01.

ECONOMICS – DEFINITION AND NATURE & SCOPE OF

ECONOMICS – DIVISIONS OF ECONOMICS

Economics is the science that deals with production, exchange and

consumption of various commodities in economic systems. It shows how scarce
resources can be used to increase wealth and human welfare. The central focus of
economics is on scarcity of resources and choices among their alternative uses.
The resources or inputs available to produce goods are limited or scarce. This
scarcity induces people to make choices among alternatives, and the knowledge
of economics is used to compare the alternatives for choosing the best among
them. For example, a farmer can grow paddy, sugarcane, banana, cotton etc. in
his garden land. But he has to choose a crop depending upon the availability of
irrigation water.

Two major factors are responsible for the emergence of economic problems.
They are: i) the existence of unlimited human wants and ii) the scarcity of
available resources. The numerous human wants are to be satisfied through the
scarce resources available in nature. Economics deals with how the numerous
human wants are to be satisfied with limited resources. Thus, the science of
economics centres on want - effort - satisfaction.

WANT

SATISFACTION EFFORT

Economics not only covers the decision making behaviour of individuals

but also the macro variables of economies like national income, public finance,
international trade and so on.

A. DEFINITIONS OF ECONOMICS
Several economists have defined economics taking different aspects into
account. The word ‘Economics’ was derived from two Greek words, oikos (a
house) and nemein (to manage) which would mean ‘managing an household’
using the limited funds available, in the most satisfactory manner possible.

i) Wealth Definition
 Adam smith (1723 - 1790), in his book “An Inquiry into Nature and Causes
of Wealth of Nations” (1776) defined economics as the science of wealth. He
explained how a nation’s wealth is created. He considered that the individual in
the society wants to promote only his own gain and in this, he is led by an
“invisible hand” to promote the interests of the society though he has no real
intention to promote the society’s interests.

Criticism: Smith defined economics only in terms of wealth and not in terms of
human welfare. Ruskin and Carlyle condemned economics as a ‘dismal science’,
as it taught selfishness which was against ethics. However, now, wealth is
considered only to be a mean to end, the end being the human welfare. Hence,
wealth definition was rejected and the emphasis was shifted from ‘wealth’ to
‘welfare’.

ii) Welfare Definition

Alfred Marshall (1842 - 1924) wrote a book “Principles of Economics”
(1890) in which he defined “Political Economy” or Economics is a study of
mankind in the ordinary business of life; it examines that part of individual and
social action which is most closely connected with the attainment and with the
use of the material requisites of well being”. The important features of
Marshall’s definition are as follows:

a) According to Marshall, economics is a study of mankind in the ordinary

business of life, i.e., economic aspect of human life.

b) Economics studies both individual and social actions aimed at promoting

economic welfare of people.

c) Marshall makes a distinction between two types of things, viz. material

things and immaterial things. Material things are those that can be seen, felt and
touched, (E.g.) book, rice etc. Immaterial things are those that cannot be seen,
felt and touched. (E.g.) skill in the operation of a thrasher, a tractor etc.,
cultivation of hybrid cotton variety and so on. In his definition, Marshall
considered only the material things that are capable of promoting welfare of
people.

Criticism: a) Marshall considered only material things. But immaterial things,

such as the services of a doctor, a teacher and so on, also promote welfare of the
people.
 b) Marshall makes a distinction between (i) those things that are capable of
promoting welfare of people and (ii) those things that are not capable of
promoting welfare of people. But anything, (E.g.) liquor, that is not capable of
promoting welfare but commands a price, comes under the purview of
economics.

c) Marshall’s definition is based on the concept of welfare. But there is no

clear-cut definition of welfare. The meaning of welfare varies from person to
person, country to country and one period to another. However, generally,
welfare means happiness or comfortable living conditions of an individual or
group of people. The welfare of an individual or nation is dependent not only on
the stock of wealth possessed but also on political, social and cultural activities
of the nation.

iii) Welfare Definition

Lionel Robbins published a book “An Essay on the Nature and Significance
of Economic Science” in 1932. According to him, “economics is a science which
studies human behaviour as a relationship between ends and scarce means which
have alternative uses”. The major features of Robbins’ definition are as follows:

a) Ends refer to human wants. Human beings have unlimited number of

wants.

b) Resources or means, on the other hand, are limited or scarce in supply.

There is scarcity of a commodity, if its demand is greater than its supply. In
other words, the scarcity of a commodity is to be considered only in relation to
its demand.

c) The scarce means are capable of having alternative uses. Hence, anyone
will choose the resource that will satisfy his particular want. Thus, economics,
according to Robbins, is a science of choice.

Criticism: a) Robbins does not make any distinction between goods conducive
to human welfare and goods that are not conducive to human welfare. In the
production of rice and alcoholic drink, scarce resources are used. But the
production of rice promotes human welfare while production of alcoholic drinks
is not conducive to human welfare. However, Robbins concludes that economics
is neutral between ends.
 b) In economics, we not only study the micro economic aspects like how
resources are allocated and how price is determined, but we also study the macro
economic aspect like how national income is generated. But, Robbins has

reduced economics merely to theory of resource allocation.

c) Robbins definition does not cover the theory of economic growth and
development.

iv) Growth Definition

Prof. Paul Samuelson defined economics as “the study of how men and
society choose, with or without the use of money, to employ scarce productive
resources which could have alternative uses, to produce various commodities
over time, and distribute them for consumption, now and in the future among
various people and groups of society”.

The major implications of this definition are as follows:

a) Samuelson has made his definition dynamic by including the element of

time in it. Therefore, it covers the theory of economic growth.

b) Samuelson stressed the problem of scarcity of means in relation to

unlimited ends. Not only the means are scarce, but they could also be put to
alternative uses.

c) The definition covers various aspects like production, distribution and

consumption.

Of all the definitions discussed above, the ‘growth’ definition stated by

Samuelson appears to be the most satisfactory. However, in modern economics,
the subject matter of economics is divided into main parts, viz., i) Micro
Economics and ii) Macro Economics.

Economics is, therefore, rightly considered as the study of allocation of

scarce resources (in relation to unlimited ends) and of determinants of income,
output, employment and economic growth.

B. SCOPE OF ECONOMICS

Scope means province or field of study. In discussing the scope of

economics, we have to indicate whether it is a science or an art and a positive
science or a normative science. It also covers the subject matter of economics.
i) Economics - A Science and an Art
a) Economics is a science: Science is a systematized body of knowledge that
traces the relationship between cause and effect. Another attribute of science is
that its phenomena should be amenable to measurement. Applying these
characteristics, we find that economics is a branch of knowledge where the
various facts relevant to it have been systematically collected, classified and
analyzed. Economics investigates the possibility of deducing generalizations as
regards the economic motives of human beings. The motives of individuals and
business firms can be very easily measured in terms of money. Thus, economics
is a science.

Economics - A Social Science: In order to understand the social aspect of

economics, we should bear in mind that labourers are working on materials
drawn from all over the world and producing commodities to be sold all over the
world in order to exchange goods from all parts of the world to satisfy their
wants. There is, thus, a close inter-dependence of millions of people living in
distant lands unknown to one another. In this way, the process of satisfying
wants is not only an individual process, but also a social process. In economics,
one has, thus, to study social behaviour i.e., behaviour of men in-groups.
b) Economics is also an art. An art is a system of rules for the attainment of a
given end. A science teaches us to know; an art teaches us to do. Applying this
definition, we find that economics offers us practical guidance in the solution of
economic problems. Science and art are complementary to each other and
economics is both a science and an art.

ii) Positive and Normative Economics

Economics is both positive and normative science.

a) Positive science: It only describes what it is and normative science prescribes

what it ought to be. Positive science does not indicate what is good or what is
bad to the society. It will simply provide results of economic analysis of a
problem.

b) Normative science: It makes distinction between good and bad. It prescribes

what should be done to promote human welfare. A positive statement is based on
facts. A normative statement involves ethical values. For example, “12 per cent
of the labour force in India was unemployed last year” is a positive statement,
which could is verified by scientific measurement. “Twelve per cent
unemployment is too high” is normative statement comparing the fact of 12 per
cent unemployment with a standard of what is unreasonable. It also suggests how
it can be rectified. Therefore, economics is a positive as well as normative
science.

iii) Methodology of Economics

Economics as a science adopts two methods for the discovery of its laws and
principles, viz., (a) deductive method and (b) inductive method.

a) Deductive method: Here, we descend from the general to particular, i.e., we

start from certain principles that are self-evident or based on strict observations.
Then, we carry them down as a process of pure reasoning to the consequences
that they implicitly contain. For instance, traders earn profit in their businesses
is a general statement which is accepted even without verifying it with the
traders. The deductive method is useful in analyzing complex economic
phenomenon where cause and effect are inextricably mixed up. However, the
deductive method is useful only if certain assumptions are valid. (Traders earn
profit, if the demand for the commodity is more).

b) Inductive method: This method mounts up from particular to general, i.e., we

begin with the observation of particular facts and then proceed with the help of
reasoning founded on experience so as to formulate laws and theorems on the
basis of observed facts. E.g. Data on consumption of poor, middle and rich
income groups of people are collected, classified, analyzed and important
conclusions are drawn out from the results.

In deductive method, we start from certain principles that are either

indisputable or based on strict observations and draw inferences about individual
cases. In inductive method, a particular case is examined to establish a general
or universal fact. Both deductive and inductive methods are useful in economic
analysis.

iv) Subject Matter of Economics

Economics can be studied through a) traditional approach and (b) modern

approach.
a) Traditional Approach: Economics is studied under five major divisions
namely consumption, production, exchange, distribution and public finance.
1.Consumption: The satisfaction of human wants through the use of goods and
services is called consumption.

2.Production: Goods that satisfy human wants are viewed as “bundles of

utility”. Hence production would mean creation of utility or producing (or
creating) things for satisfying human wants. For production, the resources like
land, labour, capital and organization are needed.

3. Exchange: Goods are produced not only for self-consumption, but also for
sales. They are sold to buyers in markets. The process of buying and selling
constitutes exchange.

4. Distribution: The production of any agricultural commodity requires four

factors, viz., land, labour, capital and organization. These four factors of
production are to be rewarded for their services rendered in the process of
production. The land owner gets rent, the labourer earns wage, the capitalist is
given with interest and the entrepreneur is rewarded with profit. The process of
determining rent, wage, interest and profit is called distribution.

5. Public finance: It studies how the government gets money and how it spends
it. Thus, in public finance, we study about public revenue and public
expenditure.

b) Modern Approach
The study of economics is divided into: i) Microeconomics and ii)
Macroeconomics.
1. Microeconomics analyses the economic behaviour of any particular decision
making unit such as a household or a firm. Microeconomics studies the flow of
economic resources or factors of production from the households or resource
owners to business firms and flow of goods and services from business firms to
households. It studies the behaviour of individual decision making unit with
regard to fixation of price and output and its reactions to the changes in demand
and supply conditions. Hence, microeconomics is also called price theory.

2. Macroeconomics studies the behaviour of the economic system as a whole or

all the decision-making units put together. Macroeconomics deals with the
behaviour of aggregates like total employment, gross national product (GNP),
national income, general price level, etc. So, macroeconomics is also known as
income theory.

Microeconomics cannot give an idea of the functioning of the economy as a

whole. Similarly, macroeconomics ignores the individual’s preference and
welfare. What is true of a part or individual may not be true of the whole and
what is true of the whole may not apply to the parts or individual decision-
making units. By studying about a single small-farmer, generalization cannot be
made about all small farmers, say in Tamil Nadu state. Similarly, the general
nature of all small farmers in the state need not be true in case of a particular
small farmer. Hence, the study of both micro and macroeconomics is essential to
understand the whole system of economic activities.
Demand and Supply
Demand
• A good consumers are willing to buy as the price per unit change.
• p

Demand

q
Factors determine
• Price
• Quality and quantity
• Availability
• Accessibility
• Income
The Law of Demand
• The law of demand states that, if all other factors remain equal, the
higher the price of a good, the less people will demand that good.
• Exceptional demand Curve
• Reasons
• Giffen paradox
• Ignorance
• Fear of shortage
P
• Necessaries
Supply
• The supply demonstrates the quantities that will be sold at a certain
price. But unlike the law of demand, the supply relationship shows an
upward slope.
P

Q
Factors Determine
• Raw materials
• Production cost
• Wages
• Interest charges
Law of Supply
• the higher the price, the higher the quantity supplied. Producers
supply more at a higher price because selling a higher quantity at a
higher price increases revenue.
Market Equilibrium
• When supply and demand are equal (i.e. when the supply function
and demand function intersect) the economy is said to be at
equilibrium.
Elasticity
• Elasticity refers to the degree of responsiveness of one variable to
another.
• Price elasticity of Demand
• Income of elasticity of Demand
• Cross elasticity of Demand
Market Mechanism
 Price Theory
Lecture 2: Supply & Demand

I. The Basic Notion of Supply & Demand

Supply-and-demand is a model for understanding the determination of the price of

quantity of a good sold on the market. The explanation works by looking at two different
groups – buyers and sellers – and asking how they interact.

II. Types of Competition

The supply-and-demand model relies on a high degree of competition, meaning that there
are enough buyers and sellers in the market for bidding to take place. Buyers bid against
each other and thereby raise the price, while sellers bid against each other and thereby
lower the price. The equilibrium is a point at which all the bidding has been done;
nobody has an incentive to offer higher prices or accept lower prices.

Perfect competition exists when there are so many buyers and sellers that no single buyer
or seller can unilaterally affect the price on the market. Imperfect competition exists
when a single buyer or seller has the power to influence the price on the market.

The supply-and-demand model applies most accurately when there is perfect

competition. This is an abstraction, because no market is actually perfectly competitive,
but the supply-and-demand framework still provides a good approximation for what is
happening much of the time.

III. The Concept of Demand

Used in the vernacular to mean almost any kind of wish or desire or need. But to an
economist, demand refers to both willingness and ability to pay.

Quantity demanded (Qd) is the total amount of a good that buyers would choose to
purchase under given conditions. The given conditions include:
• price of the good
• income and wealth
• prices of substitutes and complements
• population
• preferences (tastes)
• expectations of future prices

We refer to all of these things except the price of the good as determinants of demand.
We could talk about the relationship between quantity demanded and any one of these
things. But when we talk about a demand curve, we are focusing on the relationship
between quantity demanded and price (while holding all the others fixed).
The Law of Demand states that when the price of a good rises, and everything else
remains the same, the quantity of the good demanded will fall. In short,

↑P → ↓Qd

Note 1: “everything else remains the same” is known as the “ceteris paribus” or “other
things equal” assumption. In this context, it means that income, wealth, prices of other
goods, population, and preferences all remain fixed.

Of course, in the real world other things are rarely equal. Lots of things tend to
change at once. But that’s not a fault of the model; it’s a virtue. The whole point
is to try to discover the effects of something without being confused or distracted
by other things.

Note 2: Is the law of demand really a “law”? Well, there may be some exceedingly rare
exceptions. But by and large the law seems to hold.

Note 3: I will use the word “normal” to refer to any good for which the law of demand
holds. Please note that this is different from the book’s definition of normal.

A Demand Curve is a graphical representation of the relationship between price and

quantity demanded (ceteris paribus). It is a curve or line, each point of which is a price-
Qd pair. That point shows the amount of the good buyers would choose to buy at that
price.

Changes in demand or shifts in demand occur when one of the determinants of demand
other than price changes. In other words, shifts occur “when the ceteris are not paribus.”

The demand curve’s current position depend on those other things being equal, so when
they change, so does the demand curve’s position.

Examples:
1. The price of a substitute good drops. This implies a leftward shift.
2. The price of a complement good drops. This implies a rightward shift.
3. Incomes increase. This implies a rightward shift (for most goods).
4. Preferences change. This could cause a shift in either direction, depending on
how preferences change.

Demand versus Quantity Demanded. Remember that quantity demanded is a specific

amount associated with a specific price. Demand, on the other hand, is a relationship
between price and quantity demanded, involving quantities demanded for a range of
prices. “Change in quantity demanded” means a movement along the demand curve.
“Change in demand” refers to a shift of the demand curve, caused by something other
than a change in price.

IV. The Concept of Supply

Used in the vernacular to mean a fixed amount, such as the total amount of petroleum in
the world. Again, economists think of it differently. Supply is not just the amount of
something there, but the willingness and ability of potential sellers to produce and sell it.

Quantity supplied (Qs) is the total amount of a good that sellers would choose to produce
and sell under given conditions. The given conditions include:
• price of the good
• prices of factors of production (labor, capital)
• prices of alternative products the firm could produce
• technology
• productive capacity
• expectations of future prices

We refer to all of these, with the exception of the price of the good, as determinants of
supply.

When we talk about Supply, we’re talking about the relationship between quantity
supplied and the price of the good, while holding everything else constant.

The Law of Supply states that “when the price of a good rises, and everything else
remains the same, the quantity of the good supplied will also rise.” In short,

↑P → ↑Qs

A Supply Curve is a graphical representation of the relationship between price and

quantity supplied (ceteris paribus). It is a curve or line, each point of which is a price-Qs
pair. That point shows the amount of the good sellers would choose to sell at that price.

Changes in supply or shifts in supply occur when one of the determinants of supply other
than price changes.

Examples:
1. The price of a factor of production rises. This would cause a leftward shift the
supply curve.
2. A rise in the price of an alternative good that could be provided with the same
resources. This implies a leftward shift of supply.
3. An improvement in technology. This leads to a rightward shift of supply.

Supply versus Quantity Supplied. Analogous to the demand versus quantity demanded
distinction. “Change in quantity supplied” means a movement along the supply curve.
“Change in supply” refers to a shift of the supply curve, caused by something other than a
change in price.

V. Constructing the Market

Putting demand and supply together, we can find an equilibrium where the supply and
demand curve cross. The equilibrium consists of an equilibrium price P* and an
equilibrium quantity Q*. The equilibrium must satisfy the market-clearing condition,
which is Qd = Qs.

P
S

P*
PL
D
Qs Q* Qd Q
Mathematical example: Suppose P = 20 - .1Qd and P = 5 + .05Qs. In equilibrium,
Qd = Qs, so we have a system of equations. Solve for Q like so:
20 - .1Q = 5 + .05Q
15 = .15Q
Q* = 100.
Then plug Q* into either equation: P = 20 - .1(100) = 10.
So the market equilibrium is P* = 10, Q* = 100.

If price is below P*, at PL, then we have Qd > Qs. This is called “excess demand” or
“shortage.” The quantity that actually occurs will be Qs. For this quantity, buyers are
willing to pay much more than PL, so they’ll start bidding against each and raising the
price.

If price is below P*, at PH, then we have Qs > Qd. This is called “excess supply” or
“surplus.” The suppliers will start competing against each other for customers by
lowering the price.

Short-side rule: When there is a disequilibrium price, the actually quantity that gets sold
is given by Q = min{Qs,Qd}. This is implied by the requirement of voluntarism.

VI. Price Controls

Price floors and price ceilings are government mandated prices that attempt to control the
price of a good or service.
A price ceiling is usually imposed to keep down the price of something perceived as too
expensive. To have any effect, it must be imposed below the market price.

Example: Rent control on apartments.

What effect do we predict? As with any below-equilibrium price in the example
above, we expect to get a shortage. But in this case, buyers can’t raise the price
by bidding against each other, because by law the price cannot rise.

Using the short-side rule, we discover that rent control actually reduces the
amount of housing made available to the public.

Ironically, the price control may also raise the de facto price paid by consumers.
From the demand curve, we can see that consumers would be willing to pay a
very high price (much higher than the price ceiling or even the market price) for
the reduced quantity (Qs) available. They are willing to pay this money if they
can just find a way to do so – and they do, in the form of bribes, key fees, rental
agency fees, etc.

N.B.: If the price ceiling is imposed above the market price, it has no effect.

A price floor is usually imposed to keep up the price of something perceived as too
cheap. To have any effect, it must be set above the market price.

Example: Agricultural price supports.

These are imposed, usually, because farm lobbies have convinced the legislature
that they are not earning enough to stay in business.

What effect do we predict? As with any above-equilibrium price, we expect to

get a surplus, this time persistent because sellers can’t bid down the price. And
for many years, that’s exactly what the U.S. had. The government usually bought
up the surplus (and dumped it on 3rd World markets).

Note: If the price floor is imposed below the market price, it has no effect.

Note: It’s easy to get confused if you’re not thinking clearly. An effective price ceiling
is below the market price, while an effective price floor is above it. (Imagine a ceiling
being too low and bumping your head, or a floor rising beneath your feet.)

VII. Analyzing Changes in Market Equilibrium

Consider first a rightward shift in Demand. This could be caused by many things: an
increase in income, higher price of substitute, lower price of complements, etc. Such a
shift will tend to have two effects: raising equilibrium price, and raising equilibrium
quantity. [↑P*, ↑Q*]
 P
S
P2
P1
D2
D1
Q1 Q2 Q
Example: Consider the market for rental housing, and suppose that a new factory
or industry opens up in the city, attracting more residents. Then there will be a
rightward shift in demand, driving up both price and quantity. Note: The price of
housing does go up, but not by as much as you might think, because the change in
demand induces suppliers to bring more housing to market. This can be seen in
the movement along the Supply curve.

A leftward shift of demand would reverse the effects: a fall in both price and quantity.
The general result is that Demand shifts cause price and quantity to move in the same
direction.

Now consider a rightward shift of supply (caused by lower factor price, better
technology, or whatever). This will tend to have two effects: raising equilibrium
quantity, and lowering equilibrium price. [↓P*, ↑Q*.]

P
S1 S2

P1
P2
D
Q1 Q 2 Q
 Example: A new immigration policy allows lots of low-wage labor to enter the
steel business. The lower price of steel leads to a rightshift in the supply of cars,
so the price of cars falls and the quantity rises.

A leftshift of supply would reverse the effects, so the general result is that supply shifts
tend to cause price and quantity to move in opposite directions.

Now, what happens if both demand and supply both shift at once? In general, the two
changes have reinforcing effects on either price or quantity, and offsetting effects on the
other.

Example 1: The computer industry. Incredible improvements in technology, as

well as the entry of many new firms into the industry, have increased supply.
Simultaneously, many people have become very aware of the benefits of
computers, and new software has made computers more useful for a variety of
projects, thereby increasing demand as well.

The increase in demand tends to increase both P and Q.

The increase in supply tends to lower P and raise Q.

So both effects tend to raise quantity. But what happens to price? That depends
on the relative size of the two changes. Observation of the computer industry
shows that prices have actually fallen, so we can conclude that supply shifts have
been relatively more important than demand shifts in this market. A similar
pattern emerges in many high-tech products (CD players, DVD players).

A possible complication: Much technological change has been in the form of

higher quality, and consumers shift demand from lower quality to higher quality
machines. This is not as easy to think about in the supply-and-demand
framework. The price of a new, cutting edge computer has stayed about the same
over time, at about $2000.

Example 2: Higher education. (This example may not be totally accurate

historically, but it demonstrates the point.) Supply has fallen because higher
education is a labor-intensive business, and educated labor (which has to be
attracted from other industries) has become much more expensive. Meanwhile,
demand has increased because jobs for educated people have become increasingly
attractive relative to other jobs.

The increase in demand tends to increase both P and Q.

The decrease in supply tends to raise P while lowering Q.

So both forces tend to raise P, and that is confirmed by observation. But they
work in opposite directions on Q. Our knowledge of the market for higher
education tells us that Q has actually increased, meaning that the shift in demand
has been relatively more important.
When analyzing situations where both supply and demand shift at once, don’t let yourself
be fooled by your graph. Your graph may appear to show clear changes in both price and
quantity. But we know that one variable will experience an offsetting effect. Whether
that variable appears to rise or fall depends entirely on how large you’ve drawn the curve
shifts. (Take the computer example above. If you drew the demand shift bigger than the
supply shift, you would mistakenly conclude that price should rise.) Unless you are
provided with additional information about the size of the shifts, you can only make a
prediction about one variable.

VIII. Welfare Analysis

Aside from our positive observations about the effects of price controls (and other
policies), we can also do welfare analysis, which is a means of showing who gains and
who loses from these policies. This is where we make use of the efficiency concepts we
learned earlier in the course.

Definition of Consumer Surplus: the extra (or excess) value individuals receive from
consuming a good over what they pay for it. Or, the dollar-valued benefits to buyers
from all trade in a market. The CS is above the price paid, below the demand curve, and
to the left of the quantity purchased.

CS
P
D
Q
Definition of Producer Surplus: the extra value producers get for a good in excess of the
opportunity costs they incur by producing it. Or, the dollar valued benefits to sellers
from all trade in a market. The PS is below the price paid, above the supply curve, and to
the left of the quantity sold.

PS S
P

Q
Definition of Total Surplus: CS + PS. Total surplus represents the total value of all gains
from trade to all parties.

Welfare analysis for a price ceiling. The quantity is reduced from Q* to Qc. The CS
extends further down, but not as far right, compared to the free market. The PS does not
extend as far up, and also not as far right, compared to the free market. The transfer is
the portion of CS that used to be in PS, between the equilibrium price and the price
ceiling. Finally, the Dead Weight Loss (DWL) lies above supply, below demand, and
between Q* to Qc.

CS
DWL
S
P*
Pc

PS
D
Qc Q*

Dead-weight loss (DWL) is the reduction in the total surplus that results from a policy
that prevents mutually beneficial trades from occurring. It is the area below demand,
above supply, and between the market equilibrium quantity and the actual quantity that
gets sold.

The transfer is the portion of the total surplus that moves from CS to PS, or from PS to
CS, when a policy such as a price control displaces the market outcome. The transfer
occurs because some consumers (those who are able to buy the reduced quantity
available) are able to get a lower price; they are better off, and their gain is a loss for the
producers.

In efficiency terms, the move from free market to the price-controlled market was not a
Pareto improvement. The situations are Pareto-incomparable because some people (a
subset of consumers) gain, while others (producers and the rest of consumers) lose. But
the free market is Kaldor-Hicks superior to the price-controlled market, because the total
wealth is larger. Why? Because total wealth is smaller by the amount of the DWL under
the price ceiling. Note: The transfer is totally irrelevant from a (K-H) efficiency
perspective, because it remains in the total. The DWL is what makes the price control
inefficient.
One thing this analysis leaves out is the effect of waiting, bribes, rental agency fees, and
other means of rationing the reduced quantity of the good. These factors can reduce the
size of CS by transferring some wealth back to the PS.

Welfare analysis for a price floor. The analysis here is similar. But this time, there is a
transfer from the CS to the PS.

Consumers as a group lose from this policy. Some of the producers gain, if they are the
producers who get the privilege of selling the reduced quantity. Other producers lose,
because they don't get that privilege. Overall, since the price floor produces both winners
and losers, the price floor regime and the free market are Pareto-incomparable. But the
free market is Kaldor-Hicks superior, because it doesn't incur a DWL.

IX. Elasticity

Elasticity refers to the degree of responsiveness of one variable to another. It's not
enough to say, for instance, that a rise in price leads to a fall in quantity demanded (the
Law of Demand); we want to know how much quantity changes in response to price.

P1
P2
D
D

A simple way to see the degree of responsiveness is simply to look at the slope. A flatter
demand curve represents a greater degree of responsiveness (for a supply or demand
curve), as shown in the above graphs: the flatter demand curve produces a larger change
in quantity for the same change in price.

Using just the slope is the quick-and-easy way to think about elasticity. The extremes are
easy to remember: A perfectly elastic demand curve is horizontal, because an infinitely
small change in price corresponds to an infinitely large change in quantity; the graph
looks like the letter E for elastic. A perfectly inelastic demand curve is vertical, because
quantity will never change regardless of the change in price; the graph looks like the
letter I (for inelastic).

But using the slope can be misleading, because it doesn't tell us the significance of the
quantities. Suppose a $1 dollar increase in price leads to almost everyone choosing not to
buy the good. That would not surprise us for gumballs, but it would certainly surprise us
for televisions. The point is that a $1 increase is not much relative to the total price of
TVs, but it is huge relative to the total price of gumballs. This is why we use elasticity
instead of just the slope.
Definition of price elasticity of demand: the percentage change in quantity demanded
divided by the percentage change in price. That is,

Ed = |%∆Qd/%∆P|

How do you find the percentage change in something? You find out how much it
changed, and divide by the initial value. For example, suppose your income rises from
$400 a week to $500 a week. The change is $100, so the percentage change is $100/$400
= .25 or up 25%. N.B.: The percentage change depends on the direction you're going. If
your income went from $500 to $400, the percentage change would be - $100/$500 = -.2
or down 20%. [Note: For this reason, some textbooks, including ours, use a slightly
different formula. When calculating the percentage change in a variable, instead of
dividing by the original point, they divide by the average of the two endpoints. In this
class, we will use the original point as described above.]

Thus, we can also write

Ed = |(∆Qd/Qd)/(∆P/P)|

Now, we can rearrange this like so:

Ed = |(∆Qd/∆P) × (P/Qd)|

Look at the first term, change in Q over change in P. This is basically the slope of the
curve. I say “basically” because when we talk about the slope of a line, we usually
measure the rise (vertical distance) over the run (horizontal distance). In a supply and
demand graph, we usually measure price vertically. So actually, the slope is change in P
over change in Q. What we have here is the inverse of the slope. If we use m to stand for
the slope, we have:

Ed = |(1/m) × (P/Qd)|

This is the easiest formula to use when you have a straight line for a demand curve.

Example: You have the demand curve P = 50 –.1Qd. The slope is –.1. Using our
formula, the elasticity at the point (100, 40) is given by Ed = |(-1/.1)(40/100)| = 4.
The elasticity at the point (200, 30) is given by Ed = |(-1/.1)(30/200)| = 1.5.
Notice that the elasticity is not the same at every point on a line.

Note: In your previous classes, you may have learned “arc elasticity.” With arc
elasticity, you are finding the elasticity over a section of the demand curve. That’s what
we started with, but now I've just shown you something called “point elasticity.” Point
elasticity tells you the elasticity at a single point – specifically, at the (P, Qd) point you
plug in. Think of point elasticity as the elasticity for an interval (change in price) that is
very, very small.
We have the following definitions:
When Ed > 1, we say the curve is elastic at that point.
When Ed < 1, we say the curve is inelastic at that point.
When Ed = 1, we say the curve is unit elastic at that point.

[Note: Textbooks differ on whether to take the absolute value or not. If you don’t take
the absolute value, you’ll get a negative elasticity, which means that the demand curve is
downward sloping. But to keep things positive, we’ll always take the absolute value.]

In general, any demand curve will have one point that is unit elastic, which means that a
one percent change in price corresponds to a one percent change in quantity.

Example: continued from above. We can find the unit elastic point by setting
Ed = 1
|(-1/.1)(50 - .1Q)/Q| = 1
(50 - .1Q)/Q = .1
50 - .1Q = .1Q
50 = .2Q
Q = 250
So the point Q = 250, P = 25 is the unit elastic point.

The price elasticity of supply is almost identical to the price elasticity of demand, except
using a different curve. You can find it using the same formulas, except substituting
quantity supplied for quantity demanded. Since the supply curve is upward sloping, the
sign will be positive instead of negative.

X. Tax Incidence

So why is elasticity important? Many reasons, but here is one: it determines the
distribution of the burden of taxes. Tax incidence is the study of how the burden of a tax
is distributed over different groups. Consider the following statements:

"If we raise the tax on cigarettes, tobacco companies will just pass the tax on to
consumers." This statement implies that consumers bear the entire burden of a
sales tax, even if the government requires firms to pay the tax.

"The Social Security tax is divided between the employer and the employee. The
employer must pay half of the tax, and the employee must pay the other half."
This statement implies that the government can decide how the burden of the tax
will be distributed.

So which point of view is correct? As a general rule, neither. Consumers do not bear the
entire burden of a tax in most cases, but neither can the government decide who pays how
much. The distribution of the burden depends on the elasticity of supply and demand.
The key to understanding tax incidence is to realize that a sales tax (in fact, almost any
kind of tax) is not a tax on a person -- it's a tax on a transaction. If there is a $1 tax on
cigarettes, what that means is that there has to be a $1 difference between what the buyer
pays and what the seller gets. It doesn't really matter who sends the check to the
government.

Let's suppose, for now, that a sales tax is nominally imposed on the sellers of cigarettes.
Suppose that you were previously willing to sell a pack of cigarettes for any price higher
than $2.50. But with a $1 tax added to your costs, you're not willing to sell for anything
less than $3.50. It’s like your cost of production has gone up by $1 per pack. Overall,
the effect is to raise the supply curve by exactly $1 at every quantity. Consider the
following graph to see the result:

Stax
S

Pc
P*
Pp

D
Qt Q*
The vertical distance between S and Stax is the amount of the tax ($1 in our example).
The result of the tax is to reduce quantity from Q* to Qt, and to raise the price from P* to
Pc. But do the producers receive that price? No, they must receive a price that is $1
lower, at Pp. So how is the burden distributed? It should be apparent that consumers are
paying more than they were before, and producers are receiving less than they were
before. The burden is distributed between the two of groups.

In addition, there is also a dead-weight loss (DWL). It is the triangle between the old S
and D, and between Qt and Q*. This DWL corresponds to units that should have been
sold, because they would have been mutually beneficial exchanges. But the gains from
trade from selling these units, while positive, is not large enough to cover the tax, so the
trades don't take place.

It might appear from the graph above that the tax is distributed evenly between
consumers and producers, but that need not be true. It depends on the elasticity of supply
and demand. Suppose that demand is very inelastic (consumers are unresponsive to price
changes), and supply is very elastic (producers are very responsive to price changes).
Then we get a picture like the one below. Here, it should be apparent that the consumers
are bearing the bulk of the tax burden, while the producers' burden is very small.

Another way of thinking about this is in terms of CS and PS. When supply and demand
have about the same elasticity, the tax reduces CS and PS by about the same amount. But
when demand is inelastic and supply is elastic, the CS is reduced by more and the PS is
reduced by less.
 Stax

Pc
S
P*
Pp

D
Qt Q*
On the other hand, what if the supply were very inelastic and the demand were very
elastic? In that case, the producers would bear most of the burden. The general result is
that when demand is more elastic than supply, producers bear the larger burden, and
when supply is more elastic than demand, consumers bear the larger burden.

Consider again our examples. In the case of cigarettes, do you think the demand is
relatively elastic or relatively inelastic? Given the addictive quality of cigarettes, it seems
like demand is probably inelastic. If that's true, then a sales tax on cigarettes is likely to
be borne mainly by the consumers. In the case of the Social Security tax, do you think
the supply of labor is relatively elastic or relatively inelastic? It's probably fairly inelastic
(people need to have their jobs, and almost all legal jobs are taxed), so the suppliers (i.e.,
the employees) probably bear most of the burden.
 Page No.1

F.Y.B.COM BUSINESS ECONOMICS –I SEMESTER- II

Unit- I : Market structure: Perfect competition and Monopoly, Monopolistic

competition and Oligopoly
1. Explain the classification of the market structure?
2. What is a perfect competition? Explain its feature.
3. Illustrate the supply curve of a competitive firm
4. How can an industry attain short run under perfect competitions?
5. How can an industry attain long run under perfect competitions?
6. What does monopoly mean? What are the features of monopoly market?
7. What are the types / source of monopoly?
8. Explain price and output determination in the short run under monopoly.
9. Explain price and output determination in the long run under monopoly.

Q.1. Explain the classification of the market structure.

Market is a place where goods and services are bought and sold. It is the place where
goods are traded in. market is classified into two major classifications. Perfect competition
and Imperfect competition. Under imperfect competition monopoly, monopolistic and
oligopoly market come.

1. Perfect competition:
It is a market structure where large number sellers and buyers are involved in buying and
selling of goods at equilibrium price which is fixed by the industry. Good sold in this market
are homogenous in nature and have no substitutes. Sellers are price takers as they sell their
products at equilibrium price only. This market is hypothetical and is myth as no such market
exists actually. It is based on number of hypothetical conditions like no transport cost, no
advertisement cost, full knowledge of markets among buyers and sellers etc.

2. Imperfect competition:
a. Monopoly:
it is a market structure where only singer seller exists with number of buyers. The goods sold
by monopolist have no close substitute so cross elasticity of demand is zero in this market.
The goods sold are generally of special kind. Monopolist, being the single seller, carries price
discrimination and sells the same product to many buyers at different rates. There are many
types of monopoly such as legal, natural, technical, pure monopoly.

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.2

b. Monopolistic competition:
It is a market where are there are many sellers and buyers who are engaged in selling and
buying goods. This market is a combination of perfect competition and monopoly. Prof.
Chamberlin gave term’ Group ‘to this market as it has independent policies still competes in
the open market. No entry is restricted in this market. This market deals in differentiation
goods which are not exactly identical. Selling cost is the main feature of this market as
without advertisement this market cannot sustain.

C. Oligopoly:
This market structure has a few sellers and many buyers. The sellers in this market have
interdependence policies and compete with each other with competitive nature. Survival is
difficult in this market as competition is tough and there is reaction of each seller for other
seller’s action of policies. Price rigidity is the main feature of this market. Cartel is an
example of such as market.

Q.2.What is perfect competition and explains its features?

Perfect competition refers to the market structure where competition among the
sellers and the buyers exists in its most perfect from. In such a market, there is a single
price, which is determined by the interaction of demand and supply.
1.Many Sellers : There are many sellers or firms selling a commodity in the market. Their
number is so large that any single seller or firm cannot influence a given market price. So
an individual seller or a firm is a price-taker.
2.Many Buyers : There are many actual buyers. Their number is so large that any single
buyer cannot influence a given market price. This is because his individual demand is a
very small fraction in the total market demand so buyer is also a price-taker.
3.Homogeneous Products : All firms or producers produce and sell identical products i.e.
same in respect of size, shape, color, packaging, etc. So there is no difference in between
various products, which are perfect substitutes for each other.
4.Free Entry and Exit:-There is perfect freedom for new firms or sellers to enter a market or
an industry without any legal, economic, or any other type of restrictions or barriers,
Likewise, the existing producers or sellers are free to leave the market.
5.Perfect Knowledge: -There is perfect knowledge on the part of the buyers and sellers
regarding the market conditions especially regarding the prevailing market price and
quantity of supply. So a single price would prevail (exists) for a commodity in the entire
market.
6.Perfect Mobility of Factors of Production: - The factors of production are perfectly free
to move from one firm to another or from one industry to another or from one region to
another or from one occupation to another. This ensures freedom of entry and exit for
individuals and firms.
7.Transport Costs: -It is assumed that there are no transport costs. The transport costs
incurred by buyers and sellers to take the advantage of price changes, in a market, are
ignored.

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.3

8.Non-Intervention by the Government:-It is assumed that the government does not

interfere with the working of a market economy, i.e. it does not interfere with the
economic activities in the form of controls on the supply of raw materials, tariffs, subsidies,
rationing, licensing etc.

Q.3. Illustrate supply curve of a competitive firm.

Supply curve can be divided into two parts as: Short run and Long run.
A. Short Run Supply Curve of a Firm :
Short run is a period in which supply can be changed by changing only the variable
factors, fixed factors remaining the same. That way, if the firm shuts down, it has to bear
fixed costs. That is why in the short run, the firm will supply commodity till price is either
greater or equal to average variable cost. Thus a firm will continue supplying the commodity
till marginal cost is equal to price or average revenue. Under perfect competition average
revenue is equal to marginal revenue, so the firm will produce up to that point where
marginal revenue and marginal cost are equal.
Short run supply curve of a perfectly competitive firm is that portion of marginal cost
curve which is above average variable cost curve.

From above figure it is clear that there is no supply if price is below OP. At priceless
that OP the firm will not be covering its average variable cost (AVC).At OP price OM is the
supply. In this case firm’s marginal revenue and marginal cost cut each other at A, OM is
equilibrium output. If price goes up to OP1 the firm will produce OM1 output. This is firms
short run supply curve starts from A upwards i.e. line AB.

B. Long Run Supply Curve of Firm :

Long run is a period in which supply can be changed by changing all the factors of
production. There is no distinction between fixed and variable factors. In the long run firm
produces only at minimum average cost. In this situation long run marginal cost, marginal
revenue, average revenue, and average cost are equal i.e. LMC=LMR=LAR=LAC.

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.4

So that position of marginal cost curve will determine the supply curve which is
above the minimum average variable cost. The point where minimum average cost is equal to
marginal cost is called optimum production. Thus long run supply curve of a firm is that
portion of its marginal cost curve that lies above the minimum point of the average cost
curve.

In the above figure firm is in equilibrium at point E where LMR=LMC=LAR. LAC is

minimum corresponding to this point. This point E is also called point because at this point
LMR=LMC=LAR minimum LAC. That portion of LMC which is above E is called long run
supply curve.

Q.4. How can an firm / industry attain Short run under perfect
competitions?
Short Run equilibrium :Short-run is a period of time in which all factors of production
cannot be changed. Some factor will remain fixed. In short period equilibrium following two
conditions should be satisfied for the firm.

1. The Marginal Revenue (MR) is equal to Marginal Cost (MC) i.e. MR=MC
2. The Marginal Cost (MC) curve should cut Marginal Revenue (MR) curve from
below.

In the short run different following equilibrium position are settled down.

A. Super Normal Profit (AR > AC):Super normal profit is also known as Abnormal Profit.
The firm is in equilibrium at point E where MR=MC. With OQ as the equilibrium output.
OP is the price. Average Revenue is EQ and Average Cost is BQ. Therefore profit can be
calculated as follow :

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.5

Profit = Total Revenue (TR)–Total Cost (TC)

Total Revenue (TR) = Average Revenue x Quantity
= EQ x OQ
= OPEQ
Total Cost (TC) = Average Cost x Output
= BQ x OQ
= OABQ
Profit = TR –TC
= Area OPEQ – Area OABQ
Profit =Area APEB

B. Loss (AR < AC) :When Average cost is more than Average Revenue firm makes loss.
The loss of firm shown in following figure :

Loss = Total Cost (TC) – Total Revenue (TR)

Total Revenue (TR) = Average Revenue x Quantity

= EQ x OQ
= OPEQ
Total Cost (TC) = Average Cost x Output
= BQ x OQ
= OABQ
Loss = TC –TR
= Area OABQ – Area OPEQ
Loss = Area PABE

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.6

Average revenue is less than Average cost (AR < AC) the firm is making loss. Thus firn
in above figure suffer losses which are PABE.

C. Normal Profit (AR = AC) :The firm at equilibrium will make normal profit if at
equilibrium point AR=AC i.e. AC curve is tangent to AR.

Total Revenue (TR) = Average Revenue x Quantity

= EQ x OQ
= OPEQ
Total Cost (TC) = Average Cost x Output
= EQ x OQ
= OPEQ
Hence Total Revenue (TR) = Total Cost(TC) i.e. Area OPEQ = Area OPEQ the firm is
making normal profit.

Q.5. How can an firm/ industry attain long run under perfect
competitions?
Long Run Equilibrium :Long run is a period on which all factors of production are variable.
When some firms are earning super normal profit (AR > AC) in the short run it attracts large
number of firms into the industry. As a result output increases resulting in fall in market price
and supernormal profit will be wiped away and the normal profit will continue in the long
run.
When some firm suffers losses (AR <AC) in the short run they start leaving industry
in the long run. Reduction in the number of firms leads to contraction of industry’s output. As
a result price increases and due to this all losses will be wiped away and only normal profit
will continue in the long run.

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.7

In long run the firm is in equilibrium at the point where the LMC = LMR at the same
time LAC = LAR. If it is assumed that all the firms are facing the similar cost conditions all
the firms are in equilibrium at the point where all will earn only normal profit with LAC =
LMC = LAR = LMR

Q.6. What does monopoly mean? What are the features of monopoly
market?
The word ‘Monopoly’ is derived from two words ‘Mono’ which means single and ‘Poly’
which means sellers. Hence monopoly is a market situation in which there is one seller of
product who controls the entire market supply’
1. Single producer or seller: Monopoly is the market structure where only one seller is
involved in business activities. He has full control over his business. He is the sole
authority to take decision regarding production and pricing policies.
2. No Distinction between Firm and the industry: In this market there is no distinction
between firm and industry as it is featured with one seller. There are no competitors. So
the distinction between firm and industry disappears.
3. No close substitute: Monopoly market does not face competition there is no close
substitute available for his product. The monopolist produces all the output in a market.
4. Absence of competition: There is no competition for monopoly. So the product sold by
monopolist has no substitute or complementary product. Cross elasticity of demand is
zero in monopoly market.
5. Price maker: Monopoly is a price maker being having control over his business. He does
carry price discrimination by charging various prices to different consumers.
6. Complete control : Monopoly has complete control over the production and market
supply. Decision about production is the sole decision of his. Entry to new firms are
restricted.
7. Downward Sloping demand curve : Monopolist faces a downward sloping demand curve
which indicates that it can sell more at a lower price.

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.8

Q.7. Explain the types/ Sources of Monopoly in brief.

1. Pure/ Perfect Monopoly : A Pure or perfect monopoly is one, which has no close
substitutes. Such type of monopoly is very rare.
2. Imperfect Monopoly : Imperfect monopoly is one, which has remote substitute in the
market. Such type of monopoly is very common.
3. Legal Monopoly : Legal monopoly exists due to some statutory regulations like Patents,
Trademarks, copyrights etc.
4. Natural Monopoly :Natural monopoly arises as a result of natural advantages like good
location, minerals, Natural resources, goodwill etc. E.g Tea of Assam
5. Technological Monopoly : It arises because of some technological advantages like use of
capital goods, new methods of production etc.
6. Joint Monopoly : When many firms come together and form associations like pools,
cartels, syndicates etc. it is termed as Joint Monopoly. They come together for mutual
cooperation and carrying joint business.
7. Public Monopoly : When the production of goods and services are fully owned and
controlled by the Govt. it is termed as Public Monopoly. However the main aim of the
government is not to earn profits but to provide services. Hence they are also termed as
Welfare monopolies. For e.g Indian Railways, M.S.E.B etc.
8. Private Monopoly: When the production is owned, managed &controlled by the private
entrepreneurs, it is termed as the Private monopolies. The aim of such monopoly is to
earn maximum profits.
9. Simple Monopoly : A Simple Monopoly charges uniform price (single price) to all
customers. Monopolist cannot set a price to maximize his profit. It is termed as Simple
Monopoly.
10. Discriminating Monopoly : Discriminating Monopoly charges different prices to
different customers for the same products or service. For e.g M.S.E.B charges lower rate
for domestic consumption and higher rate for commercial consumption.

Q.8. Explain price and output determination in the short run under
monopoly.
Short Run Equilibrium :
1. Super Normal Profit : If the Average Revenue (AR) is greater than Average Cost (AC)
(AR > AC) the monopoly firm will earn supernormal profit. Profit of monopolist is
shown in following diagram.

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.9

Profit = Total Revenue (TR) – Total Cost (TC)

Total Revenue (TR) = Average Revenue x Quantity
= AQ x OQ
= OPAQ
Total Cost (TC) = Average Cost x Output
= CQ x OQ
= OBCQ
Profit = TR –TC
= Area OPAQ – Area OBCQ
Profit = Area BPAC
Hence the monopolist enjoys supernormal profit of BPAC and this is also as monopoly
profit.
2.Losses :If the Average Revenue (AR) is less than Average Cost (AC) (AR < AC) the
monopoly firm will suffer from losses. Loss of monopolist is shown in following diagram.

Loss = Total Cost (TC) – Total Revenue (TR)

Total Revenue (TR) = Average Revenue x Quantity

= AQ x OQ
= OPAQ
Total Cost (TC) = Average Cost x Output
= CQ x OQ
= OBCQ
Loss = TC –TR
= Area OPAQ – Area OBCQ
Profit = Area PBCA

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.10

3. Normal Profit :The monopoly firm at equilibrium will make normal profit if at
equilibrium point AR=AC i.e. AC curve is tangent to AR.

Total Revenue (TR) = Average Revenue x Quantity

= AQ x OQ
= OPAQ
Total Cost (TC) = Average Cost x Output
= AQ x OQ
= OPAQ
Monopoly firm in short run may also earn normal profit if SAC is tangent to the AR at
equilibrium point (E). If in short run monopolist firm earn normal profit monopolist will not
produce the output. Monopolist always wants supernormal profit.

Q.9. Explain price and output determination in the long run under
monopoly.
Long Run Equilibrium : Monopoly is associated with profits and it is called monopoly
profit. This applies to the long run equilibrium under monopoly. The monopolist will always
make profit in the long run where monopolist is not under pressure to operate on the existing
plant scale.

Above diagram shows the profit of monopolist in long run. Monopolist produced and
sold OQ quantity at price OP. For this output long run average cost (LAC) is CQ and total
cost is OBCQ while total revenue OPAQ. In long run monopolist earn profit area BPAC.

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.11

Unit II. : Market structure: Pricing and Output Decisions under imperfect
completion.
1. Explain features / characteristics of monopolistic competitions.
2. Explain the short run equilibrium of a firm under monopolistic competitions.
3. Explain the long run equilibrium of a firm under monopolistic competitions.
4. Discuss the role of advertising in monopolistic competition.
5. Explain the features of the oligopoly in brief
6. Explain the Price and Output Determination Under collusive oligopoly market. /
Illustrate Cartel in the model oligopoly.
7. Explain the Paul Sweezy model of price rigidity. / Explain the kinked Demand Curve
Model.
8. Explain the types of Price Leadership.
9. Distinguish between perfect competitions and monopolistic competitions.
10. Distinguish between Monopoly and monopolistic competitions.

Q.1. What are the features / characteristics of monopolistic competition?

Monopolistic competition was introduced by Prof. E.H. Chamberlin and Prof. Mrs. Joan
Robinson. Monopolistic competition is the type of market structure where there exist
monopoly on one side and perfect competition on other side. Simply we can also say that
it is a mixture of monopoly and perfect competition.
1.Large number of firm :In a Monopolistic competition there is relatively large number of
firms each satisfying a small share of the market demand for the product. As there are large
number of firms there exists stiff competition between them. But the size of the firm will be
relatively small.
2.Product Differentiation : In a Monopolistic competition the products produced by various
firms are not identical but slightly different from each other, which means the products
are not same but are similar and hence their prices are not much different. They are close
substitutes of each other.
3.Selling Cost : Firms in Monopolistic competition incur expenditure to promote sales,
which is called as ‘Selling Cost’. Selling cost is incurred in the form of advertisement
like on T.V., Radio, Press, Exhibitions, free samples etc. Selling cost tries to influence
consumers demand and promote sales.

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.12

4.Free entry and exist : In a Monopolistic competition it is easy for the new firms to enter
and the existing firm to leave it. Free entry means that when in the industry existing firms
are making supernormal profit new firms enter in the industry and the losses will compel
them to leave the industry or group.
5.Absence of Interdependence : Under Monopolistic competition firms are large but not
their size. They are too small. It means every firm has its own policies like production,
output, price policy etc. Thus the policy of an individual firm cannot influence the
policy of other firms which means all firms are independent but not interdependent.
6.Concept of Group : In Monopolistic Competition the word ‘industry’ loses its significance
as Prof. Chamberlin has used the word ‘Group’ which means number of producers
whose goods are fairly close substitutes.
7.Nature of Demand Curve :-In a Monopolistic competition the demand curve slopes
downward from left to right, which an individual firms can sell more by lowering price. DD
curve of monopolistic always slopes negatively.

Q.2. Explain the Short Run Equilibrium under Monopoly Market.

A firm under monopolistic completion faces three situations i.e. supernormal profit, loss,
and normal profit.
1. Super Normal Profit : If the Average Revenue (AR) is greater than Average Cost (AC)
(AR > AC) the monopoly firm will earn supernormal profit. Profit of monopolistic firm is
shown in following diagram.

Profit = Total Revenue (TR) – Total Cost (TC)

Total Revenue (TR) = Average Revenue x Quantity
= AQ x OQ = Area OPAQ
Total Cost (TC) = Average Cost x Output
= CQ x OQ = Area OBCQ
Profit = TR –TC
= Area OPAQ – Area OBCQ
Profit = Area BPAC
Hence the monopolist enjoys supernormal profit of BPAC and this is also as monopoly
profit.

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.13

2. Losses : If the Average Revenue (AR) is less than Average Cost (AC) (AR < AC) the
monopoly firm will suffer from losses. Loss of monopolistic firm is shown in following
diagram.

Loss = Total Cost (TC) – Total Revenue (TR)

Total Revenue (TR) = Average Revenue x Quantity

= AQ x OQ
= OPAQ
Total Cost (TC) = Average Cost x Output
= CQ x OQ
= OBCQ
Loss = TC –TR
= Area OPAQ – Area OBCQ
Profit = Area PBCA
4. Normal Profit : The monopolistic firm at equilibrium will make normal profit if at
equilibrium point AR=AC i.e. AC curve is tangent to AR.

Total Revenue (TR) = Average Revenue x Quantity

= AQ x OQ = Area OPAQ
Total Cost (TC) = Average Cost x Output
= AQ x OQ = Area OPAQ
Monopolistic firm in short run may also earn normal profit if SAC is tangent to the AR at
equilibrium point (E). If in short run monopolist firm earn normal profit monopolist will not
produce the output. Monopolist always wants supernormal profit.

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.14

Q.3. Explain the Long Run Equilibrium under Monopolistic competition.

In long run firms working under monopolistic completion earn only normal profits.
The equilibrium of a firm under monopolistic completion is shown in the figure below.

Above diagram shows the normal profit of monopolistic firm in long run.
Monopolistic firm produced and sold OQ quantity at price OP. For this output long run
average cost (LAC) is AQ and total cost is OQAP while total revenue OQAP. In long run
monopolist earn profit area BPAC.

Q.4. Discuss the role of advertising in monopolistic competition.

A monopolistic firm produces close substitute products and therefore each firm in
order to attract consumers towards their product and increase their market share invests
heavily on advertisement. It may result in increase in profits. Firms that sell highly
differentiated consumer goods such as perfumes, soft drinks etc. spend between 10 to 20 % of
revenue on advertising.
Debate over role of advertising in monopolistic completion.
The Critique of Advertising : It is criticized that firms advertise in order to influence
consumer’s tastes. Much advertising is psychological rather that informational.
Example. Advertisement of a brand of wrist watch. The advertisement shown in
newspaper and television does not tell the viewer about the price or quality of product.
Instead it might show a group of youngsters wearing the watch in their friends groups and
they make impression on others. The goal of the advertisement is to convey a subconscious
massage “You too can impress others and be happy, if only you wear our product” Critics
says that such a advertisements creates a desire in the consumers unnecessary and increases
the completion in the market.
The Defence of Advertising : Defenders of advertisement says that firms use
advertising provides information to consumers. Advertising also convey the message about
price of product, location of store etc. which is convenient to consumer.

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.15

Advertising makes consumers more fully informed about product and firm. In
addition advertisement allows new firms to enter more easily because advertisement gives
entrants a way to attract customers from competitors.

Q.5. Explain the features of the oligopoly in brief.

Oligopoly is a market situation where there are only few sellers in a given line at
production. Mr. Feller defines Oligopoly as “Competition among the few”. In this type of
market the firm may be producing either homogeneous products or may be having product
differentiation in the given line of production.
Features:-
1. Few Sellers:-Under Oligopoly there are few sellers producing or supplying either
homogeneous products or differentiated products.
2. Interdependence:-The firms have a high degree of interdependence in their business
policies about fixing of price and determination of output.
3. Advertisement & selling cost :-Advertisement and selling cost have strategic importance
to the firms under oligopoly. Each firm tries to attract maximum number of consumers
towards its products by spending huge amount of money on advertisement and publicity.
4. High Cross elasticity’s of demand:-Under Oligopoly the firms have a high degree of
cross elasticity’s of demand. So there is always a fear of retaliation by the rivals. For e.g. if
coke reduces its price by 2 Rs. Pepsi may retaliate by reducing its price by 3 Rs.
5. Constant Struggle:-Competition is of unique type in a Oligopolistic market. Here
competition consists of constant struggle of rivals against rivals (competitors).
6. Lack of Uniformity:-In Oligopoly the size of the firms are not uniform. Some firms are
very big in size and some firms are very small in size. Uneven sizes of firms are found in this
market.
7. Price Rigidity:-In Oligopoly market each firm sticks to its own price. This is because it is
in constant fear of retaliation by the rivals if it reduces the price.
8. Kinked Demand Curve:-According to Mr. Paul Sweezy firm is an Oligopolistic market
have Kinky demand curve. This is because when a firm changes its price the other firms also
change their price. Hence the demand curve of an Oligopolistic is not definite it goes on
changing.
Three Important Models of Oligopoly are as :
(1) Price and output determination under collusive oligopoly.
(2) Price and output determination under non-collusive oligopoly.
(3) Price leadership model.

Q.6. Explain the Price and Output Determination Under collusive oligopoly
market. / Illustrate Cartel in the model oligopoly.
Collusive Oligopoly : The term 'collusion' implies to 'play together'. When firms under
oligopoly agree formally not to compete with each other about price or output, it is
called collusive oligopoly. The firms may agree on setting output quota, or fix prices or limit

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.16

product promotion or agree not to 'poach' in each other's market. The completing firms thus
from a 'cartel'. The members of firms behave as if they are a single firm.
There are two forms of cartel:
1. Cartel aiming at joint profit maximization
2. Cartel aiming at sharing of the market
Each of the form of the model is discussed below :
1. Cartel aiming at joint profit maximization :
In this form of cartel the aim is to maximize joint industry profits. A central
administrative agency decides total quantity to be produce, price, allocation of output
among each firm and distribution of profit among each firm.
In order to maximize joint profits central agency will apply marginal list rule i.e.
equate industry marginal cost and industry marginal revenue curve.

In above figure the industry demand curve DD consisting of two firms. Marginal cost
curve (MC) is obtained by the horizontal summation of MCA and MCB. So the MR curve and
MC curve which are identical. The cartel's MR curve intersects the MC curve at point E.
Profits are maximized at output OQ, where MC = MR. The cartel will set a price OP, at
which OQ, output will be produced and demanded.
Once the allocation is done in such a way that the marginal cost o each firm is equal,
i.e. MCA = MCB = MR. The total output produced by firm A and B would be determined
points EA and EB respectively. Thus firm A produce OQA and firm B produce OQB level of
output. Therefore total output is the sum of individual output of A and B i.e. OQ = OQA +
OQB .
It is considered that firm A is low cost firm then firm A makes profits equal to PNML
while firm B makes profit PRST. The maximum joint profit is obtained by summing the
individual profit of the firm.

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.17

2. Cartel aiming at sharing of the market :

In this form of cartel members firms agree not only to a common price but also
agree on the quantity which they can sell in the market.
If there is are only two firms in the cartel each firm will sell half of the total market
demand at that price. The quotas of market share are decided by bargaining between the
firms. This is graphically shown below.

Consider two firms A and B form a cartel in industry. DD is the market demand curve
and MR is the corresponding marginal revenue curve. MC curve obtained by the horizontal
summation of MCA and MCB. at the equilibrium point E, where MC=MR the cartel will
achieve maximum profits. The total equilibrium output will be OQ and price OP.
The total output of firm A will be OQA and of firm B will be OQB. Thus total output
in the industry will be,
OQ = OQA + OQB
The total output OQ is obtained by drawing a line parallel to X- axis from point E that
intersect MCA at point EA and MCB at point EB. Thus each firm sells output at monopoly
price OP. This is called as market sharing cartel.

Q.7. Explain the Paul Sweezy model of price rigidity. / Explain the kinked
Demand Curve Model.
The Kinked demand curve model was developed by Paul Sweezy (1939). According
to him, the firms under oligopoly try to avoid any activity which could lead to price wars
among them. The firms mostly make efforts to operate in non price competition for
increasing their respective shares of the market and their profit. An analytical device which is
used to explain the oligopolistic price rigidity is the Kinked Demand Curve.
Mr. Paul Sweezy used two demand curve concepts to explain the model. These are
reproduced below:

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.18

Diagram:

In the above diagram DD is a kinked demand curve. It is made up or two segments

DB and BD. The demand curve is kinked or has a bend at point B. The kink is formed at the
prevailing market price level BM (10) . The segment of the demand curve above the
prevailing price level is highly elastic (DB) and the segment of the demand curve below the
prevailing price level is fairly inelastic (BD1). This is explained now in brief.

Explanation:
Price increase. If an oligopolistic raises the price of his products from 10 per unit to 12 per
unit, he loses a large part of the market and his sale comes down to 40 units from 120 units.
There is a loss of 80 units in sale as most of his customers are now purchasing goods from his
competitor firms who are selling the goods at 10 per units. So an increase in price above the
prevailing level-shows that the demand curve to the left of and above point B is fairly elastic.

Price reduction. If an oligopolistic reduces the prices of its goods below the prevailing price
level BM (10 per unit) for increasing his sales, his competitors will also match price changes
so that their customers do not go away from them. Let us assume that Oligopolist has lowered
the price to 4 per unit. Its competitors in the industry match the price cut. The sale of the
oligopolist with a big price cut of 6 per unit has increased by only 40 units (160 - 120 = 40).
The firm does not gain as the total revenue decreases with the price cut. The BD/ portion of
the demand curve which lies on the right side and below point B is fairly inelastic.

Rigid Prices. The firms in the oligopolist market 'have no incentive to raise or lower the
prices of the goods. They prefer to sell the goods at the prevailing price level due to reaction
function. The price BM (10 per unit) will, therefore, tend to remain stable or rigid, as every
member of the oligopoly does not see any gain by lowering or raising the price of his goods.

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.19

8. Explain the types of Price Leadership.

Price leadership is a form of collusion in which one firm sets the price and other
firms in the market follow it. Hence it is called as price leadership.

Assumptions:
(a) There are two firms A and B in the market.
(b) The output produced by the two firms is homogeneous.
(c) The firm 'A being the low cost firm or a dominant firm acts as a leader firm.
(d) Both of the firms face the same demand curve.
(e) Each of the two firms has an equal share in the market.
The price and output determination under price leadership is now explained with the
help of the diagram below.

Diagram:

In above figure DD1 is the demand curve which is faced by each of the two firms. MR
is the marginal revenue curve of each firm. MCA is the marginal cost of firm A and MCB is
the marginal cost of firm B. It is assumed that the firm A is a low cost firm than firm B. As
such the MCA lies below MCB.
The leader firm using the marginalistic rule of MC = MR is in equilibrium at point E. The
firm A maximizes profits by selling output OM and setting price MP. The firm B is in
equilibrium at point F where MCB = MR. The firm B maximizes profits by producing ON
output and selling it at NK price. The firm B has to compete firm A in the market, if the firm
B fixes the price NK per unit, it will not be able to compete with firm A which is selling
goods at MP price per unit.
Hence, the firm B will be compelled to follow the leader firm A. The firm B will also
charge MP price per unit as set by the firm A. The firm B will also produce QM output like

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
 Page No.20

the firm A. Thus both the firms will charge the same price MP and sell each of them OM
output. The total output will thus be twice of OM.
The firm A being the low cost firm will maximize profits by selling OM output at MP
price. The profits of the firm B is lower than of firm A because its costs of production is
higher than of firm A.

Q.9. Distinguish between perfect competitions and monopolistic

competitions.
Q.10. Distinguish between Monopoly and monopolistic competitions.

MARKETS STRUCTURE
Perfect Monopoly Monopolistic Oligopoly
Competition competition
Numbers Large sellers and Single seller and Many sellers and A few sellers
large buyers large buyers many buyers and large buyers

Product Homogeneous Particular or Heterogeneous Homogeneous

specialist or
heterogeneous
price Equilibrium Price Independent Interdependent
price(fixed by discrimination pricing policy pricing policy
industry where
Demand =Supply
Seller A price taker A price maker A price dictator Price imitator
Demand Horizontal to X Slopes Slopes Kink demand
curve axis downward downward(Flatter) curve(Price
(Steeper) Rigidity)
Known as Perfect Imperfect Imperfect Imperfect
competition competition competition competition
existence It is unreal market It is restricted It is in existence It is existence
Entry and Free entry and No entry Free entry and exit Entry prohibited
exit exit
Special Assumption Remote Group concept Price rigidity
feature based competitors (Chamberlin) (to stop
competitors)
Substitutes Number of No substitute Number of A few

PROF. RAJESH H.B

Prof. KARBHARI BHALCHANDRA
01. ECONOMICS – DEFINITION AND NATURE & SCOPE OF
ECONOMICS – DIVISIONS OF ECONOMICS

Economics is the science that deals with production, exchange and

consumption of various commodities in economic systems. It shows how scarce
resources can be used to increase wealth and human welfare. The central focus of
economics is on scarcity of resources and choices among their alternative uses.
The resources or inputs available to produce goods are limited or scarce. This
scarcity induces people to make choices among alternatives, and the knowledge
of economics is used to compare the alternatives for choosing the best among
them. For example, a farmer can grow paddy, sugarcane, banana, cotton etc. in
his garden land. But he has to choose a crop depending upon the availability of
irrigation water.

Two major factors are responsible for the emergence of economic problems.
They are: i) the existence of unlimited human wants and ii) the scarcity of
available resources. The numerous human wants are to be satisfied through the
scarce resources available in nature. Economics deals with how the numerous
human wants are to be satisfied with limited resources. Thus, the science of
economics centres on want - effort - satisfaction.

WANT

SATISFACTION EFFORT

Economics not only covers the decision making behaviour of individuals

but also the macro variables of economies like national income, public finance,
international trade and so on.

A. DEFINITIONS OF ECONOMICS
Several economists have defined economics taking different aspects into
account. The word ‘Economics’ was derived from two Greek words, oikos (a
house) and nemein (to manage) which would mean ‘managing an household’
using the limited funds available, in the most satisfactory manner possible.

i) Wealth Definition
 Adam smith (1723 - 1790), in his book “An Inquiry into Nature and Causes
of Wealth of Nations” (1776) defined economics as the science of wealth. He
explained how a nation’s wealth is created. He considered that the individual in
the society wants to promote only his own gain and in this, he is led by an
“invisible hand” to promote the interests of the society though he has no real
intention to promote the society’s interests.

Criticism: Smith defined economics only in terms of wealth and not in terms of
human welfare. Ruskin and Carlyle condemned economics as a ‘dismal science’,
as it taught selfishness which was against ethics. However, now, wealth is
considered only to be a mean to end, the end being the human welfare. Hence,
wealth definition was rejected and the emphasis was shifted from ‘wealth’ to
‘welfare’.

ii) Welfare Definition

Alfred Marshall (1842 - 1924) wrote a book “Principles of Economics”
(1890) in which he defined “Political Economy” or Economics is a study of
mankind in the ordinary business of life; it examines that part of individual and
social action which is most closely connected with the attainment and with the
use of the material requisites of well being”. The important features of
Marshall’s definition are as follows:

a) According to Marshall, economics is a study of mankind in the ordinary

business of life, i.e., economic aspect of human life.

b) Economics studies both individual and social actions aimed at promoting

economic welfare of people.

c) Marshall makes a distinction between two types of things, viz. material

things and immaterial things. Material things are those that can be seen, felt and
touched, (E.g.) book, rice etc. Immaterial things are those that cannot be seen,
felt and touched. (E.g.) skill in the operation of a thrasher, a tractor etc.,
cultivation of hybrid cotton variety and so on. In his definition, Marshall
considered only the material things that are capable of promoting welfare of
people.

Criticism: a) Marshall considered only material things. But immaterial things,

such as the services of a doctor, a teacher and so on, also promote welfare of the
people.
 b) Marshall makes a distinction between (i) those things that are capable of
promoting welfare of people and (ii) those things that are not capable of
promoting welfare of people. But anything, (E.g.) liquor, that is not capable of
promoting welfare but commands a price, comes under the purview of
economics.

c) Marshall’s definition is based on the concept of welfare. But there is no

clear-cut definition of welfare. The meaning of welfare varies from person to
person, country to country and one period to another. However, generally,
welfare means happiness or comfortable living conditions of an individual or
group of people. The welfare of an individual or nation is dependent not only on
the stock of wealth possessed but also on political, social and cultural activities
of the nation.

iii) Welfare Definition

Lionel Robbins published a book “An Essay on the Nature and Significance
of Economic Science” in 1932. According to him, “economics is a science which
studies human behaviour as a relationship between ends and scarce means which
have alternative uses”. The major features of Robbins’ definition are as follows:

a) Ends refer to human wants. Human beings have unlimited number of

wants.

b) Resources or means, on the other hand, are limited or scarce in supply.

There is scarcity of a commodity, if its demand is greater than its supply. In
other words, the scarcity of a commodity is to be considered only in relation to
its demand.

c) The scarce means are capable of having alternative uses. Hence, anyone
will choose the resource that will satisfy his particular want. Thus, economics,
according to Robbins, is a science of choice.

Criticism: a) Robbins does not make any distinction between goods conducive
to human welfare and goods that are not conducive to human welfare. In the
production of rice and alcoholic drink, scarce resources are used. But the
production of rice promotes human welfare while production of alcoholic drinks
is not conducive to human welfare. However, Robbins concludes that economics
is neutral between ends.
 b) In economics, we not only study the micro economic aspects like how
resources are allocated and how price is determined, but we also study the macro
economic aspect like how national income is generated. But, Robbins has

reduced economics merely to theory of resource allocation.

c) Robbins definition does not cover the theory of economic growth and
development.

iv) Growth Definition

Prof. Paul Samuelson defined economics as “the study of how men and
society choose, with or without the use of money, to employ scarce productive
resources which could have alternative uses, to produce various commodities
over time, and distribute them for consumption, now and in the future among
various people and groups of society”.

The major implications of this definition are as follows:

a) Samuelson has made his definition dynamic by including the element of

time in it. Therefore, it covers the theory of economic growth.

b) Samuelson stressed the problem of scarcity of means in relation to

unlimited ends. Not only the means are scarce, but they could also be put to
alternative uses.

c) The definition covers various aspects like production, distribution and

consumption.

Of all the definitions discussed above, the ‘growth’ definition stated by

Samuelson appears to be the most satisfactory. However, in modern economics,
the subject matter of economics is divided into main parts, viz., i) Micro
Economics and ii) Macro Economics.

Economics is, therefore, rightly considered as the study of allocation of

scarce resources (in relation to unlimited ends) and of determinants of income,
output, employment and economic growth.

B. SCOPE OF ECONOMICS

Scope means province or field of study. In discussing the scope of

economics, we have to indicate whether it is a science or an art and a positive
science or a normative science. It also covers the subject matter of economics.
i) Economics - A Science and an Art
a) Economics is a science: Science is a systematized body of knowledge that
traces the relationship between cause and effect. Another attribute of science is
that its phenomena should be amenable to measurement. Applying these
characteristics, we find that economics is a branch of knowledge where the
various facts relevant to it have been systematically collected, classified and
analyzed. Economics investigates the possibility of deducing generalizations as
regards the economic motives of human beings. The motives of individuals and
business firms can be very easily measured in terms of money. Thus, economics
is a science.

Economics - A Social Science: In order to understand the social aspect of

economics, we should bear in mind that labourers are working on materials
drawn from all over the world and producing commodities to be sold all over the
world in order to exchange goods from all parts of the world to satisfy their
wants. There is, thus, a close inter-dependence of millions of people living in
distant lands unknown to one another. In this way, the process of satisfying
wants is not only an individual process, but also a social process. In economics,
one has, thus, to study social behaviour i.e., behaviour of men in-groups.
b) Economics is also an art. An art is a system of rules for the attainment of a
given end. A science teaches us to know; an art teaches us to do. Applying this
definition, we find that economics offers us practical guidance in the solution of
economic problems. Science and art are complementary to each other and
economics is both a science and an art.

ii) Positive and Normative Economics

Economics is both positive and normative science.

a) Positive science: It only describes what it is and normative science prescribes

what it ought to be. Positive science does not indicate what is good or what is
bad to the society. It will simply provide results of economic analysis of a
problem.

b) Normative science: It makes distinction between good and bad. It prescribes

what should be done to promote human welfare. A positive statement is based on
facts. A normative statement involves ethical values. For example, “12 per cent
of the labour force in India was unemployed last year” is a positive statement,
which could is verified by scientific measurement. “Twelve per cent
unemployment is too high” is normative statement comparing the fact of 12 per
cent unemployment with a standard of what is unreasonable. It also suggests how
it can be rectified. Therefore, economics is a positive as well as normative
science.

iii) Methodology of Economics

Economics as a science adopts two methods for the discovery of its laws and
principles, viz., (a) deductive method and (b) inductive method.

a) Deductive method: Here, we descend from the general to particular, i.e., we

start from certain principles that are self-evident or based on strict observations.
Then, we carry them down as a process of pure reasoning to the consequences
that they implicitly contain. For instance, traders earn profit in their businesses
is a general statement which is accepted even without verifying it with the
traders. The deductive method is useful in analyzing complex economic
phenomenon where cause and effect are inextricably mixed up. However, the
deductive method is useful only if certain assumptions are valid. (Traders earn
profit, if the demand for the commodity is more).

b) Inductive method: This method mounts up from particular to general, i.e., we

begin with the observation of particular facts and then proceed with the help of
reasoning founded on experience so as to formulate laws and theorems on the
basis of observed facts. E.g. Data on consumption of poor, middle and rich
income groups of people are collected, classified, analyzed and important
conclusions are drawn out from the results.

In deductive method, we start from certain principles that are either

indisputable or based on strict observations and draw inferences about individual
cases. In inductive method, a particular case is examined to establish a general
or universal fact. Both deductive and inductive methods are useful in economic
analysis.

iv) Subject Matter of Economics

Economics can be studied through a) traditional approach and (b) modern

approach.
a) Traditional Approach: Economics is studied under five major divisions
namely consumption, production, exchange, distribution and public finance.
1.Consumption: The satisfaction of human wants through the use of goods and
services is called consumption.

2.Production: Goods that satisfy human wants are viewed as “bundles of

utility”. Hence production would mean creation of utility or producing (or
creating) things for satisfying human wants. For production, the resources like
land, labour, capital and organization are needed.

3. Exchange: Goods are produced not only for self-consumption, but also for
sales. They are sold to buyers in markets. The process of buying and selling
constitutes exchange.

4. Distribution: The production of any agricultural commodity requires four

factors, viz., land, labour, capital and organization. These four factors of
production are to be rewarded for their services rendered in the process of
production. The land owner gets rent, the labourer earns wage, the capitalist is
given with interest and the entrepreneur is rewarded with profit. The process of
determining rent, wage, interest and profit is called distribution.

5. Public finance: It studies how the government gets money and how it spends
it. Thus, in public finance, we study about public revenue and public
expenditure.

b) Modern Approach
The study of economics is divided into: i) Microeconomics and ii)
Macroeconomics.
1. Microeconomics analyses the economic behaviour of any particular decision
making unit such as a household or a firm. Microeconomics studies the flow of
economic resources or factors of production from the households or resource
owners to business firms and flow of goods and services from business firms to
households. It studies the behaviour of individual decision making unit with
regard to fixation of price and output and its reactions to the changes in demand
and supply conditions. Hence, microeconomics is also called price theory.

2. Macroeconomics studies the behaviour of the economic system as a whole or

all the decision-making units put together. Macroeconomics deals with the
behaviour of aggregates like total employment, gross national product (GNP),
national income, general price level, etc. So, macroeconomics is also known as
income theory.

Microeconomics cannot give an idea of the functioning of the economy as a

whole. Similarly, macroeconomics ignores the individual’s preference and
welfare. What is true of a part or individual may not be true of the whole and
what is true of the whole may not apply to the parts or individual decision-
making units. By studying about a single small-farmer, generalization cannot be
made about all small farmers, say in Tamil Nadu state. Similarly, the general
nature of all small farmers in the state need not be true in case of a particular
small farmer. Hence, the study of both micro and macroeconomics is essential to
understand the whole system of economic activities.
 Available online at www.sciencedirect.com

ScienceDirect
Procedia Economics and Finance 23 (2015) 309 – 312

2nd GLOBAL CONFERENCE on BUSINESS, ECONOMICS, MANAGEMENT and

TOURISM, 30-31 October 2014, Prague, Czech Republic

Classical, Neoclassical and New Classical Theories and Their

Impact on Macroeconomic Modelling
Oana Simona Hudea (CARAMAN)a,b,*
a
Post PhD. student - Academy of Economic Studies, 15-17 Calea Dorobantilor, Bucharest, 010552, Romania
b
Lect. PhD. - Bucharest University, 36-46 M. Kogălnicean Bld, Bucharest, 050107, Romania

Abstract

This study represents an incursion into the history of classical economic thought, aiming at capturing, from a personal
perspective, the concatenation of the vision expressed by the partisans of the issued theories, outlining, on one hand, the existing
similarities, reflected by common reference points such as the dichotomy between the nominal and the real factors of the
economy or the self-adjustment of markets, as result of the absence of any rigidity at the level of price, wage and interest rate,
and, on the other hand, the divergences manifested in compliance with the new realities of the time, like the microeconomic
fundamentals-based macroeconomic analysis or the rationality of economic agents. The specific macroeconomic modelling is
also briefly approached, focussing on the novelty elements launched and implemented during each stage of the studied period:
the classical model of Smith, analysing the labour demand and supply, as fundamental equilibrium, the general equilibrium
model of Walras, describing the economy by the aggregation of the individuals’ behaviours, in the context of several interacting
markets, or the real business cycle model, taking the attention away from the nominal interest rates, while orienting towards the
real production factors of the basic classical model, and revealing the fluctuations caused by the real shocks to the business cycle.
© 2015
© 2014 The
TheAuthors.
Authors.Published
PublishedbybyElsevier
ElsevierB.V.
B.V.This is an open access article under the CC BY-NC-ND license
Selection and/ peer-review under responsibility of Academic World Research and Education Center.
(http://creativecommons.org/licenses/by-nc-nd/4.0/).
Selection and/ peer-review under responsibility of Academic World Research and Education Center
Keywords: classical theory, macroeconomic modelling, technological shock, real business cycle

1. Introduction

In the humanity history, the economic thought has passed through various stages, marked by miscellaneous
controversies. After a period of supremacy of the ancient and medieval conceptions, we assist to the emerging of
modern theories: classical, neoclassical, Keynesian, neo-Keynesian, new classical and new Keynesian, to mention
the most relevant.

* Oana Simona Hudea (CARAMAN). Tel.: +0040.726.322.955

E-mail address: [email protected]

2212-5671 © 2015 The Authors. Published by Elsevier B.V. This is an open access article under the CC BY-NC-ND license
(http://creativecommons.org/licenses/by-nc-nd/4.0/).
Selection and/ peer-review under responsibility of Academic World Research and Education Center
doi:10.1016/S2212-5671(15)00506-7
310 Oana Simona Hudea (CARAMAN) / Procedia Economics and Finance 23 (2015) 309 – 312

This paper is meant to follow the long way of classical thought, starting from the basic variant and going all
along the new approaches, developed under the influence of the Keynesian thinking and of the real economy of the
time, the economic classicism progressively acquiring new characteristics specific to certain theories totally
unaccepted at its beginnings.
Classicism, unquestionably excluding the state intervention in economy and staking on the self-adjustment of
markets, as result of the price, wage and interest rate flexibility, is followed by neoclassicism that generates a new
vision regarding the perceived value of goods, launching the marginal utility concept, element with final impact on
the decision of consumption or production of economic agents, respectively the new classical theory which,
although having taken over the classical tradition regarding the equilibration of markets, contradictorily debates on
the dichotomy between the real and nominal economic factors.
Such theories have left traces in the macroeconomic modelling area, so that, in 1776, we find the classical model
of Smith, which, based on the results obtained at microeconomic level, analyses the labour demand and supply, as
fundamental equilibrium, then, in 1870, the classical general equilibrium model of Walras, describing the economy
by the aggregation of the individuals’ behaviours. In 1970, we assist to the outlining of the new classical model, the
real business cycle, which takes the attention away from the nominal interest rates, focussing on the real production
factors of the basic classical model. Starting from the price flexibility hypothesis, it tries to reveal how the real
shocks can cause fluctuations of the business cycle, the paper of Kydland and Prescott (1982) being deemed as a
reference element of such theory.

2. Pure Classicism

The beginnings of economic classicism are marked by the conceptions of Adam Smith, who reorients the
economy focus from the protection of one’s own interest to the support of the entire nation’s interest, starting from
the premises that price, wage and interest rate flexibility creates the conditions necessary for equilibrating the
markets, at full employment.
The market self-adjusts providing economic stability, the state intervention being necessary only to ensure the
free operation of markets and a balanced budget. We assist to the progressive development of a thinking system in a
context dominated by perfect competition, without protectionist restrictions and in the absence of any form of
monopole or unfair competition. The economy succeeds in continuously reaching the natural level of GDP, its self-
adjusting mechanisms laying the grounds for quick rebalance in case of steady state deviations.
Full employment, key element of pure classicism, is deemed to be characteristic to any freely functioning
economy. Even in disequilibrium standings, with some unemployment level, the equilibrium is re-established by
lowering the wages, naturally resulting in an increase of the labour demand and, therefore, in the reset of the initial
equilibrium. Equilibrium is also obtained in case of inequalities between the level of savings and investments. The
lowering of the investments weight in total available incomes diminishes the demand for money and leads,
indirectly, given the intention to stimulate it, to a decrease of the interest rate, thus becoming attractive for any
potential investors who would re-establish the market equilibrium.
Save for the free market theory, two other issues reflect the basic classical economic thinking, namely the law of
Say and the Fisher’s quantitative theory of money.
The Say’s law suggests that, while reaching a certain level of real GDP, any economy tends to generate also the
necessary incomes to procure it, therefore creating the premises of a demand high enough to equal the obtained
production, covering in this way the natural level of it. Even if a part of the income is oriented towards other
destinations than the acquisition of goods and services, therefore lowering the demand in relation to the supply level,
followed by the supply adjustment and, as a consequence, by underemployment, the economy will be subsequently
directed either to consumption or to investments, which, as components of gross domestic product, would help the
market in regaining its equilibrium.
According to the classical economists, money does not exert influences on the real economy, it being neutral.
Thus, the real factors of the economy, such as the production level, employment and consumption, are not
concatenated with the nominal ones, like the level of price, wage or exchange rate, reflecting the well-known
classical dichotomy in the matter. In this regard any increase of money supply, as reflected by Fisher, would be
transposed into a generalised increase of prices, not into production surplus (Snowdon & Vane, 2005, pp.69-70).
 Oana Simona Hudea (CARAMAN) / Procedia Economics and Finance 23 (2015) 309 – 312 311

3. Transition to Neoclassical Economy

The classical theory has progressively turned into a distinct theory, the neoclassicism, which, despite of having
taken over the basic elements of the classics, was also subject to the influences of the Keynesian theory and of the
changes occurred in the economic field. Thus, we find aspects specific to the neoclassical conception, such as a new
vision regarding the value of goods, analysed as depending on the utility generated by it and perceived at
consumers’ level, but also the popularisation of the marginal unit concept, with a particular impact on the economic
agents’ decision to consume or produce one product or another.
Demand and supply are now approached considering the rationality of individuals, who try to maximise their
benefits based on available relevant information (Campus, 1987). The aggregation of the market demand and supply
is grounded on the results provided by the microeconomic analysis, the interaction between the two allowing
reaching equilibrium under the conditions of price, wage and interest rate flexibility. Such conception has laid the
basis of the classical general equilibrium model, describing the economy via the aggregation of the behaviours
manifested by households and firms. Individuals, seen from a double perspective, as employees and employers,
make choices depending on their goals, considering their decreasing marginal utility and the surpassing of their
wishes by the related fulfilling possibilities.
Albeit in agreement with pure classics as for the self-adjustment of markets in the long run, at full employment,
neoclassical economists disagreed as for the short run status. On long term, any economy tends to full employment,
while maintaining the equilibrium on the market of goods and services, so that any subsequent increase in demand
will result just in an increment of prices, the aggregate supply taking the form of a vertical line. However, on short
term, any increase of the aggregated demand, due to an increase of money supply or of government expenses or to a
decrease of taxes, will stimulate producers to produce more and also to raise prices so as to annihilate the effect of
the decreasing returns.

4. Business Cycle Theory

An important step in the new classical macroeconomic analysis is represented by the introduction, by Lucas, of
the concept of rational expectations, replacing the former adaptive expectations. Based on such rational
expectations, and on the classical conception regarding the equilibration of markets, despite the abandon of the
dichotomy between the real and the nominal factors sustained by the latter, Lucas initiates, in 1973, the theory of the
real business cycle (RBC) including both the idea of compromise between the inflation and the real GDP level,
while maintaining the short-run non-neutrality of money (Snowdon & Vane, 2005), and the one relating to the
surprise element of the monetary policies, which influence the supply of goods and services if their effect on prices
is incorrectly surprised, given the incomplete information held.
Considering the vision of Lucas, a new class of models emerged, which, by accepting the classical dichotomy,
have abandoned the conception of Keynesians and of the early new classical economists (Mankiw, 1989). Based on
the microeconomic fundamentals of the neoclassical models, the RBC model captured the impact of technological
changes on the economic activity evolution and on the unemployment rate, therefore minimising the influence
exercised by the modifications occurred on the goods and services or money market.
According to this theory’s partisans, productivity is pro-cyclical, being indissolubly related to technological
fluctuations. Labour supply is stimulated only in productive times, in economic critical conditions, generating drops
in the real wage, it being lowered (Mankiw, 1990). In case of unsatisfactory technological level, we assist to the
drop down of production, consumption and investments and, therefore, to the capital diminish, the re-establishment
of the technological level not having the power to restore the level of GDP to its equilibrium value, the capital
accumulation becoming a propagation mechanism transforming apparently non-persistent shocks on the supply of
goods and services into persistent ones. The dynamics of the employment, production and real interest rate
equilibrium is independent of the monetary policy, the real variables varying only in response to technological
changes.
By synthesising, three essential elements are at the basis of the new classical model: the negligible importance of
money in influencing the business cycles, the rationality of the economic agents who respond in an optimum way to
the real shocks, mainly related to the fluctuations occurred at the level of productivity, governmental acquisitions or
312 Oana Simona Hudea (CARAMAN) / Procedia Economics and Finance 23 (2015) 309 – 312

preferences, and the orientation towards the dynamic analysis of the economy, based on rational expectations,
starting from the Walrasian general equilibrium theory which implies that economy has a unique equilibrium at full
employment, as result of price, wage and interest rate adjustment.

5. Conclusions

Although correlated at various levels, both from the perspective of the theoretical research and in the modelling
area, the classical, neoclassical and new classical theories have differentiated from one another by clearly outlined
elements. The ideas of pure classicism, based on state non-intervention, and therefore on markets self-adjustment, as
result of the absence of price, wage and interest rate rigidity, are taken over by neoclassicism, however with a new
vision on the value of goods, seen by the latter as depending on the provided utility. Neoclassicism also
distinguished by promoting the idea of rationality of economic agents, issue supported and improved thereafter,
while considering the economic agents’ expectations, by the new classical theory, which aimed at surprising the
dynamic evolution of economies.

Acknowledgements

This work was cofinanced from the European Social Fund through Sectoral Operational Programme Human
Resources Development 2007-2013, project number POSDRU/159/1.5/S/ 134197 „Performance and excellence in
doctoral and postdoctoral research in Romanian economics science domain”.

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Lucas, R. E. (1973). Some International Evidence on Output-Inflation Tradeoffs. The American Economic Review 63 (3), 326-334.
Mankiw N.G. (1989). Real Business Cycles: A New Keynesian Perspective. Journal of Economic Perspectives, 3 (3), 79-90.
Mankiw, N. G. (1990). A Quick Referesher Course in Macroeconomics. Journal of Economic Literature 28 (4), 1645-1660.
Say, J.-B. (1971). A Treatise on Political Economy: or the Production, Distribution and Consumption of Wealth. New York, NY: Augustus M.
Kelley (Work written in 1803).
Snowdon, B., & Vane, H. (2005). Modern Macroeconomics. Cheltenham, UK: Edward Elgar.
 Original article

Ecological economics: themes,

approaches, and differences
with environmental economics
Jeroen C.J.M. van den Bergh

well as between universities and other organisations, was

Abstract This article provides a short overview of active. EE integrates elements of economics, ecology,
the main themes of ecological economics (EE). It is thermodynamics, ethics, and a range of other natural and
argued that EE provides a platform that fosters social sciences to provide an integrated and biophysical
multidisciplinary environmental research by bring- perspective on environment±economy interactions, aimed
ing together the core contributing disciplines ± at contributing to structural solutions to environmental
economics and ecology. In addition, EE is regarded problems. The core of EE can be associated with the goal
as a pluralistic approach to environmental research of sustainable development, interpreted as both intra- and
that can be set opposite to, and has indeed devel- intergenerational equity; the view that the economy is a
oped as a response to, traditional environmental and subsystem of a larger local and global ecosystem which
resource economics. A comparison of the two ®elds sets limits to the physical growth of the economy; and,
is presented to clarify the essential differences be- a methodological approach based on the use of physical
tween them. In addition, speci®c themes are exam- (material, energy, chemical, biological) indicators and
ined in more detail. These include: sustainable comprehensive systems analysis.
development; the growth debate; international trade; EE provides a forum for multidisciplinary environmental
dynamic processes; and behaviour and policy. research as well as an alternative view and approach to
traditional environmental (and resource) economics
Keywords Comparison á Environmental (ERE). Various economists, ecologists and environmental
policy á Growth debate á Individual researchers have been dissatis®ed with the way in which
behaviour á International trade á Multilevel environmental problems and policy are studied by ERE. 2
dynamics On the one hand, ecological economics offers criticism of
the ERE approach, and, on the other, it tries to develop
and apply alternative methods and approaches. 3 Never-
theless, EE has perhaps been most successful in promoting
multidisciplinary research in which natural scientists
Background
The ®eld known as ``Ecological Economics'' (EE) was 1
The International Society for Ecological Economics (ISEE) was
founded at the end of the 1980s. 1 It immediately attracted founded by participants at a workshop in Barcelona in 1987, while its
a large number of researchers from various disciplinary roots go back at least to a meeting on the integration of economics
and ecology in Sweden in 1982 (Jansson 1984). Spash (1999) and
backgrounds that were involved in the study of environ- Martinez-Alier (1999) provide more details on the origins of ISEE.
mental issues. EE very quickly developed into a ®eld that The journal Ecological Economics was founded in 1989 by R. Cos-
was successful in several respects (Costanza and King tanza and H.E. Daly, who are still its editor-in-chief and associate
1999): many publications and citations to these were editor, respectively. An early collection of articles aimed at de®ning
ecological economics is supplied by Costanza and Daly (1987)
produced; regular conferences and workshops were held; 2
Traditional environmental economics is based on neoclassical
and communication among disciplines and countries, as welfare theory and microeconomics. Its core insights are critically
dependent on the assumption of rational individual behaviour (utility
or pro®t maximisation), which together with an additional assump-
tion of market clearing generates a unique economic equilibrium, that
is, a unique combination of prices and tradable quantities of each
Received: 21 February 2000 / Accepted: 22 September 2000 / product on each market (including the ones for labour and capital).
Published online first: 8 December 2000 Good introductions to traditional environmental economics are of-
ã Springer-Verlag 2001 fered by Baumol and Oates (1988), Kneese and Sweeney (1985/1993)
and Siebert (1995); a modern treatment, mixing traditional and
ecological economics perspectives is Perman et al. (1999)
J.C.J.M. van den Bergh 3
Important contributions covering both criticism and alterna-
Department of Spatial Economics, Free University, tives include the following: Georgescu-Roegen (1971), Boulding
De Boelelaan 1105, 1081 HV Amsterdam, The Netherlands (1978), Sagoff (1988), Daly and Cobb (1989), Faber and Proops (1990),
e-mail: [email protected] Costanza (1991), Daly (1977/1991), Ekins and Max-Neef (1992), Daly
Fax: +31-20-4446004 and Townsend (1993) and Norgaard (1994)

DOI. 10.1007/s101130000020 Reg Environ Change (2001) 2:13±23 13

 Original article

(notably ecologists) and social scientists (notably econo- analogies from biology (Boulding 1978) and other sciences
mists) join forces. (Boulding 1970). The statistician-economist N. Georgescu-
The economists K.E. Boulding, H.E. Daly and Roegen is best known in economics for his contributions
N. Georgescu-Roegen and the ecologists C.S. Holling and to utility theory and activity analysis. In the 1960s and
H.T. Odum are usually considered to be the intellectual 1970s he wrote seminal publications on the foundations of
founders and antecedents of EE. Martinez-Alier (2001), economics, which were very critical towards standard
Christensen (1989) and Costanza et al. (1997a, Chap. 2) neoclassical economics (Georgescu-Roegen 1966, 1971,
discuss the relevance for EE of ideas of early ± and some 1976). In particular, his interpretation of economic pro-
almost forgotten ± writers like P. Geddes, A. Lotka, cesses in the context of thermodynamics has generated
J.S. Mill, F. Soddy and many others. Finally, speci®c writ- many responses and debates in EE [see Gowdy and Mesner
ings by economists and ecologists have directly or indi- 1998; and various contributions in a special issue of Eco-
rectly in¯uenced authors and writings in EE; an incomplete logical Economics (Daly 1997)]. C.S. Holling has perhaps
list of these fundamental publications is: Kapp (1950), been the ecologist who has had the greatest direct in¯u-
Ciriacy-Wantrup (1952), Galbraith (1958), Cumberland ence on EE. His ideas on ecosystem stability and resilience
(1966), Mishan (1967), Ehrlich (1968), Hardin (1968), Ay- (Holling 1973) are the most referred to notions in theo-
res and Kneese (1969), Isard (1969, 1972), Leontief (1970), retical ecology, which have even been picked up by
Meadows et al. (1972), Clark (1973), Hueting (1974/1980), economists (see Levin et al. 1998; Perrings 1998). These
Page (1977), Costanza (1980), Norgaard (1984, 1985), notions have been translated to the context of biodiversity
Vitousek et al. (1986), Martinez-Alier (2001), and some of (Holling et al. 1995). Holling has also developed the idea
the literature mentioned in the next paragraph. that (terrestrial) ecosystems do not necessarily follow a
A short discussion of the main players can give the reader pattern of succession towards a climax, but instead can go
a feel for the issues that gave rise to the development of EE. through a repeated cycle (Holling 1986). In addition, he
At the end of the 1960s, H.E. Daly proposed the idea of a has in¯uenced approaches to integrated modelling and
``steady state economy'', associated with the objective to adaptive management (Holling 1978; and more recently
minimise the use of materials and energy (``throughput'') Gunderson et al. 1995). Finally, the systems ecologist H.T.
in the economy (Daly 1968, 1977/1991). This was an Odum has in¯uenced EE through his EMERGY analysis
essential contribution to the longstanding ``growth debate'' approach (Odum 1971), which has been applied to EE is-
(see later section). Daly has also written extensively about sues by many of his students ± including R. Costanza, C.
the maximum physical scale of the economy, international Hall and I.-M. Jansson. EMERGY analysis traces all envi-
trade, and sustainable welfare indicators (Daly 1992, 1996, ronmental products and services back to solar energy,
1999a; Daly and Cobb 1989). In particular, he can be which provides the energetic basis of ecosystem processes
characterised as someone who fosters communication and and functions. Odum himself has even proposed applying
discussion in science on issues relating to growth, eco- the method to the integrated study of economic±ecological
nomic theory, thermodynamics, population, and more interactions ranging from local to global scales (e.g., Odum
recently globalisation (see especially Daly 1999b). 1987). An ambitious and interesting study in this vein is by
K.E. Boulding was already famous and respected in Zuchetto and Jansson (1985). EMERGY analysis has its
economics before he showed an academic interest in en- strong proponents and opponents (for a short introduc-
vironmental issues. 4 He is best known in EE for an article tion, see Herendeen 1999).
in which he contrasts the ``cowboy economy'' and the EE is nowadays clearly present at an institutional level,
``spaceship economy'' (Boulding 1966). Within the cowboy with an international society see http://isee.ecoeco.org,
economy ± a metaphor for the local or national open various regional societies (US, South America, Canada,
economy ± people are little worried about the quality of Europe, Russia, Asia/Australia), and an academic jour-
environment and nature, and observe merely local envi- nal (Ecological Economics). In addition, various books
ronmental problems. Therefore, they regard migration and (van den Bergh and van der Straaten 1994, 1997; Jansson
shifts to new resources as solutions. Conversely, the et al. 1994; Krishnan et al. 1995; van den Bergh 1996;
spaceship economy ± a metaphor for the world as a whole Costanza et al. 1996, 1997a, b; Cleveland et al. 2000;
± is characterised by limited material and food supplies. Edward-Jones et al. 2000; Munasinghe et al. 2000) and
The survival strategy in this case is economic use of ma- articles (Turner et al. 1997; Martinez-Alier 1999; Spash
terials, energy and environment, and maximisation of re- 1999; Turner 1999) have appeared that offer a variety of
cycling of substances, materials and products. This perspectives on EE. These indicate that EE is pluralistic
spaceship metaphor re¯ects the implications of the mass- rather than striving towards a dominant and general
balance principle, and can also be seen as a precursor of theory. As a result, EE is internally much more hetero-
the modern view on global environmental problems. geneous than standard ERE, where the neoclassical
Boulding is renowned for often employing metaphors and paradigm de®nes the direction of research.
This article discusses the main themes within EE. These
include: sustainable development, the growth debate,
4 international trade, dynamic processes, and behaviour and
In 1949 Boulding received the prestigious John Bates Clark
Medal, awarded by the American Economics Association every policy. First, however, the section below explores the
2 years to an outstanding economist under 40. In 1968 he was elected opposition that some perceive between EE and ERE.
President of the American Economics Association (see Mott 2000)

14 Reg Environ Change (2001) 2:13±23

 Original article

Ecological versus traditional context of developing countries. Linked to this is a more

serious contribution from, and more interaction with,
environmental economics scientists from developing countries (for instance, the lo-
cations of the ISEE World Congress alternate between the
The difference between EE and ERE relates to a number of North and the South). In addition, EE generally assumes a
issues. These are discussed below. The core of ERE is the longer time horizon than ERE and, consistent with this,
theory of (negative) externalities or external costs. This pays more attention to cause±effect chains, interactions
considers environmental degradation and use of unpriced and feedback between natural and human±economic sys-
natural resources as a negative effect outside the market by tems. The concept ``co-evolution'' is relevant here, as it is
one economic agent on another, without any form of considered to re¯ect a mutual in¯uence of economic and
compensation taking place. This implies that the envi- environmental systems which creates a unique historical
ronmental problem is cast in terms of an interaction development. In this sense EE is closer in spirit to evolu-
between people (economic agents), that is, nature and tionary than to neoclassical economics. Evolutionary
environment are only implicitly described EE is instead economics is characterised by concepts like path depen-
more interested in an explicit modelling of people±envi- dence, historical accidents and irreversibility of changes.
ronment or economic±ecological relations, by mapping Path dependence implies that possibly inferior technolo-
out cause±effect relationships and dynamic processes gies can become dominant as a result of unforeseeable
within the environment (hydrological, chemical, physical historical events in combination with economies of scale,
and ecological). According to Turner et al. (1997) this is due, inter alia, to positive network externalities (witness
due to the fact that EE is more closely related to traditional the market dominance of Microsoft operating systems).
``resource economics'', notably concerning renewable An implication of co-evolution is that the market does not
resources like ®sh, forests and water (Clark 1990; Neher necessarily lead to a selection of (in a neoclassical sense)
1990), than to environmental economics in a narrow sense optimal technologies, production activities and use of
(``economics of pollution''). space, even when prices are ``correct''. Therefore, EE
Another important opposition is between scale and allo- considers systems, including markets, as adaptive and
cation. ERE is aimed at optimal allocation and thus ef®- coincidental rather than optimal.
ciency of use of scarce means (including resources). The main goals and criteria for evaluating developments,
Environmental problems are translated through the con- policies and projects differ between EE and ERE. The
cept ``externality'' (or ``external effect'' or ``external cost''). dominant criterion of ERE is ``ef®ciency'' (or sometimes a
The objective is to ®nd the optimal level of an externality, more limited version, such as cost-effectiveness). Most
which follows from striving towards optimal social welfare economists would regard this as something trivial and
or Pareto ef®ciency. The latter is de®ned as a situation in hardly ethical. Nevertheless, it presumes that ``more is
which an improvement in the welfare of any individual always better''. Furthermore, whereas in ERE distribution
cannot be achieved without a welfare loss for someone and equity are secondary criteria, EE emphasises (basic)
else. ERE considers natural resources (gas, oil, ®sh, tim- needs, North±South welfare differences, and the complex
ber), environmental quality, services rendered by the en- link between poverty and environment. In addition, EE is
vironment, and nature as scarce resources to which best characterised by the ``precautionary principle'', linked
(optimal) allocation theories are applicable. Daly (1992) to environmental sustainability, with much attention to
has since long argued that economists have neglected the ``small±probability±large±impact'' combinations. 5 This
issue of an optimal physical scale or size of the economy, precautionary principle is closely related to a concern for
and instead have focused completely on allocation issues. instability of ecosystems, loss of biodiversity, and envi-
In the context of environmental sustainability and sus- ronmental ethical considerations (``bio/eco-centric eth-
tainable development goals, the scale problem has received ics''). ``Ef®ciency'' is of secondary concern in EE.
much attention, shown also by academic and policy dis- ``Distribution'' is often considered as a more important
cussions about indicators for determining the physical criterion for evaluating policies and changes than ef®-
dimensions of the economy (Gibson et al. 2000; see also ciency. In addition, some argue that it is impossible to
the later section on `International trade and environ- analyse distribution and ef®ciency separately. This would
ment'). mean that the main tool of ERE, namely, equilibrium
EE has chosen sustainable development as its central analysis, which assumes that ef®ciency can be assessed
concept. This is subsequently approached both qualita- independent of distribution, is inaccurate at best (Marti-
tively and empirically, with particular attention to spatial nez-Alier and O'Connor 1999).
scales (ranging from local to global). Within ERE, sus-
tainable development is usually regarded as being identical
to sustainable growth, which is studied with general and
abstract models that avoid any reference to historical and 5
ERE in general emphasises uncertainty and instability within the
spatial aspects, as well as speci®c characteristics of coun- economy (macroeconomic stability, business cycles) rather than en-
tries. ERE does not seem to take absolute physical limits to vironmental uncertainty. Nevertheless, ERE has made many contri-
growth as seriously as EE, and regards the problem of a butions to studying environmental uncertainty in speci®c cases,
notably in the context of climate change modelling, and related to the
``maximum scale'' of the economy as irrelevant. A special notions of option value and quasi-option value [see a special issue of
point of attention in EE is the structure and institutional Resource and Energy Economics on ``Irreversibilities'' (Fisher 2000)]

Reg Environ Change (2001) 2:13±23 15

 Original article

Table 1
Differences in emphasis between EE and ERE
Ecological economics Traditional environmental and resource economics

1. Optimal scale 1. Optimal allocation and externalities

2. Priority to sustainability 2. Priority to ef®ciency
3. Needs ful®lled and equitable distribution 3. Optimal welfare or Pareto ef®ciency
4. Sustainable development, globally and North/South 4. Sustainable growth in abstract models
5. Growth pessimism and dif®cult choices 5. Growth optimism and ``win-win'' options
6. Unpredictable co-evolution 6. Deterministic optimisation of intertemporal welfare
7. Long-term focus 7. Short- to medium-term focus
8. Complete, integrative and descriptive 8. Partial, monodisciplinary and analytical
9. Concrete and speci®c 9. Abstract and general
10. Physical and biological indicators 10. Monetary indicators
11. Systems analysis 11. External costs and economic valuation
12. Multidimensional evaluation 12. Cost-bene®t analysis
13. Integrated models with cause±effect relationships 13. Applied general equilibrium models with external costs
14. Bounded individual rationality and uncertainty 14. Maximisation of utility or pro®t
15. Local communities 15. Global market and isolated individuals
16. Environmental ethics 16. Utilitarianism and functionalism

ERE focuses on value dimensions, namely, utility and section on `A hierarchy of dynamics'). An operational
welfare in theory, and costs and bene®ts in practice. Un- technique for the aimed integration is ecological±eco-
like neoclassical economics, EE does not regard a total nomic modelling at local, regional and global scales (see
valuation of changes in ecosystems as the sum of private Braat and van Lierop 1987; Costanza et al. 1993; van den
values. For the latter takes no account, or insuf®cient ac- Bergh 1996).
count, of internal environmental system functions, ``life- EE has often expressed a dissatisfaction with the strict and
support'' functions, future generations and non-instru- ®xed assumptions in traditional economic theory with
mental existence values. EE is inclined to add criteria to regard to individual behaviour. They are usually sum-
the economic values in the context of decision-making marised in the notion of ``(unbounded) rationality'' and
concerning management of and changes in ecosystems. models of maximisation of pro®t (®rms or entrepreneurs)
The terminology ``ecosystem health'' is used to cover as- and utility (households or consumers). These models un-
pects like productivity, stability and resilience of ecosys- derlie the analytical insights obtained by ERE with respect
tems, biodiversity (genes, species, ecosystems) and the to economic valuation and environmental policy. Various
quality of the abiotic environment (Costanza et al. 1992; branches of economics and closely related disciplines,
see also the journal Ecosystem Health). such as evolutionary economics, institutional economics,
Next, EE criticises social objectives such as those formu- experimental economics, psychology and sociology, have
lated within ERE, notably the utilitarian approach to in- presented theoretically and empirically based critiques on
tergenerational welfare. Alternatives are a Rawlsian these models. Although EE seems to be sympathetic to
principle of justice (``maximin criterion''; Rawls 1972), or a these critiques, it has generated few alternative approaches
minimum welfare level encompassing (basic) needs (Stern thus far. Van den Bergh et al. (2000) discuss the neoclas-
1997). This is, of course, all just theory and can hardly be sical approach, survey the criticism of it and present a ®rst
operationalised In practice, the striving for GDP growth at analysis of the implications of alternative models of indi-
a macro-level and cost-bene®t analysis at a project level vidual behaviour for environmental policy. Such models
remain. Which alternatives are offered by EE in this re- include, among others, `satis®cing', lexicographic prefer-
spect? Some have pleaded in favour of physical or eco- ences, relative welfare, habits and routines, imitation, re-
logical indicators [material intensity per unit of service ciprocal behaviour (including various types of altruism),
(MIPS), ``ecological footprint'', ``ecosystem health''] and changing and endogenous preferences, and various models
others in favour of a multidimensional analysis based, for of behaviour under uncertainty. Spash and Hanley (1995)
example, on multicriteria evaluation (Munda et al. 1994; argue that lexicographic preferences offer an explanation
Martinez-Alier et al. 1998). In addition, EE seems to dis- for some of the problems met in economic valuation
card consumer sovereignty when giving priority to the studies, notably that certain people are sometimes un-
interest of systems above the freedom of choice of indi- willing to make trade-offs between income compensation
viduals, as in environmental movements like ``deep and environmental change (see also Blamey and Common
ecology. 1999).
Within EE, a far-reaching integration of economics with Table 1 summarises the main differences between EE and
insights from ecology is proposed Ecology is the area ERE. 6 Note that this presents a somewhat simpli®ed
within biology that studies the relation of living organ- picture. Obviously, hybrid approaches are possible,
isms with their biotic and abiotic environment. It dis-
tinguishes various dynamic processes in ecosystems:
namely, population growth, ecosystem succession, 6
A reviewer noted an earlier comparison: namely, Table 11 in
changes of natural equilibria, and evolution (see the later Costanza et al. (1991)

16 Reg Environ Change (2001) 2:13±23

 Original article

especially in view of EE being diverse and not charac- of capital is maintained separately. ERE starts from weak
terised by a univocal theory. Moreover, some of the sustainability, which emphasises a large degree of substi-
shortcomings of ERE (according to EE) can be resolved tution of inputs in production and the economy as a
within the traditional theoretical framework of neoclas- whole. This has been criticised by EE (see Ecological
sical economics. For instance, environmental externalities Economics vol. 22, 1997). Within EE, usually some type of
can be modelled by describing dynamic causality rela- strong sustainability is emphasised, which is operationa-
tionships on the basis of ecological insights. Crocker and lised through goals such as protection of critical ecosys-
Tschirhart (1992) show that it is possible to incorporate tems, striving for at least a minimum area of nature, or
descriptions of ecosystems within a wider framework of maintenance of biodiversity.
general equilibrium with externalities. Finally, the objec- Within EE, frequently another aspect of (un)sustainability
tive of sustainable development is also broadly supported is pointed out: namely, the stability and resilience of
nowadays by ERE, although de®nitions and interpreta- ecosystems. Perrings (1998) mentions two alternative
tions are not always consistent with those adopted by EE readings: one is directed at the time necessary for a
(see next section). disturbed system to return to its original state (Pimm
In evaluating the differences between EE and ERE, it is 1984); the other is directed at the intensity of disturbance
interesting to note that one of the most in¯uential biol- that a system can absorb before moving to another state
ogists of this century, E.O. Wilson, has recently intro- (Holling 1973). In line with the latter interpretation,
duced the criterion ``consilience'' as a measure of good resilience has been phrased ``Holling sustainability'', as
science (Wilson 1998). This denotes that the methods and opposed to weak ``Solow-Hartwick sustainability'' (Com-
starting points of one scienti®c discipline need to be mon and Perrings 1992). As a result, EE studies pay
consistent with the accepted insights of other disciplines, relatively more attention to the sensitivity of ecosystems
across all areas of science, including the natural and at a micro level, often in applied studies, whereas ERE
social sciences. Gowdy and Ferrer-i-Carbonell (1999) of- extends economic growth theory with environmental
fer a discussion of ``consilience'' between biology and variables, emphasising determinism and approximate
economics, the two most important disciplines support- long-term trends in a macro-approach that lacks any
ing EE, in order to examine to what extent economists micro-detail. From this perspective, EE and ERE
and ecologists have in¯uenced each other's way of approaches to sustainability can give rise to both com-
thinking about environmental problems and their solu- plementary and contradictory insights.
tions. Within EE, a dominant idea is that ERE approaches
need to be made coherent with ®ndings in ecology and
thermodynamics. Nevertheless, this is complicated due to
distinct research traditions and methods (Shogren and The ``growth debate''
Nowell 1992). In addition, consistency with insights from
technical and other social sciences is also necessary. The discussion surrounding sustainable development can
Particularly with regard to modelling consumer and ®rm be considered as a ``terminology game'' that does not
behaviour for environmental policy analysis and mone- resolve the older ``growth debate'' but just disguises it
tary valuation, insights from psychology and sociology (see van den Bergh and de Mooij 1999). The growth
could be useful. debate can be characterised by three main questions: Is
economic growth desirable? Is it feasible? And, is it
controllable?
Both the elaboration of and the answers to these questions
Sustainability and sustainable differ between EE and ERE. With regard to the ®rst
question ERE seems to take for granted that economic
development growth increases social welfare. EE has generated some
criticism on this assumption. Since social welfare is not
There are various de®nitions of sustainability and espe- unambiguously measurable, one can discuss endlessly
cially of sustainable development (see Pezzey 1989; Toman what is a meaningful measure of welfare 7 In addition, one
et al. 1995; van den Bergh and Hofkes 1998; Ayres et al. can ask about the relationship between material welfare
2000). Notably, the opposition between strong and weak
sustainability has received much attention in the last few
years. Weak sustainability has been de®ned on the basis of 7
In this context, the discussion of GDP as a measure for ``pro-
the concepts ``economic capital'' and ``natural capital''. gress'' and welfare is relevant. EE and ERE economists agree that GDP
Economic capital comprises machines, land, labour and is unsuitable as a measure of social welfare. It is better interpreted as
re¯ecting the (national) costs incurred to reach a certain level of
knowledge. Natural capital covers resources, environment national welfare. In other words, GDP growth means an increase of
and nature. Under weak sustainability one strives for the national costs incurred to realise a decreasing or increasing wel-
maintaining ``total capital'', de®ned as the ``sum'' of both fare level. GDP was of course never meant as an indicator of welfare,
types of capital. This allows the substitution of natural but has, due to a lack of any good alternative, slowly adopted this role.
capital by economic capital, as has been analysed in eco- Although a theoretical foundation for GDP as a measure for social
welfare is completely lacking, trust in GDP growth has started to live
nomic growth theory (Solow 1974, 1986; Hartwick 1977). its own life (e.g., on ®nancial markets), resulting in GDP growth being
Strong sustainability, by contrast, requires that every type strongly correlated with economic stability

Reg Environ Change (2001) 2:13±23 17

 Original article

beyond the level of satisfaction of (basic) needs. ``Relative From an economic perspective, an important derived
income'', the income relative to the (national) income question is whether without growth other macroeconomic
distribution, is more relevant for this purpose than abso- goals, such as full employment and price stability, can be
lute income, because people measure their material welfare reached. Within EE, no clear-cut answers to these ques-
against that of individuals in their social environment, tions have been formulated, due to the fact that the issue of
which is local or national. This perspective suggests that a controllability of economic growth has been largely ne-
redistribution of income can have a more signi®cant in- glected. Obviously, if this question remains unanswered or
¯uence on social welfare than a continuation of growth. has a negative answer, any discussion of the other ques-
For addressing the second question in the growth debate: tions is a waste of time. Within ERE, the controllability
``Is economic growth feasible?'', the distinction between issue is not considered at all, which is consistent with its
weak and strong sustainability is useful. ERE is in general positive answers to the other two main questions in the
more optimistic than EE. Notably, it seems to have much growth debate.
con®dence in price and market processes that steer
behavioural responses from producers and consumers. To
take just one example, scarcity of natural resources is ar-
gued to lead through price information to responses in
terms of substitution, savings and recycling of materials, International trade
and to technological innovations at process and product
levels. EE is more pessimistic, or, better perhaps, more
and environment
``precautionary'' about such responses, and is often ac- The development of ERE during the 1990s is character-
companied by references to thermodynamics. Further- ised by considerable attention to the international di-
more, EE states that damages to nature and environment mension of environmental problems and policy, in
have assumed such proportions that continuing growth particular the relationship between international trade
will almost surely lead to ecological disasters. In this and environmental policy. The classical trade theories of
context, soil erosion, deforestation, enhanced global Ricardo and Heckscher-Ohlin state that, on the basis of
warming and loss of biodiversity are regarded as the most comparative advantages, international trade increases the
urgent problems. EE expresses serious worries about the welfare of all contributing countries. Daly and Cobb
resilience of ecosystems, which depends on the complex (1989) are, however, of the opinion that these insights no
connection between global bio±geo±chemical processes longer hold as the assumption of immobile capital ¯ows
and ``life-support'' functions of the biosphere, which are is no longer satis®ed in their view, the modern world is
presently under severe pressure from human activities. In characterised by free capital ¯ows (capital mobility). This
terms of methods of analysis of growth-versus-environ- viewpoint suggests the need for a fundamental discussion
ment, ERE has recently focused attention on partial em- about the relevance of traditional trade theories for for-
pirical analysis through studies that examine de-linking mulating environmental policy. Daly and Cobb conclude,
between certain environmental indicators and income per by referring to statements of Maynard Keynes, which
capita (``green Kuznets curves''; see de Bruyn and Heintz re¯ect the idea that production of products should,
1999). Instead, EE relies more on complex systems analysis whenever feasible, take place in the own country. An
that incorporates feedback mechanisms between economy, additional argument for this view is that sustainability at
growth, environmental quality, natural resources, popu- a regional scale can be better controlled in an autarchic
lation growth, welfare level and health status. 8 The last than in an open region.
question in the growth debate is: Can we control or direct In order to ``measure'' regional unsustainability Wacker-
economic growth? Since most governments and central nagel and Rees (1996) have formulated the concept of the
banks are committed to realising a positive rate of growth, ``ecological footprint'' (EF) and applied it to countries (as
it is hard to say whether it is feasible ± policy-wise and well as other spatial units). They conclude that many
politically ± to arrange a zero or negative rate of growth. countries, in particular small ones, use directly and indi-
rectly more surface area than is available inside their
national boundaries. Evidently, this is compensated by
international trade. Wackernagel and Rees try to argue on
8
The work of Ruth and Cleveland (1996), which focuses on thethe basis of the EF that autarchy is to be preferred to a
relation between extraction of mineral resources and fossil fuel (en-
trading region. Van den Bergh and Verbruggen (1999)
ergy) resources, ®ts into this tradition. Extraction of resources is
associated with a transformation of enormous amounts of energy,
criticise the EF indicator and applications:
both in the extraction process itself and in subsequent processes, such 1. The EF is an example of ``false concreteness'': the
as concentration, smelting, ®ltering and re®ning. In order to extract
resources from supplies with low concentrations of a desired material, resulting land area is hypothetical and too crude a
the amount of energy use per useful unit of output needs to rise, and measure of various types of environmental pressure.
increasingly so. This means that energy use will follow a progressive 2. The EF method does not distinguish between sustain-
pattern over time. Technological improvements and recycling can able and unsustainable land use, notably in agriculture.
slow down the unfolding of such a pattern, but not permanently
postpone it. Such a type of EE model of extraction is less partial than
3. Aggregation of different environmental problems
the traditional, Hotelling type of ERE model (see Dasgupta and Heal occurs through an implicit weighting that lacks any
1979) justi®cation.

18 Reg Environ Change (2001) 2:13±23

 Original article

4. CO2 emissions due to burning fossil fuels are translated, generations, or on spatially disaggregated (meta-) popu-
on the basis of an arbitrary ``sustainability scenario'' lations. Ecosystem models add relationships between bi-
(forestation to capture CO2), into hypothetical seizure otic and abiotic processes to these population models, for
of land. example the in¯uence of nutrients on the presence and
growth of certain plant species. An additional level of
Comparing the EF of countries with their available land dynamics is ecosystem succession, by which the compo-
area implies that national consumption should remain sition, structure and functions of an ecosystem change
within boundaries de®ned by national production oppor- until a climax system has been reached An alternative view
tunities, which is an ex ante ``anti-trade'' bias. This is not proposes a cyclic process without any climax. The theory
only normative but very arbitrary. Relatively small or often referred to in this context is the ``four-box model''
densely populated countries (in terms of available land for terrestrial ecosystems (Holling 1986). It depicts eco-
area) trade more relative to their national income. Indeed, systems and their changes in a two-dimensional diagram
spatial scales correlate strongly with the proportion of with ``stored capital'' (biomass) and ``connectedness''
trade in consumption. For illustration, cities trade 100% of (complexity of the foodweb) on the axes. Ecosystems can
their consumption, and the world as a whole is autarchic. then go through four phases: ``exploitation'', ``conserva-
Trade has various negative impacts in social and political tion'', ``release'' and ``reorganisation''. The ``release'' phase,
dimensions, such as weakening community structures, and for instance, is triggered by forest ®res, storms and out-
confusing individual human perceptions of the ecological break of diseases.
impact of individual consumption decisions. On the other The dynamics of ecosystems has given rise to a question
hand, one can also foresee various negative consequences of about the stability and resilience of ecosystems. EE devotes
minimising international trade, such as the worsening of much attention to this issue. At the moment, resilience is
international relationships between countries, the desta- even examined as an analogy for the functioning of social
bilisation of international trade agreements and institu- systems (bureaucracy, politics, economy, etc.; see Levin
tions, even trade wars and other con¯icts, and a lack of et al. 1998). In the above-mentioned ``four-box model'',
diffusion of knowledge and technology. The fundamental management aimed at arti®cially prolonging a certain
question of more versus less trade cannot be reduced to the phase, notably ``conservation'', can reduce the resilience of
calculation of an aggregate indicator, but needs to be dis- the system. For example, checking small forest ®res, which
cussed in a framework that allows a subtle comparison of leave seeds intact, will result in an accumulation of forest
the advantages and disadvantages of trade. 9 This needs to biomass. This in turn will increase the probability of the
pay explicit attention to the diversity of economic, ecolog- occurrence of a large forest ®re at a very high temperature,
ical, sociological and political insights about international which in turn can destroy plant seeds and thus prevent the
trade relations. To date, EE has contributed mainly to ``reorganisation'' phase from occurring successfully.
analysing the implications of international trade for A last level of dynamics that is studied within ecology and
regional cultures and communities (Daly and Cobb 1989). EE is evolution. Within biology, evolutionary theory has
provided the necessary integration of various subdisci-
plines, such as molecular biology, genetics, cell biology,
physiology, development biology and ecology. Within EE,
A hierarchy of dynamics (co-)evolution is regarded as a conceptual model for ad-
dressing the relationship between economy and environ-
In the earlier section on `Ecological versus traditional ment in the long-run. This connects closely to an historical
environmental economics', it was indicated that EE is approach to the analysis of the interaction between eco-
more closely related to resource economics than to the nomic development, environmental change, technology
``economics of pollution''. Perhaps this is best illustrated change and institutional change. Examples of such inter-
by the fact that simple models from population biology actions are: the inception of the Industrial Revolution
(ecology) have been incorporated in ERE theory of (Wilkinson 1973; Norgaard 1994); the historical transition
renewable resources. Speci®c models have been developed from the hunter±gatherers era to primitive agricultural
for the analysis of ®sheries, forestry and water manage- societies (Gowdy 1994, 1998); and perhaps even the
ment. current wave of technological innovations in the areas
EE uses more information from ecology for modelling of biotechnology and information and communication
human in¯uences on nature and environment than ERE technology.
(see Folke 1999). This includes population dynamics based Important implications of this hierarchy of dynamic pro-
on interactive populations, such as symmetric (competi- cesses are as follows. In the ®rst place, a suf®ciently large
tion, mutualism) and asymmetric (herbivore±plant, para- disturbance by humans will not only create a temporary
site±host, predator±prey) relationships, on multiple removal from an equilibrium, but will also lead to dynamic
effects throughout the hierarchy of dynamics. This can
have irreversible consequences, for example when eco-
9 system components and functions are lost.
For a variety of opinions about the Ecological Footprint, see the
discussion in Ecological Economics vol. 31, no. 3, pp. 317±321, as well The complexity of temporal dynamics often requires an
as the 12 contributions by economists and ecologists in the Forum of explicitly spatial approach: for example, land use, water
Ecological Economics vol. 32, no. 3, pp. 341±393

Reg Environ Change (2001) 2:13±23 19

 Original article

use and diffuse pollution in¯uence spatial cause±effect circumstances characterised by a large degree of uncer-
chains that bring about complex system dynamics in space tainty it would be better to take account of safety margins.
and time. Especially in water-driven systems, like wet- A ¯exible instrument to do this is an ``environmental
lands, a spatial approach is indispensable. This requires bond'' (Costanza and Perrings 1990). An investment or
the use of much detailed information, which in turn causes project that is surrounded by a great deal of uncertainty
aggregation problems, both in the description of processes concerning environmental consequences is complemented
and the evaluation of process outcomes. by an insurance bond with a value equal to that of the
maximum expected environmental damage. This bond
functions as a deposit that is completely or partly refunded
(with interest) depending on the amount of environmental
Individual behaviour damage that has resulted from the respective investment
project. If environmental damages are nil, the entire de-
and environmental policy posit is returned; if there are actual or threatening negative
environmental effects, the deposit serves to compensate or
EE criticises the points of departure of ERE with regard to prevent damage. This instrument can, inter alia, be applied
individual behaviour but generally supports its central to land reclamation, investment in infrastructure, trans-
®ndings on policy, which can best be summarised as port and treatment of hazardous (toxic, nuclear) sub-
``correct prices''. The criticism could, however, give rise to stances, and location of agriculture and industrial
a study of alternative models of individual behaviour and activities near sensitive nature areas. As a consequence of
their implications for environmental policy. The ®rst re- environmental bonds, the (expected) private costs of such
sults of such a research programme suggest that price activities will increase, causing investors to make more
instruments could certainly be less effective than is often conservative decisions, and so take account of environ-
taken for granted (van den Bergh et al. 2000). Further- mental risks associated with human activities and invest-
more, in¯uencing preferences could become an important ment projects.
pillar of environmental policy aimed at realising long-term Uncertainty within ERE is usually analysed by de®ning
sustainable development (Norton et al. 1998). Normative ``states of the world'' with associated probabilities, and
objections against preference-oriented policies are out- maximising an expected bene®t function. Fundamental or
moded; indeed, preferences have long been moulded complete uncertainty, i.e. surprises, implies, according to
through advertisements by private businesses for purely EE, a different approach, namely, ``adaptive management''.
commercial interests. Nevertheless, environmental policies This is based on the idea that management of complex and
aimed at in¯uencing preferences will be effective only if uncontrollable systems requires an interaction between
complementary instruments like environmental legislation experimental research, monitoring, learning processes,
and other types of environmental regulation are employed and policy choices, with the objective to learn from dis-
For example, to reduce speeding by cars one can combine: turbances. This recipe has been applied to problems of
downsizing of car engines, technical speed controllers on ®sheries, agriculture (ecological alternatives for pesticides)
engines, prohibiting advertisements of fast cars, and and forestry. Adaptive management also covers the inter-
obligatory driving-style courses. action between various disciplines, experts and ``stake-
A general difference between environmental policy holders'' (Holling 1978; Walters 1986; Lee 1993;
according to EE and ERE, as indicated in the section `Eco- Gunderson et al. 1995).
logical versus traditional environmental economics', con- Finally, within EE, ideas can be found about economic
cerns the difference between the main goals. ERE focuses on structural change, notably, relating to ``industrial ecolo-
internalising, or more precisely ``optimising'', external gy'' and ``industrial metabolism'' (see Ayres 1998; Duchin
costs. Economic or market-based instruments ®t well in this et al. 1994; Socolow et al. 1994; Graedel and Allenby
scheme as they provide incentives to individual producers 1995). These emphasise spatial and sectoral adjustments
and consumers which, according to the theory, lead to so- of economic activities to realise a minimal environmental
cial ef®ciency (``marginal social costs equal marginal social pressure caused by substance and material ¯ows. For this
bene®ts''). EE is aimed at sustainability and emphasises the purpose, a balance between such strategies as ``demate-
precautionary principle in dealing with complexity (eco- rialisation", recycling and reuse, waste management and
systems), surprises (environmental disasters) and uncer- increasing durability of products is needed.
tain developments (climate change). Common and Perrings
(1992) use a theoretical model to analytically illustrate that
economic±ecological systems are not completely ``observ-
able'' and ``controllable'' via prices and instruments that Conclusion
directly in¯uence prices. In other words, price instruments
fall short in the case of sustainability. The themes discussed in the previous sections illustrate
A number of instruments have been proposed to address that a simple, one-dimensional opposition between EE
the uncertainty and complexity surrounding ecosystems and ERE is impossible. Moreover, searching for interac-
and sustainability. The notion of ``safe minimum stan- tions and complementarity between EE and ERE seems
dards'' (Ciriacy-Wantrup 1952) points to the fact that fruitful. There certainly is overlap, partly because EE is
ef®ciency means exploring the borders, whereas in many not strictly con®ned ERE represents a specialist, analytic

20 Reg Environ Change (2001) 2:13±23

 Original article

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Reg Environ Change (2001) 2:13±23 23

To conclude, managerial economics, which is an offshoot traditional economics, has gained
strength to be a separate branch of knowledge.

DEMAND ANALYSIS

Introduction & Meaning: Demand in common parlance means the desire for an object. But in
economics demand is something more than this.

According to Stonier and Hague, “Demand in economics means demand backed up by enough
money to pay for the goods demanded”. This means that the demand becomes effective only it
if is backed by the purchasing power in addition to this there must be willingness to buy a
commodity. Thus demand in economics means the desire backed by the willingness to buy a
commodity and the purchasing power to pay.

In the words of “Benham” “The demand for anything at a given price is the amount of it which
will be bought per unit of time at that Price”. (Thus demand is always at a price for a definite
quantity at a specified time.) Thus demand has three essentials – price, quantity demanded and
time. Without these, demand has to significance in economics.

It deals with four aspects:

1. Consumption
2. Production
3. Exchange
4. Distribution

Basic laws of consumption:

1. Law of diminishing marginal utility

2. Law of Equi – Marginal utility
3. Consumer surplus

Demand analysis:
1. Nature and types of demand
2. Factors determining demand
3. Law of demand

Nature and types of demand:

1. Consumer goods and producer goods
2. Autonomous demand and derived damand
3. Durable and perishable demand
 4. Firm demand and industry demand
5. Short run demand and long run demand
6. New demand and replacement demand
7. Total market and segment market demand

FACTORS AFFECTING DEMAND

There are factors on which the demand for a commodity depends. These factors are economic,
social as well as political factors. The effect of all the factors on the amount demanded for the
commodity is called Demand Function. These factors are as follows:

1. Price of the Commodity: The most important factor-affecting amount demanded is the price
of the commodity. The amount of a commodity demanded at a particular price is more properly
called price demand. The relation between price and demand is called the Law of Demand. It is
not only the existing price but also the expected changes in price, which affect demand.

2. Income of the Consumer: The second most important factor influencing demand is
consumer income. In fact, we can establish a relation between the consumer income and the
demand at different levels of income, price and other things remaining the same. The demand
for a normal commodity goes up when income rises and falls down when income falls. But in
case of Giffen goods the relationship is the opposite.

3. Prices of related goods: The demand for a commodity is also affected by the changes in
prices of the related goods also. Related goods can be of two types:

(i). Substitutes which can replace each other in use; for example, tea and coffee are substitutes.
The change in price of a substitute has effect on a commodity’s demand in the same direction
in which price changes. The rise in price of coffee shall raise the demand for tea;

(ii). Complementary foods are those which are jointly demanded, such as pen and ink. In such
cases complementary goods have opposite relationship between price of one commodity and
the amount demanded for the other. If the price of pens goes up, their demand is less as a
result of which the demand for ink is also less. The price and demand go in opposite direction.
The effect of changes in price of a commodity on amounts demanded of related commodities is
called Cross Demand.

4. Tastes of the Consumers: The amount demanded also depends on consumer’s taste. Tastes
include fashion, habit, customs, etc. A consumer’s taste is also affected by advertisement. If the
taste for a commodity goes up, its amount demanded is more even at the same price. This is
called increase in demand. The opposite is called decrease in demand.

5. Wealth: The amount demanded of commodity is also affected by the amount of wealth as
well as its distribution. The wealthier are the people; higher is the demand for normal
commodities. If wealth is more equally distributed, the demand for necessaries and comforts is
more. On the other hand, if some people are rich, while the majorities are poor, the demand
for luxuries is generally higher.

6. Population: Increase in population increases demand for necessaries of life. The composition
of population also affects demand. Composition of population means the proportion of young
and old and children as well as the ratio of men to women. A change in composition of
population has an effect on the nature of demand for different commodities.

7. Government Policy: Government policy affects the demands for commodities through
taxation. Taxing a commodity increases its price and the demand goes down. Similarly, financial
help from the government increases the demand for a commodity while lowering its price.

8. Expectations regarding the future: If consumers expect changes in price of commodity in

future, they will change the demand at present even when the present price remains the same.
Similarly, if consumers expect their incomes to rise in the near future they may increase the
demand for a commodity just now.

9. Climate and weather: The climate of an area and the weather prevailing there has a decisive
effect on consumer’s demand. In cold areas woolen cloth is demanded. During hot summer
days, ice is very much in demand. On a rainy day, ice cream is not so muchdemanded.

10. State of business: The level of demand for different commodities also depends upon the
business conditions in the country. If the country is passing through boom conditions, there will
be a marked increase in demand. On the other hand, the level of demand goes down during
depression

LAW OF DEMAND

Law of demand shows the relation between price and quantity demanded of a commodity in
the market. In the words of Marshall, “the amount demand increases with a fall in price and
diminishes with a rise in price”. A rise in the price of a commodity is followed by a reduction in
demand and a fall in price is followed by an increase in demand, if a condition of demand
remains constant.

The law of demand may be explained with the help of the following demand schedule. Demand
Schedule.

Price of Apple (In. Rs.) Quantity Demanded

10 1
8 2
6 3
4 4
2 5
Law is demand is based When the price falls from Rs. 10 to 8 quantity demand increases from 1
to 2. In the same way as price falls, quantity demand increases on the basis of the demand
schedule we can draw the demand curve.

Price

The demand curve DD shows the inverse relation between price and quantity demand of apple.
It is downward sloping.

Assumptions:

1. This is no change in consumers taste and preferences.

2. Income should remain constant.
3. Prices of other goods should not change.
4. There should be no substitute for the commodity
5. The commodity should not confer at any distinction
6. The demand for the commodity should be continuous
7. People should not expect any change in the price of the commodity

EXCEPTIONAL DEMAND CURVE:

Sometimes the demand curve slopes upwards from left to right. In this case the demand curve
has a positive slope.

Price

When price increases from OP to Op1 quantity demanded also increases from to OQ1 and vice
versa. The reasons for exceptional demand curve are as follows.
1. Giffen paradox:

The Giffen good or inferior good is an exception to the law of demand. When the price of an
inferior good falls, the poor will buy less and vice versa. For example, when the price of maize
falls, the poor are willing to spend more on superior goods than on maize if the price of maize
increases, he has to increase the quantity of money spent on it. Otherwise he will have to face
starvation. Thus a fall in price is followed by reduction in quantity demanded and vice versa.
“Giffen” first explained this and therefore it is called as Giffen’s paradox.
2. Veblen or Demonstration effect:

‘Veblen’ has explained the exceptional demand curve through his doctrine of conspicuous
consumption. Rich people buy certain good because it gives social distinction or prestige for
example diamonds are bought by the richer class for the prestige it possess. It the price of
diamonds falls poor also will buy is hence they will not give prestige. Therefore, rich people may
stop buying this commodity.

3. Ignorance:

Sometimes, the quality of the commodity is Judge by its price. Consumers think that the
product is superior if the price is high. As such they buy more at a higher price.

4. Speculative effect:

If the price of the commodity is increasing the consumers will buy more of it because of the fear
that it increase still further, Thus, an increase in price may not be accomplished by a decrease in
demand.

5. Fear of shortage:

During the times of emergency of war People may expect shortage of a commodity. At that
time, they may buy more at a higher price to keep stocks for the future.

6.Necessaries:

In the case of necessaries like rice, vegetables etc. people buy more even at a higher price.

ELASTICITY OF DEMAND

Elasticity of demand explains the relationship between a change in price and consequent
change in amount demanded. “Marshall” introduced the concept of elasticity of demand.
Elasticity of demand shows the extent of change in quantity demanded to a change in price.
In the words of “Marshall”, “The elasticity of demand in a market is great or small according as
the amount demanded increases much or little for a given fall in the price and diminishes much
or little for a given rise in Price”

Elastic demand: A small change in price may lead to a great change in quantity demanded. In
this case, demand is elastic.

In-elastic demand: If a big change in price is followed by a small change in demanded then the
demand in “inelastic”.

Types and measurements of Elasticity of Demand:

There are three types of elasticity of demand:

1. Price elasticity of demand

2. Income elasticity of demand
3. Cross elasticity of demand
4. Advertising elasticity of demand

1. PRICE ELASTICITY OF DEMAND:

Marshall was the first economist to define price elasticity of demand. Price elasticity of demand
measures changes in quantity demand to a change in Price. It is the ratio of percentage change
in quantity demanded to a percentage change in price.

Proportionate change in the quantity demand of commodity

Price elasticity = -
Proportionate change in the price of commodity
There are five cases of price elasticity of demand

A. Perfectly elastic demand:

When small change in price leads to an infinitely large change is quantity demand, it is called
perfectly or infinitely elastic demand. In this case E=∞

The demand curve DD1 is horizontal straight line. It shows the at “OP” price any amount is
demand and if price increases, the consumer will not purchase the commodity.

B. Perfectly Inelastic Demand

In this case, even a large change in price fails to bring about a change in quantity demanded.

When price increases from ‘OP’ to ‘OP’, the quantity demanded remains the same. In other
words the response of demand to a change in Price is nil. In this case ‘E’=0.

C. Relatively elastic demand:

Demand changes more than proportionately to a change in price. I.e. a small change in price
loads to a very big change in the quantity demanded. In this case
E > 1. This demand curve will be flatter.

When price falls from ‘OP’ to ‘OP’, amount demanded increase from “OQ’ to “OQ1’ which is
larger than the change in price.

D. Relatively in-elastic demand.

Quantity demanded changes less than proportional to a change in price. A large change in price
leads to small change in amount demanded. Here E < 1. Demanded carve will be steeper.

When price falls from “OP’ to ‘OP1 amount demanded increases from OQ to OQ1, which is
smaller than the change in price.

E. Unit elasticity of demand:

The change in demand is exactly equal to the change in price. When both are equal E=1 and
elasticity if said to be unitary.
When price falls from ‘OP’ to ‘OP1’ quantity demanded increases from ‘OP’ to ‘OP1’, quantity
demanded increases from ‘OQ’ to ‘OQ1’. Thus a change in price has resulted in an equal change
in quantity demanded so price elasticity of demand is equal to unity.

2. INCOME ELASTICITY OF DEMAND:

Income elasticity of demand shows the change in quantity demanded as a result of a change in
income. Income elasticity of demand may be slated in the form of a formula.

Proportionate change in the quantity demand of commodity

Income Elasticity = -
Proportionate change in the income of the people

Income elasticity of demand can be classified in to five types.

A. Zero income elasticity:

Quantity demanded remains the same, even though money income increases. Symbolically, it
can be expressed as Ey=0. It can be depicted in the following way:

As income increases from OY to OY1, quantity demanded never changes.

B. Negative Income elasticity:

When income increases, quantity demanded falls. In this case, income elasticity of demand is
negative. i.e., Ey < 0.
When income increases from OY to OY1, demand falls from OQ to OQ1.

c. Unit income elasticity:

When an increase in income brings about a proportionate increase in quantity demanded, and
then income elasticity of demand is equal to one. Ey = 1

When income increases from OY to OY1, Quantity demanded also increases from OQ to OQ1.

d. Income elasticity greater than unity:

In this case, an increase in come brings about a more than proportionate increase in quantity
demanded. Symbolically it can be written as Ey > 1.

It shows high-income elasticity of demand. When income increases from OY to OY1, Quantity
demanded increases from OQ to OQ1.
e. Income elasticity leas than unity:

When income increases quantity demanded also increases but less than proportionately. In this
case E < 1.
An increase in income from OY to OY, brings what an increase in quantity demanded from OQ
to OQ1, But the increase in quantity demanded is smaller than the increase in income. Hence,
income elasticity of demand is less than one.

3. CROSS ELASTICITY OF DEMAND:

A change in the price of one commodity leads to a change in the quantity demanded of another
commodity. This is called a cross elasticity of demand. The formula for cross elasticity of
demand is:

Proportionate change in the quantity demand of commodity “X”

Cross elasticity = -
Proportionate change in the price of commodity “Y”

a. In case of substitutes, cross elasticity of demand is positive. E.g.: Coffee and Tea

When the price of coffee increases, Quantity demanded of tea increases. Both are substitutes.

Price of Coffee

b. In case of compliments, cross elasticity is negative. If increase in the price of one commodity
leads to a decrease in the quantity demanded of another and vice versa.

When price of car goes up from OP to OP, the quantity demanded of petrol decreases from OQ
to OQ!. The cross-demanded curve has negative slope.
c. In case of unrelated commodities, cross elasticity of demanded is zero. A change in the price
of one commodity will not affect the quantity demanded of another.

Quantity demanded of commodity “b” remains unchanged due to a change in the price of ‘A’,
as both are unrelated goods.

4. ADVERTISING ELASTICITY OF DEMAND:

Advertising elasticity of demand shows the change in quantity demanded as a result of a
change in cost of Advertisement.
Advertising elasticity of demand may be slated in the form of a formula.

Proportionate change in the quantity demand of commodity

Advertising Elasticity = -
Proportionate change in the advertisement cost

Factors influencing the elasticity of demand:

Elasticity of demand depends on many factors.

1. Nature of commodity: Elasticity or in-elasticity of demand depends on the nature of the

commodity i.e. whether a commodity is a necessity, comfort or luxury, normally; the demand
for Necessaries like salt, rice etc is inelastic. On the other band, the demand for comforts and
luxuries is elastic.

2. Availability of substitutes: Elasticity of demand depends on availability or non-availability of

substitutes. In case of commodities, which have substitutes, demand is elastic, but in case of
commodities, which have no substitutes, demand is in elastic.

3. Variety of uses: If a commodity can be used for several purposes, than it will have elastic
demand. i.e. electricity. On the other hand, demanded is inelastic for commodities, which can
be put to only one use.

4. Postponement of demand: If the consumption of a commodity can be postponed, than it

will have elastic demand. On the contrary, if the demand for a commodity cannot be
postpones, than demand is in elastic. The demand for rice or medicine cannot be postponed,
while the demand for Cycle or umbrella can be postponed.

5. Amount of money spent: Elasticity of demand depends on the amount of money spent on
the commodity. If the consumer spends a smaller for example a consumer spends a little
amount on salt and matchboxes. Even when price of salt or matchbox goes up, demanded will
not fall. Therefore, demand is in case of clothing a consumer spends a large proportion of his
income and an increase in price will reduce his demand for clothing. So the demandis elastic.

6. Time: Elasticity of demand varies with time. Generally, demand is inelastic during short
period and elastic during the long period. Demand is inelastic during short period because the
consumers do not have enough time to know about the change is price. Even if they are aware
of the price change, they may not immediately switch over to a new commodity, as they are
accustomed to the old commodity.

7. Range of Prices: Range of prices exerts an important influence on elasticity of demand. At a

very high price, demand is inelastic because a slight fall in price will not induce the people buy
more. Similarly at a low price also demand is inelastic. This is because at a low price all those
who want to buy the commodity would have bought it and a further fall in price will not
increase the demand. Therefore, elasticity is low at very him and very low prices.

IMPORTANCE OF ELASTICITY OF DEMAND:

The concept of elasticity of demand is of much practical importance.

1. Price fixation: Each seller under monopoly and imperfect competition has to take into
account elasticity of demand while fixing the price for his product. If the demand for the
product is inelastic, he can fix a higher price.

2. Production: Producers generally decide their production level on the basis of demand for
the product. Hence elasticity of demand helps the producers to take correct decision regarding
the level of cut put to be produced.

3. Distribution: Elasticity of demand also helps in the determination of rewards for factors of
production. For example, if the demand for labour is inelastic, trade unions will be successful in
raising wages. It is applicable to other factors of production.

4. International Trade: Elasticity of demand helps in finding out the terms of trade between
two countries. Terms of trade refers to the rate at which domestic commodity is exchanged for
foreign commodities. Terms of trade depends upon the elasticity of demand of the two
countries for each other goods.
5. Public Finance: Elasticity of demand helps the government in formulating tax policies. For
example, for imposing tax on a commodity, the Finance Minister has to take into account the
elasticity of demand.

6. Nationalization: The concept of elasticity of demand enables the government to decide

about nationalization of industries.

DEMAND FORECASTING

Introduction: The information about the future is essential for both new firms and those
planning to expand the scale of their production. Demand forecasting refers to an estimate of
future demand for the product. It is an ‘objective assessment of the future course of demand”.
In recent times, forecasting plays an important role in business decision-making. Demand
forecasting has an important influence on production planning. It is essential for a firm to
produce the required quantities at the right time. It is essential to distinguish between forecasts
of demand and forecasts of sales. Sales forecast is important for estimating revenue cash
requirements and expenses. Demand forecasts relate to production, inventory control, timing,
reliability of forecast etc. However, there is not much difference between these two terms.

Types of demand Forecasting: Based on the time span and planning requirements of business
firms, demand forecasting can be classified in to

1. Short-term demand forecasting and

2. Long – term demand forecasting.

1. Short-term demand forecasting: Short-term demand forecasting is limited to short periods,

usually for one year. It relates to policies regarding sales, purchase, price and finances. It refers
to existing production capacity of the firm. Short-term forecasting is essential for formulating is
essential for formulating a suitable price policy. If the business people expect of rise in the
prices of raw materials of shortages, they may buy early. This price forecasting helps in sale
policy formulation. Production may be undertaken based on expected sales and not on actual
sales. Further, demand forecasting assists in financial forecasting also. Prior information about
production and sales is essential to provide additional funds on reasonable terms.

2. Long – term forecasting: In long-term forecasting, the businessmen should now about the
long-term demand for the product. Planning of a new plant or expansion of an existing unit
depends on long-term demand.

METHODS OF FORECASTING:

Several methods are employed for forecasting demand. All these methods can be grouped
under survey method and statistical method. Survey methods and statistical methods are
further subdivided in to different categories.
1. Survey Method:
Chapter 3
Production and Costs
In the previous chapter, we have discussed the behaviour of the
consumers. In this chapter as well as in the next, we shall examine
the behaviour of a producer. Production is the process by which
inputs are transformed into ‘output’. Production is carried out by
producers or firms. A firm acquires different inputs like labour,
machines, land, raw materials etc. It uses these inputs to produce
output. This output can be consumed by consumers, or used by
other firms for further production. For example, a tailor uses a
sewing machine, cloth, thread and his own labour to ‘produce’
shirts. A farmer uses his land, labour, a tractor, seed, fertilizer,
water etc to produce wheat. A car manufacturer uses land for a
factory, machinery, labour, and various other inputs (steel,
aluminium, rubber etc) to produce cars. A rickshaw puller uses a
rickshaw and his own labour to ‘produce’ rickshaw rides. A
domestic helper uses her labour to produce ‘cleaning services’.
We make certain simplifying assumptions to start with. Production
is instantaneous: in our very simple model of production no
time elapses between the combination of the inputs and
the production of the output. We also tend to use the
terms production and supply synonymously and often
interchangeably.
In order to acquire inputs a firm has to pay for them.
This is called the cost of production. Once output
has been produced, the firm sell it in the market and
earns revenue. The difference between the revenue
and cost is called the firm’s profit. We assume that
the objective of a firm is to earn the maximum profit
that it can.
In this chapter, we discuss the relationship between
inputs and output. Then we look at the cost structure of
the firm. We do this to be able to identifiy the output at which
A Firm Effort firms profits are maximum.

3.1 PRODUCTION FUNCTION

The production function of a firm is a relationship between inputs
used and output produced by the firm. For various quantities of
inputs used, it gives the maximum quantity of output that can be
produced.

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 Consider the farmer we mentioned above. For simplicity, we assume that the
farmer uses only two inputs to produce wheat: land and labour. A production
function tells us the maximum amount of wheat he can produce for a given
amount of land that he uses, and a given number of hours of labour that he
performs. Suppose that he uses 2 hours of labour/ day and 1 hectare of land to
produce a maximum of 2 tonnes of wheat. Then, a function that describes this
relation is called a production function.
One possible example of the form this could take is:
q = K × L,
Where, q is the amount of wheat produced, K is the area of land in hectares,
L is the number of hours of work done in a day.
Describing a production function in this manner tells us the exact relation
between inputs and output. If either K or L increase, q will also increase. For
any L and any K, there will be only one q. Since by definition we are taking the
maximum output for any level of inputs, a production function deals only with
the efficient use of inputs. Efficiency implies that it is not possible to get any
more output from the same level of inputs.
A production function is defined for a given technology. It is the technological
knowledge that determines the maximum levels of output that can be produced
using different combinations of inputs. If the technology improves, the maximum
levels of output obtainable for different input combinations increase. We then
have a new production function.
The inputs that a firm uses in the production process are called factors of
production. In order to produce output, a firm may require any number of
different inputs. However, for the time being, here we consider a firm that produces
output using only two factors of production – labour and capital. Our production
function, therefore, tells us the maximum quantity of output (q) that can be
produced by using different combinations of these two factors of productions-
Labour (L) and Capital (K).
We may write the production function as
37
q = f(L,K) (3.1)

Production and Costs

where, L is labour and K is capital and q is the maximum output that can be
produced.
Table 3.1: Production Function
Factor Capital
0 1 2 3 4 5 6
0 0 0 0 0 0 0 0
1 0 1 3 7 10 12 13
2 0 3 10 18 24 29 33
Labour 3 0 7 18 30 40 46 50
4 0 10 24 40 50 56 57
5 0 12 29 46 56 58 59
6 0 13 33 50 57 59 60

A numerical example of production function is given in Table 3.1. The left

column shows the amount of labour and the top row shows the amount of
capital. As we move to the right along any row, capital increases and as we move
down along any column, labour increases. For different values of the two factors,

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 Isoquant
In Chapter 2, we have learnt about indifference curves. Here, we introduce a
similar concept known as isoquant. It is just an alternative way of
representing the production function. Consider a production function with
two inputs labour and capital. An
isoquant is the set of all possible
combinations of the two inputs
that yield the same maximum
possible level of output. Each
isoquant represents a particular
level of output and is labelled with
that amount of output.
Let us return to table 3.1
notice that the output of 10 units
can be produced in 3 ways (4L,
1K), (2L, 2K), (1L, 4K). All these
combination of L, K lie on the
same isoquant, which represents the level of output 10. Can you identify
the sets of inputs that will lie on the isoquant q = 50?
The diagram here generalizes this concept. We place L on the X axis and
K on the Y axis. We have three isoquants for the three output levels, namely
q = q1, q = q2 and q = q3. Two input combinations (L1, K2) and (L2, K1) give us
the same level of output q1. If we fix capital at K1 and increase labour to L3,
output increases and we reach a higher isoquant, q = q2. When marginal
products are positive, with greater amount of one input, the same level of
output can be produced only using lesser amount of the other. Therefore,
isoquants are negatively sloped.

38 the table shows the corresponding output levels. For example, with 1 unit of
Introductory
Microeconomics

labour and 1 unit of capital, the firm can produce at most 1 unit of output; with
2 units of labour and 2 units of capital, it can produce at most 10 units of
output; with 3 units of labour and 2 units of capital, it can produce at most 18
units of output and so on.
In our example, both the inputs are necessary for the production. If any of
the inputs becomes zero, there will be no production. With both inputs positive,
output will be positive. As we increase the amount of any input, output increases.

3.2 THE SHORT RUN AND THE LONG RUN

Before we begin with any further analysis, it is important to discuss two concepts–
the short run and the long run.
In the short run, at least one of the factor – labour or capital – cannot be
varied, and therefore, remains fixed. In order to vary the output level, the firm
can vary only the other factor. The factor that remains fixed is called the fixed
factor whereas the other factor which the firm can vary is called the variable
factor.
Consider the example represented through Table 3.1. Suppose, in the short
run, capital remains fixed at 4 units. Then the corresponding column shows the
different levels of output that the firm may produce using different quantities of
labour in the short run.

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 In the long run, all factors of production can be varied. A firm in order to
produce different levels of output in the long run may vary both the inputs
simultaneously. So, in the long run, there is no fixed factor.
For any particular production process, long run generally refers to a longer
time period than the short run. For different production processes, the long run
periods may be different. It is not advisable to define short run and long run in
terms of say, days, months or years. We define a period as long run or short run
simply by looking at whether all the inputs can be varied or not.

3.3 TOTAL PRODUCT, AVERAGE PRODUCT AND MARGINAL PRODUCT

3.3.1 Total Product
Suppose we vary a single input and keep all other inputs constant. Then
for different levels of that input, we get different levels of output. This
relationship between the variable input and output, keeping all other inputs
constant, is often referred to as Total Product (TP) of the variable input.
Let us again look at Table 3.1. Suppose capital is fixed at 4 units. Now in
the Table 3.1, we look at the column where capital takes the value 4. As we
move down along the column, we get the output values for different values of
labour. This is the total product of labour schedule with K2 = 4. This is also
sometimes called total return to or total physical product of the variable
input. This is shown again in the second column of table in 3.2
Once we have defined total product, it will be useful to define the concepts of
average product (AP) and marginal product (MP). They are useful in order to
describe the contribution of the variable input to the production process.

3.3.2 Average Product

Average product is defined as the output per unit of variable input. We calculate
it as
TPL
APL = (3.2) 39
L

Production and Costs

The last column of table 3.2 gives us a numerical example of average product
of labour (with capital fixed at 4) for the production function described in
table 3.1. Values in this column are obtained by dividing TP (column 2) by
L (Column 1).

3.3.3 Marginal Product

Marginal product of an input is defined as the change in output per unit of
change in the input when all other inputs are held constant. When capital is held
constant, the marginal product of labour is
Change in output
MPL =
Change in input
∆ TPL
= (3.3)
∆L
where ∆ represents the change of the variable.
The third column of table 3.2 gives us a numerical example of Marginal
Product of labour (with capital fixed at 4) for the production function described
in table 3.1. Values in this column are obtained by dividing change in TP by

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 change in L. For example, when L changes from 1 to 2, TP changes from 10 to
24.
MPL= (TP at L units) – (TP at L – 1 unit) (3.4)

Here, Change in TP = 24 -10 = 14

Change in L = 1
Marginal product of the 2nd unit of labour = 14/1 = 14
Since inputs cannot take negative values, marginal product is undefined at
zero level of input employment. For any level of an input, the sum of marginal
products of every preceeding unit of that input gives the total product. So total
product is the sum of marginal products.
Table 3.2: Total Product, Marginal product and Average product

Labour TP MPL APL

0 0 - -
1 10 10 10
2 24 14 12
3 40 16 13.33
4 50 10 12.5
5 56 6 11.2
6 57 1 9.5

Average product of an input at any level of employment is the average of all

marginal products up to that level. Average and marginal products are often
referred to as average and marginal returns, respectively, to the variable input.

3.4 THE LAW OF DIMINISHING MARGINAL PRODUCT AND

40 THE LAW OF VARIABLE PROPORTIONS
Introductory
Microeconomics

If we plot the data in table 3.2 on graph paper, placing labour on the X-axis and
output on the Y-axis, we get the curves shown in the diagram below. Let us
examine what is happening to TP. Notice that TP increases as labour input
increases. But the rate at which it increases is not constant. An increase in labour
from 1 to 2 increases TP by 10 units. An increase in labour from 2 to 3 increases
TP by 12. The rate at which TP increases, as explained above, is shown by the
MP. Notice that the MP first increases (upto 3 units of labour) and then begins to

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fall. This tendency of the MP to first increase and then fall is called the law of
variable proportions or the law of diminishing marginal product. Law of
variable proportions say that the marginal product of a factor input initially
rises with its employment level. But after reaching a certain level of employment,
it starts falling.
Why does this happen? In order to understand this, we first define the concept
of factor proportions. Factor proportions represent the ratio in which the two
inputs are combined to produce output.
As we hold one factor fixed and keep increasing the other, the factor
proportions change. Initially, as we increase the amount of the variable input,
the factor proportions become more and more suitable for the production and
marginal product increases. But after a certain level of employment, the
production process becomes too crowded with the variable input.
Suppose table 3.2 describes the output of a farmer who has 4 hectares of
land, and can choose how much labour he wants to use. If he uses only 1 worker,
he has too much land for the worker to cultivate alone. As he increases the
number of workers, the amount of labour per unit land increases, and each
worker adds proportionally more and more to the total output. Marginal product
increases in this phase. When the fourth worker is hired, the land begins to get
‘crowded’. Each worker now has insufficient land to work efficiently. So the output
added by each additional worker is now proportionally less. The marginal product
begins to fall.
We can use these observations to describe the general shapes of the TP, MP
and AP curves as below.

3.5 SHAPES OF TOTAL PRODUCT, MARGINAL PRODUCT

AND AVERAGE PRODUCT CURVES

An increase in the amount of one of the inputs keeping all other inputs constant
results in an increase in output. Table 3.2 shows how the total product changes
as the amount of labour increases. The total product curve in the input-output 41

Production and Costs

plane is a positively sloped curve. Figure 3.1 shows the shape of the total product
curve for a typical firm.
We measure units of labour
along the horizontal axis and Output
output along the vertical axis.
TPL
With L units of labour, the firm q 1
can at most produce q 1 units of
output.
According to the law of
variable proportions, the
marginal product of an input
initially rises and then after a
certain level of employment, it
starts falling. The MP curve O L
therefore, looks like an inverse Labour
‘U’-shaped curve as in figure 3.2. Fig. 3.1
Let us now see what the AP Total Product. This is a total product curve for
curve looks like. For the first unit labour. When all other inputs are held constant, it
of the variable input, one can shows the different output levels obtainable from
easily check that the MP and the different units of labour.

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 AP are same. Now as we increase
the amount of input, the MP rises. Output
AP being the average of marginal
P
products, also rises, but rises less
than MP. Then, after a point, the MP
starts falling. However, as long as
the value of MP remains higher APL
than the value of the AP, the AP
continues to rise. Once MP has
MP L
fallen sufficiently, its value becomes
less than the AP and the AP also
starts falling. So AP curve is also O L Labour
inverse ‘U’-shaped. Fig. 3.2
As long as the AP increases, it
Average and Marginal Product. These are
must be the case that MP is greater average and marginal product curves of labour.
than AP. Otherwise, AP cannot rise.
Similarly, when AP falls, MP has to be less than AP. It, follows that MP curve
cuts AP curve from above at its maximum.
Figure 3.2 shows the shapes of AP and MP curves for a typical firm.
The AP of factor 1 is maximum at L. To the left of L, AP is rising and MP is
greater than AP. To the right of L, AP is falling and MP is less than AP.

3.6 RETURNS TO SCALE

The law of variable proportions arises because factor proportions change as
long as one factor is held constant and the other is increased. What if both factors
can change? Remember that this can happen only in the long run. One special
case in the long run occurs when both factors are increased by the same
proportion, or factors are scaled up.
When a proportional increase in all inputs results in an increase in output
42
by the same proportion, the production function is said to display Constant
Microeconomics
Introductory

returns to scale (CRS).

When a proportional increase in all inputs results in an increase in output
by a larger proportion, the production function is said to display Increasing
Returns to Scale (IRS)
Decreasing Returns to Scale (DRS) holds when a proportional increase in
all inputs results in an increase in output by a smaller proportion.
For example, suppose in a production process, all inputs get doubled.
As a result, if the output gets doubled, the production function exhibits CRS.
If output is less than doubled, then DRS holds, and if it is more than doubled,
then IRS holds.

Returns to Scale
Consider a production function
q = f (x1, x2)
where the firm produces q amount of output using x1 amount of factor 1
and x2 amount of factor 2. Now suppose the firm decides to increase the
employment level of both the factors t (t > 1) times. Mathematically, we

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 can say that the production function exhibits constant returns to scale if
we have,
f (tx1, tx2) = t.f (x1, x2)
ie the new output level f (tx1, tx2) is exactly t times the previous output level
f (x1, x2).
Similarly, the production function exhibits increasing returns to scale if,
f (tx1, tx2) > t.f (x1, x2).

It exhibits decreasing returns to scale if,

f (tx1, tx2) < t.f (x1, x2).

3.7 COSTS
In order to produce output, the firm needs to employ inputs. But a given level
of output, typically, can be produced in many ways. There can be more than
one input combinations with which a firm can produce a desired level of output.
In Table 3.1, we can see that 50 units of output can be produced by three
different input combinations (L = 6, K = 3), (L = 4, K = 4) and (L = 3, K = 6). The
question is which input combination will the firm choose? With the input prices
given, it will choose that combination of inputs which is least expensive. So,
for every level of output, the firm chooses the least cost input combination.
Thus the cost function describes the least cost of producing each level of output
given prices of factors of production and technology.

Cobb-Douglas Production Function

Consider a production function
43
q = x 1α x 2β

Production and Costs

where α and β are constants. The firm produces q amount of output
using x1 amount of factor 1 and x2 amount of factor 2. This is called a
Cobb-Douglas production function. Suppose with x1 = x1 and x2 = x 2 , we
have q0 units of output, i.e.
q0 = x 1 α x 2 β
If we increase both the inputs t (t > 1) times, we get the new output
q1 = (t x1 )α (t x 2 )β
= t α + β x1 α x 2 β
When α + β = 1, we have q1 = tq0. That is, the output increases t times. So the
production function exhibits CRS. Similarly, when α + β > 1, the production
function exhibits IRS. When α + β < 1 the production function exhibits DRS.

3.7.1 Short Run Costs

We have previously discussed the short run and the long run. In the short
run, some of the factors of production cannot be varied, and therefore,
remain fixed. The cost that a firm incurs to employ these fixed inputs is
called the total fixed cost (TFC). Whatever amount of output the firm

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 produces, this cost remains fixed for the firm. To produce any required
level of output, the firm, in the short run, can adjust only variable inputs.
Accordingly, the cost that a firm incurs to employ these variable inputs is
called the total variable cost (TVC). Adding the fixed and the variable costs,
we get the total cost (TC) of a firm
TC = TVC + TFC (3.6)
In order to increase the production of output, the firm must employ more of
the variable inputs. As a result, total variable cost and total cost will increase.
Therefore, as output increases, total variable cost and total cost increase.
In Table 3.3, we have an example of cost function of a typical firm. The first
column shows different levels of output. For all levels of output, the total fixed
cost is Rs 20. Total variable cost increases as output increases. With output
zero, TVC is zero. For 1 unit of output, TVC is Rs 10; for 2 units of output, TVC
is Rs 18 and so on. In the fourth column, we obtain the total cost (TC) as the
sum of the corresponding values in second column (TFC) and third column
(TVC). At zero level of output, TC is just the fixed cost, and hence, equal to Rs
20. For 1 unit of output, total cost is Rs 30; for 2 units of output, the TC is Rs 38
and so on.
The short run average cost (SAC) incurred by the firm is defined as the
total cost per unit of output. We calculate it as
TC
SAC = q (3.7)

In Table 3.3, we get the SAC-column by dividing the values of the fourth
column by the corresponding values of the first column. At zero output, SAC is
undefined. For the first unit, SAC is Rs 30; for 2 units of output, SAC is Rs 19
and so on.
Similarly, the average variable cost (AVC) is defined as the total variable
cost per unit of output. We calculate it as
44 TVC
AVC = q (3.8)
Introductory
Microeconomics

Also, average fixed cost (AFC) is

TFC
AFC = q (3.9)

Clearly,
SAC = AVC + AFC (3.10)
In Table 3.3, we get the AFC-column by dividing the values of the second
column by the corresponding values of the first column. Similarly, we get the
AVC-column by dividing the values of the third column by the corresponding
values of the first column. At zero level of output, both AFC and AVC are
undefined. For the first unit of output, AFC is Rs 20 and AVC is Rs 10. Adding
them, we get the SAC equal to Rs 30.
The short run marginal cost (SMC) is defined as the change in total cost
per unit of change in output
change in total cos t ∆TC
SMC = change in output = ∆q (3.11)
where ∆ represents the change in the value of the variable.

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 The last column in table 3.3 gives a numerical example for the calculation of
SMC. Values in this column are obtained by dividing the change in TC by the
change in output, at each level of output.
Thus at q=5,
Change in TC = (TC at q=5) - (TC at q=4) (3.12)
= (53) – (49)
=4
Change in q = 1
SMC = 4/1 = 4
Table 3.3: Various Concepts of Costs

Output TFC TVC TC AFC AVC SAC SMC

(units) (q) (Rs) (Rs) (Rs) (Rs) (Rs) (Rs) (Rs)
0 20 0 20 – – – –
1 20 10 30 20 10 30 10
2 20 18 38 10 9 19 8
3 20 24 44 6.67 8 14.67 6
4 20 29 49 5 7.25 12.25 5
5 20 33 53 4 6.6 10.6 4
6 20 39 59 3.33 6.5 9.83 6
7 20 47 67 2.86 6.7 9.57 8
8 20 60 80 2.5 7.5 10 13
9 20 75 95 2.22 8.33 10.55 15
10 20 95 115 2 9.5 11.5 20

Just like the case of marginal product, marginal cost also is undefined at
zero level of output. It is important to note here that in the short run, fixed cost
cannot be changed. When we change the level of output, whatever change occurs
to total cost is entirely due to the change in total variable cost. So in the short 45

Production and Costs

run, marginal cost is the increase in TVC due to increase in production of one
extra unit of output. For any level of output, the sum of marginal costs up to
that level gives us the total variable cost at that level. One may wish to check this
from the example represented
through Table 3.3. Average variable Costs
cost at some level of output is TC
therefore, the average of all marginal
TVC
costs up to that level. In Table 3.3,
we see that when the output is zero, c
3
SMC is undefined. For the first unit
c
of output, SMC is Rs 10; for the 2

second unit, the SMC is Rs 8 and so

on.
c1 TFC
Shapes of the Short Run Cost
Curves O q1 Otput
Now let us see what these short run Fig. 3.3
cost curves look like. You could plot
the data from in table 3.3 by placing Costs. These are total fixed cost (TFC), total
variable cost (TVC) and total cost (TC) curves
output on the x-axis and costs on for a firm. Total cost is the vertical sum of total
the y-axis. fixed cost and total variable cost.

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 Previously, we have discussed
that in order to increase the Cost
production of output the firm needs
to employ more of the variable
inputs. This results in an increase
in total variable cost, and hence, an
increase in total cost. Therefore, as
output increases, total variable cost F C
and total cost increase. Total fixed
cost, however, is independent of the
amount of output produced and AFC
remains constant for all levels of O q
production.
1
Output
Figure 3.3 illustrates the shapes Fig. 3.4
of total fixed cost, total variable cost
Average Fixed Cost. The average fixed cost
and total cost curves for a typical curve is a rectangular hyperbola. The area
firm. We place output on the x-axis of the rectangle OFCq1 gives us the total
and costs on the y-axis. TFC is a fixed cost.
constant which takes the value c1
and does not change with the change in output. It is, therefore, a horizontal
straight line cutting the cost axis at the point c1. At q1, TVC is c2 and TC is c3.
AFC is the ratio of TFC to q. TFC is a constant. Therefore, as q increases, AFC
decreases. When output is very close to zero, AFC is arbitrarily large, and as
output moves towards infinity, AFC moves towards zero. AFC curve is, in fact, a
rectangular hyperbola. If we multiply any value q of output with its
corresponding AFC, we always get a constant, namely TFC.
Figure 3.4 shows the shape of average fixed cost curve for a typical firm.
We measure output along the horizontal axis and AFC along the vertical axis.
At q1 level of output, we get the corresponding average fixed cost at F. The TFC
can be calculated as
46 TFC = AFC × quantity
= OF × Oq1
Introductory
Microeconomics

= the area of the rectangle OFCq1

Cost
We can also calculate AFC
from TFC curve. In Figure 3.5, the
horizontal straight line cutting
the vertical axis at F is the TFC
curve. At q0 level of output, total
fixed cost is equal to OF. At q0, the F A TFC
corresponding point on the TFC
curve is A. Let the angle ∠AOq0
be θ. The AFC at q0 is
O q0 Output
TFC
AFC = quantity
Fig. 3.5
Aq0 The Total Fixed Cost Curve. The slope of
= Oq = tanθ the angle ∠AOq 0 gives us the average fixed
0
cost at q 0.

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 Let us now look at the SMC
curve. Marginal cost is the additional Cost
cost that a firm incurs to produce AVC
one extra unit of output. According
to the law of variable proportions,
initially, the marginal product of a
factor increases as employment B
V
increases, and then after a certain
point, it decreases. This means
initially to produce every extra unit
of output, the requirement of the
factor becomes less and less, and O q0
Output
then after a certain point, it becomes Fig. 3.6
greater and greater. As a result, with
The Average Variable Cost Curve. The area
the factor price given, initially the
of the rectangle OVBq0 gives us the total
SMC falls, and then after a certain variable cost at q0.
point, it rises. SMC curve is,
therefore, ‘U’-shaped.
At zero level of output, SMC is undefined. The TVC at a particular level of
output is given by the area under the SMC curve up to that level.
Now, what does the AVC curve look like? For the first unit of output, it is
easy to check that SMC and AVC are the same. So both SMC and AVC curves
start from the same point. Then, as output increases, SMC falls. AVC being the
average of marginal costs, also falls, but falls less than SMC. Then, after a point,
SMC starts rising. AVC, however, continues to fall as long as the value of SMC
remains less than the prevailing value of AVC. Once the SMC has risen sufficiently,
its value becomes greater than the value of AVC. The AVC then starts rising. The
AVC curve is therefore ‘U’-shaped.
As long as AVC is falling, SMC must be less than the AVC. As AVC rises,
SMC must be greater than the AVC. So the SMC curve cuts the AVC curve from
below at the minimum point of AVC. 47

Production and Costs

Cost
TVC
In Figure 3.7, we measure
output along the horizontal
axis and TVC along the vertical
axis. At q0 level of output, OV is
the total variable cost. Let the
angle ∠E0q0 be equal to θ. Then, E
V
at q0, the AVC can be calculated
as
TVC O
AV C = output q0 Output

Eq0 Fig. 3.7

= Oq = tan θ
0 The Total Variable Cost Curve. The slope
of the angle ∠EOqo gives us the average
variable cost at qo.

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 In Figure 3.6 we measure output along the horizontal axis and AVC along
the vertical axis. At q0 level of output, AVC is equal to OV . The total variable cost
at q0 is
TVC = AVC × quantity
= OV × Oq0
= the area of the
rectangle OV Bq0.
Let us now look at SAC. SAC is the sum of AVC and AFC. Initially, both AVC
and AFC decrease as output increases. Therefore, SAC initially falls. After a certain
level of output production, AVC starts rising, but AFC continuous to fall. Initially
the fall in AFC is greater than the rise in AVC and SAC is still falling. But, after a
certain level of production, rise in AVC becomes larger than the fall in AFC. From
this point onwards, SAC is rising. SAC curve is therefore ‘U’-shaped.
It lies above the AVC curve with the vertical difference being equal to the
value of AFC. The minimum point of SAC curve lies to the right of the minimum
point of AVC curve.
Similar to the case of AVC and SMC, as long as SAC is falling, SMC is less
than the SAC. When SAC is rising, SMC is greater than the SAC. SMC curve cuts
the SAC curve from below at the minimum point of SAC.
Figure 3.8 shows the shapes of
short run marginal cost, average
variable cost and short run average Cost
SMC
cost curves for a typical firm. AVC
reaches its minimum at q1 units of
output. To the left of q1, AVC is falling SAC
and SMC is less than AVC. To the S AVC
right of q1, AVC is rising and SMC is
greater than AVC. SMC curve cuts P
the AVC curve at ‘P ’ which is the
48
minimum point of AVC curve. The
Introductory
Microeconomics

minimum point of SAC curve is ‘S ’

which corresponds to the output q2. O q
1 q
2
Output
It is the intersection point between Fig. 3.8
SMC and SAC curves. To the left of
q2, SAC is falling and SMC is less Short Run Costs. Short run marginal cost,
than SAC. To the right of q2, SAC is average variable cost and average cost curves.
rising and SMC is greater than SAC.

3.7.2 Long Run Costs

In the long run, all inputs are variable. There are no fixed costs. The total cost
and the total variable cost therefore, coincide in the long run. Long run average
cost (LRAC) is defined as cost per unit of output, i.e.
TC
LRAC = q (3.13)
Long run marginal cost (LRMC) is the change in total cost per unit of change
in output. When output changes in discrete units, then, if we increase production
from q1–1 to q1 units of output, the marginal cost of producing q1th unit will be
measured as
LRMC = (TC at q1 units) – (TC at q1 – 1 units) (3.14)

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 Just like the short run, in the long run, the sum of all marginal costs up to
some output level gives us the total cost at that level.
Shapes of the Long Run Cost Curves
We have previously discussed the returns to scales. Now let us see their
implications for the shape of LRAC.
IRS implies that if we increase all the inputs by a certain proportion, output
increases by more than that proportion. In other words, to increase output by a
certain proportion, inputs need to be increased by less than that proportion.
With the input prices given, cost also increases by a lesser proportion. For example,
suppose we want to double the output. To do that, inputs need to be increased,
but less than double. The cost that the firm incurs to hire those inputs therefore
also need to be increased by less than double. What is happening to the average
cost here? It must be the case that as long as IRS operates, average cost falls as
the firm increases output.
DRS implies that if we want to increase the output by a certain proportion,
inputs need to be increased by more than that proportion. As a result, cost also
increases by more than that proportion. So, as long as DRS operates, the average
cost must be rising as the firm increases output.
CRS implies a proportional increase in inputs resulting in a proportional
increase in output. So the average cost remains constant as long as CRS operates.
It is argued that in a typical firm IRS is observed at the initial level of
production. This is then followed by the CRS and then by the DRS. Accordingly,
the LRAC curve is a ‘U’-shaped curve. Its downward sloping part corresponds
to IRS and upward rising part corresponds to DRS. At the minimum point of the
LRAC curve, CRS is observed.
Let us check how the LRMC curve looks like. For the first unit of output,
both LRMC and LRAC are the same. Then, as output increases, LRAC initially
falls, and then, after a certain point, it rises. As long as average cost is falling,
marginal cost must be less than
the average cost. When the LRMC 49
Cost
average cost is rising, marginal

Production and Costs

cost must be greater than the
average cost. LRMC curve is LRAC
therefore a ‘U’-shaped curve. It
cuts the LRAC curve from below
at the minimum point of the M
LRAC. Figure 3.9 shows the
shapes of the long run marginal
cost and the long run average cost
curves for a typical firm.
LRAC reaches its minimum O 1q
Output
at q1. To the left of q 1, LRAC is Fig. 3.9
falling and LRMC is less than the
Long Run Costs. Long run marginal cost and
LRAC curve. To the right of q1, average cost curves.
LRAC is rising and LRMC is
higher than LRAC.

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Chapter 3
Production and Costs
In the previous chapter, we have discussed the behaviour of the
consumers. In this chapter as well as in the next, we shall examine
the behaviour of a producer. Production is the process by which
inputs are transformed into ‘output’. Production is carried out by
producers or firms. A firm acquires different inputs like labour,
machines, land, raw materials etc. It uses these inputs to produce
output. This output can be consumed by consumers, or used by
other firms for further production. For example, a tailor uses a
sewing machine, cloth, thread and his own labour to ‘produce’
shirts. A farmer uses his land, labour, a tractor, seed, fertilizer,
water etc to produce wheat. A car manufacturer uses land for a
factory, machinery, labour, and various other inputs (steel,
aluminium, rubber etc) to produce cars. A rickshaw puller uses a
rickshaw and his own labour to ‘produce’ rickshaw rides. A
domestic helper uses her labour to produce ‘cleaning services’.
We make certain simplifying assumptions to start with. Production
is instantaneous: in our very simple model of production no
time elapses between the combination of the inputs and
the production of the output. We also tend to use the
terms production and supply synonymously and often
interchangeably.
In order to acquire inputs a firm has to pay for them.
This is called the cost of production. Once output
has been produced, the firm sell it in the market and
earns revenue. The difference between the revenue
and cost is called the firm’s profit. We assume that
the objective of a firm is to earn the maximum profit
that it can.
In this chapter, we discuss the relationship between
inputs and output. Then we look at the cost structure of
the firm. We do this to be able to identifiy the output at which
A Firm Effort firms profits are maximum.

3.1 PRODUCTION FUNCTION

The production function of a firm is a relationship between inputs
used and output produced by the firm. For various quantities of
inputs used, it gives the maximum quantity of output that can be
produced.

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 Consider the farmer we mentioned above. For simplicity, we assume that the
farmer uses only two inputs to produce wheat: land and labour. A production
function tells us the maximum amount of wheat he can produce for a given
amount of land that he uses, and a given number of hours of labour that he
performs. Suppose that he uses 2 hours of labour/ day and 1 hectare of land to
produce a maximum of 2 tonnes of wheat. Then, a function that describes this
relation is called a production function.
One possible example of the form this could take is:
q = K × L,
Where, q is the amount of wheat produced, K is the area of land in hectares,
L is the number of hours of work done in a day.
Describing a production function in this manner tells us the exact relation
between inputs and output. If either K or L increase, q will also increase. For
any L and any K, there will be only one q. Since by definition we are taking the
maximum output for any level of inputs, a production function deals only with
the efficient use of inputs. Efficiency implies that it is not possible to get any
more output from the same level of inputs.
A production function is defined for a given technology. It is the technological
knowledge that determines the maximum levels of output that can be produced
using different combinations of inputs. If the technology improves, the maximum
levels of output obtainable for different input combinations increase. We then
have a new production function.
The inputs that a firm uses in the production process are called factors of
production. In order to produce output, a firm may require any number of
different inputs. However, for the time being, here we consider a firm that produces
output using only two factors of production – labour and capital. Our production
function, therefore, tells us the maximum quantity of output (q) that can be
produced by using different combinations of these two factors of productions-
Labour (L) and Capital (K).
We may write the production function as
37
q = f(L,K) (3.1)

Production and Costs

where, L is labour and K is capital and q is the maximum output that can be
produced.
Table 3.1: Production Function
Factor Capital
0 1 2 3 4 5 6
0 0 0 0 0 0 0 0
1 0 1 3 7 10 12 13
2 0 3 10 18 24 29 33
Labour 3 0 7 18 30 40 46 50
4 0 10 24 40 50 56 57
5 0 12 29 46 56 58 59
6 0 13 33 50 57 59 60

A numerical example of production function is given in Table 3.1. The left

column shows the amount of labour and the top row shows the amount of
capital. As we move to the right along any row, capital increases and as we move
down along any column, labour increases. For different values of the two factors,

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 Isoquant
In Chapter 2, we have learnt about indifference curves. Here, we introduce a
similar concept known as isoquant. It is just an alternative way of
representing the production function. Consider a production function with
two inputs labour and capital. An
isoquant is the set of all possible
combinations of the two inputs
that yield the same maximum
possible level of output. Each
isoquant represents a particular
level of output and is labelled with
that amount of output.
Let us return to table 3.1
notice that the output of 10 units
can be produced in 3 ways (4L,
1K), (2L, 2K), (1L, 4K). All these
combination of L, K lie on the
same isoquant, which represents the level of output 10. Can you identify
the sets of inputs that will lie on the isoquant q = 50?
The diagram here generalizes this concept. We place L on the X axis and
K on the Y axis. We have three isoquants for the three output levels, namely
q = q1, q = q2 and q = q3. Two input combinations (L1, K2) and (L2, K1) give us
the same level of output q1. If we fix capital at K1 and increase labour to L3,
output increases and we reach a higher isoquant, q = q2. When marginal
products are positive, with greater amount of one input, the same level of
output can be produced only using lesser amount of the other. Therefore,
isoquants are negatively sloped.

38 the table shows the corresponding output levels. For example, with 1 unit of
Introductory
Microeconomics

labour and 1 unit of capital, the firm can produce at most 1 unit of output; with
2 units of labour and 2 units of capital, it can produce at most 10 units of
output; with 3 units of labour and 2 units of capital, it can produce at most 18
units of output and so on.
In our example, both the inputs are necessary for the production. If any of
the inputs becomes zero, there will be no production. With both inputs positive,
output will be positive. As we increase the amount of any input, output increases.

3.2 THE SHORT RUN AND THE LONG RUN

Before we begin with any further analysis, it is important to discuss two concepts–
the short run and the long run.
In the short run, at least one of the factor – labour or capital – cannot be
varied, and therefore, remains fixed. In order to vary the output level, the firm
can vary only the other factor. The factor that remains fixed is called the fixed
factor whereas the other factor which the firm can vary is called the variable
factor.
Consider the example represented through Table 3.1. Suppose, in the short
run, capital remains fixed at 4 units. Then the corresponding column shows the
different levels of output that the firm may produce using different quantities of
labour in the short run.

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 In the long run, all factors of production can be varied. A firm in order to
produce different levels of output in the long run may vary both the inputs
simultaneously. So, in the long run, there is no fixed factor.
For any particular production process, long run generally refers to a longer
time period than the short run. For different production processes, the long run
periods may be different. It is not advisable to define short run and long run in
terms of say, days, months or years. We define a period as long run or short run
simply by looking at whether all the inputs can be varied or not.

3.3 TOTAL PRODUCT, AVERAGE PRODUCT AND MARGINAL PRODUCT

3.3.1 Total Product
Suppose we vary a single input and keep all other inputs constant. Then
for different levels of that input, we get different levels of output. This
relationship between the variable input and output, keeping all other inputs
constant, is often referred to as Total Product (TP) of the variable input.
Let us again look at Table 3.1. Suppose capital is fixed at 4 units. Now in
the Table 3.1, we look at the column where capital takes the value 4. As we
move down along the column, we get the output values for different values of
labour. This is the total product of labour schedule with K2 = 4. This is also
sometimes called total return to or total physical product of the variable
input. This is shown again in the second column of table in 3.2
Once we have defined total product, it will be useful to define the concepts of
average product (AP) and marginal product (MP). They are useful in order to
describe the contribution of the variable input to the production process.

3.3.2 Average Product

Average product is defined as the output per unit of variable input. We calculate
it as
TPL
APL = (3.2) 39
L

Production and Costs

The last column of table 3.2 gives us a numerical example of average product
of labour (with capital fixed at 4) for the production function described in
table 3.1. Values in this column are obtained by dividing TP (column 2) by
L (Column 1).

3.3.3 Marginal Product

Marginal product of an input is defined as the change in output per unit of
change in the input when all other inputs are held constant. When capital is held
constant, the marginal product of labour is
Change in output
MPL =
Change in input
∆ TPL
= (3.3)
∆L
where ∆ represents the change of the variable.
The third column of table 3.2 gives us a numerical example of Marginal
Product of labour (with capital fixed at 4) for the production function described
in table 3.1. Values in this column are obtained by dividing change in TP by

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 change in L. For example, when L changes from 1 to 2, TP changes from 10 to
24.
MPL= (TP at L units) – (TP at L – 1 unit) (3.4)

Here, Change in TP = 24 -10 = 14

Change in L = 1
Marginal product of the 2nd unit of labour = 14/1 = 14
Since inputs cannot take negative values, marginal product is undefined at
zero level of input employment. For any level of an input, the sum of marginal
products of every preceeding unit of that input gives the total product. So total
product is the sum of marginal products.
Table 3.2: Total Product, Marginal product and Average product

Labour TP MPL APL

0 0 - -
1 10 10 10
2 24 14 12
3 40 16 13.33
4 50 10 12.5
5 56 6 11.2
6 57 1 9.5

Average product of an input at any level of employment is the average of all

marginal products up to that level. Average and marginal products are often
referred to as average and marginal returns, respectively, to the variable input.

3.4 THE LAW OF DIMINISHING MARGINAL PRODUCT AND

40 THE LAW OF VARIABLE PROPORTIONS
Introductory
Microeconomics

If we plot the data in table 3.2 on graph paper, placing labour on the X-axis and
output on the Y-axis, we get the curves shown in the diagram below. Let us
examine what is happening to TP. Notice that TP increases as labour input
increases. But the rate at which it increases is not constant. An increase in labour
from 1 to 2 increases TP by 10 units. An increase in labour from 2 to 3 increases
TP by 12. The rate at which TP increases, as explained above, is shown by the
MP. Notice that the MP first increases (upto 3 units of labour) and then begins to

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fall. This tendency of the MP to first increase and then fall is called the law of
variable proportions or the law of diminishing marginal product. Law of
variable proportions say that the marginal product of a factor input initially
rises with its employment level. But after reaching a certain level of employment,
it starts falling.
Why does this happen? In order to understand this, we first define the concept
of factor proportions. Factor proportions represent the ratio in which the two
inputs are combined to produce output.
As we hold one factor fixed and keep increasing the other, the factor
proportions change. Initially, as we increase the amount of the variable input,
the factor proportions become more and more suitable for the production and
marginal product increases. But after a certain level of employment, the
production process becomes too crowded with the variable input.
Suppose table 3.2 describes the output of a farmer who has 4 hectares of
land, and can choose how much labour he wants to use. If he uses only 1 worker,
he has too much land for the worker to cultivate alone. As he increases the
number of workers, the amount of labour per unit land increases, and each
worker adds proportionally more and more to the total output. Marginal product
increases in this phase. When the fourth worker is hired, the land begins to get
‘crowded’. Each worker now has insufficient land to work efficiently. So the output
added by each additional worker is now proportionally less. The marginal product
begins to fall.
We can use these observations to describe the general shapes of the TP, MP
and AP curves as below.

3.5 SHAPES OF TOTAL PRODUCT, MARGINAL PRODUCT

AND AVERAGE PRODUCT CURVES

An increase in the amount of one of the inputs keeping all other inputs constant
results in an increase in output. Table 3.2 shows how the total product changes
as the amount of labour increases. The total product curve in the input-output 41

Production and Costs

plane is a positively sloped curve. Figure 3.1 shows the shape of the total product
curve for a typical firm.
We measure units of labour
along the horizontal axis and Output
output along the vertical axis.
TPL
With L units of labour, the firm q 1
can at most produce q 1 units of
output.
According to the law of
variable proportions, the
marginal product of an input
initially rises and then after a
certain level of employment, it
starts falling. The MP curve O L
therefore, looks like an inverse Labour
‘U’-shaped curve as in figure 3.2. Fig. 3.1
Let us now see what the AP Total Product. This is a total product curve for
curve looks like. For the first unit labour. When all other inputs are held constant, it
of the variable input, one can shows the different output levels obtainable from
easily check that the MP and the different units of labour.

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 AP are same. Now as we increase
the amount of input, the MP rises. Output
AP being the average of marginal
P
products, also rises, but rises less
than MP. Then, after a point, the MP
starts falling. However, as long as
the value of MP remains higher APL
than the value of the AP, the AP
continues to rise. Once MP has
MP L
fallen sufficiently, its value becomes
less than the AP and the AP also
starts falling. So AP curve is also O L Labour
inverse ‘U’-shaped. Fig. 3.2
As long as the AP increases, it
Average and Marginal Product. These are
must be the case that MP is greater average and marginal product curves of labour.
than AP. Otherwise, AP cannot rise.
Similarly, when AP falls, MP has to be less than AP. It, follows that MP curve
cuts AP curve from above at its maximum.
Figure 3.2 shows the shapes of AP and MP curves for a typical firm.
The AP of factor 1 is maximum at L. To the left of L, AP is rising and MP is
greater than AP. To the right of L, AP is falling and MP is less than AP.

3.6 RETURNS TO SCALE

The law of variable proportions arises because factor proportions change as
long as one factor is held constant and the other is increased. What if both factors
can change? Remember that this can happen only in the long run. One special
case in the long run occurs when both factors are increased by the same
proportion, or factors are scaled up.
When a proportional increase in all inputs results in an increase in output
42
by the same proportion, the production function is said to display Constant
Microeconomics
Introductory

returns to scale (CRS).

When a proportional increase in all inputs results in an increase in output
by a larger proportion, the production function is said to display Increasing
Returns to Scale (IRS)
Decreasing Returns to Scale (DRS) holds when a proportional increase in
all inputs results in an increase in output by a smaller proportion.
For example, suppose in a production process, all inputs get doubled.
As a result, if the output gets doubled, the production function exhibits CRS.
If output is less than doubled, then DRS holds, and if it is more than doubled,
then IRS holds.

Returns to Scale
Consider a production function
q = f (x1, x2)
where the firm produces q amount of output using x1 amount of factor 1
and x2 amount of factor 2. Now suppose the firm decides to increase the
employment level of both the factors t (t > 1) times. Mathematically, we

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 can say that the production function exhibits constant returns to scale if
we have,
f (tx1, tx2) = t.f (x1, x2)
ie the new output level f (tx1, tx2) is exactly t times the previous output level
f (x1, x2).
Similarly, the production function exhibits increasing returns to scale if,
f (tx1, tx2) > t.f (x1, x2).

It exhibits decreasing returns to scale if,

f (tx1, tx2) < t.f (x1, x2).

3.7 COSTS
In order to produce output, the firm needs to employ inputs. But a given level
of output, typically, can be produced in many ways. There can be more than
one input combinations with which a firm can produce a desired level of output.
In Table 3.1, we can see that 50 units of output can be produced by three
different input combinations (L = 6, K = 3), (L = 4, K = 4) and (L = 3, K = 6). The
question is which input combination will the firm choose? With the input prices
given, it will choose that combination of inputs which is least expensive. So,
for every level of output, the firm chooses the least cost input combination.
Thus the cost function describes the least cost of producing each level of output
given prices of factors of production and technology.

Cobb-Douglas Production Function

Consider a production function
43
q = x 1α x 2β

Production and Costs

where α and β are constants. The firm produces q amount of output
using x1 amount of factor 1 and x2 amount of factor 2. This is called a
Cobb-Douglas production function. Suppose with x1 = x1 and x2 = x 2 , we
have q0 units of output, i.e.
q0 = x 1 α x 2 β
If we increase both the inputs t (t > 1) times, we get the new output
q1 = (t x1 )α (t x 2 )β
= t α + β x1 α x 2 β
When α + β = 1, we have q1 = tq0. That is, the output increases t times. So the
production function exhibits CRS. Similarly, when α + β > 1, the production
function exhibits IRS. When α + β < 1 the production function exhibits DRS.

3.7.1 Short Run Costs

We have previously discussed the short run and the long run. In the short
run, some of the factors of production cannot be varied, and therefore,
remain fixed. The cost that a firm incurs to employ these fixed inputs is
called the total fixed cost (TFC). Whatever amount of output the firm

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 produces, this cost remains fixed for the firm. To produce any required
level of output, the firm, in the short run, can adjust only variable inputs.
Accordingly, the cost that a firm incurs to employ these variable inputs is
called the total variable cost (TVC). Adding the fixed and the variable costs,
we get the total cost (TC) of a firm
TC = TVC + TFC (3.6)
In order to increase the production of output, the firm must employ more of
the variable inputs. As a result, total variable cost and total cost will increase.
Therefore, as output increases, total variable cost and total cost increase.
In Table 3.3, we have an example of cost function of a typical firm. The first
column shows different levels of output. For all levels of output, the total fixed
cost is Rs 20. Total variable cost increases as output increases. With output
zero, TVC is zero. For 1 unit of output, TVC is Rs 10; for 2 units of output, TVC
is Rs 18 and so on. In the fourth column, we obtain the total cost (TC) as the
sum of the corresponding values in second column (TFC) and third column
(TVC). At zero level of output, TC is just the fixed cost, and hence, equal to Rs
20. For 1 unit of output, total cost is Rs 30; for 2 units of output, the TC is Rs 38
and so on.
The short run average cost (SAC) incurred by the firm is defined as the
total cost per unit of output. We calculate it as
TC
SAC = q (3.7)

In Table 3.3, we get the SAC-column by dividing the values of the fourth
column by the corresponding values of the first column. At zero output, SAC is
undefined. For the first unit, SAC is Rs 30; for 2 units of output, SAC is Rs 19
and so on.
Similarly, the average variable cost (AVC) is defined as the total variable
cost per unit of output. We calculate it as
44 TVC
AVC = q (3.8)
Introductory
Microeconomics

Also, average fixed cost (AFC) is

TFC
AFC = q (3.9)

Clearly,
SAC = AVC + AFC (3.10)
In Table 3.3, we get the AFC-column by dividing the values of the second
column by the corresponding values of the first column. Similarly, we get the
AVC-column by dividing the values of the third column by the corresponding
values of the first column. At zero level of output, both AFC and AVC are
undefined. For the first unit of output, AFC is Rs 20 and AVC is Rs 10. Adding
them, we get the SAC equal to Rs 30.
The short run marginal cost (SMC) is defined as the change in total cost
per unit of change in output
change in total cos t ∆TC
SMC = change in output = ∆q (3.11)
where ∆ represents the change in the value of the variable.

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 The last column in table 3.3 gives a numerical example for the calculation of
SMC. Values in this column are obtained by dividing the change in TC by the
change in output, at each level of output.
Thus at q=5,
Change in TC = (TC at q=5) - (TC at q=4) (3.12)
= (53) – (49)
=4
Change in q = 1
SMC = 4/1 = 4
Table 3.3: Various Concepts of Costs

Output TFC TVC TC AFC AVC SAC SMC

(units) (q) (Rs) (Rs) (Rs) (Rs) (Rs) (Rs) (Rs)
0 20 0 20 – – – –
1 20 10 30 20 10 30 10
2 20 18 38 10 9 19 8
3 20 24 44 6.67 8 14.67 6
4 20 29 49 5 7.25 12.25 5
5 20 33 53 4 6.6 10.6 4
6 20 39 59 3.33 6.5 9.83 6
7 20 47 67 2.86 6.7 9.57 8
8 20 60 80 2.5 7.5 10 13
9 20 75 95 2.22 8.33 10.55 15
10 20 95 115 2 9.5 11.5 20

Just like the case of marginal product, marginal cost also is undefined at
zero level of output. It is important to note here that in the short run, fixed cost
cannot be changed. When we change the level of output, whatever change occurs
to total cost is entirely due to the change in total variable cost. So in the short 45

Production and Costs

run, marginal cost is the increase in TVC due to increase in production of one
extra unit of output. For any level of output, the sum of marginal costs up to
that level gives us the total variable cost at that level. One may wish to check this
from the example represented
through Table 3.3. Average variable Costs
cost at some level of output is TC
therefore, the average of all marginal
TVC
costs up to that level. In Table 3.3,
we see that when the output is zero, c
3
SMC is undefined. For the first unit
c
of output, SMC is Rs 10; for the 2

second unit, the SMC is Rs 8 and so

on.
c1 TFC
Shapes of the Short Run Cost
Curves O q1 Otput
Now let us see what these short run Fig. 3.3
cost curves look like. You could plot
the data from in table 3.3 by placing Costs. These are total fixed cost (TFC), total
variable cost (TVC) and total cost (TC) curves
output on the x-axis and costs on for a firm. Total cost is the vertical sum of total
the y-axis. fixed cost and total variable cost.

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 Previously, we have discussed
that in order to increase the Cost
production of output the firm needs
to employ more of the variable
inputs. This results in an increase
in total variable cost, and hence, an
increase in total cost. Therefore, as
output increases, total variable cost F C
and total cost increase. Total fixed
cost, however, is independent of the
amount of output produced and AFC
remains constant for all levels of O q
production.
1
Output
Figure 3.3 illustrates the shapes Fig. 3.4
of total fixed cost, total variable cost
Average Fixed Cost. The average fixed cost
and total cost curves for a typical curve is a rectangular hyperbola. The area
firm. We place output on the x-axis of the rectangle OFCq1 gives us the total
and costs on the y-axis. TFC is a fixed cost.
constant which takes the value c1
and does not change with the change in output. It is, therefore, a horizontal
straight line cutting the cost axis at the point c1. At q1, TVC is c2 and TC is c3.
AFC is the ratio of TFC to q. TFC is a constant. Therefore, as q increases, AFC
decreases. When output is very close to zero, AFC is arbitrarily large, and as
output moves towards infinity, AFC moves towards zero. AFC curve is, in fact, a
rectangular hyperbola. If we multiply any value q of output with its
corresponding AFC, we always get a constant, namely TFC.
Figure 3.4 shows the shape of average fixed cost curve for a typical firm.
We measure output along the horizontal axis and AFC along the vertical axis.
At q1 level of output, we get the corresponding average fixed cost at F. The TFC
can be calculated as
46 TFC = AFC × quantity
= OF × Oq1
Introductory
Microeconomics

= the area of the rectangle OFCq1

Cost
We can also calculate AFC
from TFC curve. In Figure 3.5, the
horizontal straight line cutting
the vertical axis at F is the TFC
curve. At q0 level of output, total
fixed cost is equal to OF. At q0, the F A TFC
corresponding point on the TFC
curve is A. Let the angle ∠AOq0
be θ. The AFC at q0 is
O q0 Output
TFC
AFC = quantity
Fig. 3.5
Aq0 The Total Fixed Cost Curve. The slope of
= Oq = tanθ the angle ∠AOq 0 gives us the average fixed
0
cost at q 0.

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 Let us now look at the SMC
curve. Marginal cost is the additional Cost
cost that a firm incurs to produce AVC
one extra unit of output. According
to the law of variable proportions,
initially, the marginal product of a
factor increases as employment B
V
increases, and then after a certain
point, it decreases. This means
initially to produce every extra unit
of output, the requirement of the
factor becomes less and less, and O q0
Output
then after a certain point, it becomes Fig. 3.6
greater and greater. As a result, with
The Average Variable Cost Curve. The area
the factor price given, initially the
of the rectangle OVBq0 gives us the total
SMC falls, and then after a certain variable cost at q0.
point, it rises. SMC curve is,
therefore, ‘U’-shaped.
At zero level of output, SMC is undefined. The TVC at a particular level of
output is given by the area under the SMC curve up to that level.
Now, what does the AVC curve look like? For the first unit of output, it is
easy to check that SMC and AVC are the same. So both SMC and AVC curves
start from the same point. Then, as output increases, SMC falls. AVC being the
average of marginal costs, also falls, but falls less than SMC. Then, after a point,
SMC starts rising. AVC, however, continues to fall as long as the value of SMC
remains less than the prevailing value of AVC. Once the SMC has risen sufficiently,
its value becomes greater than the value of AVC. The AVC then starts rising. The
AVC curve is therefore ‘U’-shaped.
As long as AVC is falling, SMC must be less than the AVC. As AVC rises,
SMC must be greater than the AVC. So the SMC curve cuts the AVC curve from
below at the minimum point of AVC. 47

Production and Costs

Cost
TVC
In Figure 3.7, we measure
output along the horizontal
axis and TVC along the vertical
axis. At q0 level of output, OV is
the total variable cost. Let the
angle ∠E0q0 be equal to θ. Then, E
V
at q0, the AVC can be calculated
as
TVC O
AV C = output q0 Output

Eq0 Fig. 3.7

= Oq = tan θ
0 The Total Variable Cost Curve. The slope
of the angle ∠EOqo gives us the average
variable cost at qo.

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 In Figure 3.6 we measure output along the horizontal axis and AVC along
the vertical axis. At q0 level of output, AVC is equal to OV . The total variable cost
at q0 is
TVC = AVC × quantity
= OV × Oq0
= the area of the
rectangle OV Bq0.
Let us now look at SAC. SAC is the sum of AVC and AFC. Initially, both AVC
and AFC decrease as output increases. Therefore, SAC initially falls. After a certain
level of output production, AVC starts rising, but AFC continuous to fall. Initially
the fall in AFC is greater than the rise in AVC and SAC is still falling. But, after a
certain level of production, rise in AVC becomes larger than the fall in AFC. From
this point onwards, SAC is rising. SAC curve is therefore ‘U’-shaped.
It lies above the AVC curve with the vertical difference being equal to the
value of AFC. The minimum point of SAC curve lies to the right of the minimum
point of AVC curve.
Similar to the case of AVC and SMC, as long as SAC is falling, SMC is less
than the SAC. When SAC is rising, SMC is greater than the SAC. SMC curve cuts
the SAC curve from below at the minimum point of SAC.
Figure 3.8 shows the shapes of
short run marginal cost, average
variable cost and short run average Cost
SMC
cost curves for a typical firm. AVC
reaches its minimum at q1 units of
output. To the left of q1, AVC is falling SAC
and SMC is less than AVC. To the S AVC
right of q1, AVC is rising and SMC is
greater than AVC. SMC curve cuts P
the AVC curve at ‘P ’ which is the
48
minimum point of AVC curve. The
Introductory
Microeconomics

minimum point of SAC curve is ‘S ’

which corresponds to the output q2. O q
1 q
2
Output
It is the intersection point between Fig. 3.8
SMC and SAC curves. To the left of
q2, SAC is falling and SMC is less Short Run Costs. Short run marginal cost,
than SAC. To the right of q2, SAC is average variable cost and average cost curves.
rising and SMC is greater than SAC.

3.7.2 Long Run Costs

In the long run, all inputs are variable. There are no fixed costs. The total cost
and the total variable cost therefore, coincide in the long run. Long run average
cost (LRAC) is defined as cost per unit of output, i.e.
TC
LRAC = q (3.13)
Long run marginal cost (LRMC) is the change in total cost per unit of change
in output. When output changes in discrete units, then, if we increase production
from q1–1 to q1 units of output, the marginal cost of producing q1th unit will be
measured as
LRMC = (TC at q1 units) – (TC at q1 – 1 units) (3.14)

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 Just like the short run, in the long run, the sum of all marginal costs up to
some output level gives us the total cost at that level.
Shapes of the Long Run Cost Curves
We have previously discussed the returns to scales. Now let us see their
implications for the shape of LRAC.
IRS implies that if we increase all the inputs by a certain proportion, output
increases by more than that proportion. In other words, to increase output by a
certain proportion, inputs need to be increased by less than that proportion.
With the input prices given, cost also increases by a lesser proportion. For example,
suppose we want to double the output. To do that, inputs need to be increased,
but less than double. The cost that the firm incurs to hire those inputs therefore
also need to be increased by less than double. What is happening to the average
cost here? It must be the case that as long as IRS operates, average cost falls as
the firm increases output.
DRS implies that if we want to increase the output by a certain proportion,
inputs need to be increased by more than that proportion. As a result, cost also
increases by more than that proportion. So, as long as DRS operates, the average
cost must be rising as the firm increases output.
CRS implies a proportional increase in inputs resulting in a proportional
increase in output. So the average cost remains constant as long as CRS operates.
It is argued that in a typical firm IRS is observed at the initial level of
production. This is then followed by the CRS and then by the DRS. Accordingly,
the LRAC curve is a ‘U’-shaped curve. Its downward sloping part corresponds
to IRS and upward rising part corresponds to DRS. At the minimum point of the
LRAC curve, CRS is observed.
Let us check how the LRMC curve looks like. For the first unit of output,
both LRMC and LRAC are the same. Then, as output increases, LRAC initially
falls, and then, after a certain point, it rises. As long as average cost is falling,
marginal cost must be less than
the average cost. When the LRMC 49
Cost
average cost is rising, marginal

Production and Costs

cost must be greater than the
average cost. LRMC curve is LRAC
therefore a ‘U’-shaped curve. It
cuts the LRAC curve from below
at the minimum point of the M
LRAC. Figure 3.9 shows the
shapes of the long run marginal
cost and the long run average cost
curves for a typical firm.
LRAC reaches its minimum O 1q
Output
at q1. To the left of q 1, LRAC is Fig. 3.9
falling and LRMC is less than the
Long Run Costs. Long run marginal cost and
LRAC curve. To the right of q1, average cost curves.
LRAC is rising and LRMC is
higher than LRAC.

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