Module 2

Micro Economic Concepts

The Nature of Demand

In economics, demand refers to the various quantities of a good or service that people will be willing
and able to purchase at various prices during a period of time. It is important to note that a mere desire for a
good or service does not constitute demand. Demand implies both the desire to purchase and ability to pay
for the good. Unless demand is backed by purchasing power, it does not constitute demand.

Demand Function
Demand for a commodity is determined by several factors. An individual’s demand for a commodity
depends on the own price of the commodity, his income, prices of related commodities, his tastes and
preferences, advertisement expenditure made by the produces of the commodity, expectations etc. Thus,
individual’s demand for a commodity can be expressed in the following general functional form,
Qxd = f (Px, I, Pr, T, A, E)
where, Qxd = Quantity demanded of commodity “x”, Px = Price of commodity x
I =Income of the individual consumer, Pr = Price of related commodities, T = Tastes and preferences of
individual consumer, A = Advertisement expenditure and E = Expectations
For many purposes in economics, it is useful to focus on the relationship between quantity demanded
of a good and its own price, while keeping other determining factors constant. Thus, we can write the
demand function as
Qxd = f (Px)
This implies that the quantity demanded of the commodity x is a function of its own price, other
determinants remaining constant.

Law of Demand
Law of demand expresses the functional relationship between price and quantity demanded.
According to the law of demand, other things being equal, if the price of the commodity falls the quantity
demanded of it will rise and if the price of the commodity rises, its quantity demanded will decline. Thus,
according to law of demand, there is an inverse relationship between price and quantity demanded, other
things remaining the same. The other things which are assumed to be constant are tastes and preferences of
the consumer, the income of the consumer, prices of related commodities etc. Thus, the law of demand
assumes that all things other than price remain constant.
The law of demand can be illustrated through a demand schedule and through demand curve.
Demand schedule shows various quantities of good or service that people will buy at various possible prices
during some specified period, while holding constant all other relevant economic variables on which
demand depends. A demand schedule is presented below.
Price Quantity Demanded
10 20
8 40
6 60
4 80
2 100

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 We can convert the demand schedule into demand curve by graphically plotting the various price-
quantity combinations, as shown below.

Price D

D
0
Quantity Demanded

Demand curve slopes downwards from left to the right. The downward sloping demand curve is in
accordance with the law of demand, which describes inverse price-quantity demanded relationship. The
various points on the demand curve represents alternative price -quantity combinations.

Reasons for law of Demand

Let us analyse the reasons for the inverse relationship between price and quantity demanded. This is
due to both “income effect” and “substitution effect”.
When the price of the commodity falls, the consumer can buy more quantity of the commodity with
his given income. If he chooses to buy the same amount of the commodity as before, some money will be
left with him. That is, consumer’s real income or purchasing power increases. This increase in real income
induces the consumer to buy more of the commodity. This is called the income effect of the change in price
of the commodity. This is the reason why a consumer buys more of a commodity whose price falls.
Similarly, an increase in the price of the commodity results in the reduction of real income of the consumer.
Hence, the consumer buys less of a commodity whose price rises.
Again, when price of the commodity falls, it becomes relatively cheaper than other commodities.
This induces the consumer to substitute the commodity whose price has fallen for other commodities which
have now become relatively dearer. This change in quantity demanded resulting from substituting one
commodity for another is referred to as substitution effect of the price change. As a result of this substitution
effect, the quantity demanded of the commodity whose price has fallen rises. For normal commodities, the
income and substitution effect of a price decline are positive and reinforce each other leading to a greater
quantity demanded of the commodity.

Exceptions to the Law of Demand

Law of demand is generally believed to be valid in most situations. However, some exceptions have
been pointed out. According to Thorestein Veblen, some consumers measure the utility of a commodity
entirely by its price. That is, for them, the greater the price of the commodity, the greater it’s utility. These
consumers demand more of such commodities the more expensive these commodities are in order to
impress people. E.g. Diamonds. This form of conspicuous consumption is called “Veblen effect”. When the
price of such commodities goes up, their prestige value also goes up. Consequently, quantity demanded also
will rise and law of demand breaks down.
Another exception to the law of demand is the case of some inferior commodities and was pointed
out by 19th century English economist Sir Robert Giffen. He introduced the case of some inferior goods in
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which there is a direct price-quantity demanded relationship. If the price of an inferior good falls,
consumer’s real income increases. So, instead of buying more inferior goods, consumers substitute other
superior goods. In such case, quantity demanded of inferior goods falls as price falls. After the name of
Robert Giffen, such goods are called “Giffen Goods”. In the case of Giffen goods, positive substitution
effect is smaller than negative income effect when the price of such goods falls. With the rise in the price of
such goods, its quantity demanded increases and with the fall in the price, its quantity demanded decreases.
Thus, the demand curve will slope upwards to the right and not downward in the case of Giffen goods. It
should be noted that Giffen good is an inferior good but all inferior goods are not Giffen goods. Though
occurs rarely in the real world, Giffen goods represent an exception to the law of demand.
Extension and Contraction in Demand
When as a result of change in price, the quantity demanded rises or falls, extension and/or
contraction in demand is said to have taken place (change in quantity demanded). When the quantity
demanded of a good rises due to a fall in price, it is called extension of demand. When the quantity
demanded falls due to rise in price, it is called contraction in demand.
It should be remembered that extension and contraction in the demand takes place as a result of
changes in the price alone when other non-price determinants of demand such as income, prices of related
goods etc remain constant. The extension and contraction in demand is shown below.

Pl
Price

P2
D

0
Ql Q Q2

Quantity Demanded

It can be seen that when the price is OP, the quantity demanded is OQ. If the price falls to OP 2, the
quantity demanded rises to OQ2. Thus, there is extension in demand by the amount QQ2. On the other hand,
if the price of the commodity rises from OP to OP l, there is a contraction in demand equal to the amount
QQl. Thus, as result of changes in the price of the good, the consumers move along the same demand curve.
Thus, the movement along the given demand curve is referred to as a change in quantity demanded
(extension or contraction in demand). A movement down the demand curve is an increase in quantity
demanded (extension in demand). A movement up the demand curve is called a decrease in quantity
demanded (contraction in demand).
Increase and Decrease in Demand (Shifts in Demand)
If the non-price determinants of demand such as income of the consumer, prices of related commodities
etc change, the whole demand curve will change. The demand curve will shift to a new position in response
to changes in any of the factors or variables that were held constant when original demand curve was drawn.

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When as a result of changes in these factors, the demand curve shifts upwards to the right, an increase in
demand is said to have occurred. Increase in demand means the consumer buys more of the goods at various
prices than before
An increase in demand is shown below

Dl

D
Price

Dl

D
0
Quantity Demanded

In the figure, DD is the original demand curve and D lDl is the new demand curve. An increase in
demand is shown by a shift in the demand curve to the right. The location of the demand curve has now
changed. Now at any given price greater quantity is purchased.
On the other hand, a decrease in demand means entire demand curve shifts to a lower position to the left.
Decrease in demand does not occur due to the rise in price but due to changes in other determinants of
demand.
A decrease in demand is shown below

D0
Price

D0
0
Quantity Demanded

In the figure, DD is the original demand curve and D oDo is the new demand curve. A decrease in
demand is shown by the leftward shift in the demand curve. A decrease in demand would mean that at any
given price smaller quantity would be purchased

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Elasticity of Demand

We have seen that the demand for a commodity is determined by its own price, income of the
consumer, prices of related goods etc. Quantity demanded of a good will change as a result of a change in
the size of any of these determinants of demand.

Elasticity measures the sensitivity of one variable to another. Specifically, it is a number that tells us the
percentage change that will occur in the variable in response to one percent increase in another variable.
Therefore, elasticity of demand refers to the sensitiveness or responsiveness of quantity demanded of a good
to a change in its own price, income and prices of related goods. Accordingly, there are three kinds of
elasticity of demand .They are
1. Price elasticity of demand

2. Income elasticity of demand

3. Cross elasticity of demand

Price elasticity of demand measures the sensitivity of quantity demanded to change in own price of g
good. Income elasticity of demand measures the sensitivity of quantity demanded to change in income of the
consumer. While cross elasticity of demand analyses the responsiveness of quantity demanded of one good
to changes in the price of another good.

Price elasticity of demand

Price elasticity of demand refers to the responsiveness or sensitiveness of quantity demanded of a

good to changes in its own price. In order to have a measure of the responsiveness of quantity demanded of
a good to change in its price that is independent of units of measurement, Alfred Marshall, defined it in
terms of percentage or relative change in quantity demanded to price. As such, price elasticity of demand is
given by the percentage change quantity demanded of a good divided by the percentage change in its price.
The elasticity is usually symbolised by Greek letter eta (η). Thus, we have
η = Percentage change in quantity demanded
Percentage change in price
Now denoting ΔQ for change in quantity demanded and ΔP for the change in price (the symbol Δ is
Greek letter delta; it means “the change in”) we have the formula for the price elasticity of demand as

η = ΔQ/Q
ΔP/P
Or
η = ΔQ . P
ΔP Q
Since, price and quantity demanded are inversely related the coefficient of price elasticity of demand
(η) is a negative number. In order to avoid dealing with negative values, a minus sign is often introduced
into the formula of price elasticity of demand. That is
η = _ ΔQ . P
ΔP Q

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 Thus price elasticity of demand is measured by a ratio; the percentage change in quantity demanded
divided by the percentage change in the price that brought it about. For normal negatively slopped demand
curves, price elasticity will be negative, but two elasticities are compared by comparing their absolute
values. As such, price elasticity of demand is a pure number that is it has no units of measurement attached
to it. This allows meaningful comparison between the price elasticity of demand of different commodities.
The above formula is called point elasticity formula of demand because it measures elasticity at a
point on the demand curve. The value obtained for η is just a number like 2 or 5 or ½ and is referred to as
the coefficient of elasticity. Since price elasticity is being measured at a point on the market demand curve
we are assuming that all other factors that affect market demand remain fixed.

The Arc Elasticity Formula

Formula of point elasticity of demand measures the elasticity at particular point on the demand
curve. It can be conveniently used when the changes in the price and resultant quantity demanded are
infinitesimally smaller. However, when the price change is large, we have to measure elasticity over an arc
of the demand curve rather than at a specific point on it. The arc elasticity measures elasticity of demand
between two points on the demand curve. That is, arc elasticity is a measure of average elasticity. Consider
the following figure.

A Arc Elasticity
Pl
L
Price

B
P2

0
Q1 Q2
Quantity Demanded

The initial price is Pl and corresponding quantity is Ql. When price falls to P2, quantity demanded
increases to Q2. The arc elasticity measures elasticity at the point of the cord that connects the two points A
and B on the demand curve defined by the initial and new price level. By taking the average of the two
prices and average of two quantities, we can obtain the following formula for the price elasticity of demand
η = _ Δ Q . (Pl + P2)/ 2
Δ P (Q1+Q2)/2
Or
η = _ Δ Q . (Pl + P2)
Δ P (Q1+Q2)

Total Outlay Method

Another method to measure price elasticity of demand is known as total outlay or expenditure
method. In this method, changes in the total expenditure made on the good as a result of change in its price
is analysed to measure price elasticity of demand. But with the total outlay method, we can know only
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whether price elasticity is equal to one, greater than one or less than one. With this method, we cannot find
out the exact coefficient of price elasticity of demand.
If as a result of the change in price of the commodity total expenditure remains the same, then
elasticity of demand for the commodity will be equal to unity. This is so because total expenditure made on
the commodity can remain the same only if the proportional change in the quantity demanded is equal to
proportional change in price.
On the other hand, due to fall in price of the commodity, quantity demanded rises and, as result, total
expenditure made on the commodity increases, then price elasticity of demand is said to be greater than
unity. This is so because with the fall in price of the commodity, total expenditure can increase only if the
proportional change in quantity demanded is greater than the proportional change in the price.
If as a result of fall in the price of the commodity total expenditure decreases, then price elasticity of
demand will be less than unity. This is for the reason that with the fall in price, total expenditure can
decrease only if proportional increase in quantity demanded is less than proportional change in price. Thus,
through the total outlay method, we can find out whether prices price elasticity is equal to unity or greater
than unity or less than unity. Note that with this method, we cannot know the precise value of the price
elasticity.

Degrees of Elasticity of Demand

The value of price elasticity of demand ranges from zero to infinity. That is, 0< η <∞. Based on the value
of elasticity or degree of responsiveness of quantity demanded, price elasticity of demand is classified into
five categories. They are

1) Perfectly inelastic demand

2) Inelastic demand
3) Unitary elastic demand
4) Elastic demand
5) Perfectly elastic demand
Now let us analyse each of them in detail.

(1) Perfectly inelastic demand

When quantity demanded does not change as a result of change in price, demand is said to be perfectly
inelastic. Quantity demanded is unchanged when price changes or demand shows no response to change in
price. In other words, same quantity will be bought whatever the price may be. Numerical value of elasticity
will be zero (η = 0) when there is perfectly or completely inelastic demand. The following figure illustrates
the case of perfectly inelastic demand.

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 D

P1

Price
P

0
Q
Quantity Demanded
A change in price from P to Pl leaves quantity demanded unchanged at Q units. That is, quantity
demanded does not change at all when price changes.
(2) Inelastic Demand

As long as there is some positive response of quantity demanded to change in price, the absolute value of
elasticity will exceed zero. The greater the response, the larger the elasticity. However, when percentage
change in quantity demanded is less than percentage change in price, demand is said to be inelastic. That is,
a certain percentage change in price leads to a smaller percentage in quantity demanded. The coefficient of
elasticity will be less than one but greater than zero (0< η <1) when demand is inelastic. This is shown
below.

P1
Price

0
Q1 Q

Quantity Demanded

When change in price from OP to OPl causes a less than proportionate change in quantity demanded.
That is, quantity demanded changes by a smaller percentage than the change in price.
(3) Unitary Elastic Demand

If a certain percentage change in price leads to an equal percentage change in quantity demanded, then
demand said to have unitary elasticity. Unitary elasticity is the boundary between elastic and inelastic
demand. The coefficient of elasticity will be equal to one when demand is unitary elastic (η=1). The demand
curve having unitary elasticity over its whole range is shown below

8
 D

Price P

P1

D
0
Q Q1

Quantity Demanded

OP and OQ are the initial price and quantity. A fall in price from OP to OPl causes an equal proportional
change in quantity demanded from OQ to OQl.
(4) Elastic Demand

When the percentage change in quantity demanded exceeds the percentage change in price, the demand
is said to be elastic. That is, a certain percentage change in price leads to a greater percentage change in
quantity demanded. The value of coefficient of elasticity will be greater than one but less than infinity when
demand is elastic (1<η<∞). This is shown below.

P1
P
D
Price

0
Q1 Q

Quantity Demanded

An increase in price from OP to OPl causes a more than proportionate increase in quantity demanded as
shown by the change in quantity demanded from OQ to OQ l. Thus, a small rise in price brings in more than
proportionate fall in quantity demanded.
(5) Perfectly Elastic demand

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 If a small change in price leads to an infinitely large change in quantity demanded, we can say that
demand is perfectly elastic. When demand is perfectly elastic, small price reduction will raise demand to
infinity. At the same time, a slightest rise in price causes demand to fall to zero. At the going price,
consumers will buy an infinite amount (if available).above this price, they will buy nothing. The coefficient
of elasticity will be infinity when demand will be infinite when demand is perfectly elastic (η =∞). The
graph for perfectly elastic demand is shown below.
Price

D
P

0
Quantity Demanded

When it is perfectly elastic, demand curve is a horizontal straight line. In his case an infinitely large
amount can be sold at the going price OP. A small price increase from OP decreases quantity demanded
from an infinitely large amount to zero (hyper sensitive demand).

Determinants of elasticity
Elasticity of demand for any commodity is determined or influenced by a number of factors, which are
explained below
1) Nature of the commodity: elasticity of any commodity depends upon the category to which it
belongs. Elasticity of demand is low for necessaries and is high for luxuries.
2) Availability of substitutes: commodities having substitutes have more elastic demand. If the
commodity has no close substitutes, it will have inelastic demand.
3) Number of uses: if the commodity can be put to many uses, it will have elastic demand. A
commodity which cannot be put to more than one use has less elastic demand.
4) Level of income: persons who belong to higher income group their demand for commodities is less
elastic. On the other hand, demand for persons in lower income groups is generally elastic.
5) Proportion of income spent: if the consumer spends only a small proportion of income on a
commodity at a time, the demand for that commodity is less elastic. But commodities which entail a
large proportion of income of the consumer, the demand for them is elastic.
6) Habits: people who are habituated to the consumption of a particular commodity, the demand for it
will be inelastic.
7) Level of prices: when the price level is high, the demand for commodities is elastic and when price
level is low, the demand is less elastic.
8) Time period: elasticity is low (inelastic) in the short period and higher (elastic) in the long run. In the
long run consumers change their consumption pattern.

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Income Elasticity of Demand
The responsiveness or sensitiveness of quantity demanded of a commodity to changes in income of
the consumer is termed as income elasticity of demand. It is the proportionate or percentage change in
quantity demanded resulting from proportionate change in income. Thus we have
ηy = Percentage change in quantity demanded
Percentage change in income
Now denoting ΔQ for small change in quantity demanded and ΔY for the small change in income we
may symbolically write the formula for the income elasticity of demand as
ηy = ΔQ/Q
ΔY/Y
Or
ηy = ΔQ . Y
ΔY Q
For the most commodities, increase in income leads to increase in quantity demanded. Therefore,
income elasticity is positive. If the resulting percentage change in quantity demanded is larger than the
percentage change in income, income elasticity will exceed unity (η y >1). Then the commodity’s demand is
said to be income elastic. If the percentage change in quantity demanded is smaller than the percentage
change in income, income elasticity will be less than unity (η y <1). Then the commodity’s demand is said to
be income inelastic. If the percentage changes in income and quantity demanded are equal, income elasticity
will be unity (ηy =1). The commodity’s demand is said to have unitary income elasticity of demand. Unitary
income elasticity represents a useful dividing line.
There is also a relationship between income elasticity for a commodity and proportion of income
spent on it. If the proportion of income spend on the commodity increases as income increases, then the
income elasticity of demand for the commodity is greater than unity (ηy >1). If the proportion of income
spend on the commodity decreases as income rises, then the income elasticity of demand for the commodity
is less than unity (ηy <1). At the same time, if the proportion of income spend on the commodity remains the
same as income rises, then the income elasticity of demand for the commodity is equal to unity (η y =1).
A normal commodity can be further classified as necessities and luxury using income elasticity. A
commodity is considered as necessity if the income elasticity is less than unity. That is, in the case of
necessities, the proportion of income spend on it falls as income rises. A commodity is considered to be
luxury if its income elasticity is greater than unity. The proportion of consumer’s income spend on luxuries
rises as his income increases.
Cross Elasticity of Demand

The responsiveness of quantity demanded of one commodity to changes in the prices of other
commodities if often of considerable interest. The responsiveness or sensitiveness of quantity demanded of
one commodity to the changes in the price of another commodity is called cross elasticity of demand. Thus,
cross elasticity of demand can be defined as percentage or proportionate change in quantity demanded of
commodity X resulting from a proportionate change in the price of commodity Y. the cross elasticity of
commodity X with respect to the price of Y (ηXY) can presented as

ηXY = Percentage change in quantity demanded of X

Percentage change in price of Y
ηXY = ΔQX . PY
ΔPY QX
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 Where ΔQX is the change in quantity demanded of X, ΔPY is the change in price of Y, PY is the
original price of Y and QX is the original quantity of X. The coefficient of cross elasticity can vary from
minus infinity to plus infinity. Substitute goods have positive cross elasticity and complementary goods have
negative cross elasticity.
If ηXY is positive, the commodities X and Y are said to be substitutes. X and Y are substitutes if more
of X is purchased when price of Y goes up. That is, an increase in P Y leads to an increase in QX as X is
substituted for Y in consumption. For example, consumers usually purchase more coffee when price of tea
rises. Thus coffee and tea are substitutes or competing goods. In response to the rise in the price of one
good, the demand for the other good rises.
On the other hand, if ηXY is negative, X and Y are said to be complementary goods. When X and Y
are complementary goods, less of X will be purchased when the price of Y goes up. That is, an increase in
PY leads to a reduction in QX (and QY). For example consumers usually purchase fewer scooters when the
price of petrol goes up. Thus scoter and petrol are complements. Other examples of commodities that are
complements are bread and butter, tea and sugar and so on. In the case of complements, a rise in the price of
one good brings about a decrease in demand for the other, as they are consumed together.

Nature of Supply

Supply refers to the various quantities of a good or service that sellers will be able to offer for sale at
various prices during a period of time. It shows how price of a good or service is related to the quantity
which the sellers are willing and able to make available in the market. As in the case of demand, supply
refers not to a specific quantity that will be sold at some particular price, but to a series of quantities and a
range of associated prices. Supply is a desired flow. That is, it shows how much firms are willing to sell per
period of time, not how much they actually sell.

Supply Function
Like demand, supply also depends on many things. In general, quantity supplied of a product is
expected to depend on own price, prices of related products, prices of inputs, state of technology,
expectations, number of producers (sellers) in the market etc. This list can be summarised in a supply
function
QXS = f (Px, Pr, Pi, T, E, N)
Where QXS = Quantity supplied of commodity x, Px = Price of the commodity x, Pr = Prices of related
products, Pi = Prices of inputs, T = State of technology, E = Expectations and N = Number of producers in
the market.
For a simple theory of price, we need to know how quantity supplied varies with the product’s own
price, all other things being held constant. Thus we can write the supply function as
QXS = f (Px)
That is, quantity supplied of commodity x is a function of its own price, other determinants are
assumed to remain constant.

Law of Supply
The functional relationship between price and quantity supplied is called the law of supply.
According to the law of supply, as the price of the commodity falls, the quantity supplied decreases or
alternatively, as the price of the commodity rises the quantity supplied increases, other things being equal.
Therefore, there is a direct relationship between of the commodity and quantity supplied.
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 The law of supply can be illustrated through a supply schedule and supply curve. Supply schedule is
a table that shows various quantities of a good or service that sellers are willing and able to offer for sale at
various possible prices during some specified period. A supply schedule is presented below

Price Quantity Supplied

5 40
10 60
15 80
20 100
25 120
Supply schedule shows that as price rises, a greater quantity is offered for sale. By plotting the
information contained in the supply schedule on a graph we can derive the supply curve as shown below.

S
Price

0 Quantity Supplied

The supply curve is a graph showing various quantities of a good or service that sellers are willing
and able to offer for sale at various possible prices. The supply curve slopes upwards because of the direct
relationship between price and quantity supplied. Note that the entire supply curve represents supply while a
point on the supply curve represents quantity supplied at some specific price.

Why there is a direct relationship between price and quantity supplied? The main reason is that
higher prices serve as an incentive for sellers to offer greater quantity for sale. The sellers or producers can
be induced to produce and offer a greater quantity for sale by higher prices. It is assumed that sellers or
producers aim to maximise profit from the production and sale of the commodity. The higher the prices of
the commodity, other things being equal, the greater the potential gain producers can expect from producing
and supplying it in the market. Moreover, increases in price may invite new suppliers in the market.

Market Equilibrium
The market equilibrium occurs when the prevailing price equates quantity demanded to quantity
supplied. It refers to the price-quantity pair at which this takes place. Consumers bring demand to the market
for buying goods to satisfy their wants. Producers or sellers bring supply of their goods to the market to sell
them and earn profit. The market demand and supply determine prices of goods and services exchanged
between buyers and sellers. Thus, market equilibrium is reached when market demand for and market
supply of a good are equal and as a result, equilibrium prices and equilibrium quantities are determined. At
such equilibrium, buyers find that they are able to buy exactly the same amount that they are demanding at
the prevailing price and sellers are able to sell exactly the amount they are willing to supply at the prevailing
price. In other words, there is no incentive for anyone in the market to change their behaviour. Thus
equilibrium is the condition, which once achieved tends persist in time.

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 By bringing together the market demand and supply schedules we can see how market forces determine
equilibrium price and quantity of the good. The following table presents a hypothetical demand and supply
schedules of commodity X.
Price of commodity X Quantity Quantity Surplus (+) Pressure on Price
(PX in Rupees) Supplied Demanded Shortage(-)
(QXS) (QXD)
5 140 20 120 Downward
4 100 40 60 Downward
3 60 60 0 Equilibrium
2 40 80 -40 Upward
1 20 100 -80 Upward

When the price of commodity X is Rs 1, buyers are willing and able to purchase 100 units but sellers
are willing and able to offer only 20 units for sale. Therefore, there is a shortage of 80 units. At price of Rs
5, buyers are willing and able to purchase only 20 units while sellers are willing to offer 140 units.
Therefore, there will be a surplus of 120 units in the market. Let us now consider a price of Rs 3. At this
price, buyers are willing to purchase 60 units and sellers are willing to offer 60 units for sale. That is, at this
price, there is neither a surplus nor a shortage. Quantity supplied of commodity is equal to the quantity
supplied. Thus PX = Rs 3 is the equilibrium price and QXS = QXD =6o is the equilibrium quantity.
At any other price other than the equilibrium price of Rs = 3, market forces are set in motion to raise
or lower the price. At the prices above the equilibrium price, the quantity supplied exceeds the quantity
demanded. For example, at PX = Rs 4, sellers are willing to put 100 units of commodity X on the market but
buyers are willing to take only 40 units. There will be surplus or excess quantity supplied of the commodity.
Then the sellers will attempt to dispose this surplus by lowering the price. As price falls, a greater quantity
will be demanded. At lower prices sellers supply smaller quantities and buyers demand larger quantities
until the equilibrium price of Rs 3 is reached, at which the quantity supplied of 60 units of commodity X
equals the quantity demanded and market clears.
On the other hand, at prices below the equilibrium price, the quantity supplied fall short of quantity
demanded. For example, at PX = Rs 2, buyers are willing to purchase 80 units but sellers will be able to offer
only 40 units. There is a shortage or excess quantity demanded. Unhappy with the shortage, and wanting
more commodity X, buyers will bid up the price to induce sellers to supply them the desired amount. Then
the sellers offer a greater quantity at higher prices. The price will again settle at P X = Rs 3, because at this
price, the quantity demanded equals quantity supplied. Note that, price of Rs 3 is the only price that will
prevail in the market. There will be no tendency of this price to change. Such a price is referred to as
equilibrium price and quantity traded or exchanged at this price is called equilibrium quantity. The market
for the product is said to be in equilibrium when the quantity demanded equals the quantity supplied at a
specific price. The determination of equilibrium price and quantity can also be shown graphically by
bringing together the market demand and market supply curve on the same graph, as shown below.

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 S
D
Surplus or
Excess Supply
P1

P* E
Price

P0
Shortage or
Excess Demand
S D
0
Q*
Quantity

The intersection of market demand curve DD and market supply curve SS at point E defines the
equilibrium price P* and the equilibrium quantity Q*. At the equilibrium price, quantity demanded is
equal to the quantity supplied. Because there is no excess demand or excess supply there is no pressure for
the price to change further.
As said above, the equilibrium between demand and supply is not reached at once. There is the
process of changes and adjustments which ultimately results in equilibrium price and quantity. Suppose that
price is above the equilibrium level, say at P l. At such higher price, there is excess supply or surplus of the
commodity. Then the sellers would begin to lower prices in order to sell their excess suppliers. This surplus
is eliminated as prices fall, quantity demanded increases and quantity supplied would decrease until the
equilibrium price P* is reached, at which quantity demanded = quantity supplied. The opposite will happen
if the price is below the equilibrium price, say at P O. There will be excess demand or shortage. Consumers
are unable to purchase the entire commodity they want at below-equilibrium prices and they bid up the
price. This would put upward pressure on price and quantity supplied increases and until price eventually
reach the equilibrium price P*, and the market clears.
Multinational Corporations
Multinational corporations (MNCs) are huge industrial organisations that owns or controls income
generation assets in more than one country, and in so doing, produces goods or service outside its country of
origin, that is, engages in international production. MNCs are also known as Transnational Corporations
(TNCs). Instead aiming for maximisation of their profits from one or two products, the MNCs operates in a
number of fields and from this point of view, their business strategy extends over a number of products and
over a number of countries. Thus, MNCs are multi-process, multi-product and multi-national composite
enterprises. The following are the characteristics of MNCs
a) Giant Size: the assets and sales of MNCs run into billions of dollars and they also make supernormal
profits. The MNCs keep on growing even through the route of mergers and acquisitions.
b) International operations: MNCs interests and operations sprawl across national boundaries. In effect,
MNCs have become global factories searching for opportunities anywhere in the world.
c) Oligopolistic structure: in course of time, through the process of merger and acquisition, an MNC
acquires awesome power. This coupled with its giant size makes it oligopolistic in character.

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 d) Spontaneous evolutions: MNCs usually grow in a spontaneous and unconscious manner. Very often
they develop through ‘creeping incrementalism’.
e) Collective transfer of resources: an MNC facilitate collective transfer of resources. Usually this
transfer takes place in the form of a package which includes technical know-how, equipments and
machinery, raw materials and finished products, managerial services and so on.
Case for MNCs
The case for MNCs resolve around the potential benefits that an under developed country can hope to
get from MNC operations. Some of the potential benefits of MNCs are listed below
1) Capital: MNCs provide capital resources to under developed country. The scarce capital resources
may be internally and/or externally generated
2) Technology: the main reason why MNCs are encouraged by the under developed countries is on
account of their technological superiorities which these firms possess as compared to national
companies. MNCs provide sophisticated technology not available in the host country.
3) Exports and Balance of payments: MNCs can increase exports and create positive balance of
payment effects. MNCs have access to superior global distribution and marketing system.
4) Diversification: MNCs have research and development departments engaged in the task of
developing new products and superior designs of existing products. They have technology and skills
required for the diversification of the industrial base of the host country.

Case Against MNCs

The arguments against the operations of MNCs are summarised below.
1) Payment of dividend and royalty: A large sum of money flows out of the country in terms of
payments of dividends, profits, royalties, technical fees and interest to the foreign investors.
2) Distortion of economic structure: MNCs can inflict heavy damage on the host country in various
forms such as suppression of domestic entrepreneurship, extension of oligopolistic practices,
worsening of income distribution by distorting production structure etc.
3) Technology transfer not conducive: MNCs often do not engage in research and development
activities within the under developed countries. Further, technology transferred is of capital intensive
in nature which is not useful from the point of view of a labour surplus economy.
4) Political interference: Because of their immense financial and technical power, the MNCs have
gained the necessary strength to influence the decision making process in underdeveloped countries.
The autonomy and sovereignty of the host countries is in danger.

Cartel
A cartel is an explicit agreement among independent firm on subjects like prices, output, market
sharing etc. The desire of the firms to have large joint profits gives urge to form cartels. Cartel may be the
arrangements between the producers or sellers for the purpose of regulating competition in the production
and selling of the commodity. Example: OPEC.
There are mainly two types of cartels
1) Centralized cartels
2) Market sharing cartel
A centralized or perfect cartel is an arrangement where the firms in an industry reach an agreement
which maximize joint profits. So cartel can act as a monopolist. Since the firms in the cartel are assumed to
produce homogeneous product, the market demand for the product is the cartel’s demand. It is also assumed
that the cartel management knows the demand at each possible price and also the marginal costs of all its
firms.

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 In the market sharing cartel, the firms in the industry produce homogeneous product and agree upon the
share each firm is going to have. Each firm sells at the same price but sells within a given region. Such a
system can function only if firms have identical costs.

Mergers and Acquisitions

Mergers and Acquisitions (M&A) is a general term that refers to the consolidation of companies or
assets. While there are several types of transactions classified under the notion of M&A, a merger means a
combination of two companies to form a new company, while an acquisition is the purchase of one company
by another in which no new company is formed. In a merger, the boards of directors for two companies
approve the combination and seek shareholders' approval. After the merger, the acquired company ceases to
exist and becomes part of the acquiring company. In an acquisition, the acquiring company obtains the
majority stake in the acquired firms, which does not change its name or legal structure.

Reasons for Merger

Companies would choose to merge together for different reasons:

1. The combined entity would be larger, and have corresponding larger resources for marketing,
product expansion, and obtaining financing. This could help them better compete in the marketplace.
2. The combined entity could merge similar operations to reduce costs. Corporate and administrative
functions, such as human resources and marketing, are often targets for combinations. They might
also combine the production areas if the companies produce similar products and reduce costs by
having fewer plants or facilities in operation.
3. The combined entity might have less competition in the marketplace. If the products of the two
companies competed for customers, they could combine their offerings and use resources for
improving the product, rather than marketing against each other.
4. The combined entity might have synergy in operations. Synergy is when combined operations show
lower costs or higher profits than would be expected by just adding their financial information
together on paper. This could be due to economies of scale, where costs are lower due to higher
volume of production, or due to vertical integration, where greater control over the production
process is achieved due to owning more steps in the production process.

Reasons for Acquisition

Acquisitions are undertaken for strategic reasons. For example:

1. A company might acquire another company to obtain a specific product. It can be less expensive to
purchase a company offering a product you'd like to sell than building the product yourself. Software
companies often purchase smaller companies that offer extensions to their product line if they
become popular with customers, so they can add the functionality to their primary offering.
2. A company might acquire other companies to increase its size. A larger company may have more
visibility in the marketplace, and also better access to credit and other resources.
3. A company might acquire another to obtain control over a critical resource. For example, a jewelry
company might acquire a gold mine, to ensure they have access to gold without market price
fluctuations.

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Market Structures

A market is a network of communications between individuals and firms for the purpose of buying and
selling of goods and services. The idea of a particular locality or geographical place is not necessary to the
concept of market. What is required for the market to exist is the contact between sellers and buyers so that
transaction at an agreed price can take place between them. Different markets have different characteristics,
but economists have managed to group these characteristics into four broad categories of market structures.
These are
1. Perfect Competition

2. Monopoly

3. Monopolistic Competition

4. Oligopoly

Now let us examine each of the market structure in detail

Perfect Competition
Perfect competition is the market structure that fulfils the following conditions or assumptions
1. Large number of buyers and sellers

The market includes large number of buyers and sellers so that no individual buyer or seller can influence
the existing market price of the commodity. Each buyer buys an insignificant quantity and each seller sells
an insignificant part of the total quantity bought and sold. Thus the seller or firm is price taker.
2. Homogeneous Product

The industry is defined as a group of firms producing a homogeneous product. The technical characteristics
of the product as well as services associated with its sale and delivery are identical. There is no way in
which a buyer could differentiate amoung the products of different firms
3. Free entry and exit of firms

There is no barrier to entry and exit from the industry. Firms have freedom of movement in and out of the
industry
4. Profit Maximisation

The goal of all firms is profit maximisation. No other goals are pursued.
5. No Government regulation

There is no government intervention in the market. Tariffs, subsidies etc are ruled out.
The market structure in which the above assumptions are fulfilled is called pure competition. It is different
from perfect competition, which requires the fulfillment of the following two additional assumptions.
6. Perfect mobility of factors of production

The factors of production are free to move from one firm to another. Workers can move between different
jobs. Raw materials and other factors are not monopolized and labour is not unionized.
7. Perfect knowledge

Buyers and sellers have complete knowledge of the conditions in the market. They have perfect knowledge
about the prices at which goods are bought and sold. Therefore, advertisement becomes unnecessary and so
there is no selling cost
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Monopoly
Literally monopoly means one seller. ‘Mono’ means one and ‘poly’ means seller. Monopoly is said to exist
when one firm is the sole producer or seller of a product which has no close substitutes. Thus monopoly is
negation of competition. The following are important features of monopoly.
1. There is a single producer or seller of the product. Entire supply of the product comes from this
single seller. There is no distinction between a firm and an industry in a monopoly. The firm and
industry are identical in monopoly.

2. There is no close substitute for the product. If there are some other firms which are producing close
substitutes for the product in question there will be competition between them. In the presence of
competition a firm cannot be said to have monopoly. Monopoly implies absence of all competition.

3. There is no freedom of entry. The monopolist erects strong barriers to prevent the entry of new firms.
The barriers which prevent the firms to enter the industry may be economic or institutional or
artificial in nature. In the case of monopoly, the barriers are so strong that prevent entry of all firms
except the one which is already in the field.

4. The monopolist is a price maker. But in order to sell more a monopolist had to reduce the price. He
cannot sell more units at the existing price.

5. The monopolist aims at maximisation of his profit

Monopolistic Competition
Perfect competition and monopoly are rarely found in the real world and thus they do not represent the
actual market situation. Economists often use the term imperfect competition to refer to a market
structure that is neither purely competitive nor purely monopolistic. Two forms of imperfect competition
are monopolistic competition and oligopoly.
As the name implies, monopolistic competition contains the element of both pure competition and
monopoly. Monopolistic competition may be defined as a market structure where there are many sellers
who sell differentiated products. Each producer under monopolistic competition enjoys some degree of
monopoly and at the same time faces competition. The following are important features of monopolistic
competition.
1. Large number of sellers

The market consists of relatively large number of sellers or firms each satisfying a small share of the
market demand for the commodity. Unlike perfect competition, these large numbers of firms do not
produce homogeneous products. Instead they produce and sell differentiated products which are close
substitutes of each other. Thus there is stiff competition between them.
2. Product Differentiation

Product differentiation is a key feature of monopolistic competition. Product differentiation is a situation

in which firms use number of devices to distinguish their products from those of other firms in the same
industry. Products produced by the firms are close substitutes of each other. Products are not identical
but are slightly different from each other.
3. Non price competition: Selling cost

Firms incur considerable expenditure on advertisement and other selling costs to promote the sales of
their products. Promoting sales of their products through advertisement is an important example of non-

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price competition. The expenditure incurred on advertisement is prominent amoung the various types of
selling costs
4. Freedom of entry and exit

In a monopolistically competitive industry, it is easy for new firms to enter and the existing firms to
leave it. Firms will enter in to the industry attracted by super normal profit of existing firms and existing
firms will leave industry if they are making losses. However entry may not be as easy as in perfect
competition because of the need to differentiate one’s product in a monopolistically competitive market.
5. There is absence of perfect knowledge. That is buyers and sellers do not have perfect knowledge
about market conditions

6. There is no uniform price. Different producers charge different prices for their products because
products are differentiated in some way.

Oligopoly
Oligopoly is said to prevail when there are few firms or sellers in the market producing or selling a
product. Oligopoly is often referred to as “competition amoung the few”. The simplest case of oligopoly
is duopoly which prevails when there are only two producers or sellers of the product. The following are
important features of oligopoly
1. Few firms

The market consists of only a few firms. When there are two or more than two, but not many, oligopoly
is said to exist. Each produces a relatively large share of the industry
2. Interdependence

There is interdependence in decision making of the few firms which comprise the industry. This is
because when number of competitors is few, any change in price, output etc by a firm will have a direct
effect on the fortune of its rival.
3. Selling cost

A direct effect of interdependence of monopolist is that the various firms have to employ various
aggressive and defensive marketing weapons to gain a greater share in the market or to prevent a fall in
the share. For this firms have to incur a good deal of costs on advertisement and other measures of sales
promotion.
4. Group behavior

The theory of oligopoly is a theory of group behaviour. There are few firms in the group which are very
much interdependent. Each firm considers not only the market demand but also the reaction of the other
firms when any decisions or actions are taken
5. Indeterminateness of demand curve

Another important feature of oligopoly is the indeterminateness of demand curve. This is because of
interdependence of firms in the market. Under oligopoly, a firm cannot assume that its rival will keep
their prices unchanged when it make changes in its own price. As a result of this, the demand curve
facing an oligopolistic firm loses its definiteness and determinateness.

Collusive Oligopoly
In order to avoid uncertainty arising out of interdependence and avoid price wars and cut throat
competition, firms working under oligopolistic market often enter into agreement regarding uniform

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price and output policy pursued by them. When the firms enter into such collusive agreements formally
or secretly, collusive oligopoly prevails. Collusions are two main types, namely cartel and price
leadership. In a cartel firms jointly fix a price and output policy through agreements. Cartel aims at joint
profit maximization. Cartel will ensure that there is no competition among its members. Under price
leadership, one firm sets the price and others follow it. Price leadership is of two types, namely (1) price
leadership by a low cost firm and (2) price leadership by a dominant firm. In price leadership, low cost
or dominant firm will set the price and other firms will follow them.

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