Course Name: Business Economics Course Code: 22MBACC102

MODULE 1: DEMAND & SUPPLY ANALYSIS

MEANING OF DEMAND

Demand is the quantity of consumers who are

willing and able to buy products at various prices
during a given period of time. Demand for any
commodity implies the consumers' desire to
acquire the good, the willingness and ability to
pay for it. So, for a commodity to have demand,
the consumer must possess willingness to buy it,
The demand for a commodity is its quantity the ability or means to buy it, and it must be
which consumers are able and willing to buy at related to per unit of time i.e., per day, per week,
various prices during a given period of time. per month or per year.

According to Prof. Bobber, “By demand we mean the various quantities of a given commodity or service
which consumers would buy in one market in a given period of time at various prices or at various incomes
or at various prices of related goods.”

“Demand refers to any desire for a product or service supported by the ability and the willingness to pay
the price.”

Demand = Desire + Ability to pay + Willingness to pay

Demand is a relative term. It is always expressed in terms of quantity, time & price.

Hence, demand for any commodity or service is the quantity that will be purchased at a price at any given
per unit of time.

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Course Name: Business Economics Course Code: 22MBACC102

TYPES OF DEMAND IMDFTDJPS

Individual Demand:

A commodity or good demanded by a single person is called individual demand.

Individual Demand Schedule

Price Individual Quantity
Demanded
1 4
2 3
3 2
4 1

Market Demand

A demand for a particular product by all customers and added, is called market demand. (Total all
individual demand is called as the market demand)

Table is the market demand schedule. This schedule, from the angle of simplification, is based on the
assumption that there are two buyers, A and B for X commodity. By adding up their individual demand,
the market demand schedule has been estimated:

Market demand Schedule

Price of Commodity X Demand of person Price of Commodity X Demand of person
(Rs.) (Rs.)
1 4 5 4 + 5=
2 3 4 3+4=
3 2 3 2+3=
4 1 2 1+2=

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FACTORS AFFECTING MARKET DEMAND PDCSA

Market or aggregate demand is the summation of individual demand curves. In addition to the factors
which can affect individual demand.

 Prices of products are goods.

 Distribution of income and wealth in the community.

 Community common habits.

 General standard of living and spending habits of people.

 Age structure and sex ration of population.

Direct and Indirect Demand: (or) Producers’ goods and consumers’ goods: demand for goods
that are directly used for consumption by the ultimate consumer is known as direct demand (example:
Demand for T shirts). On the other hand, demand for goods that are used by producers for producing
goods and services. (example: Demand for cotton by a textile mill).

Derived Demand and Autonomous Demand: when a produce derives its usage from the use
of some primary product it is known as derived demand. (example: demand for tyres derived from
demand for car) Autonomous demand is the demand for a product that can be independently used.
(example: demand for a washing machine)

Durable and Non-Durable Goods Demand: durable goods are those that can be used more
than once, over a period of time (example: Microwave oven) Non-durable goods can be used only once
(example: Band-Aid).

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Course Name: Business Economics Course Code: 22MBACC102

Firm and Industry Demand: firm demand is the demand for the product of a particular firm.
(example: Dove soap) The demand for the product of a particular industry is industrydemand (example:
demand for steel in India).

Total Market and Market Segment Demand: a particular segment of the markets demand is
called as segment demand (example: demand for laptops by engineering students) the sum total of the
demand for laptops by various segments in India is the total market demand. (example: demand for
laptops in India).

Short Run and Long Run Demand: short run demand refers to demand with its immediate
reaction to price changes and income fluctuations. Long run demand is that which will ultimately exist
as a result of the changes in pricing, promotion or product improvement aftermarket adjustment with
sufficient time.

Joint Demand and Composite Demand: when two goods are demanded in conjunction with
one another at the same time to satisfy a single want, it is called as joint or complementary demand.
(example: demand for petrol and two wheelers) A composite demand is one in which a good is wanted
for several different uses. (example: demand for iron rods for various purposes)

Price Demand, Income Demand and Cross Demand: demand for commodities by the
consumers at alternative prices are called as price demand. Quantity demanded by the consumers at
alternative levels of income is income demand. Cross demand refers to the quantity demanded of
commodity ‘X’ at a price of a related commodity ‘Y’ which may be a substitute or complementary to X.

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DEMAND ANALYSIS

Meaning of Demand Analysis: Ordinarily, by demand is meant the desire or want for something. In
economics, however demand means much more than that, it is effective demand i.e. the amount buyers
are willing to purchase at a given price and over a given period of time. From managerial economics point
of view, thus, the demand may be looked upon as follows: - Demand is the desire or want backed up by
money. Demand means effective desire or want for a commodity, which is backed up by the ability (i.e.
money or purchasing power) and willingness to pay for it. The demand does not mean simply the desire
or even need for a commodity obviously, a buyer’s wish for the product without possessing money to buy
it or unwillingness to pay a given price for it will not constitute a demand for it for example a beggar’s
wish for a Bike will not constitute its potential demand, as he has no ability to pay for it.

In short,

Demand = Desire + Ability to pay + Willingness to spend

PRITPI BBAD FFCC

DETERMINANTS OF DEMAND PRITFPBD BAICFC

The main determinants of demand are the following:

1. Price of the Product. The price of commodity or services directly affects its demand. The
fall in the price of a commodity leads to rise in its demand and rise in price leads to fall in its
demand. Price is the only determinant of demand in the short run.

2. Price of Related Goods. Two or more goods can be complementary or substitutes of each
other. The demand for a commodity is also affected by changes in price of its complementary or
substitute good. If two goods are substitute for each other than the increase in price of one will
result in increased demand for the other and vice-versa. E.g. Pepsi and Coca-Cola are substitute
of each other. The rise in the price of Coca-Cola increases demand for Pepsi and vice-versa.

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Complementary goods are those which, are jointly demanded to satisfy a particular demand.
There is opposite relationship between price of one complementary commodity and the amount
demand of the other complementary commodity. If price of one complimentary rises, the demand
for the other complementary falls. E.g. A fall in the price of Car will lead to increase in the
demand for petrol.

3. Level of Income. Income is an important determinant of demand for acommodity, ordinarily,

with an increase in income, demand for goods increase. There is a direct relationship between
income and quantity demanded. Rich consumers usually demand more and more goods than the
poor customers. Demand for luxury and expensive goods is related to the income.

4. Taste, Habits and preferences of Consumer. The demand for many goods also depends
on consumer's taste, habit and preferences. Demand for goods changes with change in fashion,
habits, customs, traditions and general life-style of the society. Demand forseveral products like
ice-cream, chocolates etc. depends on taste and demand tea, cigarettes, tobacco is a matter of
habits.

5. Future trend of Prices. If it is expected that in future the price of a commodity will go
up the demand for the commodity in the present also will go up. If the prices are expected to fall,
then the demand would fall.

6. Changes in Population. Generally, the demand for a commodity increases with increase
in size of population, other things being equal, it is not merely the change in the size of population
but the changes in the composition of population also affect the demand for certain commodities.
In a country of increasing population like India where hundreds of children are born daily in big
cities there will naturally be demand for toys, baby food and alike.

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7. State of Business. If the country is passing through prosperity and boom conditions, there
will be a marked increase in demand. When the country is passing through recession and
depression then level of demand would go down.

8. Distribution of Income and Wealth. If the distribution of income is more equal than the
demand for all normal goods will be more. If the income is so unevenly distributed that majority
of population is poor, then the demand for inferior and necessaries' will be larger.

9. Availability of Consumer Credit. If the credit facilities are available sufficiently to

consumers for the purchase of high priced durable goods such as car, colour TV, scooters and
alike, then their demand will increase.

10. Different Uses. When the price of a commodity is high, it will be used only in its more
important use. As the price of the commodity falls it will be used even in less important uses.
Thus, the demand increases will fall in price and vice-versa. Example of gram or electricity can
be citied.

11. Change in the number of Buyers. With the fall in the price of a commodity the number
of its purchasers increase and vice-versa. Therefore, demand increases with fall in price and
decreases with fall in price and decreases with rise in price.

12. Advertisement and Salesmanship. In the modern market, advertisement greatly

influence the demand for a commodity. In fact, the demand for many products like to toothpaste,
Cosmetics etc. is greatly affected by advertisement. The best salesmanship is the one who does
not merely sell what buyers want but who makes the buyers buy what he sells.

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13. Inventions and Innovations. introduction of new goods or substitutes as a result of

inventions and innovations in a dynamic modern economy tends to adversely affect the demand
for the existing products.

14. Climate and weather conditions. demand for certain products is determined by climatic
and weather conditions for example, in summers there is a great demand for cold drinks, fans,
air conditioners etc.

15. Fashions. the demand for many products is affected by changing fashions. For example,
demand for jeans is based on current fashions.

16. Customs. demand for certain goods is determined by social customs, festivals etc., for
example, during the Dipawali days there is a great demand for sweets & during Christmas cake
are more in demand.

LAW OF DEMAND

The law of demand describes the general tendency of consumer’s behavior in demanding a commodity
in relation to the changes in its price. The Law of demand expresses the relationship between price
and quantity demanded of a commodity. According to the law of demand the demand of a commodity
extends with fall in its price and contracts with rise in the price, other things being constant. 'Other
things being constant' means that the other determinates of demand except price remain unchanged. it
explains the inverse relationship between price and quantity demanded.

Statement of law of demand-

“Ceteris paribus, the higher the price of a commodity, the smaller is the quantity demanded and
lower the price, larger the quantity demanded”.

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Course Name: Business Economics Course Code: 22MBACC102

The law of demand can be illustrated with the help of a demand schedule. The demand schedules show
that with the fall in the price of the commodity its demand is increasing.

Price of Commodity Quantity Demanded of ‘X’(in

‘X’ kgs.)
(in Rs.)

5 10
4 20
3 30
2 40
1 50

From the above example, we can say that with a fall in price at each stage demand tends to rise. There
is an inverse relationship between price and the quantity demanded.

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ASSUMPTIONS OF THE LAW OF DEMAND:

The Law of Demand is based on the following assumptions:

(1) No change in taste, habits, preferences: It is assumed that there is no change in the taste,
habits, preferences of a rational consumer. Thus, consumers' choice of product must remain the
same.

(2) No change in the income level: If the consumer's income rises, he will demand more though
the prices of commodities rise. In such a situation, the law will not hold good.

(3) No change in population: The law is based on the assumption that there should beno change
in population, size, sex ratio, age composition, etc.

(4) No change in prices of related goods: The law assumes that the prices of close substitutes and
the complementary products should remain constant.

(5) No expectation of future change in the price: If the consumers expect high rise in the price
in future, they demand more though current price is high. In such condition, the Law of Demand
cannot be verified.

(6) No change in taxation: It is assumed that the structure of direct and indirect taxes remains
constant. Thus, the disposable income of a consumer should remain the same.

(7) No introduction of new product: It is assumed that there is no introduction of a new product
in the market. Thus, the consumer's taste, habits and preferences remain constant.

(8) No change in technology: The law assumes that the present technology of production remains
constant.

(9) No change in weather conditions: Climatic and weather conditions may bring sudden change
in demand, though there is no change in the price. Therefore, it is assumed that weather
conditions remain constant.

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EXCEPTIONS TO THE LAW OF DEMAND

Followings are the exceptions of the law of demand: PCGIFFN

1. Articles of Distinction/prestigious goods: The articles of distinction such as diamonds, gems,

costly carpets, etc. are in more demand when their prices are high. The reason is that rich
people measure the desirability of these articles in terms of their prices alone and consider
these goods as honour possession. Therefore, rich people demand more of articles of distinction
when their prices are high.

2. Giffen Goods. Price effect is the composite effect of 'income effect' and 'substitution effect.
Giffen goods (most inferior goods) are those inferior goods for which 'income effect' of change
in price is negative and is greater than the substitution effect. Therefore, the demand of Giffen
goods increases with rise in price and decreases with fall in their price.

3. Ignorance of buyers about Quality. Many a times, buyer’s due inertia or out of sheer ignorance
consider the price of the commodity as index of its quality. Due to this ignorance, a lower-price
commodity may be considered inferior. Therefore, purchasers buy lesser quantity of the
commodity at its lower price. But when the price of commodity is more, buyers consider it to be
superior and thus buy more of it than before.

4. Future changes in Prices. Purchaser also act as speculators. When the price has increased and
is expected to rise further, buyers tend to purchase more quantities of the commodity out of the
apprehension of rise in price in future. Likewise, when prices are expected to fall further, a
reduced price may not induce the buyers to purchase more of the commodity.

5. Necessities of Life. We cannot reduce the consumption of necessaries of life and conventional
necessaries even if their prices have increased sharply.

6. Change in quality: people are to demand more even at a higher price provided qualityis good.

7. Fashionable goods. Goods that are in fashion are purchased by consumers regardless of price
even at a higher price. Consumers purchases the goods which are in fashion.

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EXCEPTIONAL DEMAND CURVE:

The demand curve slopes from left to right upward if despite the increase in price of the commodity,
people tend to buy more due to reasons like fear of shortages or it may be an absolutely essential good.
The law of demand does not apply in every case and situation. The circumstances when the law of
demand becomes ineffective are known as exceptions of the law. Some of these important exceptions
are as under.

1. Giffen Goods:

Some special varieties of inferior goods are termed as Giffen goods. Cheaper varieties millets like
bajra, cheaper vegetables like potato etc. come under this category. Sir Robert Giffen of Ireland first
observed that people used to spend more of their income on inferior goods like potato and less of
their income on meat. After purchasing potato, the staple food, they did not have staple food potato
surplus to buy meat. So the rise in price of potato compelled people to buy more potato and
thus raised the demand for potato. This is against the law of demand. This is also known as Giffen
paradox.

2. Conspicuous Consumption / Veblen Effect:

This exception to the law of demand is associated with the doctrine propounded by Thorsten
Veblen. A few goods like diamonds etc. are purchased by the rich and wealthy sections of society.
The prices of these goods are so high that they are beyond the reach of the common man. The higher
the price of the diamond, the higher its prestige value. So when price of these goods falls, the
consumers think that the prestige value of these goods comes down. So quantity demanded of these
goods falls with fall in their price. So the law of demand does not hold good here.

3. Conspicuous Necessities:
Certain things become the necessities of modern life. So we have to purchase them despite their
high price. The demand for T.V. sets, automobiles and refrigerators etc. has not gone down in
spite of the increase in their price. These things have become the symbol of status. So they are

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purchased despite their rising price.

4. Ignorance:
A consumer’s ignorance is another factor that at times induces him to purchase more of the
commodity at a higher price. This is especially true, when the consumer believes that a high- priced
and branded commodity is better in quality than a low-priced one.

5. Emergencies:

During emergencies like war, famine etc., households behave in an abnormal way. Households
accentuate scarcities and induce further price rise by making increased purchases even at higher
prices because of the apprehension that they may not be available. On the other hand, during
depression, fall in prices is not a sufficient condition for consumers to demand more if they are
needed.

6. Future Changes in Prices:

Households also act as speculators. When the prices are rising households tend to purchase large
quantities of the commodity out of the apprehension that prices may still go up. When prices are
expected to fall further, they wait to buy goods in future at still lower prices. So quantitydemanded
falls when prices are falling.

7. Change in Fashion:
A change in fashion and tastes affects the market for a commodity. When a digital camera replaces
a normal manual camera, no amount of reduction in the price of the latter is sufficient to clear the
stocks. Digital cameras on the other hand, will have more customers even though its price may be
going up. The law of demand becomes ineffective.

8. Demonstration Effect:

It refers to a tendency of low income groups to imitate the consumption pattern of high income
groups. They will buy a commodity to imitate the consumption of their neighbors even if they do
not have the purchasing power.

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9. Snob Effect:

Some buyers have a desire to own unusual or unique products to show that they are different
from others. In this situation even when the price rises the demand for the commodity will be
more.

10. Speculative Goods/ Outdated Goods/ Seasonal Goods:

Speculative goods such as shares do not follow the law of demand. Whenever the prices rise, the
traders expect the prices to rise further so they buy more. Goods that go out of use due to
advancement in the underlying technology are called outdated goods. The demand for such goods
does not rise even with fall in prices

11. Seasonal Goods:

Goods which are not used during the off-season (seasonal goods) will also be subject to similar
demand behaviour.

12. Goods in Short Supply:

Goods that are available in limited quantity or whose future availability is uncertain also violate the
law of demand.

Movement along a Demand Curve and Shifts in the Demand Curve

1. Change in Quantity Demanded — Movement along a Demand Curve:

Extension and Contraction of Demand- The quantity demanded of a product does not remain constant,
but keeps on changing due to various factors. If the quantity demanded changes due to change in price
only, it is called expansion and contraction of demand. If price decreases, it results in expansion of demand
and if price increases it results in contraction of demand. This situation is shown by movement along the
same demand curve.

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In the above figure, it is expansion and contraction of demand. At price OP, quantity demanded is OQ. If
price reduces to OP1, the quantity demanded rises to OQ1. This increase of quantity demanded would be
called expansion of demand. If, however, price increases from OP to OP2, then quantity demanded falls
which would be called contraction of demand.

2. Change in Demand— Shifts in the Demand Curve:

Increase and Decrease of Demand:

If the change in quantity demanded of a product takes place due to any factor, other than price of the
product, then it is called increase or decrease of demand. This phenomenon is shown by a shift in the
entire demand curve. For example- if the income of the consumer rises then his entire demand curve shifts
to right which shows that consumer’s demand for the product has increased for every given price.

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In the above figure it is shown that if demand increases due to increase in income then demand curve
shifts to right from DD to D1D1. If, however, the demand decreases due to fall in income then the demand
curve shifts to left from DD to D2D2.

ELASTICITY OF DEMAND

The law of demand says that consumers will respond to decrease or increase in prices of goods and
services. (other things remaining constant), but law of demand explains only the concept of change in
prices of goods and services effects its demand, but does not explain to what extent demand changes if
prices of goods increase or decrease.

Elasticity of demand is a concept of showing the responsiveness of demand. As we well-known earlier,

changes in demand can be caused by several factors which determine demand for a good or commodity.
Elasticity of demand measures how much the quantity demanded changes with a given change in a
particular determent of demand (i.e. price of the item, change in consumers’ income, or change in price
of related product and advertisement etc.).

According to Alfred Marshall: "Elasticity of demand may be defined as the percentage change in quantity
demanded to the percentage change in price."

According to A.K. Cairncross : "The elasticity of demand for a commodity is the rate at which quantity
bought changes as the price changes."

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According to J.M. Keynes : "The elasticity of demand is a measure of the relative change in quantity to a
relative change in price."

According to Kenneth Boulding : "Elasticity of demand measures the responsiveness of demand to

changes in price."

The degree of responsiveness or sensitivity of consumers to a change in price is measured by the concept
of price elasticity of demand. If a small change in price is accompanied by a large change in quantity
demanded, the product is said to be elastic (or responsive to price changes). The opposite also applies; a
product is inelastic if a large change in price is accompanied by a small amount of change in demand.

1. PRICE ELASTICITY OF DEMAND

A measure of the extent to which the quantity demanded of a good change when the price of the good
changes. To determine the price elasticity of demand, we compare the percentage change in the
quantity demanded with the percentage change in price.

Ep = % change in Qty. dd.

% change in its price
Ep = Δ Q ΔP
Q P
Where, % change in Quantity Demanded=Q1-Q0/Q0 * 100

Q1 = Quantity Demanded after the change in the price

Q0 = Quantity Demanded before the change in the price

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% change in the Price of the product = P1-P0/P0 * 100

P1= Current Price. P0= Previous Price

DEGREES OF PRICE ELASTICITY

Different commodities have different price elasticities. Some commodities have more elastic demand
while others have relative elastic demand. Basically, the price elasticity of demand ranges from zero to
infinity. It can be equal to zero, less than one, greater than one and equal to unity.

Types of Price Elasticity of Demand:

1. Relatively elastic demand.

2. Relatively inelastic demand.

3. Unitary inelastic demand

4. Perfectly elastic demand.

5. Perfectly inelastic demand.

1. RELATIVELY ELASTIC DEMAND

An elastic demand is one in which the change in quantity demanded due to a change in price is large. If
the price elasticity of demand for a good is greater than one (Ed >1), the demand is price elastic. Example-
Luxury goods, like TVs and designer brands.

When the percentage change in quantity demanded is greater than the percentage change in price, the
demand is said to be elastic. In other words, relatively small changes in price cause relatively large changes
in quantity.

Observe the graph, price of the goods increased from P1 to P2 and eventually the demand for the goods
decreases from Q1 to Q2. But the proportionate change in price is less than the proportionate change in
demand.

For example, if a 40% increase in demand is the outcome of 20% fall in price then,

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EP = 40 / 20 = 2

Example: - There are commodities for which a small change in price will drastically reduce the amount
of the commodity demanded. For example, air-travel for vacationers is very sensitive to price. An increase
in the air fare will lead the vacationer to choose another mode of transportation like car or lead him to
postpone the vacation plan for the time being. Thus for a rise in airlines fare for the vacationers we would
see a relatively more drastic reduction in demand towards air travel and hence its the situation of high
price elasticity of demand.

2. RELATIVELY INELASTIC DEMAND

Relatively inelastic demand is one when the percentage change produced in demand is less than the
percentage change in the price of a product. Example- essential goods. For example, if the price of a
product increases by 30% and the demand for the product decreases only by 10%, then the demand would
be called relatively inelastic. The numerical value of relatively elastic demand ranges between zero to one
(ep<1).

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Example: if we observe the prices of petrol and comparing its demand change with the change in its price
levels (even though the price changes to great extent, there will not be much change in demand for the
petrol in the present environment conditions)

3. UNIT ELASTIC DEMAND

If price elasticity of demand for a good is equal to one (Ed =1), the demand is unit price elastic which
means that a change in the price will lead to the same percentage/proportionate change in the quantity
demanded. Demand is unitarily elastic as shown in Figure 3. For example, a 10% quantity change divided
by a 10% price change is one. This means that a 1% change in quantity occurs for every 1% change in
price.

Observe the graph below, price of the goods increased from P1 to P2 in certain proportion then the demand
for the goods decreases from Q1 to Q2 in same proportion to the price change. Therefore, the proportionate
change in price of goods and services is equal the proportionate change of demand for goods and services
in case of the unitary elastic demand.

4. PERFECTLY ELASTIC DEMAND

Perfectly elastic demand means when the percentage of change in quantity demanded is infinite even if
the percentage of change in price is zero, the demand is said to be perfectly elastic. Increasing of demand
at given price. According to law of demand, the demand for goods and services changes when there is
change in its price. But the relationship between demand and price may not be the equal and same in all

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the case, it may vary from product to product or time to time or market to conditions. So as to understand
extent of the effect of price on the demand, one should know about the price elasticity of demand concepts.

To make easy to understand the concept of perfectly elastic demand, it is showed in the graphical
presentation in the below diagram.

Here in case of perfectly elastic demand, the demand for the goods and services is at Q1 when the price is
at P1. Further the demand for goods and services increased from Q1 to Q2 without change in the price i.e
at P1 and the demand curve is extending likewise. In fact, the quantity demand should not be changed or
increased without change or decrease in price according to the law of demand, but in case of some markets
like, Automobiles and other essential services, its demand will be perfectly elastic when price remains
unchanged.

As such, this is an extreme case of elasticity which is very rarely to be found in practice but is of great
theoretical importance. In terms of our formula, a 5% increase in demand with no fall in price will give
us the equation:

EP = 5 / 0 = infinity elasticity of demand

In view of the pandemic and contagion of COVID’19, most of the people opted for personal transportation
for safety reasons instead of public transportation to commute. Consequently, the demand for the personal

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transport vehicles like bikes and cars has increased though there was no change in the price of personal
transportation vehicles in the market. Subsequently the demand for the Petrol and diesel also increased

5. PERFECTLY INELASTIC DEMAND

Perfectly inelastic demand is the situation where there no change in quantity demanded even there is
change in price of the goods, the demand is said to be perfectly inelastic. Simply mean no change in
demand for change in price. In accordance to the law of demand, the demand for goods and services
changes when there is change in its price. But the relationship between demand and price may not be the
equal in all the market conditions, it may be different from product to product or time to time or market
to conditions. So as to understand extent of the effect of price on the demand, one should know about the
price elasticity of demand concepts.

To make easy to understand the concept of perfectly inelastic demand, it is presented in the graphical
presentation in the below diagram.

See the graph, price of the goods changing or raises from P1 to P2 and P3 but there is no change in demand
at Q.

An example of perfectly inelastic demand would be a lifesaving drug that people will pay any price to
obtain. Even if the price of the drug would increase dramatically, the quantity demanded would remain
unchanged. Suppose, the price of a commodity changes by 50% but change in demand for said commodity
is zero, then 0

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EP = 0 / 50 = 0

Example: Emergency services, drugs and essential food item have perfectly inelastic demand. The price
of food item may increase or decrease; there will be no change in the demand for such goods and services

INCOME ELASTICITY OF DEMAND

The income elasticity of demand is the percentage change in quantity demanded divided by the
percentage change in income.

Income elasticity of demand= %change in quantity demanded

%change in income

For most products most of the time, the income elasticity of demand is positive. In other words, a rise in
income will cause an increase in the quantity demanded. This pattern is common enough that these goods
are referred to as normal goods.

However, for a few goods, an increase in income might mean that a person will purchase less of the good;
for example, those with a higher income might buy fewer hamburgers because they are buying more steak
instead. Those with a higher income might buy less cheap wine and more imported beer. When the income
elasticity of demand is negative, the good is called an inferior good.

A higher level of income for a normal good causes the demand curve to shift to the right, which means
that the income elasticity of demand is positive. How far the demand shifts depend on the income elasticity
of demand. A higher income elasticity means a larger shift.

For an inferior good, however, a higher level of income would cause the demand curve for that good to
shift to the left. Again, how much it shifts depends on how large the negative income elasticity is.

CROSS-PRICE ELASTICITY OF DEMAND

A change in the price of one good can shift the quantity demanded for another good. If the two goods are
complements, like bread and peanut butter, then a drop in the price of one good will lead to an increase in

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the quantity demanded of the other good. However, if the two goods are substitutes, like plane tickets and
train tickets, then a drop in the price of one good will cause people to substitute toward that good, reducing
consumption of the other good. Cheaper plane tickets lead to fewer train tickets and vice versa.

The term cross-price refers to the idea that the price of one good affects the quantity demanded of a
different good. Specifically, the cross-price elasticity of demand is the percentage change in the quantity
of good A that is demanded as a result of a percentage change in the price of good B.

Cross elasticity of demand= %change in quantity demanded of A

%change in price of good B

Substitute goods have positive cross-price elasticities of demand. If good A is a substitute for good B—
like coffee and tea—then a higher price for B will mean a greater quantity consumed of A.

Complement goods have negative cross-price elasticities. If good A is a complement for good B—like
coffee and sugar—then a higher price for B will mean a lower quantity consumed of A

Types of Cross Elasticity of Demand:

1. Positive:

When goods are substitute of each other than cross elasticity of demand is positive. In other words, when
an increase in the price of Y leads to an increase in the demand of X. For instance, with the increase in
price of tea, demand of coffee will increase.

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2. Negative:

In case of complementary goods, cross elasticity of demand is negative. A proportionate increase in price
of one commodity leads to a proportionate fall in the demand of another commodity because both are
demanded jointly.

3. Zero:

Cross elasticity of demand is zero when two goods are not related to each other. For instance, increase in
price of car does not affect the demand of cloth. Thus, cross elasticity of demand is zero.

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Measurement of Cross Elasticity of Demand:

Ec of Substitutes

Ec of complementary goods

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ADVERTISEMENT OR PROMOTIONAL ELASTICITY

Advertising Elasticity of Demand (AED) is a measure of effectiveness of increase in expenditure of

advertising in increasing demand of a product. AED is always positive, meaning that the demand always
increases with increase in advertising expenditure. Whereas values of this ratio below 1 mean that the
increase in demand is less than the increase in advertising expenditure, while values greater than 1 indicate
that the rise in demand is more than the rise in expenditure.

While this is a good way to estimate expected rise in advertising costs for growth in demand or the
expected growth with rise in expense toward advertising, this is not the most accurate way. This ratio
assumes that several other factors that may affect demand are constant, which cannot be the case in real
life.

This ratio can lie between 0 and ∞ (infinity).

Advertising Elasticity of Demand Factors

The demand of a certain good/service depends on, apart from expense on advertising, the following to
name a few factors:

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1. Income of the people of the region (state of economy): Expensive advertising may not yield very good
results if the region has been recently hit by an economic crisis where people have been laid off on a large
scale and are struggling to make ends meet; or in a region with generally low income.

2. Price of the product: No matter how much money is put in the advertising, if a similar product is in the
market for a lower price that may take away from the success of the advertising.

3. Quality/Appeal of the ad: High expense doesn’t always mean high quality in terms of audio-visual or
content. Or the ad just may lack appeal for the demographic the product is for.

All these factors can alter the demand of the product, and hence the AED. Thus, AED may not be the most
accurate measure of effectiveness of increase in advertising expenditure.

Examples of Advertising elasticity of demand

Let us take an example of Pizza chain. If the pizza outlet spends money on promotion of an existing variant
of Pizza, then the demand of that Pizza can increase and stay at that level even after the promotions are
over.

On the other hand, the impact of an offer regarding a discount offer at a pizza outlet may be drastically
high but the same may not be true for an offer at a jewellery store.

Measurement of price Elasticity of demand

Methods of estimation of Price Elasticity of demand:

1. Percentage or Ratio Method
2. Total Revenue Method
3. Point Method

Percentage method:

Percentage method is one of the commonly used approaches of measuring price elasticity of demand under
which price elasticity is measured in terms of rate of percentage change in quantity demanded to
percentage change in price.

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The price elasticity of demand is measured by its coefficient Ep. This coefficient Ep measures the
percentage change in the quantity of a commodity demanded resulting from a given percentage change in
its price: Thus

Where q refers to quantity demanded, p to price and ∆ to change. If Ep> 1, demand is elastic. If Ep < 1,
demand is inelastic, it Ep = 1 demand is unitary elastic.

(i) Suppose the price of commodity X falls from Rs. 5 per kg. toRs. 3 per kg. and its quantity demanded
rises from 10 kgs. to 30 kgs. Then

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

(ii) Let us measure elasticity by moving in the reverse direction. Suppose the price of X rises from Rs. 3
per kg. toRs. 5 per kg. and the quantity demanded falls from 30 kgs. to 10 kgs. Then

This shows unitary elasticity of demand.

(iii) Suppose the price of commodity X falls from Rs. 3 per kg. to Re. 1 per kg. and its quantity demanded
increases from 30 kgs. to 50 kgs. Then

This is again unitary elasticity.

(iv) Take the reverse order when the price rises from Re. 1 per kg. toRs. 3 per kg. and the quantity
demanded decreases from 50 kgs. to 30 kgs. Then

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This shows inelastic demand or less than unitary.

The Total Outlay /Total Revenue Method:

Marshall evolved the total outlay, total revenue or total expenditure method as a measure of elasticity. By
comparing the total revenue earned by a firm both before and after the change in price, it can be known
whether his demand for a good is elastic, unity or less elastic. Total revenue is price multiplied by the
quantity of a good purchased: Total Revenue = Price x Quantity Demanded.

There are three outcomes:

Elasticity of demand will be greater than unity (Ep > 1)

When total revenue increases with fall in price and decreases with rise in price, the value of PED will be
greater than 1. Here, rise in price and total revenue move in opposite direction.

Elasticity of demand will be equal to unity (Ep = 1)

When total revenue on commodity remains unchanged in response to change in price of the commodity,
the value of PED will be equal to 1.

Elasticity of demand will be less than unity (Ep < 1)

When total revenue decreases with fall in price and increases with rise in price, the value of PED will be
less than 1. Here, price of commodity and total revenue move in same direction.

Price ТR Ep

Falls Rises >> 1

Rises Falls

Falls Unchanged =1

Rises Unchanged

Falls Falls

Rises Rises << 1

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Point Method

The point method of measuring price elasticity of demand was also devised by Prof. Alfred Marshall. This
method is used to measure the price elasticity of demand at any given point in the curve.

According to this method, elasticity of demand will be different on each point of a demand curve. Thus,
this method is applied when there is small change in price and quantity demanded of the commodity.

According to this method, price elasticity of demand (PED) is mathematically expressed as

With the help of the point method, it is easy to point out the elasticity at any point along a demand curve.
Suppose that the straight line demand curve DC in Figure below is 6 cms. Five points L, M, N, P and Q
are taken oh this demand curve. The elasticity of demand at each point can be known with the help of the
above method. Let point N be in the middle of the demand curve.

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The Arc Method:

We have studied the measurement of elasticity at a point on a demand curve. But when elasticity is
measured between two points on the same demand curve, it is known as arc elasticity. In the words of
Prof.Baumol, “Arc elasticity is a measure of the average responsiveness to price change exhibited by a
demand curve over some finite stretch of the curve.”

Any two points on a demand curve make an arc. The area between P and M on the DD curve in Figure
11.4 is an arc which measures elasticity over a certain range of price and quantities. On any two points of
a demand curve the elasticity coefficients are likely to be different depending upon the method of
computation. Consider the price-quantity combinations P and M as given in the Table below

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Table 11.2: Demand Schedule:

Point Price (Rs.) Quantity (Kg)

P 8 10

M 6 12

If we move from P to M, the elasticity of demand is:

If we move in the reverse direction from M to P, then

Thus, the point method of measuring elasticity at two points on a demand curve gives different elasticity
coefficients because we used a different base in computing the percentage change in each case.

To avoid this discrepancy, elasticity for the arc (PM in Figure 11.4) is calculated by taking the average of
the two prices [(p1, + p2 1/2] and the average of the two quantities [(p1, + q2) 1/2]. The formula for price
elasticity of demand at the mid-point (C in Figure 11.4) of the arc on the demand curve is

On the basis of this formula, we can measure arc elasticity of demand when there is a movement either
from point P to M or from M to P.

From P to M at P, p1 = 8, q1, =10, and at M, P2 = 6, q2 = 12

Applying these values, we get

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Thus, whether we move from M to P or P to M on the arc PM of the DD curve, the formula for arc elasticity
of demand gives the same numerical value. The closer the two points P and M are, the more accurate is
the measure of elasticity on the basis of this formula. If the two points which form the arc on the demand
curve are so close that they almost merge into each other, the numerical value of arc elasticity equals the
numerical value of point elasticity.

DEMAND FORECASTING- MEANING, TYPES AND MEASUREMENT

Meaning:

A forecast is a prediction or estimation of future situation. In Demand forecasting mangers forecast the most
likely future demand of a product so that he can make necessary arrangement for the various factor of production
i.e labor, raw material, machines, money etc. Demand forecasting tells the expected level of demand at some future
date on the basis of past and present information. It helped in production planning, new product development,
capacity enhancement or new schemes etc. Demand forecasting is generally used for short term estimation as well
as long term forecasting.

Demand Forecasting is a systematic and scientific estimation of future demand for a product. Simply,
estimating the sales proceeds or demand for a product in the future is called as demand forecasting.

Features of Demand Forecasting

The main features of the demand forecasting are; Pi EE UTH

 Demand Forecasting is a process to investigate and measure the forces that determine sales for existing and
new products.

 It is an estimation of most likely future demand for a product under given business conditions. o It is
basically an educated and well thought out guesswork in terms of specific quantities

 Demand Forecasting is done in an uncertain business environment.

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 Demand Forecasting is done for a specific period of time (i.e. the sufficient time required to take a decision
and put it into action).

 It is based on historical and present information and data. o It tells us only the approximate expected future
demand for a product based on certain assumptions and cannot be 100% precise.

Types of Forecasting:

(i) Passive Forecast and

(ii) Active Forecast.

Under passive forecast prediction about future is based on the assumption that the firm does not change
the course of its action. Under active forecast, prediction is done under the condition of likely future
changes in the actions by the firms.

(i) Short term demand forecasting

(ii) long term demand forecasting.

In a short run forecast, seasonal patterns are of much importance. It may cover a period of three months,
six months or one year. It is one which provides information for tactical decisions.

Which period is chosen depends upon the nature of business. Such a forecast helps in preparing suitable
sales policy. Long term forecasts are helpful in suitable capital planning. It is one which provides
information for major strategic decisions. It helps in saving the wastages in material, man hours, machine
time and capacity. Planning of a new unit must start with an analysis of the long term demand potential
of the products of the firm.

(i) Macro-level forecasting,

(ii) Industry- level forecasting,

(iii) Firm- level forecasting and

(iv) Product-line forecasting.

Macro-level forecasting is concerned with business conditions over the whole economy. It is measured by
an appropriate index of industrial production, national income or expenditure. Industry-level forecasting
is prepared by different trade associations.

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This is based on survey of consumers’ intention and analysis of statistical trends. Firm-level forecasting
is related to an individual firm. It is most important from managerial view point. Product-line forecasting
helps the firm to decide which of the product or products should have priority in the allocation of firm’s
limited resources.

Forecasting Techniques:

1. Opinion Polling Method:

In this method, the opinion of the buyers, sales force and experts could be gathered to determine the
emerging trend in the market.

The opinion polling methods of demand forecasting are of three kinds:

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(a) Consumer’s Survey Method or Survey of Buyer’s Intentions:

In this method, the consumers are directly approached to disclose their future purchase plans. I his is done
by interviewing all consumers or a selected group of consumers out of the relevant population. This is the
direct method of estimating demand in the short run. Here the burden of forecasting is shifted to the buyer.
The firm may go in for complete enumeration or for sample surveys. If the commodity under consideration
is an intermediate product, then the industries using it as an end product are surveyed.

(i) Complete Enumeration Survey:

Under the Complete Enumeration Survey, the firm has to go for a door to door survey for the
forecast period by contacting all the households in the area. This method has an advantage of first
hand, unbiased information, yet it has its share of disadvantages also. The major limitation of this
method is that it requires lot of resources, manpower and time.

In this method, consumers may be reluctant to reveal their purchase plans due to personal privacy
or commercial secrecy. Moreover, at times the consumers may not express their opinion properly
or may deliberately misguide the investigators.

(ii) Sample Survey and Test Marketing:

Under this method some representative households are selected on random basis as samples and
their opinion is taken as the generalised opinion. This method is based on the basic assumption
that the sample truly represents the population. If the sample is the true representative, there is
likely to be no significant difference in the results obtained by the survey. Apart from that, this
method is less tedious and less costly.

A variant of sample survey technique is test marketing. Product testing essentially involves placing
the product with a number of users for a set period. Their reactions to the product are noted after
a period of time and an estimate of likely demand is made from the result. These are suitable for
new products or for radically modified old products for which no prior data exists. It is a more
scientific method of estimating likely demand because it stimulates a national launch in a closely
defined geographical area.

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(iii) End Use Method or Input-Output Method:

This method is quite useful for industries which are mainly producer’s goods. In this method, the
sale of the product under consideration is projected as the basis of demand survey of the industries
using this product as an intermediate product, that is, the demand for the final product is the end
user demand of the intermediate product used in the production of this final product.

The end user demand estimation of an intermediate product may involve many final good
industries using this product at home and abroad. It helps us to understand inter-industry’ relations.
In input-output accounting two matrices used are the transaction matrix and the input co-efficient
matrix. The major efforts required by this type are not in its operation but in the collection and
presentation of data.

(b) Sales Force Opinion Method:

This is also known as collective opinion method. In this method, instead of consumers, the opinion of the
salesmen is sought. It is sometimes referred as the “grass roots approach” as it is a bottom-up method that
requires each sales person in the company to make an individual forecast for his or her particular sales
territory.

These individual forecasts are discussed and agreed with the sales manager. The composite of all forecasts
then constitutes the sales forecast for the organisation. The advantages of this method are that it is easy
and cheap. It does not involve any elaborate statistical treatment. The main merit of this method lies in the
collective wisdom of salesmen. This method is more useful in forecasting sales of new products.

(c) Experts Opinion Method:

This method is also known as “Delphi Technique” of investigation. The Delphi method requires a panel
of experts, who are interrogated through a sequence of questionnaires in which the responses to one
questionnaire are used to produce the next questionnaire. Thus any information available to some experts
and not to others is passed on, enabling all the experts to have access to all the information for forecasting.

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The method is used for long term forecasting to estimate potential sales for new products. This method
presumes two conditions: Firstly, the panelists must be rich in their expertise, possess wide range of
knowledge and experience. Secondly, its conductors are objective in their job. This method has some
exclusive advantages of saving time and other resources.

2. Statistical Method:

Statistical methods have proved to be immensely useful in demand forecasting. In order to maintain
objectivity, that is, by consideration of all implications and viewing the problem from an external point of
view, the statistical methods are used.

The important statistical methods are:

(i) Trend Projection Method:

A firm existing for a long time will have its own data regarding sales for past years. Such data when
arranged chronologically yield what is referred to as ‘time series’. Time series shows the past sales with
effective demand for a particular product under normal conditions. Such data can be given in a tabular or
graphic form for further analysis. This is the most popular method among business firms, partly because
it is simple and inexpensive and partly because time series data often exhibit a persistent growth trend.

Time series has got four types of components namely, Secular Trend (T), Secular Variation (S), Cyclical
Element (C), and an Irregular or Random Variation (I). These elements are expressed by the equation O
= TSCI. Secular trend refers to the long run changes that occur as a result of general tendency.

Seasonal variations refer to changes in the short run weather pattern or social habits. Cyclical variations
refer to the changes that occur in industry during depression and boom. Random variation refers to the
factors which are generally able such as wars, strikes, flood, famine and so on.

When a forecast is made the seasonal, cyclical and random variations are removed from the observed data.
Thus only the secular trend is left. This trend is then projected. Trend projection fits a trend line to a
mathematical equation.

The trend can be estimated by using any one of the following methods:

(a) The Graphical Method,

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(b) The Least Square Method.

(a) Graphical Method:

This is the simplest technique to determine the trend. All values of output or sale for different years are
plotted on a graph and a smooth free hand curve is drawn passing through as many points as possible. The
direction of this free hand curve—upward or downward— shows the trend.

(b) Least Square Method:

Under the least square method, a trend line can be fitted to the time series data with the help of statistical
techniques such as least square regression. When the trend in sales over time is given by straight line, the
equation of this line is of the form: y = a + bx. Where ‘a’ is the intercept and ‘b’ shows the impact of the
independent variable. We have two variables—the independent variable x and the dependent variable y.
The line of best fit establishes a kind of mathematical relationship between the two variables .v and y.
This is expressed by the regression у on x.

In order to solve the equation Y = a + bx, we have to make use of the following normal equations:

Σ y = na + b ΣX

Σ xy =a Σ x+b Σ x2

(ii) Barometric Technique:

A barometer is an instrument of measuring change. This method is based on the notion that “the future
can be predicted from certain happenings in the present.” In other words, barometric techniques are based
on the idea that certain events of the present can be used to predict the directions of change in the future.
This is accomplished by the use of economic and statistical indicators which serve as barometers of
economic change.

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(iii) Regression Analysis:

It attempts to assess the relationship between at least two variables (one or more independent and one
dependent), the purpose being to predict the value of the dependent variable from the specific value of the
independent variable. The basis of this prediction generally is historical data. This method starts from the
assumption that a basic relationship exists between two variables.

(iv) Econometric Models:

Econometric models are an extension of the regression technique whereby a system of independent
regression equation is solved. The requirement for satisfactory use of the econometric model in forecasting
is under three heads: variables, equations and data.

The appropriate procedure in forecasting by econometric methods is model building. Econometrics

attempts to express economic theories in mathematical terms in such a way that they can be verified by
statistical methods and to measure the impact of one economic variable upon another so as to be able to
predict future events.

SUPPLY- MEANING, DETERMINANTS AND LAW OF SUPPLY

Supply: Supply refers to the amount of a good or service that the producers/providers are willing and able
to offer to the market at various prices during a period of time. Supply is the quantity of a good which is
offered for sale at a given price at a particular time.

Determinants of Supply:
PRITFG
Supply of a commodity depends not only on the price of that commodity but also on other factors.

1. Price of a product

Firstly, the most important factor that influences the supply of a commodity is its own price. And the
relationship between supply and own price is a direct one.

2. Prices of Related Goods

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Secondly, supply of any commodity largely depends not only on own price of the commodity but also on
the prices of its substitute and complementary goods.

If market price of wheat rises, the jute farmers would be interested in wheat production so that in the next
season they can increase the supply of wheat. On the other hand, in the case of a joint product, a rise in
the market price of mutton will increase the quantity of leather supplied.

3. Prices of Inputs

Price of inputs is also an important determinant of supply. If the price of an input (say, wage bill) rises,
the cost of production will surely increase. Consequently, profit will tend to decline. Seeing an
unprofitable situation, a firm will reduce the supply of a commodity and will try to switchover to the
production of another commodity which is still not unprofitable.

4. Technology

Fifthly, the state of art or the technology has an important bearing on the supply of a commodity. As newer
and modern technologies are employed in a concern, production and productivity rise and average costs
of production tend to decline. This result in a change in quantity supplied.

5. Firm’s Objectives

Sixthly, the nature of a firm’s objectives also affects the supply decisions. Firms can have different goals.
Usually, profit-maximization is the most fundamental objective of a firm. Modern business firms aim at
maximization of sales revenue rather than profit.

6. Government Policy

Finally, by imposing taxes on firms, the government can affect the supply of a commodity. The
government may ask business firms to pay taxes for polluting the atmosphere or for meeting government
services on education, health, etc. As these taxes increase costs, firms reduce supplies. Similarly, subsidies
may be given to firms so that they can produce goods needed by the society.

Law of supply

Statement: ‘Higher the price higher will be the supply and lower the price lower will be the supply
keeping other factors constant’

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Law of supply depicts the producer behaviour at the time of changes in the prices of goods and services.
When the price of a good rises, the supplier increases the supply in order to earn a profit because of higher
prices.

Assumptions:
All the factors, other than the price of a product, determining supply of that product are assumed to be
unchanged.

Supply schedule and supply curve

 A supply schedule is a table that shows the quantity supplied at each price.

 A supply curve is a graph that shows the quantity supplied at each price. Sometimes the supply
curve is called a supply schedule because it is a graphical representation of the supply schedule.

Here's an example of a supply schedule from the market for gasoline:

Price (per gallon) Quantity supplied (millions of

gallons)

$1.00 500

$1.20 550

$1.40 600

$1.60 640

$1.80 680

$2.00 700

$2.20 720

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Price is measured in dollars per gallon of gasoline, and quantity supplied is measured in millions of
gallons.

Here's the same information shown as a supply curve with quantity on the horizontal axis and the price
per gallon on the vertical axis. Note that this is an exception to the normal rule in mathematics that the
independent variable goes on the horizontal axis and the dependent variable goes on the vertical.

A supply curve for gasoline

The graph shows an upward-sloping supply curve that represents the law of supply.

The supply curve is created by graphing the points from the supply schedule and then connecting them.
The upward slope of the supply curve illustrates the law of supply—that a higher price leads to a higher
quantity supplied, and vice versa.

The shape of supply curves will vary somewhat according to the product: steeper, flatter, straighter, or
more curved. Nearly all supply curves, however, share a basic similarity: they slope up from left to right
and illustrate the law of supply. As the price increases, say, from $1.00 per gallon to $2.20 per gallon, the
quantity supplied increases from 500 million gallons to 720 million gallons. Conversely, as the price
decreases, the quantity supplied decreases.

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MARKET EQUILIBRIUM:

Equilibrium is achieved at the price at which quantities demanded and supplied are equal. We can
represent a market in equilibrium in a graph by showing the combined price and quantity at which the
supply and demand curves intersect.

DD = SS

Market equilibrium is a market state where the supply in the market is equal to the demand in the market.
The equilibrium price is the price of a good or service when the supply of it is equal to the demand for it
in the market. If a market is at equilibrium, the price will not change unless an external factor changes the
supply or demand, which results in a disruption of the equilibrium.

Supply, Demand & Equilibrium

If a market is not at equilibrium, market forces tend to move it to equilibrium. Let's break this concept
down.

If the market price is above the equilibrium value, there is an excess supply in the market (a surplus),
which means there is more supply than demand. In this situation, sellers will tend to reduce the price of
their good or service to clear their inventories. They probably will also slow down their production or stop
ordering new inventory. The lower price entices more people to buy, which will reduce the supply further.
This process will result in demand increasing and supply decreasing until the market price equals the
equilibrium price.

If the market price is below the equilibrium value, then there is excess in demand (supply shortage). In
this case, buyers will bid up the price of the good or service in order to obtain the good or service in short
supply. As the price goes up, some buyers will quit trying because they don't want to, or can't, pay the

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higher price. Additionally, sellers, more than happy to see the demand, will start to supply more of it.
Eventually, the upward pressure on price and supply will stabilize at market equilibrium.

If we know the demand and supply in a particular market, we can easily find the market equilibrium by
looking for the price at which the quantity demanded is equal to the quantity supplied. For example,
suppose that in the market for pencils the market demand is given by the linear demand function qD = 10
- p and the market supply is equal to qS = 2p - 2. In equilibrium the number of pencils that the sellers want
to sell has to be equal to the number of pencils that the buyers want to buy, i.e., quantity supplied has to
be equal to the quantity demanded, qD = qS. For the demand and supply function of our example this means

10 - p = 2p - 2.

Now we only have to solve p to find the equilibrium price which is equal to p* = 4. To find the
corresponding quantity, we plug the equilibrium price p* back into the supply or the demand function and
obtain q* = 6. Thus, in our market for pencils the equilibrium price is equal to 4, and at this price the
quantity exchanged is equal to 6 units.

This result is also shown in the graph below. The market equilibrium in a perfectly competitive market
corresponds to the point of intersection of the supply curve and the demand curve. On the x-axis we have
the quantity q of the good or service (in our case pencils) and on the y-axis the price p of the good. The
green line represents the demand curve and shows the quantity demanded at each price (for the graph
below the demand function is the same as in the example qD = 10 - p). The blue line represents the supply
curve (also taken from the example above qS = 2p - 2) and shows the quantity supplied at each price. At
the equilibrium price p* = 4, the quantity demanded is equal to the quantity supplied (qD = qS = q* = 6).

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MODULE 2: THEORY OF PRODUCTION AND COST & REVENUE

ANALYSIS

Production

Production is the process by which factor inputs are transformed into output. An increase in the quantity
of factor inputs will lead to an increase in output. The theory of production is the study of how the output
level changes as the quantity of factor inputs changes. To increase output, firms need to employ more
factor inputs which will lead to an increase in costs. The theory of costs is the study of how the cost of
production changes as the output level changes. When a firm expands its scale of production, its average
cost will usually fall and this phenomenon is called internal economies of scale, or simply known as
economies of scale. However, when the scale of production of a firm reaches a certain size, a further
expansion may lead to a rise in its average cost and this phenomenon is called internal diseconomies of
scale, or simply known as diseconomies of scale. A firm may experience a fall or rise in its average cost
when the industry expands, even though its scale of production remains unchanged, and these phenomena
are called external economies of scale and external diseconomies of scale respectively.

Factors of Production:

Factors of production are defined as inputs used or required to produce the desired output. There are four
basic factors of production namely, land, labour, capital and entrepreneurship. Land is not merely a plot
of land or area but it is anything which is gift of nature and not the result of human effort, e.g. soil, water,
forests, minerals. The owner of land is called landlord and the reward received for the use of land is rent.
Labour on the other hand is the physical or mental effort of human beings that undertakes the production
process. Labour is supplied by the workers who put in their efforts in the production process. Labour can
be skilled as well as unskilled, physical or intellectual. The reward or price of labour is termed as wages
or salary. The third basic factor, capital is the wealth which used for production such as machine,
equipment, intermediary good, etc. It is the outcome of human efforts thus; capital is man-made. The
reward of capital is interest. Enterprise also termed as Entrepreneurship or Organization is the ability and
action to take risk of collecting, coordinating, and utilizing all the factors of production for the purpose of

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uncertain economic gains. Owner of enterprise is entrepreneur and the reward of entrepreneurship is profit.

Types of Factors of Production-Function:

The factors of production can be classified as Fixed Factors and Variable Factors depending upon their
variability. Fixed Factors are the factor inputs which cannot be varied in the short-period, as and when
required. That is the quantity of fixed factors of production remains constant throughout the production
process. For example, plant, machinery, heavy equipment, factory building, land etc. Variable Factors on
the other hand are those factor inputs which can easily be varied, in the short-period as and when required
for example, labour, raw material, power, fuel etc.

The distinction between fixed factors and variable factors appears only in the short-period. In the long-
run, all the factors of production become variable factors.

Production-Function
The production function expresses a functional relationship between physical inputs and physical outputs
of a firm at any particular time period, given state of technology. The output is thus a function of inputs.

Mathematically production function can be written as:

qx = f (F1, F2, F3 ………. Fn)

Here, qx is the quantity of x commodity; F1, F2, F3 ………. Fn are the different factor-inputs. According to

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the equation, the output of x depends on the factors F1, F2, F3 ………. Fn, etc. Thus, a functional
relationship between factor inputs and the amount of goods x exists. Hence, output becomes the dependent
variable and inputs are the independent variables.

Considering then basic factors of production, production function may be written as:

Q = f (Ld, L, K, E…...)

Where,

Q = output (total product)

Ld = Land

L = Labour

K = Capital

E = Entrepreneurship

For better understanding of the concept, a simpler version of the production function is considered taking
two input factors for producing one output. These input factors are labour and capital since they are the
most important variables. Thus,

Q = f (L, K)

Different combinations of labour and capital will produce different quantities of output. Logically, more
units of input factors will produce more quantities of output. Let’s consider, one unit of labour and one
unit of capital produce one unit of output. Then more than one unit of labour and one unit of capital or
more than one unit of both labour and capital will certainly produce more than one unit of output. Taking
the example of a garment manufacturing factory, the following table gives a matrix of cotton t-shirts
produced from different combinations of inputs.

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Table 2.1: Two Input-One Output Production System

K
1 2 3 4 5 6 7 8 9 10
L

1 2 3 5 8 12 18 22 25 28 30

2 3 4 7 10 14 20 25 27 30 31

3 7 8 10 13 17 23 28 31 32 33

4 11 12 14 16 21 27 33 35 36 37

5 16 17 19 21 26 32 36 40 41 43

6 22 24 26 29 34 39 43 46 48 49

7 26 28 31 34 39 44 49 51 53 54

8 29 31 33 38 43 49 53 55 57 58

9 30 32 35 41 47 52 55 58 60 61

10 31 33 37 43 49 53 57 59 61 62

The table illustrates, different combinations of labour and capital are used to produce a given quantity of
t-shirts. For example, 3 units of labour and 5 units of capital combined together produce 17 t-shirts.

This can also be expressed as, a desired quantity of an output can be produced employing different
quantities of labour and capital. Both the inputs are essential for producing the output and can be
substituted for each other.

Importance of Production Function:

1. When inputs are specified in physical units, production function helps to estimate the level of
production.

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2. It equates when different combinations of inputs yield the same level of output.

3. It indicates the manner in which the firm can substitute one input for another without altering the
total output.

4. When price is taken into consideration, the production function helps to select the least cost
combination of inputs for the desired level of output.

5. Production function explains the maximum quantity of output, which can be produced, from any
chosen quantities of various inputs or the minimum quantities of various inputs that are required
to produce a given quantity of output.

Assumptions:
Production function has the following assumptions.

1. It is related to a particular period of time.

2. There is no change in technology.

3. The producer is using the best techniques available.

4. The factors of production are divisible.

5. Production function can be fitted to a short run or to long run.

Types of Production-Function:
Production function is classified on the basis of time period as short run and long run production function.

 Short Period Production Functions:

The time period in which some factors of production are fixed while some factors of production
are variable, is known as short period. During this period, a firm in order to make changes in its
production can bring about change only in its variable factors but not in its fixed factors. In the
short-period, a firm cannot change its scale of plant. It explains the technical relationship between
outputs and inputs in the short run. It is also known as Variable proportions type production
function.

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 Long Period Production Function:

The time period in which all the factors of production are variable is known as long period
production function. It means that all the factors of production can be changed in the long period
and there exists no difference between the fixed and variable factors of production.

Short Run Vs Long Run Production Function:

BASIS OF SHORT PERIOD LONG PERIOD PRODUCTION

DIFFERENCE PRODUCTION FUNCTION FUNCTION

MEANING It explains the technical It explains the technical relationship

relationship between outputs and between inputs and outputs in the long
inputs in the short run. run.

KNOWN AS The short period production The long period production function is
function is also known as variable also known as constant proportions type
proportions type production function production function as in this capital-
as in this the capital- labour ratio labor ratio remains constant and do not
changes. change.

LAW The short run production function The long run production function can
APPLICABLE can be explained with the help of be explained with the help of Law of
Law of returns to factor. Returns to scale.

CURVE The curve of short period The curve of long run production
production function is straight line function is upward sloping curve.
parallel to horizontal axis.

NATURE OF In this, one factor ‘capital’ is fixed In this, both factors are variable.
FACTORS and other factor ‘labour’ is variable.

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Production Function with one Variable Input:

As the quantity of a variable input (labour) increases while all other inputs are fixed, output rises. Initially,
output will rise more and more rapidly, but eventually it will slow down and perhaps even decline. This
is called the Law of Diminishing Marginal Returns. It holds that we will get less and less extra output
when we add additional doses of an input while holding other inputs fixed. It is also known as law of
Variable Proportions.

To understand the laws of production, one needs to know the concept of physical products. These are
Total Physical Product, Average Physical Product and Marginal Physical Product.

Total Product, Marginal Product and Average Product:

 Total Product (TP):

Total Product (TP) refers to the total quantity of goods produced by a firm during a given period
of time with the given number of inputs.

EXAMPLE: If 10 labourers produce 60 kg of rice, then the TP is 60 kg.

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In the short run a firm can expand TP by increasing only the variable factors. However, in the long
run, TP can be raised by increasing both fixed and variable factors. TP is also known as ‘Total
Physical Product (TPP)’ or ‘Total Return’ or ‘Total Output’.

 Average Product (AP)

Average product (AP) refers to output per unit variable input. For example, if TP is 60 kg of rice,
produced by 10 labourers (variable input), then AP will be 60/10 = 6 kg.

AP is obtained by dividing TP by number of units of variable output. AP can be written as,

AP = TP/Units of variable factor (n)

TP

AP = ——–

QL

 Marginal Product (MP):

Marginal Product (MP) refers to the addition to TP, when one more unit variable factor is
employed. MP can be written as,

MPn = TPn – TPn-1

Where,
MPn = MP of nth unit of variable factor
TPn = TP of n units of variable factor
TPn-1 = TP of (n-1) units of variable factor
n = number of units of variable factor

EXAMPLE: If 10 labourers make 60 kg of rice and 11 labourers make 67 kg of rice, then MP of

the 11th labour will be

MP11 = TP11 – TP10

MP11 = 67-60 = 7 kg

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MP is the change in TP when one more unit of variable factor is employed. However, when change
in variable factor is greater than one unit, then MP can be calculated as,

MP = Change in TP/ Change in units of Variable Factor

MP = ΔTP/ΔN

EXAMPLE: Suppose 2 labourers produce 60 units and 5 labourers produce 90 units, then MP
will be,

MP = 90-60/5-2

= 30/3

= 10 units

Law of Variable Proportions:

The Law of Variable Proportions also known as the Law of Diminishing Marginal Returns or Law of
Proportionality or Returns to Factor has played a vital role in the modern economics theory. Assume that
a firm’s production function consists of fixed quantities of all inputs (land, equipment, etc.) except labour
which is a variable input when the firm expands output by employing more and more labour it alters the
proportion between fixed and the variable inputs. The law can be stated as follows:

“When total output or production of a commodity is increased by adding units of a variable input while
the quantities of other inputs are held constant, the increase in total production becomes after some point,
smaller and smaller”.

“If equal increments of one input are added, the inputs of other production services being held constant,
beyond a certain point the resulting increments of product will decrease i.e. the marginal product will
diminish”. (G. Stigler)

“As the proportion of one factor in a combination of factors is increased, after a point, first the marginal

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and then the average product of that factor will diminish”. (F. Benham)

The law of variable proportions refers to the behaviour of output as the quantity of one factor is increased
keeping the quantity of other factors fixed and further it states that the marginal product and average
product will eventually decline. This law makes use of the concept productivity of factor, that is, total,
average and marginal physical productivity.

Assumptions of the Law:

The law is based upon the following assumptions:

i) The state of technology remains constant. If there is any improvement in technology, the
average and marginal output will not decrease but increase.

ii) Only one factor of input is made variable and other factors are kept constant. This law does
not apply to those cases where the factors must be used in rigidly fixed proportions.

iii) All units of the variable factors are homogenous.

iv) The law operates in the short-run when it is not possible to vary all factor inputs.

Three stages of law:

The behaviors of the Output when the varying quantity of one factor is combines with a fixed quantity of
the other can be divided in to three district stages. The Law of Variable Proportions can be explained using
the example of agriculture. Suppose land and labour are the only two factors of production.

By keeping land as a fixed factor, the production by variable factor i.e., labour can be shown with the help
of the following table:

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Table 2.2 Stages of Returns to Factor

Units of Units of Total Average Marginal

Land Labour Production Production Production Stages

10 Acres 0 - - -

11 Acres 1 20 20 20

12 Acres 2 50 25 30
Stage 1

13 Acres 3 90 30 40 MP>AP

14 Acres 4 120 30 30 MP=AP

15 Acres 5 140 28 20 Stage 2

MP=0
16 Acres 6 150 25 10
and

17 Acres 7 150 21.3 0 TP Maximum

Stage 3

18 Acres 8 140 17.5 -10 MP<0

Table 2.2 indicates that there are three stages of the law of variable proportion. These are as follows.

Stage-I – Stage of Increasing Returns

Stage –II – Stage of Decreasing Returns

Stage – III – Stage of Negative Returns

The stages can be explained diagrammatically as follows:

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Thus, the law of variable proportions operates in three stages.

 In the first stage, total product increases at an increasing rate. The marginal product in this stage
increases at an increasing rate resulting in a greater increase in total product. The average product
also increases. This stage continues up to the point where average product is equal to marginal
product. The law of increasing returns is in operation at this stage.

 At the second stage total product increases only at a diminishing rate. The law of diminishing
returns starts operating from the second stage awards. The average product also declines. The
second stage comes to an end where total product becomes maximum and marginal product
becomes zero.

 In the third stage marginal product becomes negative. So the total product also declines. The
average product continues to decline. Here the law of negative returns starts operating.

The above relationship can be summed up; thus,

 When AP is rising, MP rises more than AP.

 When AP is maximum and constant, MP becomes equal to AP

 When AP starts falling, MP falls faster than AP.

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Stages of Law Total Product Marginal Product Average Product

Stage I First Increases at an Increases in the First increases,

increasing rate, then at beginning then reaches continues to increase
diminishing rate. the maximum and and becomes
begins to decline. maximum.

Stage II Continues to increase at Continues to diminish Becomes equal to MP

diminishing rate and and becomes equal to and then begins to
becomes maximum. zero. decline.

Stage III Diminishes. Becomes negative. Continues to decline but

will always be greater
than zero.

Thus, the total product, marginal product and average product pass through three phases, viz., increasing,
diminishing and negative returns stage.

The Stage of Operation:

At this juncture, the question arises as to which stage a producer should to choose to produce in. the motive
of every producer is getting maximum output at minimum possible cost, that means profit maximisation.
For this reason, a rational producer will always seek to produce in stage II where both the marginal product
and average product of the variable factor are diminishing because there is no scope of increasing
production further with by increasing the variable factor. Also the total product has not started declining
yet. At which particular point in this stage, the producer will decide to produce depends upon the prices
of factors. Thus, Stage II represents the range of rational production decisions.

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Production Function with All Variable Input: Law of Returns to Scale

In the long run all factors of production are variable factors as the producer can alter then quantity all the
factors of production. All the factors are treated as variable factors. Accordingly, the scale of production
can be changed by changing the quantity of all factors of production. If all factors of production are
doubled, the total output will also be doubled.

The law of returns to scale explains the behavior of the total output in response to change in the scale of
the firm, i.e., in response to a simultaneous and proportional increase in all the inputs. More precisely, the
Law of returns to scale explains how a simultaneous and proportionate increase in all the inputs, i.e., an
increase in the scale affects the total output at its various levels. An increase in the scale means that all
inputs or factors are increased in the same proportion. When a firm expands, its scale increases all its
inputs proportionally. Hence, technically there are three possibilities.

i. The total output may increase proportionately

ii. The total output may increase more than proportionately and

iii. The total output may increase less than proportionately.

If increase in the total output is proportional to the increase in input, it means constant returns to scale.
If increase in the output is greater than the proportional increase in the inputs, it means increasing
return to scale. If increase in the output is less than proportional increase in the inputs, it means
diminishing returns to scale. Let us now explain the laws of returns to scale with the help of isoquants
for a two-input and single output production system.

Assumptions:

The concept of returns to scale is based on the following assumptions:

1. The firm is using only two factors of production that are capital and labour.

2. Labour and capital are combined in one fixed proportion.

3. Prices of factors do not change.

4. State of technology is fixed.

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Different stages of returns to scale are explained in the following diagram:

Stage I: Increasing Returns

Increasing returns is a stage in which output increase by a greater proportion than increase in factor inputs.
For example, to produce a particular product, if the quantity of inputs is doubled and the increase in output
is more than double, it is said to be an increasing return to scale. This stage arises as with an increase in
the scale of production, the average cost for per unit of output produced is lower. This is because at this
stage an organisation enjoys high economies of scale. The increasing returns to scale are attributed to the
existence of indivisibilities in machines, management, labour, finance, etc. Some items of equipment or
some activities have a minimum size and cannot be divided into smaller units. When a business unit
expands, the returns to scale increase because the indivisible factors are employed to their full capacity.

Stage II: Constant Returns to Scale

The stage of constant return to scale implies that an increase in output is equal to the increase in factor
inputs. For example, in the case of constant returns to scale, when the inputs are doubled, the output is

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also doubled. Thus, a given proportional change in the input factors or the scale of production brings about
an equal proportionate change in the output produced.

Stage III: Diminishing Returns to Scale

The third stage, i.e., stage of diminishing returns to scale refers to a situation in which output increases in
lesser proportion than the given increase in factor inputs. For example, when capital and labor are doubled,
but the output generated is less than double, the returns to scale would be termed as diminishing returns
to scale. Causes of diminishing marginal returns include fixed costs, limited demand, negative employee
impact, and worse productivity. The main cause of the operation of diminishing returns to scale is that
internal and external economies are less than internal and external diseconomies.

Returns to scale may start diminishing as the indivisible factors may become inefficient and less
productive. Business may become unwieldy and produce problems of supervision and coordination. Large
management creates difficulties of control and rigidities. To these internal diseconomies are added
external diseconomies of scale. These arise from higher factor prices or from diminishing productivities
of the factors.

ISOQUANTS

The term Isoquants is derived from the words ‘iso’ and ‘quant’ – ‘Iso’ means equal and ‘quant’ implies
quantity. Isoquant therefore, means equal quantity. A family of iso-product curves or isoquants or
production difference curves can represent a production function with two variable inputs, which are
substitutable for one another within limits. Isoquants are the curves, which represent the different
combinations of inputs producing a particular quantity of output. Any combination on the isoquant
represents the same level of output.

An isoquant is a locus of points showing all the technically efficient ways of combining factors of
production to produce a fixed level of output. It is also known as the equal product curve. In case of two
variable factors, labour and capital, the curve shows the efficient alternative techniques of production or
alternative combinations of two factors that can produce a fixed level of output.

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For a given output level firm’s production become,

Q= f (L, K)

Where, ‘Q’ indicating the units of output is a function of the quantity of two inputs ‘L’ and ‘K’.

Thus an isoquant shows all possible combinations of two inputs, which are capable of producing equal or
a given level of output. Since each combination yields same output, the producer becomes indifferent
towards these combinations.

Assumptions:

1. There are only two factors of production, viz. labour and capital.

2. The two factors can substitute each other up to certain limit.

3. The shape of the isoquant depends upon the extent of substitutability of the two inputs.

4. The technology is given over a period.

An isoquant may be explained with the help of an arithmetical example

Table 2.3 Production Possibilities Combinations

Labour Capital Output

Combination (units) (units) (quintals)

A 1 10 50

B 2 7 50

C 3 4 50

D 4 4 50

E 5 1 50

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Combination ‘A’ represent 1 unit of labour and 10 units of capital and produces ‘50’ quintals of a product.
All the other combinations in the table are assumed to yield the same given output of a product say ‘50’
quintals by employing any one of the alternative combinations of the two factors labour and capital.

Isoquant Curve: Isoquant Map:

Properties of Isoquants:

1. An isoquant lying above and to the right of another isoquant represents a higher level of
output.

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2. Two isoquants cannot cut each other

Considering IQ1

A=C

From IQ2

A=B

That implies,

A=B=C

But, B > C as B is on higher

isoquant

Thus, illogical conclusion.

3. Isoquants are convex to the origin

As the producer moves from point A to B, from B to C and C to D along an isoquant, the
marginal rate of technical substitution (MRTS) of labor for capital diminishes.

The MRTS diminishes because the two factors are not perfect substitutes.

In figure, for every increase in labor units by (ΔL) there is a corresponding decrease in the
units of capital (ΔK).

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4. No isoquant can touch either axis

5. Isoquants are negatively sloped

The logic behind this is the principle of diminishing marginal rate of technical substitution.

In order to maintain a given output, a reduction in the use of one input must be offset by an
increase in the use of another input.

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6. Isoquants need not be parallel

The shape of an isoquant depends upon the marginal rate of technical substitution. Since the
rate of substitution between two factors need not necessarily be the same in all the isoquant
schedules, they need not be parallel.

7. Each isoquant is oval-shaped

An isoquant is oval shaped containing a pair of ridged lines that it enables the firm to identify
the efficient range of production.

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Isocost Lines:

“An isocost line shows the different combinations of factors of production that can be employed with
a given total cost.” The isocost line represents the total cost C as constant for all K-L combinations
satisfying the equation.

Cost Minimisation/Producer’s Equilibrium:

The producer is in equilibrium when he secures maximum output, with the least cost combination of
factors of production. The firm seeks to minimise its cost of producing a given level of output. For
example, if the firm wants to produce six units of output, it can use the combination represented by
points A, B or C in the figure. It looks for that factor combination that is on the lowest of the isocost
lines. Where the isoquant touches (but does not cross) the lowest isocost line is the least cost position.
Thus, the point of tangency between the isoquant and the isocost line shows that optimisation in
production is reached when factor prices and marginal product are proportional, with equalised mar-
ginal product per rupee.

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COST ANALYSIS:

Entrepreneurs pay for the input factors- Wages for labour, price for raw material, rent for building hired,
interest for borrowed money, price for all the inputs used in the production process. All these payments
constitute the cost of production. The economists’ concept of cost of production is different from
accounting.

Determinants of Cost:

The cost of production of goods and services depends on various input factors used by the organization
and it differs from firm to firm. The major cost determinants are:

1. Level of output: The cost of production varies according to the quantum of output. If the size
of production is large then the cost of production will also be more.

2. Price of input factors: A rise in the cost of input factors will increase the total cost of
production.

3. Productivities of factors of production: When the productivity of the input factors is high
then the cost of production will fall.

4. Size of plant: The cost of production will be low in large plants due to mass production with
mechanization.

5. Output stability: The overall cost of production is low when the output is stable over a period
of time.

6. Lot size: Larger the size of production per batch then the cost of production will come down
because the organizations enjoy economies of scale.

7. Laws of returns: The cost of production will increase if the law of diminishing returns applies
in the firm.

8. Levels of capacity utilization: Higher the capacity utilization, lower the cost of production

9. Time period: In the long run cost of production will be stable.

10. Technology: When the organization follows advanced technology in their process then the

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cost of production will be low.

11. Experience: Over a period of time the experience in production process will help the firm to
reduce cost of production.

12. Process of range of products: Higher the range of products produced, lower the cost of
production.

13. Supply chain and logistics: Better the logistics and supply chain, lower the cost of production.

14. Government incentives: If the government provides incentives on input factors then the cost
of production will be low.

Types of Costs:
There are various classifications of costs based on the nature and the purpose of calculation. But in
economics and for accounting purpose the following are the important cost concepts.

 Money cost and Real cost

 Actual cost and Opportunity cost

 Fixed cost and Variable cost

 Explicit cost and Implicit cost

 Historical cost and Replacement cost

 Short-run cost and Long-run cost

 Accounting cost and Economic cost

Money cost and Real cost

 Production cost expressed in money terms  Real cost refers to the payment made to
is called as money cost. compensate the efforts and sacrifices of all
factor owners for their services in
 Money cost includes the expenditures such

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as cost of raw materials, payment of wages production.

and salaries, payment of rent, Interest on
 Real cost includes the efforts and sacrifices
capital, expenses on fuel and power,
of landlords in the use of. land, capitalists
expenses on transportation and other types
to save and invest, and workers, in
of production related costs.
foregoing leisure.
 Money costs are considered as out of
 Real cost are considered pains and
pocket expenses.
sacrifices of labor as real cost of
production.

Actual cost and Opportunity cost

 Costs that are actually incurred in  The opportunity cost is the notional cost of
acquiring or producing a good or service sacrificing the alternatives.
are known as actual cost.
 It is the value of a resource in its best
 These costs are real cash outflows and are alternative use, i.e. the value that must be
generally recorded in the account books, foregone in putting a resource to one
they are also called Acquisition or particular use.
accounting costs.
 Investment vs inputs of production
 E.g. rent for land and building; wages to
Labour; interest of Capital.

Fixed cost and Variable cost

 Costs that remain constant with respect to  Costs that vary with respect to the output.
the output.
 e.g. costs of raw material, wages etc.
 E.g. interest on borrowed capital, rent of
building and factory, cost of plant and

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machinery.

 Charges for electricity and telephone are

semi-variable costs.

Explicit cost and Implicit cost

 Are out-of-pocket costs for which a cash  There are some costs that don’t involve a
payment is made. cash outlay. They are called as implicit or
book costs.
 E.g. payments for raw material, utilities,
wages  E.g. depreciation and salary for owner
manager

Historical cost and Replacement cost

 The historical cost of an asset refers to the  The replacement cost stands for the cost
actual cost incurred at the time the asset which must be incurred if the asset is to be
was acquired. purchased today.

Short-run cost and Long-run cost

 It is a period during which one or more  It is the cost that varies with the
inputs of the firm are fixed. output when all the factor inputs
change.
 It is the cost that varies with the output
when plant and equipment remains the
same.

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Accounting cost and Economic cost

 The basic difference between these two  The concepts of average cost, marginal
types of costs is of being recorded in the cost, short run cost, long run cost,
books of account. opportunity cost and replacement cost are
economic costs.
 The concepts of actual cost, fixed cost,
variable cost, explicit cost, implicit cost,
etc. are accounting costs.

Types of Costs:

Different concepts of cost include Total costs, Average costs and Marginal cost.

Total Costs - The sum of all the costs, i.e., fixed, variable, explicit and implicit for the entire output is
known as total cost. Thus, in the short run,

TC = TFC + TVC

Here,

TC = Total Costs

TFC = Total Fixed Costs

TVC = Total Variable Costs

Average cost - The cost per unit of output is called average costs. It is computed by dividing the total
cost by the number of units produced. In the short run,

TC

AC = Q

Or, AC = AFC + AVC

Marginal cost - The change in total cost due to the production of one additional unit of output is called
marginal cost. It is calculated as,

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MC = MCn – MCn-1

COST FUNCTION

The cost function expresses a functional relationship between total cost and factors that determine it.
Usually, the factors that determine the total cost of production (C) of a firm are the output (Q), the level
of technology (T), the prices of factors (Pf).

Symbolically, the cost function becomes:

C = f (Q, T, Pf)

Cost Function

Short Run Cost Long Run Cost

Function Function

Fixed Costs Variable Costs

Short Run Cost

Short-run is a period during which one or more inputs of the firm are fixed. The short-run is defined as a
period of time in which output of a firm can be increased or decreased by changing the amounts of variable
factors such as labour, raw-materials, chemicals, fuel etc. While the quantity of such factors as capital
equipment, building, machinery and top management remains fixed. Thus, in the short run a firm manager

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cannot decide to build a new plant or building or abandon an old one. In the short run there fixed cost and
variable costs are distinguishing.

Therefore, the short-run cost function is written as

C = f (Q, T, Pf, F)

Here,

C = cost of production, F = functional relationship between output and factor prices,

Q = output, T = technology, Pf = factor prices, K = fixed factors

In the short run total cost is a summation of total fixed cost and total variable cost. Short run average cost
is a summation of average fixed cost and average variable cost

Short Run Fixed Costs-

Fixed costs are those costs which remain the same at a given capacity and do not vary with output during
a given time period i.e., short run. These costs will exist even if no output is produced. For example- rent
for building, interest for capital, insurance premium, business taxes etc, depreciation charges, salaries of
permanent staff.

Short Run Variable Costs-

Variable costs, on the other hand, vary directly as output changes. It rises when output expands and falls
when output contracts. When output is zero, variable cost becomes zero.

Variable costs include – payments for raw-materials, wages for labour, fuel and power charges, excise
duties, sales tax etc., transport costs.

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Y Y
Variable costs VC
C3

Fixed costs FC C2
Cost

C1
C1

M1 M2 M3 X O M1 M2 M3
O
Quantity

Cost Output Relationship in Short Run

In the short-run a change in output is possible only by making changes in the variable inputs
like raw materials, labour etc. Inputs like land and buildings, plant and machinery etc. are
fixed in the short-run. It means that short-run is a period not sufficient enoughto expand
the quantity of fixed inputs. Thus Total Cost (TC) in the short-run is composed of two
elements – Total Fixed Cost (TFC) and Total Variable Cost (TVC).

TFC remains the same throughout the period and is not influenced by the level of activity.
The firm will continue to incur these costs even if the firm is temporarily shut down. Even
though TFC remains the same fixed cost per unit varies with changes in the level of output.

On the other hand, TVC increases with increase in the level of activity, and decreases with
decrease in the level of activity. If the firm is shut down, there are no variable costs. Even
though TVC is variable, variable cost per unit is constant.

So in the short-run an increase in TC implies an increase in TVC only.

Thus:

TC = TFC + TVC

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TFC = TC – TVC

TVC = TC – TFC

TC = TFC when the output is zero.

The graph below shows Short-run cost output relationship.

In the graph X-axis measures output and Y-axis measures cost. TFC is a straight line
parallel to X-axis, because TFC does not change with increase in output. TVC curve is
upward rising from the origin because TVC is zero when there is no production and
increases as production increases. The shape of TVC curve depends upon the productivity
of the variable factors. The TVC curve above assumes the Law of Variable Proportions,
which operates in the short-run. TC curve is also upward rising not from the origin but
from the TFC line. This is because even if there is no production the TCis equal to
TFC.

It should be noted that the vertical distance between the TVC curve and TC curve is
constant throughout because the distancerepresents the amount of fixed cost which remains
constant. Hence TC curve has the same pattern of behavior as TVC curve.

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Short-run Average Cost and Marginal Cost

The concept of cost becomes more meaningful when they are expressed in terms of per
unit cost. Cost per unit can be computed with reference to fixed cost, variable cost, total
cost and marginal cost.

The following Table and diagram illustrates cost output relationship in the short-run, with
reference to different concepts of cost.

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Average F i x e d C o s t ( AFC):

Average fixed cost is obtained bydividing the TFC by the number of units produced.
Thus:

AFC = TFC/Q

where, ‘Q’ refersquantity of production.

Since TFC is constant for any level of activity, fixed cost per unit goes on diminishing as
output goes on increasing. The AFC curve is downward sloping towards the right
throughout its length, with a steep fall at the beginning.

Average Variable Cost (AVC):

Average Variable Cost is obtained bydividing the TVC by the number of units produced.
Therefore:

AVC = TVC / Q

Due to the operation of the Law of Variable Proportions AVC curve slopes downwards till it
reaches a certain level of output and then begins to rise upwards.

Average Total Cost (ATC):

Average Total Cost or simply Average Cost is obtained by dividing the TC by the number
of units produced. Thus:

ATC = TC / Q

The ATC curve is very much influenced by the AFC and AVC curves. In the beginning
both AFC curve and AVC curve decline and therefore ATC curve also declines. The AFC
curve continues the trend throughout, though at a diminishing rate. AVC curve continues
the trend till it reaches a certain level and thereafter it starts rising slowly. Since this rise

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initially is at a rate lower than the rate of decline in the AFC curve, the ATC curve continues
to decline for some more time and reaches the lowest point, which obviously is further than
the lowest point of the AVC curve. Thereafter the ATC curve starts rising because the rate
of rise in the AVC curve is greater than the rate of decline in the AFC curve.

Marginal Cost (MC):

Marginal Cost is the increase in TC as a result of an increase in output by one unit. In other
words, it is the cost of producing an additional unit of output.

MC is based on the Law of Variable Proportions. A downward trend in MC curve shows

decreasing marginal cost (i.e. increasing marginal productivity) of the variable input.
Similarly, an upward trend in MC curve shows increasing marginal cost (i.e. decreasing
marginal productivity). MC curve intersects both AVC and ATC curves at their lowest
points.

The relationship between AVC, AFC, ATC and MC can be summed up as follows.

1. If both AFC and AVC fall ATC will also fall because ATC = AFC + AVC

2. When AFC falls and AVC rises (a) ATC will fall where the drop in AFC is more
than the rise in AVC (b) ATC remains constant if the drop in AFC = the rise in
AVC, and (c) ATC will rise where the drop in AFC is less than the rise in AVC.

3. ATC will fall when MC is less than ATC and ATC will rise whenMC is
more than ATC. The lowest ATC is equal to MC.

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Cost output relationship in the long run

In order to study the cost output relationship in the long run it is necessary to know the
meaning of long run. As known in the long run the size of an industry can be expanded to
meet the increased demand for products as such in the long run all the factors of production
can be varied according to the need. Hence long runcosts are those which vary with output
when all the input factors including plant and equipment vary.

As per the above figure suppose that at a given time the firms operate under plant SAC2
and produces output OQ. If the firm decides to produce output OR and continues with the
current plant SAC2 its average cost will be uR. But if the firm decides to increase the size
of the plant to plant SAC3 its average cost of producing OR output would then be TR.
Since cost TR is less than the cost on old plant uR, therefore new plant SAC3 is preferable
and should be adopted. Thus the long run cost of producing OR output will be TR which
can be obtained by increasing the plant size.

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Features of LAC curve

To draw long run average cost curve(LAC) we start with a number of short run average
cost(SAC) curves, each such curve representing a particular size of plant including the
optimum plant. One can now draw a LAC curve which is tangential to all SAC curves. In
this connection following features are highlighted:

1. The LAC curve envelopes the SAC curves and is therefore, called as envelope curve.

2. Each point of the LAC is a point of tangency with thecorresponding SAC curve.

3. The points of tangency on the falling part of SAC curve forpoints lying to the left
of minimum point of LAC.

4. The points of tangency occur on the rising part of the SAC curves for the points
lying to the right of minimum point of LAC.

5. The optimum scale of plant is a term applied to the most efficient of all scales of
plants available. This scale of plant is the one whose SAC curve forms the
minimum point of LAC curve. It is SAC3 in our case which is tangent to LAC
curve at its minimum point at R.

6. Both LAC ad SAC curves are U shaped but the difference between the two U shapes
is that the U shape of the LAC curve is flatter or lesser pronounced from bottom.
The main reason for this is that in the long run such economies are possible which

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cannot be had in the short run, likewise some of the diseconomies which are faced
in short run may not be faced in the long run.

REVENUE ANALYSIS:

Revenue, in simple words, is the amount that a firm receives from the sale of the output. According to
Prof. Dooley, “The Revenue of a firm is its sales receipts or income “. In a firm, revenue is of three
types:

 Total Revenue

 Average Revenue

 Marginal Revenue

Total Revenue –

The Total Revenue of a firm is the amount received from the sale of the output. Therefore, the total
revenue depends on the price per unit of output and the number of units sold. Hence, we have

TR = Q x P

Where,

TR – Total Revenue, Q – Quantity of sale (units sold), and P – Price per unit of output.

Average Revenue -

Average Revenue, as the name suggests, is the revenue that a firm earns per unit of output sold.
Therefore, you can get the average revenue when you divide the total revenue with the total units sold.
Hence, we have,

AR=TR/Q

Where,

AR – Average Revenue, TR – Total Revenue, and Q – Total units sold

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Marginal Revenue -

Marginal Revenue is the amount of money that a firm receives from the sale of an additional unit. In
other words, it is the additional revenue that a firm receives when an additional unit is sold. Hence, we
have,

MR = TRn – TRn-1

Or

MR= ΔTR/ ΔQ

Where,

MR – Marginal Revenue, ΔTR – Change in the Total revenue, ΔQ – Change in the units sold,
TRn – Total Revenue of n units, and TRn-1 – Total Revenue of n-1 units.

Relationship between AR and MR

Marginal revenue is the change in total revenue when one more unit of a commodity is sold while
average revenue is the revenue per unit of output sold. The two share a distinct relationship which can
be seen as follows:

a) When AR is decreasing, MR should be decreasing faster than AR. Thus, downward sloping MR
curve is below the downward sloping AR curve (a situation of monopoly and monopolistic
competition)

b) If AR is constant, MR is equal to AR. Both are indicated by the same horizontal straight line (a
situation of perfect competition)

c) MR can be negative, but not AR.

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Break-Even Analysis (BEA)

The break-even analysis (BEA) has considerable significance for economic research, business decision
making, company management, investment analysis and public policy. The BEA is an important
technique to trace the relationship between cost, revenue and profits at the varying levels of output or
sales. IN BEA, the break-even point is located at that level of output or sales at which the net income or
profit is zero. At this point, total cost is equal to total revenue. Hence, the break-even point is the no-
profit-no loss zone. Break even analysis is an algebraic or graphic model which relates costs and revenues
for different volumes of production. It clearly demarcates the line between profit and loss. Break even
analysis, the relationship among cost, volume of sales and profit are put together graphically. The break-
even point may be defined as that level of sales in which total revenues equal total costs and net income
is equal to zero. This is also known as no-profit no loss point.

The Break-Even Chart (BEC)

In recent years, the break-even charts have been widely used by business economists, company
executives, investment analysts, government agencies and even trade unions. A break-even chart (BEC)
is a group of the short-run relation of total cost and of total revenue to the rate of output and sales.

The BEC graphically shows cost and revenue relation to the volume of output. It thus depicts profit-
output relationship. Hence, the BEC is also called profit group.

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The BEC graphically shows cost and revenue relation to the volume of output. The volume of output is
measured along the X-axis, cost and revenue are measured along the Y-axis

The fixed cost which is represented by the horizontal curve FC on the chart. The variable cost function
is also assumed to change linearly in a constant proportion to the change in output rate. The break-even
point is the point at which total revenue equals total cost so net profit is zero at OQ level of output.

Assumption

1. The cost function and the revenue function are linear.

2. The total cost is divided into fixed and variable costs (TC = FC + VC).

3. Selling price is constant.

4. Average and marginal productivity of factors are constant.

5. The product-mix is stable in the case of a multi-product firm.

6. Factor price is constant.

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Break-Even Point

The break-even point (BEP) of a firm can be found out in two ways. It may be determined in terms of
physical units and in terms of money value. In terms of physical units, it is determined by the volume of
output. In terms of money value on the other hand, it is determined by the value of sales.

Break-even point is needed to make a decision as to quantity to be produced or the quantity to be

purchased.

QBEP = FC

(Selling price – Variable cost)

= FC

Total sales revenue – Total Variable cost

Contribution

It is the difference between total sales revenue and total variable cost. For maximum profit contribution
should be always higher than fixed cost.

Contribution = Total sales revenue – Total variable cost

= TSR – TVC

ECONOMIES OF SCALE:

Production may be carried on a small scale or a large scale by a firm. When a firm expands its size of
production by increasing all the factors, it secures certain advantages known as economies of production.
Marshall has classified these economies of large-scale production into internal economies and external
economies.

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Internal economies are those, which are opened to a single factory or a single firm independently of the
action of other firms. They result from an increase in the scale of output of a firm and cannot be achieved
unless output increases. Hence internal economies depend solely upon the size of the firm and are
different for different firms.

External economies are those benefits, which are shared in by a number of firms or industries when the
scale of production in an industry or groups of industries increases. Hence external economies benefit
all firms within the industry as the size of the industry expands.

Causes of Internal Economies:

Internal economies are generally caused by two factors

 Indivisibilities

 Specialization

1. Indivisibilities

Many fixed factors of production are indivisible in the sense that they must be used in a fixed minimum
size. For instance, if a worker works half the time, he may be paid half the salary. However, he cannot
be reduced to half and asked to produce half the current output. Thus, as output increases the indivisible
factors which were being used below capacity can be utilized to their full capacity thereby reducing
costs. Such indivisibilities arise in the case of labour, machines, marketing, finance and research.

2. Specialization

Division of labour, which leads to specialization, is another cause of internal economies. Specialization
refers to the limitation of activities within a particular field of production. Specialization may be in
labour, capital, machinery and place. For example, the production process may be split into four
departments relation to manufacturing, assembling, packing and marketing under the charge of separate
managers who may work under the overall charge of the general manger and coordinate the activities of
the for departments. Thus specialization will lead to greater productive efficiency and to reduction in
costs.

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Internal Economies:

Internal economies may be of the following types.

A). Technical Economies.

Technical economies arise to a firm from the use of better machines and superior techniques of
production. As a result, production increases and per unit cost of production falls. A large firm, which
employs costly and superior plant and equipment, enjoys a technical superiority over a small firm.
Another technical economy lies in the mechanical advantage of using large machines. The cost of
operating large machines is less than that of operating mall machine. More over a larger firm is able to
reduce it’s per unit cost of production by linking the various processes of production. Technical
economies may also be associated when the large firm is able to utilize all its waste materials for the

development of by-products industry. Scope for specialization is also available in a large firm. This
increases the productive capacity of the firm and reduces the unit cost of production.

B). Managerial Economies:

These economies arise due to better and more elaborate management, which only the large size firms
can afford. There may be a separate head for manufacturing, assembling, packing, marketing, general
administration etc. Each department is under the charge of an expert. Hence the appointment of experts,
division of administration into several departments, functional specialization and scientific co-ordination
of various works make the management of the firm most efficient.

C). Marketing Economies:

The large firm reaps marketing or commercial economies in buying its requirements and in selling its
final products. The large firm generally has a separate marketing department. It can buy and sell on
behalf of the firm, when the market trends are more favorable. In the matter of buying they could enjoy
advantages like preferential treatment, transport concessions, cheap credit, prompt delivery and fine
relation with dealers. Similarly, it sells its products more effectively for a higher margin of profit.

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D). Financial Economies:

The large firm is able to secure the necessary finances either for block capital purposes or for working
capital needs more easily and cheaply. It can barrow from the public, banks and other financial
institutions at relatively cheaper rates. It is in this way that a large firm reaps financial economies.

E). Risk bearing Economies:

The large firm produces many commodities and serves wider areas. It is, therefore, able to absorb any
shock for its existence. For example, during business depression, the prices fall for every firm. There is
also a possibility for market fluctuations in a particular product of the firm. Under such circumstances
the risk-bearing economies or survival economies help the bigger firm to survive business crisis.

F). Economies of Research:

A large firm possesses larger resources and can establish its own research laboratory and employ trained
research workers. The firm may even invent new production techniques for increasing its output and
reducing cost.

G). Economies of welfare:

A large firm can provide better working conditions in-and out-side the factory. Facilities like subsidized
canteens, crèches for the infants, recreation room, cheap houses, educational and medical facilities tend
to increase the productive efficiency of the workers, which helps in raising production and reducing
costs.

External Economies
Business firm enjoys a number of external economies, which are discussed below:

A). Economies of Concentration:

When an industry is concentrated in a particular area, all the member firms reap some common
economies like skilled labour, improved means of transport and communications, banking and financial
services, supply of power and benefits from subsidiaries. All these facilities tend to lower the unit cost
of production of all the firms in the industry.

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B). Economies of Information

The industry can set up an information center which may publish a journal and pass on information
regarding the availability of raw materials, modern machines, export potentialities and provide other
information needed by the firms. It will benefit all firms and reduction in their costs.

C). Economies of Welfare:

An industry is in a better position to provide welfare facilities to the workers. It may get land at
concessional rates and procure special facilities from the local bodies for setting up housing colonies for
the workers. It may also establish public health care units, educational institutions both general and
technical so that a continuous supply of skilled labour is available to the industry. This will help the
efficiency of the workers.

D). Economies of Disintegration:

The firms in an industry may also reap the economies of specialization. When an industry expands, it
becomes possible to spilt up some of the processes which are taken over by specialist firms. For example,
in the cotton textile industry, some firms may specialize in manufacturing thread, others in printing, still
others in dyeing, some in long cloth, some in dhotis, some in shirting etc. As a result the efficiency of
the firms specializing in different fields increases and the unit cost of production falls.

Thus internal economies depend upon the size of the firm and external economies depend upon the size
of the industry.

DISECONOMIES OF LARGE SCALE PRODUCTION

Internal and external diseconomies are the limits to large-scale production. It is possible that expansion
of a firm’s output may lead to rise in costs and thus result diseconomies instead of economies. When a
firm expands beyond proper limits, it is beyond the capacity of the manager to manage it efficiently. This
is an example of an internal diseconomy. In the same manner, the expansion of an industry may result
in diseconomies, which may be called external diseconomies. Employment of additional factors of
production becomes less efficient and they are obtained at a higher cost. It is in this way that external
diseconomies result as an industry expands.

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The major diseconomies of large-scale production are discussed below:

Internal Diseconomies:

A). Financial Diseconomies:

For expanding business, the entrepreneur needs finance. But finance may not be easily available in the
required amount at the appropriate time. Lack of finance retards the production plans thereby increasing
costs of the firm.

B). Managerial diseconomies:

There are difficulties of large-scale management. Supervision becomes a difficult job. Workers do not
work efficiently, wastages arise, decision-making becomes difficult, coordination between workers and
management disappears and production costs increase.

C). Marketing Diseconomies:

As business is expanded, prices of the factors of production will rise. The cost will therefore rise. Raw
materials may not be available in sufficient quantities due to their scarcities. Additional output may
depress the price in the market. The demand for the products may fall as a result of changes in tastes and
preferences of the people. Hence cost will exceed the revenue.

D). Technical Diseconomies:

There is a limit to the division of labour and splitting down of production p0rocesses. The firm may fail
to operate its plant to its maximum capacity. As a result, cost per unit increases. Internal diseconomies
follow.

E). Diseconomies of Risk-taking:

As the scale of production of a firm expands risks also increase with it. Wrong decision by the
management may adversely affect production. In large firms are affected by any disaster, natural or
human, the economy will be put to strains.

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External Diseconomies:

When many firm get located at a particular place, the costs of transportation increases due to congestion.
The firms have to face considerable delays in getting raw materials and sending finished products to the
marketing centers. The localization of industries may lead to scarcity of raw material, shortage of various
factors of production like labour and capital, shortage of power, finance and equipment’s. All such
external diseconomies tend to raise cost per unit.

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MODULE 3: MARKET STRUCTURES

Core Concepts:

 Market
 Types of Markets
 Perfect Competition
 Monopoly
 Monopolistic competition
 Oligopoly market
 Cartel
 Game theory; Nash equilibrium.

Market Competition

Meaning of Market

 Market is generally understood to mean a particular place or locality where buyers & sellers
meet together and deal with their business transaction.

 For example, Bombay market, Delhi market, Calcutta market, Bangalore market, Mangalore
market & Mysore market etc.

 However, in economics, the term market, it is not a particular place/locality where goods are
bought and sold.

 The idea of a particular locality or geographical place is not necessary to the concept of the
market.

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 What is required for the market to exist is the contact between the sellers and buyers so that
transaction (sale and purchase of a commodity), at an agreed price.

 The buyers and sellers may be spread over a whole town, region or a country but if they are in
close communication with each other either through personal contact or exchange of letters,
mobile phones, e-mail, face-book and twitter, whatsapp etc - For example trade between
America and India.

Definition

 Prof R. Chapman, “The term market refers not necessarily to a place but always to a commodity
and buyers and sellers who are in direct competition with one another.

 In the words of Cournot – market not any particular market place in which things are bought and
sold but the whole of any region in which buyers and sellers are in such free interact with one
another.

 Essential of market are –

 Commodity which is dealt with

 The existence of buyers and sellers

 A place, be it a certain region/country/world

 Price prevailing for the commodity.

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Classification of Markets

On the On the basis

Sl. On the basis of Area On the basis On the basis
basis of of nature of
No. or Region of Time of legality
Functions commodity

Mixed
Very short Market or
1. Local Market Product Market Legal Market
period Market general
market

Specialised
2. Regional Market Short Period Stock Market Illegal Market
Market

Marketing
3. National Market Long Period Bullion Market -
by sample

Very long Marking by

4. International Market Bullion Market
period grades

 The determination of prices and output of various products depends upon the type of market
structure in which they are produced, sold and purchased.

 In this connection economists have classified the various market prevailing in a capitalist economy
into

1. Perfect Competition or Pure Competition

2. Monopolistic Competition

3. Oligopoly

4. Monopoly

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 Three-market forms, monopolistic competition, oligopoly and monopoly are generally grouped
under the general heading of imperfect competition.

Classification of Market Structure

Perfect competition and Imperfect competition

1. Perfect Competition

Market, where there is a large number of producers (firms) producing a homogeneous product,
homogeneous price existence.

2. Imperfect competition

It is an important market category where in individual firms exercise control over the price of
commodity.

Imperfect competition has several sub-markets -

1) Monopolistic competition

2) Pure Oligopoly

3) Differentiated Oligopoly

4) Monopoly

Forms of Market Competition

Barriers to
Models of Number of Number of Nature of
entry and
Competition Buyers Sellers products
exit

Perfect Identical
Very large Very large None
Competition products

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Single
Monopoly Very large One Very large
product

Monopolistic Minimum
Very large Large None
Competition differences

Large
Oligopoly Very large Very few Large
differences

PERFECT COMPETITIVE MARKET:

Features of perfect competitive market

1. Large number of buyers and sellers

2. Homogeneous product

3. Free entry and exist conditions

4. Perfect knowledge about market

5. Perfect mobility of factors of production

6. Absence of transport cost

1.Large Number of buyers and sellers

 There will be a large number of buyers and sellers existed in the market.

 Any single producer or consumers cannot influences on demand, output and prices – it is
like a drop of water put into sea like.

 Individual firm is only a price taker and not price-maker.

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2. Homogeneous Product

 Commodities produced by all the firms is homogenous and identical in all respects.

 There is no changes in terms of quality, size, taste etc between the firms.

 No. one firm’s influences prices either increase/decrease in the market.

3.Free entry and exists

 There are no artificial restrictions either preventing the entry of new firms into market or
compelling the existing firms to continue.

 The firms have full liberty to choose either to continue or go out of the industry.

4. Perfect knowledge on the part of buyers and sellers

 Both buyers and sellers got good knowledge about market conditions – price of commodities.

 Due to perfect knowledge by both buyers and sellers, there need not be any advertisement.

5. Perfect mobility of factors of production

 The factors like labour & capital should be freely mobile place to place and region to regions

6. Absence of transport cost

 If transport costs are incurred, prices should be differentiated in different sectors of the market.

 Price under perfect competition is determined by the interaction of the two forces – demand and
supply.

 Though individuals cannot change the price, but aggregate forces of demand and supply can
change.

 Demand side – marginal utility of commodity to the buyers

 Supply side – cost of production – producers

 The interaction of demand and supply is called the equilibrium price.

 Equilibrium price is that price at which quantity demanded is equal to the quantity supplied at
given price – both buyers and sellers satisfied

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Equilibrium between demand and supply: Price and Output Determination

Price of
Demand Supply Pressure on price
commodities

5 12 1

10 10 2 Excess Demand

15 08 4

20 06 6 Equilibrium

25 04 8

30 02 10 Excess Supply

35 01 12

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Elements of time – price theory

 Alfred Marshall was the first economists to introduce “Time Factor” – price determination.

 He divided time period into three ways –

1. Market Period

2. Short Period and

3. Long Period

4. Very Long Period

1. Market Period

 Market period are also called as very short period.

 The supply of a commodity is almost fixed and the demand will play a decisive role in
determining the price of products.

 This market period may be an hour, a day, or few days or even a few weeks – depends on nature
of commodities.

 Types of commodities are –

1. Perishable commodities

2. Non-perishable commodities

i. Perishable commodities

 Fish, milk, vegetables, flowers, meat and butters etc are perishable commodities. Supply is
limited in the existing stocks.

 The fundamental features of this period – supply of the commodity is absolutely fixed and
therefore, the supply curve of each firm will be a vertical straight line.

 Demand factors more important than supply in determining price.

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Perishable commodities

ii. Non-perishable/Durable commodities

 Durable goods are those which can be reproduced or those can be stored. Like perishable
goods, the supply of durable goods is not vertical throughout the length.

 Firms selling such goods have a minimum reserve price – they will not sell goods at less than
reserve price – wheat, soap & oil etc.

Factors Affecting Reserve Price

1. Price in future – if seller expects that a high price will prevail in future.

2. Liquidity preference – if the seller is in urgent need of money his reserve price will be low &
vice-versa.

3. Future cost of production – if the seller expects that in future the cost of production will fall, his
reserve price will be lower & vice-versa.

4. Storage Expenses – if the seller finds that the storage expenses are higher & the time for which
the stocks have to be held are longer, his reserve price will be lower & vice-versa.

5. Durability of commodity – more durable commodity is higher will be the reserved price.

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Short period – Price determination

 Short period refers to that period in which supply can be adjusted to a limited extent.

 Stigler in his word short period is a period in which the rate of production, change by change in
variable with existence of fixed inputs.

 In short period fixed factors – machinery, plant, building etc cannot be altered and variable
factors may be increased or decreased according to the change in demand.

 In short period, price is determined by the interaction of two forces – demand and supply.

 Demand factors were more dominated factors in short period.

Short period price determination

Under equilibrium position, a firm in short period can have the following situations:

– (1) Super Normal profit or Profit situation.

– (2) Normal profit situation.

– (3) Loss situation.

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Price-output determination in Perfect Competition (Short & Long run)

Price-output determination in Perfect Competition (Short run)

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Long period price determination

 Long period is a period of many years 5, 10, 15, 20& above.

 In this period supply conditions are fully able to meet the new demand conditions.
 In the long run no fixed & variable factors all the factors treated as variable factors.
 New plants/new firms can enter into the market & old firms leave the market.

Long run Equilibrium under Perfect Competition

Activity 4.1 Perfect Competition - Got Milk

Learning outcome:

Students understand the concept of perfect competition and the features of perfect competition.

A student from each group is asked to come forward. Having about 7 students out, 5 are made sellers of
a basic product of milk. The product is totally homogenous, and no branding or promotion or packaging
is allowed. The remaining 3 are buyers and the class observes the consumer behavior of customers
buying and how the seller change their prices accordingly- teaching the concept of “price takers”. After

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a few cycles, the cost price for production is given and the sellers reaction is observed, showing the
concept of free entry and free exit.

Through the activity the students observe and understand how perfect competition works in theory and
how profits are made in the long as well as the short run.

MONOPOLY:

The Definition of Monopoly

Monopoly: a firm that is the only seller of a good or service with no close substitutes.

This definition is abstract, just as the definition of perfect competition is abstract. And just as it’s hard to
find a market that seems perfectly competitive in all respects, it’s hard to find a firm that is a total
monopoly.

Thus, there are the following three essential conditions to constitute as Monopoly:

1. Single Producer or Seller:

There must be a single producer or seller. He may be an individual or a firm of partners or a joint stock
company. This condition is essential to eliminate competition.

2. Absence of Close Substitutes:

The commodity dealt in should have no closely competition substitutes. That is, there should be no other
firm or firms producing similar products, otherwise there will be competition.

3. Barriers to the Entry of New Firm:

There must be strict barriers to the entry of new firms either in the market or to do production.

Those three conditions ensure that the monopolist can set the price of his commodity i.e., he can pursue
an independent price output policy.

Power to influence price is the essence of Monopoly.

According to Prof. Donald Dewey – “Monopoly is the control of the sale of a commodity by a single
seller who does not fear the entry of other firms into his market.”

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Kinds of Monopoly:

Monopoly is of following kinds:

1. Simple Monopoly and Discriminating Monopoly:

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

2. Pure Monopoly and Imperfect Monopoly:

Pure monopoly is that type of monopoly in which a single firm which controls the supply of a commodity
which has no substitutes not even a remote one. It possesses an absolute Monopoly power. Such a
Monopoly is very rare. While imperfect monopoly means a limited degree of Monopoly. It refers to a
single firm which produces a commodity having no close substitutes. The degree of Monopoly is less than
perfect in this case and it relates to the availability of the closeness of a substitute. In practice, there are
many cases of such imperfect monopoly.

3. Natural Monopoly:

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

4. Legal Monopoly:

When anybody receives or acquires Monopoly due to legal provisions in the country.

For Example:

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

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5. Industrial Monopolies or Public Monopolies:

In the general interest of the nation, when a government nationalizes certain industries in the public sector,
whereby industrial or public monopolies are created. The Industrial Policy Resolution 1956, in India, for
instance, categorically lays down that certain fields like arms and ammunition, atomic energy, railways
and air transport will be the sole monopoly of the Central Government. In this way industrial monopolies
are created through statutory measures.

One electric power distributor can meet the market demand for electricity at a lower cost than two or more
firms could.

Following Figure shows a natural monopoly.

1. Economies of scale exist over the entire LRAC curve.

2. One firm can distribute 4 million kilowatt hours at a cost of 5 cents a kilowatt-hour.

3. This same total output costs 10 cents a kilowatt-hour with two firms,

4. and 15 cents a kilowatt-hour with four firms.

One firm can meet the market demand at a lower cost than two or more firms can, and the market is a
natural monopoly.

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Monopoly Price-Setting Strategies

A monopolist faces a trade-off between price and the quantity sold.

To sell a larger quantity, the monopolist must set a lower price.

There are two price-setting possibilities that create different trade-offs:

• Single price
• Price discrimination

Single Price

A single-price monopoly is a firm that must sell each unit of its output for the same price to all its
customers.

DeBeers sell diamonds (quality given) at a single price.

Price Discrimination

A price-discriminating monopoly is a firm that is able to sell different units of a good or service for
different prices.

Airlines offer different prices for the same trip.

The table shows the demand schedule and the graph shows the demand curve.

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The table also calculates total revenue and marginal revenue.

When the price is $16, the quantity demanded is 2 haircuts an hour.

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Single-Price Monopoly

Marginal Revenue and Elasticity. Recall the total revenue test, which determines whether demand is
elastic or inelastic. If a price falls increases total revenue, demand is elastic, if a price fall decreases total
revenue, demand is inelastic. Use the total revenue test to see the relationship between marginal revenue
and elasticity.

The relationship between marginal revenue and elasticity implies that a monopoly never profitably
produces an output in the inelastic range of its demand curve.

Output and Price Decision

To determine the output level and price that maximize a monopoly’s profit, we study the behaviour of
both revenue and costs as output varies.

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Is Monopoly Efficient?

Resources are used efficiently when marginal benefit equals marginal cost.

Monopoly is inefficient because it creates a deadweight loss.

But monopoly also redistributes consumer surplus. The producer gains, and the consumers lose.

Price Discrimination

Discriminating among Units of a Good, the firm charges the same prices to all its customers but offers a
lower price per unit for a larger number of units bought. < Profiting by Price Discriminating Global Air
has a monopoly on an exotic route. Regulating Natural Monopoly Unregulated profit maximizing
monopoly is inefficient. Marginal cost pricing rule is a price rule for a natural monopoly that sets price
equal to marginal cost. Average cost pricing rule a price rule for a natural monopoly that sets price equal
to average total cost and enables the firm to cover its costs and earn a normal profit.

Activity 4.2 Monopoly - Whole and Sole

Learning outcome:

Students will be able to:

 Define the features of monopoly in markets

 Determine the output and price in monopoly

 Understand long run and short run profits

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A situation of monopoly in every group is given, but every student works individually. One group could
have a situation of being the only shop in a community, the only bank in the community, the only transport
etc. (per number of groups present).

The group should discuss and draw a demand chart for the product in the community and draw the AR
and MR curve.

The concept of price optimization and price and output determination is asked to be drawn by every
student.

The 3 types of profits are introduced. Super normal, normal and loss- making situations.

Debrief of the activity conducted with graphs.

MONOPOLISTIC COMPETITION

 In the real world, either perfect competition or monopoly does not exist, but it only an imperfect
competition like monopolistic competition.

 The credit for the development of monopolistic competition goes to Joan Robinson of UK
&Chamberlin of USA in 1933.

 Mrs Joan Robinson her book “The Economic of Imperfect Competition & Prof Edward. H.
Chamberlin “The theory of Monopolistic competition” in 1933.

 Thus, monopolistic competition refers to competition among a large number of sellers producing
close substitute but not perfect substitutes.

 Further, in this market condition there is freedom of entry into & exist from the industry.

 It defined as the form of market structure in which there are a large number of firms producing
differentiated products which are close substitutes of each other.

 Monopolistic competition refers to the market organization in which there is keen competition, but
neither perfect nor pure, among a group of a large number of small producers or suppliers having
some degree of monopoly power because of their differential products.

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 Thus, monopolistic competition is a mixture of competition and a certain degree of monopoly

power.

 In other words, a market with a blend of monopoly and competition is described as monopolistic
competition.

 It is a hybrid of monopoly and competition

Examples of Monopolistic Competition:

Automobiles Electronics

Textiles Computers

Footwear Heavy Chemicals

Soap Cement

Food and Beverages Electrical machinery

Drugs and Chemicals Non-electrical machinery

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Confectionery Metals and Metal products

Cosmetics Coals and Coffee

Papers Construction

 Product differentiation
o Product differentiated – differences in the quality, tastes, preferences, workmanship,
durability, size, shape, design, colour, fragrance, packing etc.

 The products of various sellers under this market conditions are fairly similar but not
perfect/close substitutes of each other.

 Every seller has a monopoly of his own product variety but he has to face a stiff competition
from his rival sellers, selling close substitutes of his product.

o Bathing soap – which produce different brands such as Lux, Haman, Godrej, jai, dove
etc.

o Shampoo – Sunsilk, Clinic plus, Head & Shoulders etc.

o Blade – Swiss, Wilkinson, Sword & 7.0 clock etc.

o Tooth paste – Colgate, close-up, promise, Pepsudent etc.

o Two wheeler bike – Hero Honda, Pulsar, TVS Victor, Yamaha etc.

o Cool drinks – Pepsi, coco-cola, sprite, 7up, Mirinda, Maza slice etc.

Features of Monopolistic Competition

1. A large number of firms

2. Product differentiation

3. Free entry & exists of firms

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4. Advertisement expenditure

5. Non-price competition

Product variation

1. A large number of firms

 There are a relatively large number of firms existed in the market. Because of large number of
firms, there is stiff competition between them.
 Unlike perfect competition these large number of firms do not produce identical but they have
perfect substitutes between them.
 The size of each firm will be relatively small.
2. Product differentiation

 Product differentiated – differences in the quality, tastes, preferences, workmanship,

durability, size, shape, design, colour, fragrance, packing etc.
 Products produced by various firms are not identical but are slightly different from each other’s
– close substitutes of each other.
 Therefore, their prices cannot be very much different from each other. Their products are
similar & close substitutes of each other’s.
3. Freedom of entry & exist

 New firms can enter & existing firms can leave industry easily.

 If industry making super-normal profits, new firms can enter it – which leads to the expansion of
output. Existing firms can leave industry – if they incur losses.

4. Product variation

 Product variation under monopolistic competition exists because there is differentiation of

products of various firms.

 The variation of product refers to a change in the quality of the product itself, technical change,
design, better materials package etc.

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5. Non-price competition

 Selling cost and advertisement expenditure is a unique feature of monopolistic competition.

 The firms incur a considerable expenditure on advertisements & selling cost to promote the sales
of their products.

 The advertisement & other selling outlays – change he demand for its product

 Firms maximizing profits through advertisement & selling cost.

Nature of Demand curve

 Under monopolistic competition enjoys some control over the price of its product – since its
product is somewhat differentiated from others. If a firm raises the price of its product it will find
some of its customers going away to buy other products. As a result, the quantity demanded of its
product will fall.

 On the contrary if it lowers the price, it will find that buyers from other varieties of the product
will start purchasing its product & as a result the quantity demanded of its product will increase.

 Therefore, demand curve facing an individual firm under monopolistic competition slopes
downward. If a firms wants to increase the sales of its product, it must lower the price.

 Demand curve facing a firm will be his average revenue curve (AR).

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 Thus, average revenue curve of the monopolistic competitive firm slopes downward throughout
its length.

 Since average revenue curve slopes downward, marginal revenue (MR) curve lies below it.

 The implication of MR curve lying below AR curve is that the MR will be less than the price or
average revenue.

 If the firm wants to sell more, the price of its product fall MR therefore must be less than the price

Short period - Price and output determination

 Price & output determination under monopolistic competition was developed by Edward H.
Chamberlin – in the early 1930s.

 Monopolistic competition refers to large number of sellers sell differentiated products, which are
close to each other. The price and output determination – are similar to monopoly market
condition.

 Demand curve sloping downward like monopoly AR & MR. Various firms producing
differentiated product, which are close to each other.

 In the short run, firms incurring super normal profits, normal profits & economic losses, it depends
upon the nature of average cost & average revenue

Short period - Price and output determination- Graphical Representation

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Long-Run Adjustments

 Monopolistic competitors differentiate products to exploit short-run profit opportunities, and

would like their profits to persist.

 These hopes are usually frustrated because typical monopolistic competitors earn only normal
profits in the long run

 The long-run industry adjustments parallel those for pure competition. Entry of new firms seeking
profits cannot be prevented, which may increase production costs.

 Profits are also dissipated because prices fall when new competitors expand output and take
customers from existing firms.

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 This shrinks the demand for a successful firm's products. When new firms enter the market, the
demand curves of established firms shift leftward and become more elastic, ultimately leaving all
firms in an equilibrium of the sort shown in Figure

 Marginal revenue equals marginal cost at point a, and the long-run average total cost (LRATC)
curve is just tangent to the demand curve at point b.

 This tangency allows the firm to sell its output at a price just equal to average cost (Pe= ATCe),
yielding only normal profits in the long run. Product differentiation allows the prices of
comparable goods to vary in monopolistic competition, but only within a narrow range.

OLIGOPOLY

 The term Oligopoly derived from two Greek words ‘Oligos’ means few &Pollein – to sell.

 It is a competition among few big sellers each one of them selling either homogenous or
heterogeneous products.

 Thus, oligopoly refers to that form of imperfect competition where there will be only a few sellers
producing either a homogeneous product or products which are close substitutes but not perfect
substitutes.

 Oligopoly is also referred as “Competition among the few” as a few big firms will be producing
& competing in the market.

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Classification of Oligopoly

1. Pure or perfect oligopoly & differentiated or imperfect oligopoly

2. Open and Closed oligopoly

3. Collusive and non – collusive Oligopoly

4. Partial and Full Oligopoly

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Features of Oligopoly

1. Market Interdependence

2. Advertising

3. Group Behavior

4. Competition

5. Barriers of Entry

6. Lack of Uniformity

7. Existence of price rigidity

8. No unique pattern of pricing behaviour

9. Indeterminateness of Demand Curve

1. Interdependence:

The foremost characteristic of oligopoly is interdependence of the various firms in the decision making.

This fact is recognized by all the firms in an oligopolistic industry. If a small number of sizeable firms
constitute an industry and one of these firms starts advertising campaign on a big scale or designs a new
model of the product which immediately captures the market, it will surely provoke countermoves on the
part of rival firms in the industry.

Thus, different firms are closely inter-dependent on each other.

2. Advertising:

Under oligopoly a major policy change on the part of a firm is likely to have immediate effects on other
firms in the industry. Therefore, the rival firms remain all the time vigilant about the moves of the firm
which takes initiative and makes policy changes. Thus, advertising is a powerful instrument in the hands
of an oligopolistic. A firm under oligopoly can start an aggressive advertising campaign with the intention

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of capturing a large part of the market. Other firms in the industry will obviously resist its defensive
advertising.

Under perfect competition advertising is unnecessary while a monopolist may find some advertising to be
profitable when his product is new or when there exist a large number of potential consumers who have
never tried his product earlier. But according to Prof. Baumol, “under oligopoly, advertising can become
a life-and-death matter where a firm which fails to keep up with the advertising budget of its competitors
may find its customers drifting off to rival products.”

3.Group Behaviour

In oligopoly, the most relevant aspect is the behaviour of the group. There can be two firms in the group,
or three or five or even fifteen, but not a few hundred. Whatever the number, it is quite small so that each
firm knows that its actions will have some effect on other firms in the group. In contrast, under perfect
competition there are a large number of firms each attempting to maximise its profits.

Similar is the situation under monopolistic competition. Under monopoly, there is just one profit
maximising firm. Whether one considers monopoly or a competitive market, the behaviour of a firm is
generally predictable.

4. Competition:

This leads to another feature of the oligopolistic market, the presence of competition. Since under
oligopoly, there are a few sellers, a move by one seller immediately affects the rivals. So each seller is
always on the alert and keeps a close watch over the moves of its rivals in order to have a counter-move.
This is true competition, “True competition consists of the life of constant struggle, rival against rival,
whom one can only find under oligopoly.”

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5. Barriers to Entry of Firms:

As there is keen competition in an oligopolistic industry, there are no barriers to entry into or exit from it.
However, in the long-run, there are some types of barriers to entry which tend to restrain new firms from
entering the industry.

These may be:

(a) Economies of scale enjoyed by a few large firms;

(b) Control over essential and specialized inputs;

(c) High capital requirements due to plant costs, advertising costs, etc.

(d) Exclusive patents; and licenses; and

6. Lack of Uniformity:

Another feature of oligopoly market is the lack of uniformity in the size of firms. Firms differ considerably
in size. Some may be small, others very large. Such a situation is asymmetrical. This is very common in
the American economy. A symmetrical situation with firms of a uniform size is rare.

7. Existence of Price Rigidity:

In oligopoly situation, each firm has to stick to its price. If any firm tries to reduce its price, the rival firms
will retaliate by a higher reduction in their prices. This will lead to a situation of price war which benefits
none. On the other hand, if any firm increases its price with a view to increase its profits; the other rival
firms will not follow the same. Hence, no firm would like to reduce the price or to increase the price. The
price rigidity will take place.

8. No Unique Pattern of Pricing Behaviour:

The rivalry arising from interdependence among the oligopolists leads to two conflicting motives. Each
wants to remain independent and to get the maximum possible profit. Towards this end, they act and react
on the price-output movements of one another which are a continuous element of uncertainty.

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On the other hand, again motivated by profit maximisation each seller wishes to cooperate with his rivals
to reduce or eliminate the element of uncertainty. All rivals enter into tacit or formal agreement with
regard to price-output changes.

It leads to a sort of monopoly within oligopoly. They may even recognize one seller as a leader at whose
initiative all the other sellers raise or lower the price. In this case, the individual seller’s demand curve is
a part of the industry demand curve, having the elasticity of the latter. Given these conflicting attitudes, it
is not possible to predict any unique pattern of pricing behaviour in oligopoly markets.

9. Indeterminateness of Demand Curve: Kinked Demand curve

In market structures other than oligopolistic, demand curve faced by a firm is determinate. The
interdependence of the oligopolists, however, makes it impossible to draw a demand curve for such sellers
except for the situations where the form of interdependence is well defined. In real business operations,
the demand curve remains indeterminate. Under oligopoly a firm can expect at least three different
reactions of the other sellers when it lowers its prices.

Classification of Oligopoly

1. Pure or perfect oligopoly & differentiated or imperfect oligopoly

• If the firm producing/competing identical/homogeneous product it is called as pure/perfect

oligopoly. For example – Cement & Aluminum Industries.

• While, the firm producing & competing different commodities/close substitute & not perfect
substitution called different/imperfect oligopoly.

2. Open and Closed oligopoly

• Open oligopoly refers to new firms can enter the market & compete with the existing firms.

• Closed Oligopoly – no freedom to entry & exist of firms to industry.

3. Collusive and non – collusive Oligopoly

• Collusive means co-operation between the competing firms in pricing their products

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• All the existing firm acts independently in the determination of prices.

• There is no insecurity, uncertainty in the oligopoly industry.

• Whereas non-collusive oligopoly each firms undertaken independent decision making with regard
to price & output of the commodity (lack of understanding between the firms & competing within
themselves).

4. Partial and Full Oligopoly

• Partial oligopoly market one of the dominant firm undertake decision-making of price & output &
other firms follows it – price leadership.

• Whereas, full oligopoly – the market will be conspicuous by the absence of price leadership.

Features of Oligopoly

1. Market Interdependence

2. Indeterminate demand curve

3. Importance of advertising & selling costs

4. Group Behaviour

5. Element of Monopoly

6. Price Rigidity

1. Interdependence

 The price & output decisions of one firm will affect the other firms & any decision can be arrived
at only after deep consideration of the possible reaction of the rival firms in the group.

 As the number of firms are few, a change in price & output by a firm will directly affect the
fortunes of its rivals.

 Decision-making is closely connected with the price output policies of other firms.

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2. Indeterminate Demand Curve

 No firm in oligopoly market can forecast with some degree of certainty about the nature & position
of its demand curve.

 The firm cannot make an estimate of sales of its product if it were to cut the price by a certain
percentage.

 Hence the demand curve or the revenue curve of the firm is indeterminate.

3. Importance of advertisement & selling cost

 Due to indeterminate demand curve leads to the condition of aggressive advertisement to

bring more customers into the fold of the firm.

 A direct effect of interdependence & indeterminate - demand of various firms – firms incurs
the enormous selling & advertisement cost.

 Therefore, there is a great importance of advertising & selling costs under conditions of
oligopoly market.

 Prof. Baumol rightly says that “it is only under oligopoly market advertising comes fully
into its own”.

4. Group Behaviour

 The firms under oligopoly recognize their interdependence & realize the importance of
mutual co-operation.

 Therefore, there is a tendency among them for collusion.

 Collusion as well as competition prevail in the oligopolistic market leading to uncertainty

and indeterminateness.

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5. Price Rigidity

 Prices tend to be sticky or rigidity under oligopoly market – product differentiation.

 The price will be kept unchanged due to fear of retaliation & counter-action from other firms –
sticky & inflexible.

 No firm would indulge in price cutting, as it would eventually lead to a price war.

 Price War - if any one firm introduces a price cut it will attract to customers, the rival firms will
retaliate by cutting down their prices No benefit to rivals

 The price may be kept constant even without any collusion or agreement

Kinked Demand Curve

 In 1939, Prof Paul Sweezy has introduced the Kinked Demand Curve – determination of
equilibrium in oligopoly market.

 He used the kinked demand curve model – explain about price rigidity under oligopoly market.

 Demand curve facing an oligopolistic has a kink at the prevailing price.

 If he lowers the price below the prevailing level his competitors will follow him & will lower their
prices.

 But if he increases his price above the prevailing level his competitors will not follow his increase
in price.

 Upper segment of the demand curve is relatively elastic and the lower portion is relatively inelastic.

Assumptions

1. There is an established market price at which all the sellers are satisfied.

2. Each seller’s attitude depends on the attitude of his rivals.

3. An attempt of every seller to push up his ales by reducing the price will be counteracted by other
sellers.

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4. If the seller raises the price, other will not follow him rather they will stick to the prevailing price.

 dKd is the kinked demand curve of an oligopolistic firm.

 OP is the prevailing market price & OM is the equilibrium level of output.

 If an oligopolistic seller (firm) increases the price of the product above OP, this will reduce his
sales – because the rivals are not expected to follow his price.

 This is because the dk portion of the kinked demand curve is elastic & the corresponding dA
portion of the MR curve is positive.

 If the seller reduces the price of the product below OP, his rivals will also reduce their price.

 Though he increase's his sales, his profits would be less than before.

 The reason is that kd portion of the kinked demand curve below OP is less elastic & MR curve
below B is negative.

 Thus in both the price-rising & price reducing situations – the oligopolistic seller will be the loser.

 Therefore, he will stick to the prevailing market price OP which remains rigid.

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 A kinked demand curve is said to occur when there is a sudden change in the slope of the demand
curve.

Case Study: Fitness Industry in India

At the end of FY2018, revenues in the Indian fitness market amounted to USD 908 million. Further growth
in the segment, expected at a CAGR of 9.3% between 2018 and 2022, is expected to take the total market
value to a whopping USD 1,296 million in 2022.Revenue is expected to show an annual growth rate
(CAGR 2018-2022) of 9.3 % resulting in a market volume of US$1,296m in 2022.However, a fact worth
noting is that a major portion of these revenues will be driven by the consumption of fitness wearables.

Simultaneously, the number of upscale fitness centres is growing at a pace similar to the rapid rise in
disposable income among consumers between the ages of 20 to 45 years old. The Indian fitness industry is
also helping bring about a much-needed revolution in the country that’s triggered by the increasing number
of cases of obesity, diabetes, and heart disease. This is also one of the key reasons behind the sudden surge
in the number of weight loss products available in the market, as well as the spike in health club and gym
memberships. Spending money on gym memberships, which was earlier perceived to be a luxury, is now
becoming a way of life for several people. Furthermore, there is an increasing number of people in tier 2
and tier 3 cities looking for wellness and fitness solutions, with most men opting for muscle-building
training and women for cardio-vascular and strength training.

CureFit has set an ambitious aim of a tenfold surge in annual revenue to $1 billion by 2022. CureFit was
launched in May 2016 by Myntra co-founder Mukesh Bansal, and former Chief Business Officer
of Flipkart, Ankit Nagori. The company has its headquarters located in Bangalore, India. Cure.fit has
signed up Hrithik Roshan as its brand ambassador. On acquiring Cult in 2016, the company launched a
unique HRX workout with Hrithik Roshan in March 2017, and also acquired Fitness First, The Tribe, B2B
logistics startupOpinio, and online food-tech company, Kristy Kitchen. CureFit rebranded two of the three
centres of a1000yoga as mind-fit while the third was converted into a Cult fitness centre. The brand also
partnered with Tiger Shroff's clothing line, PROWL in March 2018, for a new fitness program comprising
a mix of combat, dance, and functional fitness.

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The Bengaluru-based firm has a distinctive business model of offering food (through its Eat.fit brand),
physical fitness (Cult.fit), mental wellness (Mind.fit), primary care (Care.fit), and fitness clothing (Cult
Sport) on one platform (an app). CureFit has created a tech platform to help customers manage their
everyday health regimes including food, which is backed by an offline, proprietary fulfilment network to
service them. While fitness centre chains such as Planet Fitness and Talwalkars Better Value Fitness have
gone public, CureFit is the first to provide these five interconnected offerings on one platform. Hence,
cross-selling of products has happened easily, helping grow its revenue. The company aims to have a total
of 25 million customers in the next three years on the back of its global expansion and introduction of
several new products.

Cure.fit delivers physical and mental wellbeing across 4 flagship verticals - cult.fit, eat.fit, mind.fit and
care.fit. Currently, cure.fit is serviceable in Bengaluru, Hyderabad, Delhi and Gurugram. Cult.fit is a chain
of group workout fitness centres across Bengaluru, Hyderabad, Delhi and Gurugram. It comprises
different workout formats such as Zumba, Yoga, Boxing, Strength & Conditioning, and Sports
Conditioning etc. Eat.fit is an online food ordering and delivery platform that delivers daily health meals.
It also offers weekly and monthly subscriptions. Mind.fit is a chain of mental fitness centres that
comprises Yoga and Meditation as its primary offerings. It also provides Do-it-yourself packs, such
as Sleep Stories, Yoga Nidra and Pranayama, on the cure.fit app. Care.fit provides doctor consultations
and full-body checkup at its health centre with Pharmacy & Diagnostics facility
(Ultrasound, ECG, TMT, X-ray, Blood & Urine tests). Care.fit offers zero wait time, 24*7 video
consultation and free follow up for the users.

Cult.fit, which started out in 2015 as a single centre in the Sarjapura neighbourhood and is now a chain of
12 with a loyal following. Founded by fitness enthusiast and former professional basketball player
RishabhTelang. A year later, the company was acquired for $3 million by healthcare startupCureFit. Cult
offers energetic 50-minute sessions of strength & conditioning exercises, mixed martial arts, yoga, zumba,
or boxing—no treadmills and no other machines. The secret to its success also has a lot to do with its
hyper-local strategy, focused on a handful of neighbourhoods, and a tech-savvy approach that makes the
company quintessentially Bengalurean.

Cult has around 10,000 members now, Telang said, and they’re regular in attending sessions. The
company is also profitable, he added. While a spokesperson declined to share financial information,

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Curefit’s co-founder Bansal told the Mint newspaper in June that 10 of Cult’s centres in Bengaluru each
make revenues of $10,000 every month.

A three-month Cult membership costs Rs. 9,000 and offers access to unlimited classes at any of the
centres. There’s also a more flexible, albeit costlier, option to pay Rs300 per class. In both cases, the first
week is free for new users, and everyone has to book their sessions with a click of a button on Cult’s
website or via the Curefit app, which was launched earlier this year.

Despite the presence of several large players, there are still many small independent gyms operating.
However, merger and acquisitions have occurred, indicating that the structure of industry is changing. In
both the structures, non-price competition is vital.

Questions

1. Gym-Fitness Industry in India is in monopolistic or Oligopoly market- substantiate your answer.

2. Draw a price-output determination diagram for care-fit.

3. Care-fit came out with the non-price competition products and services in the Indian market-
discuss.

4. If the fixed cost of cult fit centre is Rs. 10, 00,000 and variable cost is Rs. 2000 for three months,
Find out the BEP quantity.

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Price and output determination – Oligopoly

 There is no one system of pricing under oligopoly market.

 Price policy followed by a firm depends on the nature of oligopoly & rival reactions.

 Therefore, there are three types of pricing under oligopoly.

1. Independent Pricing

2. Pricing under Collusion

3. Pricing under Price Leadership

1. Independent Pricing or (Non-collusive oligopoly)

Homogeneous Product

 When goods produced by different oligopolists are more or less similar or homogeneous in nature.

 There will be a tendency for the firms to fix a common pricing – “Going Price” – accepting price.

 So that firm earns adequate profits at this price.

Non-homogeneous Product or Different Product

 When goods produced by different firms are different in nature, each firm will be following an
independent price policy – like monopoly.

 Due to product differentiation, each firm has some monopoly power.

 Price war between different firms & each firm may fix price at the competitive level.

 A firm tend to change prices even below the variable costs, the other firms are also cutting the
price as same as them – cut throat competition.

 Independent pricing in reality leads to antagonism, friction, rivalary, infighting, price-wars etc.

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2. Pricing under Collusion

 The term collusion means - to play together in economics. It means that the firms co-operation
between the competing firms in pricing their products.

 Three main reasons for collusion

1. Oligopoly firms wants to reduce competition & increasing profits.

2. Collusion helps them to reduce uncertainty.

3. To prevent the entry of new firms into the industry.

 Collusion based on oral agreements or written agreements.

 Oral agreements – “Gentlemen’s agreement – it does not consist of any records.

 Written agreements are called as CARTELS.

 Two kinds of collusion

 1. Perfect Collusion &

 2. Imperfect Collusion

1. Perfect collusion (centralized cartel)

 The firms surrender all their rights to a central authority when sets prices, output & quotas
for each firm, distributes profits etc.

 The cartel are similar to a monopoly, where entire oligopoly industry is controlled &
directed by the central agency.

2. Imperfect collusion

 Refers to a secret or informal agreement under which the colluding firms in the oligopoly
industry seek to fix prices & outputs of their products.

 Price leadership is an ou5tstanding example of imperfect collusion.

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Pricing under collusion

 ID industry’s demand curve & MR – marginal revenue curve. The marginal cost of the cartel
(IMC) is the sum-total of the marginal cost curves of the two firms in the industry.

 At point Q, the aggregate marginal cost of the industry (IMC) is equal to the marginal revenue.
Therefore, the cartel will naturally produce OM3 output for the industry & fix PM3 price for the
product.

 Because, it is at this output & price that the cartel is able to maximise the profits of the industry.
There are two oligopoly firms in the industry named as A & B.

 The marginal cost curve of the firm ‘A’ is MC1& of the firm B is MC2. The output of each firm
will be fixed on the basis of its efficiency. The efficiency of A firms lower than B firms.

 OM1 quantity of output with MC1 marginal cost of firm A, while firm B produces OM2 of output
with MC2 marginal cost. Thus, the output of A firm is OM. B firm is OM2& total output is OM3&
the price at which this output is old is PM3.

3. Price Leadership under oligopoly

 When price is determined by one big firms in the industry & this price is accepted by all the other
firms (small firms).

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 Price fixation is generally the result of tacit understanding rather than of a formal agreement.

 The big firms – scale of production, most senior/experienced firms etc.

 In America, price leadership industries are – biscuits, cement, cigarettes, flower, fertilizers,
petroleum, milk, steel etc.

 ID represents the total industry’s demand at OP price, the industry sells OM of output.

 The average revenue curve of the smaller firms is a horizontal straight line – because they accepted
price fixed by dominant firm.

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 We have taken three smaller firms as A, B & C.

 The price is OP1& therefore; the AR curve is a horizontal straight line.

 Therefore, their MR curve is also the same as AR curve.

 Each firms have their own separate marginal cost curves. MCA of A MCB of B &MCc of C firms.

 Q1 is the point at which the marginal cost of the firm A is equal to its marginal revenue & therefore,
it produces OM1 output.

 Q2 is the point at which the marginal cost of the firm B is equal to its marginal revenue & therefore,
it produces OM2 output.

 Similarly, the firm C produces OM3 output. The total output of the industry is OM & therefore;
the output of the dominant firm would be OM = (OM1 + OM2 + OM3).

 The dominant firm can determine its price & output by the quality of its marginal cost & marginal
revenue.

GAME THEORY

• Game theory helps us understand oligopoly and other situations where “players” interact and
behave strategically.

• Players can be anyone – firms, individuals, countries etc.

• Game is a situation where the players interest and respond to each other’s moves with an objective
in mind.

• Strategy is an action plan to win the game, taking into consideration the behaviour and likely
responses from the opponent player (s).

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Price and output determination – Oligopoly

 There is no one system of pricing under oligopoly market.

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 Price policy followed by a firm depends on the nature of oligopoly & rival reactions.

 Therefore, there are three types of pricing under oligopoly.

1. Independent Pricing

2. Pricing under Collusion

3. Pricing under Price Leadership

1. Independent Pricing or (Non-collusive oligopoly)

Homogeneous Product

 When goods produced by different oligopolists are more or less similar or homogeneous in nature.

 There will be a tendency for the firms to fix a common pricing – “Going Price” – accepting price.

 So that firm earns adequate profits at this price.

Non-homogeneous Product or Different Product

 When goods produced by different firms are different in nature, each firm will be following an
independent price policy – like monopoly.

 Due to product differentiation, each firm has some monopoly power.

 Price war between different firms & each firm may fix price at the competitive level.

 A firm tend to change prices even below the variable costs, the other firms are also cutting the
price as same as them – cut throat competition.

 Independent pricing in reality leads to antagonism, friction, rivalary, infighting, price-wars etc.

2. Pricing under Collusion

 The term collusion means - to play together in economics. It means that the firms co-operation
between the competing firms in pricing their products.

 Three main reasons for collusion

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1. Oligopoly firms wants to reduce competition & increase profits.

2. Collusion helps them to reduce uncertainty.

3. To prevent the entry of new firms into the industry.

 Collusion based on oral agreements or written agreements.

 Oral agreements – “Gentlemen’s agreement – it does not consist of any records.

 Written agreements are called as CARTELS.

 Two kinds of collusion

 1. Perfect Collusion &

 2. Imperfect Collusion

1. Perfect collusion (centralized cartel)

 The firms surrender all their rights to a central authority when sets prices, output & quotas for each
firm, distributes profits etc.

 The cartels are similar to a monopoly, where entire oligopoly industry is controlled & directed by
the central agency.

2. Imperfect collusion

 Refers to a secret or informal agreement under which the colluding firms in the oligopoly industry
seek to fix prices & outputs of their products.

 Price leadership is an outstanding example of imperfect collusion.

3. Price Leadership under oligopoly

 When price is determined by one big firm in the industry & this price is accepted by all the other
firms (small firms).

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 Price fixation is generally the result of tacit understanding rather than of a formal agreement.

 The big firms – scale of production, most senior/experienced firms etc.

 In America, price leadership industries are – biscuits, cement, cigarettes, flower, fertilizers,
petroleum, milk, steel etc.

Case Study: CARTEL

The world oil market has been through tremendous changes in the past fifty years. These changes have
affected the structure of the market and led to significant fluctuations in price and output.

Prior to 1970, world oil prices were set through negotiations among major private sector companies,
including Standard Oil of New Jersey (Exxon), Standard Oil of California, the Texas Company, and Royal
Dutch Shell. In the early 1970s, however, supply and pricing power were gradually transferred from
private companies to the governments of major oil producing countries.

The Organization of Petroleum Exporting Countries (OPEC) was born in 1960 with member countries
Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. Qatar, Indonesia, Libya, the United Arab Emirates, and
Algeria joined in the ensuing decade. In October of 1970, Libya became the first OPEC member to
independently increase its posted price and tax rate on oil produced by private companies. By tradition,
prices were posted in US dollars. Iran and Kuwait followed Libya in November of the same year. By
December, OPEC countries had all established a minimum 55 percent oil tax rate for private oil
companies. In January 1971, six OPEC governments and twenty-two major oil companies gathered in
Teheran. The oil companies agreed to accept the 55% oil production tax, which led to an immediate
increase in world prices.

Total oil production averaged more than 97 million barrels per day (b/d) in 2016, the most recent year for
which complete data are available, according to the Energy Information Administration (EIA). The top
five oil-producing countries were responsible for nearly half of the world's production.

The United States is the top oil-producing country in the world, with an average of 14.86 million b/d,
which accounts for 15.3% of the world's production. This is down from 15.12 million b/d in 2015, but it
was enough to land the United States in the No. 1 spot, which it has held for the past four years running.

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The United States overtook Russia in 2012 for the No. 2 spot, and it surpassed former leader Saudi Arabia
in 2013 to become the world's top oil producer.

Members of the Organization of the Petroleum Exporting Countries (OPEC) and other major oil producers
have agreed not to boost production despite U.S. President Donald Trump's calls for lower prices. The
decision came after OPEC members and non-members like Russia met on September 23 in Algeria. OPEC
said in a statement that it was satisfied "regarding the current oil-market outlook, with an overall healthy
balance between supply and demand."

India is the third largest consumer of crude oil in the world, after the United States and China. The country
accounted 4.81% of total world oil consumption in 2016-17. The estimated total consumption of crude oil
in India rose from 156.10 MMT in 2007-08 to 245.36 MMT in 2016-17 with a CAGR of 4.63%. India
produced 36.01 MTs of crude petroleum in 2016-17. India accounted for 0.92% of world oil production
in 2016-18. Production of crude petroleum in India had a CAGR of 0.54% between 2007-08 and 2016-
17, lowest production in recent times.

Source: https://prezi.com/3zsamj3xccou/the-petroleum-market-1970-2001/

https://www.investopedia.com/investing/worlds-top-oil-producers/

Questions:

a. Justify the market structure for oil production by drawing price-output relationship.

Students should prove why oil production countries are considered as Oligopoly market by comparing
their features. They should draw oligopoly price-output graph.

b. Is OPEC a cartel formation? Elaborate.

Students should compare cartel model features with OPEC countries and justify.

c. Explain the concept of demand and supply of crude oil in India and how it affects the price
of crude oil?

Students are expected to draw the shift in demand curve and explain the answer.

d. Provide a suitable title to the case.

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Student can provide any title related to oligopoly or cartel model.

Activity 4.3 Select your Market!!

Learning outcome:

Students will be able to:

 Define the features of monopolistic markets and oligopolistic markets

 Understand how the AR and MR curve behave in each market

 Understand long run and short run profits

Each group is asked to take a pick form a list of industries available; soap, cosmetic, airlines, mobile phone
provider, cola etc.

The groups should list out the features of this market and which competition the industry belongs to. Since
the differentiation between the 2 can be slight, if the students substantiate with proper understanding, the
group can make the decision.

Once the features are used to determine the market, the students in group are asked to describe how the
price changes in competitor firms will affect the price and output determination of their firm.

During debriefing, the concept of kinked demand curve along with MR and AR is introduced for
oligopoly. For MC the market price determination with the 3 types of profits are worked out.

Activity -Oligopoly: Prisoner’s Dilemma Game

Learning outcome:

Students understand how the cartels work under collusion and the pay-off matrix of prisoner’s dilemma.

To conduct a classroom prisoner’s dilemma, all you need is a single deck of playing cards-Red & Black

Write on board

Red: your earnings increase by $ 2

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Black: your earnings do not change but your partner’s earnings increase by $ 3

Begin by giving each student a copy of the instructions and two playing cards, one red

card (Hearts or Diamonds) and one black card (Clubs or Spades). The instructions, which are

read aloud, explain that each person will be paired with another person in the room after they

make their card play choices. The pairing is done by the instructor, who points to two people

selected spontaneously at random, and asks them to reveal their decisions.

Total 5 rounds, first one well go slow so you can get the hang of it

Everyone is going to have a partner, and to mimic the conditions of the prisoners dilemma, you cannot
communicate with your partner in any way. If you are caught communicating, you are out of the game.

You can play either your red card or your black card, by holding it to your chest.

Calculate and write down your points for the round.

We’ll play it five times. Person who gets the most points is the winner.

Who wins?

 Thoughts on the game

Draw payoffs on board

Black Red

Black 3,3 0,5

Red 5,0 2,2

Draw “Prisoner’s dilemma”

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B: Quiet/cooperate B: Defect/testify against

partner

A: Quiet/Cooperate Both serve one month A: serves one year, B: goes

free

A: Defect/testify against A: goes free, B: serves 1 Both serve three months

partner year

 How does this relate to the collective action problem?

 How is the game we played similar to and different from real world collective action problems?
(know each other)

 What are some collective action problems in your business?

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MODULE 4: Macro-Economic Concepts

BASIC ECONOMIC ACTIVITIES:

 Production- The use of economic resources in the creation of goods and services for the
satisfaction of human wants.

 Consumption- The using up of goods and services by consumer purchasing or in the production
of other goods.

 Employment- The use of economic resources in production; engagement in activity

 Income Generation- The production of maximum amount an individual can spend during a period
without being any worse off.

THE CIRCULAR FLOW OF IN A FOUR SECTOR MODEL:

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Implications of the Circular Flow of Economic Activity:

1. The goods, resources, and money payments will flow as long as households continue to consume,
and as long as firms continue to produce.

2. That since goods and resources flow in exchange for payments, the rate of payments flow will in
the end be the same.

3. Money is the inducing factor, and the pillar of the price system. Without it, there is no price
system.

NATIONAL INCOME:

National income means the value of goods and

services produced by a country during a financial
year. Thus, it is the net result of all economic
activities of any country during a period of one year
and is valued in terms of money. National income is
an uncertain term and is often used interchangeably
with the national dividend, national output, and
national expenditure. We can understand this concept
by understanding the national income definition.

Concept of National Income:

The National Income is the total amount of income accruing to a country from economic activities in a
years’ time. It includes payments made to all resources either in the form of wages, interest, rent, and
profits.

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The progress of a country can be determined by the growth of the national income of the country

National Income Definition

There are two National Income Definition

 Traditional Definition

 Modern Definition

Traditional Definition

According to Marshall: “The labor and capital of a country acting on its natural resources produce
annually a certain net aggregate of commodities, material and immaterial including services of all
kinds. This is the true net annual income or revenue of the country or national dividend.”

The definition as laid down by Marshall is being criticized on the following grounds.

Due to the varied category of goods and services, a correct estimation is very difficult.

There is a chance of double counting, hence National Income cannot be estimated correctly.

For example, a product runs in the supply from the producer to distributor to wholesaler to retailer and
then to the ultimate consumer. If on every movement commodity is taken into consideration, then the
value of National Income increases.

Also, one other reason is that there are products which are produced but not marketed.

For example, in an agriculture-oriented country like India, there are commodities which though
produced but are kept for self-consumption or exchanged with other commodities. Thus there can be an
underestimation of National Income.

Simon Kuznets defines national income as “the net output of commodities and services flowing during
the year from the country’s productive system in the hands of the ultimate consumers.”

Following are the Modern National Income definition:

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 Gross Domestic Product (GDP) - GDP at Market Price, GDP at Factor Cost

 Gross National Product (GNP) - GNP at Market Price, GNP at Factor Cost

 Net National Product (NNP) - NNP at Market Price, NNP at Factor Cost

 Net Domestic Product (NDP) - NDP at Market Price, NDP at Factor Cost

 Private Income

 Personal Income

 Disposable Income

 Real Income

 Per Capita Income

Gross Domestic Product (GDP):

The total value of goods produced and services rendered within a country during a year is its Gross
Domestic Product.

Further, GDP is calculated at market price and is defined as GDP at market prices. Different constituents
of GDP are:

1. Wages and salaries

2. Rent

3. Interest

4. Undistributed profits

5. Mixed-income

6. Direct taxes

7. Dividend

8. Depreciation

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GDP measures the total value of output (i.e., goods & services) produced within the domestic
boundaries of a country. It includes the output of the foreign owned firms with production plants
located in the country

• GDP at Market Price:

– Total value of all the goods and services produced inside the country during a given year
at market price

– GDPMP = C + I + G

• GDP at Factor Cost:

– Sum total of net value added by factors of production plus capital depreciation minus
indirect taxes plus subsidies given by the government

– GDPFC = GDPMP - IT + S

Gross National Product (GNP):

For calculation of GNP, we need to collect and assess the data from all productive activities, such as
agricultural produce, wood, minerals, commodities, the contributions to production by transport,
communications, insurance companies, professions such (as lawyers, doctors, teachers, etc.). at market
prices.

It also includes net income arising in a country from abroad. Four main constituents of GNP are:

1. Consumer goods and services

2. Gross private domestic income

3. Goods produced or services rendered

4. Income arising from abroad.

GNP is the total market value of all final goods and services produced in a country during a year plus net
foreign earnings (X – M)

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GNP at Market Prices:

Measures the market value of the annual produce of the country

GNPMP = GDPMP + (X – M)

GNP at Factor Cost:

Sum of money value of the income produced by and accruing to the various factors of production
in the country during a year

GNPFC = GNPMP - IT + S

Net National Product (NNP):

• NNP is arrived at by deducting depreciation from GNP

• NNP at Market Prices:

– Net value of final goods and services evaluated at market price during a year

– NNPMP = GNPMP - Depreciation

• NNP at Factor Cost:

– Net output evaluated at factor cost during a year

– NNPFC = NNPMP - IT + S = GNPMP –Depreciation

– IT + Subsidies

Net Domestic Product (NDP):

NDP is arrived at by deducting depreciation from GDP. The net output of the country’s economy
during a year is its NDP. During the year a country’s capital assets are subject to wear and tear due
to its use or can become obsolete. Hence, we deduct a percentage of such investment from the GDP
to arrive at NDP.

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• NDP at Market Prices:

– Net value of final goods and services produced within the country during a given year

– NDPMP = GDPMP - Depreciation

• NDP at Factor Cost:

– Is arrived at by making adjustment for net indirect taxes and subsidies in in NDPMP

– NDPFC = NDPMP - IT + Subsidies

Private Income:
Income obtained by private individuals from any sources, productive or otherwise and the retained
income of corporations. It is obtained by making adjustments in NNP at factor cost

• Private Income = NNPFC + Transfer Payments + Interest on Public Debt

– Social Security

Personal Income:

Total income received by the individuals of a county from all sources before the deduction of direct
taxes

• Personal Income = National Income – Undistributed Corporate Profits – Profit Taxes

- Social Security Contributions + Transfer Payments + Interest on
Public Debt

OR

• Personal Income = Private Income – Undistributed Corporate Profits –Profit Taxes

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Disposable Income:

The amount of money available to individuals and households during a year for the purpose of
spending.

• Disposable Income = Personal Income – Direct Taxes

Disposable income can either be consumed or saved. Thus,

• Disposable Income = Consumption + Saving

Real Income:
Real Income is the national income expressed in terms of a general level of prices of a particular
year taken as base. A particular year is taken as base year when the general price level is neither too
high nor too low. The price level of base year is assumed to be 100

• Real National Income = NI for the current year x 100 / Current Year Price Index

Per Capita Income:

The average income of people of a country in a particular Year. Per capita income is also measured
at current prices and constant prices (Real Per Capita Income).

• Per Capita Income = National Income/Population of the country in the current year

• Real Per Capita Income = Real National Income / Population of the country in the current
year

Measurement of National Income:

National income is the value of the aggregate output of the different sectors during a certain time period.
In other words, it is the flow of goods and services produced in an economy in a particular year. Thus,
the measurement of National Income becomes important.

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There are three ways of measuring the National Income of a country. They are from the income side, the
output side and the expenditure side. Thus, we can classify these perspectives into the following
methods of measurement of National Income.

Methods of Measuring National Income:

 Product Method

 Income Method

 Expenditure Method

1. Product Method

Under this method, we add the values of output produced or services rendered by the different sectors of
the economy during the year in order to calculate the National Income.

In this method, we include only the value added by each firm in the production process in the output
figure.

Hence, we use the value-added method. The value-added output of all the sectors of the economy is the
GNP at factor cost. However, this method is unscientific as it adds the value of only those goods and
services that are sold in the market or are available for sale in the market.

The total value of final goods and services produced in a country during a year is calculated at market
prices. The value of final output of all the sectors in the economy, assessed at market price is taken and
summed up to get the national income estimated. Also known as Total Product Method or Goods
Flow Method. This method is popular in USA.

 Two sub types:

 Final goods method

 Value added method

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Final Goods Method:

 Final value of goods and services are taken into account.

 Value of intermediate goods are not considered.

Value Added Method:

 Summation of value added at each stage of production is taken into consideration

Production Firms Sale Proceeds in Cost of Intermediate Value Added (Net

Stages ₹. goods in ₹. Income) in ₹.

1. Wheat Farmer 1,000 0 1,000

2. Flour Flour Mill 1,400 1,000 400

3. Bread Baker 1,800 1,400 400

4. Trade Merchant 2,000 1,800 200

Total Value Added 2,000

Considerations while using Product Method:

 Possibility of double or multiple counting

 Farm output kept for self-consumption may be ignored which should be estimated at market
price

 Deduction of indirect taxes and addition of subsidies may be missed out

 Foreign earning (export income – import expenditure) may not be accounted for

 Base year price has to be taken for valuation of goods and services

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Method:

Y = (O - D) + (S – T) + [(X – M) + (R – P)]

 Here,

o Y = National Income

o = Domestic Output of all productive Sectors

o D = Depreciation

o S = Subsidies

o T = Indirect Taxes

o X = Exports

o M = Imports

o R = Receipts from abroad

o P = payments made abroad

2. Income Method:

 Estimation of NI from the distribution point of view

 NI is measured after income appears as the income earned by individuals of factor owners

o Income of all the factors of production are added (in the form of rent, wages, interest,
profits, undistributed profit of joint stock corporations and income of self-employed
people)

o Transfer payments (subsidies, gifts) are deducted

o Net exports and net receipts are added

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Method:

Y = ∑ (r + w + i + π) + [(X – M) + (R – P)]

 Here,

o Y = National Income

o w = Wages

o r = Rent

o i = Interest

o π = profit

o X = Exports

o M = Imports

o R = Receipts from abroad

o P = payments made abroad

Considerations while using Income Method:

 Income of sales receipts of second hand good must be excluded but the brokerage on such
transactions must be accounted for

 Items to be excluded:

o Transfer payments such as unemployment allowance, pensions, charity, gift,

o earning from gambling,

o windfall gains from lotteries, etc.

 Financial investments are to be excluded

 Direct tax revenue to the government should be deducted

 All unpaid services have to be ignored

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 Undistributed profits, income from government property and profits of public enterprises
should be added

3. Expenditure Method:

 National Income is measured from the expenditure point of view

 NI is measured as the sum of consumption expenditure and investment expenditure

 Computation:

o Estimation of private and public consumption expenditure

o Addition of the value of investment in fixed capital and stocks

o Addition of the value of net exports (X-M) and value of net receipts (R-P) or net foreign
income from abroad

Method:

Y = ∑ (C + I + G) + [(X – M) + (R – P)]

 Here,

o C = Consumption Expenditure

o I = Investment Expenditure

o G = Government Spending or Expenditure

o X = Exports

o M = Imports

o R = Receipts from abroad

o P = payments made abroad

Considerations while using Expenditure Method:

 Expenditure on second hand goods should be excluded

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 Expenditure on financial assets such as equity shares, bonds, etc. should be excluded

 Expenditure on intermediate goods should be excluded

 Government expenditure on pensions, scholarships, unemployment allowance, etc. should be

ignored as these constitute transfer payments

 Expenditure on final goods and services should only be included

Difficulties in Estimation of National Income:

The difficulties encountered in measurement of national income can be studied under two heads.

• Conceptual Difficulties

• Statistical Difficulties

Conceptual Difficulties:

• Output of food and domestic poultry, kitchen garden, etc. is often not included in the NI due to
lack of data

• Value of all unpaid services are excluded from the NI as these cannot be exchanged for a price

• Defense expenditure by the government is included in the NI. Hence increase in the defense
expenditure due to failure in managing the external relations increases NI further leading to decline
in economic welfare which is not accounted for

• Illegal transactions or black money generated in the parallel economy cannot be accounted for

• A very thin line of demarcation between final and intermediate goods which is sometimes missed
out

Statistical Difficulties:

• A large portion of the agricultural output does not go through market mechanism hence it is
difficult to statistical data regarding these

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• A large number of self-employed people, subsistence farmers, etc. either under report or do not
report their income

• Illiteracy, lack of awareness openness among the people in the country makes them indifferent and
non-cooperative to official investigations

INFLATION:

Inflation refers to a situation in which the quantity of money expands faster than the growth of output,
resulting in a continuous rise in the price level – an idea propagated by the quantity theory of money (MV=
PT) which is the foundation of the classical theory. During the Great Depression of the 1930s, economists
exposed the limitations of quantity theory and propagated alternative explanations for inflation.

The Keynesian revolution provided a new framework to the classical theory.

“Inflation is a state in which the value of money is falling, and prices are rising” (Crowther, 1962).

According to A.C. Pigou “inflation exists when money income is expanding more than in proportion to
income-earning activity”.

Theoretical Background:

In the Keynesian framework, inflation is a phenomenon indicating an excess of aggregate demand over
the supply of goods and services. Rapidly rising inflation of the 1970s and 1980s posed challenges for the
Keynesian theory and the monetarists of the Chicago School revived the quantity theory to argue that high
inflation relates to a rapid increase in the money supply. Inflation is always and everywhere a monetary
phenomenon (Milton Friedman). When the economy is growing along with an increase in money supply,
the general price level may not rise.

J. S. Mill emphasized proportionality between the changes in money supply and the price level. “The
value of money, other things being same, varies inversely as its quantity, every increase of quantity lowers
the value and every diminution raising it in ratio exactly equivalent”.

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The quantity theory of money was reformulated by Milton Friedman. Monetarists draw their inspiration
from the quantity theory of money and assert that changes in the general price level can be explained in
terms of the money supply.

Fisher’s quantity theory emphasized the proportionality between the changes in the money supply and the
general price level. He has stated the quantity theory of money as an equation of exchange.

MV= PT … (Eq.1)

Where M stands for the quantity of circulating money, V stands for its velocity of circulation, P stands
for the price level, and T stands for the volume of trade.

Fisher assumed V and T to be stable in the short-run and therefore, P is dependent on M. The price
level P, changes proportionally to change in M. Therefore,

P = MV/PT … (Eq.2)

The analysis is based on Fisher’s quantity theory of money. Since inflation is a sustained increase in the
general price level, implicitly it means a sustained decline in the value of money. The value of money
refers to the purchasing power of money.

The value of money is the reciprocal of the price level.

Price Indices of Inflation:

Three different price indices of inflation - GNP Deflator, WPI and CPI - are prepared for estimating the
change in the real GDP, cost of production and cost of living and change in the value of money. As the
WPI and CPI vary, these can lead to different interpretations. A pertinent question in this regard is what
rate of the price level is considered inflationary?

A sustained price rise of around 5 percent is inflationary. Many economists consider that increase in the
general price level need not be always inflationary - as long as prices rise gradually, and inflation assists
in achieving full employment.

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According to Martin Bronfenbrenner and Franklin D. Holzman, “inflation is a condition of generalized

excess demand in which too much money chases too few goods. Inflation is a rise of money stock or
money income, either total or per capita”

India’s benchmark headline inflation rate, as measured by the consumer price index (CPI) stayed at a high
of 7.01 percent in June 2022 as against 7.04 percent in May (MoSPI). The headline inflation (WPI) had
fallen to 15 percent in June 2022 from 15.88 percent in May 2022 the highest since 1998, amid a broad-
based price increase due to disruption in global supply chains caused by the Pandemic and Russia-Ukraine
war impact.

The price rise continued for manufacturing products (10.11 percent), basic metals (18.88 percent), fuel
and power (40.63 percent) and primary articles (19.71 percent). The RBI’s Monetary Policy Committee
has failed when the average CPI inflation is outside the 2-6 percent tolerance band. The RBI’s latest
forecast pegs the average CPI inflation expectation for July- September to be at 7.4 percent. The overall
food prices have risen in June with Consumer Food Price Index rising 1.0 percent month-on-month.

Inflationary Gap:

• When the aggregate demand (consumption and

investment expenditure (C=I)) is greater than
the aggregate supply (full employment level
GNP)

• People demand more goods and services than

could be produced

• Thus, the inflationary gap is the amount by

which the aggregate demand exceeds the
aggregate supply corresponding to full
employment

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How to Remove the Inflationary Gap?

• The inflationary gap can be wiped out by:

– Increasing the level of saving so that aggregate demand can be reduced

– Increase direct taxes

Types of Inflation:

Based on factors causing Inflation

• Demand-pull

• Cost-push

• Wage-push

• Wage price spiral

• Structural inflation

Based on the magnitude of the price level rise

• Creeping/ Moderate Inflation – decimal digit

• Walking Inflation – single digit

• Running Inflation- two digit

• Galloping Inflation – three digit

• Hyper Inflation – four digit

Demand-pull Inflation:

When inflation occurs due to excess of aggregate demand over aggregate supply, it is known as demand-
pull inflation. Inflation caused by the excess of aggregate demand for all purposes (consumption,

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investment and government expenditure) over supply of goods at the current prices is known as Demand-
pull Inflation.

Cost-push Inflation:

Under cost-push inflation price rises even though there is no increase in aggregate demand due to rise in
cost (particularly wage cost). Such an inflation is known as wage induced/wage push inflation. A rise in
the level of employment leads to increase in demand for workers. This increased demand leads to increase
in wage rate in the economy. Increased wage rate further increases the labour cost or wage cost of
production, which in turn leads to rise in the price level in the economy i.e., inflation.

Level of employment ↑
↓
Demand for workers ↑
↓
Wage rate ↑
↓
Labour/wage cost of production ↑
↓
Price level in the economy ↑

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Cost-push inflation may also be caused by an increase in the profit margin of the firm, working under
monopolistic competition or oligopoly. Such an inflation is known as profit push inflation.

Profit margin ↑
↓
Price level in the economy ↑

Structural Inflation:

As the economy develops rigidities arise. The initial phase of economic expansion is marked by increase
in non-agricultural income, high growth rate of population, thus rise in demand for goods, inelastic
domestic supply of food, and thus there emerges rise in prices. Economies resort to imports of to meet the
increased demand. This leads to further rise in prices as import prices are high and the country suffers
foreign exchange constrains as well.

Reasons for Structural Inflation- Slow rate of growth in exports from the economy also leads to
structural inflation. Slow and unstable growth in exports is inadequate to support the required growth
rate of the economy. A continuous policy of import substitution is adopted which leads to cost-push rise
in prices due to high price of imported material.

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Rise in prices affects and is affected by money supply. With the rise in prices money expenditure
increases for both firms and the government. The government borrows funds from the central bank of the
country to meet this increased expenditure. This leads to monetary expansion and further rise in the rate
of inflation.

Causes of Inflation:

The causes of inflation can be studied under two heads, namely demand side factors causing inflation and
supply side factors causing inflation.

• Demand side factors causing inflation include the following:

• Increase in public expenditure

• Deficit financing

• Increase in money supply

• Corruption and black money

• Supply side factors causing inflation on the other hand, include:

• Fluctuating agricultural growth

• Hoarding of essential goods

• Inadequate rise in industrial production

Effects of Inflation:

• The salaried, wage-earners, landlords and fixed-income groups suffer

• Producers and investors gain

• Creditors lose but debtors gain by inflation

• Effect on the distribution of income and wealth

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• Effect on economic growth

Effect On Economic Growth:

• In general, profit is a rising function of the price level

• Incentive to businessmen to raise prices of their products so as to earn higher volume of

profit- hence encourage firms to make larger investments

• However, inflationary situation leads to-

• Fall in output, particularly if cost-push inflation

• Thus, an increase in aggregate demand will increase both prices and output, but a supply shock
will raise prices and lower output

Measures to control Inflation:

• Monetary Policy

• Quantitative measures

• Qualitative measures

• Fiscal policy

• Income and expenditure policy of the government

• Public distribution system

• To provide essential consumer goods particularly to BPL population at low prices

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Monetary Policy:

Policy rates go up Reserve ratios

Repo – 4.5% CRR – 4.5%

The marginal standing facility rate – SLR – 18%

5.15%
Open Market Operation
Bank rate – 5.15%
Buying of G- securities from the open
Reverse repo rate – 3.35% market.

Fiscal Policy:

• Increase direct taxes and reduce indirect taxes

• Public expenditure on the distribution side

• Price control

• Wage control

• Reduce imported inflation by cutting down customs duties

• Measures to address disruptions due to pandemics, supply and logistics, war

• Reduce fiscal deficit to prudential level

STAGFLATION:

Stagflation is a period of rising inflation but falling output and rising unemployment. Stagflation is often
a period of falling real incomes as wages struggle to keep up with rising prices. Stagflation is often caused
by a rise in the price of commodities, such as oil. Stagflation occurred in the 1970s following the tripling
in the price of oil. A degree of stagflation occurred in 2008, following the rise in the price of oil and the
start of the global recession.

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Stagflation is difficult for policy makers. For example, the Central Bank can increase interest rates to
reduce inflation or cut interest rates to reduce unemployment. But, they can’t tackle both inflation and
unemployment at the same time.

Higher oil prices increase costs of firms causing SRAS to shift to the left.

AD/AS diagram showing stagflation (higher price level P1 to P2 and lower real GDP Y1 to Y2)

Causes of stagflation:

 Oil price rise. Stagflation is often caused by a supply-side shock. For example, rising commodity
prices, such as oil prices, will cause a rise in business costs (transport more expensive) and short-
run aggregate supply will shift to the left. This causes a higher inflation rate and lower GDP.

 Powerful trade unions. If trade unions have strong bargaining power – they may be able to
bargain for higher wages, even in periods of lower economic growth. Higher wages are a
significant cause of inflation.

 Falling productivity. If an economy experiences falling productivity – workers becoming more

inefficient; costs will rise and output will fall.

 Rise in structural unemployment. If there is a decline in traditional industries, we may get more
structural unemployment and lower output. Thus we can get higher unemployment – even if
inflation is also increasing.

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 Supply shocks. If there is disruption to supply chains, there prices will start rising. The supply
shock will also cause decrease in unemployment. For example, in 2021, UK supply shocks caused
moderate degree of stagflation.

Moderate stagflation:

People may talk about stagflation if there is a rise in inflation and a fall in the growth rate (i.e. the economy
is growing at a slower rate. This is less damaging than higher inflation and negative growth. But, it still
represents a deterioration in the trade-off between unemployment and inflation.

Inflation in India:

India’s benchmark headline inflation rate, as measured by the consumer price index (CPI) stayed at a high
of 7.01 percent in June 2022 as against 7.04 percent in May (MoSPI). The headline inflation (WPI) had
fallen to 15 percent in June 2022 from 15.88 percent in May 2022 the highest since 1998, amid a broad-
based price increase due to disruption in global supply chains caused by the Pandemic and Russia-Ukraine
war impact. The price rise continued for manufacturing products (10.11 percent), basic metals (18.88
percent), fuel and power (40.63 percent) and primary articles (19.71 percent). The RBI’s Monetary Policy
Committee has failed when the average CPI inflation is outside the 2-6 percent tolerance band.

The RBI’s latest forecast pegs the average CPI inflation expectation for July- September to be at 7.4
percent. The overall food prices have risen in June with Consumer Food Price Index rising 1.0 percent
month-on-month.

India's retail inflation, as measured by the consumer price index (CPI), rose 16-month high to 6.95 per
cent in the month of March, breaching the upper limit of the Reserve Bank of India's (RBI's) target range
for the third consecutive time, according to data released by the Ministry of Statistics and Program
Implementation on Tuesday. The surge is partly due to a sustained rise in food prices.

The RBI has been mandated by the government to keep retail inflation at 4 per cent with a margin of 2 per
cent on either side. The CPI-based inflation stood at 6.07 per cent in February and 6.01 per cent in January.
The inflation rate in same month last year was 4.3 per cent.

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Food prices, which account for nearly half the inflation basket, are also expected to remain elevated as
supply chain problems related to the Russia-Ukraine war disrupt global grain production, supply of edible
oils and fertilizer exports. Prices of palm oil, the world's most widely used vegetable oil, surged nearly 50
per cent this year. Food price rises are sharply felt by millions living below the poverty line who have
already taken a hit on jobs and incomes due to the pandemic.

Reason for Inflation in India:

During the pandemic times, government spending increased on an unprecedented scale in almost all
countries, directly or indirectly resulting in a sustained increase in the price level. Central banks across
the world gave liquidity support to arrest the slowdown of economies.

The inflation in 2022 is a complex phenomenon similar to the 2008s when commodity and services prices
skyrocketed and financial asset prices (housing and share prices) crashed, a situation referred to as
skewflation. Skewflation pressures occur when the price of a particular commodity, such as onions and
potatoes, rises while the price of other commodities remains unchanged. Skewflation can also refer to

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the skewness of inflation across different sectors of the economy, with some experiencing high inflation,
some experiencing none, and others experiencing deflation.

Many economists think that new inflation is caused by excess demand arising from fiscal and monetary
bailouts, besides disruptions in production and supply chains due to Covid- 19 pandemic, and geopolitical
risk (Sri Lanka, Pakistan, China, Taiwan) disturbances caused to international trade due to sanctions on
the Russian export of oil and natural gas since the outbreak of the war.

As the political risk in Sri Lanka and other countries aggravated leading to inflationary pressures and
central banks are in an aggressive mood to fight the inflation.

This has an impact on the interest cycle moving northwards, and liquidity contraction to contain the
aggregate demand (consumption and investment).

The fiscal stimulus and the strategy have stressed the need for pushing public investment to create
multiplier effects on growth that has an additional impact on aggregate demand leading to the crowding-
out effect and inflation.

Monetarists explained different reasons for the increase in money supply leading to inflation. While
issuing currency the central bank earns a profit (seigniorage) which is surrendered to the government. The
profit is equal to the difference between the cost of issuing the money and the amount of money issued.
In this case, holders of cash lose its value.

When the government runs a deficit, it is financed by selling bonds that impose downward pressure on
bond prices and upward pressure on the interest rate. While buying bonds, the central bank creates money
leading to inflation. According to Keynes, increasing the money supply along with rising output and
employment may not be inflationary.

Inflation can be due to the excess of demand, a rise in the cost of production (rising wages and monopoly
profits) or both. Demand-pull inflation can be controlled by using monetary and fiscal tools. However,
these tools are ineffective in controlling cost-push and profit-pull inflation arising from monopoly
pressures prevailing in the goods and factor markets.

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The very immediate effect of inflation is the reduction in people’s purchasing power. High inflation rates
will also worsen the exchange rate. High inflation means the rupee is losing its power and, if the RBI
doesn’t raise interest rates fast enough

Solutions and Recommendations for Competitive Market:

Firms operating under monopoly and oligopoly markets can increase prices motivated by profits without
an increase in cost leading to profit push inflation.

The market imperfections, information asymmetry and dominance of giant corporations are factors
responsible for profit push inflation which is completely ruled out in a perfectly competitive economy.

Most countries today are dominated by industries of monopolistic and oligopolistic nature, where a few
big companies control the market share of almost everything and the possibility of profit-push inflation
has greatly increased in recent times.

Measures Taken by RBI:

The Reserve Bank of India has been in an aggressive mood to fight inflation in the last two months.

The policy rates have been revised upwards – repo rate to 4.9; bank rate and MSF rates to 5.15 percent
and reverse repo rate to 3.35 percent. The reserve ratio CRR has increased by 50 bases to 4.5 percent but
the central bank maintained the status quo for SLR at 18.5 percent.

Considering the excess liquidity available to the banking system, the RBI had introduced a new policy
tool of Statutory Deposit Facility (SDF) of 4.65 percent whereby banks are allowed to deposit the excess
liquidity with the RBI in May to absorb the excess liquidity of the banking system.

EXCHANGE RATE:

• An exchange rate is the value of one nation's currency versus the currency of another nation or
economic zone

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• For example, how many U.S. dollars does it take to buy one euro? As of August 20th, 2022, the
exchange rate is 1, meaning it takes $1 to buy €1

Types of Exchange Rates:

• Free Floating - A free-floating exchange rate rises and falls due to changes in the foreign
exchange market.

• Restricted Currencies - Some countries have restricted currencies, limiting their exchange to
within the countries' borders. Also, a restricted currency can have its value set by the government.

• Currency Peg - Sometimes a country will peg its currency to that of another nation. For instance,
the Hong Kong dollar is pegged to the U.S. dollar in a range of 7.75 to 7.85. This means the value
of the Hong Kong dollar to the U.S. dollar will remain within this range.

• Onshore Vs. Offshore - Exchange rates can also be different for the same country. In some cases,
there is an onshore rate and an offshore rate. Generally, a more favorable exchange rate can often
be found within a country’s border versus outside its borders. China is one major example of a
country that has this rate structure. Additionally, China's Yuan is a currency that is controlled by
the government. Every day, the Chinese government sets a midpoint value for the currency,
allowing the Yuan to trade in a band of 2% from the midpoint.

• Spot vs. Forward - Exchange rates can have what is called a spot rate, or cash value, which is the
current market value. Alternatively, an exchange rate may have a forward value, which is based
on expectations for the currency to rise or fall versus its spot price. Forward rate values may
fluctuate due to changes in expectations for future interest rates in one country versus another. For
example, let's say that traders have the view that the Eurozone will ease monetary policy versus

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the U.S. In this case, traders could buy the dollar versus the Euro, resulting in the value of the euro
falling

• Quotation - Typically, an exchange rate is quoted using an acronym for the national currency it
represents. For example, the acronym USD represents the U.S. dollar, while EUR represents the
euro. To quote the currency pair for the dollar and the euro, it would be EUR/USD. In this case,
the quotation is euro to dollar, and translates to 1 euro trading for the equivalent of $1 if the
exchange rate is 1. In the case of the Japanese yen, it's USD/JPY, or dollar to yen. An exchange
rate of 100 would mean that 1 dollar equals 100 yen.

BUSINESS CYCLE:

The business cycle model shows how a nation’s real GDP fluctuates over time, going through phases as
aggregate output increases and decreases. Over the long-run, the business cycle shows a steady increase
in potential output in a growing economy.

Phases and Turning Points of the Business Cycle:

The typical business cycle has four phases; which progress as follows:

Phase of cycle Description

Expansion When real GDP is increasing and unemployment is decreasing

The turning point in the business cycle at which output stops increasing and starts
Peak decreasing

Recession When output is decreasing and unemployment is increasing

Trough The turning point at which a recession ends and output starts increasing again

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Figure 1: A typical business cycle showing fluctuations in aggregate output over time and an overall trend toward increasing
output over time (economic growth)

The business cycle model shows the fluctuations in a nation’s aggregate output and employment over
time. The model shows the four phases an economy experiences over the long-run: expansion, peak,
recession, and trough. The business cycle curve is represented by the solid line in the model shown in
Figure 1, and the growth trend is represented by the dashed line in Figure 1.
Output gaps are represented by the difference between actual output. During an expansion, the business
cycle line is above the growth trend. During a recession, the business cycle is below the growth trend.

Output gaps in the business cycle:

The output gap is the difference between actual output and potential output in the business cycle. Potential
output is what a nation could be producing if all of its resources were being used efficiently. In the business
cycle model, a nation’s potential output at any given time is represented as the long-run growth trend.

Output gaps exist whenever the current amount that a nation is producing is more or less than potential
output. In the business cycle model, whenever the business cycle curve is above the growth trend that

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means an economy is experiencing a positive output gap. Whenever the business cycle curve is below the
growth trend that means the economy is experiencing a negative output gap.

When actual output is above the potential output, aggregate demand has grown faster than aggregate
supply, causing the economy to overheat. Overheating in this instance means output is occurring at an
unsustainably high level, at which the unemployment rate is lower than the natural rate of unemployment.
Eventually, the business cycle will reach a peak and enter a recession.
When actual output is below the potential output, aggregate demand or aggregate supply have fallen,
causing a fall in employment and output. When a negative output gap exists, the unemployment rate will
be higher than the natural rate of unemployment. Eventually, the business cycle will reach a trough and
enter a recovery and expansion.

Potential output in the business cycle:

Potential output is also called full-employment output. Potential output is the level of real GDP that would
be produced if all resources are used efficiently. For example, if labor is used efficiently, the actual rate
of unemployment will be equal to the natural rate of unemployment. When there is a positive output gap,
an economy is producing beyond its long-run potential and the unemployment rate will be lower than the
NRU. During a recession, real GDP falls below its potential and the unemployment rate is higher than the
NRU.

The actual unemployment rate is different than the natural rate of unemployment, at different points along
the business cycle, because cyclical unemployment changes along the business cycle. Cyclical
unemployment increases due to reduced output during recessions, and cyclical unemployment decreases
due to increased output during expansions.

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