant

An iso-quant has the following properties:

 An iso-quant slopes downward from left to the right. It happens
because when quantity of labour is increased, the quantity of
capital must be reduced so that there is no change in quantity of
output produced.
 Two iso-quants can not intersect each other. If they intersect
each other, there will be common factor combination for two
different levels of output. This has been explained with the help
of the following figure 7.4.
Fig. 7.4 : Iso-quants do not intersect each other

A
Capital

C
B

IQ 2

IQ 1
0 X
Labour

In the above figure 7.4, IQ1 and IQ2 intersect at point C. Thus,
the point C lies on IQ1. Again, point A also lies on IQ . Therefore, it
1
means that at both the points (A and C) the level of output is the
same. On the other hand, point C lies on IQ 2 meaning same level of
output at point C and point B on the iso-quant.
Thus, we found that:
Output level at point A = Output level at point C.
Output level at point B = Output level at point C.
Thus, Output level at point A = Output level at point B. This is
completely ridiculous. So, it can be said that two iso-quants can not
intersect.

118 Introduction to Economic Theory-I

Theory of Production Unit 7

 Every iso-quant is convex to the origin. The convexity property

of an iso-quant means that as we move down on the curve less
and less of capital is required to be substituted by a given Convex Curve: A
increament of labour so as to keep the level of output constant. curve is said to be
convex as the slope or
In other words, the convexity is due to the diminishing marginal
gradient of the curve
rate of technical substitution (MRTS). The degree of convexity increases as we go
of the iso-quant depends on the rate at which the MRTS down along the curve.
diminishes. If the iso-quants are concave to the origin, it would But it can not touch
any of the axis. (Refer
mean that the marginal rate of technical substitution is increasing
to Appendix A for more
and more capital is replaced to get one additional unit of labour.
detail.)
 As an iso-quant moves upward to the right, it represents higher
levels of output. In the following figure 7.5, IQ 2 is higher than IQ1
and it represents higher level of output. Similarly, IQ 3 is higher
than IQ2 representing higher level of output.
Fig. 7.5: Movement of Iso-quants

Y
Capital

IQ 4
IQ 3
IQ 2
IQ 1

0 X
Labour

 There may be a number of iso-quants in between two iso-quants.

They show various levels of output that combination of two inputs
can produce between any two iso-quants.

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Unit 7 Theory of Production

CHECK YOUR PROGRESS

Q.1: What is an iso-quant? (Answer in about 30

words)
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............................................................................................
............................................................................................
Q.2: What is meant by elasticity of substitution? (Answer in about
30 words)
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............................................................................................
............................................................................................
Q.3: What is meant by convexity of an iso-quant? (Answer in about
30 words)
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............................................................................................
............................................................................................
............................................................................................

7.5 LAW OF VARIABLE PROPORTIONS

The law of variable proportions occupies an important place in the

Classical Economics:
field of production. This law studies the changes in the quantity of production
The economic thought
when one input is variable and all other inputs used in production are kept
which evolved in UK
during the period mid constant. In other words, it shows how output changes with changes in the
eighteenth century to quantity of one input while other inputs are kept constant. The law of variable
mid-nineteenth proportions is the new name for the famous “Law of Diminishing Returns”
century. Its principal
of classical economics.
contributors were :
Smith, Malthus, Say,
Senior and J. S. Mill.
120 Introduction to Economic Theory-I
Theory of Production Unit 7

LET US KNOW

The Law of Diminishing Returns: it is a classical law

of economics. But very often the law of variable
proportions is also called the law of diminishing returns. But actually
the law of diminishing returns exactly refers to production that takes
place between the first and the third stage. This is the only stage
where production is feasible and possible. At this stage total product
increases but average and marginal products decline. Throughout
this stage, marginal product is below average product.

Assumptions: The law of variable proportions is based on the

following assumptions :
 There should not be any change in the state of technology.
 Only one input will undergo change in quantity keeping all other inputs
constant.
 All the units of the variable factor are homogenous.
 It is possible to change the proportions in which the various inputs
are combined.
Let us now go back to our previous example of the producer who
uses both labour and capital in the process of production. To study the law
of variable proportions let us assume that the producer will keep capital
constant and increases the units of labour. From the following table 7.3 it is
clear that with the successive increase in the units of labour, the marginal
product of labour (MPL) increases for some time. But with the increase of
successive units, MPL starts declining. In this way when total product is
maximum, MPL becomes zero and APL starts declining.

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Unit 7 Theory of Production

Table 7.3 : Law of Variable Proportions

Units of Total Products Marginal Product Average Product
Labour of Labour (MPL) of Labour (APL)
1 50 50 50
2 120 70 60
3 190 70 63.3
4 270 80 65
5 345 75 69
6 395 50 65.8
7 395 0 56.4
8 360 –35 45

Again, it can be seen from the above table 7.3 that total product is
the highest when marginal productivity of labour is zero. After this point both
total and average product fall and marginal product of labour becomes
negative. We can study the rise and fall of production with diagrams in three
stages.
Three Stages of the Law of Variable Proportions: From the above
table 7.3 we see the behaviour of output with varying quantity of labour and
fixed quantity of capital. The rise and fall of output can be divided into three
stages as has been shown in the following figure 7.6.
Fig. 7.6: The Three Stages of Law of Variable Proportions

H
Y

TP
1st Stage 2nd Stage 3rd Stage
Output

Point of
Inflexion
F
S

AP
0 N M X
Labour

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Theory of Production Unit 7

Stage One: In the first stage the total output to a point increases at
an increasing rate. In the above figure 7.6 it can be seen that the total output
increases rapidly up to point F. This point is called ‘the point of inflexion’.
From this point onwards in stage one, total output increases but at a slower
rate. Therefore, the slope of the curve starts to fall slightly. Stage one ends
at the point where average product is the maximum. In this stage, the quantity
of the fixed factor (capital) is too much relative to the quantity of the variable
factor (labour) so that if some of the fixed factor is withdrawn, the total product
will increase. Stage one is known as the stage of increasing returns.
Stage Two: In stage two, the total product continues to increase at
a diminishing rate until it reaches its maximum point H (figure 7.6) where
the second stage ends. At the end of second stage marginal product becomes
zero. This stage is known as the stage of decreasing returns as both the
average and marginal products of the variable factor continuously fall during
this stage.
Stage Three: In stage three the marginal product becomes negative.
Therefore, both total product and average product declines. In this stage,
total product curve and average product curve slope downward and marginal
product curve goes below the X-axis. This is the opposite of first stage. In
stage three, variable factor (labour) is too much in relation to fixed factor
(capital). This stage is called the stage of negative returns.
A rational producer will always like to produce in stage two. The
producer will not choose stage one where marginal product of fixed factor
is negative. If he chooses this stage, he will not be utilizing completely the
opportunity of production by increasing variable factor. A rational producer
will never choose stage three also. Because, in this stage, he can always
increase output by reducing the quantity of variable factor whose quantity is
excess in proportion of fixed factor. Even when the variable factor is free,
the rational producer will stop at the end of second stage.
Significance of the Law of Variable Proportions:The law of
variable proportions is very important in the field of economics. Till Marshall
it was believed that the law was applicable in the field of agriculture only.

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Unit 7 Theory of Production

But the modern economists propound that the law is equally applicable to
industries and other productive activities. If the law actually does not occur,
we can produce any amount of food grain in a small size of holding by using
more and more amount of labour and capital. But in spite of the presence of
the law of variable proportions a country like India need not be pessimistic
where there is tremendous pressure of population and agricultural production
is not sufficient. Productivity in the field of agriculture can be increased by
making advancement in technology to avoid food crisis.

CHECK YOUR PROGRESS

Q.4: Mention the assumptions of law of variable

proportions. (Answer within 40 words)
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............................................................................................
Q.5: What is ‘point of inflexion’? (Answer within 40 words)
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Q.6: Which stage is known as the stage of diminishing returns
and why? (Answer within 40 words)
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............................................................................................

7.6 RETURNS TO SCALE

Under the law of variable proportions we have known that the changes
in total output as a result of change in variable factor keeping quantity of
other factors of production constant. But when all inputs are changed in a
fixed proportion, there is change in the scale of production. The study of
124 Introduction to Economic Theory-I
Theory of Production Unit 7

changes in output as a consequence of changes in the scale is the subject

matter of “returns to scale”. Let us make the distinction between ‘the law of
variable proportions’ and ‘returns to scale’ clearer with the help of the producer
who uses both labour and capital in the process of production. When the
producer changes the quantity of labour and keeps capital constant, the law
of variable proportions or the law of diminishing returns occurs. But if the
producer changes both labour and capital in the same proportion and the
changes in total production are studied, it refers to returns to scale. It is
called so because there is change in the scale of production. In other words,
returns to scale is the rate at which output increases as inputs are increased
proportionately.
The concept of returns to scale can be explained with the help of
iso-quant. Returns to scale may be increasing, decreasing or constant.
These concepts have been discussed below.
Increasing Returns to Scale: If output more than doubles when
inputs is doubled, there is increasing returns to scale. For example, if inputs
are increased by 2 percent and consequent increase in output is 3 percent,
then it is a case of increasing returns to scale. This has been shown with
the help of the following figure 7.7.
Fig. 7.7: Increasing Returns to Scale
Y

3K
Capital

IQ5 = 50
2K
IQ4 = 40
1K IQ3 = 30
IQ2 = 20
IQ1 = 10
0 1L 2L 3L Labour X

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Unit 7 Theory of Production

In the above figure 7.7, the firm’s production function exhibits

increasing returns to scale. The line 0A originating from the origin describes
a production process in which labour and capital are used as inputs to
produce various levels of output. As the iso-quants move upward along the
line 0A, they become closer. As a result, less than twice the amount of both
inputs is needed to increase production from 10 to 20 units. When inputs
are doubled, output increases to 30 units as shown by IQ 3.
The increasing returns to scale may be due to technical or managerial
expertise. Large scale production process cannot be halved and when used
for production they are more efficient. Such large scale operation allows
managers and workers to specialize in their tasks and uses more
sophisticated large scale factories and equipments.
Constant Returns to Scale: If output increases in the same
proportion as the increase in inputs, returns to scale is said to be constant.
With constant returns to scale, the size of the firm’s operation does not
affect the productivity of its factors : one firm using a particular production
process can easily be duplicated so that two plants produce twice as much
output. For example, a large travel agency might provide the same service
per client and use the same ratio of capital and labour as a small agency
that services fewer clients.
Fig. 7.8: Constant Returns to Scale
Y

3K

IQ3 = 30
Capital

2K

1K IQ2 = 20

IQ1 = 10
0 1L 2L 3L Labour X

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Theory of Production Unit 7

In the above figure 7.8, the firm’s production function represents

constant returns to scale. When 1 unit of labour hour and one hour of machine
time are used, an output of 10 units is produced. When both inputs are
doubled, output doubles from 10 to 20 units; when both inputs triple, output
triples from 10 to 30 units.
Decreasing Returns to Scale: When the rate of increase in output
is smaller than the proportion of increase in inputs, decreasing returns to
scale is said to exist in the production process. It means that output may be
less than double when all inputs are doubled.
Fig. 7.9: Decreasing Returns to Scale

A
9K
IQ5 = 40
Capital

IQ4 = 30
3K

IQ3 = 20

1K IQ2 = 15
IQ1 = 10
0 3L 9L Labour X
1L

In the above figure 7.9, it can be seen that to increase output from
10 to 20 units inputs need to be increased more than twice. Similarly, to
raise the level output by four times from 10 to 40 units, the firm needs to
employ nine times of its initial inputs, i.e., 9 units of capital and labour
each.The common cause of diminishing returns to scale is diminishing
returns to management. As the output grows managers are overburdened
and become less efficient in rendering duties. Communication between
workers and managers can become difficult to monitor as the work place
becomes more and more impersonal. Decreasing returns to scale may
also arise due to exhaustible nature of natural resources.
Introduction to Economic Theory-I 127
Unit 7 Theory of Production

CHECK YOUR PROGRESS

Q.7: What do you mean by returns to scale?

(Answer in about 40 words)
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............................................................................................
............................................................................................
Q.8: Distinguish between returns to scale and law of variable
proportions. (Answer in about 40 words)
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............................................................................................

7.7 EQUILIBRIUM OF A FIRM

The concept of equilibrium of a firm can be explained with the help

of iso-quants and iso-cost lines. An iso-quant map represents the various
factor combinations which can yield various levels of output.
Let us now introduce the concept of the iso cost line. The prices of
factors are represented by the iso-cost line. The iso-cost line determines
what combination of factors the firm will choose for production. An iso-cost
line shows various combinations of two factors that the firm can buy with a
given outlay. Figure 7.10 shows an iso-cost line where units of labour are
measured on the X-axis and units of capital are measured on the Y-axis.
We assume that the prices of factors are given and constant for the firm. If
the firm can spend Rs. 300/- with labour cost at Rs. 4 per labour hour and
capital cost at Rs. 5 per machine hour, then the producer can buy 75 units
of labour or 60 units of capital if the entire amount of Rs. 300/- is spent on
labour or capital respectively. Let OL represent 75 units of labour and OK
represents 60 units of capital. Joining points K and L, we get the iso cost
line which passes through all combinations of labour and capital which the
128 Introduction to Economic Theory-I
Theory of Production Unit 7

firm can buy with Rs. 300/-. Thus, an iso-cost line can be defined as the
locus of various combinations of factors which a firm can buy with a constant
outlay. The iso- cost line is also called the price line or outlay line.
Fig. 7.10: Iso-cost Line

Y
K 60
Capital

70
0 Labour L X

The iso cost line shifts when the total outlay which the firm wants to
spend on the factors changes. A greater outlay will cause the iso cost line to
shift to the right.
The equilibrium condition of the firm depends on its objectives. As
mentioned earlier, an isoquant map given the various factor combinations
which can yield various levels of output, every isoquant showing those factor
combinations which can produce a specified level of output. A family of iso-
cost line represents the various levels of total cost or outlay, given the prices
of two factors.
The entrepreneur may– i) minimise cost subject to a given output or
ii) maximise output for a given cost.
If the entrepreneur has already decided about the level of output, he/
Tangent : a tangent is
she will choose the combinations of factors which minimises the cost of
a straight line which
production, i. e. he/she will choose the least cost combination of factors.
touches a curve at a
We have already said that the point of least cost combination of single point. The point
factors for any level of output is where the iso-quant is tangent to an iso- where the straight line

quant. The point of tangency is the point where a straight line touches a touches the curve is
called the point of
curve. This has been explained with the help of the following figure 7.11.
tangency.

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Unit 7 Theory of Production

Fig. 7.11: Equilibrium of a Firm

Y
D

C
R
Capital B

E
K IQ = 100
S

0 L A B C D X
Labour

In the above figure 7.11, AA, BB, CC and DD are different iso-cost
lines. They show different levels of cost at which production can take place.
An important point to note here is that iso-cost lines are always parallel to
each other. The producer wants to produce 100 units of output and he has
to decide which level of cost will maximize his profit.
Profit will be maximum at point E where the iso-quant IQ touches
the iso-cost line BB. At this point the producer uses 0L amount of labour and
0K amount of capital. Points other than E can not be point of equilibrium as
other points cannot fulfil the condition of tangency. If we consider the point
R, cost is beyond the reach of the producer. Therefore, the producer will not
choose a combination other than E which is the least cost factor combination
for producing 100 units of output.
It should be remembered that the point of tangency between the iso-
cost and the iso-quant is not a necessary condition for producer’s equilibrium.
At the point of tangency, the iso-quant must be convex to the origin. In other
words, marginal rate of technical substitution of labour for capital must be
diminishing.
The second situation of output maximisation for a given level of cost
can be explained with the help of the following diagram.

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Theory of Production Unit 7

Fig. 7.12: Output Maximisation for a Given Cost

Y

K R
S
Capital

E
H 
IQ4 (400)
IQ3 (300)
T
IQ2 (200)

J IQ1 (100)

0 N L Labour X

With the given outlay, there will be a single iso-cost line. The firm will
have to choose a factor combination lying on the given iso-cost line. The
producer will now be in equilibrium at point E where IQ 3 is tangent to KL
using ON units of labour and OH units of capital. The firm has the option of
producing at R, S, T and J but point E enables the firm to reach the highest
possible isoquant IQ3 producing 300 units of output.

CHECK YOUR PROGRESS

Q.9: What are the options available to a producer

to attain equilibrium of a flim? (Answer in about
40 words)
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............................................................................................
............................................................................................
Q.10: State the conditions for producer’s equilibrium. (Answer in
about 40 words)
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Unit 7 Theory of Production

7.8 EXPANSION PATH

After discussing how a producer reaches equilibrium, we are now in

a position to study how a producer will change his factor combination as he
expands output with given factor prices. We can study how he will proceed
with the help of iso-cost and iso-quant. Suppose, the producer uses labour
and capital and their prices are represented by the iso-cost line AA which is
shown in the next page.
In figure 7.13, parallel to the iso-cost line AA, there are other three
iso-quants BB, CC and DD which show different levels of total cost or outlay.
Suppose the producer wants to produce 100 units of output. Then he will
produce at point E1. Suppose he wants to produce 200 units of output, he
will choose to produce at E2 which is a point of tangency between iso-cost
curve BB and iso-quant IQ2. Likewise, for higher level of output 300 and
400, the firm will respectively produce at E 3 and E4. If we join all the least
cost equilibrium points E1, E2, E3 and E4, we get the expansion path. Thus,
expansion path may be defined as the locus of the points of tangency
between the equal product curves and iso-cost lines as the firm expands
output.
Fig. 7.13: Expansion Path
Y
D R

B
Capital

A E4
E3 IQ4 = 400
E2 IQ3 = 300
E1 IQ2 = 200
IQ1 = 100

0 A B C D X
Labour

132 Introduction to Economic Theory-I

Theory of Production Unit 7

The expansion path may have different shape depending upon the
relative prices of the productive factors used and the shape of the iso-quant.
Since expansion path represents minimum cost combinations for various
levels of output, it shows the cheapest way of producing each output given
the relative prices of the factors.

CHECK YOUR PROGRESS

Q.11: What does the expansion path exhibit?

(Answer in about 40 words)
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............................................................................................
............................................................................................
............................................................................................

7.9 LET US SUM UP

 A production function is a relation between inputs to the production

process and the resulting output.
 An iso-quant or equal product line is a curve that shows all possible
combinations of inputs that yield the same output. It is also known
as producer’s indifference curve.
 Amount by which the quantity of one input can be reduced when one
extra unit of another input is added without any change in output is
called marginal rate of technical substitution (MRTS).
 The degree of substitutability between two inputs is measured by
elasticity of substitution. It is the proportionate change in the ratio of
the factors divided by proportionate change in the MRTS.
 The law of variable proportions shows the changes in the quantity of
one input while other inputs are kept constant.
 There are three stages in the law of variable proportions. A rational
producer will always like to produce in stage two.

Introduction to Economic Theory-I 133

Unit 7 Theory of Production

 It was first believed that the law was applicable in the field of
agriculture only. But the modern economists propound that the law
is equally applicable to industries and other productive activities.
 The study of changes in output as a consequence of changes in the
scale is the subject matter of returns to scale.
 Returns to scale may be constant, increasing or decreasing. Returns
to scale vary among different production functions. Normally returns
to scale is greater in the production function associated with larger
firms.
 The law of variable proportions shows how output changes with
changes in the quantity of one input while other inputs are kept
constant. But in case of returns to scale, all inputs are changed in a
fixed proportion.
 The condition of equilibrium is determined at the point of tangency
between iso-cost line and iso-quant. Iso-cost is a straight line which
shows various combinations of two factors that the firm can buy
with a given outlay.
 It should be remembered that the point of tangency between the iso-
cost line and the iso-quant is not a necessary condition for producer’s
equilibrium. At the point of tangency, the iso-quant must be convex
to the origin. In other words, marginal rate of technical substitution
of labour for capital must be diminishing.
 When a firm increases output, it moves from one equilibrium point
to another. Such change of equilibrium position form one to the other
is captured by expansion path.
 Expansion path is the locus of the points of tangency between the
equal product curves and iso-cost lines as the firm expands output.
In other words, it is the locus of least cost combination points.

7.10 FURTHER READING

1) Ahuja, H.L. (2006); Modern Economics; New Delhi: S. Chand & Co.
Ltd.
134 Introduction to Economic Theory-I
Theory of Production Unit 7

2) Dewett, K.K. (2005); Modern Economic Theory; New Delhi: S. Chand

& Co. Ltd.
3) Koutsoyiannis, A. (1979); Modern Microeconomics; New Delhi:
Macmillan.
4) Sundharam, K.P.M. & Vaish, M.C. (1997); Microeconomic Theory;
New Delhi: S.Chand & Co. Ltd.

7.11 ANSWERS TO CHECK YOUR

PROGRESS

Ans. to Q. No. 1: An iso-quant or equal product line is a curve showing

all possible combinations of inputs that yield the same level of output.
This concept is analogous to consumer’s indifference curve.
Therefore, it is also known as producer’s indifference curve.
Ans. to Q. No. 2: The degree of substitutability between two inputs is
measured by elasticity of substitution. It is the proportionate change
in the ratio of the factors divided by proportionate change in the
MRTS. Therefore:
proportionate change in the ratio of the factors
Es =
proportionate change in the MRTS

where, Es = elasticity of substitution, MRTS = marginal rate of

technical substitution.
Ans. to Q. No. 3 : The convexity property of an iso-quant means that as
we move down on the curve less and less of capital is required to be
substituted by a given increment of labour so as to keep the level of
output constant. The degree of convexity of an iso-quant depends
on the rate at which the MRTS diminishes.
Ans. to Q. No. 4 : The law of variable proportions is based on the following
assumptions–
 There should not be any change in the state of technology.
 Only one input will undergo change in quantity keeping all other
inputs constant.
 All the units of the variable factor are homogenous.
Introduction to Economic Theory-I 135
Unit 7 Theory of Production

 It is possible to change the proportion in which the various inputs

are combined.
Ans. to Q. No. 5: In the first stage of production, total output increases
at an increasing rate upto a certain point. This point is called the
point of inflexion.
Ans. to Q. No. 6: The third stage is known as the stage of diminishing
returns as both the average and marginal products of the variable
factor continuously fall during this stage.
Ans. to Q. No. 7: When the producer changes both labour and capital in
the same proportion and the changes in total production are studied,
it refers to returns to scale. It is called so because there is change in
the scale of production.
Ans. to Q. No. 8: The law of variable proportions shows how output
changes with changes in the quantity of one input while other inputs
are kept constant. But in case of returns to scale, all inputs are
changed in a fixed proportion.
Ans. to Q. No. 9: The two options a firm will have to attain equilibrium
are:
 maximizing output for a given cost, or
 minimizing cost subject to a given output.
Ans. to Q. No. 10: The following two conditions must be fulfilled for the
equilibrium of a firm:
 The iso-cost line should be tangent to the iso-quant.
 At the point of tangency, the iso-quant must be convex to the
origin.
Ans. to Q. No. 11: Since expansion path represents minimum cost
combinations for various levels of output, it shows the cheapest way
of producing each output given the relative prices of the factors.

136 Introduction to Economic Theory-I

Theory of Production Unit 7

7.12 MODEL QUESTIONS

A) Very Short Questions (Answer each question in about 75 words):

Q.1: Describe the significance of the law of variable proportions.
Q.2: Write a short note on the concept of expansion path.
Q.3: Write a short notes on:
a) Constant returns to scale
b) Decreasing returns to scale
c) Increasing returns to scale
B) Short Questions (Answer each question in about 100-150 words):
Q.1: Explain the law of variable proportions with the help of suitable
diagram.
Q.2: What do you mean by returns to scale? Discuss its various types
with the help of suitable diagrams.
Q.3: Discuss the equilibrium of a firm using iso-quant and iso-cost lines.

*** ***** ***

Introduction to Economic Theory-I 137

 UNIT 8: COST OF PRODUCTION AND COST
CURVES
UNIT STRUCTURE
8.1 Learning Objectives
8.2 Introduction
8.3 Different Concepts of Costs
8.4 Nature of Cost Curves in the Short-run
8.4.1 Total Variable Cost and Total Fixed Cost
8.4.2 Average Cost Curves
8.4.3 Marginal Cost Curve
8.5 Long-Run Cost Curves of a Firm
8.5.1 Long-Run Average Cost Curve
8.5.2 Long-Run Marginal Cost Curve
8.6 Let Us Sum Up
8.7 Further Reading
8.8 Answers to Check Your Progress
8.9 Model Questions

8.1 LEARNING OBJECTIVES

After going through this unit, you will be able to:

 know various frequently applied concepts of costs
 distinguish between total variable cost and total fixed cost in the
short-run
 know about average cost curves and marginal cost curves in the
short-run
 derive long-run average cost curve
 derive long-run marginal cost curve.

8.2 INTRODUCTION

Cost plays an important role in decision making process of a firm.

Profit maximization is an important objective of a firm. Besides profit
maximization, costs determine whether a new product is to be introduced
138 Introduction to Economic Theory-I
Cost of Production and Cost Curves Unit 8

or not, whether there should be new acquisition and so on. In the language
of a layman, the sum of all expenditures incurred in the process of production
is called cost. The term ‘cost of production’ may be used in several senses.
We will discuss all of them.
The costs incurred on the production process may be studied in
both short-run and long-run. In the short-run, fixed cost cannot be changed.
Output can be increased only by varying the quantities of variable cost. The
short-run average cost curve has direct relationship with the short-run
marginal cost curve. But in the long-run there is hardly any fixed cost. A
period is called ‘long-run’ if all inputs can be changed with change in output.
In this unit, we will discuss how long-run average and long-run marginal
costs are derived. But the concept of cost discussed in this unit falls within
the purview of traditional theory of costs.

8.3 DIFFERENT CONCEPTS OF COSTS

Cost plays an important role in taking any production decision. Cost

of production is the most powerful force governing the supply of a product
which also may influence the price of the commodity. A cost function is a
derived function. Because it is derived from the production function. The
relation between cost and output is known as ‘cost function’, i.e. it relates
the cost of production to the firm’s level of output. For a better explanation of
production decision and price theory, it is necessary to know the various
frequently applied concepts of costs.
Money Costs: Money costs are the total money expenses incurred
by a firm for purchasing the inputs, together with certain other items. The
other items include wages and salaries of workers, cost of raw materials,
expenditures on capital equipments, depreciation cost, rent on buildings, Depreciation: a
interest on capital invested and borrowed, advertisement and transportation reduction in value,
cost, insurance charge, taxes and so on. It is also called nominal cost or writing down the
capital value of an
expenses of production.
asset over a period of
Real Cost: Some elements always lie behind the money cost which time in the company’s
cannot be explicitly measured. The efforts and sacrifices made by the accounts.
capitalists to save and invest, the foregone leisure by the workers are
Introduction to Economic Theory-I 139
Unit 8 Cost of Production and Cost Curves

some examples of real cost. Marshall defined such expenditure as ‘real

cost’. An unpleasant work does not always carry high wage and a pleasant
work does not carry low wage. Thus, it can be said that money cost and
real cost do not correspond to each other.
Accounting Cost and Economic Cost: The concept of cost as
conceived by an accountant is different from the idea conceived by an
economist. When an entrepreneur undertakes an act of production he has
to pay prices to the factors of production. For example, he pays wages to
workers employed, buys raw material, pays rent and interest on money
borrowed etc. All these are included in the cost of production and are termed
as accounting costs.
Economic cost include the return on capital invested by the
entrepreneur himself in his own business plus the salary/wages the
entrepreneur could have earned if the services had been employed
somewhere else and the monetary reward for all factors employed by him.
Thus, economic cost takes into acount not only the accounting cost but
also the amount the entrepreneur could have earned in the next best
alternative employment.
Opportunity Cost or Alternative Cost: The opportunity cost of
any good is the next best alternative good that is sacrificed. Since resources
are scarce, they cannot be put to uses simultaneously. If they are used to
produce one thing they have to be withdrawn from other uses. For example,
a plot of land can be used to produce either rice or wheat and it is employed
to produce rice. It means that we have sacrificed the quantity of wheat for
rice. The ‘opportunity cost’ is the cost incurred in production of rice instead
of wheat.
Sunk Costs: Sunk cost is an expenditure that has been made and
cannot be recovered. For example, let us take the case of a producer who
buys a specialized equipment designed for a particular purpose. That
equipment can be used to do only what it was originally designed for and
can not be converted for original use. It has no alternative use and, therefore,
its opportunity cost is zero. The expenditure on this equipment is called
sunk cost.
140 Introduction to Economic Theory-I
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CHECK YOUR PROGRESS

Q.1: What are the money costs? (Answer in about

40 words)
............................................................................................
............................................................................................
............................................................................................
............................................................................................
............................................................................................
Q.2: What is an alternative cost? (Answer in about 40 words)
............................................................................................
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............................................................................................
............................................................................................
............................................................................................

8.4 NATURE OF COST CURVES IN THE SHORT-RUN

The short-run is a period in which the firm can not change its plant,
equipment and the scale of organization. To increase output, it can only
employ more variable factors with the same quantity of fixed factor.

8.4.1 Total Variable Cost and Total Fixed Cost

The total cost in the short-run may further be subdivided into

‘total variable’ and ‘total fixed’ cost. The total variable costs are those
expenses of production which change with the changes in total output
of the firm. It means that they can be adjusted with the change in
output level. For example, a bread producer wants to increase the
production of bread from 200 to 350 units. Now he will require more
wheat and more labourers. Therefore, expenditure on these two
items is called variable cost. Variable costs are also called primary
cost or direct cost. Variable cost includes expenditure on labour,
raw materials, power, fuel, etc.
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Unit 8 Cost of Production and Cost Curves

On the other hand, some components of production cannot

be varied in the short-run. For example, our bread producer cannot
increase its plant size quickly in the short-run. He has to collect
capital and order the equipment for purchasing. Such expenditure
on capital equipment, building, top management personnel,
contractual rent, insurance fee, interest on capital invested,
maintenance cost, tax etc are called fixed cost. It is called so because
it can not be adjusted in the short-run. Fixed cost is the cost which
does not vary with the level of output. Fixed costs are known as
over-head cost. Both total fixed costs (TFC) and total variable cost
(TVC) together constitute total cost (TC).
In the table,
TFC = Fixed f or all Thus, TC = TVC + TFC
output levels. Let us explain the concept with the help of the following table
TVCi = MCi+TVCi-1 8.1, which corresponds to short-run. When the firm produces
Thus, TVC at the
nothing, the total fixed cost is 150. In the short-run, total fixed cost
Output level 3 is :
remains the same although there is increase in output. Total variable
MC at output level
cost is zero when the firm produces nothing.
3+TVC at output level 2.
TC = TFC + TVC Table 8.1: Total Fixed Cost, Total Variable Cost and Total Cost in the
= Columns(2+3) Short-run
MC = TVCi-TVCi-1 OUTPUT TFC TVC TC MC AFC AVC ATC
TFC (1) (2) (3) (4) (5) (6) (7) (8)
AFC =————
Output
0 150 0 150 — — — —
Column (2) 1 150 50 200 50 150.0 50.0 200.0
=——————
Column (1) 2 150 80 230 30 75.0 40.0 165.0
3 150 100 250 20 50.0 33.3 83.3
AVC = TVC
—————
Output 4 150 110 260 10 37.5 27.5 65.0
Column (3) 5 150 115 265 5 30.0 23.0 53.0
=——————
Column (1) 6 150 130 280 15 25.0 21.6 46.6
TC 7 150 155 305 25 21.4 22.1 43.5
ATC =—————
Output 8 150 190 340 35 18.7 23.7 42.5
Column (4) The distinction between fixed and variable cost will be clear
=——————
Column (1) from the following figure 8.1. In the figure, the total fixed cost curve
(TFC) is parallel to the X axis because in the short-run it will remain
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Cost of Production and Cost Curves Unit 8

constant whatever the level of output. Even if the firm does not
produce anything, the producer has to bear the total fixed cost. On
the other hand the total variable cost curve (TVC) will start from the
origin, meaning that if there is no production TVC will be zero.

Fig. 8.1: Shapes of Fixed Cost, Variable Cost and Total Cost Curves
Y
TC

st
co
le
iab
Var
l TVC
Cost

ta
To

Total Fixed cost

Output X

From the above figure 8.1 it can be seen that the TVC moves
upward, showing that as output increases the total variable cost
increases. The vertical summation of total variable cost and total
fixed cost gives the total cost of the firm.

8.4.2 Average Cost Curves

We have discussed total variable and total fixed cost. But in

economics, the concept of cost is discussed in the context of per
unit instead of total cost so that a better idea about profit is conceived
instantly. Therefore, we are going to discuss the short-run average
cost curve.
Average Total Cost (ATC) or Average Cost: The average total
cost is also called ‘average cost’. It is derived by dividing the total
cost by the quantity produced. We have already studied that total
cost (TC) is nothing but the sum of total fixed cost and total variable
cost.

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Unit 8 Cost of Production and Cost Curves

TC
ATC =
Q
TVC  TFC
Or, ATC =
Q
TVC TFC
= 
Q Q
= AVC + AFC
where, Q is the total output produced. It means that average cost is
the sum total of average variable cost and average fixed cost. The
shape of a short-run average cost curve is like U as shown in the
figure 6.2.
Average Fixed Cost: If the total fixed cost is divided by the total
number of units of output produced, we can arrive at average fixed
cost–
TFC
AFC =
Q
where, Q is the number of total output produced. The shape of the
average fixed cost curve is shown in figure 8.2.
Fig. 8.2: Shapes of Various Cost Curves
AC
AC
y MC MC
AVC
AVC
Cost

AFC
AFC
x
0 Output

From the above figure 8.2 as shown in the above, it is clear

that AFC curve gradually falls down as more and more output is
produced. We know that the fixed cost does not change in the short-
run. Therefore, an increase in output produced reduces the AFC
144 Introduction to Economic Theory-I
Cost of Production and Cost Curves Unit 8

and the AFC curve falls downward gradually. From column 6 of table
8.1, we can see that the amount of fixed cost is falling as production
is increasing.
Average Variable Cost (AVC): Average variable cost is the total
variable cost divided by the number of units of output produced. It
can be calculated in the following way:
TVC
AVC =
Q
where, Q stands for the total output produced. The average variable
cost will generally fall as output increases from zero to the normal
capacity output. But beyond the normal capacity of output it will rise
steeply because of the operation of the law of diminishing returns.
Average variable cost curve (AVC) is shown in the above figure 8.2.

8.4.3 Marginal Cost

Before discussing the concept of marginal cost, let us go

back to the concept of marginal product. Marginal product is an
additional output produced. For example, a producer produces 100
units. When he produces 101 units, the extra unit is called marginal
output. Therefore, the marginal cost is an addition to the total cost
incurred on the production of that additional unit. Since total fixed
cost does not undergo any change in the short-run, marginal cost
may also be called an addition to the total variable cost in the short-
run. There is a direct relationship between AC and MC. When AC
falls MC also falls but it is below AC. When AC rises MC is above it
and AC equals MC at the lowest point of AC. Let us again draw AC
and MC curve separately on the paper, as has been depicted in the
following figure 8.3.

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Unit 8 Cost of Production and Cost Curves

Fig. 8.3: AC and MC Curves

y MC
AC
AC
MC

Cost

Q Output x

From the above figure 8.3, it is clear that to the right of output
Q, MC is higher than AC and to the left of Q, MC is lower than AC.
But at output level Q, MC = AC. Thus, we find that:
 If MC < AC, then AC will be falling as output increases.
 If MC > AC, then AC will be rising as output increases.
 At point Q where AC is minimum, we have AC = MC.

CHECK YOUR PROGRESS

Q.3: Distinguish between fixed and variable cost.

(Answer in about 40 words)
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............................................................................................
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............................................................................................
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Q.4: What is marginal cost? (Answer in about 40 words)
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............................................................................................

146 Introduction to Economic Theory-I

Cost of Production and Cost Curves Unit 8

Q.5: What will be the variable cost when the output is zero?
(Answer in about 50 words)
............................................................................................
............................................................................................

8.5 LONG-RUN COST CURVES OF A FIRM

Long-run is the period when a firm can change its plant size and
scale of organization. In the long-run all factors are variable. Now, the question
is how short is the short-run and how long is the long-run? This depends on
the industry and the production techniques used. The period length will vary
from firm to firm. If there are no transactions and no specialized inputs, then
all inputs can be quickly adjusted, and the long-run is not very long.

8.5.1 Long-run Average Cost Curve

Let us first discuss how average cost curve is derived in the

long-run. We all know that a particular plant can produce a particular
range of output. It is the lowest point of average cost curve beyond
which production is not economic because of the operation of the
law of diminishing returns which may occur for various reasons.
Suppose, the demand for a firm’s product increases. Now the
producer will install a new plant. The firm will be making use of the
newly installed plant till it reaches the lowest point on the average
cost curve. This way more new plants will be installed with the
increase in demand for the firm’s product.
Now we will derive the long-run average cost (LAC) curve
from the short-run average cost curves by fitting a line which is tangent
to all SAC curves. The point of tangency must be the lowest point on
the short-run average cost curve because beyond that the firm will
not produce in that plant.
In the following figure 8.4, LAC is the long-run average cost
curve. Each point on the LAC curve is a point of tangency with the
corresponding short-run average cost curve. Therefore, it also called

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Unit 8 Cost of Production and Cost Curves

‘Envelope Curve’. The firm will produce 0M amount of output at the minimum
point E on the LAC curve. If the firm produces less than 0M, it is not
reaping fully the economies of production and if it produces beyond
0M, the firm’s profit will fall. In both the cases, the average cost of
production will be higher.
Fig. 8.4: Shapes of SAC Curves and the LAC Curve

y
LAC
SAC1
SAC5

SAC2
Cost

SAC4
Law of Returns to SAC3
Scale: This law
explains the rate at
E
which output changes
as the quantities of all
inputs are varied. 0 M Output X
Three laws of returns
The shape of the long-run average cost curve is like U. This
to scale exist:
shape reflects the law of returns to scale. According to this law,
Suppose, we increase
all the inputs of the unit costs of production decreases as plant size increases, due
production twice. Now, to the economies of scale, which the large plant sizes make
consequently: if output possible. It has been assumed that this plant is completely inflexible.
also increases twice,
There is no reserve capacity, not even to meet the temporary rise in
then we can say that
constant returns to demand. If this plant size increases further than this optimum size
scale exists; 2) if there are diseconomies of scale. The turning up of the LAC curve is
output increases by due to managerial diseconomies of scale when output is increased
less than twice, then
beyond the optimum size.
we can say that
decreasing returns to
8.5.2 Long-Run Marginal Cost Curve
scale exists; and finally
3) if output also The long-run marginal cost can be derived from the short-
increases by more
run marginal cost curves (SMC) but it does not envelope them like
than twice, then we
can say that the LAC curve. The LMC curve is formed from the point of intersection
increasing returns to of the SMC curves with vertical lines to the X axis drawn from the
scale exists.
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Cost of Production and Cost Curves Unit 8

points of tangency of the corresponding SAC curves and the LAC

curve. At that level of output, the LMC must be equal to the SMC
curve at which the corresponding SAC curve is tangent to the LAC Economies of Scale:
curve. In the long-run, it may
be the firm’s interest to
Fig. 8.5: Long-run Marginal Curve
change the input
y proportions as the
level of output
LAC
changes. When input
SAC1 SAC5 proportions undergo
a SMC1 LMC
SMC2 changes, the concept
SMC3 of returns to scale no
SAC4 longer applies. Rather,
Cost

SAC2
we can say that a firm
p b SAC3 enjoys economies of
scale when it doubles
q c its output for less than
twice the cost.
Conversely, there are
X diseconomies of scale
0 A B C Output
when a doubling of
output requires more
In the above figure 8.5, let us start with the point ‘a’ which is
than twice the cost.
a point of tangency between SAC and LAC. From this point a vertical
line aA is drawn on the X axis and it cuts the SMC1 at point p. Similarly
‘b’ and ‘c’ are the other two points of tangency between other two
SAC curves and the LAC curve. Corresponding to these two points
of tangency, the point of intersection between vertical lines bB and
cC are q and c. After joining p, q and c we get the LMC curve. At this
minimum point c, the LMC curve intersects the LAC curve. Long-
run marginal cost bears direct relationship with the long-run average
cost. When both LAC and LMC fall, LMC is lower than LAC. But as
LAC and LMC both increase, LMC is higher than LAC. But the LMC
cuts the LAC at the lowest point. The same relationship between AC
and MC is true in the short-run as well.

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Unit 8 Cost of Production and Cost Curves

CHECK YOUR PROGRESS

Q.6: Distinguish between short-run and long-run

period. (Answer in about 40 words)
............................................................................................
............................................................................................
............................................................................................
............................................................................................
............................................................................................
............................................................................................
Q.7: Why does the LAC look like U? Explain. (Answer in about 40
words)
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............................................................................................

8.6 LET US SUM UP

 Concept of cost can be approached from several perspectives. The

first one we have discussed is money cost. Money cost can be
explicitly measured in terms of money.
 Real costs can not be directly measured. Money costs are total
money expenses incurred by a firm in producing a commodity
whereas the efforts and sacrifices of the factor or the entrepreneur
is called real cost of production.
 Accounting costs are concerned with firm’s financial statements and
is concerned with a firm’s past performance. On the other hand,
economic cost is concerned with allocation of scarce resources
and is forward looking.
 The opportunity cost of any good is the next best alternative good
that is sacrificed.
 Sunk cost is an expenditure that has been made and can not be
recovered.
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Cost of Production and Cost Curves Unit 8

 The theory of cost may be approached from both short term and
long term perspectives. In the short-run, total cost is the sum of total
variable and total fixed cost.
 The total variable costs are those expenses of production which
change with the changes in total output of the firm.
 On the other hand, some components of production can not be varied
in the short-run. They are called fixed cost.
 Average cost is derived by dividing the firm’s total cost by the level of
output.
 Marginal cost is the increase in cost resulting from the production of
one extra unit of output.
 There is a direct relationship between AC and MC. When AC falls
MC also falls but MC is below AC. When AC rises MC also rises and
MC is above it. AC is equals to MC at the lowest point on the AC
curve.
 In the long-run, average cost curve is an envelope curve of the short-
run average cost curve. The shape of the LAC curve is like the U.
The U shape occurs due to the laws of returns to scale.
 The long-run marginal cost can be derived from the short-run
marginal cost curves (SMC) but it does not envelope the short-run
marginal cost like the LAC curve.
 The same direct relationship between average cost and marginal
cost curve which is applicable in the short is also applicable in the
long-run.

8.7 FURTHER READING

1) Ahuja, H.L. (2006); Modern Economics; New Delhi: S. Chand & Co.
Ltd.
2) Dewett, K.K. (2005); Modern Economic Theory; New Delhi: S. Chand
& Co. Ltd.
3) Koutsoyiannis, A. (1979); Modern Microeconomics; New Delhi:
Macmillan.
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Unit 8 Cost of Production and Cost Curves

4) Sundharam, K.P.M. & Vaish, M.C. (1997); Microeconomic Theory;

New Delhi: S.Chand & Co. Ltd.

8.8 ANSWERS TO CHECK YOUR PROGRESS

Ans. to Q. No. 1: Money costs are total money expenses incurred by a

firm for purchasing the inputs, together with certain other items. The
other items include wages and salaries of workers, cost of raw
materials, expenditures on capital equipment, depreciation cost, rent
on buildings, interest on capital invested and borrowed,
advertisement and transportation cost, insurance charge, taxes and
so on.
Ans. to Q. No. 2: Alternative cost of any good is the next best alternative
good that is sacrificed. Since resources are scarce, they can not be
put into all uses simultaneously. If they are used to produce one
thing they have to be withdrawn from other uses. For example, a
plot of land can be used to produce either rice or wheat and it is
employed to produce rice. Thus, the opportunity cost is the cost
incurred in the production of rice instead of wheat.
Ans. to Q. No. 3: Variable costs are those expenses of production which
change with the changes in total output of the firm. It means that
they can be adjusted with the change in output level. Variable cost
includes expenditure on labour, raw materials, power, fuel, etc.
On the other hand, some expenditure such as:
expenditures on capital equipment, building, top management
personnel, contractual rent, insurance fee, interest on capital invested,
maintenance cost, tax etc remain fixed irrespective of the volume or
time period of production. So, they are called fixed cost. Such costs
can not be adjusted in the short-run.
Ans. to Q. No. 4: Marginal cost is the increase in cost resulting from the
production of one extra unit of output.
Ans. to Q. No. 5: Variable cost will be zero when output of the firm is zero.

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Cost of Production and Cost Curves Unit 8

Ans. to Q. No. 6: Short-run is the period, when a firm cannot change all its
factors of production; neither can change its plant size and scale of
operation. Thus, some factors of production in the short-run are fixed
while others are variable. And in the short-run, while the cost of fixed
factors of production remain the same, the cost of the variable factors
of production varies according to the volume of production. On the
other hand, long-run is a period when a firm can change its plant
size and scale of operation. In the long-run all factors are variable.
Ans. to Q. No. 7: The LAC looks like the shape of ‘U’, because the laws of
returns to scale operate in the long-run.

8.9 MODEL QUESTIONS

A) Very Short Questions (Answer each question in about 75 words):

Q.1: Differentiate between accounting cost and economic cost.
Q.2: Differentiate between money cost and real cost.
Q.3: Define the following terms:
a) Sunk cost
b) Opportunity cost
c) Real cost
B) Short Questions (Answer each question in about 100-150 words):
Q.1: Discuss the different concepts of costs.
Q.2: Show the relations among Total Fixed Cost, Total Variable Cost and
Total Cost.
C) Long Questions (Answer each question in about 300-500 words) :
Q.1: How is Marginal Cost is related to Average Cost and Total Cost.
Q.2: Show the relations between different cost curves.

*** ***** ***

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